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Transcript of FISD-02-A
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Bangalore
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Part-02ABond amp Bond Markets An Introduction
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What is debtIt is a financial claim
Who issues it
The borrower of fundsFor whom it is a liability
Who holds itThe lender of funds
For whom it is an asset
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Difference between debt and equityDebt does not confer ownership rightsIt is merely an IOU
A promise to pay interest at periodic intervalsAnd to repay the principal at a pre-specified maturitydate
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It usually has a finite life spanPerpetual debt is rare
The interest payments are contractualobligations
Borrowers are required to make payments irrespectiveof their financial performance
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Interest payments to be made before anydividends for equity holders
In the event of liquidationThe claims of debt holders must be settled firstOnly then can equity holders be paid
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Bonds and debentures are termed as FixedIncome Securities
Once the rate of interest is set at the onset ofthe period for which it is due
It is not a function of the profitability of the firmFailure to pay the promised interest willtantamount to default
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Bonds may be secured or unsecuredUnsecured debt securities are termed asDebentures in the USUnsecured means no specific assets have beenearmarked as collateralSecured debt requires the firm to earmarkspecific assets as collateralSecured debt holders enjoy priority from thestandpoint of payments
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Debt securities may be negotiable or non-negotiable
Negotiable securities can be traded in thesecondary market
Can be endorsed by one party in favor of anotherExamples of non-negotiable debt securities
National savings certificatesConventional Time or Fixed deposits
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The most basic form of a bond is called thePlain Vanilla version
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This is true for all securities not just for bondsMore complicated versions are said to have`Bells and Whistlesrsquo attached
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These bonds are slightly differentThe interest rate does not remain fixedIt varies each period based on the reference rate
Short-term reference rate ndash maturity lt 1 yearFloating rate bonds
Longer-term reference rateVariable or adjustable rate bonds
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Convertible bonds can be converted to sharesof stockCallable bonds can be prematurely retired by
the issuerPutable bonds can be prematurelysurrendered by the holders
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It is the principal valueAmount payable by the borrower to the lastholder at maturityAmount on which the periodic interest paymentsare calculatedAKA as
Par ValueRedemption Value Maturity ValuePrincipal Value
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It is the time remaining in the life of thebond
The length of time for which interest has to bepaid as promisedThe the length of time after which the face valuewill be repaidAKA as
MaturityTermTenor
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The periodic interest payment that has to bemade by the borrower
The coupon rate multiplied by the face valuegives the rupeedollar value of the coupon
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Most bonds pays coupons on a semi-annual basisTrue in UKUSAustraliaJapanIn European and Eurobond markets annualpayments are the norm
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In earlier days bonds were accompanied by abooklet of post-dated coupons
Each coupon could be detached and redeemedon the corresponding coupon payment date
Even today bearer bonds come with couponsThe bearer certificate number is mentioned onthe coupon
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Bond with a face value of $1000The coupon rate is 8 per annum paid semi-annually
So the bond holder will receive1000 x 008
___ = $40 every six months2
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The rate of return if an investor buys thebond at the prevailing price and holds ittill maturity
In order to get the YTM two conditionsmust be satisfied
The bond must be held till maturity All coupon payments received before maturitymust be reinvested at the YTM
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At any point in time the YTM may beGreater thanLess than or
Equal to the Coupon RateYTM is the IRR of a bond
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Bonds involve pure cash flowsSo only ONE REAL POSITIVE YTM
Solution to a Non-Linear equation
Solved iteratively
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A holder gets a stream of contractuallypromised payments
The value of the bond is the value of this stream
of cash flowsCash flows arising at different points in timecannot be addedCash flows have to be discounted
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It is a chicken and egg storyIf we know the yield that is required we canquote a priceOnce we acquire the asset at a certain price we
can work out the corresponding yield
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A bond will pay identical coupons everyperiodAnd will repay the face value at maturity
The periodic cash flows constitutean annuity The terminal face value is a lump
sum payment
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Bond pays a semi-annual coupon of $C2and has a face value of $MAssume there are N coupons left
And that we are standing on a coupondate
We are assuming that the next coupon is exactlysix months away
The required annual yield is yImplies that the semi-annual yield is y2
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The present value of the coupon stream is
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The present value of the face value is
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So the price of the bond is
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IBM has issued a bond with a face value of$1000The coupon is 8 per year to be paid on July
15 and January 15 every yearToday is 15 July 2013 and that the bondmatures on 15 January 2033The required yield is 10 per annum
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JJ ndash 0115FA ndash 0115MS ndash 0115
AO ndash 0115MN ndash 0115JD ndash 0115
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In the example the price is less than theface value
Such a bond is called a Discount Bond
It is trading at a discount from the face valueThe reason is that
The yield is greater than the coupon
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If the yield were to equal the couponThe bond would sell at PARSuch bonds are called PAR Bonds
If the yield is less than the couponThe price will exceed the face valueSuch bonds are called Premium Bonds
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As we move from one coupon date to thenext if the YTM were to remain constant
Par bonds would continue to trade at PARPremium bonds will steadily decline in priceDiscount bonds will steadily increase in price
This is called the Pull to Par EffectAt maturity ndash ALL BONDS WILL TRADE AT PAR
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As we approach maturity the number ofcoupons reduces
The contribution of coupons to price reducesThe contribution of the PV of the face valueincreases
For premium bonds the first effect dominatesThus the price steadily declines
For discount bonds the second effectdominatesThus the price steadily increases
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A plain vanilla or Bullet Bond pays the entireface value at maturity in a lump sumAmortizing bonds pay the principal in
installmentsThe first payment occurs before maturityThe last payment is made at maturity
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Consider a 5 year amortizing bond with aface value of $1000 and an annual coupon of8
The annual cash flows are depicted below
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Time Cash Flow
1 802 803 3304 3105 540
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The first two cash flows represent interest ona principal of $1000The third cash flow is interest on $1000 plus
a principal payment of $250The outstanding principal is $750The fourth cash flow is interest on $750 plusa principal payment of $250
The outstanding principal is $500The final cash flow is interest on $500 plusthe remaining principal of $500
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Some companies issue such bonds becausethe assets being funded have a similar cashflow profile
Second the coupon on such a bond may belower than that of a bullet bondIn the case of a bullet bond the entire principalis due at a single point in timeThere is greater default risk
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Microsoft is issuing zeroes with 5 years tomaturity and a face value of $10000
The required yield is 10 per annumWhat should be the price
Price is the PV of the face valueIn practice we discount on a semi-annual basis
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This is to facilitate comparisons withconventional bonds
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A zero coupon bond can never sell at apremium
It will always trade at a discount prior tomaturityAt maturity it will trade at par
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If held to maturity a ZCB will always give riseto a capital gainIf sold prior to maturity there may be a
capital gain or a capital lossConsider a bond with 10 years to maturityThe YTM at the time of purchase was 10The cost was $37690
A year later it is sold at a YTM of 12The corresponding price is $35035
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A newly established issuerOr an issuer with a relatively virgin productor service
Or a restructured company due to a mergeror following a bankruptcyWill be perceived as more riskyInvestors will demand a high coupon
Such firms are unlikely to have high earningsRevenues will peak only after theproductservice is established
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They can ill afford high couponsThey may consider a step-up coupon bond
Where the coupon increases as the bond ages
Assume a company can issue a plain vanillaat a coupon of 8 with a maturity of 5 yearsInstead it may opt for a bond
With a coupon of 6 for the first three years
And a coupon of 10 for the last two yearsThis is a Deferred Interest Security
Provides the issuer with breathing room in theearlier years
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These pay coupons in the form of additionalsecurities and not cash
This offers the issuer time to prepare for cashoutlays
They are used as Mezzanine FinanceThey rank between senior debt and equity in thecapital structureInvestors take more risk as compared to buyersof regular bonds ndash but get higher returnsIssuers can conserve cash in earlier years when itis at a premium
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Fully backed by the federal government ofthe issuing nationConsequently they are virtually devoid ofcredit risk or the risk of defaultThe yield on such securities is a benchmarkfor setting rates on other kinds of debt
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Treasury securities are issuedTo finance expenses in excess of currentrevenuesTo pay interest on debt accumulated in earlieryears due to deficits in those yearsTo repay past debt issues that are currentlymaturing
The US Treasuries marketIs the largest bond market in the worldIs the most liquid bond market in the world
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The Treasury issues three categories ofmarketable securities
T-bills are discount securitiesThey are zero coupon securitiesT-notes and T-bonds are sold at face value andpay interest periodically
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T-bills are issued with a original time tomaturity of one year or less
They are Money market instrumentsThey have maturities of either 1 3 6 or 12months at the time of issue
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T-notes and T-bonds have a time to maturityexceeding one year at the time of issue
They are capital market instrumentsT-notes have maturities ranging from 1-10 yearsT-bonds have an original maturity in excess of 10years extending up to 30 years
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An issue may be followed later by a furtherissue
With the same remaining time to maturity andthe same couponThe issuance of further tranches is termed as aRe-opening
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Six months ago a 10-year note was issuedwith a coupon of 8 per annumToday if a note with 9 frac12 years to maturityand a coupon of 8 issued it will add to thepool that is already trading in the marketThus it is a re-opening of an existing issue
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Who is a primary dealerA PD is a dealer who is authorized to dealdirectly with the Central Bank of the countryIn the US a PD is a bank or securities broker-dealer that directly deals with the FRBNY
Importance of FRBNYIn India a PD deals directly with the RBI
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The Treasury sells bills notes and bonds byway of a competitive auction process
Most of the treasury securities are bought byprimary dealers
Individual investors submit non-competitive bidsand participate on a much smaller scale
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Bids may beCompetitive
Indicate price amp quantity or yield amp quantityNon-competitive
Indicate only quantity
Small investors and individualsgenerally submit non-competitive bids
A non-competitive bidder may not bid for more than$5MM worth of securities in a bill or bond auction
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Primary dealers bid for their accounts andon behalf of their clientsThey usually submit large competitive
bidsBids indicate the maximum price that the bidderis prepared to pay if it is a price based auctionOr the minimum yield that the bidder is
prepared to accept if it is a yield based auction
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The Treasury will net out the totalamount of non-competitive bids
The balance will be allocated to competitivebidders
There are two ways in which securitiescan be allotted
The multiple priceyield auction mechanism
French AuctionsThe uniform priceyield auction mechanism
Dutch Auctions
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Assume that the Treasury is offering 25billion dollars worth of T-bonds
2 billion dollars worth of non-competitive bidshave been receivedSo 23 billion dollars worth of bonds are availableto be offered to the competitive bidders
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There are six competitive bidders who havesubmitted the following yields
The bids have been arranged in ascending orderof yieldIn a price based auction the bids would havebeen arranged in descending order of price
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Bidder Bid Yield Bid Amount
Aggregate Amount
Alpha 5370 30 bn 30 bnBeta 5372 50 bn 80 bn
Gamma 5373 40 bn 12 bn
Delta 5375 80 bn 20 bnCharlie 5375 120 bn 32 bn
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The aggregate demand equals the amount onoffer at a yield of 5375A multiple yield auction will lead to thefollowing allocation
Alpha will get 3 bn at a yield of 5370Beta will get 5 bn at 5372Gamma will get 4 bn at 5373
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At a yield of 5375 we have only 11 bn left toallocateThere is a demand of 20 bn at this yield
8 bn from Delta and 12 bn from CharlieThus we will allocate 1120 = 55 to eachbidder at this yield
There will be pro-rata allocation
055 of 8 bn or 440 bn will go to Delta055 of 12 bn or 66 bn will go to Charlie
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The highest accepted yield is called the StopYield or High Yield
In this case it is 5375The ratio of bids received to the amountawarded is known as the bid to cover ratio
The higher the ratio the stronger is the auction
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Those who bid more than 5375 will getnothing and are said to be shutout of theauctionSince 1999 the US Treasury has beenconducting only uniform yield auctions
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WI stands for ndash When As and If IssuedThe when issued market is a market forforward trading of a bond
Which has been announced but not yet issuedTrades take place from the date ofannouncement until the actual issue date
Helps bidders to gauge the marketrsquos interestbefore the actual auction
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WI trading has ramifications for the biddingstrategies of market participantsTraders can take both long and shortpositions
Settlement is scheduled for the issue date
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It has a bearing on the outcome of theauction
It affects the strategy used by a bidder becauseit has an impact on his prior positionBidders who are long in the WI market enter theauction with a Long PositionThose who are short in the WI market enter theauction with a short position
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The WI market helps in price discoveryIt provides important information on
The strength of demand for the securityAnd on the disparity of biddersrsquo views
This help potential bidders to formulate theirstrategiesAt times a dealer may believe that he hasvery important private information
If so he may not participate in the WI market andwill directly enter the auction with bids based onhis knowledge
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On or before the date of the auction theissues trade on a yield basis
The actual price can be established only afterthe coupon is set
Starting with the day after the auctionSecurities are quoted on a price basis becausethe coupon is known
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In a coupon roll a dealer will purchase themost recently issued security from a clientAnd simultaneously sell the same amount ofthe recently announced new security
The first leg with settle on the following dayThe second leg is a forward contract
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There can be a Reverse RollThe dealer will sell the most recent issue fornext day settlementAnd buy the newly announced security forforward settlement
The forward leg in a RollReverse Roll is a WItrade
It will settle on the new issue settlement date
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The roll is the spread between the yield onthe new security and that on the outstandingissue in the same maturity segmentA GIVE in the Roll means that
The WI security provides a higher yield than theoutstanding issue
A Take in the Roll means thatThe WI security provides a lower yield
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On March 17 20XX the Treasury announcedthe auction of a 2-year note
The auction was scheduled for March 24The settlement date was March 31
Trading of the roll began as soon as the issuewas announcedA Give of 5 bp means that the dealer proposes tobuy the current issue at the prevailing yieldAnd sell the new issue at a yield that is 5 bpmoreA Take of 5 bp means that the dealer proposes tosell the new issue at a yield that is 5bp lower
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The roll achieves the followingHe acquires the outstanding issue for next daysettlementHe sells the to be issued security with the samepar value for forward delivery on 31 March
The customer is rolling over the investmentfrom the current issue to the new issue
This extends the maturity of the investment byone month
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The client can invest the funds received tillthe new issue settlesHowever he loses the accrued interest thathe would have earned had he held on to theissue
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The Treasury per se does not issue zerocoupon securitiesBut zero coupon securities can be created
which are backed by conventional bondsTake a large quantity of a T-note or bond andseparate all the cash flows from each otherSell the entitlement to each cash flowseparately
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Take the case of a two-year T-noteIt can be separated into five zero couponsecurities maturing after
6 months12 months18 months24 months
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Earlier investment banks used to buy bondsfrom the Treasury and separate the cashflows
Each cash flow was then sold separately as a zerocoupon bondSuch issues are called trademarks
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The issue of trademarks has now ceasedBecause investment banks can now createsuch instruments
In concert with the Treasury itselfThese ZCBs are known as STRIPS ndash
Separate Trading of Registered Interest andPrincipal of Securities
These are not issued or sold by the Treasury
The market is made by investment banks
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What is the motivation to create suchproductsIn practice arbitrage is possible when a
coupon security is purchased at a priceThat is lower than what could be obtained byselling each cash flow separately
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Coupon stripping reflects a case of financialengineering
Creating a risk-return profile that is nototherwise available
An investment bank would buy a largequantity of a Treasury security
The securities would be placed with an SPV
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The SPV is a single-purpose dedicated trustIt has the powers to own the bonds andcollect payments
It cannot sell or lend the bondsIt cannot write options on the bondsOr use them as collateral for borrowing
The SPV is empowered to issue zero coupon
bondsWhere each security represents the ownership ofa single cash flow from the mother bond
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Assume that 100MM USD of 15 year bondswith a coupon of 8 are placed with the SPV
The SPV can issue 6M 12M 18M extending up to14 frac12 year zeroes with a total face value of 4MM
USD eachAnd 15 year zeroes with a total face value of104MM
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The Treasury launched this program in 1985to facilitate the stripping of designatedsecurities
All new T-bonds and notes with a maturity of 10years or more are eligibleThe zeroes created in the process are directobligations of the US government
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The mechanism is as followsA dealer who owns a bond or note can ask theFRB where it is held
To replace it with an equivalent set of STRIPS
representing each payment as a separate securityEach of these securities can be traded independentlyof others
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In 1987 the Treasury started to allow dealersto reverse the process
This is called STRIPS RECONSTUTUTION If a dealer owns STRIPS representing all thecoupon and principal payments of a bond
The FED can on request convert these holdings into asingle position in the corresponding bond
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Each coupon and principal cash flow from aTreasury security is assigned a CUSIP
The mother bond is also assigned a CUSIPThe stripped coupons are known as C-STRIPSThe stripped principal is known as P-STRIPSSupply of a C-STRIP increases over time
because a C-STRIP maturing on a day like 15 FEB
2020 will have the same CUSIP irrespective ofwhich mother bond it has come fromThe original coupon rate is irrelevant
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P-STRIPS always correspond to the originalsecurityThey have a unique CUSIPTheir supply is fixed at the time of issuanceIn practice the prices of long-dated P-STRIPSare a bit higher than those of C-STRIPS withthe same maturity date
One reason is that P-STRIPS are more liquid due
to greater availabilityA $100 face value bond with a coupon of 8 willgenerate C-STRIPS with a face value of $4 but P-STRIPS with a face value of $100
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Another reason why P-STRIPS are in higherdemand is that they allow reconstitutionactivities more easily
Assume that the sum of the STRIPS is cheaper than
the mother bondIf a dealer already has the P-STRIPS only the C-STRIPSneed to be acquiredHowever if he owns some of the C-STRIPS he needs toacquire the P-STRIPS and the remaining C-STRIPSThe facility to reconstitute when profitable is pricedinto the P-STRIPSNote Buy and hold investors will prefer C-STRIPSsince they are priced lower and give a higher yield
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For Plain Vanilla bonds the specifiedcoupon rate is valid for the life of thebond
In the case of Floaters the rate is reset atthe beginning of every periodThe rate will vary directly with thebenchmark
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The rate on a Floater is specified as LIBOR+ 50 bp
The spread is positiveIf it were specified as LIBOR ndash 30bp
The spread will be negativeIf LIBOR rises the rate will increasewhereas if LIBOR falls it will decrease
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In the case of a default risk-free floater theprice will reset to par on a coupon date
It may sell at a premium or discount betweencoupon dates
Consider a floater with a coupon = 5-year T-Bond rate
Assume there are two periods left to maturity
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The price at the end of the first coupon period willbe given by
cT-1 is the coupon one period before maturityyT-1 is the YTM one period before maturity
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On a coupon reset date the YTM = couponBecause we have assumed there is no default riskAny change in the required yield as reflected inthe prevailing YTM
Will also be reflected in the coupon being setIf coupon = yield the bond should sell at par
Thus P T-1 = M
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Once again at T-2 c T-2 = yT-2 and P T-2 = MThis logic can be applied to a bond with anytime remaining till maturityHowever between two coupon dates theprice may not be equal to par
Consider the valuation at T-2+k
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Although c T-2 was set at T-2 and is equal toyT-2
yT-2+k is determined at T-2+k and will reflect theyield prevailing at that time
Thus yT-2+k need not equal c T-2 and may behigher or lower
Hence between two coupon dates a floater maysell at a premium or discount
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Now consider a floater characterized bydefault risk
The risk premium required by the market neednot be constant over time
Assume that at the time of issue YTM = 5-year T-note rate + 75bp
The coupon would have been set equal to thisrate and the bond would have been issued at par
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Six months hence the issue may be perceivedas more risky
YTM = 5-year T-note rate + 95 bpThe coupon will however be set equal to theprevailing 5-year rate + 75 bpIf so the issue will not reset to par at the nextcoupon date
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Floaters may come with a CAP or a FLOOR orBOTH
The CAP is a maximum coupon rateProtects issuers against rising rates
The FLOOR is a minimum coupon rateProtects investors against falling rates
When there is a spread over LIBORThere is a natural floorLIBOR cannot be less than zero
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Part-02ABond amp Bond Markets An Introduction
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What is debtIt is a financial claim
Who issues it
The borrower of fundsFor whom it is a liability
Who holds itThe lender of funds
For whom it is an asset
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Difference between debt and equityDebt does not confer ownership rightsIt is merely an IOU
A promise to pay interest at periodic intervalsAnd to repay the principal at a pre-specified maturitydate
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It usually has a finite life spanPerpetual debt is rare
The interest payments are contractualobligations
Borrowers are required to make payments irrespectiveof their financial performance
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Interest payments to be made before anydividends for equity holders
In the event of liquidationThe claims of debt holders must be settled firstOnly then can equity holders be paid
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Bonds and debentures are termed as FixedIncome Securities
Once the rate of interest is set at the onset ofthe period for which it is due
It is not a function of the profitability of the firmFailure to pay the promised interest willtantamount to default
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Bonds may be secured or unsecuredUnsecured debt securities are termed asDebentures in the USUnsecured means no specific assets have beenearmarked as collateralSecured debt requires the firm to earmarkspecific assets as collateralSecured debt holders enjoy priority from thestandpoint of payments
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Debt securities may be negotiable or non-negotiable
Negotiable securities can be traded in thesecondary market
Can be endorsed by one party in favor of anotherExamples of non-negotiable debt securities
National savings certificatesConventional Time or Fixed deposits
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The most basic form of a bond is called thePlain Vanilla version
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This is true for all securities not just for bondsMore complicated versions are said to have`Bells and Whistlesrsquo attached
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These bonds are slightly differentThe interest rate does not remain fixedIt varies each period based on the reference rate
Short-term reference rate ndash maturity lt 1 yearFloating rate bonds
Longer-term reference rateVariable or adjustable rate bonds
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Convertible bonds can be converted to sharesof stockCallable bonds can be prematurely retired by
the issuerPutable bonds can be prematurelysurrendered by the holders
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It is the principal valueAmount payable by the borrower to the lastholder at maturityAmount on which the periodic interest paymentsare calculatedAKA as
Par ValueRedemption Value Maturity ValuePrincipal Value
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It is the time remaining in the life of thebond
The length of time for which interest has to bepaid as promisedThe the length of time after which the face valuewill be repaidAKA as
MaturityTermTenor
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The periodic interest payment that has to bemade by the borrower
The coupon rate multiplied by the face valuegives the rupeedollar value of the coupon
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Most bonds pays coupons on a semi-annual basisTrue in UKUSAustraliaJapanIn European and Eurobond markets annualpayments are the norm
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In earlier days bonds were accompanied by abooklet of post-dated coupons
Each coupon could be detached and redeemedon the corresponding coupon payment date
Even today bearer bonds come with couponsThe bearer certificate number is mentioned onthe coupon
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Bond with a face value of $1000The coupon rate is 8 per annum paid semi-annually
So the bond holder will receive1000 x 008
___ = $40 every six months2
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The rate of return if an investor buys thebond at the prevailing price and holds ittill maturity
In order to get the YTM two conditionsmust be satisfied
The bond must be held till maturity All coupon payments received before maturitymust be reinvested at the YTM
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At any point in time the YTM may beGreater thanLess than or
Equal to the Coupon RateYTM is the IRR of a bond
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Bonds involve pure cash flowsSo only ONE REAL POSITIVE YTM
Solution to a Non-Linear equation
Solved iteratively
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A holder gets a stream of contractuallypromised payments
The value of the bond is the value of this stream
of cash flowsCash flows arising at different points in timecannot be addedCash flows have to be discounted
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It is a chicken and egg storyIf we know the yield that is required we canquote a priceOnce we acquire the asset at a certain price we
can work out the corresponding yield
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A bond will pay identical coupons everyperiodAnd will repay the face value at maturity
The periodic cash flows constitutean annuity The terminal face value is a lump
sum payment
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Bond pays a semi-annual coupon of $C2and has a face value of $MAssume there are N coupons left
And that we are standing on a coupondate
We are assuming that the next coupon is exactlysix months away
The required annual yield is yImplies that the semi-annual yield is y2
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The present value of the coupon stream is
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The present value of the face value is
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So the price of the bond is
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IBM has issued a bond with a face value of$1000The coupon is 8 per year to be paid on July
15 and January 15 every yearToday is 15 July 2013 and that the bondmatures on 15 January 2033The required yield is 10 per annum
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JJ ndash 0115FA ndash 0115MS ndash 0115
AO ndash 0115MN ndash 0115JD ndash 0115
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In the example the price is less than theface value
Such a bond is called a Discount Bond
It is trading at a discount from the face valueThe reason is that
The yield is greater than the coupon
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If the yield were to equal the couponThe bond would sell at PARSuch bonds are called PAR Bonds
If the yield is less than the couponThe price will exceed the face valueSuch bonds are called Premium Bonds
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As we move from one coupon date to thenext if the YTM were to remain constant
Par bonds would continue to trade at PARPremium bonds will steadily decline in priceDiscount bonds will steadily increase in price
This is called the Pull to Par EffectAt maturity ndash ALL BONDS WILL TRADE AT PAR
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As we approach maturity the number ofcoupons reduces
The contribution of coupons to price reducesThe contribution of the PV of the face valueincreases
For premium bonds the first effect dominatesThus the price steadily declines
For discount bonds the second effectdominatesThus the price steadily increases
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A plain vanilla or Bullet Bond pays the entireface value at maturity in a lump sumAmortizing bonds pay the principal in
installmentsThe first payment occurs before maturityThe last payment is made at maturity
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Consider a 5 year amortizing bond with aface value of $1000 and an annual coupon of8
The annual cash flows are depicted below
8282014 40
Time Cash Flow
1 802 803 3304 3105 540
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The first two cash flows represent interest ona principal of $1000The third cash flow is interest on $1000 plus
a principal payment of $250The outstanding principal is $750The fourth cash flow is interest on $750 plusa principal payment of $250
The outstanding principal is $500The final cash flow is interest on $500 plusthe remaining principal of $500
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Some companies issue such bonds becausethe assets being funded have a similar cashflow profile
Second the coupon on such a bond may belower than that of a bullet bondIn the case of a bullet bond the entire principalis due at a single point in timeThere is greater default risk
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Microsoft is issuing zeroes with 5 years tomaturity and a face value of $10000
The required yield is 10 per annumWhat should be the price
Price is the PV of the face valueIn practice we discount on a semi-annual basis
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This is to facilitate comparisons withconventional bonds
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A zero coupon bond can never sell at apremium
It will always trade at a discount prior tomaturityAt maturity it will trade at par
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If held to maturity a ZCB will always give riseto a capital gainIf sold prior to maturity there may be a
capital gain or a capital lossConsider a bond with 10 years to maturityThe YTM at the time of purchase was 10The cost was $37690
A year later it is sold at a YTM of 12The corresponding price is $35035
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A newly established issuerOr an issuer with a relatively virgin productor service
Or a restructured company due to a mergeror following a bankruptcyWill be perceived as more riskyInvestors will demand a high coupon
Such firms are unlikely to have high earningsRevenues will peak only after theproductservice is established
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They can ill afford high couponsThey may consider a step-up coupon bond
Where the coupon increases as the bond ages
Assume a company can issue a plain vanillaat a coupon of 8 with a maturity of 5 yearsInstead it may opt for a bond
With a coupon of 6 for the first three years
And a coupon of 10 for the last two yearsThis is a Deferred Interest Security
Provides the issuer with breathing room in theearlier years
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These pay coupons in the form of additionalsecurities and not cash
This offers the issuer time to prepare for cashoutlays
They are used as Mezzanine FinanceThey rank between senior debt and equity in thecapital structureInvestors take more risk as compared to buyersof regular bonds ndash but get higher returnsIssuers can conserve cash in earlier years when itis at a premium
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Fully backed by the federal government ofthe issuing nationConsequently they are virtually devoid ofcredit risk or the risk of defaultThe yield on such securities is a benchmarkfor setting rates on other kinds of debt
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Treasury securities are issuedTo finance expenses in excess of currentrevenuesTo pay interest on debt accumulated in earlieryears due to deficits in those yearsTo repay past debt issues that are currentlymaturing
The US Treasuries marketIs the largest bond market in the worldIs the most liquid bond market in the world
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The Treasury issues three categories ofmarketable securities
T-bills are discount securitiesThey are zero coupon securitiesT-notes and T-bonds are sold at face value andpay interest periodically
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T-bills are issued with a original time tomaturity of one year or less
They are Money market instrumentsThey have maturities of either 1 3 6 or 12months at the time of issue
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T-notes and T-bonds have a time to maturityexceeding one year at the time of issue
They are capital market instrumentsT-notes have maturities ranging from 1-10 yearsT-bonds have an original maturity in excess of 10years extending up to 30 years
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An issue may be followed later by a furtherissue
With the same remaining time to maturity andthe same couponThe issuance of further tranches is termed as aRe-opening
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Six months ago a 10-year note was issuedwith a coupon of 8 per annumToday if a note with 9 frac12 years to maturityand a coupon of 8 issued it will add to thepool that is already trading in the marketThus it is a re-opening of an existing issue
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Who is a primary dealerA PD is a dealer who is authorized to dealdirectly with the Central Bank of the countryIn the US a PD is a bank or securities broker-dealer that directly deals with the FRBNY
Importance of FRBNYIn India a PD deals directly with the RBI
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The Treasury sells bills notes and bonds byway of a competitive auction process
Most of the treasury securities are bought byprimary dealers
Individual investors submit non-competitive bidsand participate on a much smaller scale
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Bids may beCompetitive
Indicate price amp quantity or yield amp quantityNon-competitive
Indicate only quantity
Small investors and individualsgenerally submit non-competitive bids
A non-competitive bidder may not bid for more than$5MM worth of securities in a bill or bond auction
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Primary dealers bid for their accounts andon behalf of their clientsThey usually submit large competitive
bidsBids indicate the maximum price that the bidderis prepared to pay if it is a price based auctionOr the minimum yield that the bidder is
prepared to accept if it is a yield based auction
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The Treasury will net out the totalamount of non-competitive bids
The balance will be allocated to competitivebidders
There are two ways in which securitiescan be allotted
The multiple priceyield auction mechanism
French AuctionsThe uniform priceyield auction mechanism
Dutch Auctions
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Assume that the Treasury is offering 25billion dollars worth of T-bonds
2 billion dollars worth of non-competitive bidshave been receivedSo 23 billion dollars worth of bonds are availableto be offered to the competitive bidders
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There are six competitive bidders who havesubmitted the following yields
The bids have been arranged in ascending orderof yieldIn a price based auction the bids would havebeen arranged in descending order of price
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Bidder Bid Yield Bid Amount
Aggregate Amount
Alpha 5370 30 bn 30 bnBeta 5372 50 bn 80 bn
Gamma 5373 40 bn 12 bn
Delta 5375 80 bn 20 bnCharlie 5375 120 bn 32 bn
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The aggregate demand equals the amount onoffer at a yield of 5375A multiple yield auction will lead to thefollowing allocation
Alpha will get 3 bn at a yield of 5370Beta will get 5 bn at 5372Gamma will get 4 bn at 5373
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At a yield of 5375 we have only 11 bn left toallocateThere is a demand of 20 bn at this yield
8 bn from Delta and 12 bn from CharlieThus we will allocate 1120 = 55 to eachbidder at this yield
There will be pro-rata allocation
055 of 8 bn or 440 bn will go to Delta055 of 12 bn or 66 bn will go to Charlie
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The highest accepted yield is called the StopYield or High Yield
In this case it is 5375The ratio of bids received to the amountawarded is known as the bid to cover ratio
The higher the ratio the stronger is the auction
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Those who bid more than 5375 will getnothing and are said to be shutout of theauctionSince 1999 the US Treasury has beenconducting only uniform yield auctions
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WI stands for ndash When As and If IssuedThe when issued market is a market forforward trading of a bond
Which has been announced but not yet issuedTrades take place from the date ofannouncement until the actual issue date
Helps bidders to gauge the marketrsquos interestbefore the actual auction
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WI trading has ramifications for the biddingstrategies of market participantsTraders can take both long and shortpositions
Settlement is scheduled for the issue date
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It has a bearing on the outcome of theauction
It affects the strategy used by a bidder becauseit has an impact on his prior positionBidders who are long in the WI market enter theauction with a Long PositionThose who are short in the WI market enter theauction with a short position
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The WI market helps in price discoveryIt provides important information on
The strength of demand for the securityAnd on the disparity of biddersrsquo views
This help potential bidders to formulate theirstrategiesAt times a dealer may believe that he hasvery important private information
If so he may not participate in the WI market andwill directly enter the auction with bids based onhis knowledge
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On or before the date of the auction theissues trade on a yield basis
The actual price can be established only afterthe coupon is set
Starting with the day after the auctionSecurities are quoted on a price basis becausethe coupon is known
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In a coupon roll a dealer will purchase themost recently issued security from a clientAnd simultaneously sell the same amount ofthe recently announced new security
The first leg with settle on the following dayThe second leg is a forward contract
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There can be a Reverse RollThe dealer will sell the most recent issue fornext day settlementAnd buy the newly announced security forforward settlement
The forward leg in a RollReverse Roll is a WItrade
It will settle on the new issue settlement date
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The roll is the spread between the yield onthe new security and that on the outstandingissue in the same maturity segmentA GIVE in the Roll means that
The WI security provides a higher yield than theoutstanding issue
A Take in the Roll means thatThe WI security provides a lower yield
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On March 17 20XX the Treasury announcedthe auction of a 2-year note
The auction was scheduled for March 24The settlement date was March 31
Trading of the roll began as soon as the issuewas announcedA Give of 5 bp means that the dealer proposes tobuy the current issue at the prevailing yieldAnd sell the new issue at a yield that is 5 bpmoreA Take of 5 bp means that the dealer proposes tosell the new issue at a yield that is 5bp lower
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The roll achieves the followingHe acquires the outstanding issue for next daysettlementHe sells the to be issued security with the samepar value for forward delivery on 31 March
The customer is rolling over the investmentfrom the current issue to the new issue
This extends the maturity of the investment byone month
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The client can invest the funds received tillthe new issue settlesHowever he loses the accrued interest thathe would have earned had he held on to theissue
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The Treasury per se does not issue zerocoupon securitiesBut zero coupon securities can be created
which are backed by conventional bondsTake a large quantity of a T-note or bond andseparate all the cash flows from each otherSell the entitlement to each cash flowseparately
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Take the case of a two-year T-noteIt can be separated into five zero couponsecurities maturing after
6 months12 months18 months24 months
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Earlier investment banks used to buy bondsfrom the Treasury and separate the cashflows
Each cash flow was then sold separately as a zerocoupon bondSuch issues are called trademarks
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The issue of trademarks has now ceasedBecause investment banks can now createsuch instruments
In concert with the Treasury itselfThese ZCBs are known as STRIPS ndash
Separate Trading of Registered Interest andPrincipal of Securities
These are not issued or sold by the Treasury
The market is made by investment banks
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What is the motivation to create suchproductsIn practice arbitrage is possible when a
coupon security is purchased at a priceThat is lower than what could be obtained byselling each cash flow separately
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Coupon stripping reflects a case of financialengineering
Creating a risk-return profile that is nototherwise available
An investment bank would buy a largequantity of a Treasury security
The securities would be placed with an SPV
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The SPV is a single-purpose dedicated trustIt has the powers to own the bonds andcollect payments
It cannot sell or lend the bondsIt cannot write options on the bondsOr use them as collateral for borrowing
The SPV is empowered to issue zero coupon
bondsWhere each security represents the ownership ofa single cash flow from the mother bond
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Assume that 100MM USD of 15 year bondswith a coupon of 8 are placed with the SPV
The SPV can issue 6M 12M 18M extending up to14 frac12 year zeroes with a total face value of 4MM
USD eachAnd 15 year zeroes with a total face value of104MM
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The Treasury launched this program in 1985to facilitate the stripping of designatedsecurities
All new T-bonds and notes with a maturity of 10years or more are eligibleThe zeroes created in the process are directobligations of the US government
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The mechanism is as followsA dealer who owns a bond or note can ask theFRB where it is held
To replace it with an equivalent set of STRIPS
representing each payment as a separate securityEach of these securities can be traded independentlyof others
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In 1987 the Treasury started to allow dealersto reverse the process
This is called STRIPS RECONSTUTUTION If a dealer owns STRIPS representing all thecoupon and principal payments of a bond
The FED can on request convert these holdings into asingle position in the corresponding bond
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Each coupon and principal cash flow from aTreasury security is assigned a CUSIP
The mother bond is also assigned a CUSIPThe stripped coupons are known as C-STRIPSThe stripped principal is known as P-STRIPSSupply of a C-STRIP increases over time
because a C-STRIP maturing on a day like 15 FEB
2020 will have the same CUSIP irrespective ofwhich mother bond it has come fromThe original coupon rate is irrelevant
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P-STRIPS always correspond to the originalsecurityThey have a unique CUSIPTheir supply is fixed at the time of issuanceIn practice the prices of long-dated P-STRIPSare a bit higher than those of C-STRIPS withthe same maturity date
One reason is that P-STRIPS are more liquid due
to greater availabilityA $100 face value bond with a coupon of 8 willgenerate C-STRIPS with a face value of $4 but P-STRIPS with a face value of $100
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Another reason why P-STRIPS are in higherdemand is that they allow reconstitutionactivities more easily
Assume that the sum of the STRIPS is cheaper than
the mother bondIf a dealer already has the P-STRIPS only the C-STRIPSneed to be acquiredHowever if he owns some of the C-STRIPS he needs toacquire the P-STRIPS and the remaining C-STRIPSThe facility to reconstitute when profitable is pricedinto the P-STRIPSNote Buy and hold investors will prefer C-STRIPSsince they are priced lower and give a higher yield
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For Plain Vanilla bonds the specifiedcoupon rate is valid for the life of thebond
In the case of Floaters the rate is reset atthe beginning of every periodThe rate will vary directly with thebenchmark
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The rate on a Floater is specified as LIBOR+ 50 bp
The spread is positiveIf it were specified as LIBOR ndash 30bp
The spread will be negativeIf LIBOR rises the rate will increasewhereas if LIBOR falls it will decrease
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In the case of a default risk-free floater theprice will reset to par on a coupon date
It may sell at a premium or discount betweencoupon dates
Consider a floater with a coupon = 5-year T-Bond rate
Assume there are two periods left to maturity
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The price at the end of the first coupon period willbe given by
cT-1 is the coupon one period before maturityyT-1 is the YTM one period before maturity
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On a coupon reset date the YTM = couponBecause we have assumed there is no default riskAny change in the required yield as reflected inthe prevailing YTM
Will also be reflected in the coupon being setIf coupon = yield the bond should sell at par
Thus P T-1 = M
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Once again at T-2 c T-2 = yT-2 and P T-2 = MThis logic can be applied to a bond with anytime remaining till maturityHowever between two coupon dates theprice may not be equal to par
Consider the valuation at T-2+k
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Although c T-2 was set at T-2 and is equal toyT-2
yT-2+k is determined at T-2+k and will reflect theyield prevailing at that time
Thus yT-2+k need not equal c T-2 and may behigher or lower
Hence between two coupon dates a floater maysell at a premium or discount
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Now consider a floater characterized bydefault risk
The risk premium required by the market neednot be constant over time
Assume that at the time of issue YTM = 5-year T-note rate + 75bp
The coupon would have been set equal to thisrate and the bond would have been issued at par
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Six months hence the issue may be perceivedas more risky
YTM = 5-year T-note rate + 95 bpThe coupon will however be set equal to theprevailing 5-year rate + 75 bpIf so the issue will not reset to par at the nextcoupon date
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Floaters may come with a CAP or a FLOOR orBOTH
The CAP is a maximum coupon rateProtects issuers against rising rates
The FLOOR is a minimum coupon rateProtects investors against falling rates
When there is a spread over LIBORThere is a natural floorLIBOR cannot be less than zero
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Part-02ABond amp Bond Markets An Introduction
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What is debtIt is a financial claim
Who issues it
The borrower of fundsFor whom it is a liability
Who holds itThe lender of funds
For whom it is an asset
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Difference between debt and equityDebt does not confer ownership rightsIt is merely an IOU
A promise to pay interest at periodic intervalsAnd to repay the principal at a pre-specified maturitydate
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It usually has a finite life spanPerpetual debt is rare
The interest payments are contractualobligations
Borrowers are required to make payments irrespectiveof their financial performance
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Interest payments to be made before anydividends for equity holders
In the event of liquidationThe claims of debt holders must be settled firstOnly then can equity holders be paid
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Bonds and debentures are termed as FixedIncome Securities
Once the rate of interest is set at the onset ofthe period for which it is due
It is not a function of the profitability of the firmFailure to pay the promised interest willtantamount to default
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Bonds may be secured or unsecuredUnsecured debt securities are termed asDebentures in the USUnsecured means no specific assets have beenearmarked as collateralSecured debt requires the firm to earmarkspecific assets as collateralSecured debt holders enjoy priority from thestandpoint of payments
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Debt securities may be negotiable or non-negotiable
Negotiable securities can be traded in thesecondary market
Can be endorsed by one party in favor of anotherExamples of non-negotiable debt securities
National savings certificatesConventional Time or Fixed deposits
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The most basic form of a bond is called thePlain Vanilla version
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This is true for all securities not just for bondsMore complicated versions are said to have`Bells and Whistlesrsquo attached
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These bonds are slightly differentThe interest rate does not remain fixedIt varies each period based on the reference rate
Short-term reference rate ndash maturity lt 1 yearFloating rate bonds
Longer-term reference rateVariable or adjustable rate bonds
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Convertible bonds can be converted to sharesof stockCallable bonds can be prematurely retired by
the issuerPutable bonds can be prematurelysurrendered by the holders
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It is the principal valueAmount payable by the borrower to the lastholder at maturityAmount on which the periodic interest paymentsare calculatedAKA as
Par ValueRedemption Value Maturity ValuePrincipal Value
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It is the time remaining in the life of thebond
The length of time for which interest has to bepaid as promisedThe the length of time after which the face valuewill be repaidAKA as
MaturityTermTenor
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The periodic interest payment that has to bemade by the borrower
The coupon rate multiplied by the face valuegives the rupeedollar value of the coupon
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Most bonds pays coupons on a semi-annual basisTrue in UKUSAustraliaJapanIn European and Eurobond markets annualpayments are the norm
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In earlier days bonds were accompanied by abooklet of post-dated coupons
Each coupon could be detached and redeemedon the corresponding coupon payment date
Even today bearer bonds come with couponsThe bearer certificate number is mentioned onthe coupon
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Bond with a face value of $1000The coupon rate is 8 per annum paid semi-annually
So the bond holder will receive1000 x 008
___ = $40 every six months2
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The rate of return if an investor buys thebond at the prevailing price and holds ittill maturity
In order to get the YTM two conditionsmust be satisfied
The bond must be held till maturity All coupon payments received before maturitymust be reinvested at the YTM
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At any point in time the YTM may beGreater thanLess than or
Equal to the Coupon RateYTM is the IRR of a bond
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Bonds involve pure cash flowsSo only ONE REAL POSITIVE YTM
Solution to a Non-Linear equation
Solved iteratively
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A holder gets a stream of contractuallypromised payments
The value of the bond is the value of this stream
of cash flowsCash flows arising at different points in timecannot be addedCash flows have to be discounted
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It is a chicken and egg storyIf we know the yield that is required we canquote a priceOnce we acquire the asset at a certain price we
can work out the corresponding yield
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A bond will pay identical coupons everyperiodAnd will repay the face value at maturity
The periodic cash flows constitutean annuity The terminal face value is a lump
sum payment
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Bond pays a semi-annual coupon of $C2and has a face value of $MAssume there are N coupons left
And that we are standing on a coupondate
We are assuming that the next coupon is exactlysix months away
The required annual yield is yImplies that the semi-annual yield is y2
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The present value of the coupon stream is
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The present value of the face value is
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So the price of the bond is
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IBM has issued a bond with a face value of$1000The coupon is 8 per year to be paid on July
15 and January 15 every yearToday is 15 July 2013 and that the bondmatures on 15 January 2033The required yield is 10 per annum
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JJ ndash 0115FA ndash 0115MS ndash 0115
AO ndash 0115MN ndash 0115JD ndash 0115
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In the example the price is less than theface value
Such a bond is called a Discount Bond
It is trading at a discount from the face valueThe reason is that
The yield is greater than the coupon
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If the yield were to equal the couponThe bond would sell at PARSuch bonds are called PAR Bonds
If the yield is less than the couponThe price will exceed the face valueSuch bonds are called Premium Bonds
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As we move from one coupon date to thenext if the YTM were to remain constant
Par bonds would continue to trade at PARPremium bonds will steadily decline in priceDiscount bonds will steadily increase in price
This is called the Pull to Par EffectAt maturity ndash ALL BONDS WILL TRADE AT PAR
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As we approach maturity the number ofcoupons reduces
The contribution of coupons to price reducesThe contribution of the PV of the face valueincreases
For premium bonds the first effect dominatesThus the price steadily declines
For discount bonds the second effectdominatesThus the price steadily increases
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A plain vanilla or Bullet Bond pays the entireface value at maturity in a lump sumAmortizing bonds pay the principal in
installmentsThe first payment occurs before maturityThe last payment is made at maturity
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Consider a 5 year amortizing bond with aface value of $1000 and an annual coupon of8
The annual cash flows are depicted below
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Time Cash Flow
1 802 803 3304 3105 540
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The first two cash flows represent interest ona principal of $1000The third cash flow is interest on $1000 plus
a principal payment of $250The outstanding principal is $750The fourth cash flow is interest on $750 plusa principal payment of $250
The outstanding principal is $500The final cash flow is interest on $500 plusthe remaining principal of $500
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Some companies issue such bonds becausethe assets being funded have a similar cashflow profile
Second the coupon on such a bond may belower than that of a bullet bondIn the case of a bullet bond the entire principalis due at a single point in timeThere is greater default risk
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Microsoft is issuing zeroes with 5 years tomaturity and a face value of $10000
The required yield is 10 per annumWhat should be the price
Price is the PV of the face valueIn practice we discount on a semi-annual basis
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This is to facilitate comparisons withconventional bonds
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A zero coupon bond can never sell at apremium
It will always trade at a discount prior tomaturityAt maturity it will trade at par
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If held to maturity a ZCB will always give riseto a capital gainIf sold prior to maturity there may be a
capital gain or a capital lossConsider a bond with 10 years to maturityThe YTM at the time of purchase was 10The cost was $37690
A year later it is sold at a YTM of 12The corresponding price is $35035
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A newly established issuerOr an issuer with a relatively virgin productor service
Or a restructured company due to a mergeror following a bankruptcyWill be perceived as more riskyInvestors will demand a high coupon
Such firms are unlikely to have high earningsRevenues will peak only after theproductservice is established
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They can ill afford high couponsThey may consider a step-up coupon bond
Where the coupon increases as the bond ages
Assume a company can issue a plain vanillaat a coupon of 8 with a maturity of 5 yearsInstead it may opt for a bond
With a coupon of 6 for the first three years
And a coupon of 10 for the last two yearsThis is a Deferred Interest Security
Provides the issuer with breathing room in theearlier years
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These pay coupons in the form of additionalsecurities and not cash
This offers the issuer time to prepare for cashoutlays
They are used as Mezzanine FinanceThey rank between senior debt and equity in thecapital structureInvestors take more risk as compared to buyersof regular bonds ndash but get higher returnsIssuers can conserve cash in earlier years when itis at a premium
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Fully backed by the federal government ofthe issuing nationConsequently they are virtually devoid ofcredit risk or the risk of defaultThe yield on such securities is a benchmarkfor setting rates on other kinds of debt
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Treasury securities are issuedTo finance expenses in excess of currentrevenuesTo pay interest on debt accumulated in earlieryears due to deficits in those yearsTo repay past debt issues that are currentlymaturing
The US Treasuries marketIs the largest bond market in the worldIs the most liquid bond market in the world
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The Treasury issues three categories ofmarketable securities
T-bills are discount securitiesThey are zero coupon securitiesT-notes and T-bonds are sold at face value andpay interest periodically
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T-bills are issued with a original time tomaturity of one year or less
They are Money market instrumentsThey have maturities of either 1 3 6 or 12months at the time of issue
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T-notes and T-bonds have a time to maturityexceeding one year at the time of issue
They are capital market instrumentsT-notes have maturities ranging from 1-10 yearsT-bonds have an original maturity in excess of 10years extending up to 30 years
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An issue may be followed later by a furtherissue
With the same remaining time to maturity andthe same couponThe issuance of further tranches is termed as aRe-opening
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Six months ago a 10-year note was issuedwith a coupon of 8 per annumToday if a note with 9 frac12 years to maturityand a coupon of 8 issued it will add to thepool that is already trading in the marketThus it is a re-opening of an existing issue
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Who is a primary dealerA PD is a dealer who is authorized to dealdirectly with the Central Bank of the countryIn the US a PD is a bank or securities broker-dealer that directly deals with the FRBNY
Importance of FRBNYIn India a PD deals directly with the RBI
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The Treasury sells bills notes and bonds byway of a competitive auction process
Most of the treasury securities are bought byprimary dealers
Individual investors submit non-competitive bidsand participate on a much smaller scale
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Bids may beCompetitive
Indicate price amp quantity or yield amp quantityNon-competitive
Indicate only quantity
Small investors and individualsgenerally submit non-competitive bids
A non-competitive bidder may not bid for more than$5MM worth of securities in a bill or bond auction
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Primary dealers bid for their accounts andon behalf of their clientsThey usually submit large competitive
bidsBids indicate the maximum price that the bidderis prepared to pay if it is a price based auctionOr the minimum yield that the bidder is
prepared to accept if it is a yield based auction
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The Treasury will net out the totalamount of non-competitive bids
The balance will be allocated to competitivebidders
There are two ways in which securitiescan be allotted
The multiple priceyield auction mechanism
French AuctionsThe uniform priceyield auction mechanism
Dutch Auctions
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Assume that the Treasury is offering 25billion dollars worth of T-bonds
2 billion dollars worth of non-competitive bidshave been receivedSo 23 billion dollars worth of bonds are availableto be offered to the competitive bidders
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There are six competitive bidders who havesubmitted the following yields
The bids have been arranged in ascending orderof yieldIn a price based auction the bids would havebeen arranged in descending order of price
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Bidder Bid Yield Bid Amount
Aggregate Amount
Alpha 5370 30 bn 30 bnBeta 5372 50 bn 80 bn
Gamma 5373 40 bn 12 bn
Delta 5375 80 bn 20 bnCharlie 5375 120 bn 32 bn
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The aggregate demand equals the amount onoffer at a yield of 5375A multiple yield auction will lead to thefollowing allocation
Alpha will get 3 bn at a yield of 5370Beta will get 5 bn at 5372Gamma will get 4 bn at 5373
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At a yield of 5375 we have only 11 bn left toallocateThere is a demand of 20 bn at this yield
8 bn from Delta and 12 bn from CharlieThus we will allocate 1120 = 55 to eachbidder at this yield
There will be pro-rata allocation
055 of 8 bn or 440 bn will go to Delta055 of 12 bn or 66 bn will go to Charlie
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The highest accepted yield is called the StopYield or High Yield
In this case it is 5375The ratio of bids received to the amountawarded is known as the bid to cover ratio
The higher the ratio the stronger is the auction
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Those who bid more than 5375 will getnothing and are said to be shutout of theauctionSince 1999 the US Treasury has beenconducting only uniform yield auctions
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WI stands for ndash When As and If IssuedThe when issued market is a market forforward trading of a bond
Which has been announced but not yet issuedTrades take place from the date ofannouncement until the actual issue date
Helps bidders to gauge the marketrsquos interestbefore the actual auction
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WI trading has ramifications for the biddingstrategies of market participantsTraders can take both long and shortpositions
Settlement is scheduled for the issue date
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It has a bearing on the outcome of theauction
It affects the strategy used by a bidder becauseit has an impact on his prior positionBidders who are long in the WI market enter theauction with a Long PositionThose who are short in the WI market enter theauction with a short position
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The WI market helps in price discoveryIt provides important information on
The strength of demand for the securityAnd on the disparity of biddersrsquo views
This help potential bidders to formulate theirstrategiesAt times a dealer may believe that he hasvery important private information
If so he may not participate in the WI market andwill directly enter the auction with bids based onhis knowledge
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On or before the date of the auction theissues trade on a yield basis
The actual price can be established only afterthe coupon is set
Starting with the day after the auctionSecurities are quoted on a price basis becausethe coupon is known
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In a coupon roll a dealer will purchase themost recently issued security from a clientAnd simultaneously sell the same amount ofthe recently announced new security
The first leg with settle on the following dayThe second leg is a forward contract
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There can be a Reverse RollThe dealer will sell the most recent issue fornext day settlementAnd buy the newly announced security forforward settlement
The forward leg in a RollReverse Roll is a WItrade
It will settle on the new issue settlement date
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The roll is the spread between the yield onthe new security and that on the outstandingissue in the same maturity segmentA GIVE in the Roll means that
The WI security provides a higher yield than theoutstanding issue
A Take in the Roll means thatThe WI security provides a lower yield
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On March 17 20XX the Treasury announcedthe auction of a 2-year note
The auction was scheduled for March 24The settlement date was March 31
Trading of the roll began as soon as the issuewas announcedA Give of 5 bp means that the dealer proposes tobuy the current issue at the prevailing yieldAnd sell the new issue at a yield that is 5 bpmoreA Take of 5 bp means that the dealer proposes tosell the new issue at a yield that is 5bp lower
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The roll achieves the followingHe acquires the outstanding issue for next daysettlementHe sells the to be issued security with the samepar value for forward delivery on 31 March
The customer is rolling over the investmentfrom the current issue to the new issue
This extends the maturity of the investment byone month
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The client can invest the funds received tillthe new issue settlesHowever he loses the accrued interest thathe would have earned had he held on to theissue
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The Treasury per se does not issue zerocoupon securitiesBut zero coupon securities can be created
which are backed by conventional bondsTake a large quantity of a T-note or bond andseparate all the cash flows from each otherSell the entitlement to each cash flowseparately
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Take the case of a two-year T-noteIt can be separated into five zero couponsecurities maturing after
6 months12 months18 months24 months
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Earlier investment banks used to buy bondsfrom the Treasury and separate the cashflows
Each cash flow was then sold separately as a zerocoupon bondSuch issues are called trademarks
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The issue of trademarks has now ceasedBecause investment banks can now createsuch instruments
In concert with the Treasury itselfThese ZCBs are known as STRIPS ndash
Separate Trading of Registered Interest andPrincipal of Securities
These are not issued or sold by the Treasury
The market is made by investment banks
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What is the motivation to create suchproductsIn practice arbitrage is possible when a
coupon security is purchased at a priceThat is lower than what could be obtained byselling each cash flow separately
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Coupon stripping reflects a case of financialengineering
Creating a risk-return profile that is nototherwise available
An investment bank would buy a largequantity of a Treasury security
The securities would be placed with an SPV
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The SPV is a single-purpose dedicated trustIt has the powers to own the bonds andcollect payments
It cannot sell or lend the bondsIt cannot write options on the bondsOr use them as collateral for borrowing
The SPV is empowered to issue zero coupon
bondsWhere each security represents the ownership ofa single cash flow from the mother bond
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Assume that 100MM USD of 15 year bondswith a coupon of 8 are placed with the SPV
The SPV can issue 6M 12M 18M extending up to14 frac12 year zeroes with a total face value of 4MM
USD eachAnd 15 year zeroes with a total face value of104MM
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The Treasury launched this program in 1985to facilitate the stripping of designatedsecurities
All new T-bonds and notes with a maturity of 10years or more are eligibleThe zeroes created in the process are directobligations of the US government
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The mechanism is as followsA dealer who owns a bond or note can ask theFRB where it is held
To replace it with an equivalent set of STRIPS
representing each payment as a separate securityEach of these securities can be traded independentlyof others
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In 1987 the Treasury started to allow dealersto reverse the process
This is called STRIPS RECONSTUTUTION If a dealer owns STRIPS representing all thecoupon and principal payments of a bond
The FED can on request convert these holdings into asingle position in the corresponding bond
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Each coupon and principal cash flow from aTreasury security is assigned a CUSIP
The mother bond is also assigned a CUSIPThe stripped coupons are known as C-STRIPSThe stripped principal is known as P-STRIPSSupply of a C-STRIP increases over time
because a C-STRIP maturing on a day like 15 FEB
2020 will have the same CUSIP irrespective ofwhich mother bond it has come fromThe original coupon rate is irrelevant
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P-STRIPS always correspond to the originalsecurityThey have a unique CUSIPTheir supply is fixed at the time of issuanceIn practice the prices of long-dated P-STRIPSare a bit higher than those of C-STRIPS withthe same maturity date
One reason is that P-STRIPS are more liquid due
to greater availabilityA $100 face value bond with a coupon of 8 willgenerate C-STRIPS with a face value of $4 but P-STRIPS with a face value of $100
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Another reason why P-STRIPS are in higherdemand is that they allow reconstitutionactivities more easily
Assume that the sum of the STRIPS is cheaper than
the mother bondIf a dealer already has the P-STRIPS only the C-STRIPSneed to be acquiredHowever if he owns some of the C-STRIPS he needs toacquire the P-STRIPS and the remaining C-STRIPSThe facility to reconstitute when profitable is pricedinto the P-STRIPSNote Buy and hold investors will prefer C-STRIPSsince they are priced lower and give a higher yield
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For Plain Vanilla bonds the specifiedcoupon rate is valid for the life of thebond
In the case of Floaters the rate is reset atthe beginning of every periodThe rate will vary directly with thebenchmark
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The rate on a Floater is specified as LIBOR+ 50 bp
The spread is positiveIf it were specified as LIBOR ndash 30bp
The spread will be negativeIf LIBOR rises the rate will increasewhereas if LIBOR falls it will decrease
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In the case of a default risk-free floater theprice will reset to par on a coupon date
It may sell at a premium or discount betweencoupon dates
Consider a floater with a coupon = 5-year T-Bond rate
Assume there are two periods left to maturity
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The price at the end of the first coupon period willbe given by
cT-1 is the coupon one period before maturityyT-1 is the YTM one period before maturity
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On a coupon reset date the YTM = couponBecause we have assumed there is no default riskAny change in the required yield as reflected inthe prevailing YTM
Will also be reflected in the coupon being setIf coupon = yield the bond should sell at par
Thus P T-1 = M
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Once again at T-2 c T-2 = yT-2 and P T-2 = MThis logic can be applied to a bond with anytime remaining till maturityHowever between two coupon dates theprice may not be equal to par
Consider the valuation at T-2+k
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Although c T-2 was set at T-2 and is equal toyT-2
yT-2+k is determined at T-2+k and will reflect theyield prevailing at that time
Thus yT-2+k need not equal c T-2 and may behigher or lower
Hence between two coupon dates a floater maysell at a premium or discount
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Now consider a floater characterized bydefault risk
The risk premium required by the market neednot be constant over time
Assume that at the time of issue YTM = 5-year T-note rate + 75bp
The coupon would have been set equal to thisrate and the bond would have been issued at par
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Six months hence the issue may be perceivedas more risky
YTM = 5-year T-note rate + 95 bpThe coupon will however be set equal to theprevailing 5-year rate + 75 bpIf so the issue will not reset to par at the nextcoupon date
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Floaters may come with a CAP or a FLOOR orBOTH
The CAP is a maximum coupon rateProtects issuers against rising rates
The FLOOR is a minimum coupon rateProtects investors against falling rates
When there is a spread over LIBORThere is a natural floorLIBOR cannot be less than zero
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What is debtIt is a financial claim
Who issues it
The borrower of fundsFor whom it is a liability
Who holds itThe lender of funds
For whom it is an asset
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Difference between debt and equityDebt does not confer ownership rightsIt is merely an IOU
A promise to pay interest at periodic intervalsAnd to repay the principal at a pre-specified maturitydate
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It usually has a finite life spanPerpetual debt is rare
The interest payments are contractualobligations
Borrowers are required to make payments irrespectiveof their financial performance
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Interest payments to be made before anydividends for equity holders
In the event of liquidationThe claims of debt holders must be settled firstOnly then can equity holders be paid
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Bonds and debentures are termed as FixedIncome Securities
Once the rate of interest is set at the onset ofthe period for which it is due
It is not a function of the profitability of the firmFailure to pay the promised interest willtantamount to default
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Bonds may be secured or unsecuredUnsecured debt securities are termed asDebentures in the USUnsecured means no specific assets have beenearmarked as collateralSecured debt requires the firm to earmarkspecific assets as collateralSecured debt holders enjoy priority from thestandpoint of payments
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Debt securities may be negotiable or non-negotiable
Negotiable securities can be traded in thesecondary market
Can be endorsed by one party in favor of anotherExamples of non-negotiable debt securities
National savings certificatesConventional Time or Fixed deposits
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The most basic form of a bond is called thePlain Vanilla version
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This is true for all securities not just for bondsMore complicated versions are said to have`Bells and Whistlesrsquo attached
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These bonds are slightly differentThe interest rate does not remain fixedIt varies each period based on the reference rate
Short-term reference rate ndash maturity lt 1 yearFloating rate bonds
Longer-term reference rateVariable or adjustable rate bonds
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Convertible bonds can be converted to sharesof stockCallable bonds can be prematurely retired by
the issuerPutable bonds can be prematurelysurrendered by the holders
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It is the principal valueAmount payable by the borrower to the lastholder at maturityAmount on which the periodic interest paymentsare calculatedAKA as
Par ValueRedemption Value Maturity ValuePrincipal Value
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It is the time remaining in the life of thebond
The length of time for which interest has to bepaid as promisedThe the length of time after which the face valuewill be repaidAKA as
MaturityTermTenor
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The periodic interest payment that has to bemade by the borrower
The coupon rate multiplied by the face valuegives the rupeedollar value of the coupon
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Most bonds pays coupons on a semi-annual basisTrue in UKUSAustraliaJapanIn European and Eurobond markets annualpayments are the norm
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In earlier days bonds were accompanied by abooklet of post-dated coupons
Each coupon could be detached and redeemedon the corresponding coupon payment date
Even today bearer bonds come with couponsThe bearer certificate number is mentioned onthe coupon
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Bond with a face value of $1000The coupon rate is 8 per annum paid semi-annually
So the bond holder will receive1000 x 008
___ = $40 every six months2
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The rate of return if an investor buys thebond at the prevailing price and holds ittill maturity
In order to get the YTM two conditionsmust be satisfied
The bond must be held till maturity All coupon payments received before maturitymust be reinvested at the YTM
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At any point in time the YTM may beGreater thanLess than or
Equal to the Coupon RateYTM is the IRR of a bond
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Bonds involve pure cash flowsSo only ONE REAL POSITIVE YTM
Solution to a Non-Linear equation
Solved iteratively
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A holder gets a stream of contractuallypromised payments
The value of the bond is the value of this stream
of cash flowsCash flows arising at different points in timecannot be addedCash flows have to be discounted
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It is a chicken and egg storyIf we know the yield that is required we canquote a priceOnce we acquire the asset at a certain price we
can work out the corresponding yield
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A bond will pay identical coupons everyperiodAnd will repay the face value at maturity
The periodic cash flows constitutean annuity The terminal face value is a lump
sum payment
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Bond pays a semi-annual coupon of $C2and has a face value of $MAssume there are N coupons left
And that we are standing on a coupondate
We are assuming that the next coupon is exactlysix months away
The required annual yield is yImplies that the semi-annual yield is y2
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The present value of the coupon stream is
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The present value of the face value is
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So the price of the bond is
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IBM has issued a bond with a face value of$1000The coupon is 8 per year to be paid on July
15 and January 15 every yearToday is 15 July 2013 and that the bondmatures on 15 January 2033The required yield is 10 per annum
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JJ ndash 0115FA ndash 0115MS ndash 0115
AO ndash 0115MN ndash 0115JD ndash 0115
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In the example the price is less than theface value
Such a bond is called a Discount Bond
It is trading at a discount from the face valueThe reason is that
The yield is greater than the coupon
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If the yield were to equal the couponThe bond would sell at PARSuch bonds are called PAR Bonds
If the yield is less than the couponThe price will exceed the face valueSuch bonds are called Premium Bonds
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As we move from one coupon date to thenext if the YTM were to remain constant
Par bonds would continue to trade at PARPremium bonds will steadily decline in priceDiscount bonds will steadily increase in price
This is called the Pull to Par EffectAt maturity ndash ALL BONDS WILL TRADE AT PAR
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As we approach maturity the number ofcoupons reduces
The contribution of coupons to price reducesThe contribution of the PV of the face valueincreases
For premium bonds the first effect dominatesThus the price steadily declines
For discount bonds the second effectdominatesThus the price steadily increases
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A plain vanilla or Bullet Bond pays the entireface value at maturity in a lump sumAmortizing bonds pay the principal in
installmentsThe first payment occurs before maturityThe last payment is made at maturity
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Consider a 5 year amortizing bond with aface value of $1000 and an annual coupon of8
The annual cash flows are depicted below
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Time Cash Flow
1 802 803 3304 3105 540
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The first two cash flows represent interest ona principal of $1000The third cash flow is interest on $1000 plus
a principal payment of $250The outstanding principal is $750The fourth cash flow is interest on $750 plusa principal payment of $250
The outstanding principal is $500The final cash flow is interest on $500 plusthe remaining principal of $500
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Some companies issue such bonds becausethe assets being funded have a similar cashflow profile
Second the coupon on such a bond may belower than that of a bullet bondIn the case of a bullet bond the entire principalis due at a single point in timeThere is greater default risk
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Microsoft is issuing zeroes with 5 years tomaturity and a face value of $10000
The required yield is 10 per annumWhat should be the price
Price is the PV of the face valueIn practice we discount on a semi-annual basis
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This is to facilitate comparisons withconventional bonds
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A zero coupon bond can never sell at apremium
It will always trade at a discount prior tomaturityAt maturity it will trade at par
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If held to maturity a ZCB will always give riseto a capital gainIf sold prior to maturity there may be a
capital gain or a capital lossConsider a bond with 10 years to maturityThe YTM at the time of purchase was 10The cost was $37690
A year later it is sold at a YTM of 12The corresponding price is $35035
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A newly established issuerOr an issuer with a relatively virgin productor service
Or a restructured company due to a mergeror following a bankruptcyWill be perceived as more riskyInvestors will demand a high coupon
Such firms are unlikely to have high earningsRevenues will peak only after theproductservice is established
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They can ill afford high couponsThey may consider a step-up coupon bond
Where the coupon increases as the bond ages
Assume a company can issue a plain vanillaat a coupon of 8 with a maturity of 5 yearsInstead it may opt for a bond
With a coupon of 6 for the first three years
And a coupon of 10 for the last two yearsThis is a Deferred Interest Security
Provides the issuer with breathing room in theearlier years
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These pay coupons in the form of additionalsecurities and not cash
This offers the issuer time to prepare for cashoutlays
They are used as Mezzanine FinanceThey rank between senior debt and equity in thecapital structureInvestors take more risk as compared to buyersof regular bonds ndash but get higher returnsIssuers can conserve cash in earlier years when itis at a premium
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Fully backed by the federal government ofthe issuing nationConsequently they are virtually devoid ofcredit risk or the risk of defaultThe yield on such securities is a benchmarkfor setting rates on other kinds of debt
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Treasury securities are issuedTo finance expenses in excess of currentrevenuesTo pay interest on debt accumulated in earlieryears due to deficits in those yearsTo repay past debt issues that are currentlymaturing
The US Treasuries marketIs the largest bond market in the worldIs the most liquid bond market in the world
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The Treasury issues three categories ofmarketable securities
T-bills are discount securitiesThey are zero coupon securitiesT-notes and T-bonds are sold at face value andpay interest periodically
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T-bills are issued with a original time tomaturity of one year or less
They are Money market instrumentsThey have maturities of either 1 3 6 or 12months at the time of issue
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T-notes and T-bonds have a time to maturityexceeding one year at the time of issue
They are capital market instrumentsT-notes have maturities ranging from 1-10 yearsT-bonds have an original maturity in excess of 10years extending up to 30 years
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An issue may be followed later by a furtherissue
With the same remaining time to maturity andthe same couponThe issuance of further tranches is termed as aRe-opening
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Six months ago a 10-year note was issuedwith a coupon of 8 per annumToday if a note with 9 frac12 years to maturityand a coupon of 8 issued it will add to thepool that is already trading in the marketThus it is a re-opening of an existing issue
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Who is a primary dealerA PD is a dealer who is authorized to dealdirectly with the Central Bank of the countryIn the US a PD is a bank or securities broker-dealer that directly deals with the FRBNY
Importance of FRBNYIn India a PD deals directly with the RBI
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The Treasury sells bills notes and bonds byway of a competitive auction process
Most of the treasury securities are bought byprimary dealers
Individual investors submit non-competitive bidsand participate on a much smaller scale
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Bids may beCompetitive
Indicate price amp quantity or yield amp quantityNon-competitive
Indicate only quantity
Small investors and individualsgenerally submit non-competitive bids
A non-competitive bidder may not bid for more than$5MM worth of securities in a bill or bond auction
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Primary dealers bid for their accounts andon behalf of their clientsThey usually submit large competitive
bidsBids indicate the maximum price that the bidderis prepared to pay if it is a price based auctionOr the minimum yield that the bidder is
prepared to accept if it is a yield based auction
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The Treasury will net out the totalamount of non-competitive bids
The balance will be allocated to competitivebidders
There are two ways in which securitiescan be allotted
The multiple priceyield auction mechanism
French AuctionsThe uniform priceyield auction mechanism
Dutch Auctions
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Assume that the Treasury is offering 25billion dollars worth of T-bonds
2 billion dollars worth of non-competitive bidshave been receivedSo 23 billion dollars worth of bonds are availableto be offered to the competitive bidders
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There are six competitive bidders who havesubmitted the following yields
The bids have been arranged in ascending orderof yieldIn a price based auction the bids would havebeen arranged in descending order of price
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Bidder Bid Yield Bid Amount
Aggregate Amount
Alpha 5370 30 bn 30 bnBeta 5372 50 bn 80 bn
Gamma 5373 40 bn 12 bn
Delta 5375 80 bn 20 bnCharlie 5375 120 bn 32 bn
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The aggregate demand equals the amount onoffer at a yield of 5375A multiple yield auction will lead to thefollowing allocation
Alpha will get 3 bn at a yield of 5370Beta will get 5 bn at 5372Gamma will get 4 bn at 5373
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At a yield of 5375 we have only 11 bn left toallocateThere is a demand of 20 bn at this yield
8 bn from Delta and 12 bn from CharlieThus we will allocate 1120 = 55 to eachbidder at this yield
There will be pro-rata allocation
055 of 8 bn or 440 bn will go to Delta055 of 12 bn or 66 bn will go to Charlie
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The highest accepted yield is called the StopYield or High Yield
In this case it is 5375The ratio of bids received to the amountawarded is known as the bid to cover ratio
The higher the ratio the stronger is the auction
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Those who bid more than 5375 will getnothing and are said to be shutout of theauctionSince 1999 the US Treasury has beenconducting only uniform yield auctions
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WI stands for ndash When As and If IssuedThe when issued market is a market forforward trading of a bond
Which has been announced but not yet issuedTrades take place from the date ofannouncement until the actual issue date
Helps bidders to gauge the marketrsquos interestbefore the actual auction
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WI trading has ramifications for the biddingstrategies of market participantsTraders can take both long and shortpositions
Settlement is scheduled for the issue date
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It has a bearing on the outcome of theauction
It affects the strategy used by a bidder becauseit has an impact on his prior positionBidders who are long in the WI market enter theauction with a Long PositionThose who are short in the WI market enter theauction with a short position
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The WI market helps in price discoveryIt provides important information on
The strength of demand for the securityAnd on the disparity of biddersrsquo views
This help potential bidders to formulate theirstrategiesAt times a dealer may believe that he hasvery important private information
If so he may not participate in the WI market andwill directly enter the auction with bids based onhis knowledge
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On or before the date of the auction theissues trade on a yield basis
The actual price can be established only afterthe coupon is set
Starting with the day after the auctionSecurities are quoted on a price basis becausethe coupon is known
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In a coupon roll a dealer will purchase themost recently issued security from a clientAnd simultaneously sell the same amount ofthe recently announced new security
The first leg with settle on the following dayThe second leg is a forward contract
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There can be a Reverse RollThe dealer will sell the most recent issue fornext day settlementAnd buy the newly announced security forforward settlement
The forward leg in a RollReverse Roll is a WItrade
It will settle on the new issue settlement date
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The roll is the spread between the yield onthe new security and that on the outstandingissue in the same maturity segmentA GIVE in the Roll means that
The WI security provides a higher yield than theoutstanding issue
A Take in the Roll means thatThe WI security provides a lower yield
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On March 17 20XX the Treasury announcedthe auction of a 2-year note
The auction was scheduled for March 24The settlement date was March 31
Trading of the roll began as soon as the issuewas announcedA Give of 5 bp means that the dealer proposes tobuy the current issue at the prevailing yieldAnd sell the new issue at a yield that is 5 bpmoreA Take of 5 bp means that the dealer proposes tosell the new issue at a yield that is 5bp lower
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The roll achieves the followingHe acquires the outstanding issue for next daysettlementHe sells the to be issued security with the samepar value for forward delivery on 31 March
The customer is rolling over the investmentfrom the current issue to the new issue
This extends the maturity of the investment byone month
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The client can invest the funds received tillthe new issue settlesHowever he loses the accrued interest thathe would have earned had he held on to theissue
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The Treasury per se does not issue zerocoupon securitiesBut zero coupon securities can be created
which are backed by conventional bondsTake a large quantity of a T-note or bond andseparate all the cash flows from each otherSell the entitlement to each cash flowseparately
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Take the case of a two-year T-noteIt can be separated into five zero couponsecurities maturing after
6 months12 months18 months24 months
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Earlier investment banks used to buy bondsfrom the Treasury and separate the cashflows
Each cash flow was then sold separately as a zerocoupon bondSuch issues are called trademarks
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The issue of trademarks has now ceasedBecause investment banks can now createsuch instruments
In concert with the Treasury itselfThese ZCBs are known as STRIPS ndash
Separate Trading of Registered Interest andPrincipal of Securities
These are not issued or sold by the Treasury
The market is made by investment banks
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What is the motivation to create suchproductsIn practice arbitrage is possible when a
coupon security is purchased at a priceThat is lower than what could be obtained byselling each cash flow separately
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Coupon stripping reflects a case of financialengineering
Creating a risk-return profile that is nototherwise available
An investment bank would buy a largequantity of a Treasury security
The securities would be placed with an SPV
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The SPV is a single-purpose dedicated trustIt has the powers to own the bonds andcollect payments
It cannot sell or lend the bondsIt cannot write options on the bondsOr use them as collateral for borrowing
The SPV is empowered to issue zero coupon
bondsWhere each security represents the ownership ofa single cash flow from the mother bond
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Assume that 100MM USD of 15 year bondswith a coupon of 8 are placed with the SPV
The SPV can issue 6M 12M 18M extending up to14 frac12 year zeroes with a total face value of 4MM
USD eachAnd 15 year zeroes with a total face value of104MM
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The Treasury launched this program in 1985to facilitate the stripping of designatedsecurities
All new T-bonds and notes with a maturity of 10years or more are eligibleThe zeroes created in the process are directobligations of the US government
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The mechanism is as followsA dealer who owns a bond or note can ask theFRB where it is held
To replace it with an equivalent set of STRIPS
representing each payment as a separate securityEach of these securities can be traded independentlyof others
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In 1987 the Treasury started to allow dealersto reverse the process
This is called STRIPS RECONSTUTUTION If a dealer owns STRIPS representing all thecoupon and principal payments of a bond
The FED can on request convert these holdings into asingle position in the corresponding bond
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Each coupon and principal cash flow from aTreasury security is assigned a CUSIP
The mother bond is also assigned a CUSIPThe stripped coupons are known as C-STRIPSThe stripped principal is known as P-STRIPSSupply of a C-STRIP increases over time
because a C-STRIP maturing on a day like 15 FEB
2020 will have the same CUSIP irrespective ofwhich mother bond it has come fromThe original coupon rate is irrelevant
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P-STRIPS always correspond to the originalsecurityThey have a unique CUSIPTheir supply is fixed at the time of issuanceIn practice the prices of long-dated P-STRIPSare a bit higher than those of C-STRIPS withthe same maturity date
One reason is that P-STRIPS are more liquid due
to greater availabilityA $100 face value bond with a coupon of 8 willgenerate C-STRIPS with a face value of $4 but P-STRIPS with a face value of $100
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Another reason why P-STRIPS are in higherdemand is that they allow reconstitutionactivities more easily
Assume that the sum of the STRIPS is cheaper than
the mother bondIf a dealer already has the P-STRIPS only the C-STRIPSneed to be acquiredHowever if he owns some of the C-STRIPS he needs toacquire the P-STRIPS and the remaining C-STRIPSThe facility to reconstitute when profitable is pricedinto the P-STRIPSNote Buy and hold investors will prefer C-STRIPSsince they are priced lower and give a higher yield
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For Plain Vanilla bonds the specifiedcoupon rate is valid for the life of thebond
In the case of Floaters the rate is reset atthe beginning of every periodThe rate will vary directly with thebenchmark
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The rate on a Floater is specified as LIBOR+ 50 bp
The spread is positiveIf it were specified as LIBOR ndash 30bp
The spread will be negativeIf LIBOR rises the rate will increasewhereas if LIBOR falls it will decrease
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In the case of a default risk-free floater theprice will reset to par on a coupon date
It may sell at a premium or discount betweencoupon dates
Consider a floater with a coupon = 5-year T-Bond rate
Assume there are two periods left to maturity
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The price at the end of the first coupon period willbe given by
cT-1 is the coupon one period before maturityyT-1 is the YTM one period before maturity
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On a coupon reset date the YTM = couponBecause we have assumed there is no default riskAny change in the required yield as reflected inthe prevailing YTM
Will also be reflected in the coupon being setIf coupon = yield the bond should sell at par
Thus P T-1 = M
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Once again at T-2 c T-2 = yT-2 and P T-2 = MThis logic can be applied to a bond with anytime remaining till maturityHowever between two coupon dates theprice may not be equal to par
Consider the valuation at T-2+k
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Although c T-2 was set at T-2 and is equal toyT-2
yT-2+k is determined at T-2+k and will reflect theyield prevailing at that time
Thus yT-2+k need not equal c T-2 and may behigher or lower
Hence between two coupon dates a floater maysell at a premium or discount
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Now consider a floater characterized bydefault risk
The risk premium required by the market neednot be constant over time
Assume that at the time of issue YTM = 5-year T-note rate + 75bp
The coupon would have been set equal to thisrate and the bond would have been issued at par
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Six months hence the issue may be perceivedas more risky
YTM = 5-year T-note rate + 95 bpThe coupon will however be set equal to theprevailing 5-year rate + 75 bpIf so the issue will not reset to par at the nextcoupon date
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Floaters may come with a CAP or a FLOOR orBOTH
The CAP is a maximum coupon rateProtects issuers against rising rates
The FLOOR is a minimum coupon rateProtects investors against falling rates
When there is a spread over LIBORThere is a natural floorLIBOR cannot be less than zero
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Difference between debt and equityDebt does not confer ownership rightsIt is merely an IOU
A promise to pay interest at periodic intervalsAnd to repay the principal at a pre-specified maturitydate
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It usually has a finite life spanPerpetual debt is rare
The interest payments are contractualobligations
Borrowers are required to make payments irrespectiveof their financial performance
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Interest payments to be made before anydividends for equity holders
In the event of liquidationThe claims of debt holders must be settled firstOnly then can equity holders be paid
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Bonds and debentures are termed as FixedIncome Securities
Once the rate of interest is set at the onset ofthe period for which it is due
It is not a function of the profitability of the firmFailure to pay the promised interest willtantamount to default
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Bonds may be secured or unsecuredUnsecured debt securities are termed asDebentures in the USUnsecured means no specific assets have beenearmarked as collateralSecured debt requires the firm to earmarkspecific assets as collateralSecured debt holders enjoy priority from thestandpoint of payments
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Debt securities may be negotiable or non-negotiable
Negotiable securities can be traded in thesecondary market
Can be endorsed by one party in favor of anotherExamples of non-negotiable debt securities
National savings certificatesConventional Time or Fixed deposits
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The most basic form of a bond is called thePlain Vanilla version
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This is true for all securities not just for bondsMore complicated versions are said to have`Bells and Whistlesrsquo attached
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These bonds are slightly differentThe interest rate does not remain fixedIt varies each period based on the reference rate
Short-term reference rate ndash maturity lt 1 yearFloating rate bonds
Longer-term reference rateVariable or adjustable rate bonds
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Convertible bonds can be converted to sharesof stockCallable bonds can be prematurely retired by
the issuerPutable bonds can be prematurelysurrendered by the holders
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It is the principal valueAmount payable by the borrower to the lastholder at maturityAmount on which the periodic interest paymentsare calculatedAKA as
Par ValueRedemption Value Maturity ValuePrincipal Value
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It is the time remaining in the life of thebond
The length of time for which interest has to bepaid as promisedThe the length of time after which the face valuewill be repaidAKA as
MaturityTermTenor
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The periodic interest payment that has to bemade by the borrower
The coupon rate multiplied by the face valuegives the rupeedollar value of the coupon
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Most bonds pays coupons on a semi-annual basisTrue in UKUSAustraliaJapanIn European and Eurobond markets annualpayments are the norm
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In earlier days bonds were accompanied by abooklet of post-dated coupons
Each coupon could be detached and redeemedon the corresponding coupon payment date
Even today bearer bonds come with couponsThe bearer certificate number is mentioned onthe coupon
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Bond with a face value of $1000The coupon rate is 8 per annum paid semi-annually
So the bond holder will receive1000 x 008
___ = $40 every six months2
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The rate of return if an investor buys thebond at the prevailing price and holds ittill maturity
In order to get the YTM two conditionsmust be satisfied
The bond must be held till maturity All coupon payments received before maturitymust be reinvested at the YTM
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At any point in time the YTM may beGreater thanLess than or
Equal to the Coupon RateYTM is the IRR of a bond
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Bonds involve pure cash flowsSo only ONE REAL POSITIVE YTM
Solution to a Non-Linear equation
Solved iteratively
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A holder gets a stream of contractuallypromised payments
The value of the bond is the value of this stream
of cash flowsCash flows arising at different points in timecannot be addedCash flows have to be discounted
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It is a chicken and egg storyIf we know the yield that is required we canquote a priceOnce we acquire the asset at a certain price we
can work out the corresponding yield
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A bond will pay identical coupons everyperiodAnd will repay the face value at maturity
The periodic cash flows constitutean annuity The terminal face value is a lump
sum payment
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Bond pays a semi-annual coupon of $C2and has a face value of $MAssume there are N coupons left
And that we are standing on a coupondate
We are assuming that the next coupon is exactlysix months away
The required annual yield is yImplies that the semi-annual yield is y2
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The present value of the coupon stream is
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The present value of the face value is
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So the price of the bond is
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IBM has issued a bond with a face value of$1000The coupon is 8 per year to be paid on July
15 and January 15 every yearToday is 15 July 2013 and that the bondmatures on 15 January 2033The required yield is 10 per annum
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JJ ndash 0115FA ndash 0115MS ndash 0115
AO ndash 0115MN ndash 0115JD ndash 0115
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In the example the price is less than theface value
Such a bond is called a Discount Bond
It is trading at a discount from the face valueThe reason is that
The yield is greater than the coupon
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If the yield were to equal the couponThe bond would sell at PARSuch bonds are called PAR Bonds
If the yield is less than the couponThe price will exceed the face valueSuch bonds are called Premium Bonds
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As we move from one coupon date to thenext if the YTM were to remain constant
Par bonds would continue to trade at PARPremium bonds will steadily decline in priceDiscount bonds will steadily increase in price
This is called the Pull to Par EffectAt maturity ndash ALL BONDS WILL TRADE AT PAR
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As we approach maturity the number ofcoupons reduces
The contribution of coupons to price reducesThe contribution of the PV of the face valueincreases
For premium bonds the first effect dominatesThus the price steadily declines
For discount bonds the second effectdominatesThus the price steadily increases
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A plain vanilla or Bullet Bond pays the entireface value at maturity in a lump sumAmortizing bonds pay the principal in
installmentsThe first payment occurs before maturityThe last payment is made at maturity
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Consider a 5 year amortizing bond with aface value of $1000 and an annual coupon of8
The annual cash flows are depicted below
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Time Cash Flow
1 802 803 3304 3105 540
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The first two cash flows represent interest ona principal of $1000The third cash flow is interest on $1000 plus
a principal payment of $250The outstanding principal is $750The fourth cash flow is interest on $750 plusa principal payment of $250
The outstanding principal is $500The final cash flow is interest on $500 plusthe remaining principal of $500
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Some companies issue such bonds becausethe assets being funded have a similar cashflow profile
Second the coupon on such a bond may belower than that of a bullet bondIn the case of a bullet bond the entire principalis due at a single point in timeThere is greater default risk
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Microsoft is issuing zeroes with 5 years tomaturity and a face value of $10000
The required yield is 10 per annumWhat should be the price
Price is the PV of the face valueIn practice we discount on a semi-annual basis
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This is to facilitate comparisons withconventional bonds
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A zero coupon bond can never sell at apremium
It will always trade at a discount prior tomaturityAt maturity it will trade at par
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If held to maturity a ZCB will always give riseto a capital gainIf sold prior to maturity there may be a
capital gain or a capital lossConsider a bond with 10 years to maturityThe YTM at the time of purchase was 10The cost was $37690
A year later it is sold at a YTM of 12The corresponding price is $35035
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A newly established issuerOr an issuer with a relatively virgin productor service
Or a restructured company due to a mergeror following a bankruptcyWill be perceived as more riskyInvestors will demand a high coupon
Such firms are unlikely to have high earningsRevenues will peak only after theproductservice is established
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They can ill afford high couponsThey may consider a step-up coupon bond
Where the coupon increases as the bond ages
Assume a company can issue a plain vanillaat a coupon of 8 with a maturity of 5 yearsInstead it may opt for a bond
With a coupon of 6 for the first three years
And a coupon of 10 for the last two yearsThis is a Deferred Interest Security
Provides the issuer with breathing room in theearlier years
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These pay coupons in the form of additionalsecurities and not cash
This offers the issuer time to prepare for cashoutlays
They are used as Mezzanine FinanceThey rank between senior debt and equity in thecapital structureInvestors take more risk as compared to buyersof regular bonds ndash but get higher returnsIssuers can conserve cash in earlier years when itis at a premium
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Fully backed by the federal government ofthe issuing nationConsequently they are virtually devoid ofcredit risk or the risk of defaultThe yield on such securities is a benchmarkfor setting rates on other kinds of debt
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Treasury securities are issuedTo finance expenses in excess of currentrevenuesTo pay interest on debt accumulated in earlieryears due to deficits in those yearsTo repay past debt issues that are currentlymaturing
The US Treasuries marketIs the largest bond market in the worldIs the most liquid bond market in the world
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The Treasury issues three categories ofmarketable securities
T-bills are discount securitiesThey are zero coupon securitiesT-notes and T-bonds are sold at face value andpay interest periodically
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T-bills are issued with a original time tomaturity of one year or less
They are Money market instrumentsThey have maturities of either 1 3 6 or 12months at the time of issue
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T-notes and T-bonds have a time to maturityexceeding one year at the time of issue
They are capital market instrumentsT-notes have maturities ranging from 1-10 yearsT-bonds have an original maturity in excess of 10years extending up to 30 years
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An issue may be followed later by a furtherissue
With the same remaining time to maturity andthe same couponThe issuance of further tranches is termed as aRe-opening
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Six months ago a 10-year note was issuedwith a coupon of 8 per annumToday if a note with 9 frac12 years to maturityand a coupon of 8 issued it will add to thepool that is already trading in the marketThus it is a re-opening of an existing issue
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Who is a primary dealerA PD is a dealer who is authorized to dealdirectly with the Central Bank of the countryIn the US a PD is a bank or securities broker-dealer that directly deals with the FRBNY
Importance of FRBNYIn India a PD deals directly with the RBI
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The Treasury sells bills notes and bonds byway of a competitive auction process
Most of the treasury securities are bought byprimary dealers
Individual investors submit non-competitive bidsand participate on a much smaller scale
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Bids may beCompetitive
Indicate price amp quantity or yield amp quantityNon-competitive
Indicate only quantity
Small investors and individualsgenerally submit non-competitive bids
A non-competitive bidder may not bid for more than$5MM worth of securities in a bill or bond auction
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Primary dealers bid for their accounts andon behalf of their clientsThey usually submit large competitive
bidsBids indicate the maximum price that the bidderis prepared to pay if it is a price based auctionOr the minimum yield that the bidder is
prepared to accept if it is a yield based auction
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The Treasury will net out the totalamount of non-competitive bids
The balance will be allocated to competitivebidders
There are two ways in which securitiescan be allotted
The multiple priceyield auction mechanism
French AuctionsThe uniform priceyield auction mechanism
Dutch Auctions
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Assume that the Treasury is offering 25billion dollars worth of T-bonds
2 billion dollars worth of non-competitive bidshave been receivedSo 23 billion dollars worth of bonds are availableto be offered to the competitive bidders
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There are six competitive bidders who havesubmitted the following yields
The bids have been arranged in ascending orderof yieldIn a price based auction the bids would havebeen arranged in descending order of price
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Bidder Bid Yield Bid Amount
Aggregate Amount
Alpha 5370 30 bn 30 bnBeta 5372 50 bn 80 bn
Gamma 5373 40 bn 12 bn
Delta 5375 80 bn 20 bnCharlie 5375 120 bn 32 bn
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The aggregate demand equals the amount onoffer at a yield of 5375A multiple yield auction will lead to thefollowing allocation
Alpha will get 3 bn at a yield of 5370Beta will get 5 bn at 5372Gamma will get 4 bn at 5373
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At a yield of 5375 we have only 11 bn left toallocateThere is a demand of 20 bn at this yield
8 bn from Delta and 12 bn from CharlieThus we will allocate 1120 = 55 to eachbidder at this yield
There will be pro-rata allocation
055 of 8 bn or 440 bn will go to Delta055 of 12 bn or 66 bn will go to Charlie
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The highest accepted yield is called the StopYield or High Yield
In this case it is 5375The ratio of bids received to the amountawarded is known as the bid to cover ratio
The higher the ratio the stronger is the auction
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Those who bid more than 5375 will getnothing and are said to be shutout of theauctionSince 1999 the US Treasury has beenconducting only uniform yield auctions
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WI stands for ndash When As and If IssuedThe when issued market is a market forforward trading of a bond
Which has been announced but not yet issuedTrades take place from the date ofannouncement until the actual issue date
Helps bidders to gauge the marketrsquos interestbefore the actual auction
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WI trading has ramifications for the biddingstrategies of market participantsTraders can take both long and shortpositions
Settlement is scheduled for the issue date
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It has a bearing on the outcome of theauction
It affects the strategy used by a bidder becauseit has an impact on his prior positionBidders who are long in the WI market enter theauction with a Long PositionThose who are short in the WI market enter theauction with a short position
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The WI market helps in price discoveryIt provides important information on
The strength of demand for the securityAnd on the disparity of biddersrsquo views
This help potential bidders to formulate theirstrategiesAt times a dealer may believe that he hasvery important private information
If so he may not participate in the WI market andwill directly enter the auction with bids based onhis knowledge
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On or before the date of the auction theissues trade on a yield basis
The actual price can be established only afterthe coupon is set
Starting with the day after the auctionSecurities are quoted on a price basis becausethe coupon is known
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In a coupon roll a dealer will purchase themost recently issued security from a clientAnd simultaneously sell the same amount ofthe recently announced new security
The first leg with settle on the following dayThe second leg is a forward contract
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There can be a Reverse RollThe dealer will sell the most recent issue fornext day settlementAnd buy the newly announced security forforward settlement
The forward leg in a RollReverse Roll is a WItrade
It will settle on the new issue settlement date
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The roll is the spread between the yield onthe new security and that on the outstandingissue in the same maturity segmentA GIVE in the Roll means that
The WI security provides a higher yield than theoutstanding issue
A Take in the Roll means thatThe WI security provides a lower yield
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On March 17 20XX the Treasury announcedthe auction of a 2-year note
The auction was scheduled for March 24The settlement date was March 31
Trading of the roll began as soon as the issuewas announcedA Give of 5 bp means that the dealer proposes tobuy the current issue at the prevailing yieldAnd sell the new issue at a yield that is 5 bpmoreA Take of 5 bp means that the dealer proposes tosell the new issue at a yield that is 5bp lower
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The roll achieves the followingHe acquires the outstanding issue for next daysettlementHe sells the to be issued security with the samepar value for forward delivery on 31 March
The customer is rolling over the investmentfrom the current issue to the new issue
This extends the maturity of the investment byone month
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The client can invest the funds received tillthe new issue settlesHowever he loses the accrued interest thathe would have earned had he held on to theissue
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The Treasury per se does not issue zerocoupon securitiesBut zero coupon securities can be created
which are backed by conventional bondsTake a large quantity of a T-note or bond andseparate all the cash flows from each otherSell the entitlement to each cash flowseparately
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Take the case of a two-year T-noteIt can be separated into five zero couponsecurities maturing after
6 months12 months18 months24 months
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Earlier investment banks used to buy bondsfrom the Treasury and separate the cashflows
Each cash flow was then sold separately as a zerocoupon bondSuch issues are called trademarks
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The issue of trademarks has now ceasedBecause investment banks can now createsuch instruments
In concert with the Treasury itselfThese ZCBs are known as STRIPS ndash
Separate Trading of Registered Interest andPrincipal of Securities
These are not issued or sold by the Treasury
The market is made by investment banks
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What is the motivation to create suchproductsIn practice arbitrage is possible when a
coupon security is purchased at a priceThat is lower than what could be obtained byselling each cash flow separately
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Coupon stripping reflects a case of financialengineering
Creating a risk-return profile that is nototherwise available
An investment bank would buy a largequantity of a Treasury security
The securities would be placed with an SPV
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The SPV is a single-purpose dedicated trustIt has the powers to own the bonds andcollect payments
It cannot sell or lend the bondsIt cannot write options on the bondsOr use them as collateral for borrowing
The SPV is empowered to issue zero coupon
bondsWhere each security represents the ownership ofa single cash flow from the mother bond
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Assume that 100MM USD of 15 year bondswith a coupon of 8 are placed with the SPV
The SPV can issue 6M 12M 18M extending up to14 frac12 year zeroes with a total face value of 4MM
USD eachAnd 15 year zeroes with a total face value of104MM
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The Treasury launched this program in 1985to facilitate the stripping of designatedsecurities
All new T-bonds and notes with a maturity of 10years or more are eligibleThe zeroes created in the process are directobligations of the US government
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The mechanism is as followsA dealer who owns a bond or note can ask theFRB where it is held
To replace it with an equivalent set of STRIPS
representing each payment as a separate securityEach of these securities can be traded independentlyof others
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In 1987 the Treasury started to allow dealersto reverse the process
This is called STRIPS RECONSTUTUTION If a dealer owns STRIPS representing all thecoupon and principal payments of a bond
The FED can on request convert these holdings into asingle position in the corresponding bond
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Each coupon and principal cash flow from aTreasury security is assigned a CUSIP
The mother bond is also assigned a CUSIPThe stripped coupons are known as C-STRIPSThe stripped principal is known as P-STRIPSSupply of a C-STRIP increases over time
because a C-STRIP maturing on a day like 15 FEB
2020 will have the same CUSIP irrespective ofwhich mother bond it has come fromThe original coupon rate is irrelevant
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P-STRIPS always correspond to the originalsecurityThey have a unique CUSIPTheir supply is fixed at the time of issuanceIn practice the prices of long-dated P-STRIPSare a bit higher than those of C-STRIPS withthe same maturity date
One reason is that P-STRIPS are more liquid due
to greater availabilityA $100 face value bond with a coupon of 8 willgenerate C-STRIPS with a face value of $4 but P-STRIPS with a face value of $100
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Another reason why P-STRIPS are in higherdemand is that they allow reconstitutionactivities more easily
Assume that the sum of the STRIPS is cheaper than
the mother bondIf a dealer already has the P-STRIPS only the C-STRIPSneed to be acquiredHowever if he owns some of the C-STRIPS he needs toacquire the P-STRIPS and the remaining C-STRIPSThe facility to reconstitute when profitable is pricedinto the P-STRIPSNote Buy and hold investors will prefer C-STRIPSsince they are priced lower and give a higher yield
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For Plain Vanilla bonds the specifiedcoupon rate is valid for the life of thebond
In the case of Floaters the rate is reset atthe beginning of every periodThe rate will vary directly with thebenchmark
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The rate on a Floater is specified as LIBOR+ 50 bp
The spread is positiveIf it were specified as LIBOR ndash 30bp
The spread will be negativeIf LIBOR rises the rate will increasewhereas if LIBOR falls it will decrease
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In the case of a default risk-free floater theprice will reset to par on a coupon date
It may sell at a premium or discount betweencoupon dates
Consider a floater with a coupon = 5-year T-Bond rate
Assume there are two periods left to maturity
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The price at the end of the first coupon period willbe given by
cT-1 is the coupon one period before maturityyT-1 is the YTM one period before maturity
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On a coupon reset date the YTM = couponBecause we have assumed there is no default riskAny change in the required yield as reflected inthe prevailing YTM
Will also be reflected in the coupon being setIf coupon = yield the bond should sell at par
Thus P T-1 = M
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Once again at T-2 c T-2 = yT-2 and P T-2 = MThis logic can be applied to a bond with anytime remaining till maturityHowever between two coupon dates theprice may not be equal to par
Consider the valuation at T-2+k
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Although c T-2 was set at T-2 and is equal toyT-2
yT-2+k is determined at T-2+k and will reflect theyield prevailing at that time
Thus yT-2+k need not equal c T-2 and may behigher or lower
Hence between two coupon dates a floater maysell at a premium or discount
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Now consider a floater characterized bydefault risk
The risk premium required by the market neednot be constant over time
Assume that at the time of issue YTM = 5-year T-note rate + 75bp
The coupon would have been set equal to thisrate and the bond would have been issued at par
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Six months hence the issue may be perceivedas more risky
YTM = 5-year T-note rate + 95 bpThe coupon will however be set equal to theprevailing 5-year rate + 75 bpIf so the issue will not reset to par at the nextcoupon date
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Floaters may come with a CAP or a FLOOR orBOTH
The CAP is a maximum coupon rateProtects issuers against rising rates
The FLOOR is a minimum coupon rateProtects investors against falling rates
When there is a spread over LIBORThere is a natural floorLIBOR cannot be less than zero
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It usually has a finite life spanPerpetual debt is rare
The interest payments are contractualobligations
Borrowers are required to make payments irrespectiveof their financial performance
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Interest payments to be made before anydividends for equity holders
In the event of liquidationThe claims of debt holders must be settled firstOnly then can equity holders be paid
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Bonds and debentures are termed as FixedIncome Securities
Once the rate of interest is set at the onset ofthe period for which it is due
It is not a function of the profitability of the firmFailure to pay the promised interest willtantamount to default
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Bonds may be secured or unsecuredUnsecured debt securities are termed asDebentures in the USUnsecured means no specific assets have beenearmarked as collateralSecured debt requires the firm to earmarkspecific assets as collateralSecured debt holders enjoy priority from thestandpoint of payments
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Debt securities may be negotiable or non-negotiable
Negotiable securities can be traded in thesecondary market
Can be endorsed by one party in favor of anotherExamples of non-negotiable debt securities
National savings certificatesConventional Time or Fixed deposits
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The most basic form of a bond is called thePlain Vanilla version
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This is true for all securities not just for bondsMore complicated versions are said to have`Bells and Whistlesrsquo attached
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These bonds are slightly differentThe interest rate does not remain fixedIt varies each period based on the reference rate
Short-term reference rate ndash maturity lt 1 yearFloating rate bonds
Longer-term reference rateVariable or adjustable rate bonds
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Convertible bonds can be converted to sharesof stockCallable bonds can be prematurely retired by
the issuerPutable bonds can be prematurelysurrendered by the holders
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It is the principal valueAmount payable by the borrower to the lastholder at maturityAmount on which the periodic interest paymentsare calculatedAKA as
Par ValueRedemption Value Maturity ValuePrincipal Value
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It is the time remaining in the life of thebond
The length of time for which interest has to bepaid as promisedThe the length of time after which the face valuewill be repaidAKA as
MaturityTermTenor
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The periodic interest payment that has to bemade by the borrower
The coupon rate multiplied by the face valuegives the rupeedollar value of the coupon
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Most bonds pays coupons on a semi-annual basisTrue in UKUSAustraliaJapanIn European and Eurobond markets annualpayments are the norm
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In earlier days bonds were accompanied by abooklet of post-dated coupons
Each coupon could be detached and redeemedon the corresponding coupon payment date
Even today bearer bonds come with couponsThe bearer certificate number is mentioned onthe coupon
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Bond with a face value of $1000The coupon rate is 8 per annum paid semi-annually
So the bond holder will receive1000 x 008
___ = $40 every six months2
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The rate of return if an investor buys thebond at the prevailing price and holds ittill maturity
In order to get the YTM two conditionsmust be satisfied
The bond must be held till maturity All coupon payments received before maturitymust be reinvested at the YTM
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At any point in time the YTM may beGreater thanLess than or
Equal to the Coupon RateYTM is the IRR of a bond
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Bonds involve pure cash flowsSo only ONE REAL POSITIVE YTM
Solution to a Non-Linear equation
Solved iteratively
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A holder gets a stream of contractuallypromised payments
The value of the bond is the value of this stream
of cash flowsCash flows arising at different points in timecannot be addedCash flows have to be discounted
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It is a chicken and egg storyIf we know the yield that is required we canquote a priceOnce we acquire the asset at a certain price we
can work out the corresponding yield
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A bond will pay identical coupons everyperiodAnd will repay the face value at maturity
The periodic cash flows constitutean annuity The terminal face value is a lump
sum payment
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Bond pays a semi-annual coupon of $C2and has a face value of $MAssume there are N coupons left
And that we are standing on a coupondate
We are assuming that the next coupon is exactlysix months away
The required annual yield is yImplies that the semi-annual yield is y2
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The present value of the coupon stream is
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The present value of the face value is
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So the price of the bond is
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IBM has issued a bond with a face value of$1000The coupon is 8 per year to be paid on July
15 and January 15 every yearToday is 15 July 2013 and that the bondmatures on 15 January 2033The required yield is 10 per annum
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JJ ndash 0115FA ndash 0115MS ndash 0115
AO ndash 0115MN ndash 0115JD ndash 0115
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In the example the price is less than theface value
Such a bond is called a Discount Bond
It is trading at a discount from the face valueThe reason is that
The yield is greater than the coupon
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If the yield were to equal the couponThe bond would sell at PARSuch bonds are called PAR Bonds
If the yield is less than the couponThe price will exceed the face valueSuch bonds are called Premium Bonds
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As we move from one coupon date to thenext if the YTM were to remain constant
Par bonds would continue to trade at PARPremium bonds will steadily decline in priceDiscount bonds will steadily increase in price
This is called the Pull to Par EffectAt maturity ndash ALL BONDS WILL TRADE AT PAR
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As we approach maturity the number ofcoupons reduces
The contribution of coupons to price reducesThe contribution of the PV of the face valueincreases
For premium bonds the first effect dominatesThus the price steadily declines
For discount bonds the second effectdominatesThus the price steadily increases
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A plain vanilla or Bullet Bond pays the entireface value at maturity in a lump sumAmortizing bonds pay the principal in
installmentsThe first payment occurs before maturityThe last payment is made at maturity
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Consider a 5 year amortizing bond with aface value of $1000 and an annual coupon of8
The annual cash flows are depicted below
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Time Cash Flow
1 802 803 3304 3105 540
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The first two cash flows represent interest ona principal of $1000The third cash flow is interest on $1000 plus
a principal payment of $250The outstanding principal is $750The fourth cash flow is interest on $750 plusa principal payment of $250
The outstanding principal is $500The final cash flow is interest on $500 plusthe remaining principal of $500
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Some companies issue such bonds becausethe assets being funded have a similar cashflow profile
Second the coupon on such a bond may belower than that of a bullet bondIn the case of a bullet bond the entire principalis due at a single point in timeThere is greater default risk
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Microsoft is issuing zeroes with 5 years tomaturity and a face value of $10000
The required yield is 10 per annumWhat should be the price
Price is the PV of the face valueIn practice we discount on a semi-annual basis
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This is to facilitate comparisons withconventional bonds
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A zero coupon bond can never sell at apremium
It will always trade at a discount prior tomaturityAt maturity it will trade at par
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If held to maturity a ZCB will always give riseto a capital gainIf sold prior to maturity there may be a
capital gain or a capital lossConsider a bond with 10 years to maturityThe YTM at the time of purchase was 10The cost was $37690
A year later it is sold at a YTM of 12The corresponding price is $35035
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A newly established issuerOr an issuer with a relatively virgin productor service
Or a restructured company due to a mergeror following a bankruptcyWill be perceived as more riskyInvestors will demand a high coupon
Such firms are unlikely to have high earningsRevenues will peak only after theproductservice is established
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They can ill afford high couponsThey may consider a step-up coupon bond
Where the coupon increases as the bond ages
Assume a company can issue a plain vanillaat a coupon of 8 with a maturity of 5 yearsInstead it may opt for a bond
With a coupon of 6 for the first three years
And a coupon of 10 for the last two yearsThis is a Deferred Interest Security
Provides the issuer with breathing room in theearlier years
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These pay coupons in the form of additionalsecurities and not cash
This offers the issuer time to prepare for cashoutlays
They are used as Mezzanine FinanceThey rank between senior debt and equity in thecapital structureInvestors take more risk as compared to buyersof regular bonds ndash but get higher returnsIssuers can conserve cash in earlier years when itis at a premium
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Fully backed by the federal government ofthe issuing nationConsequently they are virtually devoid ofcredit risk or the risk of defaultThe yield on such securities is a benchmarkfor setting rates on other kinds of debt
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Treasury securities are issuedTo finance expenses in excess of currentrevenuesTo pay interest on debt accumulated in earlieryears due to deficits in those yearsTo repay past debt issues that are currentlymaturing
The US Treasuries marketIs the largest bond market in the worldIs the most liquid bond market in the world
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The Treasury issues three categories ofmarketable securities
T-bills are discount securitiesThey are zero coupon securitiesT-notes and T-bonds are sold at face value andpay interest periodically
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T-bills are issued with a original time tomaturity of one year or less
They are Money market instrumentsThey have maturities of either 1 3 6 or 12months at the time of issue
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T-notes and T-bonds have a time to maturityexceeding one year at the time of issue
They are capital market instrumentsT-notes have maturities ranging from 1-10 yearsT-bonds have an original maturity in excess of 10years extending up to 30 years
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An issue may be followed later by a furtherissue
With the same remaining time to maturity andthe same couponThe issuance of further tranches is termed as aRe-opening
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Six months ago a 10-year note was issuedwith a coupon of 8 per annumToday if a note with 9 frac12 years to maturityand a coupon of 8 issued it will add to thepool that is already trading in the marketThus it is a re-opening of an existing issue
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Who is a primary dealerA PD is a dealer who is authorized to dealdirectly with the Central Bank of the countryIn the US a PD is a bank or securities broker-dealer that directly deals with the FRBNY
Importance of FRBNYIn India a PD deals directly with the RBI
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The Treasury sells bills notes and bonds byway of a competitive auction process
Most of the treasury securities are bought byprimary dealers
Individual investors submit non-competitive bidsand participate on a much smaller scale
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Bids may beCompetitive
Indicate price amp quantity or yield amp quantityNon-competitive
Indicate only quantity
Small investors and individualsgenerally submit non-competitive bids
A non-competitive bidder may not bid for more than$5MM worth of securities in a bill or bond auction
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Primary dealers bid for their accounts andon behalf of their clientsThey usually submit large competitive
bidsBids indicate the maximum price that the bidderis prepared to pay if it is a price based auctionOr the minimum yield that the bidder is
prepared to accept if it is a yield based auction
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The Treasury will net out the totalamount of non-competitive bids
The balance will be allocated to competitivebidders
There are two ways in which securitiescan be allotted
The multiple priceyield auction mechanism
French AuctionsThe uniform priceyield auction mechanism
Dutch Auctions
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Assume that the Treasury is offering 25billion dollars worth of T-bonds
2 billion dollars worth of non-competitive bidshave been receivedSo 23 billion dollars worth of bonds are availableto be offered to the competitive bidders
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There are six competitive bidders who havesubmitted the following yields
The bids have been arranged in ascending orderof yieldIn a price based auction the bids would havebeen arranged in descending order of price
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Bidder Bid Yield Bid Amount
Aggregate Amount
Alpha 5370 30 bn 30 bnBeta 5372 50 bn 80 bn
Gamma 5373 40 bn 12 bn
Delta 5375 80 bn 20 bnCharlie 5375 120 bn 32 bn
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The aggregate demand equals the amount onoffer at a yield of 5375A multiple yield auction will lead to thefollowing allocation
Alpha will get 3 bn at a yield of 5370Beta will get 5 bn at 5372Gamma will get 4 bn at 5373
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At a yield of 5375 we have only 11 bn left toallocateThere is a demand of 20 bn at this yield
8 bn from Delta and 12 bn from CharlieThus we will allocate 1120 = 55 to eachbidder at this yield
There will be pro-rata allocation
055 of 8 bn or 440 bn will go to Delta055 of 12 bn or 66 bn will go to Charlie
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The highest accepted yield is called the StopYield or High Yield
In this case it is 5375The ratio of bids received to the amountawarded is known as the bid to cover ratio
The higher the ratio the stronger is the auction
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Those who bid more than 5375 will getnothing and are said to be shutout of theauctionSince 1999 the US Treasury has beenconducting only uniform yield auctions
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WI stands for ndash When As and If IssuedThe when issued market is a market forforward trading of a bond
Which has been announced but not yet issuedTrades take place from the date ofannouncement until the actual issue date
Helps bidders to gauge the marketrsquos interestbefore the actual auction
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WI trading has ramifications for the biddingstrategies of market participantsTraders can take both long and shortpositions
Settlement is scheduled for the issue date
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It has a bearing on the outcome of theauction
It affects the strategy used by a bidder becauseit has an impact on his prior positionBidders who are long in the WI market enter theauction with a Long PositionThose who are short in the WI market enter theauction with a short position
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The WI market helps in price discoveryIt provides important information on
The strength of demand for the securityAnd on the disparity of biddersrsquo views
This help potential bidders to formulate theirstrategiesAt times a dealer may believe that he hasvery important private information
If so he may not participate in the WI market andwill directly enter the auction with bids based onhis knowledge
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On or before the date of the auction theissues trade on a yield basis
The actual price can be established only afterthe coupon is set
Starting with the day after the auctionSecurities are quoted on a price basis becausethe coupon is known
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In a coupon roll a dealer will purchase themost recently issued security from a clientAnd simultaneously sell the same amount ofthe recently announced new security
The first leg with settle on the following dayThe second leg is a forward contract
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There can be a Reverse RollThe dealer will sell the most recent issue fornext day settlementAnd buy the newly announced security forforward settlement
The forward leg in a RollReverse Roll is a WItrade
It will settle on the new issue settlement date
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The roll is the spread between the yield onthe new security and that on the outstandingissue in the same maturity segmentA GIVE in the Roll means that
The WI security provides a higher yield than theoutstanding issue
A Take in the Roll means thatThe WI security provides a lower yield
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On March 17 20XX the Treasury announcedthe auction of a 2-year note
The auction was scheduled for March 24The settlement date was March 31
Trading of the roll began as soon as the issuewas announcedA Give of 5 bp means that the dealer proposes tobuy the current issue at the prevailing yieldAnd sell the new issue at a yield that is 5 bpmoreA Take of 5 bp means that the dealer proposes tosell the new issue at a yield that is 5bp lower
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The roll achieves the followingHe acquires the outstanding issue for next daysettlementHe sells the to be issued security with the samepar value for forward delivery on 31 March
The customer is rolling over the investmentfrom the current issue to the new issue
This extends the maturity of the investment byone month
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The client can invest the funds received tillthe new issue settlesHowever he loses the accrued interest thathe would have earned had he held on to theissue
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The Treasury per se does not issue zerocoupon securitiesBut zero coupon securities can be created
which are backed by conventional bondsTake a large quantity of a T-note or bond andseparate all the cash flows from each otherSell the entitlement to each cash flowseparately
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Take the case of a two-year T-noteIt can be separated into five zero couponsecurities maturing after
6 months12 months18 months24 months
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Earlier investment banks used to buy bondsfrom the Treasury and separate the cashflows
Each cash flow was then sold separately as a zerocoupon bondSuch issues are called trademarks
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The issue of trademarks has now ceasedBecause investment banks can now createsuch instruments
In concert with the Treasury itselfThese ZCBs are known as STRIPS ndash
Separate Trading of Registered Interest andPrincipal of Securities
These are not issued or sold by the Treasury
The market is made by investment banks
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What is the motivation to create suchproductsIn practice arbitrage is possible when a
coupon security is purchased at a priceThat is lower than what could be obtained byselling each cash flow separately
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Coupon stripping reflects a case of financialengineering
Creating a risk-return profile that is nototherwise available
An investment bank would buy a largequantity of a Treasury security
The securities would be placed with an SPV
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The SPV is a single-purpose dedicated trustIt has the powers to own the bonds andcollect payments
It cannot sell or lend the bondsIt cannot write options on the bondsOr use them as collateral for borrowing
The SPV is empowered to issue zero coupon
bondsWhere each security represents the ownership ofa single cash flow from the mother bond
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Assume that 100MM USD of 15 year bondswith a coupon of 8 are placed with the SPV
The SPV can issue 6M 12M 18M extending up to14 frac12 year zeroes with a total face value of 4MM
USD eachAnd 15 year zeroes with a total face value of104MM
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The Treasury launched this program in 1985to facilitate the stripping of designatedsecurities
All new T-bonds and notes with a maturity of 10years or more are eligibleThe zeroes created in the process are directobligations of the US government
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The mechanism is as followsA dealer who owns a bond or note can ask theFRB where it is held
To replace it with an equivalent set of STRIPS
representing each payment as a separate securityEach of these securities can be traded independentlyof others
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In 1987 the Treasury started to allow dealersto reverse the process
This is called STRIPS RECONSTUTUTION If a dealer owns STRIPS representing all thecoupon and principal payments of a bond
The FED can on request convert these holdings into asingle position in the corresponding bond
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Each coupon and principal cash flow from aTreasury security is assigned a CUSIP
The mother bond is also assigned a CUSIPThe stripped coupons are known as C-STRIPSThe stripped principal is known as P-STRIPSSupply of a C-STRIP increases over time
because a C-STRIP maturing on a day like 15 FEB
2020 will have the same CUSIP irrespective ofwhich mother bond it has come fromThe original coupon rate is irrelevant
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P-STRIPS always correspond to the originalsecurityThey have a unique CUSIPTheir supply is fixed at the time of issuanceIn practice the prices of long-dated P-STRIPSare a bit higher than those of C-STRIPS withthe same maturity date
One reason is that P-STRIPS are more liquid due
to greater availabilityA $100 face value bond with a coupon of 8 willgenerate C-STRIPS with a face value of $4 but P-STRIPS with a face value of $100
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Another reason why P-STRIPS are in higherdemand is that they allow reconstitutionactivities more easily
Assume that the sum of the STRIPS is cheaper than
the mother bondIf a dealer already has the P-STRIPS only the C-STRIPSneed to be acquiredHowever if he owns some of the C-STRIPS he needs toacquire the P-STRIPS and the remaining C-STRIPSThe facility to reconstitute when profitable is pricedinto the P-STRIPSNote Buy and hold investors will prefer C-STRIPSsince they are priced lower and give a higher yield
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For Plain Vanilla bonds the specifiedcoupon rate is valid for the life of thebond
In the case of Floaters the rate is reset atthe beginning of every periodThe rate will vary directly with thebenchmark
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The rate on a Floater is specified as LIBOR+ 50 bp
The spread is positiveIf it were specified as LIBOR ndash 30bp
The spread will be negativeIf LIBOR rises the rate will increasewhereas if LIBOR falls it will decrease
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In the case of a default risk-free floater theprice will reset to par on a coupon date
It may sell at a premium or discount betweencoupon dates
Consider a floater with a coupon = 5-year T-Bond rate
Assume there are two periods left to maturity
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The price at the end of the first coupon period willbe given by
cT-1 is the coupon one period before maturityyT-1 is the YTM one period before maturity
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On a coupon reset date the YTM = couponBecause we have assumed there is no default riskAny change in the required yield as reflected inthe prevailing YTM
Will also be reflected in the coupon being setIf coupon = yield the bond should sell at par
Thus P T-1 = M
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Once again at T-2 c T-2 = yT-2 and P T-2 = MThis logic can be applied to a bond with anytime remaining till maturityHowever between two coupon dates theprice may not be equal to par
Consider the valuation at T-2+k
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Although c T-2 was set at T-2 and is equal toyT-2
yT-2+k is determined at T-2+k and will reflect theyield prevailing at that time
Thus yT-2+k need not equal c T-2 and may behigher or lower
Hence between two coupon dates a floater maysell at a premium or discount
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Now consider a floater characterized bydefault risk
The risk premium required by the market neednot be constant over time
Assume that at the time of issue YTM = 5-year T-note rate + 75bp
The coupon would have been set equal to thisrate and the bond would have been issued at par
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Six months hence the issue may be perceivedas more risky
YTM = 5-year T-note rate + 95 bpThe coupon will however be set equal to theprevailing 5-year rate + 75 bpIf so the issue will not reset to par at the nextcoupon date
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Floaters may come with a CAP or a FLOOR orBOTH
The CAP is a maximum coupon rateProtects issuers against rising rates
The FLOOR is a minimum coupon rateProtects investors against falling rates
When there is a spread over LIBORThere is a natural floorLIBOR cannot be less than zero
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Interest payments to be made before anydividends for equity holders
In the event of liquidationThe claims of debt holders must be settled firstOnly then can equity holders be paid
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Bonds and debentures are termed as FixedIncome Securities
Once the rate of interest is set at the onset ofthe period for which it is due
It is not a function of the profitability of the firmFailure to pay the promised interest willtantamount to default
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Bonds may be secured or unsecuredUnsecured debt securities are termed asDebentures in the USUnsecured means no specific assets have beenearmarked as collateralSecured debt requires the firm to earmarkspecific assets as collateralSecured debt holders enjoy priority from thestandpoint of payments
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Debt securities may be negotiable or non-negotiable
Negotiable securities can be traded in thesecondary market
Can be endorsed by one party in favor of anotherExamples of non-negotiable debt securities
National savings certificatesConventional Time or Fixed deposits
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The most basic form of a bond is called thePlain Vanilla version
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This is true for all securities not just for bondsMore complicated versions are said to have`Bells and Whistlesrsquo attached
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These bonds are slightly differentThe interest rate does not remain fixedIt varies each period based on the reference rate
Short-term reference rate ndash maturity lt 1 yearFloating rate bonds
Longer-term reference rateVariable or adjustable rate bonds
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Convertible bonds can be converted to sharesof stockCallable bonds can be prematurely retired by
the issuerPutable bonds can be prematurelysurrendered by the holders
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It is the principal valueAmount payable by the borrower to the lastholder at maturityAmount on which the periodic interest paymentsare calculatedAKA as
Par ValueRedemption Value Maturity ValuePrincipal Value
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It is the time remaining in the life of thebond
The length of time for which interest has to bepaid as promisedThe the length of time after which the face valuewill be repaidAKA as
MaturityTermTenor
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The periodic interest payment that has to bemade by the borrower
The coupon rate multiplied by the face valuegives the rupeedollar value of the coupon
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Most bonds pays coupons on a semi-annual basisTrue in UKUSAustraliaJapanIn European and Eurobond markets annualpayments are the norm
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In earlier days bonds were accompanied by abooklet of post-dated coupons
Each coupon could be detached and redeemedon the corresponding coupon payment date
Even today bearer bonds come with couponsThe bearer certificate number is mentioned onthe coupon
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Bond with a face value of $1000The coupon rate is 8 per annum paid semi-annually
So the bond holder will receive1000 x 008
___ = $40 every six months2
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The rate of return if an investor buys thebond at the prevailing price and holds ittill maturity
In order to get the YTM two conditionsmust be satisfied
The bond must be held till maturity All coupon payments received before maturitymust be reinvested at the YTM
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At any point in time the YTM may beGreater thanLess than or
Equal to the Coupon RateYTM is the IRR of a bond
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Bonds involve pure cash flowsSo only ONE REAL POSITIVE YTM
Solution to a Non-Linear equation
Solved iteratively
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A holder gets a stream of contractuallypromised payments
The value of the bond is the value of this stream
of cash flowsCash flows arising at different points in timecannot be addedCash flows have to be discounted
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It is a chicken and egg storyIf we know the yield that is required we canquote a priceOnce we acquire the asset at a certain price we
can work out the corresponding yield
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A bond will pay identical coupons everyperiodAnd will repay the face value at maturity
The periodic cash flows constitutean annuity The terminal face value is a lump
sum payment
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Bond pays a semi-annual coupon of $C2and has a face value of $MAssume there are N coupons left
And that we are standing on a coupondate
We are assuming that the next coupon is exactlysix months away
The required annual yield is yImplies that the semi-annual yield is y2
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The present value of the coupon stream is
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The present value of the face value is
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So the price of the bond is
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IBM has issued a bond with a face value of$1000The coupon is 8 per year to be paid on July
15 and January 15 every yearToday is 15 July 2013 and that the bondmatures on 15 January 2033The required yield is 10 per annum
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JJ ndash 0115FA ndash 0115MS ndash 0115
AO ndash 0115MN ndash 0115JD ndash 0115
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In the example the price is less than theface value
Such a bond is called a Discount Bond
It is trading at a discount from the face valueThe reason is that
The yield is greater than the coupon
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If the yield were to equal the couponThe bond would sell at PARSuch bonds are called PAR Bonds
If the yield is less than the couponThe price will exceed the face valueSuch bonds are called Premium Bonds
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As we move from one coupon date to thenext if the YTM were to remain constant
Par bonds would continue to trade at PARPremium bonds will steadily decline in priceDiscount bonds will steadily increase in price
This is called the Pull to Par EffectAt maturity ndash ALL BONDS WILL TRADE AT PAR
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As we approach maturity the number ofcoupons reduces
The contribution of coupons to price reducesThe contribution of the PV of the face valueincreases
For premium bonds the first effect dominatesThus the price steadily declines
For discount bonds the second effectdominatesThus the price steadily increases
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A plain vanilla or Bullet Bond pays the entireface value at maturity in a lump sumAmortizing bonds pay the principal in
installmentsThe first payment occurs before maturityThe last payment is made at maturity
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Consider a 5 year amortizing bond with aface value of $1000 and an annual coupon of8
The annual cash flows are depicted below
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Time Cash Flow
1 802 803 3304 3105 540
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The first two cash flows represent interest ona principal of $1000The third cash flow is interest on $1000 plus
a principal payment of $250The outstanding principal is $750The fourth cash flow is interest on $750 plusa principal payment of $250
The outstanding principal is $500The final cash flow is interest on $500 plusthe remaining principal of $500
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Some companies issue such bonds becausethe assets being funded have a similar cashflow profile
Second the coupon on such a bond may belower than that of a bullet bondIn the case of a bullet bond the entire principalis due at a single point in timeThere is greater default risk
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Microsoft is issuing zeroes with 5 years tomaturity and a face value of $10000
The required yield is 10 per annumWhat should be the price
Price is the PV of the face valueIn practice we discount on a semi-annual basis
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This is to facilitate comparisons withconventional bonds
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A zero coupon bond can never sell at apremium
It will always trade at a discount prior tomaturityAt maturity it will trade at par
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If held to maturity a ZCB will always give riseto a capital gainIf sold prior to maturity there may be a
capital gain or a capital lossConsider a bond with 10 years to maturityThe YTM at the time of purchase was 10The cost was $37690
A year later it is sold at a YTM of 12The corresponding price is $35035
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A newly established issuerOr an issuer with a relatively virgin productor service
Or a restructured company due to a mergeror following a bankruptcyWill be perceived as more riskyInvestors will demand a high coupon
Such firms are unlikely to have high earningsRevenues will peak only after theproductservice is established
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They can ill afford high couponsThey may consider a step-up coupon bond
Where the coupon increases as the bond ages
Assume a company can issue a plain vanillaat a coupon of 8 with a maturity of 5 yearsInstead it may opt for a bond
With a coupon of 6 for the first three years
And a coupon of 10 for the last two yearsThis is a Deferred Interest Security
Provides the issuer with breathing room in theearlier years
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These pay coupons in the form of additionalsecurities and not cash
This offers the issuer time to prepare for cashoutlays
They are used as Mezzanine FinanceThey rank between senior debt and equity in thecapital structureInvestors take more risk as compared to buyersof regular bonds ndash but get higher returnsIssuers can conserve cash in earlier years when itis at a premium
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Fully backed by the federal government ofthe issuing nationConsequently they are virtually devoid ofcredit risk or the risk of defaultThe yield on such securities is a benchmarkfor setting rates on other kinds of debt
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Treasury securities are issuedTo finance expenses in excess of currentrevenuesTo pay interest on debt accumulated in earlieryears due to deficits in those yearsTo repay past debt issues that are currentlymaturing
The US Treasuries marketIs the largest bond market in the worldIs the most liquid bond market in the world
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The Treasury issues three categories ofmarketable securities
T-bills are discount securitiesThey are zero coupon securitiesT-notes and T-bonds are sold at face value andpay interest periodically
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T-bills are issued with a original time tomaturity of one year or less
They are Money market instrumentsThey have maturities of either 1 3 6 or 12months at the time of issue
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T-notes and T-bonds have a time to maturityexceeding one year at the time of issue
They are capital market instrumentsT-notes have maturities ranging from 1-10 yearsT-bonds have an original maturity in excess of 10years extending up to 30 years
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An issue may be followed later by a furtherissue
With the same remaining time to maturity andthe same couponThe issuance of further tranches is termed as aRe-opening
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Six months ago a 10-year note was issuedwith a coupon of 8 per annumToday if a note with 9 frac12 years to maturityand a coupon of 8 issued it will add to thepool that is already trading in the marketThus it is a re-opening of an existing issue
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Who is a primary dealerA PD is a dealer who is authorized to dealdirectly with the Central Bank of the countryIn the US a PD is a bank or securities broker-dealer that directly deals with the FRBNY
Importance of FRBNYIn India a PD deals directly with the RBI
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The Treasury sells bills notes and bonds byway of a competitive auction process
Most of the treasury securities are bought byprimary dealers
Individual investors submit non-competitive bidsand participate on a much smaller scale
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Bids may beCompetitive
Indicate price amp quantity or yield amp quantityNon-competitive
Indicate only quantity
Small investors and individualsgenerally submit non-competitive bids
A non-competitive bidder may not bid for more than$5MM worth of securities in a bill or bond auction
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Primary dealers bid for their accounts andon behalf of their clientsThey usually submit large competitive
bidsBids indicate the maximum price that the bidderis prepared to pay if it is a price based auctionOr the minimum yield that the bidder is
prepared to accept if it is a yield based auction
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The Treasury will net out the totalamount of non-competitive bids
The balance will be allocated to competitivebidders
There are two ways in which securitiescan be allotted
The multiple priceyield auction mechanism
French AuctionsThe uniform priceyield auction mechanism
Dutch Auctions
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Assume that the Treasury is offering 25billion dollars worth of T-bonds
2 billion dollars worth of non-competitive bidshave been receivedSo 23 billion dollars worth of bonds are availableto be offered to the competitive bidders
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There are six competitive bidders who havesubmitted the following yields
The bids have been arranged in ascending orderof yieldIn a price based auction the bids would havebeen arranged in descending order of price
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Bidder Bid Yield Bid Amount
Aggregate Amount
Alpha 5370 30 bn 30 bnBeta 5372 50 bn 80 bn
Gamma 5373 40 bn 12 bn
Delta 5375 80 bn 20 bnCharlie 5375 120 bn 32 bn
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The aggregate demand equals the amount onoffer at a yield of 5375A multiple yield auction will lead to thefollowing allocation
Alpha will get 3 bn at a yield of 5370Beta will get 5 bn at 5372Gamma will get 4 bn at 5373
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At a yield of 5375 we have only 11 bn left toallocateThere is a demand of 20 bn at this yield
8 bn from Delta and 12 bn from CharlieThus we will allocate 1120 = 55 to eachbidder at this yield
There will be pro-rata allocation
055 of 8 bn or 440 bn will go to Delta055 of 12 bn or 66 bn will go to Charlie
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The highest accepted yield is called the StopYield or High Yield
In this case it is 5375The ratio of bids received to the amountawarded is known as the bid to cover ratio
The higher the ratio the stronger is the auction
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Those who bid more than 5375 will getnothing and are said to be shutout of theauctionSince 1999 the US Treasury has beenconducting only uniform yield auctions
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WI stands for ndash When As and If IssuedThe when issued market is a market forforward trading of a bond
Which has been announced but not yet issuedTrades take place from the date ofannouncement until the actual issue date
Helps bidders to gauge the marketrsquos interestbefore the actual auction
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WI trading has ramifications for the biddingstrategies of market participantsTraders can take both long and shortpositions
Settlement is scheduled for the issue date
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It has a bearing on the outcome of theauction
It affects the strategy used by a bidder becauseit has an impact on his prior positionBidders who are long in the WI market enter theauction with a Long PositionThose who are short in the WI market enter theauction with a short position
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The WI market helps in price discoveryIt provides important information on
The strength of demand for the securityAnd on the disparity of biddersrsquo views
This help potential bidders to formulate theirstrategiesAt times a dealer may believe that he hasvery important private information
If so he may not participate in the WI market andwill directly enter the auction with bids based onhis knowledge
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On or before the date of the auction theissues trade on a yield basis
The actual price can be established only afterthe coupon is set
Starting with the day after the auctionSecurities are quoted on a price basis becausethe coupon is known
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In a coupon roll a dealer will purchase themost recently issued security from a clientAnd simultaneously sell the same amount ofthe recently announced new security
The first leg with settle on the following dayThe second leg is a forward contract
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There can be a Reverse RollThe dealer will sell the most recent issue fornext day settlementAnd buy the newly announced security forforward settlement
The forward leg in a RollReverse Roll is a WItrade
It will settle on the new issue settlement date
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The roll is the spread between the yield onthe new security and that on the outstandingissue in the same maturity segmentA GIVE in the Roll means that
The WI security provides a higher yield than theoutstanding issue
A Take in the Roll means thatThe WI security provides a lower yield
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On March 17 20XX the Treasury announcedthe auction of a 2-year note
The auction was scheduled for March 24The settlement date was March 31
Trading of the roll began as soon as the issuewas announcedA Give of 5 bp means that the dealer proposes tobuy the current issue at the prevailing yieldAnd sell the new issue at a yield that is 5 bpmoreA Take of 5 bp means that the dealer proposes tosell the new issue at a yield that is 5bp lower
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The roll achieves the followingHe acquires the outstanding issue for next daysettlementHe sells the to be issued security with the samepar value for forward delivery on 31 March
The customer is rolling over the investmentfrom the current issue to the new issue
This extends the maturity of the investment byone month
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The client can invest the funds received tillthe new issue settlesHowever he loses the accrued interest thathe would have earned had he held on to theissue
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The Treasury per se does not issue zerocoupon securitiesBut zero coupon securities can be created
which are backed by conventional bondsTake a large quantity of a T-note or bond andseparate all the cash flows from each otherSell the entitlement to each cash flowseparately
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Take the case of a two-year T-noteIt can be separated into five zero couponsecurities maturing after
6 months12 months18 months24 months
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Earlier investment banks used to buy bondsfrom the Treasury and separate the cashflows
Each cash flow was then sold separately as a zerocoupon bondSuch issues are called trademarks
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The issue of trademarks has now ceasedBecause investment banks can now createsuch instruments
In concert with the Treasury itselfThese ZCBs are known as STRIPS ndash
Separate Trading of Registered Interest andPrincipal of Securities
These are not issued or sold by the Treasury
The market is made by investment banks
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What is the motivation to create suchproductsIn practice arbitrage is possible when a
coupon security is purchased at a priceThat is lower than what could be obtained byselling each cash flow separately
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Coupon stripping reflects a case of financialengineering
Creating a risk-return profile that is nototherwise available
An investment bank would buy a largequantity of a Treasury security
The securities would be placed with an SPV
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The SPV is a single-purpose dedicated trustIt has the powers to own the bonds andcollect payments
It cannot sell or lend the bondsIt cannot write options on the bondsOr use them as collateral for borrowing
The SPV is empowered to issue zero coupon
bondsWhere each security represents the ownership ofa single cash flow from the mother bond
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Assume that 100MM USD of 15 year bondswith a coupon of 8 are placed with the SPV
The SPV can issue 6M 12M 18M extending up to14 frac12 year zeroes with a total face value of 4MM
USD eachAnd 15 year zeroes with a total face value of104MM
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The Treasury launched this program in 1985to facilitate the stripping of designatedsecurities
All new T-bonds and notes with a maturity of 10years or more are eligibleThe zeroes created in the process are directobligations of the US government
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The mechanism is as followsA dealer who owns a bond or note can ask theFRB where it is held
To replace it with an equivalent set of STRIPS
representing each payment as a separate securityEach of these securities can be traded independentlyof others
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In 1987 the Treasury started to allow dealersto reverse the process
This is called STRIPS RECONSTUTUTION If a dealer owns STRIPS representing all thecoupon and principal payments of a bond
The FED can on request convert these holdings into asingle position in the corresponding bond
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Each coupon and principal cash flow from aTreasury security is assigned a CUSIP
The mother bond is also assigned a CUSIPThe stripped coupons are known as C-STRIPSThe stripped principal is known as P-STRIPSSupply of a C-STRIP increases over time
because a C-STRIP maturing on a day like 15 FEB
2020 will have the same CUSIP irrespective ofwhich mother bond it has come fromThe original coupon rate is irrelevant
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P-STRIPS always correspond to the originalsecurityThey have a unique CUSIPTheir supply is fixed at the time of issuanceIn practice the prices of long-dated P-STRIPSare a bit higher than those of C-STRIPS withthe same maturity date
One reason is that P-STRIPS are more liquid due
to greater availabilityA $100 face value bond with a coupon of 8 willgenerate C-STRIPS with a face value of $4 but P-STRIPS with a face value of $100
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Another reason why P-STRIPS are in higherdemand is that they allow reconstitutionactivities more easily
Assume that the sum of the STRIPS is cheaper than
the mother bondIf a dealer already has the P-STRIPS only the C-STRIPSneed to be acquiredHowever if he owns some of the C-STRIPS he needs toacquire the P-STRIPS and the remaining C-STRIPSThe facility to reconstitute when profitable is pricedinto the P-STRIPSNote Buy and hold investors will prefer C-STRIPSsince they are priced lower and give a higher yield
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For Plain Vanilla bonds the specifiedcoupon rate is valid for the life of thebond
In the case of Floaters the rate is reset atthe beginning of every periodThe rate will vary directly with thebenchmark
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The rate on a Floater is specified as LIBOR+ 50 bp
The spread is positiveIf it were specified as LIBOR ndash 30bp
The spread will be negativeIf LIBOR rises the rate will increasewhereas if LIBOR falls it will decrease
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In the case of a default risk-free floater theprice will reset to par on a coupon date
It may sell at a premium or discount betweencoupon dates
Consider a floater with a coupon = 5-year T-Bond rate
Assume there are two periods left to maturity
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The price at the end of the first coupon period willbe given by
cT-1 is the coupon one period before maturityyT-1 is the YTM one period before maturity
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On a coupon reset date the YTM = couponBecause we have assumed there is no default riskAny change in the required yield as reflected inthe prevailing YTM
Will also be reflected in the coupon being setIf coupon = yield the bond should sell at par
Thus P T-1 = M
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Once again at T-2 c T-2 = yT-2 and P T-2 = MThis logic can be applied to a bond with anytime remaining till maturityHowever between two coupon dates theprice may not be equal to par
Consider the valuation at T-2+k
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Although c T-2 was set at T-2 and is equal toyT-2
yT-2+k is determined at T-2+k and will reflect theyield prevailing at that time
Thus yT-2+k need not equal c T-2 and may behigher or lower
Hence between two coupon dates a floater maysell at a premium or discount
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Now consider a floater characterized bydefault risk
The risk premium required by the market neednot be constant over time
Assume that at the time of issue YTM = 5-year T-note rate + 75bp
The coupon would have been set equal to thisrate and the bond would have been issued at par
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Six months hence the issue may be perceivedas more risky
YTM = 5-year T-note rate + 95 bpThe coupon will however be set equal to theprevailing 5-year rate + 75 bpIf so the issue will not reset to par at the nextcoupon date
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Floaters may come with a CAP or a FLOOR orBOTH
The CAP is a maximum coupon rateProtects issuers against rising rates
The FLOOR is a minimum coupon rateProtects investors against falling rates
When there is a spread over LIBORThere is a natural floorLIBOR cannot be less than zero
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Bonds and debentures are termed as FixedIncome Securities
Once the rate of interest is set at the onset ofthe period for which it is due
It is not a function of the profitability of the firmFailure to pay the promised interest willtantamount to default
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Bonds may be secured or unsecuredUnsecured debt securities are termed asDebentures in the USUnsecured means no specific assets have beenearmarked as collateralSecured debt requires the firm to earmarkspecific assets as collateralSecured debt holders enjoy priority from thestandpoint of payments
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Debt securities may be negotiable or non-negotiable
Negotiable securities can be traded in thesecondary market
Can be endorsed by one party in favor of anotherExamples of non-negotiable debt securities
National savings certificatesConventional Time or Fixed deposits
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The most basic form of a bond is called thePlain Vanilla version
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This is true for all securities not just for bondsMore complicated versions are said to have`Bells and Whistlesrsquo attached
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These bonds are slightly differentThe interest rate does not remain fixedIt varies each period based on the reference rate
Short-term reference rate ndash maturity lt 1 yearFloating rate bonds
Longer-term reference rateVariable or adjustable rate bonds
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Convertible bonds can be converted to sharesof stockCallable bonds can be prematurely retired by
the issuerPutable bonds can be prematurelysurrendered by the holders
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It is the principal valueAmount payable by the borrower to the lastholder at maturityAmount on which the periodic interest paymentsare calculatedAKA as
Par ValueRedemption Value Maturity ValuePrincipal Value
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It is the time remaining in the life of thebond
The length of time for which interest has to bepaid as promisedThe the length of time after which the face valuewill be repaidAKA as
MaturityTermTenor
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The periodic interest payment that has to bemade by the borrower
The coupon rate multiplied by the face valuegives the rupeedollar value of the coupon
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Most bonds pays coupons on a semi-annual basisTrue in UKUSAustraliaJapanIn European and Eurobond markets annualpayments are the norm
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In earlier days bonds were accompanied by abooklet of post-dated coupons
Each coupon could be detached and redeemedon the corresponding coupon payment date
Even today bearer bonds come with couponsThe bearer certificate number is mentioned onthe coupon
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Bond with a face value of $1000The coupon rate is 8 per annum paid semi-annually
So the bond holder will receive1000 x 008
___ = $40 every six months2
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The rate of return if an investor buys thebond at the prevailing price and holds ittill maturity
In order to get the YTM two conditionsmust be satisfied
The bond must be held till maturity All coupon payments received before maturitymust be reinvested at the YTM
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At any point in time the YTM may beGreater thanLess than or
Equal to the Coupon RateYTM is the IRR of a bond
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Bonds involve pure cash flowsSo only ONE REAL POSITIVE YTM
Solution to a Non-Linear equation
Solved iteratively
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A holder gets a stream of contractuallypromised payments
The value of the bond is the value of this stream
of cash flowsCash flows arising at different points in timecannot be addedCash flows have to be discounted
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It is a chicken and egg storyIf we know the yield that is required we canquote a priceOnce we acquire the asset at a certain price we
can work out the corresponding yield
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A bond will pay identical coupons everyperiodAnd will repay the face value at maturity
The periodic cash flows constitutean annuity The terminal face value is a lump
sum payment
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Bond pays a semi-annual coupon of $C2and has a face value of $MAssume there are N coupons left
And that we are standing on a coupondate
We are assuming that the next coupon is exactlysix months away
The required annual yield is yImplies that the semi-annual yield is y2
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The present value of the coupon stream is
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The present value of the face value is
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So the price of the bond is
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IBM has issued a bond with a face value of$1000The coupon is 8 per year to be paid on July
15 and January 15 every yearToday is 15 July 2013 and that the bondmatures on 15 January 2033The required yield is 10 per annum
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JJ ndash 0115FA ndash 0115MS ndash 0115
AO ndash 0115MN ndash 0115JD ndash 0115
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In the example the price is less than theface value
Such a bond is called a Discount Bond
It is trading at a discount from the face valueThe reason is that
The yield is greater than the coupon
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If the yield were to equal the couponThe bond would sell at PARSuch bonds are called PAR Bonds
If the yield is less than the couponThe price will exceed the face valueSuch bonds are called Premium Bonds
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As we move from one coupon date to thenext if the YTM were to remain constant
Par bonds would continue to trade at PARPremium bonds will steadily decline in priceDiscount bonds will steadily increase in price
This is called the Pull to Par EffectAt maturity ndash ALL BONDS WILL TRADE AT PAR
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As we approach maturity the number ofcoupons reduces
The contribution of coupons to price reducesThe contribution of the PV of the face valueincreases
For premium bonds the first effect dominatesThus the price steadily declines
For discount bonds the second effectdominatesThus the price steadily increases
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A plain vanilla or Bullet Bond pays the entireface value at maturity in a lump sumAmortizing bonds pay the principal in
installmentsThe first payment occurs before maturityThe last payment is made at maturity
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Consider a 5 year amortizing bond with aface value of $1000 and an annual coupon of8
The annual cash flows are depicted below
8282014 40
Time Cash Flow
1 802 803 3304 3105 540
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The first two cash flows represent interest ona principal of $1000The third cash flow is interest on $1000 plus
a principal payment of $250The outstanding principal is $750The fourth cash flow is interest on $750 plusa principal payment of $250
The outstanding principal is $500The final cash flow is interest on $500 plusthe remaining principal of $500
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Some companies issue such bonds becausethe assets being funded have a similar cashflow profile
Second the coupon on such a bond may belower than that of a bullet bondIn the case of a bullet bond the entire principalis due at a single point in timeThere is greater default risk
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Microsoft is issuing zeroes with 5 years tomaturity and a face value of $10000
The required yield is 10 per annumWhat should be the price
Price is the PV of the face valueIn practice we discount on a semi-annual basis
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This is to facilitate comparisons withconventional bonds
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A zero coupon bond can never sell at apremium
It will always trade at a discount prior tomaturityAt maturity it will trade at par
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If held to maturity a ZCB will always give riseto a capital gainIf sold prior to maturity there may be a
capital gain or a capital lossConsider a bond with 10 years to maturityThe YTM at the time of purchase was 10The cost was $37690
A year later it is sold at a YTM of 12The corresponding price is $35035
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A newly established issuerOr an issuer with a relatively virgin productor service
Or a restructured company due to a mergeror following a bankruptcyWill be perceived as more riskyInvestors will demand a high coupon
Such firms are unlikely to have high earningsRevenues will peak only after theproductservice is established
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They can ill afford high couponsThey may consider a step-up coupon bond
Where the coupon increases as the bond ages
Assume a company can issue a plain vanillaat a coupon of 8 with a maturity of 5 yearsInstead it may opt for a bond
With a coupon of 6 for the first three years
And a coupon of 10 for the last two yearsThis is a Deferred Interest Security
Provides the issuer with breathing room in theearlier years
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These pay coupons in the form of additionalsecurities and not cash
This offers the issuer time to prepare for cashoutlays
They are used as Mezzanine FinanceThey rank between senior debt and equity in thecapital structureInvestors take more risk as compared to buyersof regular bonds ndash but get higher returnsIssuers can conserve cash in earlier years when itis at a premium
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Fully backed by the federal government ofthe issuing nationConsequently they are virtually devoid ofcredit risk or the risk of defaultThe yield on such securities is a benchmarkfor setting rates on other kinds of debt
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Treasury securities are issuedTo finance expenses in excess of currentrevenuesTo pay interest on debt accumulated in earlieryears due to deficits in those yearsTo repay past debt issues that are currentlymaturing
The US Treasuries marketIs the largest bond market in the worldIs the most liquid bond market in the world
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The Treasury issues three categories ofmarketable securities
T-bills are discount securitiesThey are zero coupon securitiesT-notes and T-bonds are sold at face value andpay interest periodically
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T-bills are issued with a original time tomaturity of one year or less
They are Money market instrumentsThey have maturities of either 1 3 6 or 12months at the time of issue
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T-notes and T-bonds have a time to maturityexceeding one year at the time of issue
They are capital market instrumentsT-notes have maturities ranging from 1-10 yearsT-bonds have an original maturity in excess of 10years extending up to 30 years
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An issue may be followed later by a furtherissue
With the same remaining time to maturity andthe same couponThe issuance of further tranches is termed as aRe-opening
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Six months ago a 10-year note was issuedwith a coupon of 8 per annumToday if a note with 9 frac12 years to maturityand a coupon of 8 issued it will add to thepool that is already trading in the marketThus it is a re-opening of an existing issue
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Who is a primary dealerA PD is a dealer who is authorized to dealdirectly with the Central Bank of the countryIn the US a PD is a bank or securities broker-dealer that directly deals with the FRBNY
Importance of FRBNYIn India a PD deals directly with the RBI
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The Treasury sells bills notes and bonds byway of a competitive auction process
Most of the treasury securities are bought byprimary dealers
Individual investors submit non-competitive bidsand participate on a much smaller scale
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Bids may beCompetitive
Indicate price amp quantity or yield amp quantityNon-competitive
Indicate only quantity
Small investors and individualsgenerally submit non-competitive bids
A non-competitive bidder may not bid for more than$5MM worth of securities in a bill or bond auction
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Primary dealers bid for their accounts andon behalf of their clientsThey usually submit large competitive
bidsBids indicate the maximum price that the bidderis prepared to pay if it is a price based auctionOr the minimum yield that the bidder is
prepared to accept if it is a yield based auction
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The Treasury will net out the totalamount of non-competitive bids
The balance will be allocated to competitivebidders
There are two ways in which securitiescan be allotted
The multiple priceyield auction mechanism
French AuctionsThe uniform priceyield auction mechanism
Dutch Auctions
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Assume that the Treasury is offering 25billion dollars worth of T-bonds
2 billion dollars worth of non-competitive bidshave been receivedSo 23 billion dollars worth of bonds are availableto be offered to the competitive bidders
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There are six competitive bidders who havesubmitted the following yields
The bids have been arranged in ascending orderof yieldIn a price based auction the bids would havebeen arranged in descending order of price
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Bidder Bid Yield Bid Amount
Aggregate Amount
Alpha 5370 30 bn 30 bnBeta 5372 50 bn 80 bn
Gamma 5373 40 bn 12 bn
Delta 5375 80 bn 20 bnCharlie 5375 120 bn 32 bn
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The aggregate demand equals the amount onoffer at a yield of 5375A multiple yield auction will lead to thefollowing allocation
Alpha will get 3 bn at a yield of 5370Beta will get 5 bn at 5372Gamma will get 4 bn at 5373
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At a yield of 5375 we have only 11 bn left toallocateThere is a demand of 20 bn at this yield
8 bn from Delta and 12 bn from CharlieThus we will allocate 1120 = 55 to eachbidder at this yield
There will be pro-rata allocation
055 of 8 bn or 440 bn will go to Delta055 of 12 bn or 66 bn will go to Charlie
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The highest accepted yield is called the StopYield or High Yield
In this case it is 5375The ratio of bids received to the amountawarded is known as the bid to cover ratio
The higher the ratio the stronger is the auction
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Those who bid more than 5375 will getnothing and are said to be shutout of theauctionSince 1999 the US Treasury has beenconducting only uniform yield auctions
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WI stands for ndash When As and If IssuedThe when issued market is a market forforward trading of a bond
Which has been announced but not yet issuedTrades take place from the date ofannouncement until the actual issue date
Helps bidders to gauge the marketrsquos interestbefore the actual auction
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WI trading has ramifications for the biddingstrategies of market participantsTraders can take both long and shortpositions
Settlement is scheduled for the issue date
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It has a bearing on the outcome of theauction
It affects the strategy used by a bidder becauseit has an impact on his prior positionBidders who are long in the WI market enter theauction with a Long PositionThose who are short in the WI market enter theauction with a short position
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The WI market helps in price discoveryIt provides important information on
The strength of demand for the securityAnd on the disparity of biddersrsquo views
This help potential bidders to formulate theirstrategiesAt times a dealer may believe that he hasvery important private information
If so he may not participate in the WI market andwill directly enter the auction with bids based onhis knowledge
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On or before the date of the auction theissues trade on a yield basis
The actual price can be established only afterthe coupon is set
Starting with the day after the auctionSecurities are quoted on a price basis becausethe coupon is known
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In a coupon roll a dealer will purchase themost recently issued security from a clientAnd simultaneously sell the same amount ofthe recently announced new security
The first leg with settle on the following dayThe second leg is a forward contract
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There can be a Reverse RollThe dealer will sell the most recent issue fornext day settlementAnd buy the newly announced security forforward settlement
The forward leg in a RollReverse Roll is a WItrade
It will settle on the new issue settlement date
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The roll is the spread between the yield onthe new security and that on the outstandingissue in the same maturity segmentA GIVE in the Roll means that
The WI security provides a higher yield than theoutstanding issue
A Take in the Roll means thatThe WI security provides a lower yield
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On March 17 20XX the Treasury announcedthe auction of a 2-year note
The auction was scheduled for March 24The settlement date was March 31
Trading of the roll began as soon as the issuewas announcedA Give of 5 bp means that the dealer proposes tobuy the current issue at the prevailing yieldAnd sell the new issue at a yield that is 5 bpmoreA Take of 5 bp means that the dealer proposes tosell the new issue at a yield that is 5bp lower
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The roll achieves the followingHe acquires the outstanding issue for next daysettlementHe sells the to be issued security with the samepar value for forward delivery on 31 March
The customer is rolling over the investmentfrom the current issue to the new issue
This extends the maturity of the investment byone month
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The client can invest the funds received tillthe new issue settlesHowever he loses the accrued interest thathe would have earned had he held on to theissue
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The Treasury per se does not issue zerocoupon securitiesBut zero coupon securities can be created
which are backed by conventional bondsTake a large quantity of a T-note or bond andseparate all the cash flows from each otherSell the entitlement to each cash flowseparately
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Take the case of a two-year T-noteIt can be separated into five zero couponsecurities maturing after
6 months12 months18 months24 months
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Earlier investment banks used to buy bondsfrom the Treasury and separate the cashflows
Each cash flow was then sold separately as a zerocoupon bondSuch issues are called trademarks
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The issue of trademarks has now ceasedBecause investment banks can now createsuch instruments
In concert with the Treasury itselfThese ZCBs are known as STRIPS ndash
Separate Trading of Registered Interest andPrincipal of Securities
These are not issued or sold by the Treasury
The market is made by investment banks
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What is the motivation to create suchproductsIn practice arbitrage is possible when a
coupon security is purchased at a priceThat is lower than what could be obtained byselling each cash flow separately
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Coupon stripping reflects a case of financialengineering
Creating a risk-return profile that is nototherwise available
An investment bank would buy a largequantity of a Treasury security
The securities would be placed with an SPV
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The SPV is a single-purpose dedicated trustIt has the powers to own the bonds andcollect payments
It cannot sell or lend the bondsIt cannot write options on the bondsOr use them as collateral for borrowing
The SPV is empowered to issue zero coupon
bondsWhere each security represents the ownership ofa single cash flow from the mother bond
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Assume that 100MM USD of 15 year bondswith a coupon of 8 are placed with the SPV
The SPV can issue 6M 12M 18M extending up to14 frac12 year zeroes with a total face value of 4MM
USD eachAnd 15 year zeroes with a total face value of104MM
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The Treasury launched this program in 1985to facilitate the stripping of designatedsecurities
All new T-bonds and notes with a maturity of 10years or more are eligibleThe zeroes created in the process are directobligations of the US government
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The mechanism is as followsA dealer who owns a bond or note can ask theFRB where it is held
To replace it with an equivalent set of STRIPS
representing each payment as a separate securityEach of these securities can be traded independentlyof others
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In 1987 the Treasury started to allow dealersto reverse the process
This is called STRIPS RECONSTUTUTION If a dealer owns STRIPS representing all thecoupon and principal payments of a bond
The FED can on request convert these holdings into asingle position in the corresponding bond
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Each coupon and principal cash flow from aTreasury security is assigned a CUSIP
The mother bond is also assigned a CUSIPThe stripped coupons are known as C-STRIPSThe stripped principal is known as P-STRIPSSupply of a C-STRIP increases over time
because a C-STRIP maturing on a day like 15 FEB
2020 will have the same CUSIP irrespective ofwhich mother bond it has come fromThe original coupon rate is irrelevant
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P-STRIPS always correspond to the originalsecurityThey have a unique CUSIPTheir supply is fixed at the time of issuanceIn practice the prices of long-dated P-STRIPSare a bit higher than those of C-STRIPS withthe same maturity date
One reason is that P-STRIPS are more liquid due
to greater availabilityA $100 face value bond with a coupon of 8 willgenerate C-STRIPS with a face value of $4 but P-STRIPS with a face value of $100
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Another reason why P-STRIPS are in higherdemand is that they allow reconstitutionactivities more easily
Assume that the sum of the STRIPS is cheaper than
the mother bondIf a dealer already has the P-STRIPS only the C-STRIPSneed to be acquiredHowever if he owns some of the C-STRIPS he needs toacquire the P-STRIPS and the remaining C-STRIPSThe facility to reconstitute when profitable is pricedinto the P-STRIPSNote Buy and hold investors will prefer C-STRIPSsince they are priced lower and give a higher yield
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For Plain Vanilla bonds the specifiedcoupon rate is valid for the life of thebond
In the case of Floaters the rate is reset atthe beginning of every periodThe rate will vary directly with thebenchmark
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The rate on a Floater is specified as LIBOR+ 50 bp
The spread is positiveIf it were specified as LIBOR ndash 30bp
The spread will be negativeIf LIBOR rises the rate will increasewhereas if LIBOR falls it will decrease
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In the case of a default risk-free floater theprice will reset to par on a coupon date
It may sell at a premium or discount betweencoupon dates
Consider a floater with a coupon = 5-year T-Bond rate
Assume there are two periods left to maturity
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The price at the end of the first coupon period willbe given by
cT-1 is the coupon one period before maturityyT-1 is the YTM one period before maturity
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On a coupon reset date the YTM = couponBecause we have assumed there is no default riskAny change in the required yield as reflected inthe prevailing YTM
Will also be reflected in the coupon being setIf coupon = yield the bond should sell at par
Thus P T-1 = M
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Once again at T-2 c T-2 = yT-2 and P T-2 = MThis logic can be applied to a bond with anytime remaining till maturityHowever between two coupon dates theprice may not be equal to par
Consider the valuation at T-2+k
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Although c T-2 was set at T-2 and is equal toyT-2
yT-2+k is determined at T-2+k and will reflect theyield prevailing at that time
Thus yT-2+k need not equal c T-2 and may behigher or lower
Hence between two coupon dates a floater maysell at a premium or discount
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Now consider a floater characterized bydefault risk
The risk premium required by the market neednot be constant over time
Assume that at the time of issue YTM = 5-year T-note rate + 75bp
The coupon would have been set equal to thisrate and the bond would have been issued at par
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Six months hence the issue may be perceivedas more risky
YTM = 5-year T-note rate + 95 bpThe coupon will however be set equal to theprevailing 5-year rate + 75 bpIf so the issue will not reset to par at the nextcoupon date
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Floaters may come with a CAP or a FLOOR orBOTH
The CAP is a maximum coupon rateProtects issuers against rising rates
The FLOOR is a minimum coupon rateProtects investors against falling rates
When there is a spread over LIBORThere is a natural floorLIBOR cannot be less than zero
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Bonds may be secured or unsecuredUnsecured debt securities are termed asDebentures in the USUnsecured means no specific assets have beenearmarked as collateralSecured debt requires the firm to earmarkspecific assets as collateralSecured debt holders enjoy priority from thestandpoint of payments
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Debt securities may be negotiable or non-negotiable
Negotiable securities can be traded in thesecondary market
Can be endorsed by one party in favor of anotherExamples of non-negotiable debt securities
National savings certificatesConventional Time or Fixed deposits
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The most basic form of a bond is called thePlain Vanilla version
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This is true for all securities not just for bondsMore complicated versions are said to have`Bells and Whistlesrsquo attached
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These bonds are slightly differentThe interest rate does not remain fixedIt varies each period based on the reference rate
Short-term reference rate ndash maturity lt 1 yearFloating rate bonds
Longer-term reference rateVariable or adjustable rate bonds
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Convertible bonds can be converted to sharesof stockCallable bonds can be prematurely retired by
the issuerPutable bonds can be prematurelysurrendered by the holders
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It is the principal valueAmount payable by the borrower to the lastholder at maturityAmount on which the periodic interest paymentsare calculatedAKA as
Par ValueRedemption Value Maturity ValuePrincipal Value
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It is the time remaining in the life of thebond
The length of time for which interest has to bepaid as promisedThe the length of time after which the face valuewill be repaidAKA as
MaturityTermTenor
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The periodic interest payment that has to bemade by the borrower
The coupon rate multiplied by the face valuegives the rupeedollar value of the coupon
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Most bonds pays coupons on a semi-annual basisTrue in UKUSAustraliaJapanIn European and Eurobond markets annualpayments are the norm
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In earlier days bonds were accompanied by abooklet of post-dated coupons
Each coupon could be detached and redeemedon the corresponding coupon payment date
Even today bearer bonds come with couponsThe bearer certificate number is mentioned onthe coupon
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Bond with a face value of $1000The coupon rate is 8 per annum paid semi-annually
So the bond holder will receive1000 x 008
___ = $40 every six months2
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The rate of return if an investor buys thebond at the prevailing price and holds ittill maturity
In order to get the YTM two conditionsmust be satisfied
The bond must be held till maturity All coupon payments received before maturitymust be reinvested at the YTM
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At any point in time the YTM may beGreater thanLess than or
Equal to the Coupon RateYTM is the IRR of a bond
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Bonds involve pure cash flowsSo only ONE REAL POSITIVE YTM
Solution to a Non-Linear equation
Solved iteratively
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A holder gets a stream of contractuallypromised payments
The value of the bond is the value of this stream
of cash flowsCash flows arising at different points in timecannot be addedCash flows have to be discounted
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It is a chicken and egg storyIf we know the yield that is required we canquote a priceOnce we acquire the asset at a certain price we
can work out the corresponding yield
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A bond will pay identical coupons everyperiodAnd will repay the face value at maturity
The periodic cash flows constitutean annuity The terminal face value is a lump
sum payment
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Bond pays a semi-annual coupon of $C2and has a face value of $MAssume there are N coupons left
And that we are standing on a coupondate
We are assuming that the next coupon is exactlysix months away
The required annual yield is yImplies that the semi-annual yield is y2
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The present value of the coupon stream is
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The present value of the face value is
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So the price of the bond is
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IBM has issued a bond with a face value of$1000The coupon is 8 per year to be paid on July
15 and January 15 every yearToday is 15 July 2013 and that the bondmatures on 15 January 2033The required yield is 10 per annum
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JJ ndash 0115FA ndash 0115MS ndash 0115
AO ndash 0115MN ndash 0115JD ndash 0115
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In the example the price is less than theface value
Such a bond is called a Discount Bond
It is trading at a discount from the face valueThe reason is that
The yield is greater than the coupon
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If the yield were to equal the couponThe bond would sell at PARSuch bonds are called PAR Bonds
If the yield is less than the couponThe price will exceed the face valueSuch bonds are called Premium Bonds
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As we move from one coupon date to thenext if the YTM were to remain constant
Par bonds would continue to trade at PARPremium bonds will steadily decline in priceDiscount bonds will steadily increase in price
This is called the Pull to Par EffectAt maturity ndash ALL BONDS WILL TRADE AT PAR
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As we approach maturity the number ofcoupons reduces
The contribution of coupons to price reducesThe contribution of the PV of the face valueincreases
For premium bonds the first effect dominatesThus the price steadily declines
For discount bonds the second effectdominatesThus the price steadily increases
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A plain vanilla or Bullet Bond pays the entireface value at maturity in a lump sumAmortizing bonds pay the principal in
installmentsThe first payment occurs before maturityThe last payment is made at maturity
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Consider a 5 year amortizing bond with aface value of $1000 and an annual coupon of8
The annual cash flows are depicted below
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Time Cash Flow
1 802 803 3304 3105 540
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The first two cash flows represent interest ona principal of $1000The third cash flow is interest on $1000 plus
a principal payment of $250The outstanding principal is $750The fourth cash flow is interest on $750 plusa principal payment of $250
The outstanding principal is $500The final cash flow is interest on $500 plusthe remaining principal of $500
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Some companies issue such bonds becausethe assets being funded have a similar cashflow profile
Second the coupon on such a bond may belower than that of a bullet bondIn the case of a bullet bond the entire principalis due at a single point in timeThere is greater default risk
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Microsoft is issuing zeroes with 5 years tomaturity and a face value of $10000
The required yield is 10 per annumWhat should be the price
Price is the PV of the face valueIn practice we discount on a semi-annual basis
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This is to facilitate comparisons withconventional bonds
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A zero coupon bond can never sell at apremium
It will always trade at a discount prior tomaturityAt maturity it will trade at par
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If held to maturity a ZCB will always give riseto a capital gainIf sold prior to maturity there may be a
capital gain or a capital lossConsider a bond with 10 years to maturityThe YTM at the time of purchase was 10The cost was $37690
A year later it is sold at a YTM of 12The corresponding price is $35035
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A newly established issuerOr an issuer with a relatively virgin productor service
Or a restructured company due to a mergeror following a bankruptcyWill be perceived as more riskyInvestors will demand a high coupon
Such firms are unlikely to have high earningsRevenues will peak only after theproductservice is established
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They can ill afford high couponsThey may consider a step-up coupon bond
Where the coupon increases as the bond ages
Assume a company can issue a plain vanillaat a coupon of 8 with a maturity of 5 yearsInstead it may opt for a bond
With a coupon of 6 for the first three years
And a coupon of 10 for the last two yearsThis is a Deferred Interest Security
Provides the issuer with breathing room in theearlier years
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These pay coupons in the form of additionalsecurities and not cash
This offers the issuer time to prepare for cashoutlays
They are used as Mezzanine FinanceThey rank between senior debt and equity in thecapital structureInvestors take more risk as compared to buyersof regular bonds ndash but get higher returnsIssuers can conserve cash in earlier years when itis at a premium
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Fully backed by the federal government ofthe issuing nationConsequently they are virtually devoid ofcredit risk or the risk of defaultThe yield on such securities is a benchmarkfor setting rates on other kinds of debt
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Treasury securities are issuedTo finance expenses in excess of currentrevenuesTo pay interest on debt accumulated in earlieryears due to deficits in those yearsTo repay past debt issues that are currentlymaturing
The US Treasuries marketIs the largest bond market in the worldIs the most liquid bond market in the world
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The Treasury issues three categories ofmarketable securities
T-bills are discount securitiesThey are zero coupon securitiesT-notes and T-bonds are sold at face value andpay interest periodically
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T-bills are issued with a original time tomaturity of one year or less
They are Money market instrumentsThey have maturities of either 1 3 6 or 12months at the time of issue
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T-notes and T-bonds have a time to maturityexceeding one year at the time of issue
They are capital market instrumentsT-notes have maturities ranging from 1-10 yearsT-bonds have an original maturity in excess of 10years extending up to 30 years
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An issue may be followed later by a furtherissue
With the same remaining time to maturity andthe same couponThe issuance of further tranches is termed as aRe-opening
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Six months ago a 10-year note was issuedwith a coupon of 8 per annumToday if a note with 9 frac12 years to maturityand a coupon of 8 issued it will add to thepool that is already trading in the marketThus it is a re-opening of an existing issue
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Who is a primary dealerA PD is a dealer who is authorized to dealdirectly with the Central Bank of the countryIn the US a PD is a bank or securities broker-dealer that directly deals with the FRBNY
Importance of FRBNYIn India a PD deals directly with the RBI
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The Treasury sells bills notes and bonds byway of a competitive auction process
Most of the treasury securities are bought byprimary dealers
Individual investors submit non-competitive bidsand participate on a much smaller scale
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Bids may beCompetitive
Indicate price amp quantity or yield amp quantityNon-competitive
Indicate only quantity
Small investors and individualsgenerally submit non-competitive bids
A non-competitive bidder may not bid for more than$5MM worth of securities in a bill or bond auction
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Primary dealers bid for their accounts andon behalf of their clientsThey usually submit large competitive
bidsBids indicate the maximum price that the bidderis prepared to pay if it is a price based auctionOr the minimum yield that the bidder is
prepared to accept if it is a yield based auction
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The Treasury will net out the totalamount of non-competitive bids
The balance will be allocated to competitivebidders
There are two ways in which securitiescan be allotted
The multiple priceyield auction mechanism
French AuctionsThe uniform priceyield auction mechanism
Dutch Auctions
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Assume that the Treasury is offering 25billion dollars worth of T-bonds
2 billion dollars worth of non-competitive bidshave been receivedSo 23 billion dollars worth of bonds are availableto be offered to the competitive bidders
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There are six competitive bidders who havesubmitted the following yields
The bids have been arranged in ascending orderof yieldIn a price based auction the bids would havebeen arranged in descending order of price
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Bidder Bid Yield Bid Amount
Aggregate Amount
Alpha 5370 30 bn 30 bnBeta 5372 50 bn 80 bn
Gamma 5373 40 bn 12 bn
Delta 5375 80 bn 20 bnCharlie 5375 120 bn 32 bn
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The aggregate demand equals the amount onoffer at a yield of 5375A multiple yield auction will lead to thefollowing allocation
Alpha will get 3 bn at a yield of 5370Beta will get 5 bn at 5372Gamma will get 4 bn at 5373
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At a yield of 5375 we have only 11 bn left toallocateThere is a demand of 20 bn at this yield
8 bn from Delta and 12 bn from CharlieThus we will allocate 1120 = 55 to eachbidder at this yield
There will be pro-rata allocation
055 of 8 bn or 440 bn will go to Delta055 of 12 bn or 66 bn will go to Charlie
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The highest accepted yield is called the StopYield or High Yield
In this case it is 5375The ratio of bids received to the amountawarded is known as the bid to cover ratio
The higher the ratio the stronger is the auction
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Those who bid more than 5375 will getnothing and are said to be shutout of theauctionSince 1999 the US Treasury has beenconducting only uniform yield auctions
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WI stands for ndash When As and If IssuedThe when issued market is a market forforward trading of a bond
Which has been announced but not yet issuedTrades take place from the date ofannouncement until the actual issue date
Helps bidders to gauge the marketrsquos interestbefore the actual auction
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WI trading has ramifications for the biddingstrategies of market participantsTraders can take both long and shortpositions
Settlement is scheduled for the issue date
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It has a bearing on the outcome of theauction
It affects the strategy used by a bidder becauseit has an impact on his prior positionBidders who are long in the WI market enter theauction with a Long PositionThose who are short in the WI market enter theauction with a short position
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The WI market helps in price discoveryIt provides important information on
The strength of demand for the securityAnd on the disparity of biddersrsquo views
This help potential bidders to formulate theirstrategiesAt times a dealer may believe that he hasvery important private information
If so he may not participate in the WI market andwill directly enter the auction with bids based onhis knowledge
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On or before the date of the auction theissues trade on a yield basis
The actual price can be established only afterthe coupon is set
Starting with the day after the auctionSecurities are quoted on a price basis becausethe coupon is known
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In a coupon roll a dealer will purchase themost recently issued security from a clientAnd simultaneously sell the same amount ofthe recently announced new security
The first leg with settle on the following dayThe second leg is a forward contract
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There can be a Reverse RollThe dealer will sell the most recent issue fornext day settlementAnd buy the newly announced security forforward settlement
The forward leg in a RollReverse Roll is a WItrade
It will settle on the new issue settlement date
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The roll is the spread between the yield onthe new security and that on the outstandingissue in the same maturity segmentA GIVE in the Roll means that
The WI security provides a higher yield than theoutstanding issue
A Take in the Roll means thatThe WI security provides a lower yield
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On March 17 20XX the Treasury announcedthe auction of a 2-year note
The auction was scheduled for March 24The settlement date was March 31
Trading of the roll began as soon as the issuewas announcedA Give of 5 bp means that the dealer proposes tobuy the current issue at the prevailing yieldAnd sell the new issue at a yield that is 5 bpmoreA Take of 5 bp means that the dealer proposes tosell the new issue at a yield that is 5bp lower
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The roll achieves the followingHe acquires the outstanding issue for next daysettlementHe sells the to be issued security with the samepar value for forward delivery on 31 March
The customer is rolling over the investmentfrom the current issue to the new issue
This extends the maturity of the investment byone month
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The client can invest the funds received tillthe new issue settlesHowever he loses the accrued interest thathe would have earned had he held on to theissue
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The Treasury per se does not issue zerocoupon securitiesBut zero coupon securities can be created
which are backed by conventional bondsTake a large quantity of a T-note or bond andseparate all the cash flows from each otherSell the entitlement to each cash flowseparately
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Take the case of a two-year T-noteIt can be separated into five zero couponsecurities maturing after
6 months12 months18 months24 months
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Earlier investment banks used to buy bondsfrom the Treasury and separate the cashflows
Each cash flow was then sold separately as a zerocoupon bondSuch issues are called trademarks
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The issue of trademarks has now ceasedBecause investment banks can now createsuch instruments
In concert with the Treasury itselfThese ZCBs are known as STRIPS ndash
Separate Trading of Registered Interest andPrincipal of Securities
These are not issued or sold by the Treasury
The market is made by investment banks
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What is the motivation to create suchproductsIn practice arbitrage is possible when a
coupon security is purchased at a priceThat is lower than what could be obtained byselling each cash flow separately
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Coupon stripping reflects a case of financialengineering
Creating a risk-return profile that is nototherwise available
An investment bank would buy a largequantity of a Treasury security
The securities would be placed with an SPV
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The SPV is a single-purpose dedicated trustIt has the powers to own the bonds andcollect payments
It cannot sell or lend the bondsIt cannot write options on the bondsOr use them as collateral for borrowing
The SPV is empowered to issue zero coupon
bondsWhere each security represents the ownership ofa single cash flow from the mother bond
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Assume that 100MM USD of 15 year bondswith a coupon of 8 are placed with the SPV
The SPV can issue 6M 12M 18M extending up to14 frac12 year zeroes with a total face value of 4MM
USD eachAnd 15 year zeroes with a total face value of104MM
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The Treasury launched this program in 1985to facilitate the stripping of designatedsecurities
All new T-bonds and notes with a maturity of 10years or more are eligibleThe zeroes created in the process are directobligations of the US government
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The mechanism is as followsA dealer who owns a bond or note can ask theFRB where it is held
To replace it with an equivalent set of STRIPS
representing each payment as a separate securityEach of these securities can be traded independentlyof others
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In 1987 the Treasury started to allow dealersto reverse the process
This is called STRIPS RECONSTUTUTION If a dealer owns STRIPS representing all thecoupon and principal payments of a bond
The FED can on request convert these holdings into asingle position in the corresponding bond
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Each coupon and principal cash flow from aTreasury security is assigned a CUSIP
The mother bond is also assigned a CUSIPThe stripped coupons are known as C-STRIPSThe stripped principal is known as P-STRIPSSupply of a C-STRIP increases over time
because a C-STRIP maturing on a day like 15 FEB
2020 will have the same CUSIP irrespective ofwhich mother bond it has come fromThe original coupon rate is irrelevant
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P-STRIPS always correspond to the originalsecurityThey have a unique CUSIPTheir supply is fixed at the time of issuanceIn practice the prices of long-dated P-STRIPSare a bit higher than those of C-STRIPS withthe same maturity date
One reason is that P-STRIPS are more liquid due
to greater availabilityA $100 face value bond with a coupon of 8 willgenerate C-STRIPS with a face value of $4 but P-STRIPS with a face value of $100
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Another reason why P-STRIPS are in higherdemand is that they allow reconstitutionactivities more easily
Assume that the sum of the STRIPS is cheaper than
the mother bondIf a dealer already has the P-STRIPS only the C-STRIPSneed to be acquiredHowever if he owns some of the C-STRIPS he needs toacquire the P-STRIPS and the remaining C-STRIPSThe facility to reconstitute when profitable is pricedinto the P-STRIPSNote Buy and hold investors will prefer C-STRIPSsince they are priced lower and give a higher yield
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For Plain Vanilla bonds the specifiedcoupon rate is valid for the life of thebond
In the case of Floaters the rate is reset atthe beginning of every periodThe rate will vary directly with thebenchmark
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The rate on a Floater is specified as LIBOR+ 50 bp
The spread is positiveIf it were specified as LIBOR ndash 30bp
The spread will be negativeIf LIBOR rises the rate will increasewhereas if LIBOR falls it will decrease
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In the case of a default risk-free floater theprice will reset to par on a coupon date
It may sell at a premium or discount betweencoupon dates
Consider a floater with a coupon = 5-year T-Bond rate
Assume there are two periods left to maturity
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The price at the end of the first coupon period willbe given by
cT-1 is the coupon one period before maturityyT-1 is the YTM one period before maturity
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On a coupon reset date the YTM = couponBecause we have assumed there is no default riskAny change in the required yield as reflected inthe prevailing YTM
Will also be reflected in the coupon being setIf coupon = yield the bond should sell at par
Thus P T-1 = M
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Once again at T-2 c T-2 = yT-2 and P T-2 = MThis logic can be applied to a bond with anytime remaining till maturityHowever between two coupon dates theprice may not be equal to par
Consider the valuation at T-2+k
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Although c T-2 was set at T-2 and is equal toyT-2
yT-2+k is determined at T-2+k and will reflect theyield prevailing at that time
Thus yT-2+k need not equal c T-2 and may behigher or lower
Hence between two coupon dates a floater maysell at a premium or discount
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Now consider a floater characterized bydefault risk
The risk premium required by the market neednot be constant over time
Assume that at the time of issue YTM = 5-year T-note rate + 75bp
The coupon would have been set equal to thisrate and the bond would have been issued at par
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Six months hence the issue may be perceivedas more risky
YTM = 5-year T-note rate + 95 bpThe coupon will however be set equal to theprevailing 5-year rate + 75 bpIf so the issue will not reset to par at the nextcoupon date
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Floaters may come with a CAP or a FLOOR orBOTH
The CAP is a maximum coupon rateProtects issuers against rising rates
The FLOOR is a minimum coupon rateProtects investors against falling rates
When there is a spread over LIBORThere is a natural floorLIBOR cannot be less than zero
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Debt securities may be negotiable or non-negotiable
Negotiable securities can be traded in thesecondary market
Can be endorsed by one party in favor of anotherExamples of non-negotiable debt securities
National savings certificatesConventional Time or Fixed deposits
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The most basic form of a bond is called thePlain Vanilla version
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This is true for all securities not just for bondsMore complicated versions are said to have`Bells and Whistlesrsquo attached
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These bonds are slightly differentThe interest rate does not remain fixedIt varies each period based on the reference rate
Short-term reference rate ndash maturity lt 1 yearFloating rate bonds
Longer-term reference rateVariable or adjustable rate bonds
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Convertible bonds can be converted to sharesof stockCallable bonds can be prematurely retired by
the issuerPutable bonds can be prematurelysurrendered by the holders
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It is the principal valueAmount payable by the borrower to the lastholder at maturityAmount on which the periodic interest paymentsare calculatedAKA as
Par ValueRedemption Value Maturity ValuePrincipal Value
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It is the time remaining in the life of thebond
The length of time for which interest has to bepaid as promisedThe the length of time after which the face valuewill be repaidAKA as
MaturityTermTenor
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The periodic interest payment that has to bemade by the borrower
The coupon rate multiplied by the face valuegives the rupeedollar value of the coupon
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Most bonds pays coupons on a semi-annual basisTrue in UKUSAustraliaJapanIn European and Eurobond markets annualpayments are the norm
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In earlier days bonds were accompanied by abooklet of post-dated coupons
Each coupon could be detached and redeemedon the corresponding coupon payment date
Even today bearer bonds come with couponsThe bearer certificate number is mentioned onthe coupon
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Bond with a face value of $1000The coupon rate is 8 per annum paid semi-annually
So the bond holder will receive1000 x 008
___ = $40 every six months2
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The rate of return if an investor buys thebond at the prevailing price and holds ittill maturity
In order to get the YTM two conditionsmust be satisfied
The bond must be held till maturity All coupon payments received before maturitymust be reinvested at the YTM
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At any point in time the YTM may beGreater thanLess than or
Equal to the Coupon RateYTM is the IRR of a bond
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Bonds involve pure cash flowsSo only ONE REAL POSITIVE YTM
Solution to a Non-Linear equation
Solved iteratively
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A holder gets a stream of contractuallypromised payments
The value of the bond is the value of this stream
of cash flowsCash flows arising at different points in timecannot be addedCash flows have to be discounted
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It is a chicken and egg storyIf we know the yield that is required we canquote a priceOnce we acquire the asset at a certain price we
can work out the corresponding yield
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A bond will pay identical coupons everyperiodAnd will repay the face value at maturity
The periodic cash flows constitutean annuity The terminal face value is a lump
sum payment
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Bond pays a semi-annual coupon of $C2and has a face value of $MAssume there are N coupons left
And that we are standing on a coupondate
We are assuming that the next coupon is exactlysix months away
The required annual yield is yImplies that the semi-annual yield is y2
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The present value of the coupon stream is
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The present value of the face value is
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So the price of the bond is
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IBM has issued a bond with a face value of$1000The coupon is 8 per year to be paid on July
15 and January 15 every yearToday is 15 July 2013 and that the bondmatures on 15 January 2033The required yield is 10 per annum
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JJ ndash 0115FA ndash 0115MS ndash 0115
AO ndash 0115MN ndash 0115JD ndash 0115
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In the example the price is less than theface value
Such a bond is called a Discount Bond
It is trading at a discount from the face valueThe reason is that
The yield is greater than the coupon
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If the yield were to equal the couponThe bond would sell at PARSuch bonds are called PAR Bonds
If the yield is less than the couponThe price will exceed the face valueSuch bonds are called Premium Bonds
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As we move from one coupon date to thenext if the YTM were to remain constant
Par bonds would continue to trade at PARPremium bonds will steadily decline in priceDiscount bonds will steadily increase in price
This is called the Pull to Par EffectAt maturity ndash ALL BONDS WILL TRADE AT PAR
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As we approach maturity the number ofcoupons reduces
The contribution of coupons to price reducesThe contribution of the PV of the face valueincreases
For premium bonds the first effect dominatesThus the price steadily declines
For discount bonds the second effectdominatesThus the price steadily increases
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A plain vanilla or Bullet Bond pays the entireface value at maturity in a lump sumAmortizing bonds pay the principal in
installmentsThe first payment occurs before maturityThe last payment is made at maturity
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Consider a 5 year amortizing bond with aface value of $1000 and an annual coupon of8
The annual cash flows are depicted below
8282014 40
Time Cash Flow
1 802 803 3304 3105 540
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The first two cash flows represent interest ona principal of $1000The third cash flow is interest on $1000 plus
a principal payment of $250The outstanding principal is $750The fourth cash flow is interest on $750 plusa principal payment of $250
The outstanding principal is $500The final cash flow is interest on $500 plusthe remaining principal of $500
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Some companies issue such bonds becausethe assets being funded have a similar cashflow profile
Second the coupon on such a bond may belower than that of a bullet bondIn the case of a bullet bond the entire principalis due at a single point in timeThere is greater default risk
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Microsoft is issuing zeroes with 5 years tomaturity and a face value of $10000
The required yield is 10 per annumWhat should be the price
Price is the PV of the face valueIn practice we discount on a semi-annual basis
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This is to facilitate comparisons withconventional bonds
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A zero coupon bond can never sell at apremium
It will always trade at a discount prior tomaturityAt maturity it will trade at par
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If held to maturity a ZCB will always give riseto a capital gainIf sold prior to maturity there may be a
capital gain or a capital lossConsider a bond with 10 years to maturityThe YTM at the time of purchase was 10The cost was $37690
A year later it is sold at a YTM of 12The corresponding price is $35035
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A newly established issuerOr an issuer with a relatively virgin productor service
Or a restructured company due to a mergeror following a bankruptcyWill be perceived as more riskyInvestors will demand a high coupon
Such firms are unlikely to have high earningsRevenues will peak only after theproductservice is established
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They can ill afford high couponsThey may consider a step-up coupon bond
Where the coupon increases as the bond ages
Assume a company can issue a plain vanillaat a coupon of 8 with a maturity of 5 yearsInstead it may opt for a bond
With a coupon of 6 for the first three years
And a coupon of 10 for the last two yearsThis is a Deferred Interest Security
Provides the issuer with breathing room in theearlier years
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These pay coupons in the form of additionalsecurities and not cash
This offers the issuer time to prepare for cashoutlays
They are used as Mezzanine FinanceThey rank between senior debt and equity in thecapital structureInvestors take more risk as compared to buyersof regular bonds ndash but get higher returnsIssuers can conserve cash in earlier years when itis at a premium
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Fully backed by the federal government ofthe issuing nationConsequently they are virtually devoid ofcredit risk or the risk of defaultThe yield on such securities is a benchmarkfor setting rates on other kinds of debt
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Treasury securities are issuedTo finance expenses in excess of currentrevenuesTo pay interest on debt accumulated in earlieryears due to deficits in those yearsTo repay past debt issues that are currentlymaturing
The US Treasuries marketIs the largest bond market in the worldIs the most liquid bond market in the world
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The Treasury issues three categories ofmarketable securities
T-bills are discount securitiesThey are zero coupon securitiesT-notes and T-bonds are sold at face value andpay interest periodically
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T-bills are issued with a original time tomaturity of one year or less
They are Money market instrumentsThey have maturities of either 1 3 6 or 12months at the time of issue
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T-notes and T-bonds have a time to maturityexceeding one year at the time of issue
They are capital market instrumentsT-notes have maturities ranging from 1-10 yearsT-bonds have an original maturity in excess of 10years extending up to 30 years
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An issue may be followed later by a furtherissue
With the same remaining time to maturity andthe same couponThe issuance of further tranches is termed as aRe-opening
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Six months ago a 10-year note was issuedwith a coupon of 8 per annumToday if a note with 9 frac12 years to maturityand a coupon of 8 issued it will add to thepool that is already trading in the marketThus it is a re-opening of an existing issue
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Who is a primary dealerA PD is a dealer who is authorized to dealdirectly with the Central Bank of the countryIn the US a PD is a bank or securities broker-dealer that directly deals with the FRBNY
Importance of FRBNYIn India a PD deals directly with the RBI
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The Treasury sells bills notes and bonds byway of a competitive auction process
Most of the treasury securities are bought byprimary dealers
Individual investors submit non-competitive bidsand participate on a much smaller scale
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Bids may beCompetitive
Indicate price amp quantity or yield amp quantityNon-competitive
Indicate only quantity
Small investors and individualsgenerally submit non-competitive bids
A non-competitive bidder may not bid for more than$5MM worth of securities in a bill or bond auction
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Primary dealers bid for their accounts andon behalf of their clientsThey usually submit large competitive
bidsBids indicate the maximum price that the bidderis prepared to pay if it is a price based auctionOr the minimum yield that the bidder is
prepared to accept if it is a yield based auction
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The Treasury will net out the totalamount of non-competitive bids
The balance will be allocated to competitivebidders
There are two ways in which securitiescan be allotted
The multiple priceyield auction mechanism
French AuctionsThe uniform priceyield auction mechanism
Dutch Auctions
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Assume that the Treasury is offering 25billion dollars worth of T-bonds
2 billion dollars worth of non-competitive bidshave been receivedSo 23 billion dollars worth of bonds are availableto be offered to the competitive bidders
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There are six competitive bidders who havesubmitted the following yields
The bids have been arranged in ascending orderof yieldIn a price based auction the bids would havebeen arranged in descending order of price
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Bidder Bid Yield Bid Amount
Aggregate Amount
Alpha 5370 30 bn 30 bnBeta 5372 50 bn 80 bn
Gamma 5373 40 bn 12 bn
Delta 5375 80 bn 20 bnCharlie 5375 120 bn 32 bn
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The aggregate demand equals the amount onoffer at a yield of 5375A multiple yield auction will lead to thefollowing allocation
Alpha will get 3 bn at a yield of 5370Beta will get 5 bn at 5372Gamma will get 4 bn at 5373
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At a yield of 5375 we have only 11 bn left toallocateThere is a demand of 20 bn at this yield
8 bn from Delta and 12 bn from CharlieThus we will allocate 1120 = 55 to eachbidder at this yield
There will be pro-rata allocation
055 of 8 bn or 440 bn will go to Delta055 of 12 bn or 66 bn will go to Charlie
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The highest accepted yield is called the StopYield or High Yield
In this case it is 5375The ratio of bids received to the amountawarded is known as the bid to cover ratio
The higher the ratio the stronger is the auction
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Those who bid more than 5375 will getnothing and are said to be shutout of theauctionSince 1999 the US Treasury has beenconducting only uniform yield auctions
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WI stands for ndash When As and If IssuedThe when issued market is a market forforward trading of a bond
Which has been announced but not yet issuedTrades take place from the date ofannouncement until the actual issue date
Helps bidders to gauge the marketrsquos interestbefore the actual auction
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WI trading has ramifications for the biddingstrategies of market participantsTraders can take both long and shortpositions
Settlement is scheduled for the issue date
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It has a bearing on the outcome of theauction
It affects the strategy used by a bidder becauseit has an impact on his prior positionBidders who are long in the WI market enter theauction with a Long PositionThose who are short in the WI market enter theauction with a short position
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The WI market helps in price discoveryIt provides important information on
The strength of demand for the securityAnd on the disparity of biddersrsquo views
This help potential bidders to formulate theirstrategiesAt times a dealer may believe that he hasvery important private information
If so he may not participate in the WI market andwill directly enter the auction with bids based onhis knowledge
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On or before the date of the auction theissues trade on a yield basis
The actual price can be established only afterthe coupon is set
Starting with the day after the auctionSecurities are quoted on a price basis becausethe coupon is known
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In a coupon roll a dealer will purchase themost recently issued security from a clientAnd simultaneously sell the same amount ofthe recently announced new security
The first leg with settle on the following dayThe second leg is a forward contract
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There can be a Reverse RollThe dealer will sell the most recent issue fornext day settlementAnd buy the newly announced security forforward settlement
The forward leg in a RollReverse Roll is a WItrade
It will settle on the new issue settlement date
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The roll is the spread between the yield onthe new security and that on the outstandingissue in the same maturity segmentA GIVE in the Roll means that
The WI security provides a higher yield than theoutstanding issue
A Take in the Roll means thatThe WI security provides a lower yield
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On March 17 20XX the Treasury announcedthe auction of a 2-year note
The auction was scheduled for March 24The settlement date was March 31
Trading of the roll began as soon as the issuewas announcedA Give of 5 bp means that the dealer proposes tobuy the current issue at the prevailing yieldAnd sell the new issue at a yield that is 5 bpmoreA Take of 5 bp means that the dealer proposes tosell the new issue at a yield that is 5bp lower
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The roll achieves the followingHe acquires the outstanding issue for next daysettlementHe sells the to be issued security with the samepar value for forward delivery on 31 March
The customer is rolling over the investmentfrom the current issue to the new issue
This extends the maturity of the investment byone month
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The client can invest the funds received tillthe new issue settlesHowever he loses the accrued interest thathe would have earned had he held on to theissue
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The Treasury per se does not issue zerocoupon securitiesBut zero coupon securities can be created
which are backed by conventional bondsTake a large quantity of a T-note or bond andseparate all the cash flows from each otherSell the entitlement to each cash flowseparately
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Take the case of a two-year T-noteIt can be separated into five zero couponsecurities maturing after
6 months12 months18 months24 months
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Earlier investment banks used to buy bondsfrom the Treasury and separate the cashflows
Each cash flow was then sold separately as a zerocoupon bondSuch issues are called trademarks
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The issue of trademarks has now ceasedBecause investment banks can now createsuch instruments
In concert with the Treasury itselfThese ZCBs are known as STRIPS ndash
Separate Trading of Registered Interest andPrincipal of Securities
These are not issued or sold by the Treasury
The market is made by investment banks
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What is the motivation to create suchproductsIn practice arbitrage is possible when a
coupon security is purchased at a priceThat is lower than what could be obtained byselling each cash flow separately
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Coupon stripping reflects a case of financialengineering
Creating a risk-return profile that is nototherwise available
An investment bank would buy a largequantity of a Treasury security
The securities would be placed with an SPV
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The SPV is a single-purpose dedicated trustIt has the powers to own the bonds andcollect payments
It cannot sell or lend the bondsIt cannot write options on the bondsOr use them as collateral for borrowing
The SPV is empowered to issue zero coupon
bondsWhere each security represents the ownership ofa single cash flow from the mother bond
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Assume that 100MM USD of 15 year bondswith a coupon of 8 are placed with the SPV
The SPV can issue 6M 12M 18M extending up to14 frac12 year zeroes with a total face value of 4MM
USD eachAnd 15 year zeroes with a total face value of104MM
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The Treasury launched this program in 1985to facilitate the stripping of designatedsecurities
All new T-bonds and notes with a maturity of 10years or more are eligibleThe zeroes created in the process are directobligations of the US government
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The mechanism is as followsA dealer who owns a bond or note can ask theFRB where it is held
To replace it with an equivalent set of STRIPS
representing each payment as a separate securityEach of these securities can be traded independentlyof others
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In 1987 the Treasury started to allow dealersto reverse the process
This is called STRIPS RECONSTUTUTION If a dealer owns STRIPS representing all thecoupon and principal payments of a bond
The FED can on request convert these holdings into asingle position in the corresponding bond
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Each coupon and principal cash flow from aTreasury security is assigned a CUSIP
The mother bond is also assigned a CUSIPThe stripped coupons are known as C-STRIPSThe stripped principal is known as P-STRIPSSupply of a C-STRIP increases over time
because a C-STRIP maturing on a day like 15 FEB
2020 will have the same CUSIP irrespective ofwhich mother bond it has come fromThe original coupon rate is irrelevant
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P-STRIPS always correspond to the originalsecurityThey have a unique CUSIPTheir supply is fixed at the time of issuanceIn practice the prices of long-dated P-STRIPSare a bit higher than those of C-STRIPS withthe same maturity date
One reason is that P-STRIPS are more liquid due
to greater availabilityA $100 face value bond with a coupon of 8 willgenerate C-STRIPS with a face value of $4 but P-STRIPS with a face value of $100
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Another reason why P-STRIPS are in higherdemand is that they allow reconstitutionactivities more easily
Assume that the sum of the STRIPS is cheaper than
the mother bondIf a dealer already has the P-STRIPS only the C-STRIPSneed to be acquiredHowever if he owns some of the C-STRIPS he needs toacquire the P-STRIPS and the remaining C-STRIPSThe facility to reconstitute when profitable is pricedinto the P-STRIPSNote Buy and hold investors will prefer C-STRIPSsince they are priced lower and give a higher yield
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For Plain Vanilla bonds the specifiedcoupon rate is valid for the life of thebond
In the case of Floaters the rate is reset atthe beginning of every periodThe rate will vary directly with thebenchmark
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The rate on a Floater is specified as LIBOR+ 50 bp
The spread is positiveIf it were specified as LIBOR ndash 30bp
The spread will be negativeIf LIBOR rises the rate will increasewhereas if LIBOR falls it will decrease
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In the case of a default risk-free floater theprice will reset to par on a coupon date
It may sell at a premium or discount betweencoupon dates
Consider a floater with a coupon = 5-year T-Bond rate
Assume there are two periods left to maturity
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The price at the end of the first coupon period willbe given by
cT-1 is the coupon one period before maturityyT-1 is the YTM one period before maturity
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On a coupon reset date the YTM = couponBecause we have assumed there is no default riskAny change in the required yield as reflected inthe prevailing YTM
Will also be reflected in the coupon being setIf coupon = yield the bond should sell at par
Thus P T-1 = M
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Once again at T-2 c T-2 = yT-2 and P T-2 = MThis logic can be applied to a bond with anytime remaining till maturityHowever between two coupon dates theprice may not be equal to par
Consider the valuation at T-2+k
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Although c T-2 was set at T-2 and is equal toyT-2
yT-2+k is determined at T-2+k and will reflect theyield prevailing at that time
Thus yT-2+k need not equal c T-2 and may behigher or lower
Hence between two coupon dates a floater maysell at a premium or discount
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Now consider a floater characterized bydefault risk
The risk premium required by the market neednot be constant over time
Assume that at the time of issue YTM = 5-year T-note rate + 75bp
The coupon would have been set equal to thisrate and the bond would have been issued at par
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Six months hence the issue may be perceivedas more risky
YTM = 5-year T-note rate + 95 bpThe coupon will however be set equal to theprevailing 5-year rate + 75 bpIf so the issue will not reset to par at the nextcoupon date
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Floaters may come with a CAP or a FLOOR orBOTH
The CAP is a maximum coupon rateProtects issuers against rising rates
The FLOOR is a minimum coupon rateProtects investors against falling rates
When there is a spread over LIBORThere is a natural floorLIBOR cannot be less than zero
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The most basic form of a bond is called thePlain Vanilla version
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This is true for all securities not just for bondsMore complicated versions are said to have`Bells and Whistlesrsquo attached
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These bonds are slightly differentThe interest rate does not remain fixedIt varies each period based on the reference rate
Short-term reference rate ndash maturity lt 1 yearFloating rate bonds
Longer-term reference rateVariable or adjustable rate bonds
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Convertible bonds can be converted to sharesof stockCallable bonds can be prematurely retired by
the issuerPutable bonds can be prematurelysurrendered by the holders
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It is the principal valueAmount payable by the borrower to the lastholder at maturityAmount on which the periodic interest paymentsare calculatedAKA as
Par ValueRedemption Value Maturity ValuePrincipal Value
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It is the time remaining in the life of thebond
The length of time for which interest has to bepaid as promisedThe the length of time after which the face valuewill be repaidAKA as
MaturityTermTenor
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The periodic interest payment that has to bemade by the borrower
The coupon rate multiplied by the face valuegives the rupeedollar value of the coupon
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Most bonds pays coupons on a semi-annual basisTrue in UKUSAustraliaJapanIn European and Eurobond markets annualpayments are the norm
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In earlier days bonds were accompanied by abooklet of post-dated coupons
Each coupon could be detached and redeemedon the corresponding coupon payment date
Even today bearer bonds come with couponsThe bearer certificate number is mentioned onthe coupon
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Bond with a face value of $1000The coupon rate is 8 per annum paid semi-annually
So the bond holder will receive1000 x 008
___ = $40 every six months2
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The rate of return if an investor buys thebond at the prevailing price and holds ittill maturity
In order to get the YTM two conditionsmust be satisfied
The bond must be held till maturity All coupon payments received before maturitymust be reinvested at the YTM
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At any point in time the YTM may beGreater thanLess than or
Equal to the Coupon RateYTM is the IRR of a bond
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Bonds involve pure cash flowsSo only ONE REAL POSITIVE YTM
Solution to a Non-Linear equation
Solved iteratively
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A holder gets a stream of contractuallypromised payments
The value of the bond is the value of this stream
of cash flowsCash flows arising at different points in timecannot be addedCash flows have to be discounted
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It is a chicken and egg storyIf we know the yield that is required we canquote a priceOnce we acquire the asset at a certain price we
can work out the corresponding yield
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A bond will pay identical coupons everyperiodAnd will repay the face value at maturity
The periodic cash flows constitutean annuity The terminal face value is a lump
sum payment
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Bond pays a semi-annual coupon of $C2and has a face value of $MAssume there are N coupons left
And that we are standing on a coupondate
We are assuming that the next coupon is exactlysix months away
The required annual yield is yImplies that the semi-annual yield is y2
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The present value of the coupon stream is
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The present value of the face value is
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So the price of the bond is
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IBM has issued a bond with a face value of$1000The coupon is 8 per year to be paid on July
15 and January 15 every yearToday is 15 July 2013 and that the bondmatures on 15 January 2033The required yield is 10 per annum
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JJ ndash 0115FA ndash 0115MS ndash 0115
AO ndash 0115MN ndash 0115JD ndash 0115
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In the example the price is less than theface value
Such a bond is called a Discount Bond
It is trading at a discount from the face valueThe reason is that
The yield is greater than the coupon
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If the yield were to equal the couponThe bond would sell at PARSuch bonds are called PAR Bonds
If the yield is less than the couponThe price will exceed the face valueSuch bonds are called Premium Bonds
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As we move from one coupon date to thenext if the YTM were to remain constant
Par bonds would continue to trade at PARPremium bonds will steadily decline in priceDiscount bonds will steadily increase in price
This is called the Pull to Par EffectAt maturity ndash ALL BONDS WILL TRADE AT PAR
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As we approach maturity the number ofcoupons reduces
The contribution of coupons to price reducesThe contribution of the PV of the face valueincreases
For premium bonds the first effect dominatesThus the price steadily declines
For discount bonds the second effectdominatesThus the price steadily increases
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A plain vanilla or Bullet Bond pays the entireface value at maturity in a lump sumAmortizing bonds pay the principal in
installmentsThe first payment occurs before maturityThe last payment is made at maturity
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Consider a 5 year amortizing bond with aface value of $1000 and an annual coupon of8
The annual cash flows are depicted below
8282014 40
Time Cash Flow
1 802 803 3304 3105 540
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The first two cash flows represent interest ona principal of $1000The third cash flow is interest on $1000 plus
a principal payment of $250The outstanding principal is $750The fourth cash flow is interest on $750 plusa principal payment of $250
The outstanding principal is $500The final cash flow is interest on $500 plusthe remaining principal of $500
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Some companies issue such bonds becausethe assets being funded have a similar cashflow profile
Second the coupon on such a bond may belower than that of a bullet bondIn the case of a bullet bond the entire principalis due at a single point in timeThere is greater default risk
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Microsoft is issuing zeroes with 5 years tomaturity and a face value of $10000
The required yield is 10 per annumWhat should be the price
Price is the PV of the face valueIn practice we discount on a semi-annual basis
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This is to facilitate comparisons withconventional bonds
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A zero coupon bond can never sell at apremium
It will always trade at a discount prior tomaturityAt maturity it will trade at par
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If held to maturity a ZCB will always give riseto a capital gainIf sold prior to maturity there may be a
capital gain or a capital lossConsider a bond with 10 years to maturityThe YTM at the time of purchase was 10The cost was $37690
A year later it is sold at a YTM of 12The corresponding price is $35035
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A newly established issuerOr an issuer with a relatively virgin productor service
Or a restructured company due to a mergeror following a bankruptcyWill be perceived as more riskyInvestors will demand a high coupon
Such firms are unlikely to have high earningsRevenues will peak only after theproductservice is established
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They can ill afford high couponsThey may consider a step-up coupon bond
Where the coupon increases as the bond ages
Assume a company can issue a plain vanillaat a coupon of 8 with a maturity of 5 yearsInstead it may opt for a bond
With a coupon of 6 for the first three years
And a coupon of 10 for the last two yearsThis is a Deferred Interest Security
Provides the issuer with breathing room in theearlier years
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These pay coupons in the form of additionalsecurities and not cash
This offers the issuer time to prepare for cashoutlays
They are used as Mezzanine FinanceThey rank between senior debt and equity in thecapital structureInvestors take more risk as compared to buyersof regular bonds ndash but get higher returnsIssuers can conserve cash in earlier years when itis at a premium
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Fully backed by the federal government ofthe issuing nationConsequently they are virtually devoid ofcredit risk or the risk of defaultThe yield on such securities is a benchmarkfor setting rates on other kinds of debt
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Treasury securities are issuedTo finance expenses in excess of currentrevenuesTo pay interest on debt accumulated in earlieryears due to deficits in those yearsTo repay past debt issues that are currentlymaturing
The US Treasuries marketIs the largest bond market in the worldIs the most liquid bond market in the world
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The Treasury issues three categories ofmarketable securities
T-bills are discount securitiesThey are zero coupon securitiesT-notes and T-bonds are sold at face value andpay interest periodically
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T-bills are issued with a original time tomaturity of one year or less
They are Money market instrumentsThey have maturities of either 1 3 6 or 12months at the time of issue
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T-notes and T-bonds have a time to maturityexceeding one year at the time of issue
They are capital market instrumentsT-notes have maturities ranging from 1-10 yearsT-bonds have an original maturity in excess of 10years extending up to 30 years
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An issue may be followed later by a furtherissue
With the same remaining time to maturity andthe same couponThe issuance of further tranches is termed as aRe-opening
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Six months ago a 10-year note was issuedwith a coupon of 8 per annumToday if a note with 9 frac12 years to maturityand a coupon of 8 issued it will add to thepool that is already trading in the marketThus it is a re-opening of an existing issue
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Who is a primary dealerA PD is a dealer who is authorized to dealdirectly with the Central Bank of the countryIn the US a PD is a bank or securities broker-dealer that directly deals with the FRBNY
Importance of FRBNYIn India a PD deals directly with the RBI
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The Treasury sells bills notes and bonds byway of a competitive auction process
Most of the treasury securities are bought byprimary dealers
Individual investors submit non-competitive bidsand participate on a much smaller scale
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Bids may beCompetitive
Indicate price amp quantity or yield amp quantityNon-competitive
Indicate only quantity
Small investors and individualsgenerally submit non-competitive bids
A non-competitive bidder may not bid for more than$5MM worth of securities in a bill or bond auction
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Primary dealers bid for their accounts andon behalf of their clientsThey usually submit large competitive
bidsBids indicate the maximum price that the bidderis prepared to pay if it is a price based auctionOr the minimum yield that the bidder is
prepared to accept if it is a yield based auction
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The Treasury will net out the totalamount of non-competitive bids
The balance will be allocated to competitivebidders
There are two ways in which securitiescan be allotted
The multiple priceyield auction mechanism
French AuctionsThe uniform priceyield auction mechanism
Dutch Auctions
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Assume that the Treasury is offering 25billion dollars worth of T-bonds
2 billion dollars worth of non-competitive bidshave been receivedSo 23 billion dollars worth of bonds are availableto be offered to the competitive bidders
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There are six competitive bidders who havesubmitted the following yields
The bids have been arranged in ascending orderof yieldIn a price based auction the bids would havebeen arranged in descending order of price
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Bidder Bid Yield Bid Amount
Aggregate Amount
Alpha 5370 30 bn 30 bnBeta 5372 50 bn 80 bn
Gamma 5373 40 bn 12 bn
Delta 5375 80 bn 20 bnCharlie 5375 120 bn 32 bn
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The aggregate demand equals the amount onoffer at a yield of 5375A multiple yield auction will lead to thefollowing allocation
Alpha will get 3 bn at a yield of 5370Beta will get 5 bn at 5372Gamma will get 4 bn at 5373
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At a yield of 5375 we have only 11 bn left toallocateThere is a demand of 20 bn at this yield
8 bn from Delta and 12 bn from CharlieThus we will allocate 1120 = 55 to eachbidder at this yield
There will be pro-rata allocation
055 of 8 bn or 440 bn will go to Delta055 of 12 bn or 66 bn will go to Charlie
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The highest accepted yield is called the StopYield or High Yield
In this case it is 5375The ratio of bids received to the amountawarded is known as the bid to cover ratio
The higher the ratio the stronger is the auction
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Those who bid more than 5375 will getnothing and are said to be shutout of theauctionSince 1999 the US Treasury has beenconducting only uniform yield auctions
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WI stands for ndash When As and If IssuedThe when issued market is a market forforward trading of a bond
Which has been announced but not yet issuedTrades take place from the date ofannouncement until the actual issue date
Helps bidders to gauge the marketrsquos interestbefore the actual auction
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WI trading has ramifications for the biddingstrategies of market participantsTraders can take both long and shortpositions
Settlement is scheduled for the issue date
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It has a bearing on the outcome of theauction
It affects the strategy used by a bidder becauseit has an impact on his prior positionBidders who are long in the WI market enter theauction with a Long PositionThose who are short in the WI market enter theauction with a short position
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The WI market helps in price discoveryIt provides important information on
The strength of demand for the securityAnd on the disparity of biddersrsquo views
This help potential bidders to formulate theirstrategiesAt times a dealer may believe that he hasvery important private information
If so he may not participate in the WI market andwill directly enter the auction with bids based onhis knowledge
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On or before the date of the auction theissues trade on a yield basis
The actual price can be established only afterthe coupon is set
Starting with the day after the auctionSecurities are quoted on a price basis becausethe coupon is known
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In a coupon roll a dealer will purchase themost recently issued security from a clientAnd simultaneously sell the same amount ofthe recently announced new security
The first leg with settle on the following dayThe second leg is a forward contract
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There can be a Reverse RollThe dealer will sell the most recent issue fornext day settlementAnd buy the newly announced security forforward settlement
The forward leg in a RollReverse Roll is a WItrade
It will settle on the new issue settlement date
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The roll is the spread between the yield onthe new security and that on the outstandingissue in the same maturity segmentA GIVE in the Roll means that
The WI security provides a higher yield than theoutstanding issue
A Take in the Roll means thatThe WI security provides a lower yield
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On March 17 20XX the Treasury announcedthe auction of a 2-year note
The auction was scheduled for March 24The settlement date was March 31
Trading of the roll began as soon as the issuewas announcedA Give of 5 bp means that the dealer proposes tobuy the current issue at the prevailing yieldAnd sell the new issue at a yield that is 5 bpmoreA Take of 5 bp means that the dealer proposes tosell the new issue at a yield that is 5bp lower
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The roll achieves the followingHe acquires the outstanding issue for next daysettlementHe sells the to be issued security with the samepar value for forward delivery on 31 March
The customer is rolling over the investmentfrom the current issue to the new issue
This extends the maturity of the investment byone month
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The client can invest the funds received tillthe new issue settlesHowever he loses the accrued interest thathe would have earned had he held on to theissue
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The Treasury per se does not issue zerocoupon securitiesBut zero coupon securities can be created
which are backed by conventional bondsTake a large quantity of a T-note or bond andseparate all the cash flows from each otherSell the entitlement to each cash flowseparately
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Take the case of a two-year T-noteIt can be separated into five zero couponsecurities maturing after
6 months12 months18 months24 months
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Earlier investment banks used to buy bondsfrom the Treasury and separate the cashflows
Each cash flow was then sold separately as a zerocoupon bondSuch issues are called trademarks
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The issue of trademarks has now ceasedBecause investment banks can now createsuch instruments
In concert with the Treasury itselfThese ZCBs are known as STRIPS ndash
Separate Trading of Registered Interest andPrincipal of Securities
These are not issued or sold by the Treasury
The market is made by investment banks
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What is the motivation to create suchproductsIn practice arbitrage is possible when a
coupon security is purchased at a priceThat is lower than what could be obtained byselling each cash flow separately
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Coupon stripping reflects a case of financialengineering
Creating a risk-return profile that is nototherwise available
An investment bank would buy a largequantity of a Treasury security
The securities would be placed with an SPV
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The SPV is a single-purpose dedicated trustIt has the powers to own the bonds andcollect payments
It cannot sell or lend the bondsIt cannot write options on the bondsOr use them as collateral for borrowing
The SPV is empowered to issue zero coupon
bondsWhere each security represents the ownership ofa single cash flow from the mother bond
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Assume that 100MM USD of 15 year bondswith a coupon of 8 are placed with the SPV
The SPV can issue 6M 12M 18M extending up to14 frac12 year zeroes with a total face value of 4MM
USD eachAnd 15 year zeroes with a total face value of104MM
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The Treasury launched this program in 1985to facilitate the stripping of designatedsecurities
All new T-bonds and notes with a maturity of 10years or more are eligibleThe zeroes created in the process are directobligations of the US government
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The mechanism is as followsA dealer who owns a bond or note can ask theFRB where it is held
To replace it with an equivalent set of STRIPS
representing each payment as a separate securityEach of these securities can be traded independentlyof others
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In 1987 the Treasury started to allow dealersto reverse the process
This is called STRIPS RECONSTUTUTION If a dealer owns STRIPS representing all thecoupon and principal payments of a bond
The FED can on request convert these holdings into asingle position in the corresponding bond
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Each coupon and principal cash flow from aTreasury security is assigned a CUSIP
The mother bond is also assigned a CUSIPThe stripped coupons are known as C-STRIPSThe stripped principal is known as P-STRIPSSupply of a C-STRIP increases over time
because a C-STRIP maturing on a day like 15 FEB
2020 will have the same CUSIP irrespective ofwhich mother bond it has come fromThe original coupon rate is irrelevant
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P-STRIPS always correspond to the originalsecurityThey have a unique CUSIPTheir supply is fixed at the time of issuanceIn practice the prices of long-dated P-STRIPSare a bit higher than those of C-STRIPS withthe same maturity date
One reason is that P-STRIPS are more liquid due
to greater availabilityA $100 face value bond with a coupon of 8 willgenerate C-STRIPS with a face value of $4 but P-STRIPS with a face value of $100
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Another reason why P-STRIPS are in higherdemand is that they allow reconstitutionactivities more easily
Assume that the sum of the STRIPS is cheaper than
the mother bondIf a dealer already has the P-STRIPS only the C-STRIPSneed to be acquiredHowever if he owns some of the C-STRIPS he needs toacquire the P-STRIPS and the remaining C-STRIPSThe facility to reconstitute when profitable is pricedinto the P-STRIPSNote Buy and hold investors will prefer C-STRIPSsince they are priced lower and give a higher yield
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For Plain Vanilla bonds the specifiedcoupon rate is valid for the life of thebond
In the case of Floaters the rate is reset atthe beginning of every periodThe rate will vary directly with thebenchmark
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The rate on a Floater is specified as LIBOR+ 50 bp
The spread is positiveIf it were specified as LIBOR ndash 30bp
The spread will be negativeIf LIBOR rises the rate will increasewhereas if LIBOR falls it will decrease
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In the case of a default risk-free floater theprice will reset to par on a coupon date
It may sell at a premium or discount betweencoupon dates
Consider a floater with a coupon = 5-year T-Bond rate
Assume there are two periods left to maturity
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The price at the end of the first coupon period willbe given by
cT-1 is the coupon one period before maturityyT-1 is the YTM one period before maturity
8112019 FISD-02-A
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On a coupon reset date the YTM = couponBecause we have assumed there is no default riskAny change in the required yield as reflected inthe prevailing YTM
Will also be reflected in the coupon being setIf coupon = yield the bond should sell at par
Thus P T-1 = M
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Once again at T-2 c T-2 = yT-2 and P T-2 = MThis logic can be applied to a bond with anytime remaining till maturityHowever between two coupon dates theprice may not be equal to par
Consider the valuation at T-2+k
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Although c T-2 was set at T-2 and is equal toyT-2
yT-2+k is determined at T-2+k and will reflect theyield prevailing at that time
Thus yT-2+k need not equal c T-2 and may behigher or lower
Hence between two coupon dates a floater maysell at a premium or discount
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Now consider a floater characterized bydefault risk
The risk premium required by the market neednot be constant over time
Assume that at the time of issue YTM = 5-year T-note rate + 75bp
The coupon would have been set equal to thisrate and the bond would have been issued at par
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Six months hence the issue may be perceivedas more risky
YTM = 5-year T-note rate + 95 bpThe coupon will however be set equal to theprevailing 5-year rate + 75 bpIf so the issue will not reset to par at the nextcoupon date
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Floaters may come with a CAP or a FLOOR orBOTH
The CAP is a maximum coupon rateProtects issuers against rising rates
The FLOOR is a minimum coupon rateProtects investors against falling rates
When there is a spread over LIBORThere is a natural floorLIBOR cannot be less than zero
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This is true for all securities not just for bondsMore complicated versions are said to have`Bells and Whistlesrsquo attached
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These bonds are slightly differentThe interest rate does not remain fixedIt varies each period based on the reference rate
Short-term reference rate ndash maturity lt 1 yearFloating rate bonds
Longer-term reference rateVariable or adjustable rate bonds
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Convertible bonds can be converted to sharesof stockCallable bonds can be prematurely retired by
the issuerPutable bonds can be prematurelysurrendered by the holders
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It is the principal valueAmount payable by the borrower to the lastholder at maturityAmount on which the periodic interest paymentsare calculatedAKA as
Par ValueRedemption Value Maturity ValuePrincipal Value
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It is the time remaining in the life of thebond
The length of time for which interest has to bepaid as promisedThe the length of time after which the face valuewill be repaidAKA as
MaturityTermTenor
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The periodic interest payment that has to bemade by the borrower
The coupon rate multiplied by the face valuegives the rupeedollar value of the coupon
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Most bonds pays coupons on a semi-annual basisTrue in UKUSAustraliaJapanIn European and Eurobond markets annualpayments are the norm
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In earlier days bonds were accompanied by abooklet of post-dated coupons
Each coupon could be detached and redeemedon the corresponding coupon payment date
Even today bearer bonds come with couponsThe bearer certificate number is mentioned onthe coupon
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Bond with a face value of $1000The coupon rate is 8 per annum paid semi-annually
So the bond holder will receive1000 x 008
___ = $40 every six months2
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The rate of return if an investor buys thebond at the prevailing price and holds ittill maturity
In order to get the YTM two conditionsmust be satisfied
The bond must be held till maturity All coupon payments received before maturitymust be reinvested at the YTM
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At any point in time the YTM may beGreater thanLess than or
Equal to the Coupon RateYTM is the IRR of a bond
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Bonds involve pure cash flowsSo only ONE REAL POSITIVE YTM
Solution to a Non-Linear equation
Solved iteratively
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A holder gets a stream of contractuallypromised payments
The value of the bond is the value of this stream
of cash flowsCash flows arising at different points in timecannot be addedCash flows have to be discounted
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It is a chicken and egg storyIf we know the yield that is required we canquote a priceOnce we acquire the asset at a certain price we
can work out the corresponding yield
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A bond will pay identical coupons everyperiodAnd will repay the face value at maturity
The periodic cash flows constitutean annuity The terminal face value is a lump
sum payment
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Bond pays a semi-annual coupon of $C2and has a face value of $MAssume there are N coupons left
And that we are standing on a coupondate
We are assuming that the next coupon is exactlysix months away
The required annual yield is yImplies that the semi-annual yield is y2
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The present value of the coupon stream is
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The present value of the face value is
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So the price of the bond is
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IBM has issued a bond with a face value of$1000The coupon is 8 per year to be paid on July
15 and January 15 every yearToday is 15 July 2013 and that the bondmatures on 15 January 2033The required yield is 10 per annum
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JJ ndash 0115FA ndash 0115MS ndash 0115
AO ndash 0115MN ndash 0115JD ndash 0115
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In the example the price is less than theface value
Such a bond is called a Discount Bond
It is trading at a discount from the face valueThe reason is that
The yield is greater than the coupon
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If the yield were to equal the couponThe bond would sell at PARSuch bonds are called PAR Bonds
If the yield is less than the couponThe price will exceed the face valueSuch bonds are called Premium Bonds
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As we move from one coupon date to thenext if the YTM were to remain constant
Par bonds would continue to trade at PARPremium bonds will steadily decline in priceDiscount bonds will steadily increase in price
This is called the Pull to Par EffectAt maturity ndash ALL BONDS WILL TRADE AT PAR
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As we approach maturity the number ofcoupons reduces
The contribution of coupons to price reducesThe contribution of the PV of the face valueincreases
For premium bonds the first effect dominatesThus the price steadily declines
For discount bonds the second effectdominatesThus the price steadily increases
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A plain vanilla or Bullet Bond pays the entireface value at maturity in a lump sumAmortizing bonds pay the principal in
installmentsThe first payment occurs before maturityThe last payment is made at maturity
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Consider a 5 year amortizing bond with aface value of $1000 and an annual coupon of8
The annual cash flows are depicted below
8282014 40
Time Cash Flow
1 802 803 3304 3105 540
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The first two cash flows represent interest ona principal of $1000The third cash flow is interest on $1000 plus
a principal payment of $250The outstanding principal is $750The fourth cash flow is interest on $750 plusa principal payment of $250
The outstanding principal is $500The final cash flow is interest on $500 plusthe remaining principal of $500
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Some companies issue such bonds becausethe assets being funded have a similar cashflow profile
Second the coupon on such a bond may belower than that of a bullet bondIn the case of a bullet bond the entire principalis due at a single point in timeThere is greater default risk
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Microsoft is issuing zeroes with 5 years tomaturity and a face value of $10000
The required yield is 10 per annumWhat should be the price
Price is the PV of the face valueIn practice we discount on a semi-annual basis
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This is to facilitate comparisons withconventional bonds
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A zero coupon bond can never sell at apremium
It will always trade at a discount prior tomaturityAt maturity it will trade at par
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If held to maturity a ZCB will always give riseto a capital gainIf sold prior to maturity there may be a
capital gain or a capital lossConsider a bond with 10 years to maturityThe YTM at the time of purchase was 10The cost was $37690
A year later it is sold at a YTM of 12The corresponding price is $35035
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A newly established issuerOr an issuer with a relatively virgin productor service
Or a restructured company due to a mergeror following a bankruptcyWill be perceived as more riskyInvestors will demand a high coupon
Such firms are unlikely to have high earningsRevenues will peak only after theproductservice is established
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They can ill afford high couponsThey may consider a step-up coupon bond
Where the coupon increases as the bond ages
Assume a company can issue a plain vanillaat a coupon of 8 with a maturity of 5 yearsInstead it may opt for a bond
With a coupon of 6 for the first three years
And a coupon of 10 for the last two yearsThis is a Deferred Interest Security
Provides the issuer with breathing room in theearlier years
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These pay coupons in the form of additionalsecurities and not cash
This offers the issuer time to prepare for cashoutlays
They are used as Mezzanine FinanceThey rank between senior debt and equity in thecapital structureInvestors take more risk as compared to buyersof regular bonds ndash but get higher returnsIssuers can conserve cash in earlier years when itis at a premium
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Fully backed by the federal government ofthe issuing nationConsequently they are virtually devoid ofcredit risk or the risk of defaultThe yield on such securities is a benchmarkfor setting rates on other kinds of debt
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Treasury securities are issuedTo finance expenses in excess of currentrevenuesTo pay interest on debt accumulated in earlieryears due to deficits in those yearsTo repay past debt issues that are currentlymaturing
The US Treasuries marketIs the largest bond market in the worldIs the most liquid bond market in the world
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The Treasury issues three categories ofmarketable securities
T-bills are discount securitiesThey are zero coupon securitiesT-notes and T-bonds are sold at face value andpay interest periodically
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T-bills are issued with a original time tomaturity of one year or less
They are Money market instrumentsThey have maturities of either 1 3 6 or 12months at the time of issue
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T-notes and T-bonds have a time to maturityexceeding one year at the time of issue
They are capital market instrumentsT-notes have maturities ranging from 1-10 yearsT-bonds have an original maturity in excess of 10years extending up to 30 years
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An issue may be followed later by a furtherissue
With the same remaining time to maturity andthe same couponThe issuance of further tranches is termed as aRe-opening
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Six months ago a 10-year note was issuedwith a coupon of 8 per annumToday if a note with 9 frac12 years to maturityand a coupon of 8 issued it will add to thepool that is already trading in the marketThus it is a re-opening of an existing issue
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Who is a primary dealerA PD is a dealer who is authorized to dealdirectly with the Central Bank of the countryIn the US a PD is a bank or securities broker-dealer that directly deals with the FRBNY
Importance of FRBNYIn India a PD deals directly with the RBI
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The Treasury sells bills notes and bonds byway of a competitive auction process
Most of the treasury securities are bought byprimary dealers
Individual investors submit non-competitive bidsand participate on a much smaller scale
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Bids may beCompetitive
Indicate price amp quantity or yield amp quantityNon-competitive
Indicate only quantity
Small investors and individualsgenerally submit non-competitive bids
A non-competitive bidder may not bid for more than$5MM worth of securities in a bill or bond auction
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Primary dealers bid for their accounts andon behalf of their clientsThey usually submit large competitive
bidsBids indicate the maximum price that the bidderis prepared to pay if it is a price based auctionOr the minimum yield that the bidder is
prepared to accept if it is a yield based auction
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The Treasury will net out the totalamount of non-competitive bids
The balance will be allocated to competitivebidders
There are two ways in which securitiescan be allotted
The multiple priceyield auction mechanism
French AuctionsThe uniform priceyield auction mechanism
Dutch Auctions
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Assume that the Treasury is offering 25billion dollars worth of T-bonds
2 billion dollars worth of non-competitive bidshave been receivedSo 23 billion dollars worth of bonds are availableto be offered to the competitive bidders
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There are six competitive bidders who havesubmitted the following yields
The bids have been arranged in ascending orderof yieldIn a price based auction the bids would havebeen arranged in descending order of price
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Bidder Bid Yield Bid Amount
Aggregate Amount
Alpha 5370 30 bn 30 bnBeta 5372 50 bn 80 bn
Gamma 5373 40 bn 12 bn
Delta 5375 80 bn 20 bnCharlie 5375 120 bn 32 bn
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The aggregate demand equals the amount onoffer at a yield of 5375A multiple yield auction will lead to thefollowing allocation
Alpha will get 3 bn at a yield of 5370Beta will get 5 bn at 5372Gamma will get 4 bn at 5373
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At a yield of 5375 we have only 11 bn left toallocateThere is a demand of 20 bn at this yield
8 bn from Delta and 12 bn from CharlieThus we will allocate 1120 = 55 to eachbidder at this yield
There will be pro-rata allocation
055 of 8 bn or 440 bn will go to Delta055 of 12 bn or 66 bn will go to Charlie
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The highest accepted yield is called the StopYield or High Yield
In this case it is 5375The ratio of bids received to the amountawarded is known as the bid to cover ratio
The higher the ratio the stronger is the auction
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Those who bid more than 5375 will getnothing and are said to be shutout of theauctionSince 1999 the US Treasury has beenconducting only uniform yield auctions
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WI stands for ndash When As and If IssuedThe when issued market is a market forforward trading of a bond
Which has been announced but not yet issuedTrades take place from the date ofannouncement until the actual issue date
Helps bidders to gauge the marketrsquos interestbefore the actual auction
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WI trading has ramifications for the biddingstrategies of market participantsTraders can take both long and shortpositions
Settlement is scheduled for the issue date
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It has a bearing on the outcome of theauction
It affects the strategy used by a bidder becauseit has an impact on his prior positionBidders who are long in the WI market enter theauction with a Long PositionThose who are short in the WI market enter theauction with a short position
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The WI market helps in price discoveryIt provides important information on
The strength of demand for the securityAnd on the disparity of biddersrsquo views
This help potential bidders to formulate theirstrategiesAt times a dealer may believe that he hasvery important private information
If so he may not participate in the WI market andwill directly enter the auction with bids based onhis knowledge
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On or before the date of the auction theissues trade on a yield basis
The actual price can be established only afterthe coupon is set
Starting with the day after the auctionSecurities are quoted on a price basis becausethe coupon is known
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In a coupon roll a dealer will purchase themost recently issued security from a clientAnd simultaneously sell the same amount ofthe recently announced new security
The first leg with settle on the following dayThe second leg is a forward contract
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There can be a Reverse RollThe dealer will sell the most recent issue fornext day settlementAnd buy the newly announced security forforward settlement
The forward leg in a RollReverse Roll is a WItrade
It will settle on the new issue settlement date
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The roll is the spread between the yield onthe new security and that on the outstandingissue in the same maturity segmentA GIVE in the Roll means that
The WI security provides a higher yield than theoutstanding issue
A Take in the Roll means thatThe WI security provides a lower yield
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On March 17 20XX the Treasury announcedthe auction of a 2-year note
The auction was scheduled for March 24The settlement date was March 31
Trading of the roll began as soon as the issuewas announcedA Give of 5 bp means that the dealer proposes tobuy the current issue at the prevailing yieldAnd sell the new issue at a yield that is 5 bpmoreA Take of 5 bp means that the dealer proposes tosell the new issue at a yield that is 5bp lower
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The roll achieves the followingHe acquires the outstanding issue for next daysettlementHe sells the to be issued security with the samepar value for forward delivery on 31 March
The customer is rolling over the investmentfrom the current issue to the new issue
This extends the maturity of the investment byone month
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The client can invest the funds received tillthe new issue settlesHowever he loses the accrued interest thathe would have earned had he held on to theissue
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The Treasury per se does not issue zerocoupon securitiesBut zero coupon securities can be created
which are backed by conventional bondsTake a large quantity of a T-note or bond andseparate all the cash flows from each otherSell the entitlement to each cash flowseparately
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Take the case of a two-year T-noteIt can be separated into five zero couponsecurities maturing after
6 months12 months18 months24 months
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Earlier investment banks used to buy bondsfrom the Treasury and separate the cashflows
Each cash flow was then sold separately as a zerocoupon bondSuch issues are called trademarks
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The issue of trademarks has now ceasedBecause investment banks can now createsuch instruments
In concert with the Treasury itselfThese ZCBs are known as STRIPS ndash
Separate Trading of Registered Interest andPrincipal of Securities
These are not issued or sold by the Treasury
The market is made by investment banks
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What is the motivation to create suchproductsIn practice arbitrage is possible when a
coupon security is purchased at a priceThat is lower than what could be obtained byselling each cash flow separately
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Coupon stripping reflects a case of financialengineering
Creating a risk-return profile that is nototherwise available
An investment bank would buy a largequantity of a Treasury security
The securities would be placed with an SPV
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The SPV is a single-purpose dedicated trustIt has the powers to own the bonds andcollect payments
It cannot sell or lend the bondsIt cannot write options on the bondsOr use them as collateral for borrowing
The SPV is empowered to issue zero coupon
bondsWhere each security represents the ownership ofa single cash flow from the mother bond
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Assume that 100MM USD of 15 year bondswith a coupon of 8 are placed with the SPV
The SPV can issue 6M 12M 18M extending up to14 frac12 year zeroes with a total face value of 4MM
USD eachAnd 15 year zeroes with a total face value of104MM
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The Treasury launched this program in 1985to facilitate the stripping of designatedsecurities
All new T-bonds and notes with a maturity of 10years or more are eligibleThe zeroes created in the process are directobligations of the US government
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The mechanism is as followsA dealer who owns a bond or note can ask theFRB where it is held
To replace it with an equivalent set of STRIPS
representing each payment as a separate securityEach of these securities can be traded independentlyof others
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In 1987 the Treasury started to allow dealersto reverse the process
This is called STRIPS RECONSTUTUTION If a dealer owns STRIPS representing all thecoupon and principal payments of a bond
The FED can on request convert these holdings into asingle position in the corresponding bond
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Each coupon and principal cash flow from aTreasury security is assigned a CUSIP
The mother bond is also assigned a CUSIPThe stripped coupons are known as C-STRIPSThe stripped principal is known as P-STRIPSSupply of a C-STRIP increases over time
because a C-STRIP maturing on a day like 15 FEB
2020 will have the same CUSIP irrespective ofwhich mother bond it has come fromThe original coupon rate is irrelevant
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P-STRIPS always correspond to the originalsecurityThey have a unique CUSIPTheir supply is fixed at the time of issuanceIn practice the prices of long-dated P-STRIPSare a bit higher than those of C-STRIPS withthe same maturity date
One reason is that P-STRIPS are more liquid due
to greater availabilityA $100 face value bond with a coupon of 8 willgenerate C-STRIPS with a face value of $4 but P-STRIPS with a face value of $100
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Another reason why P-STRIPS are in higherdemand is that they allow reconstitutionactivities more easily
Assume that the sum of the STRIPS is cheaper than
the mother bondIf a dealer already has the P-STRIPS only the C-STRIPSneed to be acquiredHowever if he owns some of the C-STRIPS he needs toacquire the P-STRIPS and the remaining C-STRIPSThe facility to reconstitute when profitable is pricedinto the P-STRIPSNote Buy and hold investors will prefer C-STRIPSsince they are priced lower and give a higher yield
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For Plain Vanilla bonds the specifiedcoupon rate is valid for the life of thebond
In the case of Floaters the rate is reset atthe beginning of every periodThe rate will vary directly with thebenchmark
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The rate on a Floater is specified as LIBOR+ 50 bp
The spread is positiveIf it were specified as LIBOR ndash 30bp
The spread will be negativeIf LIBOR rises the rate will increasewhereas if LIBOR falls it will decrease
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In the case of a default risk-free floater theprice will reset to par on a coupon date
It may sell at a premium or discount betweencoupon dates
Consider a floater with a coupon = 5-year T-Bond rate
Assume there are two periods left to maturity
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The price at the end of the first coupon period willbe given by
cT-1 is the coupon one period before maturityyT-1 is the YTM one period before maturity
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On a coupon reset date the YTM = couponBecause we have assumed there is no default riskAny change in the required yield as reflected inthe prevailing YTM
Will also be reflected in the coupon being setIf coupon = yield the bond should sell at par
Thus P T-1 = M
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Once again at T-2 c T-2 = yT-2 and P T-2 = MThis logic can be applied to a bond with anytime remaining till maturityHowever between two coupon dates theprice may not be equal to par
Consider the valuation at T-2+k
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Although c T-2 was set at T-2 and is equal toyT-2
yT-2+k is determined at T-2+k and will reflect theyield prevailing at that time
Thus yT-2+k need not equal c T-2 and may behigher or lower
Hence between two coupon dates a floater maysell at a premium or discount
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Now consider a floater characterized bydefault risk
The risk premium required by the market neednot be constant over time
Assume that at the time of issue YTM = 5-year T-note rate + 75bp
The coupon would have been set equal to thisrate and the bond would have been issued at par
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Six months hence the issue may be perceivedas more risky
YTM = 5-year T-note rate + 95 bpThe coupon will however be set equal to theprevailing 5-year rate + 75 bpIf so the issue will not reset to par at the nextcoupon date
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Floaters may come with a CAP or a FLOOR orBOTH
The CAP is a maximum coupon rateProtects issuers against rising rates
The FLOOR is a minimum coupon rateProtects investors against falling rates
When there is a spread over LIBORThere is a natural floorLIBOR cannot be less than zero
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These bonds are slightly differentThe interest rate does not remain fixedIt varies each period based on the reference rate
Short-term reference rate ndash maturity lt 1 yearFloating rate bonds
Longer-term reference rateVariable or adjustable rate bonds
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Convertible bonds can be converted to sharesof stockCallable bonds can be prematurely retired by
the issuerPutable bonds can be prematurelysurrendered by the holders
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It is the principal valueAmount payable by the borrower to the lastholder at maturityAmount on which the periodic interest paymentsare calculatedAKA as
Par ValueRedemption Value Maturity ValuePrincipal Value
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It is the time remaining in the life of thebond
The length of time for which interest has to bepaid as promisedThe the length of time after which the face valuewill be repaidAKA as
MaturityTermTenor
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The periodic interest payment that has to bemade by the borrower
The coupon rate multiplied by the face valuegives the rupeedollar value of the coupon
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Most bonds pays coupons on a semi-annual basisTrue in UKUSAustraliaJapanIn European and Eurobond markets annualpayments are the norm
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In earlier days bonds were accompanied by abooklet of post-dated coupons
Each coupon could be detached and redeemedon the corresponding coupon payment date
Even today bearer bonds come with couponsThe bearer certificate number is mentioned onthe coupon
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Bond with a face value of $1000The coupon rate is 8 per annum paid semi-annually
So the bond holder will receive1000 x 008
___ = $40 every six months2
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The rate of return if an investor buys thebond at the prevailing price and holds ittill maturity
In order to get the YTM two conditionsmust be satisfied
The bond must be held till maturity All coupon payments received before maturitymust be reinvested at the YTM
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At any point in time the YTM may beGreater thanLess than or
Equal to the Coupon RateYTM is the IRR of a bond
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Bonds involve pure cash flowsSo only ONE REAL POSITIVE YTM
Solution to a Non-Linear equation
Solved iteratively
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A holder gets a stream of contractuallypromised payments
The value of the bond is the value of this stream
of cash flowsCash flows arising at different points in timecannot be addedCash flows have to be discounted
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It is a chicken and egg storyIf we know the yield that is required we canquote a priceOnce we acquire the asset at a certain price we
can work out the corresponding yield
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A bond will pay identical coupons everyperiodAnd will repay the face value at maturity
The periodic cash flows constitutean annuity The terminal face value is a lump
sum payment
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Bond pays a semi-annual coupon of $C2and has a face value of $MAssume there are N coupons left
And that we are standing on a coupondate
We are assuming that the next coupon is exactlysix months away
The required annual yield is yImplies that the semi-annual yield is y2
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The present value of the coupon stream is
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The present value of the face value is
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So the price of the bond is
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IBM has issued a bond with a face value of$1000The coupon is 8 per year to be paid on July
15 and January 15 every yearToday is 15 July 2013 and that the bondmatures on 15 January 2033The required yield is 10 per annum
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JJ ndash 0115FA ndash 0115MS ndash 0115
AO ndash 0115MN ndash 0115JD ndash 0115
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In the example the price is less than theface value
Such a bond is called a Discount Bond
It is trading at a discount from the face valueThe reason is that
The yield is greater than the coupon
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If the yield were to equal the couponThe bond would sell at PARSuch bonds are called PAR Bonds
If the yield is less than the couponThe price will exceed the face valueSuch bonds are called Premium Bonds
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As we move from one coupon date to thenext if the YTM were to remain constant
Par bonds would continue to trade at PARPremium bonds will steadily decline in priceDiscount bonds will steadily increase in price
This is called the Pull to Par EffectAt maturity ndash ALL BONDS WILL TRADE AT PAR
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As we approach maturity the number ofcoupons reduces
The contribution of coupons to price reducesThe contribution of the PV of the face valueincreases
For premium bonds the first effect dominatesThus the price steadily declines
For discount bonds the second effectdominatesThus the price steadily increases
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A plain vanilla or Bullet Bond pays the entireface value at maturity in a lump sumAmortizing bonds pay the principal in
installmentsThe first payment occurs before maturityThe last payment is made at maturity
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Consider a 5 year amortizing bond with aface value of $1000 and an annual coupon of8
The annual cash flows are depicted below
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Time Cash Flow
1 802 803 3304 3105 540
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The first two cash flows represent interest ona principal of $1000The third cash flow is interest on $1000 plus
a principal payment of $250The outstanding principal is $750The fourth cash flow is interest on $750 plusa principal payment of $250
The outstanding principal is $500The final cash flow is interest on $500 plusthe remaining principal of $500
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Some companies issue such bonds becausethe assets being funded have a similar cashflow profile
Second the coupon on such a bond may belower than that of a bullet bondIn the case of a bullet bond the entire principalis due at a single point in timeThere is greater default risk
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Microsoft is issuing zeroes with 5 years tomaturity and a face value of $10000
The required yield is 10 per annumWhat should be the price
Price is the PV of the face valueIn practice we discount on a semi-annual basis
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This is to facilitate comparisons withconventional bonds
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A zero coupon bond can never sell at apremium
It will always trade at a discount prior tomaturityAt maturity it will trade at par
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If held to maturity a ZCB will always give riseto a capital gainIf sold prior to maturity there may be a
capital gain or a capital lossConsider a bond with 10 years to maturityThe YTM at the time of purchase was 10The cost was $37690
A year later it is sold at a YTM of 12The corresponding price is $35035
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A newly established issuerOr an issuer with a relatively virgin productor service
Or a restructured company due to a mergeror following a bankruptcyWill be perceived as more riskyInvestors will demand a high coupon
Such firms are unlikely to have high earningsRevenues will peak only after theproductservice is established
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They can ill afford high couponsThey may consider a step-up coupon bond
Where the coupon increases as the bond ages
Assume a company can issue a plain vanillaat a coupon of 8 with a maturity of 5 yearsInstead it may opt for a bond
With a coupon of 6 for the first three years
And a coupon of 10 for the last two yearsThis is a Deferred Interest Security
Provides the issuer with breathing room in theearlier years
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These pay coupons in the form of additionalsecurities and not cash
This offers the issuer time to prepare for cashoutlays
They are used as Mezzanine FinanceThey rank between senior debt and equity in thecapital structureInvestors take more risk as compared to buyersof regular bonds ndash but get higher returnsIssuers can conserve cash in earlier years when itis at a premium
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Fully backed by the federal government ofthe issuing nationConsequently they are virtually devoid ofcredit risk or the risk of defaultThe yield on such securities is a benchmarkfor setting rates on other kinds of debt
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Treasury securities are issuedTo finance expenses in excess of currentrevenuesTo pay interest on debt accumulated in earlieryears due to deficits in those yearsTo repay past debt issues that are currentlymaturing
The US Treasuries marketIs the largest bond market in the worldIs the most liquid bond market in the world
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The Treasury issues three categories ofmarketable securities
T-bills are discount securitiesThey are zero coupon securitiesT-notes and T-bonds are sold at face value andpay interest periodically
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T-bills are issued with a original time tomaturity of one year or less
They are Money market instrumentsThey have maturities of either 1 3 6 or 12months at the time of issue
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T-notes and T-bonds have a time to maturityexceeding one year at the time of issue
They are capital market instrumentsT-notes have maturities ranging from 1-10 yearsT-bonds have an original maturity in excess of 10years extending up to 30 years
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An issue may be followed later by a furtherissue
With the same remaining time to maturity andthe same couponThe issuance of further tranches is termed as aRe-opening
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Six months ago a 10-year note was issuedwith a coupon of 8 per annumToday if a note with 9 frac12 years to maturityand a coupon of 8 issued it will add to thepool that is already trading in the marketThus it is a re-opening of an existing issue
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Who is a primary dealerA PD is a dealer who is authorized to dealdirectly with the Central Bank of the countryIn the US a PD is a bank or securities broker-dealer that directly deals with the FRBNY
Importance of FRBNYIn India a PD deals directly with the RBI
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The Treasury sells bills notes and bonds byway of a competitive auction process
Most of the treasury securities are bought byprimary dealers
Individual investors submit non-competitive bidsand participate on a much smaller scale
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Bids may beCompetitive
Indicate price amp quantity or yield amp quantityNon-competitive
Indicate only quantity
Small investors and individualsgenerally submit non-competitive bids
A non-competitive bidder may not bid for more than$5MM worth of securities in a bill or bond auction
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Primary dealers bid for their accounts andon behalf of their clientsThey usually submit large competitive
bidsBids indicate the maximum price that the bidderis prepared to pay if it is a price based auctionOr the minimum yield that the bidder is
prepared to accept if it is a yield based auction
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The Treasury will net out the totalamount of non-competitive bids
The balance will be allocated to competitivebidders
There are two ways in which securitiescan be allotted
The multiple priceyield auction mechanism
French AuctionsThe uniform priceyield auction mechanism
Dutch Auctions
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Assume that the Treasury is offering 25billion dollars worth of T-bonds
2 billion dollars worth of non-competitive bidshave been receivedSo 23 billion dollars worth of bonds are availableto be offered to the competitive bidders
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There are six competitive bidders who havesubmitted the following yields
The bids have been arranged in ascending orderof yieldIn a price based auction the bids would havebeen arranged in descending order of price
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Bidder Bid Yield Bid Amount
Aggregate Amount
Alpha 5370 30 bn 30 bnBeta 5372 50 bn 80 bn
Gamma 5373 40 bn 12 bn
Delta 5375 80 bn 20 bnCharlie 5375 120 bn 32 bn
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The aggregate demand equals the amount onoffer at a yield of 5375A multiple yield auction will lead to thefollowing allocation
Alpha will get 3 bn at a yield of 5370Beta will get 5 bn at 5372Gamma will get 4 bn at 5373
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At a yield of 5375 we have only 11 bn left toallocateThere is a demand of 20 bn at this yield
8 bn from Delta and 12 bn from CharlieThus we will allocate 1120 = 55 to eachbidder at this yield
There will be pro-rata allocation
055 of 8 bn or 440 bn will go to Delta055 of 12 bn or 66 bn will go to Charlie
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The highest accepted yield is called the StopYield or High Yield
In this case it is 5375The ratio of bids received to the amountawarded is known as the bid to cover ratio
The higher the ratio the stronger is the auction
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Those who bid more than 5375 will getnothing and are said to be shutout of theauctionSince 1999 the US Treasury has beenconducting only uniform yield auctions
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WI stands for ndash When As and If IssuedThe when issued market is a market forforward trading of a bond
Which has been announced but not yet issuedTrades take place from the date ofannouncement until the actual issue date
Helps bidders to gauge the marketrsquos interestbefore the actual auction
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WI trading has ramifications for the biddingstrategies of market participantsTraders can take both long and shortpositions
Settlement is scheduled for the issue date
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It has a bearing on the outcome of theauction
It affects the strategy used by a bidder becauseit has an impact on his prior positionBidders who are long in the WI market enter theauction with a Long PositionThose who are short in the WI market enter theauction with a short position
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The WI market helps in price discoveryIt provides important information on
The strength of demand for the securityAnd on the disparity of biddersrsquo views
This help potential bidders to formulate theirstrategiesAt times a dealer may believe that he hasvery important private information
If so he may not participate in the WI market andwill directly enter the auction with bids based onhis knowledge
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On or before the date of the auction theissues trade on a yield basis
The actual price can be established only afterthe coupon is set
Starting with the day after the auctionSecurities are quoted on a price basis becausethe coupon is known
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In a coupon roll a dealer will purchase themost recently issued security from a clientAnd simultaneously sell the same amount ofthe recently announced new security
The first leg with settle on the following dayThe second leg is a forward contract
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There can be a Reverse RollThe dealer will sell the most recent issue fornext day settlementAnd buy the newly announced security forforward settlement
The forward leg in a RollReverse Roll is a WItrade
It will settle on the new issue settlement date
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The roll is the spread between the yield onthe new security and that on the outstandingissue in the same maturity segmentA GIVE in the Roll means that
The WI security provides a higher yield than theoutstanding issue
A Take in the Roll means thatThe WI security provides a lower yield
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On March 17 20XX the Treasury announcedthe auction of a 2-year note
The auction was scheduled for March 24The settlement date was March 31
Trading of the roll began as soon as the issuewas announcedA Give of 5 bp means that the dealer proposes tobuy the current issue at the prevailing yieldAnd sell the new issue at a yield that is 5 bpmoreA Take of 5 bp means that the dealer proposes tosell the new issue at a yield that is 5bp lower
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The roll achieves the followingHe acquires the outstanding issue for next daysettlementHe sells the to be issued security with the samepar value for forward delivery on 31 March
The customer is rolling over the investmentfrom the current issue to the new issue
This extends the maturity of the investment byone month
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The client can invest the funds received tillthe new issue settlesHowever he loses the accrued interest thathe would have earned had he held on to theissue
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The Treasury per se does not issue zerocoupon securitiesBut zero coupon securities can be created
which are backed by conventional bondsTake a large quantity of a T-note or bond andseparate all the cash flows from each otherSell the entitlement to each cash flowseparately
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Take the case of a two-year T-noteIt can be separated into five zero couponsecurities maturing after
6 months12 months18 months24 months
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Earlier investment banks used to buy bondsfrom the Treasury and separate the cashflows
Each cash flow was then sold separately as a zerocoupon bondSuch issues are called trademarks
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The issue of trademarks has now ceasedBecause investment banks can now createsuch instruments
In concert with the Treasury itselfThese ZCBs are known as STRIPS ndash
Separate Trading of Registered Interest andPrincipal of Securities
These are not issued or sold by the Treasury
The market is made by investment banks
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What is the motivation to create suchproductsIn practice arbitrage is possible when a
coupon security is purchased at a priceThat is lower than what could be obtained byselling each cash flow separately
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Coupon stripping reflects a case of financialengineering
Creating a risk-return profile that is nototherwise available
An investment bank would buy a largequantity of a Treasury security
The securities would be placed with an SPV
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The SPV is a single-purpose dedicated trustIt has the powers to own the bonds andcollect payments
It cannot sell or lend the bondsIt cannot write options on the bondsOr use them as collateral for borrowing
The SPV is empowered to issue zero coupon
bondsWhere each security represents the ownership ofa single cash flow from the mother bond
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Assume that 100MM USD of 15 year bondswith a coupon of 8 are placed with the SPV
The SPV can issue 6M 12M 18M extending up to14 frac12 year zeroes with a total face value of 4MM
USD eachAnd 15 year zeroes with a total face value of104MM
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The Treasury launched this program in 1985to facilitate the stripping of designatedsecurities
All new T-bonds and notes with a maturity of 10years or more are eligibleThe zeroes created in the process are directobligations of the US government
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The mechanism is as followsA dealer who owns a bond or note can ask theFRB where it is held
To replace it with an equivalent set of STRIPS
representing each payment as a separate securityEach of these securities can be traded independentlyof others
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In 1987 the Treasury started to allow dealersto reverse the process
This is called STRIPS RECONSTUTUTION If a dealer owns STRIPS representing all thecoupon and principal payments of a bond
The FED can on request convert these holdings into asingle position in the corresponding bond
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Each coupon and principal cash flow from aTreasury security is assigned a CUSIP
The mother bond is also assigned a CUSIPThe stripped coupons are known as C-STRIPSThe stripped principal is known as P-STRIPSSupply of a C-STRIP increases over time
because a C-STRIP maturing on a day like 15 FEB
2020 will have the same CUSIP irrespective ofwhich mother bond it has come fromThe original coupon rate is irrelevant
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P-STRIPS always correspond to the originalsecurityThey have a unique CUSIPTheir supply is fixed at the time of issuanceIn practice the prices of long-dated P-STRIPSare a bit higher than those of C-STRIPS withthe same maturity date
One reason is that P-STRIPS are more liquid due
to greater availabilityA $100 face value bond with a coupon of 8 willgenerate C-STRIPS with a face value of $4 but P-STRIPS with a face value of $100
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Another reason why P-STRIPS are in higherdemand is that they allow reconstitutionactivities more easily
Assume that the sum of the STRIPS is cheaper than
the mother bondIf a dealer already has the P-STRIPS only the C-STRIPSneed to be acquiredHowever if he owns some of the C-STRIPS he needs toacquire the P-STRIPS and the remaining C-STRIPSThe facility to reconstitute when profitable is pricedinto the P-STRIPSNote Buy and hold investors will prefer C-STRIPSsince they are priced lower and give a higher yield
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For Plain Vanilla bonds the specifiedcoupon rate is valid for the life of thebond
In the case of Floaters the rate is reset atthe beginning of every periodThe rate will vary directly with thebenchmark
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The rate on a Floater is specified as LIBOR+ 50 bp
The spread is positiveIf it were specified as LIBOR ndash 30bp
The spread will be negativeIf LIBOR rises the rate will increasewhereas if LIBOR falls it will decrease
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In the case of a default risk-free floater theprice will reset to par on a coupon date
It may sell at a premium or discount betweencoupon dates
Consider a floater with a coupon = 5-year T-Bond rate
Assume there are two periods left to maturity
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The price at the end of the first coupon period willbe given by
cT-1 is the coupon one period before maturityyT-1 is the YTM one period before maturity
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On a coupon reset date the YTM = couponBecause we have assumed there is no default riskAny change in the required yield as reflected inthe prevailing YTM
Will also be reflected in the coupon being setIf coupon = yield the bond should sell at par
Thus P T-1 = M
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Once again at T-2 c T-2 = yT-2 and P T-2 = MThis logic can be applied to a bond with anytime remaining till maturityHowever between two coupon dates theprice may not be equal to par
Consider the valuation at T-2+k
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Although c T-2 was set at T-2 and is equal toyT-2
yT-2+k is determined at T-2+k and will reflect theyield prevailing at that time
Thus yT-2+k need not equal c T-2 and may behigher or lower
Hence between two coupon dates a floater maysell at a premium or discount
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Now consider a floater characterized bydefault risk
The risk premium required by the market neednot be constant over time
Assume that at the time of issue YTM = 5-year T-note rate + 75bp
The coupon would have been set equal to thisrate and the bond would have been issued at par
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Six months hence the issue may be perceivedas more risky
YTM = 5-year T-note rate + 95 bpThe coupon will however be set equal to theprevailing 5-year rate + 75 bpIf so the issue will not reset to par at the nextcoupon date
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Floaters may come with a CAP or a FLOOR orBOTH
The CAP is a maximum coupon rateProtects issuers against rising rates
The FLOOR is a minimum coupon rateProtects investors against falling rates
When there is a spread over LIBORThere is a natural floorLIBOR cannot be less than zero
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Convertible bonds can be converted to sharesof stockCallable bonds can be prematurely retired by
the issuerPutable bonds can be prematurelysurrendered by the holders
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It is the principal valueAmount payable by the borrower to the lastholder at maturityAmount on which the periodic interest paymentsare calculatedAKA as
Par ValueRedemption Value Maturity ValuePrincipal Value
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It is the time remaining in the life of thebond
The length of time for which interest has to bepaid as promisedThe the length of time after which the face valuewill be repaidAKA as
MaturityTermTenor
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The periodic interest payment that has to bemade by the borrower
The coupon rate multiplied by the face valuegives the rupeedollar value of the coupon
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Most bonds pays coupons on a semi-annual basisTrue in UKUSAustraliaJapanIn European and Eurobond markets annualpayments are the norm
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In earlier days bonds were accompanied by abooklet of post-dated coupons
Each coupon could be detached and redeemedon the corresponding coupon payment date
Even today bearer bonds come with couponsThe bearer certificate number is mentioned onthe coupon
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Bond with a face value of $1000The coupon rate is 8 per annum paid semi-annually
So the bond holder will receive1000 x 008
___ = $40 every six months2
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The rate of return if an investor buys thebond at the prevailing price and holds ittill maturity
In order to get the YTM two conditionsmust be satisfied
The bond must be held till maturity All coupon payments received before maturitymust be reinvested at the YTM
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At any point in time the YTM may beGreater thanLess than or
Equal to the Coupon RateYTM is the IRR of a bond
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Bonds involve pure cash flowsSo only ONE REAL POSITIVE YTM
Solution to a Non-Linear equation
Solved iteratively
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A holder gets a stream of contractuallypromised payments
The value of the bond is the value of this stream
of cash flowsCash flows arising at different points in timecannot be addedCash flows have to be discounted
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It is a chicken and egg storyIf we know the yield that is required we canquote a priceOnce we acquire the asset at a certain price we
can work out the corresponding yield
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A bond will pay identical coupons everyperiodAnd will repay the face value at maturity
The periodic cash flows constitutean annuity The terminal face value is a lump
sum payment
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Bond pays a semi-annual coupon of $C2and has a face value of $MAssume there are N coupons left
And that we are standing on a coupondate
We are assuming that the next coupon is exactlysix months away
The required annual yield is yImplies that the semi-annual yield is y2
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The present value of the coupon stream is
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The present value of the face value is
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So the price of the bond is
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IBM has issued a bond with a face value of$1000The coupon is 8 per year to be paid on July
15 and January 15 every yearToday is 15 July 2013 and that the bondmatures on 15 January 2033The required yield is 10 per annum
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JJ ndash 0115FA ndash 0115MS ndash 0115
AO ndash 0115MN ndash 0115JD ndash 0115
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In the example the price is less than theface value
Such a bond is called a Discount Bond
It is trading at a discount from the face valueThe reason is that
The yield is greater than the coupon
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If the yield were to equal the couponThe bond would sell at PARSuch bonds are called PAR Bonds
If the yield is less than the couponThe price will exceed the face valueSuch bonds are called Premium Bonds
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As we move from one coupon date to thenext if the YTM were to remain constant
Par bonds would continue to trade at PARPremium bonds will steadily decline in priceDiscount bonds will steadily increase in price
This is called the Pull to Par EffectAt maturity ndash ALL BONDS WILL TRADE AT PAR
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As we approach maturity the number ofcoupons reduces
The contribution of coupons to price reducesThe contribution of the PV of the face valueincreases
For premium bonds the first effect dominatesThus the price steadily declines
For discount bonds the second effectdominatesThus the price steadily increases
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A plain vanilla or Bullet Bond pays the entireface value at maturity in a lump sumAmortizing bonds pay the principal in
installmentsThe first payment occurs before maturityThe last payment is made at maturity
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Consider a 5 year amortizing bond with aface value of $1000 and an annual coupon of8
The annual cash flows are depicted below
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Time Cash Flow
1 802 803 3304 3105 540
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The first two cash flows represent interest ona principal of $1000The third cash flow is interest on $1000 plus
a principal payment of $250The outstanding principal is $750The fourth cash flow is interest on $750 plusa principal payment of $250
The outstanding principal is $500The final cash flow is interest on $500 plusthe remaining principal of $500
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Some companies issue such bonds becausethe assets being funded have a similar cashflow profile
Second the coupon on such a bond may belower than that of a bullet bondIn the case of a bullet bond the entire principalis due at a single point in timeThere is greater default risk
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Microsoft is issuing zeroes with 5 years tomaturity and a face value of $10000
The required yield is 10 per annumWhat should be the price
Price is the PV of the face valueIn practice we discount on a semi-annual basis
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This is to facilitate comparisons withconventional bonds
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A zero coupon bond can never sell at apremium
It will always trade at a discount prior tomaturityAt maturity it will trade at par
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If held to maturity a ZCB will always give riseto a capital gainIf sold prior to maturity there may be a
capital gain or a capital lossConsider a bond with 10 years to maturityThe YTM at the time of purchase was 10The cost was $37690
A year later it is sold at a YTM of 12The corresponding price is $35035
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A newly established issuerOr an issuer with a relatively virgin productor service
Or a restructured company due to a mergeror following a bankruptcyWill be perceived as more riskyInvestors will demand a high coupon
Such firms are unlikely to have high earningsRevenues will peak only after theproductservice is established
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They can ill afford high couponsThey may consider a step-up coupon bond
Where the coupon increases as the bond ages
Assume a company can issue a plain vanillaat a coupon of 8 with a maturity of 5 yearsInstead it may opt for a bond
With a coupon of 6 for the first three years
And a coupon of 10 for the last two yearsThis is a Deferred Interest Security
Provides the issuer with breathing room in theearlier years
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These pay coupons in the form of additionalsecurities and not cash
This offers the issuer time to prepare for cashoutlays
They are used as Mezzanine FinanceThey rank between senior debt and equity in thecapital structureInvestors take more risk as compared to buyersof regular bonds ndash but get higher returnsIssuers can conserve cash in earlier years when itis at a premium
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Fully backed by the federal government ofthe issuing nationConsequently they are virtually devoid ofcredit risk or the risk of defaultThe yield on such securities is a benchmarkfor setting rates on other kinds of debt
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Treasury securities are issuedTo finance expenses in excess of currentrevenuesTo pay interest on debt accumulated in earlieryears due to deficits in those yearsTo repay past debt issues that are currentlymaturing
The US Treasuries marketIs the largest bond market in the worldIs the most liquid bond market in the world
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The Treasury issues three categories ofmarketable securities
T-bills are discount securitiesThey are zero coupon securitiesT-notes and T-bonds are sold at face value andpay interest periodically
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T-bills are issued with a original time tomaturity of one year or less
They are Money market instrumentsThey have maturities of either 1 3 6 or 12months at the time of issue
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T-notes and T-bonds have a time to maturityexceeding one year at the time of issue
They are capital market instrumentsT-notes have maturities ranging from 1-10 yearsT-bonds have an original maturity in excess of 10years extending up to 30 years
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An issue may be followed later by a furtherissue
With the same remaining time to maturity andthe same couponThe issuance of further tranches is termed as aRe-opening
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Six months ago a 10-year note was issuedwith a coupon of 8 per annumToday if a note with 9 frac12 years to maturityand a coupon of 8 issued it will add to thepool that is already trading in the marketThus it is a re-opening of an existing issue
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Who is a primary dealerA PD is a dealer who is authorized to dealdirectly with the Central Bank of the countryIn the US a PD is a bank or securities broker-dealer that directly deals with the FRBNY
Importance of FRBNYIn India a PD deals directly with the RBI
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The Treasury sells bills notes and bonds byway of a competitive auction process
Most of the treasury securities are bought byprimary dealers
Individual investors submit non-competitive bidsand participate on a much smaller scale
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Bids may beCompetitive
Indicate price amp quantity or yield amp quantityNon-competitive
Indicate only quantity
Small investors and individualsgenerally submit non-competitive bids
A non-competitive bidder may not bid for more than$5MM worth of securities in a bill or bond auction
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Primary dealers bid for their accounts andon behalf of their clientsThey usually submit large competitive
bidsBids indicate the maximum price that the bidderis prepared to pay if it is a price based auctionOr the minimum yield that the bidder is
prepared to accept if it is a yield based auction
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The Treasury will net out the totalamount of non-competitive bids
The balance will be allocated to competitivebidders
There are two ways in which securitiescan be allotted
The multiple priceyield auction mechanism
French AuctionsThe uniform priceyield auction mechanism
Dutch Auctions
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Assume that the Treasury is offering 25billion dollars worth of T-bonds
2 billion dollars worth of non-competitive bidshave been receivedSo 23 billion dollars worth of bonds are availableto be offered to the competitive bidders
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There are six competitive bidders who havesubmitted the following yields
The bids have been arranged in ascending orderof yieldIn a price based auction the bids would havebeen arranged in descending order of price
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Bidder Bid Yield Bid Amount
Aggregate Amount
Alpha 5370 30 bn 30 bnBeta 5372 50 bn 80 bn
Gamma 5373 40 bn 12 bn
Delta 5375 80 bn 20 bnCharlie 5375 120 bn 32 bn
Tango 5380 30 bn 35 bn8282014 69
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The aggregate demand equals the amount onoffer at a yield of 5375A multiple yield auction will lead to thefollowing allocation
Alpha will get 3 bn at a yield of 5370Beta will get 5 bn at 5372Gamma will get 4 bn at 5373
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At a yield of 5375 we have only 11 bn left toallocateThere is a demand of 20 bn at this yield
8 bn from Delta and 12 bn from CharlieThus we will allocate 1120 = 55 to eachbidder at this yield
There will be pro-rata allocation
055 of 8 bn or 440 bn will go to Delta055 of 12 bn or 66 bn will go to Charlie
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The highest accepted yield is called the StopYield or High Yield
In this case it is 5375The ratio of bids received to the amountawarded is known as the bid to cover ratio
The higher the ratio the stronger is the auction
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Those who bid more than 5375 will getnothing and are said to be shutout of theauctionSince 1999 the US Treasury has beenconducting only uniform yield auctions
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WI stands for ndash When As and If IssuedThe when issued market is a market forforward trading of a bond
Which has been announced but not yet issuedTrades take place from the date ofannouncement until the actual issue date
Helps bidders to gauge the marketrsquos interestbefore the actual auction
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WI trading has ramifications for the biddingstrategies of market participantsTraders can take both long and shortpositions
Settlement is scheduled for the issue date
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It has a bearing on the outcome of theauction
It affects the strategy used by a bidder becauseit has an impact on his prior positionBidders who are long in the WI market enter theauction with a Long PositionThose who are short in the WI market enter theauction with a short position
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The WI market helps in price discoveryIt provides important information on
The strength of demand for the securityAnd on the disparity of biddersrsquo views
This help potential bidders to formulate theirstrategiesAt times a dealer may believe that he hasvery important private information
If so he may not participate in the WI market andwill directly enter the auction with bids based onhis knowledge
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On or before the date of the auction theissues trade on a yield basis
The actual price can be established only afterthe coupon is set
Starting with the day after the auctionSecurities are quoted on a price basis becausethe coupon is known
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In a coupon roll a dealer will purchase themost recently issued security from a clientAnd simultaneously sell the same amount ofthe recently announced new security
The first leg with settle on the following dayThe second leg is a forward contract
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There can be a Reverse RollThe dealer will sell the most recent issue fornext day settlementAnd buy the newly announced security forforward settlement
The forward leg in a RollReverse Roll is a WItrade
It will settle on the new issue settlement date
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The roll is the spread between the yield onthe new security and that on the outstandingissue in the same maturity segmentA GIVE in the Roll means that
The WI security provides a higher yield than theoutstanding issue
A Take in the Roll means thatThe WI security provides a lower yield
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On March 17 20XX the Treasury announcedthe auction of a 2-year note
The auction was scheduled for March 24The settlement date was March 31
Trading of the roll began as soon as the issuewas announcedA Give of 5 bp means that the dealer proposes tobuy the current issue at the prevailing yieldAnd sell the new issue at a yield that is 5 bpmoreA Take of 5 bp means that the dealer proposes tosell the new issue at a yield that is 5bp lower
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The roll achieves the followingHe acquires the outstanding issue for next daysettlementHe sells the to be issued security with the samepar value for forward delivery on 31 March
The customer is rolling over the investmentfrom the current issue to the new issue
This extends the maturity of the investment byone month
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The client can invest the funds received tillthe new issue settlesHowever he loses the accrued interest thathe would have earned had he held on to theissue
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The Treasury per se does not issue zerocoupon securitiesBut zero coupon securities can be created
which are backed by conventional bondsTake a large quantity of a T-note or bond andseparate all the cash flows from each otherSell the entitlement to each cash flowseparately
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Take the case of a two-year T-noteIt can be separated into five zero couponsecurities maturing after
6 months12 months18 months24 months
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Earlier investment banks used to buy bondsfrom the Treasury and separate the cashflows
Each cash flow was then sold separately as a zerocoupon bondSuch issues are called trademarks
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The issue of trademarks has now ceasedBecause investment banks can now createsuch instruments
In concert with the Treasury itselfThese ZCBs are known as STRIPS ndash
Separate Trading of Registered Interest andPrincipal of Securities
These are not issued or sold by the Treasury
The market is made by investment banks
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What is the motivation to create suchproductsIn practice arbitrage is possible when a
coupon security is purchased at a priceThat is lower than what could be obtained byselling each cash flow separately
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Coupon stripping reflects a case of financialengineering
Creating a risk-return profile that is nototherwise available
An investment bank would buy a largequantity of a Treasury security
The securities would be placed with an SPV
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The SPV is a single-purpose dedicated trustIt has the powers to own the bonds andcollect payments
It cannot sell or lend the bondsIt cannot write options on the bondsOr use them as collateral for borrowing
The SPV is empowered to issue zero coupon
bondsWhere each security represents the ownership ofa single cash flow from the mother bond
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Assume that 100MM USD of 15 year bondswith a coupon of 8 are placed with the SPV
The SPV can issue 6M 12M 18M extending up to14 frac12 year zeroes with a total face value of 4MM
USD eachAnd 15 year zeroes with a total face value of104MM
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The Treasury launched this program in 1985to facilitate the stripping of designatedsecurities
All new T-bonds and notes with a maturity of 10years or more are eligibleThe zeroes created in the process are directobligations of the US government
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The mechanism is as followsA dealer who owns a bond or note can ask theFRB where it is held
To replace it with an equivalent set of STRIPS
representing each payment as a separate securityEach of these securities can be traded independentlyof others
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In 1987 the Treasury started to allow dealersto reverse the process
This is called STRIPS RECONSTUTUTION If a dealer owns STRIPS representing all thecoupon and principal payments of a bond
The FED can on request convert these holdings into asingle position in the corresponding bond
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Each coupon and principal cash flow from aTreasury security is assigned a CUSIP
The mother bond is also assigned a CUSIPThe stripped coupons are known as C-STRIPSThe stripped principal is known as P-STRIPSSupply of a C-STRIP increases over time
because a C-STRIP maturing on a day like 15 FEB
2020 will have the same CUSIP irrespective ofwhich mother bond it has come fromThe original coupon rate is irrelevant
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P-STRIPS always correspond to the originalsecurityThey have a unique CUSIPTheir supply is fixed at the time of issuanceIn practice the prices of long-dated P-STRIPSare a bit higher than those of C-STRIPS withthe same maturity date
One reason is that P-STRIPS are more liquid due
to greater availabilityA $100 face value bond with a coupon of 8 willgenerate C-STRIPS with a face value of $4 but P-STRIPS with a face value of $100
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Another reason why P-STRIPS are in higherdemand is that they allow reconstitutionactivities more easily
Assume that the sum of the STRIPS is cheaper than
the mother bondIf a dealer already has the P-STRIPS only the C-STRIPSneed to be acquiredHowever if he owns some of the C-STRIPS he needs toacquire the P-STRIPS and the remaining C-STRIPSThe facility to reconstitute when profitable is pricedinto the P-STRIPSNote Buy and hold investors will prefer C-STRIPSsince they are priced lower and give a higher yield
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For Plain Vanilla bonds the specifiedcoupon rate is valid for the life of thebond
In the case of Floaters the rate is reset atthe beginning of every periodThe rate will vary directly with thebenchmark
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The rate on a Floater is specified as LIBOR+ 50 bp
The spread is positiveIf it were specified as LIBOR ndash 30bp
The spread will be negativeIf LIBOR rises the rate will increasewhereas if LIBOR falls it will decrease
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In the case of a default risk-free floater theprice will reset to par on a coupon date
It may sell at a premium or discount betweencoupon dates
Consider a floater with a coupon = 5-year T-Bond rate
Assume there are two periods left to maturity
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The price at the end of the first coupon period willbe given by
cT-1 is the coupon one period before maturityyT-1 is the YTM one period before maturity
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On a coupon reset date the YTM = couponBecause we have assumed there is no default riskAny change in the required yield as reflected inthe prevailing YTM
Will also be reflected in the coupon being setIf coupon = yield the bond should sell at par
Thus P T-1 = M
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Once again at T-2 c T-2 = yT-2 and P T-2 = MThis logic can be applied to a bond with anytime remaining till maturityHowever between two coupon dates theprice may not be equal to par
Consider the valuation at T-2+k
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Although c T-2 was set at T-2 and is equal toyT-2
yT-2+k is determined at T-2+k and will reflect theyield prevailing at that time
Thus yT-2+k need not equal c T-2 and may behigher or lower
Hence between two coupon dates a floater maysell at a premium or discount
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Now consider a floater characterized bydefault risk
The risk premium required by the market neednot be constant over time
Assume that at the time of issue YTM = 5-year T-note rate + 75bp
The coupon would have been set equal to thisrate and the bond would have been issued at par
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Six months hence the issue may be perceivedas more risky
YTM = 5-year T-note rate + 95 bpThe coupon will however be set equal to theprevailing 5-year rate + 75 bpIf so the issue will not reset to par at the nextcoupon date
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Floaters may come with a CAP or a FLOOR orBOTH
The CAP is a maximum coupon rateProtects issuers against rising rates
The FLOOR is a minimum coupon rateProtects investors against falling rates
When there is a spread over LIBORThere is a natural floorLIBOR cannot be less than zero
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It is the principal valueAmount payable by the borrower to the lastholder at maturityAmount on which the periodic interest paymentsare calculatedAKA as
Par ValueRedemption Value Maturity ValuePrincipal Value
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It is the time remaining in the life of thebond
The length of time for which interest has to bepaid as promisedThe the length of time after which the face valuewill be repaidAKA as
MaturityTermTenor
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The periodic interest payment that has to bemade by the borrower
The coupon rate multiplied by the face valuegives the rupeedollar value of the coupon
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Most bonds pays coupons on a semi-annual basisTrue in UKUSAustraliaJapanIn European and Eurobond markets annualpayments are the norm
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In earlier days bonds were accompanied by abooklet of post-dated coupons
Each coupon could be detached and redeemedon the corresponding coupon payment date
Even today bearer bonds come with couponsThe bearer certificate number is mentioned onthe coupon
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Bond with a face value of $1000The coupon rate is 8 per annum paid semi-annually
So the bond holder will receive1000 x 008
___ = $40 every six months2
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The rate of return if an investor buys thebond at the prevailing price and holds ittill maturity
In order to get the YTM two conditionsmust be satisfied
The bond must be held till maturity All coupon payments received before maturitymust be reinvested at the YTM
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At any point in time the YTM may beGreater thanLess than or
Equal to the Coupon RateYTM is the IRR of a bond
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Bonds involve pure cash flowsSo only ONE REAL POSITIVE YTM
Solution to a Non-Linear equation
Solved iteratively
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A holder gets a stream of contractuallypromised payments
The value of the bond is the value of this stream
of cash flowsCash flows arising at different points in timecannot be addedCash flows have to be discounted
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It is a chicken and egg storyIf we know the yield that is required we canquote a priceOnce we acquire the asset at a certain price we
can work out the corresponding yield
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A bond will pay identical coupons everyperiodAnd will repay the face value at maturity
The periodic cash flows constitutean annuity The terminal face value is a lump
sum payment
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Bond pays a semi-annual coupon of $C2and has a face value of $MAssume there are N coupons left
And that we are standing on a coupondate
We are assuming that the next coupon is exactlysix months away
The required annual yield is yImplies that the semi-annual yield is y2
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The present value of the coupon stream is
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The present value of the face value is
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So the price of the bond is
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IBM has issued a bond with a face value of$1000The coupon is 8 per year to be paid on July
15 and January 15 every yearToday is 15 July 2013 and that the bondmatures on 15 January 2033The required yield is 10 per annum
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JJ ndash 0115FA ndash 0115MS ndash 0115
AO ndash 0115MN ndash 0115JD ndash 0115
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In the example the price is less than theface value
Such a bond is called a Discount Bond
It is trading at a discount from the face valueThe reason is that
The yield is greater than the coupon
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If the yield were to equal the couponThe bond would sell at PARSuch bonds are called PAR Bonds
If the yield is less than the couponThe price will exceed the face valueSuch bonds are called Premium Bonds
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As we move from one coupon date to thenext if the YTM were to remain constant
Par bonds would continue to trade at PARPremium bonds will steadily decline in priceDiscount bonds will steadily increase in price
This is called the Pull to Par EffectAt maturity ndash ALL BONDS WILL TRADE AT PAR
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As we approach maturity the number ofcoupons reduces
The contribution of coupons to price reducesThe contribution of the PV of the face valueincreases
For premium bonds the first effect dominatesThus the price steadily declines
For discount bonds the second effectdominatesThus the price steadily increases
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A plain vanilla or Bullet Bond pays the entireface value at maturity in a lump sumAmortizing bonds pay the principal in
installmentsThe first payment occurs before maturityThe last payment is made at maturity
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Consider a 5 year amortizing bond with aface value of $1000 and an annual coupon of8
The annual cash flows are depicted below
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Time Cash Flow
1 802 803 3304 3105 540
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The first two cash flows represent interest ona principal of $1000The third cash flow is interest on $1000 plus
a principal payment of $250The outstanding principal is $750The fourth cash flow is interest on $750 plusa principal payment of $250
The outstanding principal is $500The final cash flow is interest on $500 plusthe remaining principal of $500
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Some companies issue such bonds becausethe assets being funded have a similar cashflow profile
Second the coupon on such a bond may belower than that of a bullet bondIn the case of a bullet bond the entire principalis due at a single point in timeThere is greater default risk
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Microsoft is issuing zeroes with 5 years tomaturity and a face value of $10000
The required yield is 10 per annumWhat should be the price
Price is the PV of the face valueIn practice we discount on a semi-annual basis
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This is to facilitate comparisons withconventional bonds
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A zero coupon bond can never sell at apremium
It will always trade at a discount prior tomaturityAt maturity it will trade at par
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If held to maturity a ZCB will always give riseto a capital gainIf sold prior to maturity there may be a
capital gain or a capital lossConsider a bond with 10 years to maturityThe YTM at the time of purchase was 10The cost was $37690
A year later it is sold at a YTM of 12The corresponding price is $35035
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A newly established issuerOr an issuer with a relatively virgin productor service
Or a restructured company due to a mergeror following a bankruptcyWill be perceived as more riskyInvestors will demand a high coupon
Such firms are unlikely to have high earningsRevenues will peak only after theproductservice is established
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They can ill afford high couponsThey may consider a step-up coupon bond
Where the coupon increases as the bond ages
Assume a company can issue a plain vanillaat a coupon of 8 with a maturity of 5 yearsInstead it may opt for a bond
With a coupon of 6 for the first three years
And a coupon of 10 for the last two yearsThis is a Deferred Interest Security
Provides the issuer with breathing room in theearlier years
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These pay coupons in the form of additionalsecurities and not cash
This offers the issuer time to prepare for cashoutlays
They are used as Mezzanine FinanceThey rank between senior debt and equity in thecapital structureInvestors take more risk as compared to buyersof regular bonds ndash but get higher returnsIssuers can conserve cash in earlier years when itis at a premium
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Fully backed by the federal government ofthe issuing nationConsequently they are virtually devoid ofcredit risk or the risk of defaultThe yield on such securities is a benchmarkfor setting rates on other kinds of debt
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Treasury securities are issuedTo finance expenses in excess of currentrevenuesTo pay interest on debt accumulated in earlieryears due to deficits in those yearsTo repay past debt issues that are currentlymaturing
The US Treasuries marketIs the largest bond market in the worldIs the most liquid bond market in the world
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The Treasury issues three categories ofmarketable securities
T-bills are discount securitiesThey are zero coupon securitiesT-notes and T-bonds are sold at face value andpay interest periodically
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T-bills are issued with a original time tomaturity of one year or less
They are Money market instrumentsThey have maturities of either 1 3 6 or 12months at the time of issue
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T-notes and T-bonds have a time to maturityexceeding one year at the time of issue
They are capital market instrumentsT-notes have maturities ranging from 1-10 yearsT-bonds have an original maturity in excess of 10years extending up to 30 years
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An issue may be followed later by a furtherissue
With the same remaining time to maturity andthe same couponThe issuance of further tranches is termed as aRe-opening
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Six months ago a 10-year note was issuedwith a coupon of 8 per annumToday if a note with 9 frac12 years to maturityand a coupon of 8 issued it will add to thepool that is already trading in the marketThus it is a re-opening of an existing issue
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Who is a primary dealerA PD is a dealer who is authorized to dealdirectly with the Central Bank of the countryIn the US a PD is a bank or securities broker-dealer that directly deals with the FRBNY
Importance of FRBNYIn India a PD deals directly with the RBI
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The Treasury sells bills notes and bonds byway of a competitive auction process
Most of the treasury securities are bought byprimary dealers
Individual investors submit non-competitive bidsand participate on a much smaller scale
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Bids may beCompetitive
Indicate price amp quantity or yield amp quantityNon-competitive
Indicate only quantity
Small investors and individualsgenerally submit non-competitive bids
A non-competitive bidder may not bid for more than$5MM worth of securities in a bill or bond auction
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Primary dealers bid for their accounts andon behalf of their clientsThey usually submit large competitive
bidsBids indicate the maximum price that the bidderis prepared to pay if it is a price based auctionOr the minimum yield that the bidder is
prepared to accept if it is a yield based auction
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The Treasury will net out the totalamount of non-competitive bids
The balance will be allocated to competitivebidders
There are two ways in which securitiescan be allotted
The multiple priceyield auction mechanism
French AuctionsThe uniform priceyield auction mechanism
Dutch Auctions
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Assume that the Treasury is offering 25billion dollars worth of T-bonds
2 billion dollars worth of non-competitive bidshave been receivedSo 23 billion dollars worth of bonds are availableto be offered to the competitive bidders
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There are six competitive bidders who havesubmitted the following yields
The bids have been arranged in ascending orderof yieldIn a price based auction the bids would havebeen arranged in descending order of price
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Bidder Bid Yield Bid Amount
Aggregate Amount
Alpha 5370 30 bn 30 bnBeta 5372 50 bn 80 bn
Gamma 5373 40 bn 12 bn
Delta 5375 80 bn 20 bnCharlie 5375 120 bn 32 bn
Tango 5380 30 bn 35 bn8282014 69
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The aggregate demand equals the amount onoffer at a yield of 5375A multiple yield auction will lead to thefollowing allocation
Alpha will get 3 bn at a yield of 5370Beta will get 5 bn at 5372Gamma will get 4 bn at 5373
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At a yield of 5375 we have only 11 bn left toallocateThere is a demand of 20 bn at this yield
8 bn from Delta and 12 bn from CharlieThus we will allocate 1120 = 55 to eachbidder at this yield
There will be pro-rata allocation
055 of 8 bn or 440 bn will go to Delta055 of 12 bn or 66 bn will go to Charlie
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The highest accepted yield is called the StopYield or High Yield
In this case it is 5375The ratio of bids received to the amountawarded is known as the bid to cover ratio
The higher the ratio the stronger is the auction
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Those who bid more than 5375 will getnothing and are said to be shutout of theauctionSince 1999 the US Treasury has beenconducting only uniform yield auctions
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WI stands for ndash When As and If IssuedThe when issued market is a market forforward trading of a bond
Which has been announced but not yet issuedTrades take place from the date ofannouncement until the actual issue date
Helps bidders to gauge the marketrsquos interestbefore the actual auction
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WI trading has ramifications for the biddingstrategies of market participantsTraders can take both long and shortpositions
Settlement is scheduled for the issue date
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It has a bearing on the outcome of theauction
It affects the strategy used by a bidder becauseit has an impact on his prior positionBidders who are long in the WI market enter theauction with a Long PositionThose who are short in the WI market enter theauction with a short position
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The WI market helps in price discoveryIt provides important information on
The strength of demand for the securityAnd on the disparity of biddersrsquo views
This help potential bidders to formulate theirstrategiesAt times a dealer may believe that he hasvery important private information
If so he may not participate in the WI market andwill directly enter the auction with bids based onhis knowledge
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On or before the date of the auction theissues trade on a yield basis
The actual price can be established only afterthe coupon is set
Starting with the day after the auctionSecurities are quoted on a price basis becausethe coupon is known
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In a coupon roll a dealer will purchase themost recently issued security from a clientAnd simultaneously sell the same amount ofthe recently announced new security
The first leg with settle on the following dayThe second leg is a forward contract
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There can be a Reverse RollThe dealer will sell the most recent issue fornext day settlementAnd buy the newly announced security forforward settlement
The forward leg in a RollReverse Roll is a WItrade
It will settle on the new issue settlement date
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The roll is the spread between the yield onthe new security and that on the outstandingissue in the same maturity segmentA GIVE in the Roll means that
The WI security provides a higher yield than theoutstanding issue
A Take in the Roll means thatThe WI security provides a lower yield
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On March 17 20XX the Treasury announcedthe auction of a 2-year note
The auction was scheduled for March 24The settlement date was March 31
Trading of the roll began as soon as the issuewas announcedA Give of 5 bp means that the dealer proposes tobuy the current issue at the prevailing yieldAnd sell the new issue at a yield that is 5 bpmoreA Take of 5 bp means that the dealer proposes tosell the new issue at a yield that is 5bp lower
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The roll achieves the followingHe acquires the outstanding issue for next daysettlementHe sells the to be issued security with the samepar value for forward delivery on 31 March
The customer is rolling over the investmentfrom the current issue to the new issue
This extends the maturity of the investment byone month
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The client can invest the funds received tillthe new issue settlesHowever he loses the accrued interest thathe would have earned had he held on to theissue
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The Treasury per se does not issue zerocoupon securitiesBut zero coupon securities can be created
which are backed by conventional bondsTake a large quantity of a T-note or bond andseparate all the cash flows from each otherSell the entitlement to each cash flowseparately
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Take the case of a two-year T-noteIt can be separated into five zero couponsecurities maturing after
6 months12 months18 months24 months
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Earlier investment banks used to buy bondsfrom the Treasury and separate the cashflows
Each cash flow was then sold separately as a zerocoupon bondSuch issues are called trademarks
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The issue of trademarks has now ceasedBecause investment banks can now createsuch instruments
In concert with the Treasury itselfThese ZCBs are known as STRIPS ndash
Separate Trading of Registered Interest andPrincipal of Securities
These are not issued or sold by the Treasury
The market is made by investment banks
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What is the motivation to create suchproductsIn practice arbitrage is possible when a
coupon security is purchased at a priceThat is lower than what could be obtained byselling each cash flow separately
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Coupon stripping reflects a case of financialengineering
Creating a risk-return profile that is nototherwise available
An investment bank would buy a largequantity of a Treasury security
The securities would be placed with an SPV
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The SPV is a single-purpose dedicated trustIt has the powers to own the bonds andcollect payments
It cannot sell or lend the bondsIt cannot write options on the bondsOr use them as collateral for borrowing
The SPV is empowered to issue zero coupon
bondsWhere each security represents the ownership ofa single cash flow from the mother bond
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Assume that 100MM USD of 15 year bondswith a coupon of 8 are placed with the SPV
The SPV can issue 6M 12M 18M extending up to14 frac12 year zeroes with a total face value of 4MM
USD eachAnd 15 year zeroes with a total face value of104MM
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The Treasury launched this program in 1985to facilitate the stripping of designatedsecurities
All new T-bonds and notes with a maturity of 10years or more are eligibleThe zeroes created in the process are directobligations of the US government
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The mechanism is as followsA dealer who owns a bond or note can ask theFRB where it is held
To replace it with an equivalent set of STRIPS
representing each payment as a separate securityEach of these securities can be traded independentlyof others
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In 1987 the Treasury started to allow dealersto reverse the process
This is called STRIPS RECONSTUTUTION If a dealer owns STRIPS representing all thecoupon and principal payments of a bond
The FED can on request convert these holdings into asingle position in the corresponding bond
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Each coupon and principal cash flow from aTreasury security is assigned a CUSIP
The mother bond is also assigned a CUSIPThe stripped coupons are known as C-STRIPSThe stripped principal is known as P-STRIPSSupply of a C-STRIP increases over time
because a C-STRIP maturing on a day like 15 FEB
2020 will have the same CUSIP irrespective ofwhich mother bond it has come fromThe original coupon rate is irrelevant
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P-STRIPS always correspond to the originalsecurityThey have a unique CUSIPTheir supply is fixed at the time of issuanceIn practice the prices of long-dated P-STRIPSare a bit higher than those of C-STRIPS withthe same maturity date
One reason is that P-STRIPS are more liquid due
to greater availabilityA $100 face value bond with a coupon of 8 willgenerate C-STRIPS with a face value of $4 but P-STRIPS with a face value of $100
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Another reason why P-STRIPS are in higherdemand is that they allow reconstitutionactivities more easily
Assume that the sum of the STRIPS is cheaper than
the mother bondIf a dealer already has the P-STRIPS only the C-STRIPSneed to be acquiredHowever if he owns some of the C-STRIPS he needs toacquire the P-STRIPS and the remaining C-STRIPSThe facility to reconstitute when profitable is pricedinto the P-STRIPSNote Buy and hold investors will prefer C-STRIPSsince they are priced lower and give a higher yield
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For Plain Vanilla bonds the specifiedcoupon rate is valid for the life of thebond
In the case of Floaters the rate is reset atthe beginning of every periodThe rate will vary directly with thebenchmark
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The rate on a Floater is specified as LIBOR+ 50 bp
The spread is positiveIf it were specified as LIBOR ndash 30bp
The spread will be negativeIf LIBOR rises the rate will increasewhereas if LIBOR falls it will decrease
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In the case of a default risk-free floater theprice will reset to par on a coupon date
It may sell at a premium or discount betweencoupon dates
Consider a floater with a coupon = 5-year T-Bond rate
Assume there are two periods left to maturity
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The price at the end of the first coupon period willbe given by
cT-1 is the coupon one period before maturityyT-1 is the YTM one period before maturity
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On a coupon reset date the YTM = couponBecause we have assumed there is no default riskAny change in the required yield as reflected inthe prevailing YTM
Will also be reflected in the coupon being setIf coupon = yield the bond should sell at par
Thus P T-1 = M
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Once again at T-2 c T-2 = yT-2 and P T-2 = MThis logic can be applied to a bond with anytime remaining till maturityHowever between two coupon dates theprice may not be equal to par
Consider the valuation at T-2+k
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Although c T-2 was set at T-2 and is equal toyT-2
yT-2+k is determined at T-2+k and will reflect theyield prevailing at that time
Thus yT-2+k need not equal c T-2 and may behigher or lower
Hence between two coupon dates a floater maysell at a premium or discount
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Now consider a floater characterized bydefault risk
The risk premium required by the market neednot be constant over time
Assume that at the time of issue YTM = 5-year T-note rate + 75bp
The coupon would have been set equal to thisrate and the bond would have been issued at par
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Six months hence the issue may be perceivedas more risky
YTM = 5-year T-note rate + 95 bpThe coupon will however be set equal to theprevailing 5-year rate + 75 bpIf so the issue will not reset to par at the nextcoupon date
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Floaters may come with a CAP or a FLOOR orBOTH
The CAP is a maximum coupon rateProtects issuers against rising rates
The FLOOR is a minimum coupon rateProtects investors against falling rates
When there is a spread over LIBORThere is a natural floorLIBOR cannot be less than zero
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It is the time remaining in the life of thebond
The length of time for which interest has to bepaid as promisedThe the length of time after which the face valuewill be repaidAKA as
MaturityTermTenor
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The periodic interest payment that has to bemade by the borrower
The coupon rate multiplied by the face valuegives the rupeedollar value of the coupon
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Most bonds pays coupons on a semi-annual basisTrue in UKUSAustraliaJapanIn European and Eurobond markets annualpayments are the norm
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In earlier days bonds were accompanied by abooklet of post-dated coupons
Each coupon could be detached and redeemedon the corresponding coupon payment date
Even today bearer bonds come with couponsThe bearer certificate number is mentioned onthe coupon
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Bond with a face value of $1000The coupon rate is 8 per annum paid semi-annually
So the bond holder will receive1000 x 008
___ = $40 every six months2
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The rate of return if an investor buys thebond at the prevailing price and holds ittill maturity
In order to get the YTM two conditionsmust be satisfied
The bond must be held till maturity All coupon payments received before maturitymust be reinvested at the YTM
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At any point in time the YTM may beGreater thanLess than or
Equal to the Coupon RateYTM is the IRR of a bond
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Bonds involve pure cash flowsSo only ONE REAL POSITIVE YTM
Solution to a Non-Linear equation
Solved iteratively
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A holder gets a stream of contractuallypromised payments
The value of the bond is the value of this stream
of cash flowsCash flows arising at different points in timecannot be addedCash flows have to be discounted
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It is a chicken and egg storyIf we know the yield that is required we canquote a priceOnce we acquire the asset at a certain price we
can work out the corresponding yield
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A bond will pay identical coupons everyperiodAnd will repay the face value at maturity
The periodic cash flows constitutean annuity The terminal face value is a lump
sum payment
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Bond pays a semi-annual coupon of $C2and has a face value of $MAssume there are N coupons left
And that we are standing on a coupondate
We are assuming that the next coupon is exactlysix months away
The required annual yield is yImplies that the semi-annual yield is y2
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The present value of the coupon stream is
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The present value of the face value is
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So the price of the bond is
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IBM has issued a bond with a face value of$1000The coupon is 8 per year to be paid on July
15 and January 15 every yearToday is 15 July 2013 and that the bondmatures on 15 January 2033The required yield is 10 per annum
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JJ ndash 0115FA ndash 0115MS ndash 0115
AO ndash 0115MN ndash 0115JD ndash 0115
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In the example the price is less than theface value
Such a bond is called a Discount Bond
It is trading at a discount from the face valueThe reason is that
The yield is greater than the coupon
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If the yield were to equal the couponThe bond would sell at PARSuch bonds are called PAR Bonds
If the yield is less than the couponThe price will exceed the face valueSuch bonds are called Premium Bonds
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As we move from one coupon date to thenext if the YTM were to remain constant
Par bonds would continue to trade at PARPremium bonds will steadily decline in priceDiscount bonds will steadily increase in price
This is called the Pull to Par EffectAt maturity ndash ALL BONDS WILL TRADE AT PAR
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As we approach maturity the number ofcoupons reduces
The contribution of coupons to price reducesThe contribution of the PV of the face valueincreases
For premium bonds the first effect dominatesThus the price steadily declines
For discount bonds the second effectdominatesThus the price steadily increases
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A plain vanilla or Bullet Bond pays the entireface value at maturity in a lump sumAmortizing bonds pay the principal in
installmentsThe first payment occurs before maturityThe last payment is made at maturity
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Consider a 5 year amortizing bond with aface value of $1000 and an annual coupon of8
The annual cash flows are depicted below
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Time Cash Flow
1 802 803 3304 3105 540
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The first two cash flows represent interest ona principal of $1000The third cash flow is interest on $1000 plus
a principal payment of $250The outstanding principal is $750The fourth cash flow is interest on $750 plusa principal payment of $250
The outstanding principal is $500The final cash flow is interest on $500 plusthe remaining principal of $500
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Some companies issue such bonds becausethe assets being funded have a similar cashflow profile
Second the coupon on such a bond may belower than that of a bullet bondIn the case of a bullet bond the entire principalis due at a single point in timeThere is greater default risk
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Microsoft is issuing zeroes with 5 years tomaturity and a face value of $10000
The required yield is 10 per annumWhat should be the price
Price is the PV of the face valueIn practice we discount on a semi-annual basis
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This is to facilitate comparisons withconventional bonds
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A zero coupon bond can never sell at apremium
It will always trade at a discount prior tomaturityAt maturity it will trade at par
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If held to maturity a ZCB will always give riseto a capital gainIf sold prior to maturity there may be a
capital gain or a capital lossConsider a bond with 10 years to maturityThe YTM at the time of purchase was 10The cost was $37690
A year later it is sold at a YTM of 12The corresponding price is $35035
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A newly established issuerOr an issuer with a relatively virgin productor service
Or a restructured company due to a mergeror following a bankruptcyWill be perceived as more riskyInvestors will demand a high coupon
Such firms are unlikely to have high earningsRevenues will peak only after theproductservice is established
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They can ill afford high couponsThey may consider a step-up coupon bond
Where the coupon increases as the bond ages
Assume a company can issue a plain vanillaat a coupon of 8 with a maturity of 5 yearsInstead it may opt for a bond
With a coupon of 6 for the first three years
And a coupon of 10 for the last two yearsThis is a Deferred Interest Security
Provides the issuer with breathing room in theearlier years
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These pay coupons in the form of additionalsecurities and not cash
This offers the issuer time to prepare for cashoutlays
They are used as Mezzanine FinanceThey rank between senior debt and equity in thecapital structureInvestors take more risk as compared to buyersof regular bonds ndash but get higher returnsIssuers can conserve cash in earlier years when itis at a premium
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Fully backed by the federal government ofthe issuing nationConsequently they are virtually devoid ofcredit risk or the risk of defaultThe yield on such securities is a benchmarkfor setting rates on other kinds of debt
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Treasury securities are issuedTo finance expenses in excess of currentrevenuesTo pay interest on debt accumulated in earlieryears due to deficits in those yearsTo repay past debt issues that are currentlymaturing
The US Treasuries marketIs the largest bond market in the worldIs the most liquid bond market in the world
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The Treasury issues three categories ofmarketable securities
T-bills are discount securitiesThey are zero coupon securitiesT-notes and T-bonds are sold at face value andpay interest periodically
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T-bills are issued with a original time tomaturity of one year or less
They are Money market instrumentsThey have maturities of either 1 3 6 or 12months at the time of issue
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T-notes and T-bonds have a time to maturityexceeding one year at the time of issue
They are capital market instrumentsT-notes have maturities ranging from 1-10 yearsT-bonds have an original maturity in excess of 10years extending up to 30 years
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An issue may be followed later by a furtherissue
With the same remaining time to maturity andthe same couponThe issuance of further tranches is termed as aRe-opening
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Six months ago a 10-year note was issuedwith a coupon of 8 per annumToday if a note with 9 frac12 years to maturityand a coupon of 8 issued it will add to thepool that is already trading in the marketThus it is a re-opening of an existing issue
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Who is a primary dealerA PD is a dealer who is authorized to dealdirectly with the Central Bank of the countryIn the US a PD is a bank or securities broker-dealer that directly deals with the FRBNY
Importance of FRBNYIn India a PD deals directly with the RBI
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The Treasury sells bills notes and bonds byway of a competitive auction process
Most of the treasury securities are bought byprimary dealers
Individual investors submit non-competitive bidsand participate on a much smaller scale
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Bids may beCompetitive
Indicate price amp quantity or yield amp quantityNon-competitive
Indicate only quantity
Small investors and individualsgenerally submit non-competitive bids
A non-competitive bidder may not bid for more than$5MM worth of securities in a bill or bond auction
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Primary dealers bid for their accounts andon behalf of their clientsThey usually submit large competitive
bidsBids indicate the maximum price that the bidderis prepared to pay if it is a price based auctionOr the minimum yield that the bidder is
prepared to accept if it is a yield based auction
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The Treasury will net out the totalamount of non-competitive bids
The balance will be allocated to competitivebidders
There are two ways in which securitiescan be allotted
The multiple priceyield auction mechanism
French AuctionsThe uniform priceyield auction mechanism
Dutch Auctions
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Assume that the Treasury is offering 25billion dollars worth of T-bonds
2 billion dollars worth of non-competitive bidshave been receivedSo 23 billion dollars worth of bonds are availableto be offered to the competitive bidders
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There are six competitive bidders who havesubmitted the following yields
The bids have been arranged in ascending orderof yieldIn a price based auction the bids would havebeen arranged in descending order of price
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Bidder Bid Yield Bid Amount
Aggregate Amount
Alpha 5370 30 bn 30 bnBeta 5372 50 bn 80 bn
Gamma 5373 40 bn 12 bn
Delta 5375 80 bn 20 bnCharlie 5375 120 bn 32 bn
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The aggregate demand equals the amount onoffer at a yield of 5375A multiple yield auction will lead to thefollowing allocation
Alpha will get 3 bn at a yield of 5370Beta will get 5 bn at 5372Gamma will get 4 bn at 5373
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At a yield of 5375 we have only 11 bn left toallocateThere is a demand of 20 bn at this yield
8 bn from Delta and 12 bn from CharlieThus we will allocate 1120 = 55 to eachbidder at this yield
There will be pro-rata allocation
055 of 8 bn or 440 bn will go to Delta055 of 12 bn or 66 bn will go to Charlie
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The highest accepted yield is called the StopYield or High Yield
In this case it is 5375The ratio of bids received to the amountawarded is known as the bid to cover ratio
The higher the ratio the stronger is the auction
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Those who bid more than 5375 will getnothing and are said to be shutout of theauctionSince 1999 the US Treasury has beenconducting only uniform yield auctions
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WI stands for ndash When As and If IssuedThe when issued market is a market forforward trading of a bond
Which has been announced but not yet issuedTrades take place from the date ofannouncement until the actual issue date
Helps bidders to gauge the marketrsquos interestbefore the actual auction
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WI trading has ramifications for the biddingstrategies of market participantsTraders can take both long and shortpositions
Settlement is scheduled for the issue date
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It has a bearing on the outcome of theauction
It affects the strategy used by a bidder becauseit has an impact on his prior positionBidders who are long in the WI market enter theauction with a Long PositionThose who are short in the WI market enter theauction with a short position
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The WI market helps in price discoveryIt provides important information on
The strength of demand for the securityAnd on the disparity of biddersrsquo views
This help potential bidders to formulate theirstrategiesAt times a dealer may believe that he hasvery important private information
If so he may not participate in the WI market andwill directly enter the auction with bids based onhis knowledge
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On or before the date of the auction theissues trade on a yield basis
The actual price can be established only afterthe coupon is set
Starting with the day after the auctionSecurities are quoted on a price basis becausethe coupon is known
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In a coupon roll a dealer will purchase themost recently issued security from a clientAnd simultaneously sell the same amount ofthe recently announced new security
The first leg with settle on the following dayThe second leg is a forward contract
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There can be a Reverse RollThe dealer will sell the most recent issue fornext day settlementAnd buy the newly announced security forforward settlement
The forward leg in a RollReverse Roll is a WItrade
It will settle on the new issue settlement date
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The roll is the spread between the yield onthe new security and that on the outstandingissue in the same maturity segmentA GIVE in the Roll means that
The WI security provides a higher yield than theoutstanding issue
A Take in the Roll means thatThe WI security provides a lower yield
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On March 17 20XX the Treasury announcedthe auction of a 2-year note
The auction was scheduled for March 24The settlement date was March 31
Trading of the roll began as soon as the issuewas announcedA Give of 5 bp means that the dealer proposes tobuy the current issue at the prevailing yieldAnd sell the new issue at a yield that is 5 bpmoreA Take of 5 bp means that the dealer proposes tosell the new issue at a yield that is 5bp lower
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The roll achieves the followingHe acquires the outstanding issue for next daysettlementHe sells the to be issued security with the samepar value for forward delivery on 31 March
The customer is rolling over the investmentfrom the current issue to the new issue
This extends the maturity of the investment byone month
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The client can invest the funds received tillthe new issue settlesHowever he loses the accrued interest thathe would have earned had he held on to theissue
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The Treasury per se does not issue zerocoupon securitiesBut zero coupon securities can be created
which are backed by conventional bondsTake a large quantity of a T-note or bond andseparate all the cash flows from each otherSell the entitlement to each cash flowseparately
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Take the case of a two-year T-noteIt can be separated into five zero couponsecurities maturing after
6 months12 months18 months24 months
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Earlier investment banks used to buy bondsfrom the Treasury and separate the cashflows
Each cash flow was then sold separately as a zerocoupon bondSuch issues are called trademarks
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The issue of trademarks has now ceasedBecause investment banks can now createsuch instruments
In concert with the Treasury itselfThese ZCBs are known as STRIPS ndash
Separate Trading of Registered Interest andPrincipal of Securities
These are not issued or sold by the Treasury
The market is made by investment banks
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What is the motivation to create suchproductsIn practice arbitrage is possible when a
coupon security is purchased at a priceThat is lower than what could be obtained byselling each cash flow separately
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Coupon stripping reflects a case of financialengineering
Creating a risk-return profile that is nototherwise available
An investment bank would buy a largequantity of a Treasury security
The securities would be placed with an SPV
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The SPV is a single-purpose dedicated trustIt has the powers to own the bonds andcollect payments
It cannot sell or lend the bondsIt cannot write options on the bondsOr use them as collateral for borrowing
The SPV is empowered to issue zero coupon
bondsWhere each security represents the ownership ofa single cash flow from the mother bond
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Assume that 100MM USD of 15 year bondswith a coupon of 8 are placed with the SPV
The SPV can issue 6M 12M 18M extending up to14 frac12 year zeroes with a total face value of 4MM
USD eachAnd 15 year zeroes with a total face value of104MM
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The Treasury launched this program in 1985to facilitate the stripping of designatedsecurities
All new T-bonds and notes with a maturity of 10years or more are eligibleThe zeroes created in the process are directobligations of the US government
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The mechanism is as followsA dealer who owns a bond or note can ask theFRB where it is held
To replace it with an equivalent set of STRIPS
representing each payment as a separate securityEach of these securities can be traded independentlyof others
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In 1987 the Treasury started to allow dealersto reverse the process
This is called STRIPS RECONSTUTUTION If a dealer owns STRIPS representing all thecoupon and principal payments of a bond
The FED can on request convert these holdings into asingle position in the corresponding bond
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Each coupon and principal cash flow from aTreasury security is assigned a CUSIP
The mother bond is also assigned a CUSIPThe stripped coupons are known as C-STRIPSThe stripped principal is known as P-STRIPSSupply of a C-STRIP increases over time
because a C-STRIP maturing on a day like 15 FEB
2020 will have the same CUSIP irrespective ofwhich mother bond it has come fromThe original coupon rate is irrelevant
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P-STRIPS always correspond to the originalsecurityThey have a unique CUSIPTheir supply is fixed at the time of issuanceIn practice the prices of long-dated P-STRIPSare a bit higher than those of C-STRIPS withthe same maturity date
One reason is that P-STRIPS are more liquid due
to greater availabilityA $100 face value bond with a coupon of 8 willgenerate C-STRIPS with a face value of $4 but P-STRIPS with a face value of $100
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Another reason why P-STRIPS are in higherdemand is that they allow reconstitutionactivities more easily
Assume that the sum of the STRIPS is cheaper than
the mother bondIf a dealer already has the P-STRIPS only the C-STRIPSneed to be acquiredHowever if he owns some of the C-STRIPS he needs toacquire the P-STRIPS and the remaining C-STRIPSThe facility to reconstitute when profitable is pricedinto the P-STRIPSNote Buy and hold investors will prefer C-STRIPSsince they are priced lower and give a higher yield
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For Plain Vanilla bonds the specifiedcoupon rate is valid for the life of thebond
In the case of Floaters the rate is reset atthe beginning of every periodThe rate will vary directly with thebenchmark
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The rate on a Floater is specified as LIBOR+ 50 bp
The spread is positiveIf it were specified as LIBOR ndash 30bp
The spread will be negativeIf LIBOR rises the rate will increasewhereas if LIBOR falls it will decrease
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In the case of a default risk-free floater theprice will reset to par on a coupon date
It may sell at a premium or discount betweencoupon dates
Consider a floater with a coupon = 5-year T-Bond rate
Assume there are two periods left to maturity
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The price at the end of the first coupon period willbe given by
cT-1 is the coupon one period before maturityyT-1 is the YTM one period before maturity
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On a coupon reset date the YTM = couponBecause we have assumed there is no default riskAny change in the required yield as reflected inthe prevailing YTM
Will also be reflected in the coupon being setIf coupon = yield the bond should sell at par
Thus P T-1 = M
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Once again at T-2 c T-2 = yT-2 and P T-2 = MThis logic can be applied to a bond with anytime remaining till maturityHowever between two coupon dates theprice may not be equal to par
Consider the valuation at T-2+k
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Although c T-2 was set at T-2 and is equal toyT-2
yT-2+k is determined at T-2+k and will reflect theyield prevailing at that time
Thus yT-2+k need not equal c T-2 and may behigher or lower
Hence between two coupon dates a floater maysell at a premium or discount
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Now consider a floater characterized bydefault risk
The risk premium required by the market neednot be constant over time
Assume that at the time of issue YTM = 5-year T-note rate + 75bp
The coupon would have been set equal to thisrate and the bond would have been issued at par
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Six months hence the issue may be perceivedas more risky
YTM = 5-year T-note rate + 95 bpThe coupon will however be set equal to theprevailing 5-year rate + 75 bpIf so the issue will not reset to par at the nextcoupon date
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Floaters may come with a CAP or a FLOOR orBOTH
The CAP is a maximum coupon rateProtects issuers against rising rates
The FLOOR is a minimum coupon rateProtects investors against falling rates
When there is a spread over LIBORThere is a natural floorLIBOR cannot be less than zero
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The periodic interest payment that has to bemade by the borrower
The coupon rate multiplied by the face valuegives the rupeedollar value of the coupon
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Most bonds pays coupons on a semi-annual basisTrue in UKUSAustraliaJapanIn European and Eurobond markets annualpayments are the norm
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In earlier days bonds were accompanied by abooklet of post-dated coupons
Each coupon could be detached and redeemedon the corresponding coupon payment date
Even today bearer bonds come with couponsThe bearer certificate number is mentioned onthe coupon
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Bond with a face value of $1000The coupon rate is 8 per annum paid semi-annually
So the bond holder will receive1000 x 008
___ = $40 every six months2
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The rate of return if an investor buys thebond at the prevailing price and holds ittill maturity
In order to get the YTM two conditionsmust be satisfied
The bond must be held till maturity All coupon payments received before maturitymust be reinvested at the YTM
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At any point in time the YTM may beGreater thanLess than or
Equal to the Coupon RateYTM is the IRR of a bond
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Bonds involve pure cash flowsSo only ONE REAL POSITIVE YTM
Solution to a Non-Linear equation
Solved iteratively
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A holder gets a stream of contractuallypromised payments
The value of the bond is the value of this stream
of cash flowsCash flows arising at different points in timecannot be addedCash flows have to be discounted
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It is a chicken and egg storyIf we know the yield that is required we canquote a priceOnce we acquire the asset at a certain price we
can work out the corresponding yield
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A bond will pay identical coupons everyperiodAnd will repay the face value at maturity
The periodic cash flows constitutean annuity The terminal face value is a lump
sum payment
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Bond pays a semi-annual coupon of $C2and has a face value of $MAssume there are N coupons left
And that we are standing on a coupondate
We are assuming that the next coupon is exactlysix months away
The required annual yield is yImplies that the semi-annual yield is y2
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The present value of the coupon stream is
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The present value of the face value is
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So the price of the bond is
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IBM has issued a bond with a face value of$1000The coupon is 8 per year to be paid on July
15 and January 15 every yearToday is 15 July 2013 and that the bondmatures on 15 January 2033The required yield is 10 per annum
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JJ ndash 0115FA ndash 0115MS ndash 0115
AO ndash 0115MN ndash 0115JD ndash 0115
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In the example the price is less than theface value
Such a bond is called a Discount Bond
It is trading at a discount from the face valueThe reason is that
The yield is greater than the coupon
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If the yield were to equal the couponThe bond would sell at PARSuch bonds are called PAR Bonds
If the yield is less than the couponThe price will exceed the face valueSuch bonds are called Premium Bonds
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As we move from one coupon date to thenext if the YTM were to remain constant
Par bonds would continue to trade at PARPremium bonds will steadily decline in priceDiscount bonds will steadily increase in price
This is called the Pull to Par EffectAt maturity ndash ALL BONDS WILL TRADE AT PAR
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As we approach maturity the number ofcoupons reduces
The contribution of coupons to price reducesThe contribution of the PV of the face valueincreases
For premium bonds the first effect dominatesThus the price steadily declines
For discount bonds the second effectdominatesThus the price steadily increases
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A plain vanilla or Bullet Bond pays the entireface value at maturity in a lump sumAmortizing bonds pay the principal in
installmentsThe first payment occurs before maturityThe last payment is made at maturity
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Consider a 5 year amortizing bond with aface value of $1000 and an annual coupon of8
The annual cash flows are depicted below
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Time Cash Flow
1 802 803 3304 3105 540
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The first two cash flows represent interest ona principal of $1000The third cash flow is interest on $1000 plus
a principal payment of $250The outstanding principal is $750The fourth cash flow is interest on $750 plusa principal payment of $250
The outstanding principal is $500The final cash flow is interest on $500 plusthe remaining principal of $500
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Some companies issue such bonds becausethe assets being funded have a similar cashflow profile
Second the coupon on such a bond may belower than that of a bullet bondIn the case of a bullet bond the entire principalis due at a single point in timeThere is greater default risk
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Microsoft is issuing zeroes with 5 years tomaturity and a face value of $10000
The required yield is 10 per annumWhat should be the price
Price is the PV of the face valueIn practice we discount on a semi-annual basis
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This is to facilitate comparisons withconventional bonds
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A zero coupon bond can never sell at apremium
It will always trade at a discount prior tomaturityAt maturity it will trade at par
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If held to maturity a ZCB will always give riseto a capital gainIf sold prior to maturity there may be a
capital gain or a capital lossConsider a bond with 10 years to maturityThe YTM at the time of purchase was 10The cost was $37690
A year later it is sold at a YTM of 12The corresponding price is $35035
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A newly established issuerOr an issuer with a relatively virgin productor service
Or a restructured company due to a mergeror following a bankruptcyWill be perceived as more riskyInvestors will demand a high coupon
Such firms are unlikely to have high earningsRevenues will peak only after theproductservice is established
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They can ill afford high couponsThey may consider a step-up coupon bond
Where the coupon increases as the bond ages
Assume a company can issue a plain vanillaat a coupon of 8 with a maturity of 5 yearsInstead it may opt for a bond
With a coupon of 6 for the first three years
And a coupon of 10 for the last two yearsThis is a Deferred Interest Security
Provides the issuer with breathing room in theearlier years
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These pay coupons in the form of additionalsecurities and not cash
This offers the issuer time to prepare for cashoutlays
They are used as Mezzanine FinanceThey rank between senior debt and equity in thecapital structureInvestors take more risk as compared to buyersof regular bonds ndash but get higher returnsIssuers can conserve cash in earlier years when itis at a premium
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Fully backed by the federal government ofthe issuing nationConsequently they are virtually devoid ofcredit risk or the risk of defaultThe yield on such securities is a benchmarkfor setting rates on other kinds of debt
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Treasury securities are issuedTo finance expenses in excess of currentrevenuesTo pay interest on debt accumulated in earlieryears due to deficits in those yearsTo repay past debt issues that are currentlymaturing
The US Treasuries marketIs the largest bond market in the worldIs the most liquid bond market in the world
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The Treasury issues three categories ofmarketable securities
T-bills are discount securitiesThey are zero coupon securitiesT-notes and T-bonds are sold at face value andpay interest periodically
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T-bills are issued with a original time tomaturity of one year or less
They are Money market instrumentsThey have maturities of either 1 3 6 or 12months at the time of issue
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T-notes and T-bonds have a time to maturityexceeding one year at the time of issue
They are capital market instrumentsT-notes have maturities ranging from 1-10 yearsT-bonds have an original maturity in excess of 10years extending up to 30 years
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An issue may be followed later by a furtherissue
With the same remaining time to maturity andthe same couponThe issuance of further tranches is termed as aRe-opening
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Six months ago a 10-year note was issuedwith a coupon of 8 per annumToday if a note with 9 frac12 years to maturityand a coupon of 8 issued it will add to thepool that is already trading in the marketThus it is a re-opening of an existing issue
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Who is a primary dealerA PD is a dealer who is authorized to dealdirectly with the Central Bank of the countryIn the US a PD is a bank or securities broker-dealer that directly deals with the FRBNY
Importance of FRBNYIn India a PD deals directly with the RBI
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The Treasury sells bills notes and bonds byway of a competitive auction process
Most of the treasury securities are bought byprimary dealers
Individual investors submit non-competitive bidsand participate on a much smaller scale
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Bids may beCompetitive
Indicate price amp quantity or yield amp quantityNon-competitive
Indicate only quantity
Small investors and individualsgenerally submit non-competitive bids
A non-competitive bidder may not bid for more than$5MM worth of securities in a bill or bond auction
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Primary dealers bid for their accounts andon behalf of their clientsThey usually submit large competitive
bidsBids indicate the maximum price that the bidderis prepared to pay if it is a price based auctionOr the minimum yield that the bidder is
prepared to accept if it is a yield based auction
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The Treasury will net out the totalamount of non-competitive bids
The balance will be allocated to competitivebidders
There are two ways in which securitiescan be allotted
The multiple priceyield auction mechanism
French AuctionsThe uniform priceyield auction mechanism
Dutch Auctions
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Assume that the Treasury is offering 25billion dollars worth of T-bonds
2 billion dollars worth of non-competitive bidshave been receivedSo 23 billion dollars worth of bonds are availableto be offered to the competitive bidders
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There are six competitive bidders who havesubmitted the following yields
The bids have been arranged in ascending orderof yieldIn a price based auction the bids would havebeen arranged in descending order of price
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Bidder Bid Yield Bid Amount
Aggregate Amount
Alpha 5370 30 bn 30 bnBeta 5372 50 bn 80 bn
Gamma 5373 40 bn 12 bn
Delta 5375 80 bn 20 bnCharlie 5375 120 bn 32 bn
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The aggregate demand equals the amount onoffer at a yield of 5375A multiple yield auction will lead to thefollowing allocation
Alpha will get 3 bn at a yield of 5370Beta will get 5 bn at 5372Gamma will get 4 bn at 5373
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At a yield of 5375 we have only 11 bn left toallocateThere is a demand of 20 bn at this yield
8 bn from Delta and 12 bn from CharlieThus we will allocate 1120 = 55 to eachbidder at this yield
There will be pro-rata allocation
055 of 8 bn or 440 bn will go to Delta055 of 12 bn or 66 bn will go to Charlie
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The highest accepted yield is called the StopYield or High Yield
In this case it is 5375The ratio of bids received to the amountawarded is known as the bid to cover ratio
The higher the ratio the stronger is the auction
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Those who bid more than 5375 will getnothing and are said to be shutout of theauctionSince 1999 the US Treasury has beenconducting only uniform yield auctions
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WI stands for ndash When As and If IssuedThe when issued market is a market forforward trading of a bond
Which has been announced but not yet issuedTrades take place from the date ofannouncement until the actual issue date
Helps bidders to gauge the marketrsquos interestbefore the actual auction
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WI trading has ramifications for the biddingstrategies of market participantsTraders can take both long and shortpositions
Settlement is scheduled for the issue date
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It has a bearing on the outcome of theauction
It affects the strategy used by a bidder becauseit has an impact on his prior positionBidders who are long in the WI market enter theauction with a Long PositionThose who are short in the WI market enter theauction with a short position
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The WI market helps in price discoveryIt provides important information on
The strength of demand for the securityAnd on the disparity of biddersrsquo views
This help potential bidders to formulate theirstrategiesAt times a dealer may believe that he hasvery important private information
If so he may not participate in the WI market andwill directly enter the auction with bids based onhis knowledge
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On or before the date of the auction theissues trade on a yield basis
The actual price can be established only afterthe coupon is set
Starting with the day after the auctionSecurities are quoted on a price basis becausethe coupon is known
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In a coupon roll a dealer will purchase themost recently issued security from a clientAnd simultaneously sell the same amount ofthe recently announced new security
The first leg with settle on the following dayThe second leg is a forward contract
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There can be a Reverse RollThe dealer will sell the most recent issue fornext day settlementAnd buy the newly announced security forforward settlement
The forward leg in a RollReverse Roll is a WItrade
It will settle on the new issue settlement date
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The roll is the spread between the yield onthe new security and that on the outstandingissue in the same maturity segmentA GIVE in the Roll means that
The WI security provides a higher yield than theoutstanding issue
A Take in the Roll means thatThe WI security provides a lower yield
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On March 17 20XX the Treasury announcedthe auction of a 2-year note
The auction was scheduled for March 24The settlement date was March 31
Trading of the roll began as soon as the issuewas announcedA Give of 5 bp means that the dealer proposes tobuy the current issue at the prevailing yieldAnd sell the new issue at a yield that is 5 bpmoreA Take of 5 bp means that the dealer proposes tosell the new issue at a yield that is 5bp lower
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The roll achieves the followingHe acquires the outstanding issue for next daysettlementHe sells the to be issued security with the samepar value for forward delivery on 31 March
The customer is rolling over the investmentfrom the current issue to the new issue
This extends the maturity of the investment byone month
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The client can invest the funds received tillthe new issue settlesHowever he loses the accrued interest thathe would have earned had he held on to theissue
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The Treasury per se does not issue zerocoupon securitiesBut zero coupon securities can be created
which are backed by conventional bondsTake a large quantity of a T-note or bond andseparate all the cash flows from each otherSell the entitlement to each cash flowseparately
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Take the case of a two-year T-noteIt can be separated into five zero couponsecurities maturing after
6 months12 months18 months24 months
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Earlier investment banks used to buy bondsfrom the Treasury and separate the cashflows
Each cash flow was then sold separately as a zerocoupon bondSuch issues are called trademarks
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The issue of trademarks has now ceasedBecause investment banks can now createsuch instruments
In concert with the Treasury itselfThese ZCBs are known as STRIPS ndash
Separate Trading of Registered Interest andPrincipal of Securities
These are not issued or sold by the Treasury
The market is made by investment banks
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What is the motivation to create suchproductsIn practice arbitrage is possible when a
coupon security is purchased at a priceThat is lower than what could be obtained byselling each cash flow separately
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Coupon stripping reflects a case of financialengineering
Creating a risk-return profile that is nototherwise available
An investment bank would buy a largequantity of a Treasury security
The securities would be placed with an SPV
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The SPV is a single-purpose dedicated trustIt has the powers to own the bonds andcollect payments
It cannot sell or lend the bondsIt cannot write options on the bondsOr use them as collateral for borrowing
The SPV is empowered to issue zero coupon
bondsWhere each security represents the ownership ofa single cash flow from the mother bond
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Assume that 100MM USD of 15 year bondswith a coupon of 8 are placed with the SPV
The SPV can issue 6M 12M 18M extending up to14 frac12 year zeroes with a total face value of 4MM
USD eachAnd 15 year zeroes with a total face value of104MM
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The Treasury launched this program in 1985to facilitate the stripping of designatedsecurities
All new T-bonds and notes with a maturity of 10years or more are eligibleThe zeroes created in the process are directobligations of the US government
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The mechanism is as followsA dealer who owns a bond or note can ask theFRB where it is held
To replace it with an equivalent set of STRIPS
representing each payment as a separate securityEach of these securities can be traded independentlyof others
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In 1987 the Treasury started to allow dealersto reverse the process
This is called STRIPS RECONSTUTUTION If a dealer owns STRIPS representing all thecoupon and principal payments of a bond
The FED can on request convert these holdings into asingle position in the corresponding bond
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Each coupon and principal cash flow from aTreasury security is assigned a CUSIP
The mother bond is also assigned a CUSIPThe stripped coupons are known as C-STRIPSThe stripped principal is known as P-STRIPSSupply of a C-STRIP increases over time
because a C-STRIP maturing on a day like 15 FEB
2020 will have the same CUSIP irrespective ofwhich mother bond it has come fromThe original coupon rate is irrelevant
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P-STRIPS always correspond to the originalsecurityThey have a unique CUSIPTheir supply is fixed at the time of issuanceIn practice the prices of long-dated P-STRIPSare a bit higher than those of C-STRIPS withthe same maturity date
One reason is that P-STRIPS are more liquid due
to greater availabilityA $100 face value bond with a coupon of 8 willgenerate C-STRIPS with a face value of $4 but P-STRIPS with a face value of $100
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Another reason why P-STRIPS are in higherdemand is that they allow reconstitutionactivities more easily
Assume that the sum of the STRIPS is cheaper than
the mother bondIf a dealer already has the P-STRIPS only the C-STRIPSneed to be acquiredHowever if he owns some of the C-STRIPS he needs toacquire the P-STRIPS and the remaining C-STRIPSThe facility to reconstitute when profitable is pricedinto the P-STRIPSNote Buy and hold investors will prefer C-STRIPSsince they are priced lower and give a higher yield
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For Plain Vanilla bonds the specifiedcoupon rate is valid for the life of thebond
In the case of Floaters the rate is reset atthe beginning of every periodThe rate will vary directly with thebenchmark
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The rate on a Floater is specified as LIBOR+ 50 bp
The spread is positiveIf it were specified as LIBOR ndash 30bp
The spread will be negativeIf LIBOR rises the rate will increasewhereas if LIBOR falls it will decrease
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In the case of a default risk-free floater theprice will reset to par on a coupon date
It may sell at a premium or discount betweencoupon dates
Consider a floater with a coupon = 5-year T-Bond rate
Assume there are two periods left to maturity
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The price at the end of the first coupon period willbe given by
cT-1 is the coupon one period before maturityyT-1 is the YTM one period before maturity
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On a coupon reset date the YTM = couponBecause we have assumed there is no default riskAny change in the required yield as reflected inthe prevailing YTM
Will also be reflected in the coupon being setIf coupon = yield the bond should sell at par
Thus P T-1 = M
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Once again at T-2 c T-2 = yT-2 and P T-2 = MThis logic can be applied to a bond with anytime remaining till maturityHowever between two coupon dates theprice may not be equal to par
Consider the valuation at T-2+k
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Although c T-2 was set at T-2 and is equal toyT-2
yT-2+k is determined at T-2+k and will reflect theyield prevailing at that time
Thus yT-2+k need not equal c T-2 and may behigher or lower
Hence between two coupon dates a floater maysell at a premium or discount
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Now consider a floater characterized bydefault risk
The risk premium required by the market neednot be constant over time
Assume that at the time of issue YTM = 5-year T-note rate + 75bp
The coupon would have been set equal to thisrate and the bond would have been issued at par
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Six months hence the issue may be perceivedas more risky
YTM = 5-year T-note rate + 95 bpThe coupon will however be set equal to theprevailing 5-year rate + 75 bpIf so the issue will not reset to par at the nextcoupon date
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Floaters may come with a CAP or a FLOOR orBOTH
The CAP is a maximum coupon rateProtects issuers against rising rates
The FLOOR is a minimum coupon rateProtects investors against falling rates
When there is a spread over LIBORThere is a natural floorLIBOR cannot be less than zero
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The periodic interest payment that has to bemade by the borrower
The coupon rate multiplied by the face valuegives the rupeedollar value of the coupon
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Most bonds pays coupons on a semi-annual basisTrue in UKUSAustraliaJapanIn European and Eurobond markets annualpayments are the norm
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In earlier days bonds were accompanied by abooklet of post-dated coupons
Each coupon could be detached and redeemedon the corresponding coupon payment date
Even today bearer bonds come with couponsThe bearer certificate number is mentioned onthe coupon
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Bond with a face value of $1000The coupon rate is 8 per annum paid semi-annually
So the bond holder will receive1000 x 008
___ = $40 every six months2
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The rate of return if an investor buys thebond at the prevailing price and holds ittill maturity
In order to get the YTM two conditionsmust be satisfied
The bond must be held till maturity All coupon payments received before maturitymust be reinvested at the YTM
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At any point in time the YTM may beGreater thanLess than or
Equal to the Coupon RateYTM is the IRR of a bond
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Bonds involve pure cash flowsSo only ONE REAL POSITIVE YTM
Solution to a Non-Linear equation
Solved iteratively
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A holder gets a stream of contractuallypromised payments
The value of the bond is the value of this stream
of cash flowsCash flows arising at different points in timecannot be addedCash flows have to be discounted
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It is a chicken and egg storyIf we know the yield that is required we canquote a priceOnce we acquire the asset at a certain price we
can work out the corresponding yield
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A bond will pay identical coupons everyperiodAnd will repay the face value at maturity
The periodic cash flows constitutean annuity The terminal face value is a lump
sum payment
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Bond pays a semi-annual coupon of $C2and has a face value of $MAssume there are N coupons left
And that we are standing on a coupondate
We are assuming that the next coupon is exactlysix months away
The required annual yield is yImplies that the semi-annual yield is y2
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The present value of the coupon stream is
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The present value of the face value is
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So the price of the bond is
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IBM has issued a bond with a face value of$1000The coupon is 8 per year to be paid on July
15 and January 15 every yearToday is 15 July 2013 and that the bondmatures on 15 January 2033The required yield is 10 per annum
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JJ ndash 0115FA ndash 0115MS ndash 0115
AO ndash 0115MN ndash 0115JD ndash 0115
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In the example the price is less than theface value
Such a bond is called a Discount Bond
It is trading at a discount from the face valueThe reason is that
The yield is greater than the coupon
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If the yield were to equal the couponThe bond would sell at PARSuch bonds are called PAR Bonds
If the yield is less than the couponThe price will exceed the face valueSuch bonds are called Premium Bonds
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As we move from one coupon date to thenext if the YTM were to remain constant
Par bonds would continue to trade at PARPremium bonds will steadily decline in priceDiscount bonds will steadily increase in price
This is called the Pull to Par EffectAt maturity ndash ALL BONDS WILL TRADE AT PAR
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As we approach maturity the number ofcoupons reduces
The contribution of coupons to price reducesThe contribution of the PV of the face valueincreases
For premium bonds the first effect dominatesThus the price steadily declines
For discount bonds the second effectdominatesThus the price steadily increases
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A plain vanilla or Bullet Bond pays the entireface value at maturity in a lump sumAmortizing bonds pay the principal in
installmentsThe first payment occurs before maturityThe last payment is made at maturity
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Consider a 5 year amortizing bond with aface value of $1000 and an annual coupon of8
The annual cash flows are depicted below
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Time Cash Flow
1 802 803 3304 3105 540
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The first two cash flows represent interest ona principal of $1000The third cash flow is interest on $1000 plus
a principal payment of $250The outstanding principal is $750The fourth cash flow is interest on $750 plusa principal payment of $250
The outstanding principal is $500The final cash flow is interest on $500 plusthe remaining principal of $500
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Some companies issue such bonds becausethe assets being funded have a similar cashflow profile
Second the coupon on such a bond may belower than that of a bullet bondIn the case of a bullet bond the entire principalis due at a single point in timeThere is greater default risk
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Microsoft is issuing zeroes with 5 years tomaturity and a face value of $10000
The required yield is 10 per annumWhat should be the price
Price is the PV of the face valueIn practice we discount on a semi-annual basis
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This is to facilitate comparisons withconventional bonds
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A zero coupon bond can never sell at apremium
It will always trade at a discount prior tomaturityAt maturity it will trade at par
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If held to maturity a ZCB will always give riseto a capital gainIf sold prior to maturity there may be a
capital gain or a capital lossConsider a bond with 10 years to maturityThe YTM at the time of purchase was 10The cost was $37690
A year later it is sold at a YTM of 12The corresponding price is $35035
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A newly established issuerOr an issuer with a relatively virgin productor service
Or a restructured company due to a mergeror following a bankruptcyWill be perceived as more riskyInvestors will demand a high coupon
Such firms are unlikely to have high earningsRevenues will peak only after theproductservice is established
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They can ill afford high couponsThey may consider a step-up coupon bond
Where the coupon increases as the bond ages
Assume a company can issue a plain vanillaat a coupon of 8 with a maturity of 5 yearsInstead it may opt for a bond
With a coupon of 6 for the first three years
And a coupon of 10 for the last two yearsThis is a Deferred Interest Security
Provides the issuer with breathing room in theearlier years
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These pay coupons in the form of additionalsecurities and not cash
This offers the issuer time to prepare for cashoutlays
They are used as Mezzanine FinanceThey rank between senior debt and equity in thecapital structureInvestors take more risk as compared to buyersof regular bonds ndash but get higher returnsIssuers can conserve cash in earlier years when itis at a premium
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Fully backed by the federal government ofthe issuing nationConsequently they are virtually devoid ofcredit risk or the risk of defaultThe yield on such securities is a benchmarkfor setting rates on other kinds of debt
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Treasury securities are issuedTo finance expenses in excess of currentrevenuesTo pay interest on debt accumulated in earlieryears due to deficits in those yearsTo repay past debt issues that are currentlymaturing
The US Treasuries marketIs the largest bond market in the worldIs the most liquid bond market in the world
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The Treasury issues three categories ofmarketable securities
T-bills are discount securitiesThey are zero coupon securitiesT-notes and T-bonds are sold at face value andpay interest periodically
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T-bills are issued with a original time tomaturity of one year or less
They are Money market instrumentsThey have maturities of either 1 3 6 or 12months at the time of issue
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T-notes and T-bonds have a time to maturityexceeding one year at the time of issue
They are capital market instrumentsT-notes have maturities ranging from 1-10 yearsT-bonds have an original maturity in excess of 10years extending up to 30 years
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An issue may be followed later by a furtherissue
With the same remaining time to maturity andthe same couponThe issuance of further tranches is termed as aRe-opening
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Six months ago a 10-year note was issuedwith a coupon of 8 per annumToday if a note with 9 frac12 years to maturityand a coupon of 8 issued it will add to thepool that is already trading in the marketThus it is a re-opening of an existing issue
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Who is a primary dealerA PD is a dealer who is authorized to dealdirectly with the Central Bank of the countryIn the US a PD is a bank or securities broker-dealer that directly deals with the FRBNY
Importance of FRBNYIn India a PD deals directly with the RBI
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The Treasury sells bills notes and bonds byway of a competitive auction process
Most of the treasury securities are bought byprimary dealers
Individual investors submit non-competitive bidsand participate on a much smaller scale
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Bids may beCompetitive
Indicate price amp quantity or yield amp quantityNon-competitive
Indicate only quantity
Small investors and individualsgenerally submit non-competitive bids
A non-competitive bidder may not bid for more than$5MM worth of securities in a bill or bond auction
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Primary dealers bid for their accounts andon behalf of their clientsThey usually submit large competitive
bidsBids indicate the maximum price that the bidderis prepared to pay if it is a price based auctionOr the minimum yield that the bidder is
prepared to accept if it is a yield based auction
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The Treasury will net out the totalamount of non-competitive bids
The balance will be allocated to competitivebidders
There are two ways in which securitiescan be allotted
The multiple priceyield auction mechanism
French AuctionsThe uniform priceyield auction mechanism
Dutch Auctions
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Assume that the Treasury is offering 25billion dollars worth of T-bonds
2 billion dollars worth of non-competitive bidshave been receivedSo 23 billion dollars worth of bonds are availableto be offered to the competitive bidders
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There are six competitive bidders who havesubmitted the following yields
The bids have been arranged in ascending orderof yieldIn a price based auction the bids would havebeen arranged in descending order of price
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Bidder Bid Yield Bid Amount
Aggregate Amount
Alpha 5370 30 bn 30 bnBeta 5372 50 bn 80 bn
Gamma 5373 40 bn 12 bn
Delta 5375 80 bn 20 bnCharlie 5375 120 bn 32 bn
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The aggregate demand equals the amount onoffer at a yield of 5375A multiple yield auction will lead to thefollowing allocation
Alpha will get 3 bn at a yield of 5370Beta will get 5 bn at 5372Gamma will get 4 bn at 5373
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At a yield of 5375 we have only 11 bn left toallocateThere is a demand of 20 bn at this yield
8 bn from Delta and 12 bn from CharlieThus we will allocate 1120 = 55 to eachbidder at this yield
There will be pro-rata allocation
055 of 8 bn or 440 bn will go to Delta055 of 12 bn or 66 bn will go to Charlie
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The highest accepted yield is called the StopYield or High Yield
In this case it is 5375The ratio of bids received to the amountawarded is known as the bid to cover ratio
The higher the ratio the stronger is the auction
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Those who bid more than 5375 will getnothing and are said to be shutout of theauctionSince 1999 the US Treasury has beenconducting only uniform yield auctions
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WI stands for ndash When As and If IssuedThe when issued market is a market forforward trading of a bond
Which has been announced but not yet issuedTrades take place from the date ofannouncement until the actual issue date
Helps bidders to gauge the marketrsquos interestbefore the actual auction
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WI trading has ramifications for the biddingstrategies of market participantsTraders can take both long and shortpositions
Settlement is scheduled for the issue date
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It has a bearing on the outcome of theauction
It affects the strategy used by a bidder becauseit has an impact on his prior positionBidders who are long in the WI market enter theauction with a Long PositionThose who are short in the WI market enter theauction with a short position
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The WI market helps in price discoveryIt provides important information on
The strength of demand for the securityAnd on the disparity of biddersrsquo views
This help potential bidders to formulate theirstrategiesAt times a dealer may believe that he hasvery important private information
If so he may not participate in the WI market andwill directly enter the auction with bids based onhis knowledge
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On or before the date of the auction theissues trade on a yield basis
The actual price can be established only afterthe coupon is set
Starting with the day after the auctionSecurities are quoted on a price basis becausethe coupon is known
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In a coupon roll a dealer will purchase themost recently issued security from a clientAnd simultaneously sell the same amount ofthe recently announced new security
The first leg with settle on the following dayThe second leg is a forward contract
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There can be a Reverse RollThe dealer will sell the most recent issue fornext day settlementAnd buy the newly announced security forforward settlement
The forward leg in a RollReverse Roll is a WItrade
It will settle on the new issue settlement date
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The roll is the spread between the yield onthe new security and that on the outstandingissue in the same maturity segmentA GIVE in the Roll means that
The WI security provides a higher yield than theoutstanding issue
A Take in the Roll means thatThe WI security provides a lower yield
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On March 17 20XX the Treasury announcedthe auction of a 2-year note
The auction was scheduled for March 24The settlement date was March 31
Trading of the roll began as soon as the issuewas announcedA Give of 5 bp means that the dealer proposes tobuy the current issue at the prevailing yieldAnd sell the new issue at a yield that is 5 bpmoreA Take of 5 bp means that the dealer proposes tosell the new issue at a yield that is 5bp lower
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The roll achieves the followingHe acquires the outstanding issue for next daysettlementHe sells the to be issued security with the samepar value for forward delivery on 31 March
The customer is rolling over the investmentfrom the current issue to the new issue
This extends the maturity of the investment byone month
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The client can invest the funds received tillthe new issue settlesHowever he loses the accrued interest thathe would have earned had he held on to theissue
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The Treasury per se does not issue zerocoupon securitiesBut zero coupon securities can be created
which are backed by conventional bondsTake a large quantity of a T-note or bond andseparate all the cash flows from each otherSell the entitlement to each cash flowseparately
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Take the case of a two-year T-noteIt can be separated into five zero couponsecurities maturing after
6 months12 months18 months24 months
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Earlier investment banks used to buy bondsfrom the Treasury and separate the cashflows
Each cash flow was then sold separately as a zerocoupon bondSuch issues are called trademarks
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The issue of trademarks has now ceasedBecause investment banks can now createsuch instruments
In concert with the Treasury itselfThese ZCBs are known as STRIPS ndash
Separate Trading of Registered Interest andPrincipal of Securities
These are not issued or sold by the Treasury
The market is made by investment banks
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What is the motivation to create suchproductsIn practice arbitrage is possible when a
coupon security is purchased at a priceThat is lower than what could be obtained byselling each cash flow separately
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Coupon stripping reflects a case of financialengineering
Creating a risk-return profile that is nototherwise available
An investment bank would buy a largequantity of a Treasury security
The securities would be placed with an SPV
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The SPV is a single-purpose dedicated trustIt has the powers to own the bonds andcollect payments
It cannot sell or lend the bondsIt cannot write options on the bondsOr use them as collateral for borrowing
The SPV is empowered to issue zero coupon
bondsWhere each security represents the ownership ofa single cash flow from the mother bond
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Assume that 100MM USD of 15 year bondswith a coupon of 8 are placed with the SPV
The SPV can issue 6M 12M 18M extending up to14 frac12 year zeroes with a total face value of 4MM
USD eachAnd 15 year zeroes with a total face value of104MM
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The Treasury launched this program in 1985to facilitate the stripping of designatedsecurities
All new T-bonds and notes with a maturity of 10years or more are eligibleThe zeroes created in the process are directobligations of the US government
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The mechanism is as followsA dealer who owns a bond or note can ask theFRB where it is held
To replace it with an equivalent set of STRIPS
representing each payment as a separate securityEach of these securities can be traded independentlyof others
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In 1987 the Treasury started to allow dealersto reverse the process
This is called STRIPS RECONSTUTUTION If a dealer owns STRIPS representing all thecoupon and principal payments of a bond
The FED can on request convert these holdings into asingle position in the corresponding bond
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Each coupon and principal cash flow from aTreasury security is assigned a CUSIP
The mother bond is also assigned a CUSIPThe stripped coupons are known as C-STRIPSThe stripped principal is known as P-STRIPSSupply of a C-STRIP increases over time
because a C-STRIP maturing on a day like 15 FEB
2020 will have the same CUSIP irrespective ofwhich mother bond it has come fromThe original coupon rate is irrelevant
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P-STRIPS always correspond to the originalsecurityThey have a unique CUSIPTheir supply is fixed at the time of issuanceIn practice the prices of long-dated P-STRIPSare a bit higher than those of C-STRIPS withthe same maturity date
One reason is that P-STRIPS are more liquid due
to greater availabilityA $100 face value bond with a coupon of 8 willgenerate C-STRIPS with a face value of $4 but P-STRIPS with a face value of $100
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Another reason why P-STRIPS are in higherdemand is that they allow reconstitutionactivities more easily
Assume that the sum of the STRIPS is cheaper than
the mother bondIf a dealer already has the P-STRIPS only the C-STRIPSneed to be acquiredHowever if he owns some of the C-STRIPS he needs toacquire the P-STRIPS and the remaining C-STRIPSThe facility to reconstitute when profitable is pricedinto the P-STRIPSNote Buy and hold investors will prefer C-STRIPSsince they are priced lower and give a higher yield
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For Plain Vanilla bonds the specifiedcoupon rate is valid for the life of thebond
In the case of Floaters the rate is reset atthe beginning of every periodThe rate will vary directly with thebenchmark
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The rate on a Floater is specified as LIBOR+ 50 bp
The spread is positiveIf it were specified as LIBOR ndash 30bp
The spread will be negativeIf LIBOR rises the rate will increasewhereas if LIBOR falls it will decrease
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In the case of a default risk-free floater theprice will reset to par on a coupon date
It may sell at a premium or discount betweencoupon dates
Consider a floater with a coupon = 5-year T-Bond rate
Assume there are two periods left to maturity
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The price at the end of the first coupon period willbe given by
cT-1 is the coupon one period before maturityyT-1 is the YTM one period before maturity
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On a coupon reset date the YTM = couponBecause we have assumed there is no default riskAny change in the required yield as reflected inthe prevailing YTM
Will also be reflected in the coupon being setIf coupon = yield the bond should sell at par
Thus P T-1 = M
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Once again at T-2 c T-2 = yT-2 and P T-2 = MThis logic can be applied to a bond with anytime remaining till maturityHowever between two coupon dates theprice may not be equal to par
Consider the valuation at T-2+k
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Although c T-2 was set at T-2 and is equal toyT-2
yT-2+k is determined at T-2+k and will reflect theyield prevailing at that time
Thus yT-2+k need not equal c T-2 and may behigher or lower
Hence between two coupon dates a floater maysell at a premium or discount
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Now consider a floater characterized bydefault risk
The risk premium required by the market neednot be constant over time
Assume that at the time of issue YTM = 5-year T-note rate + 75bp
The coupon would have been set equal to thisrate and the bond would have been issued at par
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Six months hence the issue may be perceivedas more risky
YTM = 5-year T-note rate + 95 bpThe coupon will however be set equal to theprevailing 5-year rate + 75 bpIf so the issue will not reset to par at the nextcoupon date
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Floaters may come with a CAP or a FLOOR orBOTH
The CAP is a maximum coupon rateProtects issuers against rising rates
The FLOOR is a minimum coupon rateProtects investors against falling rates
When there is a spread over LIBORThere is a natural floorLIBOR cannot be less than zero
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Most bonds pays coupons on a semi-annual basisTrue in UKUSAustraliaJapanIn European and Eurobond markets annualpayments are the norm
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In earlier days bonds were accompanied by abooklet of post-dated coupons
Each coupon could be detached and redeemedon the corresponding coupon payment date
Even today bearer bonds come with couponsThe bearer certificate number is mentioned onthe coupon
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Bond with a face value of $1000The coupon rate is 8 per annum paid semi-annually
So the bond holder will receive1000 x 008
___ = $40 every six months2
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The rate of return if an investor buys thebond at the prevailing price and holds ittill maturity
In order to get the YTM two conditionsmust be satisfied
The bond must be held till maturity All coupon payments received before maturitymust be reinvested at the YTM
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At any point in time the YTM may beGreater thanLess than or
Equal to the Coupon RateYTM is the IRR of a bond
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Bonds involve pure cash flowsSo only ONE REAL POSITIVE YTM
Solution to a Non-Linear equation
Solved iteratively
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A holder gets a stream of contractuallypromised payments
The value of the bond is the value of this stream
of cash flowsCash flows arising at different points in timecannot be addedCash flows have to be discounted
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It is a chicken and egg storyIf we know the yield that is required we canquote a priceOnce we acquire the asset at a certain price we
can work out the corresponding yield
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A bond will pay identical coupons everyperiodAnd will repay the face value at maturity
The periodic cash flows constitutean annuity The terminal face value is a lump
sum payment
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Bond pays a semi-annual coupon of $C2and has a face value of $MAssume there are N coupons left
And that we are standing on a coupondate
We are assuming that the next coupon is exactlysix months away
The required annual yield is yImplies that the semi-annual yield is y2
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The present value of the coupon stream is
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The present value of the face value is
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So the price of the bond is
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IBM has issued a bond with a face value of$1000The coupon is 8 per year to be paid on July
15 and January 15 every yearToday is 15 July 2013 and that the bondmatures on 15 January 2033The required yield is 10 per annum
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JJ ndash 0115FA ndash 0115MS ndash 0115
AO ndash 0115MN ndash 0115JD ndash 0115
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In the example the price is less than theface value
Such a bond is called a Discount Bond
It is trading at a discount from the face valueThe reason is that
The yield is greater than the coupon
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If the yield were to equal the couponThe bond would sell at PARSuch bonds are called PAR Bonds
If the yield is less than the couponThe price will exceed the face valueSuch bonds are called Premium Bonds
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As we move from one coupon date to thenext if the YTM were to remain constant
Par bonds would continue to trade at PARPremium bonds will steadily decline in priceDiscount bonds will steadily increase in price
This is called the Pull to Par EffectAt maturity ndash ALL BONDS WILL TRADE AT PAR
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As we approach maturity the number ofcoupons reduces
The contribution of coupons to price reducesThe contribution of the PV of the face valueincreases
For premium bonds the first effect dominatesThus the price steadily declines
For discount bonds the second effectdominatesThus the price steadily increases
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A plain vanilla or Bullet Bond pays the entireface value at maturity in a lump sumAmortizing bonds pay the principal in
installmentsThe first payment occurs before maturityThe last payment is made at maturity
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Consider a 5 year amortizing bond with aface value of $1000 and an annual coupon of8
The annual cash flows are depicted below
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Time Cash Flow
1 802 803 3304 3105 540
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The first two cash flows represent interest ona principal of $1000The third cash flow is interest on $1000 plus
a principal payment of $250The outstanding principal is $750The fourth cash flow is interest on $750 plusa principal payment of $250
The outstanding principal is $500The final cash flow is interest on $500 plusthe remaining principal of $500
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Some companies issue such bonds becausethe assets being funded have a similar cashflow profile
Second the coupon on such a bond may belower than that of a bullet bondIn the case of a bullet bond the entire principalis due at a single point in timeThere is greater default risk
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Microsoft is issuing zeroes with 5 years tomaturity and a face value of $10000
The required yield is 10 per annumWhat should be the price
Price is the PV of the face valueIn practice we discount on a semi-annual basis
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This is to facilitate comparisons withconventional bonds
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A zero coupon bond can never sell at apremium
It will always trade at a discount prior tomaturityAt maturity it will trade at par
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If held to maturity a ZCB will always give riseto a capital gainIf sold prior to maturity there may be a
capital gain or a capital lossConsider a bond with 10 years to maturityThe YTM at the time of purchase was 10The cost was $37690
A year later it is sold at a YTM of 12The corresponding price is $35035
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A newly established issuerOr an issuer with a relatively virgin productor service
Or a restructured company due to a mergeror following a bankruptcyWill be perceived as more riskyInvestors will demand a high coupon
Such firms are unlikely to have high earningsRevenues will peak only after theproductservice is established
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They can ill afford high couponsThey may consider a step-up coupon bond
Where the coupon increases as the bond ages
Assume a company can issue a plain vanillaat a coupon of 8 with a maturity of 5 yearsInstead it may opt for a bond
With a coupon of 6 for the first three years
And a coupon of 10 for the last two yearsThis is a Deferred Interest Security
Provides the issuer with breathing room in theearlier years
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These pay coupons in the form of additionalsecurities and not cash
This offers the issuer time to prepare for cashoutlays
They are used as Mezzanine FinanceThey rank between senior debt and equity in thecapital structureInvestors take more risk as compared to buyersof regular bonds ndash but get higher returnsIssuers can conserve cash in earlier years when itis at a premium
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Fully backed by the federal government ofthe issuing nationConsequently they are virtually devoid ofcredit risk or the risk of defaultThe yield on such securities is a benchmarkfor setting rates on other kinds of debt
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Treasury securities are issuedTo finance expenses in excess of currentrevenuesTo pay interest on debt accumulated in earlieryears due to deficits in those yearsTo repay past debt issues that are currentlymaturing
The US Treasuries marketIs the largest bond market in the worldIs the most liquid bond market in the world
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The Treasury issues three categories ofmarketable securities
T-bills are discount securitiesThey are zero coupon securitiesT-notes and T-bonds are sold at face value andpay interest periodically
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T-bills are issued with a original time tomaturity of one year or less
They are Money market instrumentsThey have maturities of either 1 3 6 or 12months at the time of issue
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T-notes and T-bonds have a time to maturityexceeding one year at the time of issue
They are capital market instrumentsT-notes have maturities ranging from 1-10 yearsT-bonds have an original maturity in excess of 10years extending up to 30 years
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An issue may be followed later by a furtherissue
With the same remaining time to maturity andthe same couponThe issuance of further tranches is termed as aRe-opening
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Six months ago a 10-year note was issuedwith a coupon of 8 per annumToday if a note with 9 frac12 years to maturityand a coupon of 8 issued it will add to thepool that is already trading in the marketThus it is a re-opening of an existing issue
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Who is a primary dealerA PD is a dealer who is authorized to dealdirectly with the Central Bank of the countryIn the US a PD is a bank or securities broker-dealer that directly deals with the FRBNY
Importance of FRBNYIn India a PD deals directly with the RBI
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The Treasury sells bills notes and bonds byway of a competitive auction process
Most of the treasury securities are bought byprimary dealers
Individual investors submit non-competitive bidsand participate on a much smaller scale
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Bids may beCompetitive
Indicate price amp quantity or yield amp quantityNon-competitive
Indicate only quantity
Small investors and individualsgenerally submit non-competitive bids
A non-competitive bidder may not bid for more than$5MM worth of securities in a bill or bond auction
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Primary dealers bid for their accounts andon behalf of their clientsThey usually submit large competitive
bidsBids indicate the maximum price that the bidderis prepared to pay if it is a price based auctionOr the minimum yield that the bidder is
prepared to accept if it is a yield based auction
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The Treasury will net out the totalamount of non-competitive bids
The balance will be allocated to competitivebidders
There are two ways in which securitiescan be allotted
The multiple priceyield auction mechanism
French AuctionsThe uniform priceyield auction mechanism
Dutch Auctions
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Assume that the Treasury is offering 25billion dollars worth of T-bonds
2 billion dollars worth of non-competitive bidshave been receivedSo 23 billion dollars worth of bonds are availableto be offered to the competitive bidders
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There are six competitive bidders who havesubmitted the following yields
The bids have been arranged in ascending orderof yieldIn a price based auction the bids would havebeen arranged in descending order of price
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Bidder Bid Yield Bid Amount
Aggregate Amount
Alpha 5370 30 bn 30 bnBeta 5372 50 bn 80 bn
Gamma 5373 40 bn 12 bn
Delta 5375 80 bn 20 bnCharlie 5375 120 bn 32 bn
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The aggregate demand equals the amount onoffer at a yield of 5375A multiple yield auction will lead to thefollowing allocation
Alpha will get 3 bn at a yield of 5370Beta will get 5 bn at 5372Gamma will get 4 bn at 5373
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At a yield of 5375 we have only 11 bn left toallocateThere is a demand of 20 bn at this yield
8 bn from Delta and 12 bn from CharlieThus we will allocate 1120 = 55 to eachbidder at this yield
There will be pro-rata allocation
055 of 8 bn or 440 bn will go to Delta055 of 12 bn or 66 bn will go to Charlie
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The highest accepted yield is called the StopYield or High Yield
In this case it is 5375The ratio of bids received to the amountawarded is known as the bid to cover ratio
The higher the ratio the stronger is the auction
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Those who bid more than 5375 will getnothing and are said to be shutout of theauctionSince 1999 the US Treasury has beenconducting only uniform yield auctions
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WI stands for ndash When As and If IssuedThe when issued market is a market forforward trading of a bond
Which has been announced but not yet issuedTrades take place from the date ofannouncement until the actual issue date
Helps bidders to gauge the marketrsquos interestbefore the actual auction
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WI trading has ramifications for the biddingstrategies of market participantsTraders can take both long and shortpositions
Settlement is scheduled for the issue date
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It has a bearing on the outcome of theauction
It affects the strategy used by a bidder becauseit has an impact on his prior positionBidders who are long in the WI market enter theauction with a Long PositionThose who are short in the WI market enter theauction with a short position
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The WI market helps in price discoveryIt provides important information on
The strength of demand for the securityAnd on the disparity of biddersrsquo views
This help potential bidders to formulate theirstrategiesAt times a dealer may believe that he hasvery important private information
If so he may not participate in the WI market andwill directly enter the auction with bids based onhis knowledge
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On or before the date of the auction theissues trade on a yield basis
The actual price can be established only afterthe coupon is set
Starting with the day after the auctionSecurities are quoted on a price basis becausethe coupon is known
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In a coupon roll a dealer will purchase themost recently issued security from a clientAnd simultaneously sell the same amount ofthe recently announced new security
The first leg with settle on the following dayThe second leg is a forward contract
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There can be a Reverse RollThe dealer will sell the most recent issue fornext day settlementAnd buy the newly announced security forforward settlement
The forward leg in a RollReverse Roll is a WItrade
It will settle on the new issue settlement date
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The roll is the spread between the yield onthe new security and that on the outstandingissue in the same maturity segmentA GIVE in the Roll means that
The WI security provides a higher yield than theoutstanding issue
A Take in the Roll means thatThe WI security provides a lower yield
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On March 17 20XX the Treasury announcedthe auction of a 2-year note
The auction was scheduled for March 24The settlement date was March 31
Trading of the roll began as soon as the issuewas announcedA Give of 5 bp means that the dealer proposes tobuy the current issue at the prevailing yieldAnd sell the new issue at a yield that is 5 bpmoreA Take of 5 bp means that the dealer proposes tosell the new issue at a yield that is 5bp lower
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The roll achieves the followingHe acquires the outstanding issue for next daysettlementHe sells the to be issued security with the samepar value for forward delivery on 31 March
The customer is rolling over the investmentfrom the current issue to the new issue
This extends the maturity of the investment byone month
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The client can invest the funds received tillthe new issue settlesHowever he loses the accrued interest thathe would have earned had he held on to theissue
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The Treasury per se does not issue zerocoupon securitiesBut zero coupon securities can be created
which are backed by conventional bondsTake a large quantity of a T-note or bond andseparate all the cash flows from each otherSell the entitlement to each cash flowseparately
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Take the case of a two-year T-noteIt can be separated into five zero couponsecurities maturing after
6 months12 months18 months24 months
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Earlier investment banks used to buy bondsfrom the Treasury and separate the cashflows
Each cash flow was then sold separately as a zerocoupon bondSuch issues are called trademarks
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The issue of trademarks has now ceasedBecause investment banks can now createsuch instruments
In concert with the Treasury itselfThese ZCBs are known as STRIPS ndash
Separate Trading of Registered Interest andPrincipal of Securities
These are not issued or sold by the Treasury
The market is made by investment banks
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What is the motivation to create suchproductsIn practice arbitrage is possible when a
coupon security is purchased at a priceThat is lower than what could be obtained byselling each cash flow separately
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Coupon stripping reflects a case of financialengineering
Creating a risk-return profile that is nototherwise available
An investment bank would buy a largequantity of a Treasury security
The securities would be placed with an SPV
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The SPV is a single-purpose dedicated trustIt has the powers to own the bonds andcollect payments
It cannot sell or lend the bondsIt cannot write options on the bondsOr use them as collateral for borrowing
The SPV is empowered to issue zero coupon
bondsWhere each security represents the ownership ofa single cash flow from the mother bond
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Assume that 100MM USD of 15 year bondswith a coupon of 8 are placed with the SPV
The SPV can issue 6M 12M 18M extending up to14 frac12 year zeroes with a total face value of 4MM
USD eachAnd 15 year zeroes with a total face value of104MM
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The Treasury launched this program in 1985to facilitate the stripping of designatedsecurities
All new T-bonds and notes with a maturity of 10years or more are eligibleThe zeroes created in the process are directobligations of the US government
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The mechanism is as followsA dealer who owns a bond or note can ask theFRB where it is held
To replace it with an equivalent set of STRIPS
representing each payment as a separate securityEach of these securities can be traded independentlyof others
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In 1987 the Treasury started to allow dealersto reverse the process
This is called STRIPS RECONSTUTUTION If a dealer owns STRIPS representing all thecoupon and principal payments of a bond
The FED can on request convert these holdings into asingle position in the corresponding bond
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Each coupon and principal cash flow from aTreasury security is assigned a CUSIP
The mother bond is also assigned a CUSIPThe stripped coupons are known as C-STRIPSThe stripped principal is known as P-STRIPSSupply of a C-STRIP increases over time
because a C-STRIP maturing on a day like 15 FEB
2020 will have the same CUSIP irrespective ofwhich mother bond it has come fromThe original coupon rate is irrelevant
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P-STRIPS always correspond to the originalsecurityThey have a unique CUSIPTheir supply is fixed at the time of issuanceIn practice the prices of long-dated P-STRIPSare a bit higher than those of C-STRIPS withthe same maturity date
One reason is that P-STRIPS are more liquid due
to greater availabilityA $100 face value bond with a coupon of 8 willgenerate C-STRIPS with a face value of $4 but P-STRIPS with a face value of $100
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Another reason why P-STRIPS are in higherdemand is that they allow reconstitutionactivities more easily
Assume that the sum of the STRIPS is cheaper than
the mother bondIf a dealer already has the P-STRIPS only the C-STRIPSneed to be acquiredHowever if he owns some of the C-STRIPS he needs toacquire the P-STRIPS and the remaining C-STRIPSThe facility to reconstitute when profitable is pricedinto the P-STRIPSNote Buy and hold investors will prefer C-STRIPSsince they are priced lower and give a higher yield
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For Plain Vanilla bonds the specifiedcoupon rate is valid for the life of thebond
In the case of Floaters the rate is reset atthe beginning of every periodThe rate will vary directly with thebenchmark
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The rate on a Floater is specified as LIBOR+ 50 bp
The spread is positiveIf it were specified as LIBOR ndash 30bp
The spread will be negativeIf LIBOR rises the rate will increasewhereas if LIBOR falls it will decrease
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In the case of a default risk-free floater theprice will reset to par on a coupon date
It may sell at a premium or discount betweencoupon dates
Consider a floater with a coupon = 5-year T-Bond rate
Assume there are two periods left to maturity
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The price at the end of the first coupon period willbe given by
cT-1 is the coupon one period before maturityyT-1 is the YTM one period before maturity
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On a coupon reset date the YTM = couponBecause we have assumed there is no default riskAny change in the required yield as reflected inthe prevailing YTM
Will also be reflected in the coupon being setIf coupon = yield the bond should sell at par
Thus P T-1 = M
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Once again at T-2 c T-2 = yT-2 and P T-2 = MThis logic can be applied to a bond with anytime remaining till maturityHowever between two coupon dates theprice may not be equal to par
Consider the valuation at T-2+k
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Although c T-2 was set at T-2 and is equal toyT-2
yT-2+k is determined at T-2+k and will reflect theyield prevailing at that time
Thus yT-2+k need not equal c T-2 and may behigher or lower
Hence between two coupon dates a floater maysell at a premium or discount
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Now consider a floater characterized bydefault risk
The risk premium required by the market neednot be constant over time
Assume that at the time of issue YTM = 5-year T-note rate + 75bp
The coupon would have been set equal to thisrate and the bond would have been issued at par
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Six months hence the issue may be perceivedas more risky
YTM = 5-year T-note rate + 95 bpThe coupon will however be set equal to theprevailing 5-year rate + 75 bpIf so the issue will not reset to par at the nextcoupon date
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Floaters may come with a CAP or a FLOOR orBOTH
The CAP is a maximum coupon rateProtects issuers against rising rates
The FLOOR is a minimum coupon rateProtects investors against falling rates
When there is a spread over LIBORThere is a natural floorLIBOR cannot be less than zero
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In earlier days bonds were accompanied by abooklet of post-dated coupons
Each coupon could be detached and redeemedon the corresponding coupon payment date
Even today bearer bonds come with couponsThe bearer certificate number is mentioned onthe coupon
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Bond with a face value of $1000The coupon rate is 8 per annum paid semi-annually
So the bond holder will receive1000 x 008
___ = $40 every six months2
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The rate of return if an investor buys thebond at the prevailing price and holds ittill maturity
In order to get the YTM two conditionsmust be satisfied
The bond must be held till maturity All coupon payments received before maturitymust be reinvested at the YTM
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At any point in time the YTM may beGreater thanLess than or
Equal to the Coupon RateYTM is the IRR of a bond
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Bonds involve pure cash flowsSo only ONE REAL POSITIVE YTM
Solution to a Non-Linear equation
Solved iteratively
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A holder gets a stream of contractuallypromised payments
The value of the bond is the value of this stream
of cash flowsCash flows arising at different points in timecannot be addedCash flows have to be discounted
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It is a chicken and egg storyIf we know the yield that is required we canquote a priceOnce we acquire the asset at a certain price we
can work out the corresponding yield
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A bond will pay identical coupons everyperiodAnd will repay the face value at maturity
The periodic cash flows constitutean annuity The terminal face value is a lump
sum payment
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Bond pays a semi-annual coupon of $C2and has a face value of $MAssume there are N coupons left
And that we are standing on a coupondate
We are assuming that the next coupon is exactlysix months away
The required annual yield is yImplies that the semi-annual yield is y2
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The present value of the coupon stream is
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The present value of the face value is
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So the price of the bond is
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IBM has issued a bond with a face value of$1000The coupon is 8 per year to be paid on July
15 and January 15 every yearToday is 15 July 2013 and that the bondmatures on 15 January 2033The required yield is 10 per annum
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JJ ndash 0115FA ndash 0115MS ndash 0115
AO ndash 0115MN ndash 0115JD ndash 0115
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In the example the price is less than theface value
Such a bond is called a Discount Bond
It is trading at a discount from the face valueThe reason is that
The yield is greater than the coupon
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If the yield were to equal the couponThe bond would sell at PARSuch bonds are called PAR Bonds
If the yield is less than the couponThe price will exceed the face valueSuch bonds are called Premium Bonds
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As we move from one coupon date to thenext if the YTM were to remain constant
Par bonds would continue to trade at PARPremium bonds will steadily decline in priceDiscount bonds will steadily increase in price
This is called the Pull to Par EffectAt maturity ndash ALL BONDS WILL TRADE AT PAR
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As we approach maturity the number ofcoupons reduces
The contribution of coupons to price reducesThe contribution of the PV of the face valueincreases
For premium bonds the first effect dominatesThus the price steadily declines
For discount bonds the second effectdominatesThus the price steadily increases
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A plain vanilla or Bullet Bond pays the entireface value at maturity in a lump sumAmortizing bonds pay the principal in
installmentsThe first payment occurs before maturityThe last payment is made at maturity
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Consider a 5 year amortizing bond with aface value of $1000 and an annual coupon of8
The annual cash flows are depicted below
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Time Cash Flow
1 802 803 3304 3105 540
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The first two cash flows represent interest ona principal of $1000The third cash flow is interest on $1000 plus
a principal payment of $250The outstanding principal is $750The fourth cash flow is interest on $750 plusa principal payment of $250
The outstanding principal is $500The final cash flow is interest on $500 plusthe remaining principal of $500
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Some companies issue such bonds becausethe assets being funded have a similar cashflow profile
Second the coupon on such a bond may belower than that of a bullet bondIn the case of a bullet bond the entire principalis due at a single point in timeThere is greater default risk
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Microsoft is issuing zeroes with 5 years tomaturity and a face value of $10000
The required yield is 10 per annumWhat should be the price
Price is the PV of the face valueIn practice we discount on a semi-annual basis
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This is to facilitate comparisons withconventional bonds
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A zero coupon bond can never sell at apremium
It will always trade at a discount prior tomaturityAt maturity it will trade at par
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If held to maturity a ZCB will always give riseto a capital gainIf sold prior to maturity there may be a
capital gain or a capital lossConsider a bond with 10 years to maturityThe YTM at the time of purchase was 10The cost was $37690
A year later it is sold at a YTM of 12The corresponding price is $35035
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A newly established issuerOr an issuer with a relatively virgin productor service
Or a restructured company due to a mergeror following a bankruptcyWill be perceived as more riskyInvestors will demand a high coupon
Such firms are unlikely to have high earningsRevenues will peak only after theproductservice is established
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They can ill afford high couponsThey may consider a step-up coupon bond
Where the coupon increases as the bond ages
Assume a company can issue a plain vanillaat a coupon of 8 with a maturity of 5 yearsInstead it may opt for a bond
With a coupon of 6 for the first three years
And a coupon of 10 for the last two yearsThis is a Deferred Interest Security
Provides the issuer with breathing room in theearlier years
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These pay coupons in the form of additionalsecurities and not cash
This offers the issuer time to prepare for cashoutlays
They are used as Mezzanine FinanceThey rank between senior debt and equity in thecapital structureInvestors take more risk as compared to buyersof regular bonds ndash but get higher returnsIssuers can conserve cash in earlier years when itis at a premium
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Fully backed by the federal government ofthe issuing nationConsequently they are virtually devoid ofcredit risk or the risk of defaultThe yield on such securities is a benchmarkfor setting rates on other kinds of debt
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Treasury securities are issuedTo finance expenses in excess of currentrevenuesTo pay interest on debt accumulated in earlieryears due to deficits in those yearsTo repay past debt issues that are currentlymaturing
The US Treasuries marketIs the largest bond market in the worldIs the most liquid bond market in the world
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The Treasury issues three categories ofmarketable securities
T-bills are discount securitiesThey are zero coupon securitiesT-notes and T-bonds are sold at face value andpay interest periodically
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T-bills are issued with a original time tomaturity of one year or less
They are Money market instrumentsThey have maturities of either 1 3 6 or 12months at the time of issue
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T-notes and T-bonds have a time to maturityexceeding one year at the time of issue
They are capital market instrumentsT-notes have maturities ranging from 1-10 yearsT-bonds have an original maturity in excess of 10years extending up to 30 years
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An issue may be followed later by a furtherissue
With the same remaining time to maturity andthe same couponThe issuance of further tranches is termed as aRe-opening
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Six months ago a 10-year note was issuedwith a coupon of 8 per annumToday if a note with 9 frac12 years to maturityand a coupon of 8 issued it will add to thepool that is already trading in the marketThus it is a re-opening of an existing issue
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Who is a primary dealerA PD is a dealer who is authorized to dealdirectly with the Central Bank of the countryIn the US a PD is a bank or securities broker-dealer that directly deals with the FRBNY
Importance of FRBNYIn India a PD deals directly with the RBI
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The Treasury sells bills notes and bonds byway of a competitive auction process
Most of the treasury securities are bought byprimary dealers
Individual investors submit non-competitive bidsand participate on a much smaller scale
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Bids may beCompetitive
Indicate price amp quantity or yield amp quantityNon-competitive
Indicate only quantity
Small investors and individualsgenerally submit non-competitive bids
A non-competitive bidder may not bid for more than$5MM worth of securities in a bill or bond auction
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Primary dealers bid for their accounts andon behalf of their clientsThey usually submit large competitive
bidsBids indicate the maximum price that the bidderis prepared to pay if it is a price based auctionOr the minimum yield that the bidder is
prepared to accept if it is a yield based auction
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The Treasury will net out the totalamount of non-competitive bids
The balance will be allocated to competitivebidders
There are two ways in which securitiescan be allotted
The multiple priceyield auction mechanism
French AuctionsThe uniform priceyield auction mechanism
Dutch Auctions
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Assume that the Treasury is offering 25billion dollars worth of T-bonds
2 billion dollars worth of non-competitive bidshave been receivedSo 23 billion dollars worth of bonds are availableto be offered to the competitive bidders
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There are six competitive bidders who havesubmitted the following yields
The bids have been arranged in ascending orderof yieldIn a price based auction the bids would havebeen arranged in descending order of price
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Bidder Bid Yield Bid Amount
Aggregate Amount
Alpha 5370 30 bn 30 bnBeta 5372 50 bn 80 bn
Gamma 5373 40 bn 12 bn
Delta 5375 80 bn 20 bnCharlie 5375 120 bn 32 bn
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The aggregate demand equals the amount onoffer at a yield of 5375A multiple yield auction will lead to thefollowing allocation
Alpha will get 3 bn at a yield of 5370Beta will get 5 bn at 5372Gamma will get 4 bn at 5373
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At a yield of 5375 we have only 11 bn left toallocateThere is a demand of 20 bn at this yield
8 bn from Delta and 12 bn from CharlieThus we will allocate 1120 = 55 to eachbidder at this yield
There will be pro-rata allocation
055 of 8 bn or 440 bn will go to Delta055 of 12 bn or 66 bn will go to Charlie
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The highest accepted yield is called the StopYield or High Yield
In this case it is 5375The ratio of bids received to the amountawarded is known as the bid to cover ratio
The higher the ratio the stronger is the auction
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Those who bid more than 5375 will getnothing and are said to be shutout of theauctionSince 1999 the US Treasury has beenconducting only uniform yield auctions
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WI stands for ndash When As and If IssuedThe when issued market is a market forforward trading of a bond
Which has been announced but not yet issuedTrades take place from the date ofannouncement until the actual issue date
Helps bidders to gauge the marketrsquos interestbefore the actual auction
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WI trading has ramifications for the biddingstrategies of market participantsTraders can take both long and shortpositions
Settlement is scheduled for the issue date
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It has a bearing on the outcome of theauction
It affects the strategy used by a bidder becauseit has an impact on his prior positionBidders who are long in the WI market enter theauction with a Long PositionThose who are short in the WI market enter theauction with a short position
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The WI market helps in price discoveryIt provides important information on
The strength of demand for the securityAnd on the disparity of biddersrsquo views
This help potential bidders to formulate theirstrategiesAt times a dealer may believe that he hasvery important private information
If so he may not participate in the WI market andwill directly enter the auction with bids based onhis knowledge
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On or before the date of the auction theissues trade on a yield basis
The actual price can be established only afterthe coupon is set
Starting with the day after the auctionSecurities are quoted on a price basis becausethe coupon is known
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In a coupon roll a dealer will purchase themost recently issued security from a clientAnd simultaneously sell the same amount ofthe recently announced new security
The first leg with settle on the following dayThe second leg is a forward contract
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There can be a Reverse RollThe dealer will sell the most recent issue fornext day settlementAnd buy the newly announced security forforward settlement
The forward leg in a RollReverse Roll is a WItrade
It will settle on the new issue settlement date
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The roll is the spread between the yield onthe new security and that on the outstandingissue in the same maturity segmentA GIVE in the Roll means that
The WI security provides a higher yield than theoutstanding issue
A Take in the Roll means thatThe WI security provides a lower yield
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On March 17 20XX the Treasury announcedthe auction of a 2-year note
The auction was scheduled for March 24The settlement date was March 31
Trading of the roll began as soon as the issuewas announcedA Give of 5 bp means that the dealer proposes tobuy the current issue at the prevailing yieldAnd sell the new issue at a yield that is 5 bpmoreA Take of 5 bp means that the dealer proposes tosell the new issue at a yield that is 5bp lower
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The roll achieves the followingHe acquires the outstanding issue for next daysettlementHe sells the to be issued security with the samepar value for forward delivery on 31 March
The customer is rolling over the investmentfrom the current issue to the new issue
This extends the maturity of the investment byone month
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The client can invest the funds received tillthe new issue settlesHowever he loses the accrued interest thathe would have earned had he held on to theissue
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The Treasury per se does not issue zerocoupon securitiesBut zero coupon securities can be created
which are backed by conventional bondsTake a large quantity of a T-note or bond andseparate all the cash flows from each otherSell the entitlement to each cash flowseparately
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Take the case of a two-year T-noteIt can be separated into five zero couponsecurities maturing after
6 months12 months18 months24 months
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Earlier investment banks used to buy bondsfrom the Treasury and separate the cashflows
Each cash flow was then sold separately as a zerocoupon bondSuch issues are called trademarks
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The issue of trademarks has now ceasedBecause investment banks can now createsuch instruments
In concert with the Treasury itselfThese ZCBs are known as STRIPS ndash
Separate Trading of Registered Interest andPrincipal of Securities
These are not issued or sold by the Treasury
The market is made by investment banks
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What is the motivation to create suchproductsIn practice arbitrage is possible when a
coupon security is purchased at a priceThat is lower than what could be obtained byselling each cash flow separately
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Coupon stripping reflects a case of financialengineering
Creating a risk-return profile that is nototherwise available
An investment bank would buy a largequantity of a Treasury security
The securities would be placed with an SPV
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The SPV is a single-purpose dedicated trustIt has the powers to own the bonds andcollect payments
It cannot sell or lend the bondsIt cannot write options on the bondsOr use them as collateral for borrowing
The SPV is empowered to issue zero coupon
bondsWhere each security represents the ownership ofa single cash flow from the mother bond
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Assume that 100MM USD of 15 year bondswith a coupon of 8 are placed with the SPV
The SPV can issue 6M 12M 18M extending up to14 frac12 year zeroes with a total face value of 4MM
USD eachAnd 15 year zeroes with a total face value of104MM
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The Treasury launched this program in 1985to facilitate the stripping of designatedsecurities
All new T-bonds and notes with a maturity of 10years or more are eligibleThe zeroes created in the process are directobligations of the US government
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The mechanism is as followsA dealer who owns a bond or note can ask theFRB where it is held
To replace it with an equivalent set of STRIPS
representing each payment as a separate securityEach of these securities can be traded independentlyof others
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In 1987 the Treasury started to allow dealersto reverse the process
This is called STRIPS RECONSTUTUTION If a dealer owns STRIPS representing all thecoupon and principal payments of a bond
The FED can on request convert these holdings into asingle position in the corresponding bond
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Each coupon and principal cash flow from aTreasury security is assigned a CUSIP
The mother bond is also assigned a CUSIPThe stripped coupons are known as C-STRIPSThe stripped principal is known as P-STRIPSSupply of a C-STRIP increases over time
because a C-STRIP maturing on a day like 15 FEB
2020 will have the same CUSIP irrespective ofwhich mother bond it has come fromThe original coupon rate is irrelevant
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P-STRIPS always correspond to the originalsecurityThey have a unique CUSIPTheir supply is fixed at the time of issuanceIn practice the prices of long-dated P-STRIPSare a bit higher than those of C-STRIPS withthe same maturity date
One reason is that P-STRIPS are more liquid due
to greater availabilityA $100 face value bond with a coupon of 8 willgenerate C-STRIPS with a face value of $4 but P-STRIPS with a face value of $100
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Another reason why P-STRIPS are in higherdemand is that they allow reconstitutionactivities more easily
Assume that the sum of the STRIPS is cheaper than
the mother bondIf a dealer already has the P-STRIPS only the C-STRIPSneed to be acquiredHowever if he owns some of the C-STRIPS he needs toacquire the P-STRIPS and the remaining C-STRIPSThe facility to reconstitute when profitable is pricedinto the P-STRIPSNote Buy and hold investors will prefer C-STRIPSsince they are priced lower and give a higher yield
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For Plain Vanilla bonds the specifiedcoupon rate is valid for the life of thebond
In the case of Floaters the rate is reset atthe beginning of every periodThe rate will vary directly with thebenchmark
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The rate on a Floater is specified as LIBOR+ 50 bp
The spread is positiveIf it were specified as LIBOR ndash 30bp
The spread will be negativeIf LIBOR rises the rate will increasewhereas if LIBOR falls it will decrease
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In the case of a default risk-free floater theprice will reset to par on a coupon date
It may sell at a premium or discount betweencoupon dates
Consider a floater with a coupon = 5-year T-Bond rate
Assume there are two periods left to maturity
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The price at the end of the first coupon period willbe given by
cT-1 is the coupon one period before maturityyT-1 is the YTM one period before maturity
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On a coupon reset date the YTM = couponBecause we have assumed there is no default riskAny change in the required yield as reflected inthe prevailing YTM
Will also be reflected in the coupon being setIf coupon = yield the bond should sell at par
Thus P T-1 = M
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Once again at T-2 c T-2 = yT-2 and P T-2 = MThis logic can be applied to a bond with anytime remaining till maturityHowever between two coupon dates theprice may not be equal to par
Consider the valuation at T-2+k
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Although c T-2 was set at T-2 and is equal toyT-2
yT-2+k is determined at T-2+k and will reflect theyield prevailing at that time
Thus yT-2+k need not equal c T-2 and may behigher or lower
Hence between two coupon dates a floater maysell at a premium or discount
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Now consider a floater characterized bydefault risk
The risk premium required by the market neednot be constant over time
Assume that at the time of issue YTM = 5-year T-note rate + 75bp
The coupon would have been set equal to thisrate and the bond would have been issued at par
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Six months hence the issue may be perceivedas more risky
YTM = 5-year T-note rate + 95 bpThe coupon will however be set equal to theprevailing 5-year rate + 75 bpIf so the issue will not reset to par at the nextcoupon date
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Floaters may come with a CAP or a FLOOR orBOTH
The CAP is a maximum coupon rateProtects issuers against rising rates
The FLOOR is a minimum coupon rateProtects investors against falling rates
When there is a spread over LIBORThere is a natural floorLIBOR cannot be less than zero
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Bond with a face value of $1000The coupon rate is 8 per annum paid semi-annually
So the bond holder will receive1000 x 008
___ = $40 every six months2
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The rate of return if an investor buys thebond at the prevailing price and holds ittill maturity
In order to get the YTM two conditionsmust be satisfied
The bond must be held till maturity All coupon payments received before maturitymust be reinvested at the YTM
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At any point in time the YTM may beGreater thanLess than or
Equal to the Coupon RateYTM is the IRR of a bond
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Bonds involve pure cash flowsSo only ONE REAL POSITIVE YTM
Solution to a Non-Linear equation
Solved iteratively
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A holder gets a stream of contractuallypromised payments
The value of the bond is the value of this stream
of cash flowsCash flows arising at different points in timecannot be addedCash flows have to be discounted
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It is a chicken and egg storyIf we know the yield that is required we canquote a priceOnce we acquire the asset at a certain price we
can work out the corresponding yield
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A bond will pay identical coupons everyperiodAnd will repay the face value at maturity
The periodic cash flows constitutean annuity The terminal face value is a lump
sum payment
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Bond pays a semi-annual coupon of $C2and has a face value of $MAssume there are N coupons left
And that we are standing on a coupondate
We are assuming that the next coupon is exactlysix months away
The required annual yield is yImplies that the semi-annual yield is y2
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The present value of the coupon stream is
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The present value of the face value is
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So the price of the bond is
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IBM has issued a bond with a face value of$1000The coupon is 8 per year to be paid on July
15 and January 15 every yearToday is 15 July 2013 and that the bondmatures on 15 January 2033The required yield is 10 per annum
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JJ ndash 0115FA ndash 0115MS ndash 0115
AO ndash 0115MN ndash 0115JD ndash 0115
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In the example the price is less than theface value
Such a bond is called a Discount Bond
It is trading at a discount from the face valueThe reason is that
The yield is greater than the coupon
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If the yield were to equal the couponThe bond would sell at PARSuch bonds are called PAR Bonds
If the yield is less than the couponThe price will exceed the face valueSuch bonds are called Premium Bonds
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As we move from one coupon date to thenext if the YTM were to remain constant
Par bonds would continue to trade at PARPremium bonds will steadily decline in priceDiscount bonds will steadily increase in price
This is called the Pull to Par EffectAt maturity ndash ALL BONDS WILL TRADE AT PAR
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As we approach maturity the number ofcoupons reduces
The contribution of coupons to price reducesThe contribution of the PV of the face valueincreases
For premium bonds the first effect dominatesThus the price steadily declines
For discount bonds the second effectdominatesThus the price steadily increases
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A plain vanilla or Bullet Bond pays the entireface value at maturity in a lump sumAmortizing bonds pay the principal in
installmentsThe first payment occurs before maturityThe last payment is made at maturity
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Consider a 5 year amortizing bond with aface value of $1000 and an annual coupon of8
The annual cash flows are depicted below
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Time Cash Flow
1 802 803 3304 3105 540
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The first two cash flows represent interest ona principal of $1000The third cash flow is interest on $1000 plus
a principal payment of $250The outstanding principal is $750The fourth cash flow is interest on $750 plusa principal payment of $250
The outstanding principal is $500The final cash flow is interest on $500 plusthe remaining principal of $500
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Some companies issue such bonds becausethe assets being funded have a similar cashflow profile
Second the coupon on such a bond may belower than that of a bullet bondIn the case of a bullet bond the entire principalis due at a single point in timeThere is greater default risk
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Microsoft is issuing zeroes with 5 years tomaturity and a face value of $10000
The required yield is 10 per annumWhat should be the price
Price is the PV of the face valueIn practice we discount on a semi-annual basis
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This is to facilitate comparisons withconventional bonds
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A zero coupon bond can never sell at apremium
It will always trade at a discount prior tomaturityAt maturity it will trade at par
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If held to maturity a ZCB will always give riseto a capital gainIf sold prior to maturity there may be a
capital gain or a capital lossConsider a bond with 10 years to maturityThe YTM at the time of purchase was 10The cost was $37690
A year later it is sold at a YTM of 12The corresponding price is $35035
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A newly established issuerOr an issuer with a relatively virgin productor service
Or a restructured company due to a mergeror following a bankruptcyWill be perceived as more riskyInvestors will demand a high coupon
Such firms are unlikely to have high earningsRevenues will peak only after theproductservice is established
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They can ill afford high couponsThey may consider a step-up coupon bond
Where the coupon increases as the bond ages
Assume a company can issue a plain vanillaat a coupon of 8 with a maturity of 5 yearsInstead it may opt for a bond
With a coupon of 6 for the first three years
And a coupon of 10 for the last two yearsThis is a Deferred Interest Security
Provides the issuer with breathing room in theearlier years
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These pay coupons in the form of additionalsecurities and not cash
This offers the issuer time to prepare for cashoutlays
They are used as Mezzanine FinanceThey rank between senior debt and equity in thecapital structureInvestors take more risk as compared to buyersof regular bonds ndash but get higher returnsIssuers can conserve cash in earlier years when itis at a premium
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Fully backed by the federal government ofthe issuing nationConsequently they are virtually devoid ofcredit risk or the risk of defaultThe yield on such securities is a benchmarkfor setting rates on other kinds of debt
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Treasury securities are issuedTo finance expenses in excess of currentrevenuesTo pay interest on debt accumulated in earlieryears due to deficits in those yearsTo repay past debt issues that are currentlymaturing
The US Treasuries marketIs the largest bond market in the worldIs the most liquid bond market in the world
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The Treasury issues three categories ofmarketable securities
T-bills are discount securitiesThey are zero coupon securitiesT-notes and T-bonds are sold at face value andpay interest periodically
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T-bills are issued with a original time tomaturity of one year or less
They are Money market instrumentsThey have maturities of either 1 3 6 or 12months at the time of issue
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T-notes and T-bonds have a time to maturityexceeding one year at the time of issue
They are capital market instrumentsT-notes have maturities ranging from 1-10 yearsT-bonds have an original maturity in excess of 10years extending up to 30 years
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An issue may be followed later by a furtherissue
With the same remaining time to maturity andthe same couponThe issuance of further tranches is termed as aRe-opening
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Six months ago a 10-year note was issuedwith a coupon of 8 per annumToday if a note with 9 frac12 years to maturityand a coupon of 8 issued it will add to thepool that is already trading in the marketThus it is a re-opening of an existing issue
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Who is a primary dealerA PD is a dealer who is authorized to dealdirectly with the Central Bank of the countryIn the US a PD is a bank or securities broker-dealer that directly deals with the FRBNY
Importance of FRBNYIn India a PD deals directly with the RBI
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The Treasury sells bills notes and bonds byway of a competitive auction process
Most of the treasury securities are bought byprimary dealers
Individual investors submit non-competitive bidsand participate on a much smaller scale
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Bids may beCompetitive
Indicate price amp quantity or yield amp quantityNon-competitive
Indicate only quantity
Small investors and individualsgenerally submit non-competitive bids
A non-competitive bidder may not bid for more than$5MM worth of securities in a bill or bond auction
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Primary dealers bid for their accounts andon behalf of their clientsThey usually submit large competitive
bidsBids indicate the maximum price that the bidderis prepared to pay if it is a price based auctionOr the minimum yield that the bidder is
prepared to accept if it is a yield based auction
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The Treasury will net out the totalamount of non-competitive bids
The balance will be allocated to competitivebidders
There are two ways in which securitiescan be allotted
The multiple priceyield auction mechanism
French AuctionsThe uniform priceyield auction mechanism
Dutch Auctions
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Assume that the Treasury is offering 25billion dollars worth of T-bonds
2 billion dollars worth of non-competitive bidshave been receivedSo 23 billion dollars worth of bonds are availableto be offered to the competitive bidders
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There are six competitive bidders who havesubmitted the following yields
The bids have been arranged in ascending orderof yieldIn a price based auction the bids would havebeen arranged in descending order of price
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Bidder Bid Yield Bid Amount
Aggregate Amount
Alpha 5370 30 bn 30 bnBeta 5372 50 bn 80 bn
Gamma 5373 40 bn 12 bn
Delta 5375 80 bn 20 bnCharlie 5375 120 bn 32 bn
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The aggregate demand equals the amount onoffer at a yield of 5375A multiple yield auction will lead to thefollowing allocation
Alpha will get 3 bn at a yield of 5370Beta will get 5 bn at 5372Gamma will get 4 bn at 5373
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At a yield of 5375 we have only 11 bn left toallocateThere is a demand of 20 bn at this yield
8 bn from Delta and 12 bn from CharlieThus we will allocate 1120 = 55 to eachbidder at this yield
There will be pro-rata allocation
055 of 8 bn or 440 bn will go to Delta055 of 12 bn or 66 bn will go to Charlie
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The highest accepted yield is called the StopYield or High Yield
In this case it is 5375The ratio of bids received to the amountawarded is known as the bid to cover ratio
The higher the ratio the stronger is the auction
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Those who bid more than 5375 will getnothing and are said to be shutout of theauctionSince 1999 the US Treasury has beenconducting only uniform yield auctions
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WI stands for ndash When As and If IssuedThe when issued market is a market forforward trading of a bond
Which has been announced but not yet issuedTrades take place from the date ofannouncement until the actual issue date
Helps bidders to gauge the marketrsquos interestbefore the actual auction
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WI trading has ramifications for the biddingstrategies of market participantsTraders can take both long and shortpositions
Settlement is scheduled for the issue date
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It has a bearing on the outcome of theauction
It affects the strategy used by a bidder becauseit has an impact on his prior positionBidders who are long in the WI market enter theauction with a Long PositionThose who are short in the WI market enter theauction with a short position
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The WI market helps in price discoveryIt provides important information on
The strength of demand for the securityAnd on the disparity of biddersrsquo views
This help potential bidders to formulate theirstrategiesAt times a dealer may believe that he hasvery important private information
If so he may not participate in the WI market andwill directly enter the auction with bids based onhis knowledge
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On or before the date of the auction theissues trade on a yield basis
The actual price can be established only afterthe coupon is set
Starting with the day after the auctionSecurities are quoted on a price basis becausethe coupon is known
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In a coupon roll a dealer will purchase themost recently issued security from a clientAnd simultaneously sell the same amount ofthe recently announced new security
The first leg with settle on the following dayThe second leg is a forward contract
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There can be a Reverse RollThe dealer will sell the most recent issue fornext day settlementAnd buy the newly announced security forforward settlement
The forward leg in a RollReverse Roll is a WItrade
It will settle on the new issue settlement date
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The roll is the spread between the yield onthe new security and that on the outstandingissue in the same maturity segmentA GIVE in the Roll means that
The WI security provides a higher yield than theoutstanding issue
A Take in the Roll means thatThe WI security provides a lower yield
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On March 17 20XX the Treasury announcedthe auction of a 2-year note
The auction was scheduled for March 24The settlement date was March 31
Trading of the roll began as soon as the issuewas announcedA Give of 5 bp means that the dealer proposes tobuy the current issue at the prevailing yieldAnd sell the new issue at a yield that is 5 bpmoreA Take of 5 bp means that the dealer proposes tosell the new issue at a yield that is 5bp lower
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The roll achieves the followingHe acquires the outstanding issue for next daysettlementHe sells the to be issued security with the samepar value for forward delivery on 31 March
The customer is rolling over the investmentfrom the current issue to the new issue
This extends the maturity of the investment byone month
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The client can invest the funds received tillthe new issue settlesHowever he loses the accrued interest thathe would have earned had he held on to theissue
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The Treasury per se does not issue zerocoupon securitiesBut zero coupon securities can be created
which are backed by conventional bondsTake a large quantity of a T-note or bond andseparate all the cash flows from each otherSell the entitlement to each cash flowseparately
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Take the case of a two-year T-noteIt can be separated into five zero couponsecurities maturing after
6 months12 months18 months24 months
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Earlier investment banks used to buy bondsfrom the Treasury and separate the cashflows
Each cash flow was then sold separately as a zerocoupon bondSuch issues are called trademarks
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The issue of trademarks has now ceasedBecause investment banks can now createsuch instruments
In concert with the Treasury itselfThese ZCBs are known as STRIPS ndash
Separate Trading of Registered Interest andPrincipal of Securities
These are not issued or sold by the Treasury
The market is made by investment banks
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What is the motivation to create suchproductsIn practice arbitrage is possible when a
coupon security is purchased at a priceThat is lower than what could be obtained byselling each cash flow separately
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Coupon stripping reflects a case of financialengineering
Creating a risk-return profile that is nototherwise available
An investment bank would buy a largequantity of a Treasury security
The securities would be placed with an SPV
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The SPV is a single-purpose dedicated trustIt has the powers to own the bonds andcollect payments
It cannot sell or lend the bondsIt cannot write options on the bondsOr use them as collateral for borrowing
The SPV is empowered to issue zero coupon
bondsWhere each security represents the ownership ofa single cash flow from the mother bond
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Assume that 100MM USD of 15 year bondswith a coupon of 8 are placed with the SPV
The SPV can issue 6M 12M 18M extending up to14 frac12 year zeroes with a total face value of 4MM
USD eachAnd 15 year zeroes with a total face value of104MM
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The Treasury launched this program in 1985to facilitate the stripping of designatedsecurities
All new T-bonds and notes with a maturity of 10years or more are eligibleThe zeroes created in the process are directobligations of the US government
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The mechanism is as followsA dealer who owns a bond or note can ask theFRB where it is held
To replace it with an equivalent set of STRIPS
representing each payment as a separate securityEach of these securities can be traded independentlyof others
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In 1987 the Treasury started to allow dealersto reverse the process
This is called STRIPS RECONSTUTUTION If a dealer owns STRIPS representing all thecoupon and principal payments of a bond
The FED can on request convert these holdings into asingle position in the corresponding bond
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Each coupon and principal cash flow from aTreasury security is assigned a CUSIP
The mother bond is also assigned a CUSIPThe stripped coupons are known as C-STRIPSThe stripped principal is known as P-STRIPSSupply of a C-STRIP increases over time
because a C-STRIP maturing on a day like 15 FEB
2020 will have the same CUSIP irrespective ofwhich mother bond it has come fromThe original coupon rate is irrelevant
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P-STRIPS always correspond to the originalsecurityThey have a unique CUSIPTheir supply is fixed at the time of issuanceIn practice the prices of long-dated P-STRIPSare a bit higher than those of C-STRIPS withthe same maturity date
One reason is that P-STRIPS are more liquid due
to greater availabilityA $100 face value bond with a coupon of 8 willgenerate C-STRIPS with a face value of $4 but P-STRIPS with a face value of $100
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Another reason why P-STRIPS are in higherdemand is that they allow reconstitutionactivities more easily
Assume that the sum of the STRIPS is cheaper than
the mother bondIf a dealer already has the P-STRIPS only the C-STRIPSneed to be acquiredHowever if he owns some of the C-STRIPS he needs toacquire the P-STRIPS and the remaining C-STRIPSThe facility to reconstitute when profitable is pricedinto the P-STRIPSNote Buy and hold investors will prefer C-STRIPSsince they are priced lower and give a higher yield
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For Plain Vanilla bonds the specifiedcoupon rate is valid for the life of thebond
In the case of Floaters the rate is reset atthe beginning of every periodThe rate will vary directly with thebenchmark
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The rate on a Floater is specified as LIBOR+ 50 bp
The spread is positiveIf it were specified as LIBOR ndash 30bp
The spread will be negativeIf LIBOR rises the rate will increasewhereas if LIBOR falls it will decrease
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In the case of a default risk-free floater theprice will reset to par on a coupon date
It may sell at a premium or discount betweencoupon dates
Consider a floater with a coupon = 5-year T-Bond rate
Assume there are two periods left to maturity
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The price at the end of the first coupon period willbe given by
cT-1 is the coupon one period before maturityyT-1 is the YTM one period before maturity
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On a coupon reset date the YTM = couponBecause we have assumed there is no default riskAny change in the required yield as reflected inthe prevailing YTM
Will also be reflected in the coupon being setIf coupon = yield the bond should sell at par
Thus P T-1 = M
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Once again at T-2 c T-2 = yT-2 and P T-2 = MThis logic can be applied to a bond with anytime remaining till maturityHowever between two coupon dates theprice may not be equal to par
Consider the valuation at T-2+k
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Although c T-2 was set at T-2 and is equal toyT-2
yT-2+k is determined at T-2+k and will reflect theyield prevailing at that time
Thus yT-2+k need not equal c T-2 and may behigher or lower
Hence between two coupon dates a floater maysell at a premium or discount
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Now consider a floater characterized bydefault risk
The risk premium required by the market neednot be constant over time
Assume that at the time of issue YTM = 5-year T-note rate + 75bp
The coupon would have been set equal to thisrate and the bond would have been issued at par
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Six months hence the issue may be perceivedas more risky
YTM = 5-year T-note rate + 95 bpThe coupon will however be set equal to theprevailing 5-year rate + 75 bpIf so the issue will not reset to par at the nextcoupon date
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Floaters may come with a CAP or a FLOOR orBOTH
The CAP is a maximum coupon rateProtects issuers against rising rates
The FLOOR is a minimum coupon rateProtects investors against falling rates
When there is a spread over LIBORThere is a natural floorLIBOR cannot be less than zero
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The rate of return if an investor buys thebond at the prevailing price and holds ittill maturity
In order to get the YTM two conditionsmust be satisfied
The bond must be held till maturity All coupon payments received before maturitymust be reinvested at the YTM
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At any point in time the YTM may beGreater thanLess than or
Equal to the Coupon RateYTM is the IRR of a bond
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Bonds involve pure cash flowsSo only ONE REAL POSITIVE YTM
Solution to a Non-Linear equation
Solved iteratively
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A holder gets a stream of contractuallypromised payments
The value of the bond is the value of this stream
of cash flowsCash flows arising at different points in timecannot be addedCash flows have to be discounted
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It is a chicken and egg storyIf we know the yield that is required we canquote a priceOnce we acquire the asset at a certain price we
can work out the corresponding yield
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A bond will pay identical coupons everyperiodAnd will repay the face value at maturity
The periodic cash flows constitutean annuity The terminal face value is a lump
sum payment
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Bond pays a semi-annual coupon of $C2and has a face value of $MAssume there are N coupons left
And that we are standing on a coupondate
We are assuming that the next coupon is exactlysix months away
The required annual yield is yImplies that the semi-annual yield is y2
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The present value of the coupon stream is
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The present value of the face value is
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So the price of the bond is
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IBM has issued a bond with a face value of$1000The coupon is 8 per year to be paid on July
15 and January 15 every yearToday is 15 July 2013 and that the bondmatures on 15 January 2033The required yield is 10 per annum
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JJ ndash 0115FA ndash 0115MS ndash 0115
AO ndash 0115MN ndash 0115JD ndash 0115
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In the example the price is less than theface value
Such a bond is called a Discount Bond
It is trading at a discount from the face valueThe reason is that
The yield is greater than the coupon
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If the yield were to equal the couponThe bond would sell at PARSuch bonds are called PAR Bonds
If the yield is less than the couponThe price will exceed the face valueSuch bonds are called Premium Bonds
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As we move from one coupon date to thenext if the YTM were to remain constant
Par bonds would continue to trade at PARPremium bonds will steadily decline in priceDiscount bonds will steadily increase in price
This is called the Pull to Par EffectAt maturity ndash ALL BONDS WILL TRADE AT PAR
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As we approach maturity the number ofcoupons reduces
The contribution of coupons to price reducesThe contribution of the PV of the face valueincreases
For premium bonds the first effect dominatesThus the price steadily declines
For discount bonds the second effectdominatesThus the price steadily increases
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A plain vanilla or Bullet Bond pays the entireface value at maturity in a lump sumAmortizing bonds pay the principal in
installmentsThe first payment occurs before maturityThe last payment is made at maturity
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Consider a 5 year amortizing bond with aface value of $1000 and an annual coupon of8
The annual cash flows are depicted below
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Time Cash Flow
1 802 803 3304 3105 540
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The first two cash flows represent interest ona principal of $1000The third cash flow is interest on $1000 plus
a principal payment of $250The outstanding principal is $750The fourth cash flow is interest on $750 plusa principal payment of $250
The outstanding principal is $500The final cash flow is interest on $500 plusthe remaining principal of $500
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Some companies issue such bonds becausethe assets being funded have a similar cashflow profile
Second the coupon on such a bond may belower than that of a bullet bondIn the case of a bullet bond the entire principalis due at a single point in timeThere is greater default risk
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Microsoft is issuing zeroes with 5 years tomaturity and a face value of $10000
The required yield is 10 per annumWhat should be the price
Price is the PV of the face valueIn practice we discount on a semi-annual basis
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This is to facilitate comparisons withconventional bonds
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A zero coupon bond can never sell at apremium
It will always trade at a discount prior tomaturityAt maturity it will trade at par
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If held to maturity a ZCB will always give riseto a capital gainIf sold prior to maturity there may be a
capital gain or a capital lossConsider a bond with 10 years to maturityThe YTM at the time of purchase was 10The cost was $37690
A year later it is sold at a YTM of 12The corresponding price is $35035
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A newly established issuerOr an issuer with a relatively virgin productor service
Or a restructured company due to a mergeror following a bankruptcyWill be perceived as more riskyInvestors will demand a high coupon
Such firms are unlikely to have high earningsRevenues will peak only after theproductservice is established
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They can ill afford high couponsThey may consider a step-up coupon bond
Where the coupon increases as the bond ages
Assume a company can issue a plain vanillaat a coupon of 8 with a maturity of 5 yearsInstead it may opt for a bond
With a coupon of 6 for the first three years
And a coupon of 10 for the last two yearsThis is a Deferred Interest Security
Provides the issuer with breathing room in theearlier years
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These pay coupons in the form of additionalsecurities and not cash
This offers the issuer time to prepare for cashoutlays
They are used as Mezzanine FinanceThey rank between senior debt and equity in thecapital structureInvestors take more risk as compared to buyersof regular bonds ndash but get higher returnsIssuers can conserve cash in earlier years when itis at a premium
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Fully backed by the federal government ofthe issuing nationConsequently they are virtually devoid ofcredit risk or the risk of defaultThe yield on such securities is a benchmarkfor setting rates on other kinds of debt
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Treasury securities are issuedTo finance expenses in excess of currentrevenuesTo pay interest on debt accumulated in earlieryears due to deficits in those yearsTo repay past debt issues that are currentlymaturing
The US Treasuries marketIs the largest bond market in the worldIs the most liquid bond market in the world
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The Treasury issues three categories ofmarketable securities
T-bills are discount securitiesThey are zero coupon securitiesT-notes and T-bonds are sold at face value andpay interest periodically
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T-bills are issued with a original time tomaturity of one year or less
They are Money market instrumentsThey have maturities of either 1 3 6 or 12months at the time of issue
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T-notes and T-bonds have a time to maturityexceeding one year at the time of issue
They are capital market instrumentsT-notes have maturities ranging from 1-10 yearsT-bonds have an original maturity in excess of 10years extending up to 30 years
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An issue may be followed later by a furtherissue
With the same remaining time to maturity andthe same couponThe issuance of further tranches is termed as aRe-opening
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Six months ago a 10-year note was issuedwith a coupon of 8 per annumToday if a note with 9 frac12 years to maturityand a coupon of 8 issued it will add to thepool that is already trading in the marketThus it is a re-opening of an existing issue
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Who is a primary dealerA PD is a dealer who is authorized to dealdirectly with the Central Bank of the countryIn the US a PD is a bank or securities broker-dealer that directly deals with the FRBNY
Importance of FRBNYIn India a PD deals directly with the RBI
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The Treasury sells bills notes and bonds byway of a competitive auction process
Most of the treasury securities are bought byprimary dealers
Individual investors submit non-competitive bidsand participate on a much smaller scale
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Bids may beCompetitive
Indicate price amp quantity or yield amp quantityNon-competitive
Indicate only quantity
Small investors and individualsgenerally submit non-competitive bids
A non-competitive bidder may not bid for more than$5MM worth of securities in a bill or bond auction
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Primary dealers bid for their accounts andon behalf of their clientsThey usually submit large competitive
bidsBids indicate the maximum price that the bidderis prepared to pay if it is a price based auctionOr the minimum yield that the bidder is
prepared to accept if it is a yield based auction
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The Treasury will net out the totalamount of non-competitive bids
The balance will be allocated to competitivebidders
There are two ways in which securitiescan be allotted
The multiple priceyield auction mechanism
French AuctionsThe uniform priceyield auction mechanism
Dutch Auctions
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Assume that the Treasury is offering 25billion dollars worth of T-bonds
2 billion dollars worth of non-competitive bidshave been receivedSo 23 billion dollars worth of bonds are availableto be offered to the competitive bidders
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There are six competitive bidders who havesubmitted the following yields
The bids have been arranged in ascending orderof yieldIn a price based auction the bids would havebeen arranged in descending order of price
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Bidder Bid Yield Bid Amount
Aggregate Amount
Alpha 5370 30 bn 30 bnBeta 5372 50 bn 80 bn
Gamma 5373 40 bn 12 bn
Delta 5375 80 bn 20 bnCharlie 5375 120 bn 32 bn
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The aggregate demand equals the amount onoffer at a yield of 5375A multiple yield auction will lead to thefollowing allocation
Alpha will get 3 bn at a yield of 5370Beta will get 5 bn at 5372Gamma will get 4 bn at 5373
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At a yield of 5375 we have only 11 bn left toallocateThere is a demand of 20 bn at this yield
8 bn from Delta and 12 bn from CharlieThus we will allocate 1120 = 55 to eachbidder at this yield
There will be pro-rata allocation
055 of 8 bn or 440 bn will go to Delta055 of 12 bn or 66 bn will go to Charlie
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The highest accepted yield is called the StopYield or High Yield
In this case it is 5375The ratio of bids received to the amountawarded is known as the bid to cover ratio
The higher the ratio the stronger is the auction
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Those who bid more than 5375 will getnothing and are said to be shutout of theauctionSince 1999 the US Treasury has beenconducting only uniform yield auctions
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WI stands for ndash When As and If IssuedThe when issued market is a market forforward trading of a bond
Which has been announced but not yet issuedTrades take place from the date ofannouncement until the actual issue date
Helps bidders to gauge the marketrsquos interestbefore the actual auction
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WI trading has ramifications for the biddingstrategies of market participantsTraders can take both long and shortpositions
Settlement is scheduled for the issue date
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It has a bearing on the outcome of theauction
It affects the strategy used by a bidder becauseit has an impact on his prior positionBidders who are long in the WI market enter theauction with a Long PositionThose who are short in the WI market enter theauction with a short position
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The WI market helps in price discoveryIt provides important information on
The strength of demand for the securityAnd on the disparity of biddersrsquo views
This help potential bidders to formulate theirstrategiesAt times a dealer may believe that he hasvery important private information
If so he may not participate in the WI market andwill directly enter the auction with bids based onhis knowledge
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On or before the date of the auction theissues trade on a yield basis
The actual price can be established only afterthe coupon is set
Starting with the day after the auctionSecurities are quoted on a price basis becausethe coupon is known
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In a coupon roll a dealer will purchase themost recently issued security from a clientAnd simultaneously sell the same amount ofthe recently announced new security
The first leg with settle on the following dayThe second leg is a forward contract
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There can be a Reverse RollThe dealer will sell the most recent issue fornext day settlementAnd buy the newly announced security forforward settlement
The forward leg in a RollReverse Roll is a WItrade
It will settle on the new issue settlement date
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The roll is the spread between the yield onthe new security and that on the outstandingissue in the same maturity segmentA GIVE in the Roll means that
The WI security provides a higher yield than theoutstanding issue
A Take in the Roll means thatThe WI security provides a lower yield
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On March 17 20XX the Treasury announcedthe auction of a 2-year note
The auction was scheduled for March 24The settlement date was March 31
Trading of the roll began as soon as the issuewas announcedA Give of 5 bp means that the dealer proposes tobuy the current issue at the prevailing yieldAnd sell the new issue at a yield that is 5 bpmoreA Take of 5 bp means that the dealer proposes tosell the new issue at a yield that is 5bp lower
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The roll achieves the followingHe acquires the outstanding issue for next daysettlementHe sells the to be issued security with the samepar value for forward delivery on 31 March
The customer is rolling over the investmentfrom the current issue to the new issue
This extends the maturity of the investment byone month
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The client can invest the funds received tillthe new issue settlesHowever he loses the accrued interest thathe would have earned had he held on to theissue
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The Treasury per se does not issue zerocoupon securitiesBut zero coupon securities can be created
which are backed by conventional bondsTake a large quantity of a T-note or bond andseparate all the cash flows from each otherSell the entitlement to each cash flowseparately
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Take the case of a two-year T-noteIt can be separated into five zero couponsecurities maturing after
6 months12 months18 months24 months
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Earlier investment banks used to buy bondsfrom the Treasury and separate the cashflows
Each cash flow was then sold separately as a zerocoupon bondSuch issues are called trademarks
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The issue of trademarks has now ceasedBecause investment banks can now createsuch instruments
In concert with the Treasury itselfThese ZCBs are known as STRIPS ndash
Separate Trading of Registered Interest andPrincipal of Securities
These are not issued or sold by the Treasury
The market is made by investment banks
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What is the motivation to create suchproductsIn practice arbitrage is possible when a
coupon security is purchased at a priceThat is lower than what could be obtained byselling each cash flow separately
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Coupon stripping reflects a case of financialengineering
Creating a risk-return profile that is nototherwise available
An investment bank would buy a largequantity of a Treasury security
The securities would be placed with an SPV
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The SPV is a single-purpose dedicated trustIt has the powers to own the bonds andcollect payments
It cannot sell or lend the bondsIt cannot write options on the bondsOr use them as collateral for borrowing
The SPV is empowered to issue zero coupon
bondsWhere each security represents the ownership ofa single cash flow from the mother bond
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Assume that 100MM USD of 15 year bondswith a coupon of 8 are placed with the SPV
The SPV can issue 6M 12M 18M extending up to14 frac12 year zeroes with a total face value of 4MM
USD eachAnd 15 year zeroes with a total face value of104MM
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The Treasury launched this program in 1985to facilitate the stripping of designatedsecurities
All new T-bonds and notes with a maturity of 10years or more are eligibleThe zeroes created in the process are directobligations of the US government
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The mechanism is as followsA dealer who owns a bond or note can ask theFRB where it is held
To replace it with an equivalent set of STRIPS
representing each payment as a separate securityEach of these securities can be traded independentlyof others
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In 1987 the Treasury started to allow dealersto reverse the process
This is called STRIPS RECONSTUTUTION If a dealer owns STRIPS representing all thecoupon and principal payments of a bond
The FED can on request convert these holdings into asingle position in the corresponding bond
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Each coupon and principal cash flow from aTreasury security is assigned a CUSIP
The mother bond is also assigned a CUSIPThe stripped coupons are known as C-STRIPSThe stripped principal is known as P-STRIPSSupply of a C-STRIP increases over time
because a C-STRIP maturing on a day like 15 FEB
2020 will have the same CUSIP irrespective ofwhich mother bond it has come fromThe original coupon rate is irrelevant
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P-STRIPS always correspond to the originalsecurityThey have a unique CUSIPTheir supply is fixed at the time of issuanceIn practice the prices of long-dated P-STRIPSare a bit higher than those of C-STRIPS withthe same maturity date
One reason is that P-STRIPS are more liquid due
to greater availabilityA $100 face value bond with a coupon of 8 willgenerate C-STRIPS with a face value of $4 but P-STRIPS with a face value of $100
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Another reason why P-STRIPS are in higherdemand is that they allow reconstitutionactivities more easily
Assume that the sum of the STRIPS is cheaper than
the mother bondIf a dealer already has the P-STRIPS only the C-STRIPSneed to be acquiredHowever if he owns some of the C-STRIPS he needs toacquire the P-STRIPS and the remaining C-STRIPSThe facility to reconstitute when profitable is pricedinto the P-STRIPSNote Buy and hold investors will prefer C-STRIPSsince they are priced lower and give a higher yield
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For Plain Vanilla bonds the specifiedcoupon rate is valid for the life of thebond
In the case of Floaters the rate is reset atthe beginning of every periodThe rate will vary directly with thebenchmark
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The rate on a Floater is specified as LIBOR+ 50 bp
The spread is positiveIf it were specified as LIBOR ndash 30bp
The spread will be negativeIf LIBOR rises the rate will increasewhereas if LIBOR falls it will decrease
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In the case of a default risk-free floater theprice will reset to par on a coupon date
It may sell at a premium or discount betweencoupon dates
Consider a floater with a coupon = 5-year T-Bond rate
Assume there are two periods left to maturity
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The price at the end of the first coupon period willbe given by
cT-1 is the coupon one period before maturityyT-1 is the YTM one period before maturity
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On a coupon reset date the YTM = couponBecause we have assumed there is no default riskAny change in the required yield as reflected inthe prevailing YTM
Will also be reflected in the coupon being setIf coupon = yield the bond should sell at par
Thus P T-1 = M
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Once again at T-2 c T-2 = yT-2 and P T-2 = MThis logic can be applied to a bond with anytime remaining till maturityHowever between two coupon dates theprice may not be equal to par
Consider the valuation at T-2+k
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Although c T-2 was set at T-2 and is equal toyT-2
yT-2+k is determined at T-2+k and will reflect theyield prevailing at that time
Thus yT-2+k need not equal c T-2 and may behigher or lower
Hence between two coupon dates a floater maysell at a premium or discount
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Now consider a floater characterized bydefault risk
The risk premium required by the market neednot be constant over time
Assume that at the time of issue YTM = 5-year T-note rate + 75bp
The coupon would have been set equal to thisrate and the bond would have been issued at par
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Six months hence the issue may be perceivedas more risky
YTM = 5-year T-note rate + 95 bpThe coupon will however be set equal to theprevailing 5-year rate + 75 bpIf so the issue will not reset to par at the nextcoupon date
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Floaters may come with a CAP or a FLOOR orBOTH
The CAP is a maximum coupon rateProtects issuers against rising rates
The FLOOR is a minimum coupon rateProtects investors against falling rates
When there is a spread over LIBORThere is a natural floorLIBOR cannot be less than zero
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At any point in time the YTM may beGreater thanLess than or
Equal to the Coupon RateYTM is the IRR of a bond
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Bonds involve pure cash flowsSo only ONE REAL POSITIVE YTM
Solution to a Non-Linear equation
Solved iteratively
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A holder gets a stream of contractuallypromised payments
The value of the bond is the value of this stream
of cash flowsCash flows arising at different points in timecannot be addedCash flows have to be discounted
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It is a chicken and egg storyIf we know the yield that is required we canquote a priceOnce we acquire the asset at a certain price we
can work out the corresponding yield
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A bond will pay identical coupons everyperiodAnd will repay the face value at maturity
The periodic cash flows constitutean annuity The terminal face value is a lump
sum payment
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Bond pays a semi-annual coupon of $C2and has a face value of $MAssume there are N coupons left
And that we are standing on a coupondate
We are assuming that the next coupon is exactlysix months away
The required annual yield is yImplies that the semi-annual yield is y2
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The present value of the coupon stream is
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The present value of the face value is
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So the price of the bond is
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IBM has issued a bond with a face value of$1000The coupon is 8 per year to be paid on July
15 and January 15 every yearToday is 15 July 2013 and that the bondmatures on 15 January 2033The required yield is 10 per annum
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JJ ndash 0115FA ndash 0115MS ndash 0115
AO ndash 0115MN ndash 0115JD ndash 0115
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In the example the price is less than theface value
Such a bond is called a Discount Bond
It is trading at a discount from the face valueThe reason is that
The yield is greater than the coupon
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If the yield were to equal the couponThe bond would sell at PARSuch bonds are called PAR Bonds
If the yield is less than the couponThe price will exceed the face valueSuch bonds are called Premium Bonds
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As we move from one coupon date to thenext if the YTM were to remain constant
Par bonds would continue to trade at PARPremium bonds will steadily decline in priceDiscount bonds will steadily increase in price
This is called the Pull to Par EffectAt maturity ndash ALL BONDS WILL TRADE AT PAR
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As we approach maturity the number ofcoupons reduces
The contribution of coupons to price reducesThe contribution of the PV of the face valueincreases
For premium bonds the first effect dominatesThus the price steadily declines
For discount bonds the second effectdominatesThus the price steadily increases
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A plain vanilla or Bullet Bond pays the entireface value at maturity in a lump sumAmortizing bonds pay the principal in
installmentsThe first payment occurs before maturityThe last payment is made at maturity
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Consider a 5 year amortizing bond with aface value of $1000 and an annual coupon of8
The annual cash flows are depicted below
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Time Cash Flow
1 802 803 3304 3105 540
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The first two cash flows represent interest ona principal of $1000The third cash flow is interest on $1000 plus
a principal payment of $250The outstanding principal is $750The fourth cash flow is interest on $750 plusa principal payment of $250
The outstanding principal is $500The final cash flow is interest on $500 plusthe remaining principal of $500
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Some companies issue such bonds becausethe assets being funded have a similar cashflow profile
Second the coupon on such a bond may belower than that of a bullet bondIn the case of a bullet bond the entire principalis due at a single point in timeThere is greater default risk
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Microsoft is issuing zeroes with 5 years tomaturity and a face value of $10000
The required yield is 10 per annumWhat should be the price
Price is the PV of the face valueIn practice we discount on a semi-annual basis
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This is to facilitate comparisons withconventional bonds
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A zero coupon bond can never sell at apremium
It will always trade at a discount prior tomaturityAt maturity it will trade at par
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If held to maturity a ZCB will always give riseto a capital gainIf sold prior to maturity there may be a
capital gain or a capital lossConsider a bond with 10 years to maturityThe YTM at the time of purchase was 10The cost was $37690
A year later it is sold at a YTM of 12The corresponding price is $35035
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A newly established issuerOr an issuer with a relatively virgin productor service
Or a restructured company due to a mergeror following a bankruptcyWill be perceived as more riskyInvestors will demand a high coupon
Such firms are unlikely to have high earningsRevenues will peak only after theproductservice is established
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They can ill afford high couponsThey may consider a step-up coupon bond
Where the coupon increases as the bond ages
Assume a company can issue a plain vanillaat a coupon of 8 with a maturity of 5 yearsInstead it may opt for a bond
With a coupon of 6 for the first three years
And a coupon of 10 for the last two yearsThis is a Deferred Interest Security
Provides the issuer with breathing room in theearlier years
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These pay coupons in the form of additionalsecurities and not cash
This offers the issuer time to prepare for cashoutlays
They are used as Mezzanine FinanceThey rank between senior debt and equity in thecapital structureInvestors take more risk as compared to buyersof regular bonds ndash but get higher returnsIssuers can conserve cash in earlier years when itis at a premium
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Fully backed by the federal government ofthe issuing nationConsequently they are virtually devoid ofcredit risk or the risk of defaultThe yield on such securities is a benchmarkfor setting rates on other kinds of debt
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Treasury securities are issuedTo finance expenses in excess of currentrevenuesTo pay interest on debt accumulated in earlieryears due to deficits in those yearsTo repay past debt issues that are currentlymaturing
The US Treasuries marketIs the largest bond market in the worldIs the most liquid bond market in the world
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The Treasury issues three categories ofmarketable securities
T-bills are discount securitiesThey are zero coupon securitiesT-notes and T-bonds are sold at face value andpay interest periodically
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T-bills are issued with a original time tomaturity of one year or less
They are Money market instrumentsThey have maturities of either 1 3 6 or 12months at the time of issue
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T-notes and T-bonds have a time to maturityexceeding one year at the time of issue
They are capital market instrumentsT-notes have maturities ranging from 1-10 yearsT-bonds have an original maturity in excess of 10years extending up to 30 years
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An issue may be followed later by a furtherissue
With the same remaining time to maturity andthe same couponThe issuance of further tranches is termed as aRe-opening
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Six months ago a 10-year note was issuedwith a coupon of 8 per annumToday if a note with 9 frac12 years to maturityand a coupon of 8 issued it will add to thepool that is already trading in the marketThus it is a re-opening of an existing issue
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Who is a primary dealerA PD is a dealer who is authorized to dealdirectly with the Central Bank of the countryIn the US a PD is a bank or securities broker-dealer that directly deals with the FRBNY
Importance of FRBNYIn India a PD deals directly with the RBI
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The Treasury sells bills notes and bonds byway of a competitive auction process
Most of the treasury securities are bought byprimary dealers
Individual investors submit non-competitive bidsand participate on a much smaller scale
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Bids may beCompetitive
Indicate price amp quantity or yield amp quantityNon-competitive
Indicate only quantity
Small investors and individualsgenerally submit non-competitive bids
A non-competitive bidder may not bid for more than$5MM worth of securities in a bill or bond auction
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Primary dealers bid for their accounts andon behalf of their clientsThey usually submit large competitive
bidsBids indicate the maximum price that the bidderis prepared to pay if it is a price based auctionOr the minimum yield that the bidder is
prepared to accept if it is a yield based auction
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The Treasury will net out the totalamount of non-competitive bids
The balance will be allocated to competitivebidders
There are two ways in which securitiescan be allotted
The multiple priceyield auction mechanism
French AuctionsThe uniform priceyield auction mechanism
Dutch Auctions
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Assume that the Treasury is offering 25billion dollars worth of T-bonds
2 billion dollars worth of non-competitive bidshave been receivedSo 23 billion dollars worth of bonds are availableto be offered to the competitive bidders
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There are six competitive bidders who havesubmitted the following yields
The bids have been arranged in ascending orderof yieldIn a price based auction the bids would havebeen arranged in descending order of price
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Bidder Bid Yield Bid Amount
Aggregate Amount
Alpha 5370 30 bn 30 bnBeta 5372 50 bn 80 bn
Gamma 5373 40 bn 12 bn
Delta 5375 80 bn 20 bnCharlie 5375 120 bn 32 bn
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The aggregate demand equals the amount onoffer at a yield of 5375A multiple yield auction will lead to thefollowing allocation
Alpha will get 3 bn at a yield of 5370Beta will get 5 bn at 5372Gamma will get 4 bn at 5373
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At a yield of 5375 we have only 11 bn left toallocateThere is a demand of 20 bn at this yield
8 bn from Delta and 12 bn from CharlieThus we will allocate 1120 = 55 to eachbidder at this yield
There will be pro-rata allocation
055 of 8 bn or 440 bn will go to Delta055 of 12 bn or 66 bn will go to Charlie
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The highest accepted yield is called the StopYield or High Yield
In this case it is 5375The ratio of bids received to the amountawarded is known as the bid to cover ratio
The higher the ratio the stronger is the auction
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Those who bid more than 5375 will getnothing and are said to be shutout of theauctionSince 1999 the US Treasury has beenconducting only uniform yield auctions
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WI stands for ndash When As and If IssuedThe when issued market is a market forforward trading of a bond
Which has been announced but not yet issuedTrades take place from the date ofannouncement until the actual issue date
Helps bidders to gauge the marketrsquos interestbefore the actual auction
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WI trading has ramifications for the biddingstrategies of market participantsTraders can take both long and shortpositions
Settlement is scheduled for the issue date
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It has a bearing on the outcome of theauction
It affects the strategy used by a bidder becauseit has an impact on his prior positionBidders who are long in the WI market enter theauction with a Long PositionThose who are short in the WI market enter theauction with a short position
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The WI market helps in price discoveryIt provides important information on
The strength of demand for the securityAnd on the disparity of biddersrsquo views
This help potential bidders to formulate theirstrategiesAt times a dealer may believe that he hasvery important private information
If so he may not participate in the WI market andwill directly enter the auction with bids based onhis knowledge
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On or before the date of the auction theissues trade on a yield basis
The actual price can be established only afterthe coupon is set
Starting with the day after the auctionSecurities are quoted on a price basis becausethe coupon is known
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In a coupon roll a dealer will purchase themost recently issued security from a clientAnd simultaneously sell the same amount ofthe recently announced new security
The first leg with settle on the following dayThe second leg is a forward contract
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There can be a Reverse RollThe dealer will sell the most recent issue fornext day settlementAnd buy the newly announced security forforward settlement
The forward leg in a RollReverse Roll is a WItrade
It will settle on the new issue settlement date
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The roll is the spread between the yield onthe new security and that on the outstandingissue in the same maturity segmentA GIVE in the Roll means that
The WI security provides a higher yield than theoutstanding issue
A Take in the Roll means thatThe WI security provides a lower yield
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On March 17 20XX the Treasury announcedthe auction of a 2-year note
The auction was scheduled for March 24The settlement date was March 31
Trading of the roll began as soon as the issuewas announcedA Give of 5 bp means that the dealer proposes tobuy the current issue at the prevailing yieldAnd sell the new issue at a yield that is 5 bpmoreA Take of 5 bp means that the dealer proposes tosell the new issue at a yield that is 5bp lower
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The roll achieves the followingHe acquires the outstanding issue for next daysettlementHe sells the to be issued security with the samepar value for forward delivery on 31 March
The customer is rolling over the investmentfrom the current issue to the new issue
This extends the maturity of the investment byone month
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The client can invest the funds received tillthe new issue settlesHowever he loses the accrued interest thathe would have earned had he held on to theissue
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The Treasury per se does not issue zerocoupon securitiesBut zero coupon securities can be created
which are backed by conventional bondsTake a large quantity of a T-note or bond andseparate all the cash flows from each otherSell the entitlement to each cash flowseparately
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Take the case of a two-year T-noteIt can be separated into five zero couponsecurities maturing after
6 months12 months18 months24 months
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Earlier investment banks used to buy bondsfrom the Treasury and separate the cashflows
Each cash flow was then sold separately as a zerocoupon bondSuch issues are called trademarks
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The issue of trademarks has now ceasedBecause investment banks can now createsuch instruments
In concert with the Treasury itselfThese ZCBs are known as STRIPS ndash
Separate Trading of Registered Interest andPrincipal of Securities
These are not issued or sold by the Treasury
The market is made by investment banks
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What is the motivation to create suchproductsIn practice arbitrage is possible when a
coupon security is purchased at a priceThat is lower than what could be obtained byselling each cash flow separately
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Coupon stripping reflects a case of financialengineering
Creating a risk-return profile that is nototherwise available
An investment bank would buy a largequantity of a Treasury security
The securities would be placed with an SPV
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The SPV is a single-purpose dedicated trustIt has the powers to own the bonds andcollect payments
It cannot sell or lend the bondsIt cannot write options on the bondsOr use them as collateral for borrowing
The SPV is empowered to issue zero coupon
bondsWhere each security represents the ownership ofa single cash flow from the mother bond
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Assume that 100MM USD of 15 year bondswith a coupon of 8 are placed with the SPV
The SPV can issue 6M 12M 18M extending up to14 frac12 year zeroes with a total face value of 4MM
USD eachAnd 15 year zeroes with a total face value of104MM
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The Treasury launched this program in 1985to facilitate the stripping of designatedsecurities
All new T-bonds and notes with a maturity of 10years or more are eligibleThe zeroes created in the process are directobligations of the US government
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The mechanism is as followsA dealer who owns a bond or note can ask theFRB where it is held
To replace it with an equivalent set of STRIPS
representing each payment as a separate securityEach of these securities can be traded independentlyof others
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In 1987 the Treasury started to allow dealersto reverse the process
This is called STRIPS RECONSTUTUTION If a dealer owns STRIPS representing all thecoupon and principal payments of a bond
The FED can on request convert these holdings into asingle position in the corresponding bond
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Each coupon and principal cash flow from aTreasury security is assigned a CUSIP
The mother bond is also assigned a CUSIPThe stripped coupons are known as C-STRIPSThe stripped principal is known as P-STRIPSSupply of a C-STRIP increases over time
because a C-STRIP maturing on a day like 15 FEB
2020 will have the same CUSIP irrespective ofwhich mother bond it has come fromThe original coupon rate is irrelevant
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P-STRIPS always correspond to the originalsecurityThey have a unique CUSIPTheir supply is fixed at the time of issuanceIn practice the prices of long-dated P-STRIPSare a bit higher than those of C-STRIPS withthe same maturity date
One reason is that P-STRIPS are more liquid due
to greater availabilityA $100 face value bond with a coupon of 8 willgenerate C-STRIPS with a face value of $4 but P-STRIPS with a face value of $100
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Another reason why P-STRIPS are in higherdemand is that they allow reconstitutionactivities more easily
Assume that the sum of the STRIPS is cheaper than
the mother bondIf a dealer already has the P-STRIPS only the C-STRIPSneed to be acquiredHowever if he owns some of the C-STRIPS he needs toacquire the P-STRIPS and the remaining C-STRIPSThe facility to reconstitute when profitable is pricedinto the P-STRIPSNote Buy and hold investors will prefer C-STRIPSsince they are priced lower and give a higher yield
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For Plain Vanilla bonds the specifiedcoupon rate is valid for the life of thebond
In the case of Floaters the rate is reset atthe beginning of every periodThe rate will vary directly with thebenchmark
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The rate on a Floater is specified as LIBOR+ 50 bp
The spread is positiveIf it were specified as LIBOR ndash 30bp
The spread will be negativeIf LIBOR rises the rate will increasewhereas if LIBOR falls it will decrease
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In the case of a default risk-free floater theprice will reset to par on a coupon date
It may sell at a premium or discount betweencoupon dates
Consider a floater with a coupon = 5-year T-Bond rate
Assume there are two periods left to maturity
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The price at the end of the first coupon period willbe given by
cT-1 is the coupon one period before maturityyT-1 is the YTM one period before maturity
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On a coupon reset date the YTM = couponBecause we have assumed there is no default riskAny change in the required yield as reflected inthe prevailing YTM
Will also be reflected in the coupon being setIf coupon = yield the bond should sell at par
Thus P T-1 = M
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Once again at T-2 c T-2 = yT-2 and P T-2 = MThis logic can be applied to a bond with anytime remaining till maturityHowever between two coupon dates theprice may not be equal to par
Consider the valuation at T-2+k
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Although c T-2 was set at T-2 and is equal toyT-2
yT-2+k is determined at T-2+k and will reflect theyield prevailing at that time
Thus yT-2+k need not equal c T-2 and may behigher or lower
Hence between two coupon dates a floater maysell at a premium or discount
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Now consider a floater characterized bydefault risk
The risk premium required by the market neednot be constant over time
Assume that at the time of issue YTM = 5-year T-note rate + 75bp
The coupon would have been set equal to thisrate and the bond would have been issued at par
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Six months hence the issue may be perceivedas more risky
YTM = 5-year T-note rate + 95 bpThe coupon will however be set equal to theprevailing 5-year rate + 75 bpIf so the issue will not reset to par at the nextcoupon date
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Floaters may come with a CAP or a FLOOR orBOTH
The CAP is a maximum coupon rateProtects issuers against rising rates
The FLOOR is a minimum coupon rateProtects investors against falling rates
When there is a spread over LIBORThere is a natural floorLIBOR cannot be less than zero
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Bonds involve pure cash flowsSo only ONE REAL POSITIVE YTM
Solution to a Non-Linear equation
Solved iteratively
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A holder gets a stream of contractuallypromised payments
The value of the bond is the value of this stream
of cash flowsCash flows arising at different points in timecannot be addedCash flows have to be discounted
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It is a chicken and egg storyIf we know the yield that is required we canquote a priceOnce we acquire the asset at a certain price we
can work out the corresponding yield
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A bond will pay identical coupons everyperiodAnd will repay the face value at maturity
The periodic cash flows constitutean annuity The terminal face value is a lump
sum payment
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Bond pays a semi-annual coupon of $C2and has a face value of $MAssume there are N coupons left
And that we are standing on a coupondate
We are assuming that the next coupon is exactlysix months away
The required annual yield is yImplies that the semi-annual yield is y2
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The present value of the coupon stream is
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The present value of the face value is
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So the price of the bond is
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IBM has issued a bond with a face value of$1000The coupon is 8 per year to be paid on July
15 and January 15 every yearToday is 15 July 2013 and that the bondmatures on 15 January 2033The required yield is 10 per annum
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JJ ndash 0115FA ndash 0115MS ndash 0115
AO ndash 0115MN ndash 0115JD ndash 0115
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In the example the price is less than theface value
Such a bond is called a Discount Bond
It is trading at a discount from the face valueThe reason is that
The yield is greater than the coupon
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If the yield were to equal the couponThe bond would sell at PARSuch bonds are called PAR Bonds
If the yield is less than the couponThe price will exceed the face valueSuch bonds are called Premium Bonds
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As we move from one coupon date to thenext if the YTM were to remain constant
Par bonds would continue to trade at PARPremium bonds will steadily decline in priceDiscount bonds will steadily increase in price
This is called the Pull to Par EffectAt maturity ndash ALL BONDS WILL TRADE AT PAR
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As we approach maturity the number ofcoupons reduces
The contribution of coupons to price reducesThe contribution of the PV of the face valueincreases
For premium bonds the first effect dominatesThus the price steadily declines
For discount bonds the second effectdominatesThus the price steadily increases
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A plain vanilla or Bullet Bond pays the entireface value at maturity in a lump sumAmortizing bonds pay the principal in
installmentsThe first payment occurs before maturityThe last payment is made at maturity
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Consider a 5 year amortizing bond with aface value of $1000 and an annual coupon of8
The annual cash flows are depicted below
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Time Cash Flow
1 802 803 3304 3105 540
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The first two cash flows represent interest ona principal of $1000The third cash flow is interest on $1000 plus
a principal payment of $250The outstanding principal is $750The fourth cash flow is interest on $750 plusa principal payment of $250
The outstanding principal is $500The final cash flow is interest on $500 plusthe remaining principal of $500
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Some companies issue such bonds becausethe assets being funded have a similar cashflow profile
Second the coupon on such a bond may belower than that of a bullet bondIn the case of a bullet bond the entire principalis due at a single point in timeThere is greater default risk
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Microsoft is issuing zeroes with 5 years tomaturity and a face value of $10000
The required yield is 10 per annumWhat should be the price
Price is the PV of the face valueIn practice we discount on a semi-annual basis
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This is to facilitate comparisons withconventional bonds
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A zero coupon bond can never sell at apremium
It will always trade at a discount prior tomaturityAt maturity it will trade at par
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If held to maturity a ZCB will always give riseto a capital gainIf sold prior to maturity there may be a
capital gain or a capital lossConsider a bond with 10 years to maturityThe YTM at the time of purchase was 10The cost was $37690
A year later it is sold at a YTM of 12The corresponding price is $35035
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A newly established issuerOr an issuer with a relatively virgin productor service
Or a restructured company due to a mergeror following a bankruptcyWill be perceived as more riskyInvestors will demand a high coupon
Such firms are unlikely to have high earningsRevenues will peak only after theproductservice is established
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They can ill afford high couponsThey may consider a step-up coupon bond
Where the coupon increases as the bond ages
Assume a company can issue a plain vanillaat a coupon of 8 with a maturity of 5 yearsInstead it may opt for a bond
With a coupon of 6 for the first three years
And a coupon of 10 for the last two yearsThis is a Deferred Interest Security
Provides the issuer with breathing room in theearlier years
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These pay coupons in the form of additionalsecurities and not cash
This offers the issuer time to prepare for cashoutlays
They are used as Mezzanine FinanceThey rank between senior debt and equity in thecapital structureInvestors take more risk as compared to buyersof regular bonds ndash but get higher returnsIssuers can conserve cash in earlier years when itis at a premium
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Fully backed by the federal government ofthe issuing nationConsequently they are virtually devoid ofcredit risk or the risk of defaultThe yield on such securities is a benchmarkfor setting rates on other kinds of debt
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Treasury securities are issuedTo finance expenses in excess of currentrevenuesTo pay interest on debt accumulated in earlieryears due to deficits in those yearsTo repay past debt issues that are currentlymaturing
The US Treasuries marketIs the largest bond market in the worldIs the most liquid bond market in the world
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The Treasury issues three categories ofmarketable securities
T-bills are discount securitiesThey are zero coupon securitiesT-notes and T-bonds are sold at face value andpay interest periodically
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T-bills are issued with a original time tomaturity of one year or less
They are Money market instrumentsThey have maturities of either 1 3 6 or 12months at the time of issue
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T-notes and T-bonds have a time to maturityexceeding one year at the time of issue
They are capital market instrumentsT-notes have maturities ranging from 1-10 yearsT-bonds have an original maturity in excess of 10years extending up to 30 years
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An issue may be followed later by a furtherissue
With the same remaining time to maturity andthe same couponThe issuance of further tranches is termed as aRe-opening
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Six months ago a 10-year note was issuedwith a coupon of 8 per annumToday if a note with 9 frac12 years to maturityand a coupon of 8 issued it will add to thepool that is already trading in the marketThus it is a re-opening of an existing issue
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Who is a primary dealerA PD is a dealer who is authorized to dealdirectly with the Central Bank of the countryIn the US a PD is a bank or securities broker-dealer that directly deals with the FRBNY
Importance of FRBNYIn India a PD deals directly with the RBI
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The Treasury sells bills notes and bonds byway of a competitive auction process
Most of the treasury securities are bought byprimary dealers
Individual investors submit non-competitive bidsand participate on a much smaller scale
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Bids may beCompetitive
Indicate price amp quantity or yield amp quantityNon-competitive
Indicate only quantity
Small investors and individualsgenerally submit non-competitive bids
A non-competitive bidder may not bid for more than$5MM worth of securities in a bill or bond auction
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Primary dealers bid for their accounts andon behalf of their clientsThey usually submit large competitive
bidsBids indicate the maximum price that the bidderis prepared to pay if it is a price based auctionOr the minimum yield that the bidder is
prepared to accept if it is a yield based auction
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The Treasury will net out the totalamount of non-competitive bids
The balance will be allocated to competitivebidders
There are two ways in which securitiescan be allotted
The multiple priceyield auction mechanism
French AuctionsThe uniform priceyield auction mechanism
Dutch Auctions
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Assume that the Treasury is offering 25billion dollars worth of T-bonds
2 billion dollars worth of non-competitive bidshave been receivedSo 23 billion dollars worth of bonds are availableto be offered to the competitive bidders
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There are six competitive bidders who havesubmitted the following yields
The bids have been arranged in ascending orderof yieldIn a price based auction the bids would havebeen arranged in descending order of price
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Bidder Bid Yield Bid Amount
Aggregate Amount
Alpha 5370 30 bn 30 bnBeta 5372 50 bn 80 bn
Gamma 5373 40 bn 12 bn
Delta 5375 80 bn 20 bnCharlie 5375 120 bn 32 bn
Tango 5380 30 bn 35 bn8282014 69
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The aggregate demand equals the amount onoffer at a yield of 5375A multiple yield auction will lead to thefollowing allocation
Alpha will get 3 bn at a yield of 5370Beta will get 5 bn at 5372Gamma will get 4 bn at 5373
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At a yield of 5375 we have only 11 bn left toallocateThere is a demand of 20 bn at this yield
8 bn from Delta and 12 bn from CharlieThus we will allocate 1120 = 55 to eachbidder at this yield
There will be pro-rata allocation
055 of 8 bn or 440 bn will go to Delta055 of 12 bn or 66 bn will go to Charlie
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The highest accepted yield is called the StopYield or High Yield
In this case it is 5375The ratio of bids received to the amountawarded is known as the bid to cover ratio
The higher the ratio the stronger is the auction
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Those who bid more than 5375 will getnothing and are said to be shutout of theauctionSince 1999 the US Treasury has beenconducting only uniform yield auctions
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WI stands for ndash When As and If IssuedThe when issued market is a market forforward trading of a bond
Which has been announced but not yet issuedTrades take place from the date ofannouncement until the actual issue date
Helps bidders to gauge the marketrsquos interestbefore the actual auction
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WI trading has ramifications for the biddingstrategies of market participantsTraders can take both long and shortpositions
Settlement is scheduled for the issue date
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It has a bearing on the outcome of theauction
It affects the strategy used by a bidder becauseit has an impact on his prior positionBidders who are long in the WI market enter theauction with a Long PositionThose who are short in the WI market enter theauction with a short position
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The WI market helps in price discoveryIt provides important information on
The strength of demand for the securityAnd on the disparity of biddersrsquo views
This help potential bidders to formulate theirstrategiesAt times a dealer may believe that he hasvery important private information
If so he may not participate in the WI market andwill directly enter the auction with bids based onhis knowledge
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On or before the date of the auction theissues trade on a yield basis
The actual price can be established only afterthe coupon is set
Starting with the day after the auctionSecurities are quoted on a price basis becausethe coupon is known
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In a coupon roll a dealer will purchase themost recently issued security from a clientAnd simultaneously sell the same amount ofthe recently announced new security
The first leg with settle on the following dayThe second leg is a forward contract
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There can be a Reverse RollThe dealer will sell the most recent issue fornext day settlementAnd buy the newly announced security forforward settlement
The forward leg in a RollReverse Roll is a WItrade
It will settle on the new issue settlement date
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The roll is the spread between the yield onthe new security and that on the outstandingissue in the same maturity segmentA GIVE in the Roll means that
The WI security provides a higher yield than theoutstanding issue
A Take in the Roll means thatThe WI security provides a lower yield
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On March 17 20XX the Treasury announcedthe auction of a 2-year note
The auction was scheduled for March 24The settlement date was March 31
Trading of the roll began as soon as the issuewas announcedA Give of 5 bp means that the dealer proposes tobuy the current issue at the prevailing yieldAnd sell the new issue at a yield that is 5 bpmoreA Take of 5 bp means that the dealer proposes tosell the new issue at a yield that is 5bp lower
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The roll achieves the followingHe acquires the outstanding issue for next daysettlementHe sells the to be issued security with the samepar value for forward delivery on 31 March
The customer is rolling over the investmentfrom the current issue to the new issue
This extends the maturity of the investment byone month
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The client can invest the funds received tillthe new issue settlesHowever he loses the accrued interest thathe would have earned had he held on to theissue
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The Treasury per se does not issue zerocoupon securitiesBut zero coupon securities can be created
which are backed by conventional bondsTake a large quantity of a T-note or bond andseparate all the cash flows from each otherSell the entitlement to each cash flowseparately
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Take the case of a two-year T-noteIt can be separated into five zero couponsecurities maturing after
6 months12 months18 months24 months
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Earlier investment banks used to buy bondsfrom the Treasury and separate the cashflows
Each cash flow was then sold separately as a zerocoupon bondSuch issues are called trademarks
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The issue of trademarks has now ceasedBecause investment banks can now createsuch instruments
In concert with the Treasury itselfThese ZCBs are known as STRIPS ndash
Separate Trading of Registered Interest andPrincipal of Securities
These are not issued or sold by the Treasury
The market is made by investment banks
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What is the motivation to create suchproductsIn practice arbitrage is possible when a
coupon security is purchased at a priceThat is lower than what could be obtained byselling each cash flow separately
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Coupon stripping reflects a case of financialengineering
Creating a risk-return profile that is nototherwise available
An investment bank would buy a largequantity of a Treasury security
The securities would be placed with an SPV
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The SPV is a single-purpose dedicated trustIt has the powers to own the bonds andcollect payments
It cannot sell or lend the bondsIt cannot write options on the bondsOr use them as collateral for borrowing
The SPV is empowered to issue zero coupon
bondsWhere each security represents the ownership ofa single cash flow from the mother bond
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Assume that 100MM USD of 15 year bondswith a coupon of 8 are placed with the SPV
The SPV can issue 6M 12M 18M extending up to14 frac12 year zeroes with a total face value of 4MM
USD eachAnd 15 year zeroes with a total face value of104MM
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The Treasury launched this program in 1985to facilitate the stripping of designatedsecurities
All new T-bonds and notes with a maturity of 10years or more are eligibleThe zeroes created in the process are directobligations of the US government
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The mechanism is as followsA dealer who owns a bond or note can ask theFRB where it is held
To replace it with an equivalent set of STRIPS
representing each payment as a separate securityEach of these securities can be traded independentlyof others
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In 1987 the Treasury started to allow dealersto reverse the process
This is called STRIPS RECONSTUTUTION If a dealer owns STRIPS representing all thecoupon and principal payments of a bond
The FED can on request convert these holdings into asingle position in the corresponding bond
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Each coupon and principal cash flow from aTreasury security is assigned a CUSIP
The mother bond is also assigned a CUSIPThe stripped coupons are known as C-STRIPSThe stripped principal is known as P-STRIPSSupply of a C-STRIP increases over time
because a C-STRIP maturing on a day like 15 FEB
2020 will have the same CUSIP irrespective ofwhich mother bond it has come fromThe original coupon rate is irrelevant
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P-STRIPS always correspond to the originalsecurityThey have a unique CUSIPTheir supply is fixed at the time of issuanceIn practice the prices of long-dated P-STRIPSare a bit higher than those of C-STRIPS withthe same maturity date
One reason is that P-STRIPS are more liquid due
to greater availabilityA $100 face value bond with a coupon of 8 willgenerate C-STRIPS with a face value of $4 but P-STRIPS with a face value of $100
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Another reason why P-STRIPS are in higherdemand is that they allow reconstitutionactivities more easily
Assume that the sum of the STRIPS is cheaper than
the mother bondIf a dealer already has the P-STRIPS only the C-STRIPSneed to be acquiredHowever if he owns some of the C-STRIPS he needs toacquire the P-STRIPS and the remaining C-STRIPSThe facility to reconstitute when profitable is pricedinto the P-STRIPSNote Buy and hold investors will prefer C-STRIPSsince they are priced lower and give a higher yield
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For Plain Vanilla bonds the specifiedcoupon rate is valid for the life of thebond
In the case of Floaters the rate is reset atthe beginning of every periodThe rate will vary directly with thebenchmark
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The rate on a Floater is specified as LIBOR+ 50 bp
The spread is positiveIf it were specified as LIBOR ndash 30bp
The spread will be negativeIf LIBOR rises the rate will increasewhereas if LIBOR falls it will decrease
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In the case of a default risk-free floater theprice will reset to par on a coupon date
It may sell at a premium or discount betweencoupon dates
Consider a floater with a coupon = 5-year T-Bond rate
Assume there are two periods left to maturity
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The price at the end of the first coupon period willbe given by
cT-1 is the coupon one period before maturityyT-1 is the YTM one period before maturity
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On a coupon reset date the YTM = couponBecause we have assumed there is no default riskAny change in the required yield as reflected inthe prevailing YTM
Will also be reflected in the coupon being setIf coupon = yield the bond should sell at par
Thus P T-1 = M
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Once again at T-2 c T-2 = yT-2 and P T-2 = MThis logic can be applied to a bond with anytime remaining till maturityHowever between two coupon dates theprice may not be equal to par
Consider the valuation at T-2+k
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Although c T-2 was set at T-2 and is equal toyT-2
yT-2+k is determined at T-2+k and will reflect theyield prevailing at that time
Thus yT-2+k need not equal c T-2 and may behigher or lower
Hence between two coupon dates a floater maysell at a premium or discount
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Now consider a floater characterized bydefault risk
The risk premium required by the market neednot be constant over time
Assume that at the time of issue YTM = 5-year T-note rate + 75bp
The coupon would have been set equal to thisrate and the bond would have been issued at par
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Six months hence the issue may be perceivedas more risky
YTM = 5-year T-note rate + 95 bpThe coupon will however be set equal to theprevailing 5-year rate + 75 bpIf so the issue will not reset to par at the nextcoupon date
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Floaters may come with a CAP or a FLOOR orBOTH
The CAP is a maximum coupon rateProtects issuers against rising rates
The FLOOR is a minimum coupon rateProtects investors against falling rates
When there is a spread over LIBORThere is a natural floorLIBOR cannot be less than zero
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A holder gets a stream of contractuallypromised payments
The value of the bond is the value of this stream
of cash flowsCash flows arising at different points in timecannot be addedCash flows have to be discounted
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It is a chicken and egg storyIf we know the yield that is required we canquote a priceOnce we acquire the asset at a certain price we
can work out the corresponding yield
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A bond will pay identical coupons everyperiodAnd will repay the face value at maturity
The periodic cash flows constitutean annuity The terminal face value is a lump
sum payment
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Bond pays a semi-annual coupon of $C2and has a face value of $MAssume there are N coupons left
And that we are standing on a coupondate
We are assuming that the next coupon is exactlysix months away
The required annual yield is yImplies that the semi-annual yield is y2
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The present value of the coupon stream is
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The present value of the face value is
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So the price of the bond is
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IBM has issued a bond with a face value of$1000The coupon is 8 per year to be paid on July
15 and January 15 every yearToday is 15 July 2013 and that the bondmatures on 15 January 2033The required yield is 10 per annum
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JJ ndash 0115FA ndash 0115MS ndash 0115
AO ndash 0115MN ndash 0115JD ndash 0115
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In the example the price is less than theface value
Such a bond is called a Discount Bond
It is trading at a discount from the face valueThe reason is that
The yield is greater than the coupon
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If the yield were to equal the couponThe bond would sell at PARSuch bonds are called PAR Bonds
If the yield is less than the couponThe price will exceed the face valueSuch bonds are called Premium Bonds
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As we move from one coupon date to thenext if the YTM were to remain constant
Par bonds would continue to trade at PARPremium bonds will steadily decline in priceDiscount bonds will steadily increase in price
This is called the Pull to Par EffectAt maturity ndash ALL BONDS WILL TRADE AT PAR
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As we approach maturity the number ofcoupons reduces
The contribution of coupons to price reducesThe contribution of the PV of the face valueincreases
For premium bonds the first effect dominatesThus the price steadily declines
For discount bonds the second effectdominatesThus the price steadily increases
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A plain vanilla or Bullet Bond pays the entireface value at maturity in a lump sumAmortizing bonds pay the principal in
installmentsThe first payment occurs before maturityThe last payment is made at maturity
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Consider a 5 year amortizing bond with aface value of $1000 and an annual coupon of8
The annual cash flows are depicted below
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Time Cash Flow
1 802 803 3304 3105 540
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The first two cash flows represent interest ona principal of $1000The third cash flow is interest on $1000 plus
a principal payment of $250The outstanding principal is $750The fourth cash flow is interest on $750 plusa principal payment of $250
The outstanding principal is $500The final cash flow is interest on $500 plusthe remaining principal of $500
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Some companies issue such bonds becausethe assets being funded have a similar cashflow profile
Second the coupon on such a bond may belower than that of a bullet bondIn the case of a bullet bond the entire principalis due at a single point in timeThere is greater default risk
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Microsoft is issuing zeroes with 5 years tomaturity and a face value of $10000
The required yield is 10 per annumWhat should be the price
Price is the PV of the face valueIn practice we discount on a semi-annual basis
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This is to facilitate comparisons withconventional bonds
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A zero coupon bond can never sell at apremium
It will always trade at a discount prior tomaturityAt maturity it will trade at par
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If held to maturity a ZCB will always give riseto a capital gainIf sold prior to maturity there may be a
capital gain or a capital lossConsider a bond with 10 years to maturityThe YTM at the time of purchase was 10The cost was $37690
A year later it is sold at a YTM of 12The corresponding price is $35035
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A newly established issuerOr an issuer with a relatively virgin productor service
Or a restructured company due to a mergeror following a bankruptcyWill be perceived as more riskyInvestors will demand a high coupon
Such firms are unlikely to have high earningsRevenues will peak only after theproductservice is established
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They can ill afford high couponsThey may consider a step-up coupon bond
Where the coupon increases as the bond ages
Assume a company can issue a plain vanillaat a coupon of 8 with a maturity of 5 yearsInstead it may opt for a bond
With a coupon of 6 for the first three years
And a coupon of 10 for the last two yearsThis is a Deferred Interest Security
Provides the issuer with breathing room in theearlier years
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These pay coupons in the form of additionalsecurities and not cash
This offers the issuer time to prepare for cashoutlays
They are used as Mezzanine FinanceThey rank between senior debt and equity in thecapital structureInvestors take more risk as compared to buyersof regular bonds ndash but get higher returnsIssuers can conserve cash in earlier years when itis at a premium
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Fully backed by the federal government ofthe issuing nationConsequently they are virtually devoid ofcredit risk or the risk of defaultThe yield on such securities is a benchmarkfor setting rates on other kinds of debt
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Treasury securities are issuedTo finance expenses in excess of currentrevenuesTo pay interest on debt accumulated in earlieryears due to deficits in those yearsTo repay past debt issues that are currentlymaturing
The US Treasuries marketIs the largest bond market in the worldIs the most liquid bond market in the world
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The Treasury issues three categories ofmarketable securities
T-bills are discount securitiesThey are zero coupon securitiesT-notes and T-bonds are sold at face value andpay interest periodically
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T-bills are issued with a original time tomaturity of one year or less
They are Money market instrumentsThey have maturities of either 1 3 6 or 12months at the time of issue
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T-notes and T-bonds have a time to maturityexceeding one year at the time of issue
They are capital market instrumentsT-notes have maturities ranging from 1-10 yearsT-bonds have an original maturity in excess of 10years extending up to 30 years
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An issue may be followed later by a furtherissue
With the same remaining time to maturity andthe same couponThe issuance of further tranches is termed as aRe-opening
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Six months ago a 10-year note was issuedwith a coupon of 8 per annumToday if a note with 9 frac12 years to maturityand a coupon of 8 issued it will add to thepool that is already trading in the marketThus it is a re-opening of an existing issue
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Who is a primary dealerA PD is a dealer who is authorized to dealdirectly with the Central Bank of the countryIn the US a PD is a bank or securities broker-dealer that directly deals with the FRBNY
Importance of FRBNYIn India a PD deals directly with the RBI
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The Treasury sells bills notes and bonds byway of a competitive auction process
Most of the treasury securities are bought byprimary dealers
Individual investors submit non-competitive bidsand participate on a much smaller scale
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Bids may beCompetitive
Indicate price amp quantity or yield amp quantityNon-competitive
Indicate only quantity
Small investors and individualsgenerally submit non-competitive bids
A non-competitive bidder may not bid for more than$5MM worth of securities in a bill or bond auction
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Primary dealers bid for their accounts andon behalf of their clientsThey usually submit large competitive
bidsBids indicate the maximum price that the bidderis prepared to pay if it is a price based auctionOr the minimum yield that the bidder is
prepared to accept if it is a yield based auction
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The Treasury will net out the totalamount of non-competitive bids
The balance will be allocated to competitivebidders
There are two ways in which securitiescan be allotted
The multiple priceyield auction mechanism
French AuctionsThe uniform priceyield auction mechanism
Dutch Auctions
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Assume that the Treasury is offering 25billion dollars worth of T-bonds
2 billion dollars worth of non-competitive bidshave been receivedSo 23 billion dollars worth of bonds are availableto be offered to the competitive bidders
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There are six competitive bidders who havesubmitted the following yields
The bids have been arranged in ascending orderof yieldIn a price based auction the bids would havebeen arranged in descending order of price
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Bidder Bid Yield Bid Amount
Aggregate Amount
Alpha 5370 30 bn 30 bnBeta 5372 50 bn 80 bn
Gamma 5373 40 bn 12 bn
Delta 5375 80 bn 20 bnCharlie 5375 120 bn 32 bn
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The aggregate demand equals the amount onoffer at a yield of 5375A multiple yield auction will lead to thefollowing allocation
Alpha will get 3 bn at a yield of 5370Beta will get 5 bn at 5372Gamma will get 4 bn at 5373
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At a yield of 5375 we have only 11 bn left toallocateThere is a demand of 20 bn at this yield
8 bn from Delta and 12 bn from CharlieThus we will allocate 1120 = 55 to eachbidder at this yield
There will be pro-rata allocation
055 of 8 bn or 440 bn will go to Delta055 of 12 bn or 66 bn will go to Charlie
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The highest accepted yield is called the StopYield or High Yield
In this case it is 5375The ratio of bids received to the amountawarded is known as the bid to cover ratio
The higher the ratio the stronger is the auction
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Those who bid more than 5375 will getnothing and are said to be shutout of theauctionSince 1999 the US Treasury has beenconducting only uniform yield auctions
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WI stands for ndash When As and If IssuedThe when issued market is a market forforward trading of a bond
Which has been announced but not yet issuedTrades take place from the date ofannouncement until the actual issue date
Helps bidders to gauge the marketrsquos interestbefore the actual auction
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WI trading has ramifications for the biddingstrategies of market participantsTraders can take both long and shortpositions
Settlement is scheduled for the issue date
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It has a bearing on the outcome of theauction
It affects the strategy used by a bidder becauseit has an impact on his prior positionBidders who are long in the WI market enter theauction with a Long PositionThose who are short in the WI market enter theauction with a short position
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The WI market helps in price discoveryIt provides important information on
The strength of demand for the securityAnd on the disparity of biddersrsquo views
This help potential bidders to formulate theirstrategiesAt times a dealer may believe that he hasvery important private information
If so he may not participate in the WI market andwill directly enter the auction with bids based onhis knowledge
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On or before the date of the auction theissues trade on a yield basis
The actual price can be established only afterthe coupon is set
Starting with the day after the auctionSecurities are quoted on a price basis becausethe coupon is known
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In a coupon roll a dealer will purchase themost recently issued security from a clientAnd simultaneously sell the same amount ofthe recently announced new security
The first leg with settle on the following dayThe second leg is a forward contract
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There can be a Reverse RollThe dealer will sell the most recent issue fornext day settlementAnd buy the newly announced security forforward settlement
The forward leg in a RollReverse Roll is a WItrade
It will settle on the new issue settlement date
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The roll is the spread between the yield onthe new security and that on the outstandingissue in the same maturity segmentA GIVE in the Roll means that
The WI security provides a higher yield than theoutstanding issue
A Take in the Roll means thatThe WI security provides a lower yield
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On March 17 20XX the Treasury announcedthe auction of a 2-year note
The auction was scheduled for March 24The settlement date was March 31
Trading of the roll began as soon as the issuewas announcedA Give of 5 bp means that the dealer proposes tobuy the current issue at the prevailing yieldAnd sell the new issue at a yield that is 5 bpmoreA Take of 5 bp means that the dealer proposes tosell the new issue at a yield that is 5bp lower
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The roll achieves the followingHe acquires the outstanding issue for next daysettlementHe sells the to be issued security with the samepar value for forward delivery on 31 March
The customer is rolling over the investmentfrom the current issue to the new issue
This extends the maturity of the investment byone month
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The client can invest the funds received tillthe new issue settlesHowever he loses the accrued interest thathe would have earned had he held on to theissue
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The Treasury per se does not issue zerocoupon securitiesBut zero coupon securities can be created
which are backed by conventional bondsTake a large quantity of a T-note or bond andseparate all the cash flows from each otherSell the entitlement to each cash flowseparately
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Take the case of a two-year T-noteIt can be separated into five zero couponsecurities maturing after
6 months12 months18 months24 months
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Earlier investment banks used to buy bondsfrom the Treasury and separate the cashflows
Each cash flow was then sold separately as a zerocoupon bondSuch issues are called trademarks
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The issue of trademarks has now ceasedBecause investment banks can now createsuch instruments
In concert with the Treasury itselfThese ZCBs are known as STRIPS ndash
Separate Trading of Registered Interest andPrincipal of Securities
These are not issued or sold by the Treasury
The market is made by investment banks
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What is the motivation to create suchproductsIn practice arbitrage is possible when a
coupon security is purchased at a priceThat is lower than what could be obtained byselling each cash flow separately
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Coupon stripping reflects a case of financialengineering
Creating a risk-return profile that is nototherwise available
An investment bank would buy a largequantity of a Treasury security
The securities would be placed with an SPV
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The SPV is a single-purpose dedicated trustIt has the powers to own the bonds andcollect payments
It cannot sell or lend the bondsIt cannot write options on the bondsOr use them as collateral for borrowing
The SPV is empowered to issue zero coupon
bondsWhere each security represents the ownership ofa single cash flow from the mother bond
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Assume that 100MM USD of 15 year bondswith a coupon of 8 are placed with the SPV
The SPV can issue 6M 12M 18M extending up to14 frac12 year zeroes with a total face value of 4MM
USD eachAnd 15 year zeroes with a total face value of104MM
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The Treasury launched this program in 1985to facilitate the stripping of designatedsecurities
All new T-bonds and notes with a maturity of 10years or more are eligibleThe zeroes created in the process are directobligations of the US government
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The mechanism is as followsA dealer who owns a bond or note can ask theFRB where it is held
To replace it with an equivalent set of STRIPS
representing each payment as a separate securityEach of these securities can be traded independentlyof others
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In 1987 the Treasury started to allow dealersto reverse the process
This is called STRIPS RECONSTUTUTION If a dealer owns STRIPS representing all thecoupon and principal payments of a bond
The FED can on request convert these holdings into asingle position in the corresponding bond
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Each coupon and principal cash flow from aTreasury security is assigned a CUSIP
The mother bond is also assigned a CUSIPThe stripped coupons are known as C-STRIPSThe stripped principal is known as P-STRIPSSupply of a C-STRIP increases over time
because a C-STRIP maturing on a day like 15 FEB
2020 will have the same CUSIP irrespective ofwhich mother bond it has come fromThe original coupon rate is irrelevant
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P-STRIPS always correspond to the originalsecurityThey have a unique CUSIPTheir supply is fixed at the time of issuanceIn practice the prices of long-dated P-STRIPSare a bit higher than those of C-STRIPS withthe same maturity date
One reason is that P-STRIPS are more liquid due
to greater availabilityA $100 face value bond with a coupon of 8 willgenerate C-STRIPS with a face value of $4 but P-STRIPS with a face value of $100
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Another reason why P-STRIPS are in higherdemand is that they allow reconstitutionactivities more easily
Assume that the sum of the STRIPS is cheaper than
the mother bondIf a dealer already has the P-STRIPS only the C-STRIPSneed to be acquiredHowever if he owns some of the C-STRIPS he needs toacquire the P-STRIPS and the remaining C-STRIPSThe facility to reconstitute when profitable is pricedinto the P-STRIPSNote Buy and hold investors will prefer C-STRIPSsince they are priced lower and give a higher yield
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For Plain Vanilla bonds the specifiedcoupon rate is valid for the life of thebond
In the case of Floaters the rate is reset atthe beginning of every periodThe rate will vary directly with thebenchmark
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The rate on a Floater is specified as LIBOR+ 50 bp
The spread is positiveIf it were specified as LIBOR ndash 30bp
The spread will be negativeIf LIBOR rises the rate will increasewhereas if LIBOR falls it will decrease
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In the case of a default risk-free floater theprice will reset to par on a coupon date
It may sell at a premium or discount betweencoupon dates
Consider a floater with a coupon = 5-year T-Bond rate
Assume there are two periods left to maturity
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The price at the end of the first coupon period willbe given by
cT-1 is the coupon one period before maturityyT-1 is the YTM one period before maturity
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On a coupon reset date the YTM = couponBecause we have assumed there is no default riskAny change in the required yield as reflected inthe prevailing YTM
Will also be reflected in the coupon being setIf coupon = yield the bond should sell at par
Thus P T-1 = M
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Once again at T-2 c T-2 = yT-2 and P T-2 = MThis logic can be applied to a bond with anytime remaining till maturityHowever between two coupon dates theprice may not be equal to par
Consider the valuation at T-2+k
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Although c T-2 was set at T-2 and is equal toyT-2
yT-2+k is determined at T-2+k and will reflect theyield prevailing at that time
Thus yT-2+k need not equal c T-2 and may behigher or lower
Hence between two coupon dates a floater maysell at a premium or discount
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Now consider a floater characterized bydefault risk
The risk premium required by the market neednot be constant over time
Assume that at the time of issue YTM = 5-year T-note rate + 75bp
The coupon would have been set equal to thisrate and the bond would have been issued at par
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Six months hence the issue may be perceivedas more risky
YTM = 5-year T-note rate + 95 bpThe coupon will however be set equal to theprevailing 5-year rate + 75 bpIf so the issue will not reset to par at the nextcoupon date
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Floaters may come with a CAP or a FLOOR orBOTH
The CAP is a maximum coupon rateProtects issuers against rising rates
The FLOOR is a minimum coupon rateProtects investors against falling rates
When there is a spread over LIBORThere is a natural floorLIBOR cannot be less than zero
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It is a chicken and egg storyIf we know the yield that is required we canquote a priceOnce we acquire the asset at a certain price we
can work out the corresponding yield
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A bond will pay identical coupons everyperiodAnd will repay the face value at maturity
The periodic cash flows constitutean annuity The terminal face value is a lump
sum payment
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Bond pays a semi-annual coupon of $C2and has a face value of $MAssume there are N coupons left
And that we are standing on a coupondate
We are assuming that the next coupon is exactlysix months away
The required annual yield is yImplies that the semi-annual yield is y2
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The present value of the coupon stream is
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The present value of the face value is
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So the price of the bond is
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IBM has issued a bond with a face value of$1000The coupon is 8 per year to be paid on July
15 and January 15 every yearToday is 15 July 2013 and that the bondmatures on 15 January 2033The required yield is 10 per annum
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JJ ndash 0115FA ndash 0115MS ndash 0115
AO ndash 0115MN ndash 0115JD ndash 0115
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In the example the price is less than theface value
Such a bond is called a Discount Bond
It is trading at a discount from the face valueThe reason is that
The yield is greater than the coupon
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If the yield were to equal the couponThe bond would sell at PARSuch bonds are called PAR Bonds
If the yield is less than the couponThe price will exceed the face valueSuch bonds are called Premium Bonds
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As we move from one coupon date to thenext if the YTM were to remain constant
Par bonds would continue to trade at PARPremium bonds will steadily decline in priceDiscount bonds will steadily increase in price
This is called the Pull to Par EffectAt maturity ndash ALL BONDS WILL TRADE AT PAR
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As we approach maturity the number ofcoupons reduces
The contribution of coupons to price reducesThe contribution of the PV of the face valueincreases
For premium bonds the first effect dominatesThus the price steadily declines
For discount bonds the second effectdominatesThus the price steadily increases
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A plain vanilla or Bullet Bond pays the entireface value at maturity in a lump sumAmortizing bonds pay the principal in
installmentsThe first payment occurs before maturityThe last payment is made at maturity
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Consider a 5 year amortizing bond with aface value of $1000 and an annual coupon of8
The annual cash flows are depicted below
8282014 40
Time Cash Flow
1 802 803 3304 3105 540
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The first two cash flows represent interest ona principal of $1000The third cash flow is interest on $1000 plus
a principal payment of $250The outstanding principal is $750The fourth cash flow is interest on $750 plusa principal payment of $250
The outstanding principal is $500The final cash flow is interest on $500 plusthe remaining principal of $500
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Some companies issue such bonds becausethe assets being funded have a similar cashflow profile
Second the coupon on such a bond may belower than that of a bullet bondIn the case of a bullet bond the entire principalis due at a single point in timeThere is greater default risk
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Microsoft is issuing zeroes with 5 years tomaturity and a face value of $10000
The required yield is 10 per annumWhat should be the price
Price is the PV of the face valueIn practice we discount on a semi-annual basis
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This is to facilitate comparisons withconventional bonds
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A zero coupon bond can never sell at apremium
It will always trade at a discount prior tomaturityAt maturity it will trade at par
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If held to maturity a ZCB will always give riseto a capital gainIf sold prior to maturity there may be a
capital gain or a capital lossConsider a bond with 10 years to maturityThe YTM at the time of purchase was 10The cost was $37690
A year later it is sold at a YTM of 12The corresponding price is $35035
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A newly established issuerOr an issuer with a relatively virgin productor service
Or a restructured company due to a mergeror following a bankruptcyWill be perceived as more riskyInvestors will demand a high coupon
Such firms are unlikely to have high earningsRevenues will peak only after theproductservice is established
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They can ill afford high couponsThey may consider a step-up coupon bond
Where the coupon increases as the bond ages
Assume a company can issue a plain vanillaat a coupon of 8 with a maturity of 5 yearsInstead it may opt for a bond
With a coupon of 6 for the first three years
And a coupon of 10 for the last two yearsThis is a Deferred Interest Security
Provides the issuer with breathing room in theearlier years
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These pay coupons in the form of additionalsecurities and not cash
This offers the issuer time to prepare for cashoutlays
They are used as Mezzanine FinanceThey rank between senior debt and equity in thecapital structureInvestors take more risk as compared to buyersof regular bonds ndash but get higher returnsIssuers can conserve cash in earlier years when itis at a premium
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Fully backed by the federal government ofthe issuing nationConsequently they are virtually devoid ofcredit risk or the risk of defaultThe yield on such securities is a benchmarkfor setting rates on other kinds of debt
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Treasury securities are issuedTo finance expenses in excess of currentrevenuesTo pay interest on debt accumulated in earlieryears due to deficits in those yearsTo repay past debt issues that are currentlymaturing
The US Treasuries marketIs the largest bond market in the worldIs the most liquid bond market in the world
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The Treasury issues three categories ofmarketable securities
T-bills are discount securitiesThey are zero coupon securitiesT-notes and T-bonds are sold at face value andpay interest periodically
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T-bills are issued with a original time tomaturity of one year or less
They are Money market instrumentsThey have maturities of either 1 3 6 or 12months at the time of issue
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T-notes and T-bonds have a time to maturityexceeding one year at the time of issue
They are capital market instrumentsT-notes have maturities ranging from 1-10 yearsT-bonds have an original maturity in excess of 10years extending up to 30 years
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An issue may be followed later by a furtherissue
With the same remaining time to maturity andthe same couponThe issuance of further tranches is termed as aRe-opening
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Six months ago a 10-year note was issuedwith a coupon of 8 per annumToday if a note with 9 frac12 years to maturityand a coupon of 8 issued it will add to thepool that is already trading in the marketThus it is a re-opening of an existing issue
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Who is a primary dealerA PD is a dealer who is authorized to dealdirectly with the Central Bank of the countryIn the US a PD is a bank or securities broker-dealer that directly deals with the FRBNY
Importance of FRBNYIn India a PD deals directly with the RBI
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The Treasury sells bills notes and bonds byway of a competitive auction process
Most of the treasury securities are bought byprimary dealers
Individual investors submit non-competitive bidsand participate on a much smaller scale
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Bids may beCompetitive
Indicate price amp quantity or yield amp quantityNon-competitive
Indicate only quantity
Small investors and individualsgenerally submit non-competitive bids
A non-competitive bidder may not bid for more than$5MM worth of securities in a bill or bond auction
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Primary dealers bid for their accounts andon behalf of their clientsThey usually submit large competitive
bidsBids indicate the maximum price that the bidderis prepared to pay if it is a price based auctionOr the minimum yield that the bidder is
prepared to accept if it is a yield based auction
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The Treasury will net out the totalamount of non-competitive bids
The balance will be allocated to competitivebidders
There are two ways in which securitiescan be allotted
The multiple priceyield auction mechanism
French AuctionsThe uniform priceyield auction mechanism
Dutch Auctions
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Assume that the Treasury is offering 25billion dollars worth of T-bonds
2 billion dollars worth of non-competitive bidshave been receivedSo 23 billion dollars worth of bonds are availableto be offered to the competitive bidders
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There are six competitive bidders who havesubmitted the following yields
The bids have been arranged in ascending orderof yieldIn a price based auction the bids would havebeen arranged in descending order of price
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Bidder Bid Yield Bid Amount
Aggregate Amount
Alpha 5370 30 bn 30 bnBeta 5372 50 bn 80 bn
Gamma 5373 40 bn 12 bn
Delta 5375 80 bn 20 bnCharlie 5375 120 bn 32 bn
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The aggregate demand equals the amount onoffer at a yield of 5375A multiple yield auction will lead to thefollowing allocation
Alpha will get 3 bn at a yield of 5370Beta will get 5 bn at 5372Gamma will get 4 bn at 5373
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At a yield of 5375 we have only 11 bn left toallocateThere is a demand of 20 bn at this yield
8 bn from Delta and 12 bn from CharlieThus we will allocate 1120 = 55 to eachbidder at this yield
There will be pro-rata allocation
055 of 8 bn or 440 bn will go to Delta055 of 12 bn or 66 bn will go to Charlie
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The highest accepted yield is called the StopYield or High Yield
In this case it is 5375The ratio of bids received to the amountawarded is known as the bid to cover ratio
The higher the ratio the stronger is the auction
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Those who bid more than 5375 will getnothing and are said to be shutout of theauctionSince 1999 the US Treasury has beenconducting only uniform yield auctions
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WI stands for ndash When As and If IssuedThe when issued market is a market forforward trading of a bond
Which has been announced but not yet issuedTrades take place from the date ofannouncement until the actual issue date
Helps bidders to gauge the marketrsquos interestbefore the actual auction
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WI trading has ramifications for the biddingstrategies of market participantsTraders can take both long and shortpositions
Settlement is scheduled for the issue date
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It has a bearing on the outcome of theauction
It affects the strategy used by a bidder becauseit has an impact on his prior positionBidders who are long in the WI market enter theauction with a Long PositionThose who are short in the WI market enter theauction with a short position
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The WI market helps in price discoveryIt provides important information on
The strength of demand for the securityAnd on the disparity of biddersrsquo views
This help potential bidders to formulate theirstrategiesAt times a dealer may believe that he hasvery important private information
If so he may not participate in the WI market andwill directly enter the auction with bids based onhis knowledge
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On or before the date of the auction theissues trade on a yield basis
The actual price can be established only afterthe coupon is set
Starting with the day after the auctionSecurities are quoted on a price basis becausethe coupon is known
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In a coupon roll a dealer will purchase themost recently issued security from a clientAnd simultaneously sell the same amount ofthe recently announced new security
The first leg with settle on the following dayThe second leg is a forward contract
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There can be a Reverse RollThe dealer will sell the most recent issue fornext day settlementAnd buy the newly announced security forforward settlement
The forward leg in a RollReverse Roll is a WItrade
It will settle on the new issue settlement date
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The roll is the spread between the yield onthe new security and that on the outstandingissue in the same maturity segmentA GIVE in the Roll means that
The WI security provides a higher yield than theoutstanding issue
A Take in the Roll means thatThe WI security provides a lower yield
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On March 17 20XX the Treasury announcedthe auction of a 2-year note
The auction was scheduled for March 24The settlement date was March 31
Trading of the roll began as soon as the issuewas announcedA Give of 5 bp means that the dealer proposes tobuy the current issue at the prevailing yieldAnd sell the new issue at a yield that is 5 bpmoreA Take of 5 bp means that the dealer proposes tosell the new issue at a yield that is 5bp lower
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The roll achieves the followingHe acquires the outstanding issue for next daysettlementHe sells the to be issued security with the samepar value for forward delivery on 31 March
The customer is rolling over the investmentfrom the current issue to the new issue
This extends the maturity of the investment byone month
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The client can invest the funds received tillthe new issue settlesHowever he loses the accrued interest thathe would have earned had he held on to theissue
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The Treasury per se does not issue zerocoupon securitiesBut zero coupon securities can be created
which are backed by conventional bondsTake a large quantity of a T-note or bond andseparate all the cash flows from each otherSell the entitlement to each cash flowseparately
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Take the case of a two-year T-noteIt can be separated into five zero couponsecurities maturing after
6 months12 months18 months24 months
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Earlier investment banks used to buy bondsfrom the Treasury and separate the cashflows
Each cash flow was then sold separately as a zerocoupon bondSuch issues are called trademarks
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The issue of trademarks has now ceasedBecause investment banks can now createsuch instruments
In concert with the Treasury itselfThese ZCBs are known as STRIPS ndash
Separate Trading of Registered Interest andPrincipal of Securities
These are not issued or sold by the Treasury
The market is made by investment banks
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What is the motivation to create suchproductsIn practice arbitrage is possible when a
coupon security is purchased at a priceThat is lower than what could be obtained byselling each cash flow separately
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Coupon stripping reflects a case of financialengineering
Creating a risk-return profile that is nototherwise available
An investment bank would buy a largequantity of a Treasury security
The securities would be placed with an SPV
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The SPV is a single-purpose dedicated trustIt has the powers to own the bonds andcollect payments
It cannot sell or lend the bondsIt cannot write options on the bondsOr use them as collateral for borrowing
The SPV is empowered to issue zero coupon
bondsWhere each security represents the ownership ofa single cash flow from the mother bond
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Assume that 100MM USD of 15 year bondswith a coupon of 8 are placed with the SPV
The SPV can issue 6M 12M 18M extending up to14 frac12 year zeroes with a total face value of 4MM
USD eachAnd 15 year zeroes with a total face value of104MM
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The Treasury launched this program in 1985to facilitate the stripping of designatedsecurities
All new T-bonds and notes with a maturity of 10years or more are eligibleThe zeroes created in the process are directobligations of the US government
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The mechanism is as followsA dealer who owns a bond or note can ask theFRB where it is held
To replace it with an equivalent set of STRIPS
representing each payment as a separate securityEach of these securities can be traded independentlyof others
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In 1987 the Treasury started to allow dealersto reverse the process
This is called STRIPS RECONSTUTUTION If a dealer owns STRIPS representing all thecoupon and principal payments of a bond
The FED can on request convert these holdings into asingle position in the corresponding bond
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Each coupon and principal cash flow from aTreasury security is assigned a CUSIP
The mother bond is also assigned a CUSIPThe stripped coupons are known as C-STRIPSThe stripped principal is known as P-STRIPSSupply of a C-STRIP increases over time
because a C-STRIP maturing on a day like 15 FEB
2020 will have the same CUSIP irrespective ofwhich mother bond it has come fromThe original coupon rate is irrelevant
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P-STRIPS always correspond to the originalsecurityThey have a unique CUSIPTheir supply is fixed at the time of issuanceIn practice the prices of long-dated P-STRIPSare a bit higher than those of C-STRIPS withthe same maturity date
One reason is that P-STRIPS are more liquid due
to greater availabilityA $100 face value bond with a coupon of 8 willgenerate C-STRIPS with a face value of $4 but P-STRIPS with a face value of $100
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Another reason why P-STRIPS are in higherdemand is that they allow reconstitutionactivities more easily
Assume that the sum of the STRIPS is cheaper than
the mother bondIf a dealer already has the P-STRIPS only the C-STRIPSneed to be acquiredHowever if he owns some of the C-STRIPS he needs toacquire the P-STRIPS and the remaining C-STRIPSThe facility to reconstitute when profitable is pricedinto the P-STRIPSNote Buy and hold investors will prefer C-STRIPSsince they are priced lower and give a higher yield
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For Plain Vanilla bonds the specifiedcoupon rate is valid for the life of thebond
In the case of Floaters the rate is reset atthe beginning of every periodThe rate will vary directly with thebenchmark
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The rate on a Floater is specified as LIBOR+ 50 bp
The spread is positiveIf it were specified as LIBOR ndash 30bp
The spread will be negativeIf LIBOR rises the rate will increasewhereas if LIBOR falls it will decrease
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In the case of a default risk-free floater theprice will reset to par on a coupon date
It may sell at a premium or discount betweencoupon dates
Consider a floater with a coupon = 5-year T-Bond rate
Assume there are two periods left to maturity
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The price at the end of the first coupon period willbe given by
cT-1 is the coupon one period before maturityyT-1 is the YTM one period before maturity
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On a coupon reset date the YTM = couponBecause we have assumed there is no default riskAny change in the required yield as reflected inthe prevailing YTM
Will also be reflected in the coupon being setIf coupon = yield the bond should sell at par
Thus P T-1 = M
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Once again at T-2 c T-2 = yT-2 and P T-2 = MThis logic can be applied to a bond with anytime remaining till maturityHowever between two coupon dates theprice may not be equal to par
Consider the valuation at T-2+k
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Although c T-2 was set at T-2 and is equal toyT-2
yT-2+k is determined at T-2+k and will reflect theyield prevailing at that time
Thus yT-2+k need not equal c T-2 and may behigher or lower
Hence between two coupon dates a floater maysell at a premium or discount
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Now consider a floater characterized bydefault risk
The risk premium required by the market neednot be constant over time
Assume that at the time of issue YTM = 5-year T-note rate + 75bp
The coupon would have been set equal to thisrate and the bond would have been issued at par
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Six months hence the issue may be perceivedas more risky
YTM = 5-year T-note rate + 95 bpThe coupon will however be set equal to theprevailing 5-year rate + 75 bpIf so the issue will not reset to par at the nextcoupon date
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Floaters may come with a CAP or a FLOOR orBOTH
The CAP is a maximum coupon rateProtects issuers against rising rates
The FLOOR is a minimum coupon rateProtects investors against falling rates
When there is a spread over LIBORThere is a natural floorLIBOR cannot be less than zero
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A bond will pay identical coupons everyperiodAnd will repay the face value at maturity
The periodic cash flows constitutean annuity The terminal face value is a lump
sum payment
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Bond pays a semi-annual coupon of $C2and has a face value of $MAssume there are N coupons left
And that we are standing on a coupondate
We are assuming that the next coupon is exactlysix months away
The required annual yield is yImplies that the semi-annual yield is y2
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The present value of the coupon stream is
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The present value of the face value is
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So the price of the bond is
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IBM has issued a bond with a face value of$1000The coupon is 8 per year to be paid on July
15 and January 15 every yearToday is 15 July 2013 and that the bondmatures on 15 January 2033The required yield is 10 per annum
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JJ ndash 0115FA ndash 0115MS ndash 0115
AO ndash 0115MN ndash 0115JD ndash 0115
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In the example the price is less than theface value
Such a bond is called a Discount Bond
It is trading at a discount from the face valueThe reason is that
The yield is greater than the coupon
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If the yield were to equal the couponThe bond would sell at PARSuch bonds are called PAR Bonds
If the yield is less than the couponThe price will exceed the face valueSuch bonds are called Premium Bonds
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As we move from one coupon date to thenext if the YTM were to remain constant
Par bonds would continue to trade at PARPremium bonds will steadily decline in priceDiscount bonds will steadily increase in price
This is called the Pull to Par EffectAt maturity ndash ALL BONDS WILL TRADE AT PAR
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As we approach maturity the number ofcoupons reduces
The contribution of coupons to price reducesThe contribution of the PV of the face valueincreases
For premium bonds the first effect dominatesThus the price steadily declines
For discount bonds the second effectdominatesThus the price steadily increases
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A plain vanilla or Bullet Bond pays the entireface value at maturity in a lump sumAmortizing bonds pay the principal in
installmentsThe first payment occurs before maturityThe last payment is made at maturity
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Consider a 5 year amortizing bond with aface value of $1000 and an annual coupon of8
The annual cash flows are depicted below
8282014 40
Time Cash Flow
1 802 803 3304 3105 540
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The first two cash flows represent interest ona principal of $1000The third cash flow is interest on $1000 plus
a principal payment of $250The outstanding principal is $750The fourth cash flow is interest on $750 plusa principal payment of $250
The outstanding principal is $500The final cash flow is interest on $500 plusthe remaining principal of $500
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Some companies issue such bonds becausethe assets being funded have a similar cashflow profile
Second the coupon on such a bond may belower than that of a bullet bondIn the case of a bullet bond the entire principalis due at a single point in timeThere is greater default risk
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Microsoft is issuing zeroes with 5 years tomaturity and a face value of $10000
The required yield is 10 per annumWhat should be the price
Price is the PV of the face valueIn practice we discount on a semi-annual basis
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This is to facilitate comparisons withconventional bonds
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A zero coupon bond can never sell at apremium
It will always trade at a discount prior tomaturityAt maturity it will trade at par
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If held to maturity a ZCB will always give riseto a capital gainIf sold prior to maturity there may be a
capital gain or a capital lossConsider a bond with 10 years to maturityThe YTM at the time of purchase was 10The cost was $37690
A year later it is sold at a YTM of 12The corresponding price is $35035
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A newly established issuerOr an issuer with a relatively virgin productor service
Or a restructured company due to a mergeror following a bankruptcyWill be perceived as more riskyInvestors will demand a high coupon
Such firms are unlikely to have high earningsRevenues will peak only after theproductservice is established
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They can ill afford high couponsThey may consider a step-up coupon bond
Where the coupon increases as the bond ages
Assume a company can issue a plain vanillaat a coupon of 8 with a maturity of 5 yearsInstead it may opt for a bond
With a coupon of 6 for the first three years
And a coupon of 10 for the last two yearsThis is a Deferred Interest Security
Provides the issuer with breathing room in theearlier years
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These pay coupons in the form of additionalsecurities and not cash
This offers the issuer time to prepare for cashoutlays
They are used as Mezzanine FinanceThey rank between senior debt and equity in thecapital structureInvestors take more risk as compared to buyersof regular bonds ndash but get higher returnsIssuers can conserve cash in earlier years when itis at a premium
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Fully backed by the federal government ofthe issuing nationConsequently they are virtually devoid ofcredit risk or the risk of defaultThe yield on such securities is a benchmarkfor setting rates on other kinds of debt
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Treasury securities are issuedTo finance expenses in excess of currentrevenuesTo pay interest on debt accumulated in earlieryears due to deficits in those yearsTo repay past debt issues that are currentlymaturing
The US Treasuries marketIs the largest bond market in the worldIs the most liquid bond market in the world
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The Treasury issues three categories ofmarketable securities
T-bills are discount securitiesThey are zero coupon securitiesT-notes and T-bonds are sold at face value andpay interest periodically
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T-bills are issued with a original time tomaturity of one year or less
They are Money market instrumentsThey have maturities of either 1 3 6 or 12months at the time of issue
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T-notes and T-bonds have a time to maturityexceeding one year at the time of issue
They are capital market instrumentsT-notes have maturities ranging from 1-10 yearsT-bonds have an original maturity in excess of 10years extending up to 30 years
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An issue may be followed later by a furtherissue
With the same remaining time to maturity andthe same couponThe issuance of further tranches is termed as aRe-opening
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Six months ago a 10-year note was issuedwith a coupon of 8 per annumToday if a note with 9 frac12 years to maturityand a coupon of 8 issued it will add to thepool that is already trading in the marketThus it is a re-opening of an existing issue
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Who is a primary dealerA PD is a dealer who is authorized to dealdirectly with the Central Bank of the countryIn the US a PD is a bank or securities broker-dealer that directly deals with the FRBNY
Importance of FRBNYIn India a PD deals directly with the RBI
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The Treasury sells bills notes and bonds byway of a competitive auction process
Most of the treasury securities are bought byprimary dealers
Individual investors submit non-competitive bidsand participate on a much smaller scale
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Bids may beCompetitive
Indicate price amp quantity or yield amp quantityNon-competitive
Indicate only quantity
Small investors and individualsgenerally submit non-competitive bids
A non-competitive bidder may not bid for more than$5MM worth of securities in a bill or bond auction
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Primary dealers bid for their accounts andon behalf of their clientsThey usually submit large competitive
bidsBids indicate the maximum price that the bidderis prepared to pay if it is a price based auctionOr the minimum yield that the bidder is
prepared to accept if it is a yield based auction
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The Treasury will net out the totalamount of non-competitive bids
The balance will be allocated to competitivebidders
There are two ways in which securitiescan be allotted
The multiple priceyield auction mechanism
French AuctionsThe uniform priceyield auction mechanism
Dutch Auctions
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Assume that the Treasury is offering 25billion dollars worth of T-bonds
2 billion dollars worth of non-competitive bidshave been receivedSo 23 billion dollars worth of bonds are availableto be offered to the competitive bidders
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There are six competitive bidders who havesubmitted the following yields
The bids have been arranged in ascending orderof yieldIn a price based auction the bids would havebeen arranged in descending order of price
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Bidder Bid Yield Bid Amount
Aggregate Amount
Alpha 5370 30 bn 30 bnBeta 5372 50 bn 80 bn
Gamma 5373 40 bn 12 bn
Delta 5375 80 bn 20 bnCharlie 5375 120 bn 32 bn
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The aggregate demand equals the amount onoffer at a yield of 5375A multiple yield auction will lead to thefollowing allocation
Alpha will get 3 bn at a yield of 5370Beta will get 5 bn at 5372Gamma will get 4 bn at 5373
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At a yield of 5375 we have only 11 bn left toallocateThere is a demand of 20 bn at this yield
8 bn from Delta and 12 bn from CharlieThus we will allocate 1120 = 55 to eachbidder at this yield
There will be pro-rata allocation
055 of 8 bn or 440 bn will go to Delta055 of 12 bn or 66 bn will go to Charlie
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The highest accepted yield is called the StopYield or High Yield
In this case it is 5375The ratio of bids received to the amountawarded is known as the bid to cover ratio
The higher the ratio the stronger is the auction
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Those who bid more than 5375 will getnothing and are said to be shutout of theauctionSince 1999 the US Treasury has beenconducting only uniform yield auctions
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WI stands for ndash When As and If IssuedThe when issued market is a market forforward trading of a bond
Which has been announced but not yet issuedTrades take place from the date ofannouncement until the actual issue date
Helps bidders to gauge the marketrsquos interestbefore the actual auction
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WI trading has ramifications for the biddingstrategies of market participantsTraders can take both long and shortpositions
Settlement is scheduled for the issue date
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It has a bearing on the outcome of theauction
It affects the strategy used by a bidder becauseit has an impact on his prior positionBidders who are long in the WI market enter theauction with a Long PositionThose who are short in the WI market enter theauction with a short position
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The WI market helps in price discoveryIt provides important information on
The strength of demand for the securityAnd on the disparity of biddersrsquo views
This help potential bidders to formulate theirstrategiesAt times a dealer may believe that he hasvery important private information
If so he may not participate in the WI market andwill directly enter the auction with bids based onhis knowledge
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On or before the date of the auction theissues trade on a yield basis
The actual price can be established only afterthe coupon is set
Starting with the day after the auctionSecurities are quoted on a price basis becausethe coupon is known
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In a coupon roll a dealer will purchase themost recently issued security from a clientAnd simultaneously sell the same amount ofthe recently announced new security
The first leg with settle on the following dayThe second leg is a forward contract
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There can be a Reverse RollThe dealer will sell the most recent issue fornext day settlementAnd buy the newly announced security forforward settlement
The forward leg in a RollReverse Roll is a WItrade
It will settle on the new issue settlement date
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The roll is the spread between the yield onthe new security and that on the outstandingissue in the same maturity segmentA GIVE in the Roll means that
The WI security provides a higher yield than theoutstanding issue
A Take in the Roll means thatThe WI security provides a lower yield
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On March 17 20XX the Treasury announcedthe auction of a 2-year note
The auction was scheduled for March 24The settlement date was March 31
Trading of the roll began as soon as the issuewas announcedA Give of 5 bp means that the dealer proposes tobuy the current issue at the prevailing yieldAnd sell the new issue at a yield that is 5 bpmoreA Take of 5 bp means that the dealer proposes tosell the new issue at a yield that is 5bp lower
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The roll achieves the followingHe acquires the outstanding issue for next daysettlementHe sells the to be issued security with the samepar value for forward delivery on 31 March
The customer is rolling over the investmentfrom the current issue to the new issue
This extends the maturity of the investment byone month
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The client can invest the funds received tillthe new issue settlesHowever he loses the accrued interest thathe would have earned had he held on to theissue
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The Treasury per se does not issue zerocoupon securitiesBut zero coupon securities can be created
which are backed by conventional bondsTake a large quantity of a T-note or bond andseparate all the cash flows from each otherSell the entitlement to each cash flowseparately
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Take the case of a two-year T-noteIt can be separated into five zero couponsecurities maturing after
6 months12 months18 months24 months
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Earlier investment banks used to buy bondsfrom the Treasury and separate the cashflows
Each cash flow was then sold separately as a zerocoupon bondSuch issues are called trademarks
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The issue of trademarks has now ceasedBecause investment banks can now createsuch instruments
In concert with the Treasury itselfThese ZCBs are known as STRIPS ndash
Separate Trading of Registered Interest andPrincipal of Securities
These are not issued or sold by the Treasury
The market is made by investment banks
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What is the motivation to create suchproductsIn practice arbitrage is possible when a
coupon security is purchased at a priceThat is lower than what could be obtained byselling each cash flow separately
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Coupon stripping reflects a case of financialengineering
Creating a risk-return profile that is nototherwise available
An investment bank would buy a largequantity of a Treasury security
The securities would be placed with an SPV
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The SPV is a single-purpose dedicated trustIt has the powers to own the bonds andcollect payments
It cannot sell or lend the bondsIt cannot write options on the bondsOr use them as collateral for borrowing
The SPV is empowered to issue zero coupon
bondsWhere each security represents the ownership ofa single cash flow from the mother bond
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Assume that 100MM USD of 15 year bondswith a coupon of 8 are placed with the SPV
The SPV can issue 6M 12M 18M extending up to14 frac12 year zeroes with a total face value of 4MM
USD eachAnd 15 year zeroes with a total face value of104MM
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The Treasury launched this program in 1985to facilitate the stripping of designatedsecurities
All new T-bonds and notes with a maturity of 10years or more are eligibleThe zeroes created in the process are directobligations of the US government
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The mechanism is as followsA dealer who owns a bond or note can ask theFRB where it is held
To replace it with an equivalent set of STRIPS
representing each payment as a separate securityEach of these securities can be traded independentlyof others
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In 1987 the Treasury started to allow dealersto reverse the process
This is called STRIPS RECONSTUTUTION If a dealer owns STRIPS representing all thecoupon and principal payments of a bond
The FED can on request convert these holdings into asingle position in the corresponding bond
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Each coupon and principal cash flow from aTreasury security is assigned a CUSIP
The mother bond is also assigned a CUSIPThe stripped coupons are known as C-STRIPSThe stripped principal is known as P-STRIPSSupply of a C-STRIP increases over time
because a C-STRIP maturing on a day like 15 FEB
2020 will have the same CUSIP irrespective ofwhich mother bond it has come fromThe original coupon rate is irrelevant
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P-STRIPS always correspond to the originalsecurityThey have a unique CUSIPTheir supply is fixed at the time of issuanceIn practice the prices of long-dated P-STRIPSare a bit higher than those of C-STRIPS withthe same maturity date
One reason is that P-STRIPS are more liquid due
to greater availabilityA $100 face value bond with a coupon of 8 willgenerate C-STRIPS with a face value of $4 but P-STRIPS with a face value of $100
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Another reason why P-STRIPS are in higherdemand is that they allow reconstitutionactivities more easily
Assume that the sum of the STRIPS is cheaper than
the mother bondIf a dealer already has the P-STRIPS only the C-STRIPSneed to be acquiredHowever if he owns some of the C-STRIPS he needs toacquire the P-STRIPS and the remaining C-STRIPSThe facility to reconstitute when profitable is pricedinto the P-STRIPSNote Buy and hold investors will prefer C-STRIPSsince they are priced lower and give a higher yield
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For Plain Vanilla bonds the specifiedcoupon rate is valid for the life of thebond
In the case of Floaters the rate is reset atthe beginning of every periodThe rate will vary directly with thebenchmark
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The rate on a Floater is specified as LIBOR+ 50 bp
The spread is positiveIf it were specified as LIBOR ndash 30bp
The spread will be negativeIf LIBOR rises the rate will increasewhereas if LIBOR falls it will decrease
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In the case of a default risk-free floater theprice will reset to par on a coupon date
It may sell at a premium or discount betweencoupon dates
Consider a floater with a coupon = 5-year T-Bond rate
Assume there are two periods left to maturity
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The price at the end of the first coupon period willbe given by
cT-1 is the coupon one period before maturityyT-1 is the YTM one period before maturity
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On a coupon reset date the YTM = couponBecause we have assumed there is no default riskAny change in the required yield as reflected inthe prevailing YTM
Will also be reflected in the coupon being setIf coupon = yield the bond should sell at par
Thus P T-1 = M
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Once again at T-2 c T-2 = yT-2 and P T-2 = MThis logic can be applied to a bond with anytime remaining till maturityHowever between two coupon dates theprice may not be equal to par
Consider the valuation at T-2+k
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Although c T-2 was set at T-2 and is equal toyT-2
yT-2+k is determined at T-2+k and will reflect theyield prevailing at that time
Thus yT-2+k need not equal c T-2 and may behigher or lower
Hence between two coupon dates a floater maysell at a premium or discount
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Now consider a floater characterized bydefault risk
The risk premium required by the market neednot be constant over time
Assume that at the time of issue YTM = 5-year T-note rate + 75bp
The coupon would have been set equal to thisrate and the bond would have been issued at par
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Six months hence the issue may be perceivedas more risky
YTM = 5-year T-note rate + 95 bpThe coupon will however be set equal to theprevailing 5-year rate + 75 bpIf so the issue will not reset to par at the nextcoupon date
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Floaters may come with a CAP or a FLOOR orBOTH
The CAP is a maximum coupon rateProtects issuers against rising rates
The FLOOR is a minimum coupon rateProtects investors against falling rates
When there is a spread over LIBORThere is a natural floorLIBOR cannot be less than zero
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Bond pays a semi-annual coupon of $C2and has a face value of $MAssume there are N coupons left
And that we are standing on a coupondate
We are assuming that the next coupon is exactlysix months away
The required annual yield is yImplies that the semi-annual yield is y2
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The present value of the coupon stream is
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The present value of the face value is
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So the price of the bond is
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IBM has issued a bond with a face value of$1000The coupon is 8 per year to be paid on July
15 and January 15 every yearToday is 15 July 2013 and that the bondmatures on 15 January 2033The required yield is 10 per annum
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JJ ndash 0115FA ndash 0115MS ndash 0115
AO ndash 0115MN ndash 0115JD ndash 0115
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In the example the price is less than theface value
Such a bond is called a Discount Bond
It is trading at a discount from the face valueThe reason is that
The yield is greater than the coupon
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If the yield were to equal the couponThe bond would sell at PARSuch bonds are called PAR Bonds
If the yield is less than the couponThe price will exceed the face valueSuch bonds are called Premium Bonds
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As we move from one coupon date to thenext if the YTM were to remain constant
Par bonds would continue to trade at PARPremium bonds will steadily decline in priceDiscount bonds will steadily increase in price
This is called the Pull to Par EffectAt maturity ndash ALL BONDS WILL TRADE AT PAR
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As we approach maturity the number ofcoupons reduces
The contribution of coupons to price reducesThe contribution of the PV of the face valueincreases
For premium bonds the first effect dominatesThus the price steadily declines
For discount bonds the second effectdominatesThus the price steadily increases
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A plain vanilla or Bullet Bond pays the entireface value at maturity in a lump sumAmortizing bonds pay the principal in
installmentsThe first payment occurs before maturityThe last payment is made at maturity
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Consider a 5 year amortizing bond with aface value of $1000 and an annual coupon of8
The annual cash flows are depicted below
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Time Cash Flow
1 802 803 3304 3105 540
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The first two cash flows represent interest ona principal of $1000The third cash flow is interest on $1000 plus
a principal payment of $250The outstanding principal is $750The fourth cash flow is interest on $750 plusa principal payment of $250
The outstanding principal is $500The final cash flow is interest on $500 plusthe remaining principal of $500
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Some companies issue such bonds becausethe assets being funded have a similar cashflow profile
Second the coupon on such a bond may belower than that of a bullet bondIn the case of a bullet bond the entire principalis due at a single point in timeThere is greater default risk
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Microsoft is issuing zeroes with 5 years tomaturity and a face value of $10000
The required yield is 10 per annumWhat should be the price
Price is the PV of the face valueIn practice we discount on a semi-annual basis
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This is to facilitate comparisons withconventional bonds
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A zero coupon bond can never sell at apremium
It will always trade at a discount prior tomaturityAt maturity it will trade at par
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If held to maturity a ZCB will always give riseto a capital gainIf sold prior to maturity there may be a
capital gain or a capital lossConsider a bond with 10 years to maturityThe YTM at the time of purchase was 10The cost was $37690
A year later it is sold at a YTM of 12The corresponding price is $35035
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A newly established issuerOr an issuer with a relatively virgin productor service
Or a restructured company due to a mergeror following a bankruptcyWill be perceived as more riskyInvestors will demand a high coupon
Such firms are unlikely to have high earningsRevenues will peak only after theproductservice is established
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They can ill afford high couponsThey may consider a step-up coupon bond
Where the coupon increases as the bond ages
Assume a company can issue a plain vanillaat a coupon of 8 with a maturity of 5 yearsInstead it may opt for a bond
With a coupon of 6 for the first three years
And a coupon of 10 for the last two yearsThis is a Deferred Interest Security
Provides the issuer with breathing room in theearlier years
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These pay coupons in the form of additionalsecurities and not cash
This offers the issuer time to prepare for cashoutlays
They are used as Mezzanine FinanceThey rank between senior debt and equity in thecapital structureInvestors take more risk as compared to buyersof regular bonds ndash but get higher returnsIssuers can conserve cash in earlier years when itis at a premium
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Fully backed by the federal government ofthe issuing nationConsequently they are virtually devoid ofcredit risk or the risk of defaultThe yield on such securities is a benchmarkfor setting rates on other kinds of debt
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Treasury securities are issuedTo finance expenses in excess of currentrevenuesTo pay interest on debt accumulated in earlieryears due to deficits in those yearsTo repay past debt issues that are currentlymaturing
The US Treasuries marketIs the largest bond market in the worldIs the most liquid bond market in the world
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The Treasury issues three categories ofmarketable securities
T-bills are discount securitiesThey are zero coupon securitiesT-notes and T-bonds are sold at face value andpay interest periodically
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T-bills are issued with a original time tomaturity of one year or less
They are Money market instrumentsThey have maturities of either 1 3 6 or 12months at the time of issue
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T-notes and T-bonds have a time to maturityexceeding one year at the time of issue
They are capital market instrumentsT-notes have maturities ranging from 1-10 yearsT-bonds have an original maturity in excess of 10years extending up to 30 years
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An issue may be followed later by a furtherissue
With the same remaining time to maturity andthe same couponThe issuance of further tranches is termed as aRe-opening
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Six months ago a 10-year note was issuedwith a coupon of 8 per annumToday if a note with 9 frac12 years to maturityand a coupon of 8 issued it will add to thepool that is already trading in the marketThus it is a re-opening of an existing issue
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Who is a primary dealerA PD is a dealer who is authorized to dealdirectly with the Central Bank of the countryIn the US a PD is a bank or securities broker-dealer that directly deals with the FRBNY
Importance of FRBNYIn India a PD deals directly with the RBI
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The Treasury sells bills notes and bonds byway of a competitive auction process
Most of the treasury securities are bought byprimary dealers
Individual investors submit non-competitive bidsand participate on a much smaller scale
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Bids may beCompetitive
Indicate price amp quantity or yield amp quantityNon-competitive
Indicate only quantity
Small investors and individualsgenerally submit non-competitive bids
A non-competitive bidder may not bid for more than$5MM worth of securities in a bill or bond auction
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Primary dealers bid for their accounts andon behalf of their clientsThey usually submit large competitive
bidsBids indicate the maximum price that the bidderis prepared to pay if it is a price based auctionOr the minimum yield that the bidder is
prepared to accept if it is a yield based auction
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The Treasury will net out the totalamount of non-competitive bids
The balance will be allocated to competitivebidders
There are two ways in which securitiescan be allotted
The multiple priceyield auction mechanism
French AuctionsThe uniform priceyield auction mechanism
Dutch Auctions
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Assume that the Treasury is offering 25billion dollars worth of T-bonds
2 billion dollars worth of non-competitive bidshave been receivedSo 23 billion dollars worth of bonds are availableto be offered to the competitive bidders
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There are six competitive bidders who havesubmitted the following yields
The bids have been arranged in ascending orderof yieldIn a price based auction the bids would havebeen arranged in descending order of price
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Bidder Bid Yield Bid Amount
Aggregate Amount
Alpha 5370 30 bn 30 bnBeta 5372 50 bn 80 bn
Gamma 5373 40 bn 12 bn
Delta 5375 80 bn 20 bnCharlie 5375 120 bn 32 bn
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The aggregate demand equals the amount onoffer at a yield of 5375A multiple yield auction will lead to thefollowing allocation
Alpha will get 3 bn at a yield of 5370Beta will get 5 bn at 5372Gamma will get 4 bn at 5373
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At a yield of 5375 we have only 11 bn left toallocateThere is a demand of 20 bn at this yield
8 bn from Delta and 12 bn from CharlieThus we will allocate 1120 = 55 to eachbidder at this yield
There will be pro-rata allocation
055 of 8 bn or 440 bn will go to Delta055 of 12 bn or 66 bn will go to Charlie
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The highest accepted yield is called the StopYield or High Yield
In this case it is 5375The ratio of bids received to the amountawarded is known as the bid to cover ratio
The higher the ratio the stronger is the auction
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Those who bid more than 5375 will getnothing and are said to be shutout of theauctionSince 1999 the US Treasury has beenconducting only uniform yield auctions
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WI stands for ndash When As and If IssuedThe when issued market is a market forforward trading of a bond
Which has been announced but not yet issuedTrades take place from the date ofannouncement until the actual issue date
Helps bidders to gauge the marketrsquos interestbefore the actual auction
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WI trading has ramifications for the biddingstrategies of market participantsTraders can take both long and shortpositions
Settlement is scheduled for the issue date
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It has a bearing on the outcome of theauction
It affects the strategy used by a bidder becauseit has an impact on his prior positionBidders who are long in the WI market enter theauction with a Long PositionThose who are short in the WI market enter theauction with a short position
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The WI market helps in price discoveryIt provides important information on
The strength of demand for the securityAnd on the disparity of biddersrsquo views
This help potential bidders to formulate theirstrategiesAt times a dealer may believe that he hasvery important private information
If so he may not participate in the WI market andwill directly enter the auction with bids based onhis knowledge
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On or before the date of the auction theissues trade on a yield basis
The actual price can be established only afterthe coupon is set
Starting with the day after the auctionSecurities are quoted on a price basis becausethe coupon is known
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In a coupon roll a dealer will purchase themost recently issued security from a clientAnd simultaneously sell the same amount ofthe recently announced new security
The first leg with settle on the following dayThe second leg is a forward contract
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There can be a Reverse RollThe dealer will sell the most recent issue fornext day settlementAnd buy the newly announced security forforward settlement
The forward leg in a RollReverse Roll is a WItrade
It will settle on the new issue settlement date
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The roll is the spread between the yield onthe new security and that on the outstandingissue in the same maturity segmentA GIVE in the Roll means that
The WI security provides a higher yield than theoutstanding issue
A Take in the Roll means thatThe WI security provides a lower yield
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On March 17 20XX the Treasury announcedthe auction of a 2-year note
The auction was scheduled for March 24The settlement date was March 31
Trading of the roll began as soon as the issuewas announcedA Give of 5 bp means that the dealer proposes tobuy the current issue at the prevailing yieldAnd sell the new issue at a yield that is 5 bpmoreA Take of 5 bp means that the dealer proposes tosell the new issue at a yield that is 5bp lower
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The roll achieves the followingHe acquires the outstanding issue for next daysettlementHe sells the to be issued security with the samepar value for forward delivery on 31 March
The customer is rolling over the investmentfrom the current issue to the new issue
This extends the maturity of the investment byone month
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The client can invest the funds received tillthe new issue settlesHowever he loses the accrued interest thathe would have earned had he held on to theissue
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The Treasury per se does not issue zerocoupon securitiesBut zero coupon securities can be created
which are backed by conventional bondsTake a large quantity of a T-note or bond andseparate all the cash flows from each otherSell the entitlement to each cash flowseparately
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Take the case of a two-year T-noteIt can be separated into five zero couponsecurities maturing after
6 months12 months18 months24 months
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Earlier investment banks used to buy bondsfrom the Treasury and separate the cashflows
Each cash flow was then sold separately as a zerocoupon bondSuch issues are called trademarks
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The issue of trademarks has now ceasedBecause investment banks can now createsuch instruments
In concert with the Treasury itselfThese ZCBs are known as STRIPS ndash
Separate Trading of Registered Interest andPrincipal of Securities
These are not issued or sold by the Treasury
The market is made by investment banks
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What is the motivation to create suchproductsIn practice arbitrage is possible when a
coupon security is purchased at a priceThat is lower than what could be obtained byselling each cash flow separately
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Coupon stripping reflects a case of financialengineering
Creating a risk-return profile that is nototherwise available
An investment bank would buy a largequantity of a Treasury security
The securities would be placed with an SPV
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The SPV is a single-purpose dedicated trustIt has the powers to own the bonds andcollect payments
It cannot sell or lend the bondsIt cannot write options on the bondsOr use them as collateral for borrowing
The SPV is empowered to issue zero coupon
bondsWhere each security represents the ownership ofa single cash flow from the mother bond
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Assume that 100MM USD of 15 year bondswith a coupon of 8 are placed with the SPV
The SPV can issue 6M 12M 18M extending up to14 frac12 year zeroes with a total face value of 4MM
USD eachAnd 15 year zeroes with a total face value of104MM
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The Treasury launched this program in 1985to facilitate the stripping of designatedsecurities
All new T-bonds and notes with a maturity of 10years or more are eligibleThe zeroes created in the process are directobligations of the US government
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The mechanism is as followsA dealer who owns a bond or note can ask theFRB where it is held
To replace it with an equivalent set of STRIPS
representing each payment as a separate securityEach of these securities can be traded independentlyof others
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In 1987 the Treasury started to allow dealersto reverse the process
This is called STRIPS RECONSTUTUTION If a dealer owns STRIPS representing all thecoupon and principal payments of a bond
The FED can on request convert these holdings into asingle position in the corresponding bond
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Each coupon and principal cash flow from aTreasury security is assigned a CUSIP
The mother bond is also assigned a CUSIPThe stripped coupons are known as C-STRIPSThe stripped principal is known as P-STRIPSSupply of a C-STRIP increases over time
because a C-STRIP maturing on a day like 15 FEB
2020 will have the same CUSIP irrespective ofwhich mother bond it has come fromThe original coupon rate is irrelevant
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P-STRIPS always correspond to the originalsecurityThey have a unique CUSIPTheir supply is fixed at the time of issuanceIn practice the prices of long-dated P-STRIPSare a bit higher than those of C-STRIPS withthe same maturity date
One reason is that P-STRIPS are more liquid due
to greater availabilityA $100 face value bond with a coupon of 8 willgenerate C-STRIPS with a face value of $4 but P-STRIPS with a face value of $100
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Another reason why P-STRIPS are in higherdemand is that they allow reconstitutionactivities more easily
Assume that the sum of the STRIPS is cheaper than
the mother bondIf a dealer already has the P-STRIPS only the C-STRIPSneed to be acquiredHowever if he owns some of the C-STRIPS he needs toacquire the P-STRIPS and the remaining C-STRIPSThe facility to reconstitute when profitable is pricedinto the P-STRIPSNote Buy and hold investors will prefer C-STRIPSsince they are priced lower and give a higher yield
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For Plain Vanilla bonds the specifiedcoupon rate is valid for the life of thebond
In the case of Floaters the rate is reset atthe beginning of every periodThe rate will vary directly with thebenchmark
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The rate on a Floater is specified as LIBOR+ 50 bp
The spread is positiveIf it were specified as LIBOR ndash 30bp
The spread will be negativeIf LIBOR rises the rate will increasewhereas if LIBOR falls it will decrease
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In the case of a default risk-free floater theprice will reset to par on a coupon date
It may sell at a premium or discount betweencoupon dates
Consider a floater with a coupon = 5-year T-Bond rate
Assume there are two periods left to maturity
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The price at the end of the first coupon period willbe given by
cT-1 is the coupon one period before maturityyT-1 is the YTM one period before maturity
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On a coupon reset date the YTM = couponBecause we have assumed there is no default riskAny change in the required yield as reflected inthe prevailing YTM
Will also be reflected in the coupon being setIf coupon = yield the bond should sell at par
Thus P T-1 = M
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Once again at T-2 c T-2 = yT-2 and P T-2 = MThis logic can be applied to a bond with anytime remaining till maturityHowever between two coupon dates theprice may not be equal to par
Consider the valuation at T-2+k
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Although c T-2 was set at T-2 and is equal toyT-2
yT-2+k is determined at T-2+k and will reflect theyield prevailing at that time
Thus yT-2+k need not equal c T-2 and may behigher or lower
Hence between two coupon dates a floater maysell at a premium or discount
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Now consider a floater characterized bydefault risk
The risk premium required by the market neednot be constant over time
Assume that at the time of issue YTM = 5-year T-note rate + 75bp
The coupon would have been set equal to thisrate and the bond would have been issued at par
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Six months hence the issue may be perceivedas more risky
YTM = 5-year T-note rate + 95 bpThe coupon will however be set equal to theprevailing 5-year rate + 75 bpIf so the issue will not reset to par at the nextcoupon date
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Floaters may come with a CAP or a FLOOR orBOTH
The CAP is a maximum coupon rateProtects issuers against rising rates
The FLOOR is a minimum coupon rateProtects investors against falling rates
When there is a spread over LIBORThere is a natural floorLIBOR cannot be less than zero
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The present value of the coupon stream is
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The present value of the face value is
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So the price of the bond is
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IBM has issued a bond with a face value of$1000The coupon is 8 per year to be paid on July
15 and January 15 every yearToday is 15 July 2013 and that the bondmatures on 15 January 2033The required yield is 10 per annum
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JJ ndash 0115FA ndash 0115MS ndash 0115
AO ndash 0115MN ndash 0115JD ndash 0115
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In the example the price is less than theface value
Such a bond is called a Discount Bond
It is trading at a discount from the face valueThe reason is that
The yield is greater than the coupon
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If the yield were to equal the couponThe bond would sell at PARSuch bonds are called PAR Bonds
If the yield is less than the couponThe price will exceed the face valueSuch bonds are called Premium Bonds
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As we move from one coupon date to thenext if the YTM were to remain constant
Par bonds would continue to trade at PARPremium bonds will steadily decline in priceDiscount bonds will steadily increase in price
This is called the Pull to Par EffectAt maturity ndash ALL BONDS WILL TRADE AT PAR
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As we approach maturity the number ofcoupons reduces
The contribution of coupons to price reducesThe contribution of the PV of the face valueincreases
For premium bonds the first effect dominatesThus the price steadily declines
For discount bonds the second effectdominatesThus the price steadily increases
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A plain vanilla or Bullet Bond pays the entireface value at maturity in a lump sumAmortizing bonds pay the principal in
installmentsThe first payment occurs before maturityThe last payment is made at maturity
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Consider a 5 year amortizing bond with aface value of $1000 and an annual coupon of8
The annual cash flows are depicted below
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Time Cash Flow
1 802 803 3304 3105 540
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The first two cash flows represent interest ona principal of $1000The third cash flow is interest on $1000 plus
a principal payment of $250The outstanding principal is $750The fourth cash flow is interest on $750 plusa principal payment of $250
The outstanding principal is $500The final cash flow is interest on $500 plusthe remaining principal of $500
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Some companies issue such bonds becausethe assets being funded have a similar cashflow profile
Second the coupon on such a bond may belower than that of a bullet bondIn the case of a bullet bond the entire principalis due at a single point in timeThere is greater default risk
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Microsoft is issuing zeroes with 5 years tomaturity and a face value of $10000
The required yield is 10 per annumWhat should be the price
Price is the PV of the face valueIn practice we discount on a semi-annual basis
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This is to facilitate comparisons withconventional bonds
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A zero coupon bond can never sell at apremium
It will always trade at a discount prior tomaturityAt maturity it will trade at par
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If held to maturity a ZCB will always give riseto a capital gainIf sold prior to maturity there may be a
capital gain or a capital lossConsider a bond with 10 years to maturityThe YTM at the time of purchase was 10The cost was $37690
A year later it is sold at a YTM of 12The corresponding price is $35035
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A newly established issuerOr an issuer with a relatively virgin productor service
Or a restructured company due to a mergeror following a bankruptcyWill be perceived as more riskyInvestors will demand a high coupon
Such firms are unlikely to have high earningsRevenues will peak only after theproductservice is established
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They can ill afford high couponsThey may consider a step-up coupon bond
Where the coupon increases as the bond ages
Assume a company can issue a plain vanillaat a coupon of 8 with a maturity of 5 yearsInstead it may opt for a bond
With a coupon of 6 for the first three years
And a coupon of 10 for the last two yearsThis is a Deferred Interest Security
Provides the issuer with breathing room in theearlier years
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These pay coupons in the form of additionalsecurities and not cash
This offers the issuer time to prepare for cashoutlays
They are used as Mezzanine FinanceThey rank between senior debt and equity in thecapital structureInvestors take more risk as compared to buyersof regular bonds ndash but get higher returnsIssuers can conserve cash in earlier years when itis at a premium
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Fully backed by the federal government ofthe issuing nationConsequently they are virtually devoid ofcredit risk or the risk of defaultThe yield on such securities is a benchmarkfor setting rates on other kinds of debt
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Treasury securities are issuedTo finance expenses in excess of currentrevenuesTo pay interest on debt accumulated in earlieryears due to deficits in those yearsTo repay past debt issues that are currentlymaturing
The US Treasuries marketIs the largest bond market in the worldIs the most liquid bond market in the world
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The Treasury issues three categories ofmarketable securities
T-bills are discount securitiesThey are zero coupon securitiesT-notes and T-bonds are sold at face value andpay interest periodically
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T-bills are issued with a original time tomaturity of one year or less
They are Money market instrumentsThey have maturities of either 1 3 6 or 12months at the time of issue
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T-notes and T-bonds have a time to maturityexceeding one year at the time of issue
They are capital market instrumentsT-notes have maturities ranging from 1-10 yearsT-bonds have an original maturity in excess of 10years extending up to 30 years
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An issue may be followed later by a furtherissue
With the same remaining time to maturity andthe same couponThe issuance of further tranches is termed as aRe-opening
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Six months ago a 10-year note was issuedwith a coupon of 8 per annumToday if a note with 9 frac12 years to maturityand a coupon of 8 issued it will add to thepool that is already trading in the marketThus it is a re-opening of an existing issue
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Who is a primary dealerA PD is a dealer who is authorized to dealdirectly with the Central Bank of the countryIn the US a PD is a bank or securities broker-dealer that directly deals with the FRBNY
Importance of FRBNYIn India a PD deals directly with the RBI
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The Treasury sells bills notes and bonds byway of a competitive auction process
Most of the treasury securities are bought byprimary dealers
Individual investors submit non-competitive bidsand participate on a much smaller scale
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Bids may beCompetitive
Indicate price amp quantity or yield amp quantityNon-competitive
Indicate only quantity
Small investors and individualsgenerally submit non-competitive bids
A non-competitive bidder may not bid for more than$5MM worth of securities in a bill or bond auction
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Primary dealers bid for their accounts andon behalf of their clientsThey usually submit large competitive
bidsBids indicate the maximum price that the bidderis prepared to pay if it is a price based auctionOr the minimum yield that the bidder is
prepared to accept if it is a yield based auction
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The Treasury will net out the totalamount of non-competitive bids
The balance will be allocated to competitivebidders
There are two ways in which securitiescan be allotted
The multiple priceyield auction mechanism
French AuctionsThe uniform priceyield auction mechanism
Dutch Auctions
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Assume that the Treasury is offering 25billion dollars worth of T-bonds
2 billion dollars worth of non-competitive bidshave been receivedSo 23 billion dollars worth of bonds are availableto be offered to the competitive bidders
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There are six competitive bidders who havesubmitted the following yields
The bids have been arranged in ascending orderof yieldIn a price based auction the bids would havebeen arranged in descending order of price
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Bidder Bid Yield Bid Amount
Aggregate Amount
Alpha 5370 30 bn 30 bnBeta 5372 50 bn 80 bn
Gamma 5373 40 bn 12 bn
Delta 5375 80 bn 20 bnCharlie 5375 120 bn 32 bn
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The aggregate demand equals the amount onoffer at a yield of 5375A multiple yield auction will lead to thefollowing allocation
Alpha will get 3 bn at a yield of 5370Beta will get 5 bn at 5372Gamma will get 4 bn at 5373
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At a yield of 5375 we have only 11 bn left toallocateThere is a demand of 20 bn at this yield
8 bn from Delta and 12 bn from CharlieThus we will allocate 1120 = 55 to eachbidder at this yield
There will be pro-rata allocation
055 of 8 bn or 440 bn will go to Delta055 of 12 bn or 66 bn will go to Charlie
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The highest accepted yield is called the StopYield or High Yield
In this case it is 5375The ratio of bids received to the amountawarded is known as the bid to cover ratio
The higher the ratio the stronger is the auction
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Those who bid more than 5375 will getnothing and are said to be shutout of theauctionSince 1999 the US Treasury has beenconducting only uniform yield auctions
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WI stands for ndash When As and If IssuedThe when issued market is a market forforward trading of a bond
Which has been announced but not yet issuedTrades take place from the date ofannouncement until the actual issue date
Helps bidders to gauge the marketrsquos interestbefore the actual auction
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WI trading has ramifications for the biddingstrategies of market participantsTraders can take both long and shortpositions
Settlement is scheduled for the issue date
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It has a bearing on the outcome of theauction
It affects the strategy used by a bidder becauseit has an impact on his prior positionBidders who are long in the WI market enter theauction with a Long PositionThose who are short in the WI market enter theauction with a short position
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The WI market helps in price discoveryIt provides important information on
The strength of demand for the securityAnd on the disparity of biddersrsquo views
This help potential bidders to formulate theirstrategiesAt times a dealer may believe that he hasvery important private information
If so he may not participate in the WI market andwill directly enter the auction with bids based onhis knowledge
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On or before the date of the auction theissues trade on a yield basis
The actual price can be established only afterthe coupon is set
Starting with the day after the auctionSecurities are quoted on a price basis becausethe coupon is known
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In a coupon roll a dealer will purchase themost recently issued security from a clientAnd simultaneously sell the same amount ofthe recently announced new security
The first leg with settle on the following dayThe second leg is a forward contract
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There can be a Reverse RollThe dealer will sell the most recent issue fornext day settlementAnd buy the newly announced security forforward settlement
The forward leg in a RollReverse Roll is a WItrade
It will settle on the new issue settlement date
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The roll is the spread between the yield onthe new security and that on the outstandingissue in the same maturity segmentA GIVE in the Roll means that
The WI security provides a higher yield than theoutstanding issue
A Take in the Roll means thatThe WI security provides a lower yield
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On March 17 20XX the Treasury announcedthe auction of a 2-year note
The auction was scheduled for March 24The settlement date was March 31
Trading of the roll began as soon as the issuewas announcedA Give of 5 bp means that the dealer proposes tobuy the current issue at the prevailing yieldAnd sell the new issue at a yield that is 5 bpmoreA Take of 5 bp means that the dealer proposes tosell the new issue at a yield that is 5bp lower
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The roll achieves the followingHe acquires the outstanding issue for next daysettlementHe sells the to be issued security with the samepar value for forward delivery on 31 March
The customer is rolling over the investmentfrom the current issue to the new issue
This extends the maturity of the investment byone month
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The client can invest the funds received tillthe new issue settlesHowever he loses the accrued interest thathe would have earned had he held on to theissue
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The Treasury per se does not issue zerocoupon securitiesBut zero coupon securities can be created
which are backed by conventional bondsTake a large quantity of a T-note or bond andseparate all the cash flows from each otherSell the entitlement to each cash flowseparately
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Take the case of a two-year T-noteIt can be separated into five zero couponsecurities maturing after
6 months12 months18 months24 months
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Earlier investment banks used to buy bondsfrom the Treasury and separate the cashflows
Each cash flow was then sold separately as a zerocoupon bondSuch issues are called trademarks
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The issue of trademarks has now ceasedBecause investment banks can now createsuch instruments
In concert with the Treasury itselfThese ZCBs are known as STRIPS ndash
Separate Trading of Registered Interest andPrincipal of Securities
These are not issued or sold by the Treasury
The market is made by investment banks
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What is the motivation to create suchproductsIn practice arbitrage is possible when a
coupon security is purchased at a priceThat is lower than what could be obtained byselling each cash flow separately
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Coupon stripping reflects a case of financialengineering
Creating a risk-return profile that is nototherwise available
An investment bank would buy a largequantity of a Treasury security
The securities would be placed with an SPV
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The SPV is a single-purpose dedicated trustIt has the powers to own the bonds andcollect payments
It cannot sell or lend the bondsIt cannot write options on the bondsOr use them as collateral for borrowing
The SPV is empowered to issue zero coupon
bondsWhere each security represents the ownership ofa single cash flow from the mother bond
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Assume that 100MM USD of 15 year bondswith a coupon of 8 are placed with the SPV
The SPV can issue 6M 12M 18M extending up to14 frac12 year zeroes with a total face value of 4MM
USD eachAnd 15 year zeroes with a total face value of104MM
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The Treasury launched this program in 1985to facilitate the stripping of designatedsecurities
All new T-bonds and notes with a maturity of 10years or more are eligibleThe zeroes created in the process are directobligations of the US government
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The mechanism is as followsA dealer who owns a bond or note can ask theFRB where it is held
To replace it with an equivalent set of STRIPS
representing each payment as a separate securityEach of these securities can be traded independentlyof others
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In 1987 the Treasury started to allow dealersto reverse the process
This is called STRIPS RECONSTUTUTION If a dealer owns STRIPS representing all thecoupon and principal payments of a bond
The FED can on request convert these holdings into asingle position in the corresponding bond
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Each coupon and principal cash flow from aTreasury security is assigned a CUSIP
The mother bond is also assigned a CUSIPThe stripped coupons are known as C-STRIPSThe stripped principal is known as P-STRIPSSupply of a C-STRIP increases over time
because a C-STRIP maturing on a day like 15 FEB
2020 will have the same CUSIP irrespective ofwhich mother bond it has come fromThe original coupon rate is irrelevant
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P-STRIPS always correspond to the originalsecurityThey have a unique CUSIPTheir supply is fixed at the time of issuanceIn practice the prices of long-dated P-STRIPSare a bit higher than those of C-STRIPS withthe same maturity date
One reason is that P-STRIPS are more liquid due
to greater availabilityA $100 face value bond with a coupon of 8 willgenerate C-STRIPS with a face value of $4 but P-STRIPS with a face value of $100
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Another reason why P-STRIPS are in higherdemand is that they allow reconstitutionactivities more easily
Assume that the sum of the STRIPS is cheaper than
the mother bondIf a dealer already has the P-STRIPS only the C-STRIPSneed to be acquiredHowever if he owns some of the C-STRIPS he needs toacquire the P-STRIPS and the remaining C-STRIPSThe facility to reconstitute when profitable is pricedinto the P-STRIPSNote Buy and hold investors will prefer C-STRIPSsince they are priced lower and give a higher yield
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For Plain Vanilla bonds the specifiedcoupon rate is valid for the life of thebond
In the case of Floaters the rate is reset atthe beginning of every periodThe rate will vary directly with thebenchmark
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The rate on a Floater is specified as LIBOR+ 50 bp
The spread is positiveIf it were specified as LIBOR ndash 30bp
The spread will be negativeIf LIBOR rises the rate will increasewhereas if LIBOR falls it will decrease
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In the case of a default risk-free floater theprice will reset to par on a coupon date
It may sell at a premium or discount betweencoupon dates
Consider a floater with a coupon = 5-year T-Bond rate
Assume there are two periods left to maturity
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The price at the end of the first coupon period willbe given by
cT-1 is the coupon one period before maturityyT-1 is the YTM one period before maturity
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On a coupon reset date the YTM = couponBecause we have assumed there is no default riskAny change in the required yield as reflected inthe prevailing YTM
Will also be reflected in the coupon being setIf coupon = yield the bond should sell at par
Thus P T-1 = M
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Once again at T-2 c T-2 = yT-2 and P T-2 = MThis logic can be applied to a bond with anytime remaining till maturityHowever between two coupon dates theprice may not be equal to par
Consider the valuation at T-2+k
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Although c T-2 was set at T-2 and is equal toyT-2
yT-2+k is determined at T-2+k and will reflect theyield prevailing at that time
Thus yT-2+k need not equal c T-2 and may behigher or lower
Hence between two coupon dates a floater maysell at a premium or discount
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Now consider a floater characterized bydefault risk
The risk premium required by the market neednot be constant over time
Assume that at the time of issue YTM = 5-year T-note rate + 75bp
The coupon would have been set equal to thisrate and the bond would have been issued at par
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Six months hence the issue may be perceivedas more risky
YTM = 5-year T-note rate + 95 bpThe coupon will however be set equal to theprevailing 5-year rate + 75 bpIf so the issue will not reset to par at the nextcoupon date
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Floaters may come with a CAP or a FLOOR orBOTH
The CAP is a maximum coupon rateProtects issuers against rising rates
The FLOOR is a minimum coupon rateProtects investors against falling rates
When there is a spread over LIBORThere is a natural floorLIBOR cannot be less than zero
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The present value of the face value is
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So the price of the bond is
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IBM has issued a bond with a face value of$1000The coupon is 8 per year to be paid on July
15 and January 15 every yearToday is 15 July 2013 and that the bondmatures on 15 January 2033The required yield is 10 per annum
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JJ ndash 0115FA ndash 0115MS ndash 0115
AO ndash 0115MN ndash 0115JD ndash 0115
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In the example the price is less than theface value
Such a bond is called a Discount Bond
It is trading at a discount from the face valueThe reason is that
The yield is greater than the coupon
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If the yield were to equal the couponThe bond would sell at PARSuch bonds are called PAR Bonds
If the yield is less than the couponThe price will exceed the face valueSuch bonds are called Premium Bonds
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As we move from one coupon date to thenext if the YTM were to remain constant
Par bonds would continue to trade at PARPremium bonds will steadily decline in priceDiscount bonds will steadily increase in price
This is called the Pull to Par EffectAt maturity ndash ALL BONDS WILL TRADE AT PAR
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As we approach maturity the number ofcoupons reduces
The contribution of coupons to price reducesThe contribution of the PV of the face valueincreases
For premium bonds the first effect dominatesThus the price steadily declines
For discount bonds the second effectdominatesThus the price steadily increases
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A plain vanilla or Bullet Bond pays the entireface value at maturity in a lump sumAmortizing bonds pay the principal in
installmentsThe first payment occurs before maturityThe last payment is made at maturity
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Consider a 5 year amortizing bond with aface value of $1000 and an annual coupon of8
The annual cash flows are depicted below
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Time Cash Flow
1 802 803 3304 3105 540
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The first two cash flows represent interest ona principal of $1000The third cash flow is interest on $1000 plus
a principal payment of $250The outstanding principal is $750The fourth cash flow is interest on $750 plusa principal payment of $250
The outstanding principal is $500The final cash flow is interest on $500 plusthe remaining principal of $500
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Some companies issue such bonds becausethe assets being funded have a similar cashflow profile
Second the coupon on such a bond may belower than that of a bullet bondIn the case of a bullet bond the entire principalis due at a single point in timeThere is greater default risk
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Microsoft is issuing zeroes with 5 years tomaturity and a face value of $10000
The required yield is 10 per annumWhat should be the price
Price is the PV of the face valueIn practice we discount on a semi-annual basis
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This is to facilitate comparisons withconventional bonds
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A zero coupon bond can never sell at apremium
It will always trade at a discount prior tomaturityAt maturity it will trade at par
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If held to maturity a ZCB will always give riseto a capital gainIf sold prior to maturity there may be a
capital gain or a capital lossConsider a bond with 10 years to maturityThe YTM at the time of purchase was 10The cost was $37690
A year later it is sold at a YTM of 12The corresponding price is $35035
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A newly established issuerOr an issuer with a relatively virgin productor service
Or a restructured company due to a mergeror following a bankruptcyWill be perceived as more riskyInvestors will demand a high coupon
Such firms are unlikely to have high earningsRevenues will peak only after theproductservice is established
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They can ill afford high couponsThey may consider a step-up coupon bond
Where the coupon increases as the bond ages
Assume a company can issue a plain vanillaat a coupon of 8 with a maturity of 5 yearsInstead it may opt for a bond
With a coupon of 6 for the first three years
And a coupon of 10 for the last two yearsThis is a Deferred Interest Security
Provides the issuer with breathing room in theearlier years
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These pay coupons in the form of additionalsecurities and not cash
This offers the issuer time to prepare for cashoutlays
They are used as Mezzanine FinanceThey rank between senior debt and equity in thecapital structureInvestors take more risk as compared to buyersof regular bonds ndash but get higher returnsIssuers can conserve cash in earlier years when itis at a premium
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Fully backed by the federal government ofthe issuing nationConsequently they are virtually devoid ofcredit risk or the risk of defaultThe yield on such securities is a benchmarkfor setting rates on other kinds of debt
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Treasury securities are issuedTo finance expenses in excess of currentrevenuesTo pay interest on debt accumulated in earlieryears due to deficits in those yearsTo repay past debt issues that are currentlymaturing
The US Treasuries marketIs the largest bond market in the worldIs the most liquid bond market in the world
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The Treasury issues three categories ofmarketable securities
T-bills are discount securitiesThey are zero coupon securitiesT-notes and T-bonds are sold at face value andpay interest periodically
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T-bills are issued with a original time tomaturity of one year or less
They are Money market instrumentsThey have maturities of either 1 3 6 or 12months at the time of issue
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T-notes and T-bonds have a time to maturityexceeding one year at the time of issue
They are capital market instrumentsT-notes have maturities ranging from 1-10 yearsT-bonds have an original maturity in excess of 10years extending up to 30 years
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An issue may be followed later by a furtherissue
With the same remaining time to maturity andthe same couponThe issuance of further tranches is termed as aRe-opening
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Six months ago a 10-year note was issuedwith a coupon of 8 per annumToday if a note with 9 frac12 years to maturityand a coupon of 8 issued it will add to thepool that is already trading in the marketThus it is a re-opening of an existing issue
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Who is a primary dealerA PD is a dealer who is authorized to dealdirectly with the Central Bank of the countryIn the US a PD is a bank or securities broker-dealer that directly deals with the FRBNY
Importance of FRBNYIn India a PD deals directly with the RBI
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The Treasury sells bills notes and bonds byway of a competitive auction process
Most of the treasury securities are bought byprimary dealers
Individual investors submit non-competitive bidsand participate on a much smaller scale
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Bids may beCompetitive
Indicate price amp quantity or yield amp quantityNon-competitive
Indicate only quantity
Small investors and individualsgenerally submit non-competitive bids
A non-competitive bidder may not bid for more than$5MM worth of securities in a bill or bond auction
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Primary dealers bid for their accounts andon behalf of their clientsThey usually submit large competitive
bidsBids indicate the maximum price that the bidderis prepared to pay if it is a price based auctionOr the minimum yield that the bidder is
prepared to accept if it is a yield based auction
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The Treasury will net out the totalamount of non-competitive bids
The balance will be allocated to competitivebidders
There are two ways in which securitiescan be allotted
The multiple priceyield auction mechanism
French AuctionsThe uniform priceyield auction mechanism
Dutch Auctions
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Assume that the Treasury is offering 25billion dollars worth of T-bonds
2 billion dollars worth of non-competitive bidshave been receivedSo 23 billion dollars worth of bonds are availableto be offered to the competitive bidders
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There are six competitive bidders who havesubmitted the following yields
The bids have been arranged in ascending orderof yieldIn a price based auction the bids would havebeen arranged in descending order of price
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Bidder Bid Yield Bid Amount
Aggregate Amount
Alpha 5370 30 bn 30 bnBeta 5372 50 bn 80 bn
Gamma 5373 40 bn 12 bn
Delta 5375 80 bn 20 bnCharlie 5375 120 bn 32 bn
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The aggregate demand equals the amount onoffer at a yield of 5375A multiple yield auction will lead to thefollowing allocation
Alpha will get 3 bn at a yield of 5370Beta will get 5 bn at 5372Gamma will get 4 bn at 5373
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At a yield of 5375 we have only 11 bn left toallocateThere is a demand of 20 bn at this yield
8 bn from Delta and 12 bn from CharlieThus we will allocate 1120 = 55 to eachbidder at this yield
There will be pro-rata allocation
055 of 8 bn or 440 bn will go to Delta055 of 12 bn or 66 bn will go to Charlie
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The highest accepted yield is called the StopYield or High Yield
In this case it is 5375The ratio of bids received to the amountawarded is known as the bid to cover ratio
The higher the ratio the stronger is the auction
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Those who bid more than 5375 will getnothing and are said to be shutout of theauctionSince 1999 the US Treasury has beenconducting only uniform yield auctions
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WI stands for ndash When As and If IssuedThe when issued market is a market forforward trading of a bond
Which has been announced but not yet issuedTrades take place from the date ofannouncement until the actual issue date
Helps bidders to gauge the marketrsquos interestbefore the actual auction
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WI trading has ramifications for the biddingstrategies of market participantsTraders can take both long and shortpositions
Settlement is scheduled for the issue date
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It has a bearing on the outcome of theauction
It affects the strategy used by a bidder becauseit has an impact on his prior positionBidders who are long in the WI market enter theauction with a Long PositionThose who are short in the WI market enter theauction with a short position
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The WI market helps in price discoveryIt provides important information on
The strength of demand for the securityAnd on the disparity of biddersrsquo views
This help potential bidders to formulate theirstrategiesAt times a dealer may believe that he hasvery important private information
If so he may not participate in the WI market andwill directly enter the auction with bids based onhis knowledge
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On or before the date of the auction theissues trade on a yield basis
The actual price can be established only afterthe coupon is set
Starting with the day after the auctionSecurities are quoted on a price basis becausethe coupon is known
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In a coupon roll a dealer will purchase themost recently issued security from a clientAnd simultaneously sell the same amount ofthe recently announced new security
The first leg with settle on the following dayThe second leg is a forward contract
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There can be a Reverse RollThe dealer will sell the most recent issue fornext day settlementAnd buy the newly announced security forforward settlement
The forward leg in a RollReverse Roll is a WItrade
It will settle on the new issue settlement date
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The roll is the spread between the yield onthe new security and that on the outstandingissue in the same maturity segmentA GIVE in the Roll means that
The WI security provides a higher yield than theoutstanding issue
A Take in the Roll means thatThe WI security provides a lower yield
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On March 17 20XX the Treasury announcedthe auction of a 2-year note
The auction was scheduled for March 24The settlement date was March 31
Trading of the roll began as soon as the issuewas announcedA Give of 5 bp means that the dealer proposes tobuy the current issue at the prevailing yieldAnd sell the new issue at a yield that is 5 bpmoreA Take of 5 bp means that the dealer proposes tosell the new issue at a yield that is 5bp lower
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The roll achieves the followingHe acquires the outstanding issue for next daysettlementHe sells the to be issued security with the samepar value for forward delivery on 31 March
The customer is rolling over the investmentfrom the current issue to the new issue
This extends the maturity of the investment byone month
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The client can invest the funds received tillthe new issue settlesHowever he loses the accrued interest thathe would have earned had he held on to theissue
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The Treasury per se does not issue zerocoupon securitiesBut zero coupon securities can be created
which are backed by conventional bondsTake a large quantity of a T-note or bond andseparate all the cash flows from each otherSell the entitlement to each cash flowseparately
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Take the case of a two-year T-noteIt can be separated into five zero couponsecurities maturing after
6 months12 months18 months24 months
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Earlier investment banks used to buy bondsfrom the Treasury and separate the cashflows
Each cash flow was then sold separately as a zerocoupon bondSuch issues are called trademarks
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The issue of trademarks has now ceasedBecause investment banks can now createsuch instruments
In concert with the Treasury itselfThese ZCBs are known as STRIPS ndash
Separate Trading of Registered Interest andPrincipal of Securities
These are not issued or sold by the Treasury
The market is made by investment banks
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What is the motivation to create suchproductsIn practice arbitrage is possible when a
coupon security is purchased at a priceThat is lower than what could be obtained byselling each cash flow separately
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Coupon stripping reflects a case of financialengineering
Creating a risk-return profile that is nototherwise available
An investment bank would buy a largequantity of a Treasury security
The securities would be placed with an SPV
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The SPV is a single-purpose dedicated trustIt has the powers to own the bonds andcollect payments
It cannot sell or lend the bondsIt cannot write options on the bondsOr use them as collateral for borrowing
The SPV is empowered to issue zero coupon
bondsWhere each security represents the ownership ofa single cash flow from the mother bond
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Assume that 100MM USD of 15 year bondswith a coupon of 8 are placed with the SPV
The SPV can issue 6M 12M 18M extending up to14 frac12 year zeroes with a total face value of 4MM
USD eachAnd 15 year zeroes with a total face value of104MM
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The Treasury launched this program in 1985to facilitate the stripping of designatedsecurities
All new T-bonds and notes with a maturity of 10years or more are eligibleThe zeroes created in the process are directobligations of the US government
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The mechanism is as followsA dealer who owns a bond or note can ask theFRB where it is held
To replace it with an equivalent set of STRIPS
representing each payment as a separate securityEach of these securities can be traded independentlyof others
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In 1987 the Treasury started to allow dealersto reverse the process
This is called STRIPS RECONSTUTUTION If a dealer owns STRIPS representing all thecoupon and principal payments of a bond
The FED can on request convert these holdings into asingle position in the corresponding bond
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Each coupon and principal cash flow from aTreasury security is assigned a CUSIP
The mother bond is also assigned a CUSIPThe stripped coupons are known as C-STRIPSThe stripped principal is known as P-STRIPSSupply of a C-STRIP increases over time
because a C-STRIP maturing on a day like 15 FEB
2020 will have the same CUSIP irrespective ofwhich mother bond it has come fromThe original coupon rate is irrelevant
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P-STRIPS always correspond to the originalsecurityThey have a unique CUSIPTheir supply is fixed at the time of issuanceIn practice the prices of long-dated P-STRIPSare a bit higher than those of C-STRIPS withthe same maturity date
One reason is that P-STRIPS are more liquid due
to greater availabilityA $100 face value bond with a coupon of 8 willgenerate C-STRIPS with a face value of $4 but P-STRIPS with a face value of $100
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Another reason why P-STRIPS are in higherdemand is that they allow reconstitutionactivities more easily
Assume that the sum of the STRIPS is cheaper than
the mother bondIf a dealer already has the P-STRIPS only the C-STRIPSneed to be acquiredHowever if he owns some of the C-STRIPS he needs toacquire the P-STRIPS and the remaining C-STRIPSThe facility to reconstitute when profitable is pricedinto the P-STRIPSNote Buy and hold investors will prefer C-STRIPSsince they are priced lower and give a higher yield
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For Plain Vanilla bonds the specifiedcoupon rate is valid for the life of thebond
In the case of Floaters the rate is reset atthe beginning of every periodThe rate will vary directly with thebenchmark
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The rate on a Floater is specified as LIBOR+ 50 bp
The spread is positiveIf it were specified as LIBOR ndash 30bp
The spread will be negativeIf LIBOR rises the rate will increasewhereas if LIBOR falls it will decrease
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In the case of a default risk-free floater theprice will reset to par on a coupon date
It may sell at a premium or discount betweencoupon dates
Consider a floater with a coupon = 5-year T-Bond rate
Assume there are two periods left to maturity
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The price at the end of the first coupon period willbe given by
cT-1 is the coupon one period before maturityyT-1 is the YTM one period before maturity
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On a coupon reset date the YTM = couponBecause we have assumed there is no default riskAny change in the required yield as reflected inthe prevailing YTM
Will also be reflected in the coupon being setIf coupon = yield the bond should sell at par
Thus P T-1 = M
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Once again at T-2 c T-2 = yT-2 and P T-2 = MThis logic can be applied to a bond with anytime remaining till maturityHowever between two coupon dates theprice may not be equal to par
Consider the valuation at T-2+k
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Although c T-2 was set at T-2 and is equal toyT-2
yT-2+k is determined at T-2+k and will reflect theyield prevailing at that time
Thus yT-2+k need not equal c T-2 and may behigher or lower
Hence between two coupon dates a floater maysell at a premium or discount
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Now consider a floater characterized bydefault risk
The risk premium required by the market neednot be constant over time
Assume that at the time of issue YTM = 5-year T-note rate + 75bp
The coupon would have been set equal to thisrate and the bond would have been issued at par
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Six months hence the issue may be perceivedas more risky
YTM = 5-year T-note rate + 95 bpThe coupon will however be set equal to theprevailing 5-year rate + 75 bpIf so the issue will not reset to par at the nextcoupon date
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Floaters may come with a CAP or a FLOOR orBOTH
The CAP is a maximum coupon rateProtects issuers against rising rates
The FLOOR is a minimum coupon rateProtects investors against falling rates
When there is a spread over LIBORThere is a natural floorLIBOR cannot be less than zero
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So the price of the bond is
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IBM has issued a bond with a face value of$1000The coupon is 8 per year to be paid on July
15 and January 15 every yearToday is 15 July 2013 and that the bondmatures on 15 January 2033The required yield is 10 per annum
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JJ ndash 0115FA ndash 0115MS ndash 0115
AO ndash 0115MN ndash 0115JD ndash 0115
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In the example the price is less than theface value
Such a bond is called a Discount Bond
It is trading at a discount from the face valueThe reason is that
The yield is greater than the coupon
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If the yield were to equal the couponThe bond would sell at PARSuch bonds are called PAR Bonds
If the yield is less than the couponThe price will exceed the face valueSuch bonds are called Premium Bonds
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As we move from one coupon date to thenext if the YTM were to remain constant
Par bonds would continue to trade at PARPremium bonds will steadily decline in priceDiscount bonds will steadily increase in price
This is called the Pull to Par EffectAt maturity ndash ALL BONDS WILL TRADE AT PAR
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As we approach maturity the number ofcoupons reduces
The contribution of coupons to price reducesThe contribution of the PV of the face valueincreases
For premium bonds the first effect dominatesThus the price steadily declines
For discount bonds the second effectdominatesThus the price steadily increases
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A plain vanilla or Bullet Bond pays the entireface value at maturity in a lump sumAmortizing bonds pay the principal in
installmentsThe first payment occurs before maturityThe last payment is made at maturity
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Consider a 5 year amortizing bond with aface value of $1000 and an annual coupon of8
The annual cash flows are depicted below
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Time Cash Flow
1 802 803 3304 3105 540
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The first two cash flows represent interest ona principal of $1000The third cash flow is interest on $1000 plus
a principal payment of $250The outstanding principal is $750The fourth cash flow is interest on $750 plusa principal payment of $250
The outstanding principal is $500The final cash flow is interest on $500 plusthe remaining principal of $500
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Some companies issue such bonds becausethe assets being funded have a similar cashflow profile
Second the coupon on such a bond may belower than that of a bullet bondIn the case of a bullet bond the entire principalis due at a single point in timeThere is greater default risk
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Microsoft is issuing zeroes with 5 years tomaturity and a face value of $10000
The required yield is 10 per annumWhat should be the price
Price is the PV of the face valueIn practice we discount on a semi-annual basis
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This is to facilitate comparisons withconventional bonds
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A zero coupon bond can never sell at apremium
It will always trade at a discount prior tomaturityAt maturity it will trade at par
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If held to maturity a ZCB will always give riseto a capital gainIf sold prior to maturity there may be a
capital gain or a capital lossConsider a bond with 10 years to maturityThe YTM at the time of purchase was 10The cost was $37690
A year later it is sold at a YTM of 12The corresponding price is $35035
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A newly established issuerOr an issuer with a relatively virgin productor service
Or a restructured company due to a mergeror following a bankruptcyWill be perceived as more riskyInvestors will demand a high coupon
Such firms are unlikely to have high earningsRevenues will peak only after theproductservice is established
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They can ill afford high couponsThey may consider a step-up coupon bond
Where the coupon increases as the bond ages
Assume a company can issue a plain vanillaat a coupon of 8 with a maturity of 5 yearsInstead it may opt for a bond
With a coupon of 6 for the first three years
And a coupon of 10 for the last two yearsThis is a Deferred Interest Security
Provides the issuer with breathing room in theearlier years
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These pay coupons in the form of additionalsecurities and not cash
This offers the issuer time to prepare for cashoutlays
They are used as Mezzanine FinanceThey rank between senior debt and equity in thecapital structureInvestors take more risk as compared to buyersof regular bonds ndash but get higher returnsIssuers can conserve cash in earlier years when itis at a premium
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Fully backed by the federal government ofthe issuing nationConsequently they are virtually devoid ofcredit risk or the risk of defaultThe yield on such securities is a benchmarkfor setting rates on other kinds of debt
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Treasury securities are issuedTo finance expenses in excess of currentrevenuesTo pay interest on debt accumulated in earlieryears due to deficits in those yearsTo repay past debt issues that are currentlymaturing
The US Treasuries marketIs the largest bond market in the worldIs the most liquid bond market in the world
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The Treasury issues three categories ofmarketable securities
T-bills are discount securitiesThey are zero coupon securitiesT-notes and T-bonds are sold at face value andpay interest periodically
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T-bills are issued with a original time tomaturity of one year or less
They are Money market instrumentsThey have maturities of either 1 3 6 or 12months at the time of issue
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T-notes and T-bonds have a time to maturityexceeding one year at the time of issue
They are capital market instrumentsT-notes have maturities ranging from 1-10 yearsT-bonds have an original maturity in excess of 10years extending up to 30 years
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An issue may be followed later by a furtherissue
With the same remaining time to maturity andthe same couponThe issuance of further tranches is termed as aRe-opening
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Six months ago a 10-year note was issuedwith a coupon of 8 per annumToday if a note with 9 frac12 years to maturityand a coupon of 8 issued it will add to thepool that is already trading in the marketThus it is a re-opening of an existing issue
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Who is a primary dealerA PD is a dealer who is authorized to dealdirectly with the Central Bank of the countryIn the US a PD is a bank or securities broker-dealer that directly deals with the FRBNY
Importance of FRBNYIn India a PD deals directly with the RBI
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The Treasury sells bills notes and bonds byway of a competitive auction process
Most of the treasury securities are bought byprimary dealers
Individual investors submit non-competitive bidsand participate on a much smaller scale
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Bids may beCompetitive
Indicate price amp quantity or yield amp quantityNon-competitive
Indicate only quantity
Small investors and individualsgenerally submit non-competitive bids
A non-competitive bidder may not bid for more than$5MM worth of securities in a bill or bond auction
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Primary dealers bid for their accounts andon behalf of their clientsThey usually submit large competitive
bidsBids indicate the maximum price that the bidderis prepared to pay if it is a price based auctionOr the minimum yield that the bidder is
prepared to accept if it is a yield based auction
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The Treasury will net out the totalamount of non-competitive bids
The balance will be allocated to competitivebidders
There are two ways in which securitiescan be allotted
The multiple priceyield auction mechanism
French AuctionsThe uniform priceyield auction mechanism
Dutch Auctions
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Assume that the Treasury is offering 25billion dollars worth of T-bonds
2 billion dollars worth of non-competitive bidshave been receivedSo 23 billion dollars worth of bonds are availableto be offered to the competitive bidders
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There are six competitive bidders who havesubmitted the following yields
The bids have been arranged in ascending orderof yieldIn a price based auction the bids would havebeen arranged in descending order of price
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Bidder Bid Yield Bid Amount
Aggregate Amount
Alpha 5370 30 bn 30 bnBeta 5372 50 bn 80 bn
Gamma 5373 40 bn 12 bn
Delta 5375 80 bn 20 bnCharlie 5375 120 bn 32 bn
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The aggregate demand equals the amount onoffer at a yield of 5375A multiple yield auction will lead to thefollowing allocation
Alpha will get 3 bn at a yield of 5370Beta will get 5 bn at 5372Gamma will get 4 bn at 5373
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At a yield of 5375 we have only 11 bn left toallocateThere is a demand of 20 bn at this yield
8 bn from Delta and 12 bn from CharlieThus we will allocate 1120 = 55 to eachbidder at this yield
There will be pro-rata allocation
055 of 8 bn or 440 bn will go to Delta055 of 12 bn or 66 bn will go to Charlie
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The highest accepted yield is called the StopYield or High Yield
In this case it is 5375The ratio of bids received to the amountawarded is known as the bid to cover ratio
The higher the ratio the stronger is the auction
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Those who bid more than 5375 will getnothing and are said to be shutout of theauctionSince 1999 the US Treasury has beenconducting only uniform yield auctions
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WI stands for ndash When As and If IssuedThe when issued market is a market forforward trading of a bond
Which has been announced but not yet issuedTrades take place from the date ofannouncement until the actual issue date
Helps bidders to gauge the marketrsquos interestbefore the actual auction
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WI trading has ramifications for the biddingstrategies of market participantsTraders can take both long and shortpositions
Settlement is scheduled for the issue date
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It has a bearing on the outcome of theauction
It affects the strategy used by a bidder becauseit has an impact on his prior positionBidders who are long in the WI market enter theauction with a Long PositionThose who are short in the WI market enter theauction with a short position
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The WI market helps in price discoveryIt provides important information on
The strength of demand for the securityAnd on the disparity of biddersrsquo views
This help potential bidders to formulate theirstrategiesAt times a dealer may believe that he hasvery important private information
If so he may not participate in the WI market andwill directly enter the auction with bids based onhis knowledge
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On or before the date of the auction theissues trade on a yield basis
The actual price can be established only afterthe coupon is set
Starting with the day after the auctionSecurities are quoted on a price basis becausethe coupon is known
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In a coupon roll a dealer will purchase themost recently issued security from a clientAnd simultaneously sell the same amount ofthe recently announced new security
The first leg with settle on the following dayThe second leg is a forward contract
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There can be a Reverse RollThe dealer will sell the most recent issue fornext day settlementAnd buy the newly announced security forforward settlement
The forward leg in a RollReverse Roll is a WItrade
It will settle on the new issue settlement date
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The roll is the spread between the yield onthe new security and that on the outstandingissue in the same maturity segmentA GIVE in the Roll means that
The WI security provides a higher yield than theoutstanding issue
A Take in the Roll means thatThe WI security provides a lower yield
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On March 17 20XX the Treasury announcedthe auction of a 2-year note
The auction was scheduled for March 24The settlement date was March 31
Trading of the roll began as soon as the issuewas announcedA Give of 5 bp means that the dealer proposes tobuy the current issue at the prevailing yieldAnd sell the new issue at a yield that is 5 bpmoreA Take of 5 bp means that the dealer proposes tosell the new issue at a yield that is 5bp lower
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The roll achieves the followingHe acquires the outstanding issue for next daysettlementHe sells the to be issued security with the samepar value for forward delivery on 31 March
The customer is rolling over the investmentfrom the current issue to the new issue
This extends the maturity of the investment byone month
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The client can invest the funds received tillthe new issue settlesHowever he loses the accrued interest thathe would have earned had he held on to theissue
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The Treasury per se does not issue zerocoupon securitiesBut zero coupon securities can be created
which are backed by conventional bondsTake a large quantity of a T-note or bond andseparate all the cash flows from each otherSell the entitlement to each cash flowseparately
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Take the case of a two-year T-noteIt can be separated into five zero couponsecurities maturing after
6 months12 months18 months24 months
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Earlier investment banks used to buy bondsfrom the Treasury and separate the cashflows
Each cash flow was then sold separately as a zerocoupon bondSuch issues are called trademarks
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The issue of trademarks has now ceasedBecause investment banks can now createsuch instruments
In concert with the Treasury itselfThese ZCBs are known as STRIPS ndash
Separate Trading of Registered Interest andPrincipal of Securities
These are not issued or sold by the Treasury
The market is made by investment banks
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What is the motivation to create suchproductsIn practice arbitrage is possible when a
coupon security is purchased at a priceThat is lower than what could be obtained byselling each cash flow separately
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Coupon stripping reflects a case of financialengineering
Creating a risk-return profile that is nototherwise available
An investment bank would buy a largequantity of a Treasury security
The securities would be placed with an SPV
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The SPV is a single-purpose dedicated trustIt has the powers to own the bonds andcollect payments
It cannot sell or lend the bondsIt cannot write options on the bondsOr use them as collateral for borrowing
The SPV is empowered to issue zero coupon
bondsWhere each security represents the ownership ofa single cash flow from the mother bond
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Assume that 100MM USD of 15 year bondswith a coupon of 8 are placed with the SPV
The SPV can issue 6M 12M 18M extending up to14 frac12 year zeroes with a total face value of 4MM
USD eachAnd 15 year zeroes with a total face value of104MM
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The Treasury launched this program in 1985to facilitate the stripping of designatedsecurities
All new T-bonds and notes with a maturity of 10years or more are eligibleThe zeroes created in the process are directobligations of the US government
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The mechanism is as followsA dealer who owns a bond or note can ask theFRB where it is held
To replace it with an equivalent set of STRIPS
representing each payment as a separate securityEach of these securities can be traded independentlyof others
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In 1987 the Treasury started to allow dealersto reverse the process
This is called STRIPS RECONSTUTUTION If a dealer owns STRIPS representing all thecoupon and principal payments of a bond
The FED can on request convert these holdings into asingle position in the corresponding bond
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Each coupon and principal cash flow from aTreasury security is assigned a CUSIP
The mother bond is also assigned a CUSIPThe stripped coupons are known as C-STRIPSThe stripped principal is known as P-STRIPSSupply of a C-STRIP increases over time
because a C-STRIP maturing on a day like 15 FEB
2020 will have the same CUSIP irrespective ofwhich mother bond it has come fromThe original coupon rate is irrelevant
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P-STRIPS always correspond to the originalsecurityThey have a unique CUSIPTheir supply is fixed at the time of issuanceIn practice the prices of long-dated P-STRIPSare a bit higher than those of C-STRIPS withthe same maturity date
One reason is that P-STRIPS are more liquid due
to greater availabilityA $100 face value bond with a coupon of 8 willgenerate C-STRIPS with a face value of $4 but P-STRIPS with a face value of $100
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Another reason why P-STRIPS are in higherdemand is that they allow reconstitutionactivities more easily
Assume that the sum of the STRIPS is cheaper than
the mother bondIf a dealer already has the P-STRIPS only the C-STRIPSneed to be acquiredHowever if he owns some of the C-STRIPS he needs toacquire the P-STRIPS and the remaining C-STRIPSThe facility to reconstitute when profitable is pricedinto the P-STRIPSNote Buy and hold investors will prefer C-STRIPSsince they are priced lower and give a higher yield
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For Plain Vanilla bonds the specifiedcoupon rate is valid for the life of thebond
In the case of Floaters the rate is reset atthe beginning of every periodThe rate will vary directly with thebenchmark
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The rate on a Floater is specified as LIBOR+ 50 bp
The spread is positiveIf it were specified as LIBOR ndash 30bp
The spread will be negativeIf LIBOR rises the rate will increasewhereas if LIBOR falls it will decrease
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In the case of a default risk-free floater theprice will reset to par on a coupon date
It may sell at a premium or discount betweencoupon dates
Consider a floater with a coupon = 5-year T-Bond rate
Assume there are two periods left to maturity
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The price at the end of the first coupon period willbe given by
cT-1 is the coupon one period before maturityyT-1 is the YTM one period before maturity
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On a coupon reset date the YTM = couponBecause we have assumed there is no default riskAny change in the required yield as reflected inthe prevailing YTM
Will also be reflected in the coupon being setIf coupon = yield the bond should sell at par
Thus P T-1 = M
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Once again at T-2 c T-2 = yT-2 and P T-2 = MThis logic can be applied to a bond with anytime remaining till maturityHowever between two coupon dates theprice may not be equal to par
Consider the valuation at T-2+k
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Although c T-2 was set at T-2 and is equal toyT-2
yT-2+k is determined at T-2+k and will reflect theyield prevailing at that time
Thus yT-2+k need not equal c T-2 and may behigher or lower
Hence between two coupon dates a floater maysell at a premium or discount
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Now consider a floater characterized bydefault risk
The risk premium required by the market neednot be constant over time
Assume that at the time of issue YTM = 5-year T-note rate + 75bp
The coupon would have been set equal to thisrate and the bond would have been issued at par
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Six months hence the issue may be perceivedas more risky
YTM = 5-year T-note rate + 95 bpThe coupon will however be set equal to theprevailing 5-year rate + 75 bpIf so the issue will not reset to par at the nextcoupon date
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Floaters may come with a CAP or a FLOOR orBOTH
The CAP is a maximum coupon rateProtects issuers against rising rates
The FLOOR is a minimum coupon rateProtects investors against falling rates
When there is a spread over LIBORThere is a natural floorLIBOR cannot be less than zero
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IBM has issued a bond with a face value of$1000The coupon is 8 per year to be paid on July
15 and January 15 every yearToday is 15 July 2013 and that the bondmatures on 15 January 2033The required yield is 10 per annum
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JJ ndash 0115FA ndash 0115MS ndash 0115
AO ndash 0115MN ndash 0115JD ndash 0115
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In the example the price is less than theface value
Such a bond is called a Discount Bond
It is trading at a discount from the face valueThe reason is that
The yield is greater than the coupon
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If the yield were to equal the couponThe bond would sell at PARSuch bonds are called PAR Bonds
If the yield is less than the couponThe price will exceed the face valueSuch bonds are called Premium Bonds
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As we move from one coupon date to thenext if the YTM were to remain constant
Par bonds would continue to trade at PARPremium bonds will steadily decline in priceDiscount bonds will steadily increase in price
This is called the Pull to Par EffectAt maturity ndash ALL BONDS WILL TRADE AT PAR
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As we approach maturity the number ofcoupons reduces
The contribution of coupons to price reducesThe contribution of the PV of the face valueincreases
For premium bonds the first effect dominatesThus the price steadily declines
For discount bonds the second effectdominatesThus the price steadily increases
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A plain vanilla or Bullet Bond pays the entireface value at maturity in a lump sumAmortizing bonds pay the principal in
installmentsThe first payment occurs before maturityThe last payment is made at maturity
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Consider a 5 year amortizing bond with aface value of $1000 and an annual coupon of8
The annual cash flows are depicted below
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Time Cash Flow
1 802 803 3304 3105 540
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The first two cash flows represent interest ona principal of $1000The third cash flow is interest on $1000 plus
a principal payment of $250The outstanding principal is $750The fourth cash flow is interest on $750 plusa principal payment of $250
The outstanding principal is $500The final cash flow is interest on $500 plusthe remaining principal of $500
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Some companies issue such bonds becausethe assets being funded have a similar cashflow profile
Second the coupon on such a bond may belower than that of a bullet bondIn the case of a bullet bond the entire principalis due at a single point in timeThere is greater default risk
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Microsoft is issuing zeroes with 5 years tomaturity and a face value of $10000
The required yield is 10 per annumWhat should be the price
Price is the PV of the face valueIn practice we discount on a semi-annual basis
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This is to facilitate comparisons withconventional bonds
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A zero coupon bond can never sell at apremium
It will always trade at a discount prior tomaturityAt maturity it will trade at par
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If held to maturity a ZCB will always give riseto a capital gainIf sold prior to maturity there may be a
capital gain or a capital lossConsider a bond with 10 years to maturityThe YTM at the time of purchase was 10The cost was $37690
A year later it is sold at a YTM of 12The corresponding price is $35035
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A newly established issuerOr an issuer with a relatively virgin productor service
Or a restructured company due to a mergeror following a bankruptcyWill be perceived as more riskyInvestors will demand a high coupon
Such firms are unlikely to have high earningsRevenues will peak only after theproductservice is established
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They can ill afford high couponsThey may consider a step-up coupon bond
Where the coupon increases as the bond ages
Assume a company can issue a plain vanillaat a coupon of 8 with a maturity of 5 yearsInstead it may opt for a bond
With a coupon of 6 for the first three years
And a coupon of 10 for the last two yearsThis is a Deferred Interest Security
Provides the issuer with breathing room in theearlier years
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These pay coupons in the form of additionalsecurities and not cash
This offers the issuer time to prepare for cashoutlays
They are used as Mezzanine FinanceThey rank between senior debt and equity in thecapital structureInvestors take more risk as compared to buyersof regular bonds ndash but get higher returnsIssuers can conserve cash in earlier years when itis at a premium
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Fully backed by the federal government ofthe issuing nationConsequently they are virtually devoid ofcredit risk or the risk of defaultThe yield on such securities is a benchmarkfor setting rates on other kinds of debt
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Treasury securities are issuedTo finance expenses in excess of currentrevenuesTo pay interest on debt accumulated in earlieryears due to deficits in those yearsTo repay past debt issues that are currentlymaturing
The US Treasuries marketIs the largest bond market in the worldIs the most liquid bond market in the world
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The Treasury issues three categories ofmarketable securities
T-bills are discount securitiesThey are zero coupon securitiesT-notes and T-bonds are sold at face value andpay interest periodically
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T-bills are issued with a original time tomaturity of one year or less
They are Money market instrumentsThey have maturities of either 1 3 6 or 12months at the time of issue
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T-notes and T-bonds have a time to maturityexceeding one year at the time of issue
They are capital market instrumentsT-notes have maturities ranging from 1-10 yearsT-bonds have an original maturity in excess of 10years extending up to 30 years
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An issue may be followed later by a furtherissue
With the same remaining time to maturity andthe same couponThe issuance of further tranches is termed as aRe-opening
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Six months ago a 10-year note was issuedwith a coupon of 8 per annumToday if a note with 9 frac12 years to maturityand a coupon of 8 issued it will add to thepool that is already trading in the marketThus it is a re-opening of an existing issue
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Who is a primary dealerA PD is a dealer who is authorized to dealdirectly with the Central Bank of the countryIn the US a PD is a bank or securities broker-dealer that directly deals with the FRBNY
Importance of FRBNYIn India a PD deals directly with the RBI
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The Treasury sells bills notes and bonds byway of a competitive auction process
Most of the treasury securities are bought byprimary dealers
Individual investors submit non-competitive bidsand participate on a much smaller scale
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Bids may beCompetitive
Indicate price amp quantity or yield amp quantityNon-competitive
Indicate only quantity
Small investors and individualsgenerally submit non-competitive bids
A non-competitive bidder may not bid for more than$5MM worth of securities in a bill or bond auction
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Primary dealers bid for their accounts andon behalf of their clientsThey usually submit large competitive
bidsBids indicate the maximum price that the bidderis prepared to pay if it is a price based auctionOr the minimum yield that the bidder is
prepared to accept if it is a yield based auction
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The Treasury will net out the totalamount of non-competitive bids
The balance will be allocated to competitivebidders
There are two ways in which securitiescan be allotted
The multiple priceyield auction mechanism
French AuctionsThe uniform priceyield auction mechanism
Dutch Auctions
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Assume that the Treasury is offering 25billion dollars worth of T-bonds
2 billion dollars worth of non-competitive bidshave been receivedSo 23 billion dollars worth of bonds are availableto be offered to the competitive bidders
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There are six competitive bidders who havesubmitted the following yields
The bids have been arranged in ascending orderof yieldIn a price based auction the bids would havebeen arranged in descending order of price
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Bidder Bid Yield Bid Amount
Aggregate Amount
Alpha 5370 30 bn 30 bnBeta 5372 50 bn 80 bn
Gamma 5373 40 bn 12 bn
Delta 5375 80 bn 20 bnCharlie 5375 120 bn 32 bn
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The aggregate demand equals the amount onoffer at a yield of 5375A multiple yield auction will lead to thefollowing allocation
Alpha will get 3 bn at a yield of 5370Beta will get 5 bn at 5372Gamma will get 4 bn at 5373
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At a yield of 5375 we have only 11 bn left toallocateThere is a demand of 20 bn at this yield
8 bn from Delta and 12 bn from CharlieThus we will allocate 1120 = 55 to eachbidder at this yield
There will be pro-rata allocation
055 of 8 bn or 440 bn will go to Delta055 of 12 bn or 66 bn will go to Charlie
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The highest accepted yield is called the StopYield or High Yield
In this case it is 5375The ratio of bids received to the amountawarded is known as the bid to cover ratio
The higher the ratio the stronger is the auction
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Those who bid more than 5375 will getnothing and are said to be shutout of theauctionSince 1999 the US Treasury has beenconducting only uniform yield auctions
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WI stands for ndash When As and If IssuedThe when issued market is a market forforward trading of a bond
Which has been announced but not yet issuedTrades take place from the date ofannouncement until the actual issue date
Helps bidders to gauge the marketrsquos interestbefore the actual auction
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WI trading has ramifications for the biddingstrategies of market participantsTraders can take both long and shortpositions
Settlement is scheduled for the issue date
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It has a bearing on the outcome of theauction
It affects the strategy used by a bidder becauseit has an impact on his prior positionBidders who are long in the WI market enter theauction with a Long PositionThose who are short in the WI market enter theauction with a short position
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The WI market helps in price discoveryIt provides important information on
The strength of demand for the securityAnd on the disparity of biddersrsquo views
This help potential bidders to formulate theirstrategiesAt times a dealer may believe that he hasvery important private information
If so he may not participate in the WI market andwill directly enter the auction with bids based onhis knowledge
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On or before the date of the auction theissues trade on a yield basis
The actual price can be established only afterthe coupon is set
Starting with the day after the auctionSecurities are quoted on a price basis becausethe coupon is known
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In a coupon roll a dealer will purchase themost recently issued security from a clientAnd simultaneously sell the same amount ofthe recently announced new security
The first leg with settle on the following dayThe second leg is a forward contract
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There can be a Reverse RollThe dealer will sell the most recent issue fornext day settlementAnd buy the newly announced security forforward settlement
The forward leg in a RollReverse Roll is a WItrade
It will settle on the new issue settlement date
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The roll is the spread between the yield onthe new security and that on the outstandingissue in the same maturity segmentA GIVE in the Roll means that
The WI security provides a higher yield than theoutstanding issue
A Take in the Roll means thatThe WI security provides a lower yield
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On March 17 20XX the Treasury announcedthe auction of a 2-year note
The auction was scheduled for March 24The settlement date was March 31
Trading of the roll began as soon as the issuewas announcedA Give of 5 bp means that the dealer proposes tobuy the current issue at the prevailing yieldAnd sell the new issue at a yield that is 5 bpmoreA Take of 5 bp means that the dealer proposes tosell the new issue at a yield that is 5bp lower
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The roll achieves the followingHe acquires the outstanding issue for next daysettlementHe sells the to be issued security with the samepar value for forward delivery on 31 March
The customer is rolling over the investmentfrom the current issue to the new issue
This extends the maturity of the investment byone month
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The client can invest the funds received tillthe new issue settlesHowever he loses the accrued interest thathe would have earned had he held on to theissue
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The Treasury per se does not issue zerocoupon securitiesBut zero coupon securities can be created
which are backed by conventional bondsTake a large quantity of a T-note or bond andseparate all the cash flows from each otherSell the entitlement to each cash flowseparately
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Take the case of a two-year T-noteIt can be separated into five zero couponsecurities maturing after
6 months12 months18 months24 months
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Earlier investment banks used to buy bondsfrom the Treasury and separate the cashflows
Each cash flow was then sold separately as a zerocoupon bondSuch issues are called trademarks
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The issue of trademarks has now ceasedBecause investment banks can now createsuch instruments
In concert with the Treasury itselfThese ZCBs are known as STRIPS ndash
Separate Trading of Registered Interest andPrincipal of Securities
These are not issued or sold by the Treasury
The market is made by investment banks
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What is the motivation to create suchproductsIn practice arbitrage is possible when a
coupon security is purchased at a priceThat is lower than what could be obtained byselling each cash flow separately
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Coupon stripping reflects a case of financialengineering
Creating a risk-return profile that is nototherwise available
An investment bank would buy a largequantity of a Treasury security
The securities would be placed with an SPV
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The SPV is a single-purpose dedicated trustIt has the powers to own the bonds andcollect payments
It cannot sell or lend the bondsIt cannot write options on the bondsOr use them as collateral for borrowing
The SPV is empowered to issue zero coupon
bondsWhere each security represents the ownership ofa single cash flow from the mother bond
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Assume that 100MM USD of 15 year bondswith a coupon of 8 are placed with the SPV
The SPV can issue 6M 12M 18M extending up to14 frac12 year zeroes with a total face value of 4MM
USD eachAnd 15 year zeroes with a total face value of104MM
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The Treasury launched this program in 1985to facilitate the stripping of designatedsecurities
All new T-bonds and notes with a maturity of 10years or more are eligibleThe zeroes created in the process are directobligations of the US government
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The mechanism is as followsA dealer who owns a bond or note can ask theFRB where it is held
To replace it with an equivalent set of STRIPS
representing each payment as a separate securityEach of these securities can be traded independentlyof others
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In 1987 the Treasury started to allow dealersto reverse the process
This is called STRIPS RECONSTUTUTION If a dealer owns STRIPS representing all thecoupon and principal payments of a bond
The FED can on request convert these holdings into asingle position in the corresponding bond
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Each coupon and principal cash flow from aTreasury security is assigned a CUSIP
The mother bond is also assigned a CUSIPThe stripped coupons are known as C-STRIPSThe stripped principal is known as P-STRIPSSupply of a C-STRIP increases over time
because a C-STRIP maturing on a day like 15 FEB
2020 will have the same CUSIP irrespective ofwhich mother bond it has come fromThe original coupon rate is irrelevant
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P-STRIPS always correspond to the originalsecurityThey have a unique CUSIPTheir supply is fixed at the time of issuanceIn practice the prices of long-dated P-STRIPSare a bit higher than those of C-STRIPS withthe same maturity date
One reason is that P-STRIPS are more liquid due
to greater availabilityA $100 face value bond with a coupon of 8 willgenerate C-STRIPS with a face value of $4 but P-STRIPS with a face value of $100
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Another reason why P-STRIPS are in higherdemand is that they allow reconstitutionactivities more easily
Assume that the sum of the STRIPS is cheaper than
the mother bondIf a dealer already has the P-STRIPS only the C-STRIPSneed to be acquiredHowever if he owns some of the C-STRIPS he needs toacquire the P-STRIPS and the remaining C-STRIPSThe facility to reconstitute when profitable is pricedinto the P-STRIPSNote Buy and hold investors will prefer C-STRIPSsince they are priced lower and give a higher yield
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For Plain Vanilla bonds the specifiedcoupon rate is valid for the life of thebond
In the case of Floaters the rate is reset atthe beginning of every periodThe rate will vary directly with thebenchmark
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The rate on a Floater is specified as LIBOR+ 50 bp
The spread is positiveIf it were specified as LIBOR ndash 30bp
The spread will be negativeIf LIBOR rises the rate will increasewhereas if LIBOR falls it will decrease
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In the case of a default risk-free floater theprice will reset to par on a coupon date
It may sell at a premium or discount betweencoupon dates
Consider a floater with a coupon = 5-year T-Bond rate
Assume there are two periods left to maturity
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The price at the end of the first coupon period willbe given by
cT-1 is the coupon one period before maturityyT-1 is the YTM one period before maturity
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On a coupon reset date the YTM = couponBecause we have assumed there is no default riskAny change in the required yield as reflected inthe prevailing YTM
Will also be reflected in the coupon being setIf coupon = yield the bond should sell at par
Thus P T-1 = M
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Once again at T-2 c T-2 = yT-2 and P T-2 = MThis logic can be applied to a bond with anytime remaining till maturityHowever between two coupon dates theprice may not be equal to par
Consider the valuation at T-2+k
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Although c T-2 was set at T-2 and is equal toyT-2
yT-2+k is determined at T-2+k and will reflect theyield prevailing at that time
Thus yT-2+k need not equal c T-2 and may behigher or lower
Hence between two coupon dates a floater maysell at a premium or discount
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Now consider a floater characterized bydefault risk
The risk premium required by the market neednot be constant over time
Assume that at the time of issue YTM = 5-year T-note rate + 75bp
The coupon would have been set equal to thisrate and the bond would have been issued at par
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Six months hence the issue may be perceivedas more risky
YTM = 5-year T-note rate + 95 bpThe coupon will however be set equal to theprevailing 5-year rate + 75 bpIf so the issue will not reset to par at the nextcoupon date
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Floaters may come with a CAP or a FLOOR orBOTH
The CAP is a maximum coupon rateProtects issuers against rising rates
The FLOOR is a minimum coupon rateProtects investors against falling rates
When there is a spread over LIBORThere is a natural floorLIBOR cannot be less than zero
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JJ ndash 0115FA ndash 0115MS ndash 0115
AO ndash 0115MN ndash 0115JD ndash 0115
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In the example the price is less than theface value
Such a bond is called a Discount Bond
It is trading at a discount from the face valueThe reason is that
The yield is greater than the coupon
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If the yield were to equal the couponThe bond would sell at PARSuch bonds are called PAR Bonds
If the yield is less than the couponThe price will exceed the face valueSuch bonds are called Premium Bonds
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As we move from one coupon date to thenext if the YTM were to remain constant
Par bonds would continue to trade at PARPremium bonds will steadily decline in priceDiscount bonds will steadily increase in price
This is called the Pull to Par EffectAt maturity ndash ALL BONDS WILL TRADE AT PAR
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As we approach maturity the number ofcoupons reduces
The contribution of coupons to price reducesThe contribution of the PV of the face valueincreases
For premium bonds the first effect dominatesThus the price steadily declines
For discount bonds the second effectdominatesThus the price steadily increases
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A plain vanilla or Bullet Bond pays the entireface value at maturity in a lump sumAmortizing bonds pay the principal in
installmentsThe first payment occurs before maturityThe last payment is made at maturity
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Consider a 5 year amortizing bond with aface value of $1000 and an annual coupon of8
The annual cash flows are depicted below
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Time Cash Flow
1 802 803 3304 3105 540
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The first two cash flows represent interest ona principal of $1000The third cash flow is interest on $1000 plus
a principal payment of $250The outstanding principal is $750The fourth cash flow is interest on $750 plusa principal payment of $250
The outstanding principal is $500The final cash flow is interest on $500 plusthe remaining principal of $500
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Some companies issue such bonds becausethe assets being funded have a similar cashflow profile
Second the coupon on such a bond may belower than that of a bullet bondIn the case of a bullet bond the entire principalis due at a single point in timeThere is greater default risk
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Microsoft is issuing zeroes with 5 years tomaturity and a face value of $10000
The required yield is 10 per annumWhat should be the price
Price is the PV of the face valueIn practice we discount on a semi-annual basis
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This is to facilitate comparisons withconventional bonds
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A zero coupon bond can never sell at apremium
It will always trade at a discount prior tomaturityAt maturity it will trade at par
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If held to maturity a ZCB will always give riseto a capital gainIf sold prior to maturity there may be a
capital gain or a capital lossConsider a bond with 10 years to maturityThe YTM at the time of purchase was 10The cost was $37690
A year later it is sold at a YTM of 12The corresponding price is $35035
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A newly established issuerOr an issuer with a relatively virgin productor service
Or a restructured company due to a mergeror following a bankruptcyWill be perceived as more riskyInvestors will demand a high coupon
Such firms are unlikely to have high earningsRevenues will peak only after theproductservice is established
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They can ill afford high couponsThey may consider a step-up coupon bond
Where the coupon increases as the bond ages
Assume a company can issue a plain vanillaat a coupon of 8 with a maturity of 5 yearsInstead it may opt for a bond
With a coupon of 6 for the first three years
And a coupon of 10 for the last two yearsThis is a Deferred Interest Security
Provides the issuer with breathing room in theearlier years
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These pay coupons in the form of additionalsecurities and not cash
This offers the issuer time to prepare for cashoutlays
They are used as Mezzanine FinanceThey rank between senior debt and equity in thecapital structureInvestors take more risk as compared to buyersof regular bonds ndash but get higher returnsIssuers can conserve cash in earlier years when itis at a premium
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Fully backed by the federal government ofthe issuing nationConsequently they are virtually devoid ofcredit risk or the risk of defaultThe yield on such securities is a benchmarkfor setting rates on other kinds of debt
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Treasury securities are issuedTo finance expenses in excess of currentrevenuesTo pay interest on debt accumulated in earlieryears due to deficits in those yearsTo repay past debt issues that are currentlymaturing
The US Treasuries marketIs the largest bond market in the worldIs the most liquid bond market in the world
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The Treasury issues three categories ofmarketable securities
T-bills are discount securitiesThey are zero coupon securitiesT-notes and T-bonds are sold at face value andpay interest periodically
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T-bills are issued with a original time tomaturity of one year or less
They are Money market instrumentsThey have maturities of either 1 3 6 or 12months at the time of issue
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T-notes and T-bonds have a time to maturityexceeding one year at the time of issue
They are capital market instrumentsT-notes have maturities ranging from 1-10 yearsT-bonds have an original maturity in excess of 10years extending up to 30 years
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An issue may be followed later by a furtherissue
With the same remaining time to maturity andthe same couponThe issuance of further tranches is termed as aRe-opening
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Six months ago a 10-year note was issuedwith a coupon of 8 per annumToday if a note with 9 frac12 years to maturityand a coupon of 8 issued it will add to thepool that is already trading in the marketThus it is a re-opening of an existing issue
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Who is a primary dealerA PD is a dealer who is authorized to dealdirectly with the Central Bank of the countryIn the US a PD is a bank or securities broker-dealer that directly deals with the FRBNY
Importance of FRBNYIn India a PD deals directly with the RBI
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The Treasury sells bills notes and bonds byway of a competitive auction process
Most of the treasury securities are bought byprimary dealers
Individual investors submit non-competitive bidsand participate on a much smaller scale
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Bids may beCompetitive
Indicate price amp quantity or yield amp quantityNon-competitive
Indicate only quantity
Small investors and individualsgenerally submit non-competitive bids
A non-competitive bidder may not bid for more than$5MM worth of securities in a bill or bond auction
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Primary dealers bid for their accounts andon behalf of their clientsThey usually submit large competitive
bidsBids indicate the maximum price that the bidderis prepared to pay if it is a price based auctionOr the minimum yield that the bidder is
prepared to accept if it is a yield based auction
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The Treasury will net out the totalamount of non-competitive bids
The balance will be allocated to competitivebidders
There are two ways in which securitiescan be allotted
The multiple priceyield auction mechanism
French AuctionsThe uniform priceyield auction mechanism
Dutch Auctions
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Assume that the Treasury is offering 25billion dollars worth of T-bonds
2 billion dollars worth of non-competitive bidshave been receivedSo 23 billion dollars worth of bonds are availableto be offered to the competitive bidders
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There are six competitive bidders who havesubmitted the following yields
The bids have been arranged in ascending orderof yieldIn a price based auction the bids would havebeen arranged in descending order of price
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Bidder Bid Yield Bid Amount
Aggregate Amount
Alpha 5370 30 bn 30 bnBeta 5372 50 bn 80 bn
Gamma 5373 40 bn 12 bn
Delta 5375 80 bn 20 bnCharlie 5375 120 bn 32 bn
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The aggregate demand equals the amount onoffer at a yield of 5375A multiple yield auction will lead to thefollowing allocation
Alpha will get 3 bn at a yield of 5370Beta will get 5 bn at 5372Gamma will get 4 bn at 5373
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At a yield of 5375 we have only 11 bn left toallocateThere is a demand of 20 bn at this yield
8 bn from Delta and 12 bn from CharlieThus we will allocate 1120 = 55 to eachbidder at this yield
There will be pro-rata allocation
055 of 8 bn or 440 bn will go to Delta055 of 12 bn or 66 bn will go to Charlie
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The highest accepted yield is called the StopYield or High Yield
In this case it is 5375The ratio of bids received to the amountawarded is known as the bid to cover ratio
The higher the ratio the stronger is the auction
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Those who bid more than 5375 will getnothing and are said to be shutout of theauctionSince 1999 the US Treasury has beenconducting only uniform yield auctions
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WI stands for ndash When As and If IssuedThe when issued market is a market forforward trading of a bond
Which has been announced but not yet issuedTrades take place from the date ofannouncement until the actual issue date
Helps bidders to gauge the marketrsquos interestbefore the actual auction
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WI trading has ramifications for the biddingstrategies of market participantsTraders can take both long and shortpositions
Settlement is scheduled for the issue date
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It has a bearing on the outcome of theauction
It affects the strategy used by a bidder becauseit has an impact on his prior positionBidders who are long in the WI market enter theauction with a Long PositionThose who are short in the WI market enter theauction with a short position
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The WI market helps in price discoveryIt provides important information on
The strength of demand for the securityAnd on the disparity of biddersrsquo views
This help potential bidders to formulate theirstrategiesAt times a dealer may believe that he hasvery important private information
If so he may not participate in the WI market andwill directly enter the auction with bids based onhis knowledge
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On or before the date of the auction theissues trade on a yield basis
The actual price can be established only afterthe coupon is set
Starting with the day after the auctionSecurities are quoted on a price basis becausethe coupon is known
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In a coupon roll a dealer will purchase themost recently issued security from a clientAnd simultaneously sell the same amount ofthe recently announced new security
The first leg with settle on the following dayThe second leg is a forward contract
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There can be a Reverse RollThe dealer will sell the most recent issue fornext day settlementAnd buy the newly announced security forforward settlement
The forward leg in a RollReverse Roll is a WItrade
It will settle on the new issue settlement date
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The roll is the spread between the yield onthe new security and that on the outstandingissue in the same maturity segmentA GIVE in the Roll means that
The WI security provides a higher yield than theoutstanding issue
A Take in the Roll means thatThe WI security provides a lower yield
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On March 17 20XX the Treasury announcedthe auction of a 2-year note
The auction was scheduled for March 24The settlement date was March 31
Trading of the roll began as soon as the issuewas announcedA Give of 5 bp means that the dealer proposes tobuy the current issue at the prevailing yieldAnd sell the new issue at a yield that is 5 bpmoreA Take of 5 bp means that the dealer proposes tosell the new issue at a yield that is 5bp lower
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The roll achieves the followingHe acquires the outstanding issue for next daysettlementHe sells the to be issued security with the samepar value for forward delivery on 31 March
The customer is rolling over the investmentfrom the current issue to the new issue
This extends the maturity of the investment byone month
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The client can invest the funds received tillthe new issue settlesHowever he loses the accrued interest thathe would have earned had he held on to theissue
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The Treasury per se does not issue zerocoupon securitiesBut zero coupon securities can be created
which are backed by conventional bondsTake a large quantity of a T-note or bond andseparate all the cash flows from each otherSell the entitlement to each cash flowseparately
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Take the case of a two-year T-noteIt can be separated into five zero couponsecurities maturing after
6 months12 months18 months24 months
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Earlier investment banks used to buy bondsfrom the Treasury and separate the cashflows
Each cash flow was then sold separately as a zerocoupon bondSuch issues are called trademarks
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The issue of trademarks has now ceasedBecause investment banks can now createsuch instruments
In concert with the Treasury itselfThese ZCBs are known as STRIPS ndash
Separate Trading of Registered Interest andPrincipal of Securities
These are not issued or sold by the Treasury
The market is made by investment banks
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What is the motivation to create suchproductsIn practice arbitrage is possible when a
coupon security is purchased at a priceThat is lower than what could be obtained byselling each cash flow separately
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Coupon stripping reflects a case of financialengineering
Creating a risk-return profile that is nototherwise available
An investment bank would buy a largequantity of a Treasury security
The securities would be placed with an SPV
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The SPV is a single-purpose dedicated trustIt has the powers to own the bonds andcollect payments
It cannot sell or lend the bondsIt cannot write options on the bondsOr use them as collateral for borrowing
The SPV is empowered to issue zero coupon
bondsWhere each security represents the ownership ofa single cash flow from the mother bond
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Assume that 100MM USD of 15 year bondswith a coupon of 8 are placed with the SPV
The SPV can issue 6M 12M 18M extending up to14 frac12 year zeroes with a total face value of 4MM
USD eachAnd 15 year zeroes with a total face value of104MM
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The Treasury launched this program in 1985to facilitate the stripping of designatedsecurities
All new T-bonds and notes with a maturity of 10years or more are eligibleThe zeroes created in the process are directobligations of the US government
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The mechanism is as followsA dealer who owns a bond or note can ask theFRB where it is held
To replace it with an equivalent set of STRIPS
representing each payment as a separate securityEach of these securities can be traded independentlyof others
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In 1987 the Treasury started to allow dealersto reverse the process
This is called STRIPS RECONSTUTUTION If a dealer owns STRIPS representing all thecoupon and principal payments of a bond
The FED can on request convert these holdings into asingle position in the corresponding bond
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Each coupon and principal cash flow from aTreasury security is assigned a CUSIP
The mother bond is also assigned a CUSIPThe stripped coupons are known as C-STRIPSThe stripped principal is known as P-STRIPSSupply of a C-STRIP increases over time
because a C-STRIP maturing on a day like 15 FEB
2020 will have the same CUSIP irrespective ofwhich mother bond it has come fromThe original coupon rate is irrelevant
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P-STRIPS always correspond to the originalsecurityThey have a unique CUSIPTheir supply is fixed at the time of issuanceIn practice the prices of long-dated P-STRIPSare a bit higher than those of C-STRIPS withthe same maturity date
One reason is that P-STRIPS are more liquid due
to greater availabilityA $100 face value bond with a coupon of 8 willgenerate C-STRIPS with a face value of $4 but P-STRIPS with a face value of $100
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Another reason why P-STRIPS are in higherdemand is that they allow reconstitutionactivities more easily
Assume that the sum of the STRIPS is cheaper than
the mother bondIf a dealer already has the P-STRIPS only the C-STRIPSneed to be acquiredHowever if he owns some of the C-STRIPS he needs toacquire the P-STRIPS and the remaining C-STRIPSThe facility to reconstitute when profitable is pricedinto the P-STRIPSNote Buy and hold investors will prefer C-STRIPSsince they are priced lower and give a higher yield
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For Plain Vanilla bonds the specifiedcoupon rate is valid for the life of thebond
In the case of Floaters the rate is reset atthe beginning of every periodThe rate will vary directly with thebenchmark
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The rate on a Floater is specified as LIBOR+ 50 bp
The spread is positiveIf it were specified as LIBOR ndash 30bp
The spread will be negativeIf LIBOR rises the rate will increasewhereas if LIBOR falls it will decrease
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In the case of a default risk-free floater theprice will reset to par on a coupon date
It may sell at a premium or discount betweencoupon dates
Consider a floater with a coupon = 5-year T-Bond rate
Assume there are two periods left to maturity
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The price at the end of the first coupon period willbe given by
cT-1 is the coupon one period before maturityyT-1 is the YTM one period before maturity
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On a coupon reset date the YTM = couponBecause we have assumed there is no default riskAny change in the required yield as reflected inthe prevailing YTM
Will also be reflected in the coupon being setIf coupon = yield the bond should sell at par
Thus P T-1 = M
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Once again at T-2 c T-2 = yT-2 and P T-2 = MThis logic can be applied to a bond with anytime remaining till maturityHowever between two coupon dates theprice may not be equal to par
Consider the valuation at T-2+k
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Although c T-2 was set at T-2 and is equal toyT-2
yT-2+k is determined at T-2+k and will reflect theyield prevailing at that time
Thus yT-2+k need not equal c T-2 and may behigher or lower
Hence between two coupon dates a floater maysell at a premium or discount
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Now consider a floater characterized bydefault risk
The risk premium required by the market neednot be constant over time
Assume that at the time of issue YTM = 5-year T-note rate + 75bp
The coupon would have been set equal to thisrate and the bond would have been issued at par
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Six months hence the issue may be perceivedas more risky
YTM = 5-year T-note rate + 95 bpThe coupon will however be set equal to theprevailing 5-year rate + 75 bpIf so the issue will not reset to par at the nextcoupon date
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Floaters may come with a CAP or a FLOOR orBOTH
The CAP is a maximum coupon rateProtects issuers against rising rates
The FLOOR is a minimum coupon rateProtects investors against falling rates
When there is a spread over LIBORThere is a natural floorLIBOR cannot be less than zero
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In the example the price is less than theface value
Such a bond is called a Discount Bond
It is trading at a discount from the face valueThe reason is that
The yield is greater than the coupon
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If the yield were to equal the couponThe bond would sell at PARSuch bonds are called PAR Bonds
If the yield is less than the couponThe price will exceed the face valueSuch bonds are called Premium Bonds
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As we move from one coupon date to thenext if the YTM were to remain constant
Par bonds would continue to trade at PARPremium bonds will steadily decline in priceDiscount bonds will steadily increase in price
This is called the Pull to Par EffectAt maturity ndash ALL BONDS WILL TRADE AT PAR
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As we approach maturity the number ofcoupons reduces
The contribution of coupons to price reducesThe contribution of the PV of the face valueincreases
For premium bonds the first effect dominatesThus the price steadily declines
For discount bonds the second effectdominatesThus the price steadily increases
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A plain vanilla or Bullet Bond pays the entireface value at maturity in a lump sumAmortizing bonds pay the principal in
installmentsThe first payment occurs before maturityThe last payment is made at maturity
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Consider a 5 year amortizing bond with aface value of $1000 and an annual coupon of8
The annual cash flows are depicted below
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Time Cash Flow
1 802 803 3304 3105 540
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The first two cash flows represent interest ona principal of $1000The third cash flow is interest on $1000 plus
a principal payment of $250The outstanding principal is $750The fourth cash flow is interest on $750 plusa principal payment of $250
The outstanding principal is $500The final cash flow is interest on $500 plusthe remaining principal of $500
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Some companies issue such bonds becausethe assets being funded have a similar cashflow profile
Second the coupon on such a bond may belower than that of a bullet bondIn the case of a bullet bond the entire principalis due at a single point in timeThere is greater default risk
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Microsoft is issuing zeroes with 5 years tomaturity and a face value of $10000
The required yield is 10 per annumWhat should be the price
Price is the PV of the face valueIn practice we discount on a semi-annual basis
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This is to facilitate comparisons withconventional bonds
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A zero coupon bond can never sell at apremium
It will always trade at a discount prior tomaturityAt maturity it will trade at par
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If held to maturity a ZCB will always give riseto a capital gainIf sold prior to maturity there may be a
capital gain or a capital lossConsider a bond with 10 years to maturityThe YTM at the time of purchase was 10The cost was $37690
A year later it is sold at a YTM of 12The corresponding price is $35035
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A newly established issuerOr an issuer with a relatively virgin productor service
Or a restructured company due to a mergeror following a bankruptcyWill be perceived as more riskyInvestors will demand a high coupon
Such firms are unlikely to have high earningsRevenues will peak only after theproductservice is established
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They can ill afford high couponsThey may consider a step-up coupon bond
Where the coupon increases as the bond ages
Assume a company can issue a plain vanillaat a coupon of 8 with a maturity of 5 yearsInstead it may opt for a bond
With a coupon of 6 for the first three years
And a coupon of 10 for the last two yearsThis is a Deferred Interest Security
Provides the issuer with breathing room in theearlier years
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These pay coupons in the form of additionalsecurities and not cash
This offers the issuer time to prepare for cashoutlays
They are used as Mezzanine FinanceThey rank between senior debt and equity in thecapital structureInvestors take more risk as compared to buyersof regular bonds ndash but get higher returnsIssuers can conserve cash in earlier years when itis at a premium
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Fully backed by the federal government ofthe issuing nationConsequently they are virtually devoid ofcredit risk or the risk of defaultThe yield on such securities is a benchmarkfor setting rates on other kinds of debt
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Treasury securities are issuedTo finance expenses in excess of currentrevenuesTo pay interest on debt accumulated in earlieryears due to deficits in those yearsTo repay past debt issues that are currentlymaturing
The US Treasuries marketIs the largest bond market in the worldIs the most liquid bond market in the world
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The Treasury issues three categories ofmarketable securities
T-bills are discount securitiesThey are zero coupon securitiesT-notes and T-bonds are sold at face value andpay interest periodically
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T-bills are issued with a original time tomaturity of one year or less
They are Money market instrumentsThey have maturities of either 1 3 6 or 12months at the time of issue
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T-notes and T-bonds have a time to maturityexceeding one year at the time of issue
They are capital market instrumentsT-notes have maturities ranging from 1-10 yearsT-bonds have an original maturity in excess of 10years extending up to 30 years
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An issue may be followed later by a furtherissue
With the same remaining time to maturity andthe same couponThe issuance of further tranches is termed as aRe-opening
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Six months ago a 10-year note was issuedwith a coupon of 8 per annumToday if a note with 9 frac12 years to maturityand a coupon of 8 issued it will add to thepool that is already trading in the marketThus it is a re-opening of an existing issue
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Who is a primary dealerA PD is a dealer who is authorized to dealdirectly with the Central Bank of the countryIn the US a PD is a bank or securities broker-dealer that directly deals with the FRBNY
Importance of FRBNYIn India a PD deals directly with the RBI
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The Treasury sells bills notes and bonds byway of a competitive auction process
Most of the treasury securities are bought byprimary dealers
Individual investors submit non-competitive bidsand participate on a much smaller scale
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Bids may beCompetitive
Indicate price amp quantity or yield amp quantityNon-competitive
Indicate only quantity
Small investors and individualsgenerally submit non-competitive bids
A non-competitive bidder may not bid for more than$5MM worth of securities in a bill or bond auction
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Primary dealers bid for their accounts andon behalf of their clientsThey usually submit large competitive
bidsBids indicate the maximum price that the bidderis prepared to pay if it is a price based auctionOr the minimum yield that the bidder is
prepared to accept if it is a yield based auction
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The Treasury will net out the totalamount of non-competitive bids
The balance will be allocated to competitivebidders
There are two ways in which securitiescan be allotted
The multiple priceyield auction mechanism
French AuctionsThe uniform priceyield auction mechanism
Dutch Auctions
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Assume that the Treasury is offering 25billion dollars worth of T-bonds
2 billion dollars worth of non-competitive bidshave been receivedSo 23 billion dollars worth of bonds are availableto be offered to the competitive bidders
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There are six competitive bidders who havesubmitted the following yields
The bids have been arranged in ascending orderof yieldIn a price based auction the bids would havebeen arranged in descending order of price
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Bidder Bid Yield Bid Amount
Aggregate Amount
Alpha 5370 30 bn 30 bnBeta 5372 50 bn 80 bn
Gamma 5373 40 bn 12 bn
Delta 5375 80 bn 20 bnCharlie 5375 120 bn 32 bn
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The aggregate demand equals the amount onoffer at a yield of 5375A multiple yield auction will lead to thefollowing allocation
Alpha will get 3 bn at a yield of 5370Beta will get 5 bn at 5372Gamma will get 4 bn at 5373
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At a yield of 5375 we have only 11 bn left toallocateThere is a demand of 20 bn at this yield
8 bn from Delta and 12 bn from CharlieThus we will allocate 1120 = 55 to eachbidder at this yield
There will be pro-rata allocation
055 of 8 bn or 440 bn will go to Delta055 of 12 bn or 66 bn will go to Charlie
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The highest accepted yield is called the StopYield or High Yield
In this case it is 5375The ratio of bids received to the amountawarded is known as the bid to cover ratio
The higher the ratio the stronger is the auction
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Those who bid more than 5375 will getnothing and are said to be shutout of theauctionSince 1999 the US Treasury has beenconducting only uniform yield auctions
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WI stands for ndash When As and If IssuedThe when issued market is a market forforward trading of a bond
Which has been announced but not yet issuedTrades take place from the date ofannouncement until the actual issue date
Helps bidders to gauge the marketrsquos interestbefore the actual auction
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WI trading has ramifications for the biddingstrategies of market participantsTraders can take both long and shortpositions
Settlement is scheduled for the issue date
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It has a bearing on the outcome of theauction
It affects the strategy used by a bidder becauseit has an impact on his prior positionBidders who are long in the WI market enter theauction with a Long PositionThose who are short in the WI market enter theauction with a short position
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The WI market helps in price discoveryIt provides important information on
The strength of demand for the securityAnd on the disparity of biddersrsquo views
This help potential bidders to formulate theirstrategiesAt times a dealer may believe that he hasvery important private information
If so he may not participate in the WI market andwill directly enter the auction with bids based onhis knowledge
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On or before the date of the auction theissues trade on a yield basis
The actual price can be established only afterthe coupon is set
Starting with the day after the auctionSecurities are quoted on a price basis becausethe coupon is known
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In a coupon roll a dealer will purchase themost recently issued security from a clientAnd simultaneously sell the same amount ofthe recently announced new security
The first leg with settle on the following dayThe second leg is a forward contract
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There can be a Reverse RollThe dealer will sell the most recent issue fornext day settlementAnd buy the newly announced security forforward settlement
The forward leg in a RollReverse Roll is a WItrade
It will settle on the new issue settlement date
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The roll is the spread between the yield onthe new security and that on the outstandingissue in the same maturity segmentA GIVE in the Roll means that
The WI security provides a higher yield than theoutstanding issue
A Take in the Roll means thatThe WI security provides a lower yield
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On March 17 20XX the Treasury announcedthe auction of a 2-year note
The auction was scheduled for March 24The settlement date was March 31
Trading of the roll began as soon as the issuewas announcedA Give of 5 bp means that the dealer proposes tobuy the current issue at the prevailing yieldAnd sell the new issue at a yield that is 5 bpmoreA Take of 5 bp means that the dealer proposes tosell the new issue at a yield that is 5bp lower
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The roll achieves the followingHe acquires the outstanding issue for next daysettlementHe sells the to be issued security with the samepar value for forward delivery on 31 March
The customer is rolling over the investmentfrom the current issue to the new issue
This extends the maturity of the investment byone month
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The client can invest the funds received tillthe new issue settlesHowever he loses the accrued interest thathe would have earned had he held on to theissue
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The Treasury per se does not issue zerocoupon securitiesBut zero coupon securities can be created
which are backed by conventional bondsTake a large quantity of a T-note or bond andseparate all the cash flows from each otherSell the entitlement to each cash flowseparately
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Take the case of a two-year T-noteIt can be separated into five zero couponsecurities maturing after
6 months12 months18 months24 months
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Earlier investment banks used to buy bondsfrom the Treasury and separate the cashflows
Each cash flow was then sold separately as a zerocoupon bondSuch issues are called trademarks
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The issue of trademarks has now ceasedBecause investment banks can now createsuch instruments
In concert with the Treasury itselfThese ZCBs are known as STRIPS ndash
Separate Trading of Registered Interest andPrincipal of Securities
These are not issued or sold by the Treasury
The market is made by investment banks
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What is the motivation to create suchproductsIn practice arbitrage is possible when a
coupon security is purchased at a priceThat is lower than what could be obtained byselling each cash flow separately
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Coupon stripping reflects a case of financialengineering
Creating a risk-return profile that is nototherwise available
An investment bank would buy a largequantity of a Treasury security
The securities would be placed with an SPV
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The SPV is a single-purpose dedicated trustIt has the powers to own the bonds andcollect payments
It cannot sell or lend the bondsIt cannot write options on the bondsOr use them as collateral for borrowing
The SPV is empowered to issue zero coupon
bondsWhere each security represents the ownership ofa single cash flow from the mother bond
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Assume that 100MM USD of 15 year bondswith a coupon of 8 are placed with the SPV
The SPV can issue 6M 12M 18M extending up to14 frac12 year zeroes with a total face value of 4MM
USD eachAnd 15 year zeroes with a total face value of104MM
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The Treasury launched this program in 1985to facilitate the stripping of designatedsecurities
All new T-bonds and notes with a maturity of 10years or more are eligibleThe zeroes created in the process are directobligations of the US government
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The mechanism is as followsA dealer who owns a bond or note can ask theFRB where it is held
To replace it with an equivalent set of STRIPS
representing each payment as a separate securityEach of these securities can be traded independentlyof others
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In 1987 the Treasury started to allow dealersto reverse the process
This is called STRIPS RECONSTUTUTION If a dealer owns STRIPS representing all thecoupon and principal payments of a bond
The FED can on request convert these holdings into asingle position in the corresponding bond
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Each coupon and principal cash flow from aTreasury security is assigned a CUSIP
The mother bond is also assigned a CUSIPThe stripped coupons are known as C-STRIPSThe stripped principal is known as P-STRIPSSupply of a C-STRIP increases over time
because a C-STRIP maturing on a day like 15 FEB
2020 will have the same CUSIP irrespective ofwhich mother bond it has come fromThe original coupon rate is irrelevant
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P-STRIPS always correspond to the originalsecurityThey have a unique CUSIPTheir supply is fixed at the time of issuanceIn practice the prices of long-dated P-STRIPSare a bit higher than those of C-STRIPS withthe same maturity date
One reason is that P-STRIPS are more liquid due
to greater availabilityA $100 face value bond with a coupon of 8 willgenerate C-STRIPS with a face value of $4 but P-STRIPS with a face value of $100
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Another reason why P-STRIPS are in higherdemand is that they allow reconstitutionactivities more easily
Assume that the sum of the STRIPS is cheaper than
the mother bondIf a dealer already has the P-STRIPS only the C-STRIPSneed to be acquiredHowever if he owns some of the C-STRIPS he needs toacquire the P-STRIPS and the remaining C-STRIPSThe facility to reconstitute when profitable is pricedinto the P-STRIPSNote Buy and hold investors will prefer C-STRIPSsince they are priced lower and give a higher yield
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For Plain Vanilla bonds the specifiedcoupon rate is valid for the life of thebond
In the case of Floaters the rate is reset atthe beginning of every periodThe rate will vary directly with thebenchmark
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The rate on a Floater is specified as LIBOR+ 50 bp
The spread is positiveIf it were specified as LIBOR ndash 30bp
The spread will be negativeIf LIBOR rises the rate will increasewhereas if LIBOR falls it will decrease
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In the case of a default risk-free floater theprice will reset to par on a coupon date
It may sell at a premium or discount betweencoupon dates
Consider a floater with a coupon = 5-year T-Bond rate
Assume there are two periods left to maturity
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The price at the end of the first coupon period willbe given by
cT-1 is the coupon one period before maturityyT-1 is the YTM one period before maturity
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On a coupon reset date the YTM = couponBecause we have assumed there is no default riskAny change in the required yield as reflected inthe prevailing YTM
Will also be reflected in the coupon being setIf coupon = yield the bond should sell at par
Thus P T-1 = M
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Once again at T-2 c T-2 = yT-2 and P T-2 = MThis logic can be applied to a bond with anytime remaining till maturityHowever between two coupon dates theprice may not be equal to par
Consider the valuation at T-2+k
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Although c T-2 was set at T-2 and is equal toyT-2
yT-2+k is determined at T-2+k and will reflect theyield prevailing at that time
Thus yT-2+k need not equal c T-2 and may behigher or lower
Hence between two coupon dates a floater maysell at a premium or discount
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Now consider a floater characterized bydefault risk
The risk premium required by the market neednot be constant over time
Assume that at the time of issue YTM = 5-year T-note rate + 75bp
The coupon would have been set equal to thisrate and the bond would have been issued at par
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Six months hence the issue may be perceivedas more risky
YTM = 5-year T-note rate + 95 bpThe coupon will however be set equal to theprevailing 5-year rate + 75 bpIf so the issue will not reset to par at the nextcoupon date
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Floaters may come with a CAP or a FLOOR orBOTH
The CAP is a maximum coupon rateProtects issuers against rising rates
The FLOOR is a minimum coupon rateProtects investors against falling rates
When there is a spread over LIBORThere is a natural floorLIBOR cannot be less than zero
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In the example the price is less than theface value
Such a bond is called a Discount Bond
It is trading at a discount from the face valueThe reason is that
The yield is greater than the coupon
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If the yield were to equal the couponThe bond would sell at PARSuch bonds are called PAR Bonds
If the yield is less than the couponThe price will exceed the face valueSuch bonds are called Premium Bonds
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As we move from one coupon date to thenext if the YTM were to remain constant
Par bonds would continue to trade at PARPremium bonds will steadily decline in priceDiscount bonds will steadily increase in price
This is called the Pull to Par EffectAt maturity ndash ALL BONDS WILL TRADE AT PAR
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As we approach maturity the number ofcoupons reduces
The contribution of coupons to price reducesThe contribution of the PV of the face valueincreases
For premium bonds the first effect dominatesThus the price steadily declines
For discount bonds the second effectdominatesThus the price steadily increases
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A plain vanilla or Bullet Bond pays the entireface value at maturity in a lump sumAmortizing bonds pay the principal in
installmentsThe first payment occurs before maturityThe last payment is made at maturity
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Consider a 5 year amortizing bond with aface value of $1000 and an annual coupon of8
The annual cash flows are depicted below
8282014 40
Time Cash Flow
1 802 803 3304 3105 540
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The first two cash flows represent interest ona principal of $1000The third cash flow is interest on $1000 plus
a principal payment of $250The outstanding principal is $750The fourth cash flow is interest on $750 plusa principal payment of $250
The outstanding principal is $500The final cash flow is interest on $500 plusthe remaining principal of $500
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Some companies issue such bonds becausethe assets being funded have a similar cashflow profile
Second the coupon on such a bond may belower than that of a bullet bondIn the case of a bullet bond the entire principalis due at a single point in timeThere is greater default risk
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Microsoft is issuing zeroes with 5 years tomaturity and a face value of $10000
The required yield is 10 per annumWhat should be the price
Price is the PV of the face valueIn practice we discount on a semi-annual basis
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This is to facilitate comparisons withconventional bonds
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A zero coupon bond can never sell at apremium
It will always trade at a discount prior tomaturityAt maturity it will trade at par
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If held to maturity a ZCB will always give riseto a capital gainIf sold prior to maturity there may be a
capital gain or a capital lossConsider a bond with 10 years to maturityThe YTM at the time of purchase was 10The cost was $37690
A year later it is sold at a YTM of 12The corresponding price is $35035
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A newly established issuerOr an issuer with a relatively virgin productor service
Or a restructured company due to a mergeror following a bankruptcyWill be perceived as more riskyInvestors will demand a high coupon
Such firms are unlikely to have high earningsRevenues will peak only after theproductservice is established
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They can ill afford high couponsThey may consider a step-up coupon bond
Where the coupon increases as the bond ages
Assume a company can issue a plain vanillaat a coupon of 8 with a maturity of 5 yearsInstead it may opt for a bond
With a coupon of 6 for the first three years
And a coupon of 10 for the last two yearsThis is a Deferred Interest Security
Provides the issuer with breathing room in theearlier years
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These pay coupons in the form of additionalsecurities and not cash
This offers the issuer time to prepare for cashoutlays
They are used as Mezzanine FinanceThey rank between senior debt and equity in thecapital structureInvestors take more risk as compared to buyersof regular bonds ndash but get higher returnsIssuers can conserve cash in earlier years when itis at a premium
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Fully backed by the federal government ofthe issuing nationConsequently they are virtually devoid ofcredit risk or the risk of defaultThe yield on such securities is a benchmarkfor setting rates on other kinds of debt
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Treasury securities are issuedTo finance expenses in excess of currentrevenuesTo pay interest on debt accumulated in earlieryears due to deficits in those yearsTo repay past debt issues that are currentlymaturing
The US Treasuries marketIs the largest bond market in the worldIs the most liquid bond market in the world
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The Treasury issues three categories ofmarketable securities
T-bills are discount securitiesThey are zero coupon securitiesT-notes and T-bonds are sold at face value andpay interest periodically
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T-bills are issued with a original time tomaturity of one year or less
They are Money market instrumentsThey have maturities of either 1 3 6 or 12months at the time of issue
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T-notes and T-bonds have a time to maturityexceeding one year at the time of issue
They are capital market instrumentsT-notes have maturities ranging from 1-10 yearsT-bonds have an original maturity in excess of 10years extending up to 30 years
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An issue may be followed later by a furtherissue
With the same remaining time to maturity andthe same couponThe issuance of further tranches is termed as aRe-opening
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Six months ago a 10-year note was issuedwith a coupon of 8 per annumToday if a note with 9 frac12 years to maturityand a coupon of 8 issued it will add to thepool that is already trading in the marketThus it is a re-opening of an existing issue
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Who is a primary dealerA PD is a dealer who is authorized to dealdirectly with the Central Bank of the countryIn the US a PD is a bank or securities broker-dealer that directly deals with the FRBNY
Importance of FRBNYIn India a PD deals directly with the RBI
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The Treasury sells bills notes and bonds byway of a competitive auction process
Most of the treasury securities are bought byprimary dealers
Individual investors submit non-competitive bidsand participate on a much smaller scale
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Bids may beCompetitive
Indicate price amp quantity or yield amp quantityNon-competitive
Indicate only quantity
Small investors and individualsgenerally submit non-competitive bids
A non-competitive bidder may not bid for more than$5MM worth of securities in a bill or bond auction
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Primary dealers bid for their accounts andon behalf of their clientsThey usually submit large competitive
bidsBids indicate the maximum price that the bidderis prepared to pay if it is a price based auctionOr the minimum yield that the bidder is
prepared to accept if it is a yield based auction
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The Treasury will net out the totalamount of non-competitive bids
The balance will be allocated to competitivebidders
There are two ways in which securitiescan be allotted
The multiple priceyield auction mechanism
French AuctionsThe uniform priceyield auction mechanism
Dutch Auctions
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Assume that the Treasury is offering 25billion dollars worth of T-bonds
2 billion dollars worth of non-competitive bidshave been receivedSo 23 billion dollars worth of bonds are availableto be offered to the competitive bidders
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There are six competitive bidders who havesubmitted the following yields
The bids have been arranged in ascending orderof yieldIn a price based auction the bids would havebeen arranged in descending order of price
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Bidder Bid Yield Bid Amount
Aggregate Amount
Alpha 5370 30 bn 30 bnBeta 5372 50 bn 80 bn
Gamma 5373 40 bn 12 bn
Delta 5375 80 bn 20 bnCharlie 5375 120 bn 32 bn
Tango 5380 30 bn 35 bn8282014 69
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The aggregate demand equals the amount onoffer at a yield of 5375A multiple yield auction will lead to thefollowing allocation
Alpha will get 3 bn at a yield of 5370Beta will get 5 bn at 5372Gamma will get 4 bn at 5373
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At a yield of 5375 we have only 11 bn left toallocateThere is a demand of 20 bn at this yield
8 bn from Delta and 12 bn from CharlieThus we will allocate 1120 = 55 to eachbidder at this yield
There will be pro-rata allocation
055 of 8 bn or 440 bn will go to Delta055 of 12 bn or 66 bn will go to Charlie
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The highest accepted yield is called the StopYield or High Yield
In this case it is 5375The ratio of bids received to the amountawarded is known as the bid to cover ratio
The higher the ratio the stronger is the auction
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Those who bid more than 5375 will getnothing and are said to be shutout of theauctionSince 1999 the US Treasury has beenconducting only uniform yield auctions
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WI stands for ndash When As and If IssuedThe when issued market is a market forforward trading of a bond
Which has been announced but not yet issuedTrades take place from the date ofannouncement until the actual issue date
Helps bidders to gauge the marketrsquos interestbefore the actual auction
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WI trading has ramifications for the biddingstrategies of market participantsTraders can take both long and shortpositions
Settlement is scheduled for the issue date
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It has a bearing on the outcome of theauction
It affects the strategy used by a bidder becauseit has an impact on his prior positionBidders who are long in the WI market enter theauction with a Long PositionThose who are short in the WI market enter theauction with a short position
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The WI market helps in price discoveryIt provides important information on
The strength of demand for the securityAnd on the disparity of biddersrsquo views
This help potential bidders to formulate theirstrategiesAt times a dealer may believe that he hasvery important private information
If so he may not participate in the WI market andwill directly enter the auction with bids based onhis knowledge
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On or before the date of the auction theissues trade on a yield basis
The actual price can be established only afterthe coupon is set
Starting with the day after the auctionSecurities are quoted on a price basis becausethe coupon is known
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In a coupon roll a dealer will purchase themost recently issued security from a clientAnd simultaneously sell the same amount ofthe recently announced new security
The first leg with settle on the following dayThe second leg is a forward contract
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There can be a Reverse RollThe dealer will sell the most recent issue fornext day settlementAnd buy the newly announced security forforward settlement
The forward leg in a RollReverse Roll is a WItrade
It will settle on the new issue settlement date
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The roll is the spread between the yield onthe new security and that on the outstandingissue in the same maturity segmentA GIVE in the Roll means that
The WI security provides a higher yield than theoutstanding issue
A Take in the Roll means thatThe WI security provides a lower yield
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On March 17 20XX the Treasury announcedthe auction of a 2-year note
The auction was scheduled for March 24The settlement date was March 31
Trading of the roll began as soon as the issuewas announcedA Give of 5 bp means that the dealer proposes tobuy the current issue at the prevailing yieldAnd sell the new issue at a yield that is 5 bpmoreA Take of 5 bp means that the dealer proposes tosell the new issue at a yield that is 5bp lower
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The roll achieves the followingHe acquires the outstanding issue for next daysettlementHe sells the to be issued security with the samepar value for forward delivery on 31 March
The customer is rolling over the investmentfrom the current issue to the new issue
This extends the maturity of the investment byone month
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The client can invest the funds received tillthe new issue settlesHowever he loses the accrued interest thathe would have earned had he held on to theissue
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The Treasury per se does not issue zerocoupon securitiesBut zero coupon securities can be created
which are backed by conventional bondsTake a large quantity of a T-note or bond andseparate all the cash flows from each otherSell the entitlement to each cash flowseparately
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Take the case of a two-year T-noteIt can be separated into five zero couponsecurities maturing after
6 months12 months18 months24 months
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Earlier investment banks used to buy bondsfrom the Treasury and separate the cashflows
Each cash flow was then sold separately as a zerocoupon bondSuch issues are called trademarks
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The issue of trademarks has now ceasedBecause investment banks can now createsuch instruments
In concert with the Treasury itselfThese ZCBs are known as STRIPS ndash
Separate Trading of Registered Interest andPrincipal of Securities
These are not issued or sold by the Treasury
The market is made by investment banks
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What is the motivation to create suchproductsIn practice arbitrage is possible when a
coupon security is purchased at a priceThat is lower than what could be obtained byselling each cash flow separately
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Coupon stripping reflects a case of financialengineering
Creating a risk-return profile that is nototherwise available
An investment bank would buy a largequantity of a Treasury security
The securities would be placed with an SPV
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The SPV is a single-purpose dedicated trustIt has the powers to own the bonds andcollect payments
It cannot sell or lend the bondsIt cannot write options on the bondsOr use them as collateral for borrowing
The SPV is empowered to issue zero coupon
bondsWhere each security represents the ownership ofa single cash flow from the mother bond
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Assume that 100MM USD of 15 year bondswith a coupon of 8 are placed with the SPV
The SPV can issue 6M 12M 18M extending up to14 frac12 year zeroes with a total face value of 4MM
USD eachAnd 15 year zeroes with a total face value of104MM
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The Treasury launched this program in 1985to facilitate the stripping of designatedsecurities
All new T-bonds and notes with a maturity of 10years or more are eligibleThe zeroes created in the process are directobligations of the US government
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The mechanism is as followsA dealer who owns a bond or note can ask theFRB where it is held
To replace it with an equivalent set of STRIPS
representing each payment as a separate securityEach of these securities can be traded independentlyof others
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In 1987 the Treasury started to allow dealersto reverse the process
This is called STRIPS RECONSTUTUTION If a dealer owns STRIPS representing all thecoupon and principal payments of a bond
The FED can on request convert these holdings into asingle position in the corresponding bond
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Each coupon and principal cash flow from aTreasury security is assigned a CUSIP
The mother bond is also assigned a CUSIPThe stripped coupons are known as C-STRIPSThe stripped principal is known as P-STRIPSSupply of a C-STRIP increases over time
because a C-STRIP maturing on a day like 15 FEB
2020 will have the same CUSIP irrespective ofwhich mother bond it has come fromThe original coupon rate is irrelevant
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P-STRIPS always correspond to the originalsecurityThey have a unique CUSIPTheir supply is fixed at the time of issuanceIn practice the prices of long-dated P-STRIPSare a bit higher than those of C-STRIPS withthe same maturity date
One reason is that P-STRIPS are more liquid due
to greater availabilityA $100 face value bond with a coupon of 8 willgenerate C-STRIPS with a face value of $4 but P-STRIPS with a face value of $100
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Another reason why P-STRIPS are in higherdemand is that they allow reconstitutionactivities more easily
Assume that the sum of the STRIPS is cheaper than
the mother bondIf a dealer already has the P-STRIPS only the C-STRIPSneed to be acquiredHowever if he owns some of the C-STRIPS he needs toacquire the P-STRIPS and the remaining C-STRIPSThe facility to reconstitute when profitable is pricedinto the P-STRIPSNote Buy and hold investors will prefer C-STRIPSsince they are priced lower and give a higher yield
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For Plain Vanilla bonds the specifiedcoupon rate is valid for the life of thebond
In the case of Floaters the rate is reset atthe beginning of every periodThe rate will vary directly with thebenchmark
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The rate on a Floater is specified as LIBOR+ 50 bp
The spread is positiveIf it were specified as LIBOR ndash 30bp
The spread will be negativeIf LIBOR rises the rate will increasewhereas if LIBOR falls it will decrease
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In the case of a default risk-free floater theprice will reset to par on a coupon date
It may sell at a premium or discount betweencoupon dates
Consider a floater with a coupon = 5-year T-Bond rate
Assume there are two periods left to maturity
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The price at the end of the first coupon period willbe given by
cT-1 is the coupon one period before maturityyT-1 is the YTM one period before maturity
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On a coupon reset date the YTM = couponBecause we have assumed there is no default riskAny change in the required yield as reflected inthe prevailing YTM
Will also be reflected in the coupon being setIf coupon = yield the bond should sell at par
Thus P T-1 = M
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Once again at T-2 c T-2 = yT-2 and P T-2 = MThis logic can be applied to a bond with anytime remaining till maturityHowever between two coupon dates theprice may not be equal to par
Consider the valuation at T-2+k
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Although c T-2 was set at T-2 and is equal toyT-2
yT-2+k is determined at T-2+k and will reflect theyield prevailing at that time
Thus yT-2+k need not equal c T-2 and may behigher or lower
Hence between two coupon dates a floater maysell at a premium or discount
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Now consider a floater characterized bydefault risk
The risk premium required by the market neednot be constant over time
Assume that at the time of issue YTM = 5-year T-note rate + 75bp
The coupon would have been set equal to thisrate and the bond would have been issued at par
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Six months hence the issue may be perceivedas more risky
YTM = 5-year T-note rate + 95 bpThe coupon will however be set equal to theprevailing 5-year rate + 75 bpIf so the issue will not reset to par at the nextcoupon date
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Floaters may come with a CAP or a FLOOR orBOTH
The CAP is a maximum coupon rateProtects issuers against rising rates
The FLOOR is a minimum coupon rateProtects investors against falling rates
When there is a spread over LIBORThere is a natural floorLIBOR cannot be less than zero
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If the yield were to equal the couponThe bond would sell at PARSuch bonds are called PAR Bonds
If the yield is less than the couponThe price will exceed the face valueSuch bonds are called Premium Bonds
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As we move from one coupon date to thenext if the YTM were to remain constant
Par bonds would continue to trade at PARPremium bonds will steadily decline in priceDiscount bonds will steadily increase in price
This is called the Pull to Par EffectAt maturity ndash ALL BONDS WILL TRADE AT PAR
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As we approach maturity the number ofcoupons reduces
The contribution of coupons to price reducesThe contribution of the PV of the face valueincreases
For premium bonds the first effect dominatesThus the price steadily declines
For discount bonds the second effectdominatesThus the price steadily increases
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A plain vanilla or Bullet Bond pays the entireface value at maturity in a lump sumAmortizing bonds pay the principal in
installmentsThe first payment occurs before maturityThe last payment is made at maturity
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Consider a 5 year amortizing bond with aface value of $1000 and an annual coupon of8
The annual cash flows are depicted below
8282014 40
Time Cash Flow
1 802 803 3304 3105 540
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The first two cash flows represent interest ona principal of $1000The third cash flow is interest on $1000 plus
a principal payment of $250The outstanding principal is $750The fourth cash flow is interest on $750 plusa principal payment of $250
The outstanding principal is $500The final cash flow is interest on $500 plusthe remaining principal of $500
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Some companies issue such bonds becausethe assets being funded have a similar cashflow profile
Second the coupon on such a bond may belower than that of a bullet bondIn the case of a bullet bond the entire principalis due at a single point in timeThere is greater default risk
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Microsoft is issuing zeroes with 5 years tomaturity and a face value of $10000
The required yield is 10 per annumWhat should be the price
Price is the PV of the face valueIn practice we discount on a semi-annual basis
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This is to facilitate comparisons withconventional bonds
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A zero coupon bond can never sell at apremium
It will always trade at a discount prior tomaturityAt maturity it will trade at par
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If held to maturity a ZCB will always give riseto a capital gainIf sold prior to maturity there may be a
capital gain or a capital lossConsider a bond with 10 years to maturityThe YTM at the time of purchase was 10The cost was $37690
A year later it is sold at a YTM of 12The corresponding price is $35035
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A newly established issuerOr an issuer with a relatively virgin productor service
Or a restructured company due to a mergeror following a bankruptcyWill be perceived as more riskyInvestors will demand a high coupon
Such firms are unlikely to have high earningsRevenues will peak only after theproductservice is established
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They can ill afford high couponsThey may consider a step-up coupon bond
Where the coupon increases as the bond ages
Assume a company can issue a plain vanillaat a coupon of 8 with a maturity of 5 yearsInstead it may opt for a bond
With a coupon of 6 for the first three years
And a coupon of 10 for the last two yearsThis is a Deferred Interest Security
Provides the issuer with breathing room in theearlier years
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These pay coupons in the form of additionalsecurities and not cash
This offers the issuer time to prepare for cashoutlays
They are used as Mezzanine FinanceThey rank between senior debt and equity in thecapital structureInvestors take more risk as compared to buyersof regular bonds ndash but get higher returnsIssuers can conserve cash in earlier years when itis at a premium
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Fully backed by the federal government ofthe issuing nationConsequently they are virtually devoid ofcredit risk or the risk of defaultThe yield on such securities is a benchmarkfor setting rates on other kinds of debt
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Treasury securities are issuedTo finance expenses in excess of currentrevenuesTo pay interest on debt accumulated in earlieryears due to deficits in those yearsTo repay past debt issues that are currentlymaturing
The US Treasuries marketIs the largest bond market in the worldIs the most liquid bond market in the world
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The Treasury issues three categories ofmarketable securities
T-bills are discount securitiesThey are zero coupon securitiesT-notes and T-bonds are sold at face value andpay interest periodically
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T-bills are issued with a original time tomaturity of one year or less
They are Money market instrumentsThey have maturities of either 1 3 6 or 12months at the time of issue
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T-notes and T-bonds have a time to maturityexceeding one year at the time of issue
They are capital market instrumentsT-notes have maturities ranging from 1-10 yearsT-bonds have an original maturity in excess of 10years extending up to 30 years
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An issue may be followed later by a furtherissue
With the same remaining time to maturity andthe same couponThe issuance of further tranches is termed as aRe-opening
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Six months ago a 10-year note was issuedwith a coupon of 8 per annumToday if a note with 9 frac12 years to maturityand a coupon of 8 issued it will add to thepool that is already trading in the marketThus it is a re-opening of an existing issue
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Who is a primary dealerA PD is a dealer who is authorized to dealdirectly with the Central Bank of the countryIn the US a PD is a bank or securities broker-dealer that directly deals with the FRBNY
Importance of FRBNYIn India a PD deals directly with the RBI
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The Treasury sells bills notes and bonds byway of a competitive auction process
Most of the treasury securities are bought byprimary dealers
Individual investors submit non-competitive bidsand participate on a much smaller scale
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Bids may beCompetitive
Indicate price amp quantity or yield amp quantityNon-competitive
Indicate only quantity
Small investors and individualsgenerally submit non-competitive bids
A non-competitive bidder may not bid for more than$5MM worth of securities in a bill or bond auction
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Primary dealers bid for their accounts andon behalf of their clientsThey usually submit large competitive
bidsBids indicate the maximum price that the bidderis prepared to pay if it is a price based auctionOr the minimum yield that the bidder is
prepared to accept if it is a yield based auction
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The Treasury will net out the totalamount of non-competitive bids
The balance will be allocated to competitivebidders
There are two ways in which securitiescan be allotted
The multiple priceyield auction mechanism
French AuctionsThe uniform priceyield auction mechanism
Dutch Auctions
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Assume that the Treasury is offering 25billion dollars worth of T-bonds
2 billion dollars worth of non-competitive bidshave been receivedSo 23 billion dollars worth of bonds are availableto be offered to the competitive bidders
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There are six competitive bidders who havesubmitted the following yields
The bids have been arranged in ascending orderof yieldIn a price based auction the bids would havebeen arranged in descending order of price
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Bidder Bid Yield Bid Amount
Aggregate Amount
Alpha 5370 30 bn 30 bnBeta 5372 50 bn 80 bn
Gamma 5373 40 bn 12 bn
Delta 5375 80 bn 20 bnCharlie 5375 120 bn 32 bn
Tango 5380 30 bn 35 bn8282014 69
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The aggregate demand equals the amount onoffer at a yield of 5375A multiple yield auction will lead to thefollowing allocation
Alpha will get 3 bn at a yield of 5370Beta will get 5 bn at 5372Gamma will get 4 bn at 5373
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At a yield of 5375 we have only 11 bn left toallocateThere is a demand of 20 bn at this yield
8 bn from Delta and 12 bn from CharlieThus we will allocate 1120 = 55 to eachbidder at this yield
There will be pro-rata allocation
055 of 8 bn or 440 bn will go to Delta055 of 12 bn or 66 bn will go to Charlie
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The highest accepted yield is called the StopYield or High Yield
In this case it is 5375The ratio of bids received to the amountawarded is known as the bid to cover ratio
The higher the ratio the stronger is the auction
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Those who bid more than 5375 will getnothing and are said to be shutout of theauctionSince 1999 the US Treasury has beenconducting only uniform yield auctions
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WI stands for ndash When As and If IssuedThe when issued market is a market forforward trading of a bond
Which has been announced but not yet issuedTrades take place from the date ofannouncement until the actual issue date
Helps bidders to gauge the marketrsquos interestbefore the actual auction
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WI trading has ramifications for the biddingstrategies of market participantsTraders can take both long and shortpositions
Settlement is scheduled for the issue date
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It has a bearing on the outcome of theauction
It affects the strategy used by a bidder becauseit has an impact on his prior positionBidders who are long in the WI market enter theauction with a Long PositionThose who are short in the WI market enter theauction with a short position
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The WI market helps in price discoveryIt provides important information on
The strength of demand for the securityAnd on the disparity of biddersrsquo views
This help potential bidders to formulate theirstrategiesAt times a dealer may believe that he hasvery important private information
If so he may not participate in the WI market andwill directly enter the auction with bids based onhis knowledge
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On or before the date of the auction theissues trade on a yield basis
The actual price can be established only afterthe coupon is set
Starting with the day after the auctionSecurities are quoted on a price basis becausethe coupon is known
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In a coupon roll a dealer will purchase themost recently issued security from a clientAnd simultaneously sell the same amount ofthe recently announced new security
The first leg with settle on the following dayThe second leg is a forward contract
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There can be a Reverse RollThe dealer will sell the most recent issue fornext day settlementAnd buy the newly announced security forforward settlement
The forward leg in a RollReverse Roll is a WItrade
It will settle on the new issue settlement date
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The roll is the spread between the yield onthe new security and that on the outstandingissue in the same maturity segmentA GIVE in the Roll means that
The WI security provides a higher yield than theoutstanding issue
A Take in the Roll means thatThe WI security provides a lower yield
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On March 17 20XX the Treasury announcedthe auction of a 2-year note
The auction was scheduled for March 24The settlement date was March 31
Trading of the roll began as soon as the issuewas announcedA Give of 5 bp means that the dealer proposes tobuy the current issue at the prevailing yieldAnd sell the new issue at a yield that is 5 bpmoreA Take of 5 bp means that the dealer proposes tosell the new issue at a yield that is 5bp lower
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The roll achieves the followingHe acquires the outstanding issue for next daysettlementHe sells the to be issued security with the samepar value for forward delivery on 31 March
The customer is rolling over the investmentfrom the current issue to the new issue
This extends the maturity of the investment byone month
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The client can invest the funds received tillthe new issue settlesHowever he loses the accrued interest thathe would have earned had he held on to theissue
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The Treasury per se does not issue zerocoupon securitiesBut zero coupon securities can be created
which are backed by conventional bondsTake a large quantity of a T-note or bond andseparate all the cash flows from each otherSell the entitlement to each cash flowseparately
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Take the case of a two-year T-noteIt can be separated into five zero couponsecurities maturing after
6 months12 months18 months24 months
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Earlier investment banks used to buy bondsfrom the Treasury and separate the cashflows
Each cash flow was then sold separately as a zerocoupon bondSuch issues are called trademarks
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The issue of trademarks has now ceasedBecause investment banks can now createsuch instruments
In concert with the Treasury itselfThese ZCBs are known as STRIPS ndash
Separate Trading of Registered Interest andPrincipal of Securities
These are not issued or sold by the Treasury
The market is made by investment banks
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What is the motivation to create suchproductsIn practice arbitrage is possible when a
coupon security is purchased at a priceThat is lower than what could be obtained byselling each cash flow separately
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Coupon stripping reflects a case of financialengineering
Creating a risk-return profile that is nototherwise available
An investment bank would buy a largequantity of a Treasury security
The securities would be placed with an SPV
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The SPV is a single-purpose dedicated trustIt has the powers to own the bonds andcollect payments
It cannot sell or lend the bondsIt cannot write options on the bondsOr use them as collateral for borrowing
The SPV is empowered to issue zero coupon
bondsWhere each security represents the ownership ofa single cash flow from the mother bond
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Assume that 100MM USD of 15 year bondswith a coupon of 8 are placed with the SPV
The SPV can issue 6M 12M 18M extending up to14 frac12 year zeroes with a total face value of 4MM
USD eachAnd 15 year zeroes with a total face value of104MM
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The Treasury launched this program in 1985to facilitate the stripping of designatedsecurities
All new T-bonds and notes with a maturity of 10years or more are eligibleThe zeroes created in the process are directobligations of the US government
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The mechanism is as followsA dealer who owns a bond or note can ask theFRB where it is held
To replace it with an equivalent set of STRIPS
representing each payment as a separate securityEach of these securities can be traded independentlyof others
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In 1987 the Treasury started to allow dealersto reverse the process
This is called STRIPS RECONSTUTUTION If a dealer owns STRIPS representing all thecoupon and principal payments of a bond
The FED can on request convert these holdings into asingle position in the corresponding bond
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Each coupon and principal cash flow from aTreasury security is assigned a CUSIP
The mother bond is also assigned a CUSIPThe stripped coupons are known as C-STRIPSThe stripped principal is known as P-STRIPSSupply of a C-STRIP increases over time
because a C-STRIP maturing on a day like 15 FEB
2020 will have the same CUSIP irrespective ofwhich mother bond it has come fromThe original coupon rate is irrelevant
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P-STRIPS always correspond to the originalsecurityThey have a unique CUSIPTheir supply is fixed at the time of issuanceIn practice the prices of long-dated P-STRIPSare a bit higher than those of C-STRIPS withthe same maturity date
One reason is that P-STRIPS are more liquid due
to greater availabilityA $100 face value bond with a coupon of 8 willgenerate C-STRIPS with a face value of $4 but P-STRIPS with a face value of $100
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Another reason why P-STRIPS are in higherdemand is that they allow reconstitutionactivities more easily
Assume that the sum of the STRIPS is cheaper than
the mother bondIf a dealer already has the P-STRIPS only the C-STRIPSneed to be acquiredHowever if he owns some of the C-STRIPS he needs toacquire the P-STRIPS and the remaining C-STRIPSThe facility to reconstitute when profitable is pricedinto the P-STRIPSNote Buy and hold investors will prefer C-STRIPSsince they are priced lower and give a higher yield
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For Plain Vanilla bonds the specifiedcoupon rate is valid for the life of thebond
In the case of Floaters the rate is reset atthe beginning of every periodThe rate will vary directly with thebenchmark
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The rate on a Floater is specified as LIBOR+ 50 bp
The spread is positiveIf it were specified as LIBOR ndash 30bp
The spread will be negativeIf LIBOR rises the rate will increasewhereas if LIBOR falls it will decrease
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In the case of a default risk-free floater theprice will reset to par on a coupon date
It may sell at a premium or discount betweencoupon dates
Consider a floater with a coupon = 5-year T-Bond rate
Assume there are two periods left to maturity
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The price at the end of the first coupon period willbe given by
cT-1 is the coupon one period before maturityyT-1 is the YTM one period before maturity
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On a coupon reset date the YTM = couponBecause we have assumed there is no default riskAny change in the required yield as reflected inthe prevailing YTM
Will also be reflected in the coupon being setIf coupon = yield the bond should sell at par
Thus P T-1 = M
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Once again at T-2 c T-2 = yT-2 and P T-2 = MThis logic can be applied to a bond with anytime remaining till maturityHowever between two coupon dates theprice may not be equal to par
Consider the valuation at T-2+k
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Although c T-2 was set at T-2 and is equal toyT-2
yT-2+k is determined at T-2+k and will reflect theyield prevailing at that time
Thus yT-2+k need not equal c T-2 and may behigher or lower
Hence between two coupon dates a floater maysell at a premium or discount
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Now consider a floater characterized bydefault risk
The risk premium required by the market neednot be constant over time
Assume that at the time of issue YTM = 5-year T-note rate + 75bp
The coupon would have been set equal to thisrate and the bond would have been issued at par
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Six months hence the issue may be perceivedas more risky
YTM = 5-year T-note rate + 95 bpThe coupon will however be set equal to theprevailing 5-year rate + 75 bpIf so the issue will not reset to par at the nextcoupon date
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Floaters may come with a CAP or a FLOOR orBOTH
The CAP is a maximum coupon rateProtects issuers against rising rates
The FLOOR is a minimum coupon rateProtects investors against falling rates
When there is a spread over LIBORThere is a natural floorLIBOR cannot be less than zero
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As we move from one coupon date to thenext if the YTM were to remain constant
Par bonds would continue to trade at PARPremium bonds will steadily decline in priceDiscount bonds will steadily increase in price
This is called the Pull to Par EffectAt maturity ndash ALL BONDS WILL TRADE AT PAR
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As we approach maturity the number ofcoupons reduces
The contribution of coupons to price reducesThe contribution of the PV of the face valueincreases
For premium bonds the first effect dominatesThus the price steadily declines
For discount bonds the second effectdominatesThus the price steadily increases
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A plain vanilla or Bullet Bond pays the entireface value at maturity in a lump sumAmortizing bonds pay the principal in
installmentsThe first payment occurs before maturityThe last payment is made at maturity
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Consider a 5 year amortizing bond with aface value of $1000 and an annual coupon of8
The annual cash flows are depicted below
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Time Cash Flow
1 802 803 3304 3105 540
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The first two cash flows represent interest ona principal of $1000The third cash flow is interest on $1000 plus
a principal payment of $250The outstanding principal is $750The fourth cash flow is interest on $750 plusa principal payment of $250
The outstanding principal is $500The final cash flow is interest on $500 plusthe remaining principal of $500
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Some companies issue such bonds becausethe assets being funded have a similar cashflow profile
Second the coupon on such a bond may belower than that of a bullet bondIn the case of a bullet bond the entire principalis due at a single point in timeThere is greater default risk
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Microsoft is issuing zeroes with 5 years tomaturity and a face value of $10000
The required yield is 10 per annumWhat should be the price
Price is the PV of the face valueIn practice we discount on a semi-annual basis
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This is to facilitate comparisons withconventional bonds
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A zero coupon bond can never sell at apremium
It will always trade at a discount prior tomaturityAt maturity it will trade at par
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If held to maturity a ZCB will always give riseto a capital gainIf sold prior to maturity there may be a
capital gain or a capital lossConsider a bond with 10 years to maturityThe YTM at the time of purchase was 10The cost was $37690
A year later it is sold at a YTM of 12The corresponding price is $35035
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A newly established issuerOr an issuer with a relatively virgin productor service
Or a restructured company due to a mergeror following a bankruptcyWill be perceived as more riskyInvestors will demand a high coupon
Such firms are unlikely to have high earningsRevenues will peak only after theproductservice is established
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They can ill afford high couponsThey may consider a step-up coupon bond
Where the coupon increases as the bond ages
Assume a company can issue a plain vanillaat a coupon of 8 with a maturity of 5 yearsInstead it may opt for a bond
With a coupon of 6 for the first three years
And a coupon of 10 for the last two yearsThis is a Deferred Interest Security
Provides the issuer with breathing room in theearlier years
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These pay coupons in the form of additionalsecurities and not cash
This offers the issuer time to prepare for cashoutlays
They are used as Mezzanine FinanceThey rank between senior debt and equity in thecapital structureInvestors take more risk as compared to buyersof regular bonds ndash but get higher returnsIssuers can conserve cash in earlier years when itis at a premium
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Fully backed by the federal government ofthe issuing nationConsequently they are virtually devoid ofcredit risk or the risk of defaultThe yield on such securities is a benchmarkfor setting rates on other kinds of debt
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Treasury securities are issuedTo finance expenses in excess of currentrevenuesTo pay interest on debt accumulated in earlieryears due to deficits in those yearsTo repay past debt issues that are currentlymaturing
The US Treasuries marketIs the largest bond market in the worldIs the most liquid bond market in the world
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The Treasury issues three categories ofmarketable securities
T-bills are discount securitiesThey are zero coupon securitiesT-notes and T-bonds are sold at face value andpay interest periodically
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T-bills are issued with a original time tomaturity of one year or less
They are Money market instrumentsThey have maturities of either 1 3 6 or 12months at the time of issue
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T-notes and T-bonds have a time to maturityexceeding one year at the time of issue
They are capital market instrumentsT-notes have maturities ranging from 1-10 yearsT-bonds have an original maturity in excess of 10years extending up to 30 years
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An issue may be followed later by a furtherissue
With the same remaining time to maturity andthe same couponThe issuance of further tranches is termed as aRe-opening
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Six months ago a 10-year note was issuedwith a coupon of 8 per annumToday if a note with 9 frac12 years to maturityand a coupon of 8 issued it will add to thepool that is already trading in the marketThus it is a re-opening of an existing issue
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Who is a primary dealerA PD is a dealer who is authorized to dealdirectly with the Central Bank of the countryIn the US a PD is a bank or securities broker-dealer that directly deals with the FRBNY
Importance of FRBNYIn India a PD deals directly with the RBI
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The Treasury sells bills notes and bonds byway of a competitive auction process
Most of the treasury securities are bought byprimary dealers
Individual investors submit non-competitive bidsand participate on a much smaller scale
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Bids may beCompetitive
Indicate price amp quantity or yield amp quantityNon-competitive
Indicate only quantity
Small investors and individualsgenerally submit non-competitive bids
A non-competitive bidder may not bid for more than$5MM worth of securities in a bill or bond auction
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Primary dealers bid for their accounts andon behalf of their clientsThey usually submit large competitive
bidsBids indicate the maximum price that the bidderis prepared to pay if it is a price based auctionOr the minimum yield that the bidder is
prepared to accept if it is a yield based auction
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The Treasury will net out the totalamount of non-competitive bids
The balance will be allocated to competitivebidders
There are two ways in which securitiescan be allotted
The multiple priceyield auction mechanism
French AuctionsThe uniform priceyield auction mechanism
Dutch Auctions
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Assume that the Treasury is offering 25billion dollars worth of T-bonds
2 billion dollars worth of non-competitive bidshave been receivedSo 23 billion dollars worth of bonds are availableto be offered to the competitive bidders
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There are six competitive bidders who havesubmitted the following yields
The bids have been arranged in ascending orderof yieldIn a price based auction the bids would havebeen arranged in descending order of price
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Bidder Bid Yield Bid Amount
Aggregate Amount
Alpha 5370 30 bn 30 bnBeta 5372 50 bn 80 bn
Gamma 5373 40 bn 12 bn
Delta 5375 80 bn 20 bnCharlie 5375 120 bn 32 bn
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The aggregate demand equals the amount onoffer at a yield of 5375A multiple yield auction will lead to thefollowing allocation
Alpha will get 3 bn at a yield of 5370Beta will get 5 bn at 5372Gamma will get 4 bn at 5373
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At a yield of 5375 we have only 11 bn left toallocateThere is a demand of 20 bn at this yield
8 bn from Delta and 12 bn from CharlieThus we will allocate 1120 = 55 to eachbidder at this yield
There will be pro-rata allocation
055 of 8 bn or 440 bn will go to Delta055 of 12 bn or 66 bn will go to Charlie
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The highest accepted yield is called the StopYield or High Yield
In this case it is 5375The ratio of bids received to the amountawarded is known as the bid to cover ratio
The higher the ratio the stronger is the auction
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Those who bid more than 5375 will getnothing and are said to be shutout of theauctionSince 1999 the US Treasury has beenconducting only uniform yield auctions
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WI stands for ndash When As and If IssuedThe when issued market is a market forforward trading of a bond
Which has been announced but not yet issuedTrades take place from the date ofannouncement until the actual issue date
Helps bidders to gauge the marketrsquos interestbefore the actual auction
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WI trading has ramifications for the biddingstrategies of market participantsTraders can take both long and shortpositions
Settlement is scheduled for the issue date
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It has a bearing on the outcome of theauction
It affects the strategy used by a bidder becauseit has an impact on his prior positionBidders who are long in the WI market enter theauction with a Long PositionThose who are short in the WI market enter theauction with a short position
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The WI market helps in price discoveryIt provides important information on
The strength of demand for the securityAnd on the disparity of biddersrsquo views
This help potential bidders to formulate theirstrategiesAt times a dealer may believe that he hasvery important private information
If so he may not participate in the WI market andwill directly enter the auction with bids based onhis knowledge
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On or before the date of the auction theissues trade on a yield basis
The actual price can be established only afterthe coupon is set
Starting with the day after the auctionSecurities are quoted on a price basis becausethe coupon is known
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In a coupon roll a dealer will purchase themost recently issued security from a clientAnd simultaneously sell the same amount ofthe recently announced new security
The first leg with settle on the following dayThe second leg is a forward contract
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There can be a Reverse RollThe dealer will sell the most recent issue fornext day settlementAnd buy the newly announced security forforward settlement
The forward leg in a RollReverse Roll is a WItrade
It will settle on the new issue settlement date
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The roll is the spread between the yield onthe new security and that on the outstandingissue in the same maturity segmentA GIVE in the Roll means that
The WI security provides a higher yield than theoutstanding issue
A Take in the Roll means thatThe WI security provides a lower yield
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On March 17 20XX the Treasury announcedthe auction of a 2-year note
The auction was scheduled for March 24The settlement date was March 31
Trading of the roll began as soon as the issuewas announcedA Give of 5 bp means that the dealer proposes tobuy the current issue at the prevailing yieldAnd sell the new issue at a yield that is 5 bpmoreA Take of 5 bp means that the dealer proposes tosell the new issue at a yield that is 5bp lower
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The roll achieves the followingHe acquires the outstanding issue for next daysettlementHe sells the to be issued security with the samepar value for forward delivery on 31 March
The customer is rolling over the investmentfrom the current issue to the new issue
This extends the maturity of the investment byone month
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The client can invest the funds received tillthe new issue settlesHowever he loses the accrued interest thathe would have earned had he held on to theissue
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The Treasury per se does not issue zerocoupon securitiesBut zero coupon securities can be created
which are backed by conventional bondsTake a large quantity of a T-note or bond andseparate all the cash flows from each otherSell the entitlement to each cash flowseparately
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Take the case of a two-year T-noteIt can be separated into five zero couponsecurities maturing after
6 months12 months18 months24 months
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Earlier investment banks used to buy bondsfrom the Treasury and separate the cashflows
Each cash flow was then sold separately as a zerocoupon bondSuch issues are called trademarks
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The issue of trademarks has now ceasedBecause investment banks can now createsuch instruments
In concert with the Treasury itselfThese ZCBs are known as STRIPS ndash
Separate Trading of Registered Interest andPrincipal of Securities
These are not issued or sold by the Treasury
The market is made by investment banks
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What is the motivation to create suchproductsIn practice arbitrage is possible when a
coupon security is purchased at a priceThat is lower than what could be obtained byselling each cash flow separately
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Coupon stripping reflects a case of financialengineering
Creating a risk-return profile that is nototherwise available
An investment bank would buy a largequantity of a Treasury security
The securities would be placed with an SPV
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The SPV is a single-purpose dedicated trustIt has the powers to own the bonds andcollect payments
It cannot sell or lend the bondsIt cannot write options on the bondsOr use them as collateral for borrowing
The SPV is empowered to issue zero coupon
bondsWhere each security represents the ownership ofa single cash flow from the mother bond
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Assume that 100MM USD of 15 year bondswith a coupon of 8 are placed with the SPV
The SPV can issue 6M 12M 18M extending up to14 frac12 year zeroes with a total face value of 4MM
USD eachAnd 15 year zeroes with a total face value of104MM
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The Treasury launched this program in 1985to facilitate the stripping of designatedsecurities
All new T-bonds and notes with a maturity of 10years or more are eligibleThe zeroes created in the process are directobligations of the US government
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The mechanism is as followsA dealer who owns a bond or note can ask theFRB where it is held
To replace it with an equivalent set of STRIPS
representing each payment as a separate securityEach of these securities can be traded independentlyof others
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In 1987 the Treasury started to allow dealersto reverse the process
This is called STRIPS RECONSTUTUTION If a dealer owns STRIPS representing all thecoupon and principal payments of a bond
The FED can on request convert these holdings into asingle position in the corresponding bond
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Each coupon and principal cash flow from aTreasury security is assigned a CUSIP
The mother bond is also assigned a CUSIPThe stripped coupons are known as C-STRIPSThe stripped principal is known as P-STRIPSSupply of a C-STRIP increases over time
because a C-STRIP maturing on a day like 15 FEB
2020 will have the same CUSIP irrespective ofwhich mother bond it has come fromThe original coupon rate is irrelevant
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P-STRIPS always correspond to the originalsecurityThey have a unique CUSIPTheir supply is fixed at the time of issuanceIn practice the prices of long-dated P-STRIPSare a bit higher than those of C-STRIPS withthe same maturity date
One reason is that P-STRIPS are more liquid due
to greater availabilityA $100 face value bond with a coupon of 8 willgenerate C-STRIPS with a face value of $4 but P-STRIPS with a face value of $100
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Another reason why P-STRIPS are in higherdemand is that they allow reconstitutionactivities more easily
Assume that the sum of the STRIPS is cheaper than
the mother bondIf a dealer already has the P-STRIPS only the C-STRIPSneed to be acquiredHowever if he owns some of the C-STRIPS he needs toacquire the P-STRIPS and the remaining C-STRIPSThe facility to reconstitute when profitable is pricedinto the P-STRIPSNote Buy and hold investors will prefer C-STRIPSsince they are priced lower and give a higher yield
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For Plain Vanilla bonds the specifiedcoupon rate is valid for the life of thebond
In the case of Floaters the rate is reset atthe beginning of every periodThe rate will vary directly with thebenchmark
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The rate on a Floater is specified as LIBOR+ 50 bp
The spread is positiveIf it were specified as LIBOR ndash 30bp
The spread will be negativeIf LIBOR rises the rate will increasewhereas if LIBOR falls it will decrease
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In the case of a default risk-free floater theprice will reset to par on a coupon date
It may sell at a premium or discount betweencoupon dates
Consider a floater with a coupon = 5-year T-Bond rate
Assume there are two periods left to maturity
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The price at the end of the first coupon period willbe given by
cT-1 is the coupon one period before maturityyT-1 is the YTM one period before maturity
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On a coupon reset date the YTM = couponBecause we have assumed there is no default riskAny change in the required yield as reflected inthe prevailing YTM
Will also be reflected in the coupon being setIf coupon = yield the bond should sell at par
Thus P T-1 = M
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Once again at T-2 c T-2 = yT-2 and P T-2 = MThis logic can be applied to a bond with anytime remaining till maturityHowever between two coupon dates theprice may not be equal to par
Consider the valuation at T-2+k
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Although c T-2 was set at T-2 and is equal toyT-2
yT-2+k is determined at T-2+k and will reflect theyield prevailing at that time
Thus yT-2+k need not equal c T-2 and may behigher or lower
Hence between two coupon dates a floater maysell at a premium or discount
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Now consider a floater characterized bydefault risk
The risk premium required by the market neednot be constant over time
Assume that at the time of issue YTM = 5-year T-note rate + 75bp
The coupon would have been set equal to thisrate and the bond would have been issued at par
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Six months hence the issue may be perceivedas more risky
YTM = 5-year T-note rate + 95 bpThe coupon will however be set equal to theprevailing 5-year rate + 75 bpIf so the issue will not reset to par at the nextcoupon date
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Floaters may come with a CAP or a FLOOR orBOTH
The CAP is a maximum coupon rateProtects issuers against rising rates
The FLOOR is a minimum coupon rateProtects investors against falling rates
When there is a spread over LIBORThere is a natural floorLIBOR cannot be less than zero
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As we approach maturity the number ofcoupons reduces
The contribution of coupons to price reducesThe contribution of the PV of the face valueincreases
For premium bonds the first effect dominatesThus the price steadily declines
For discount bonds the second effectdominatesThus the price steadily increases
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A plain vanilla or Bullet Bond pays the entireface value at maturity in a lump sumAmortizing bonds pay the principal in
installmentsThe first payment occurs before maturityThe last payment is made at maturity
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Consider a 5 year amortizing bond with aface value of $1000 and an annual coupon of8
The annual cash flows are depicted below
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Time Cash Flow
1 802 803 3304 3105 540
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The first two cash flows represent interest ona principal of $1000The third cash flow is interest on $1000 plus
a principal payment of $250The outstanding principal is $750The fourth cash flow is interest on $750 plusa principal payment of $250
The outstanding principal is $500The final cash flow is interest on $500 plusthe remaining principal of $500
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Some companies issue such bonds becausethe assets being funded have a similar cashflow profile
Second the coupon on such a bond may belower than that of a bullet bondIn the case of a bullet bond the entire principalis due at a single point in timeThere is greater default risk
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Microsoft is issuing zeroes with 5 years tomaturity and a face value of $10000
The required yield is 10 per annumWhat should be the price
Price is the PV of the face valueIn practice we discount on a semi-annual basis
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This is to facilitate comparisons withconventional bonds
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A zero coupon bond can never sell at apremium
It will always trade at a discount prior tomaturityAt maturity it will trade at par
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If held to maturity a ZCB will always give riseto a capital gainIf sold prior to maturity there may be a
capital gain or a capital lossConsider a bond with 10 years to maturityThe YTM at the time of purchase was 10The cost was $37690
A year later it is sold at a YTM of 12The corresponding price is $35035
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A newly established issuerOr an issuer with a relatively virgin productor service
Or a restructured company due to a mergeror following a bankruptcyWill be perceived as more riskyInvestors will demand a high coupon
Such firms are unlikely to have high earningsRevenues will peak only after theproductservice is established
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They can ill afford high couponsThey may consider a step-up coupon bond
Where the coupon increases as the bond ages
Assume a company can issue a plain vanillaat a coupon of 8 with a maturity of 5 yearsInstead it may opt for a bond
With a coupon of 6 for the first three years
And a coupon of 10 for the last two yearsThis is a Deferred Interest Security
Provides the issuer with breathing room in theearlier years
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These pay coupons in the form of additionalsecurities and not cash
This offers the issuer time to prepare for cashoutlays
They are used as Mezzanine FinanceThey rank between senior debt and equity in thecapital structureInvestors take more risk as compared to buyersof regular bonds ndash but get higher returnsIssuers can conserve cash in earlier years when itis at a premium
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Fully backed by the federal government ofthe issuing nationConsequently they are virtually devoid ofcredit risk or the risk of defaultThe yield on such securities is a benchmarkfor setting rates on other kinds of debt
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Treasury securities are issuedTo finance expenses in excess of currentrevenuesTo pay interest on debt accumulated in earlieryears due to deficits in those yearsTo repay past debt issues that are currentlymaturing
The US Treasuries marketIs the largest bond market in the worldIs the most liquid bond market in the world
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The Treasury issues three categories ofmarketable securities
T-bills are discount securitiesThey are zero coupon securitiesT-notes and T-bonds are sold at face value andpay interest periodically
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T-bills are issued with a original time tomaturity of one year or less
They are Money market instrumentsThey have maturities of either 1 3 6 or 12months at the time of issue
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T-notes and T-bonds have a time to maturityexceeding one year at the time of issue
They are capital market instrumentsT-notes have maturities ranging from 1-10 yearsT-bonds have an original maturity in excess of 10years extending up to 30 years
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An issue may be followed later by a furtherissue
With the same remaining time to maturity andthe same couponThe issuance of further tranches is termed as aRe-opening
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Six months ago a 10-year note was issuedwith a coupon of 8 per annumToday if a note with 9 frac12 years to maturityand a coupon of 8 issued it will add to thepool that is already trading in the marketThus it is a re-opening of an existing issue
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Who is a primary dealerA PD is a dealer who is authorized to dealdirectly with the Central Bank of the countryIn the US a PD is a bank or securities broker-dealer that directly deals with the FRBNY
Importance of FRBNYIn India a PD deals directly with the RBI
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The Treasury sells bills notes and bonds byway of a competitive auction process
Most of the treasury securities are bought byprimary dealers
Individual investors submit non-competitive bidsand participate on a much smaller scale
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Bids may beCompetitive
Indicate price amp quantity or yield amp quantityNon-competitive
Indicate only quantity
Small investors and individualsgenerally submit non-competitive bids
A non-competitive bidder may not bid for more than$5MM worth of securities in a bill or bond auction
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Primary dealers bid for their accounts andon behalf of their clientsThey usually submit large competitive
bidsBids indicate the maximum price that the bidderis prepared to pay if it is a price based auctionOr the minimum yield that the bidder is
prepared to accept if it is a yield based auction
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The Treasury will net out the totalamount of non-competitive bids
The balance will be allocated to competitivebidders
There are two ways in which securitiescan be allotted
The multiple priceyield auction mechanism
French AuctionsThe uniform priceyield auction mechanism
Dutch Auctions
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Assume that the Treasury is offering 25billion dollars worth of T-bonds
2 billion dollars worth of non-competitive bidshave been receivedSo 23 billion dollars worth of bonds are availableto be offered to the competitive bidders
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There are six competitive bidders who havesubmitted the following yields
The bids have been arranged in ascending orderof yieldIn a price based auction the bids would havebeen arranged in descending order of price
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Bidder Bid Yield Bid Amount
Aggregate Amount
Alpha 5370 30 bn 30 bnBeta 5372 50 bn 80 bn
Gamma 5373 40 bn 12 bn
Delta 5375 80 bn 20 bnCharlie 5375 120 bn 32 bn
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The aggregate demand equals the amount onoffer at a yield of 5375A multiple yield auction will lead to thefollowing allocation
Alpha will get 3 bn at a yield of 5370Beta will get 5 bn at 5372Gamma will get 4 bn at 5373
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At a yield of 5375 we have only 11 bn left toallocateThere is a demand of 20 bn at this yield
8 bn from Delta and 12 bn from CharlieThus we will allocate 1120 = 55 to eachbidder at this yield
There will be pro-rata allocation
055 of 8 bn or 440 bn will go to Delta055 of 12 bn or 66 bn will go to Charlie
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The highest accepted yield is called the StopYield or High Yield
In this case it is 5375The ratio of bids received to the amountawarded is known as the bid to cover ratio
The higher the ratio the stronger is the auction
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Those who bid more than 5375 will getnothing and are said to be shutout of theauctionSince 1999 the US Treasury has beenconducting only uniform yield auctions
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WI stands for ndash When As and If IssuedThe when issued market is a market forforward trading of a bond
Which has been announced but not yet issuedTrades take place from the date ofannouncement until the actual issue date
Helps bidders to gauge the marketrsquos interestbefore the actual auction
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WI trading has ramifications for the biddingstrategies of market participantsTraders can take both long and shortpositions
Settlement is scheduled for the issue date
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It has a bearing on the outcome of theauction
It affects the strategy used by a bidder becauseit has an impact on his prior positionBidders who are long in the WI market enter theauction with a Long PositionThose who are short in the WI market enter theauction with a short position
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The WI market helps in price discoveryIt provides important information on
The strength of demand for the securityAnd on the disparity of biddersrsquo views
This help potential bidders to formulate theirstrategiesAt times a dealer may believe that he hasvery important private information
If so he may not participate in the WI market andwill directly enter the auction with bids based onhis knowledge
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On or before the date of the auction theissues trade on a yield basis
The actual price can be established only afterthe coupon is set
Starting with the day after the auctionSecurities are quoted on a price basis becausethe coupon is known
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In a coupon roll a dealer will purchase themost recently issued security from a clientAnd simultaneously sell the same amount ofthe recently announced new security
The first leg with settle on the following dayThe second leg is a forward contract
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There can be a Reverse RollThe dealer will sell the most recent issue fornext day settlementAnd buy the newly announced security forforward settlement
The forward leg in a RollReverse Roll is a WItrade
It will settle on the new issue settlement date
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The roll is the spread between the yield onthe new security and that on the outstandingissue in the same maturity segmentA GIVE in the Roll means that
The WI security provides a higher yield than theoutstanding issue
A Take in the Roll means thatThe WI security provides a lower yield
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On March 17 20XX the Treasury announcedthe auction of a 2-year note
The auction was scheduled for March 24The settlement date was March 31
Trading of the roll began as soon as the issuewas announcedA Give of 5 bp means that the dealer proposes tobuy the current issue at the prevailing yieldAnd sell the new issue at a yield that is 5 bpmoreA Take of 5 bp means that the dealer proposes tosell the new issue at a yield that is 5bp lower
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The roll achieves the followingHe acquires the outstanding issue for next daysettlementHe sells the to be issued security with the samepar value for forward delivery on 31 March
The customer is rolling over the investmentfrom the current issue to the new issue
This extends the maturity of the investment byone month
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The client can invest the funds received tillthe new issue settlesHowever he loses the accrued interest thathe would have earned had he held on to theissue
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The Treasury per se does not issue zerocoupon securitiesBut zero coupon securities can be created
which are backed by conventional bondsTake a large quantity of a T-note or bond andseparate all the cash flows from each otherSell the entitlement to each cash flowseparately
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Take the case of a two-year T-noteIt can be separated into five zero couponsecurities maturing after
6 months12 months18 months24 months
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Earlier investment banks used to buy bondsfrom the Treasury and separate the cashflows
Each cash flow was then sold separately as a zerocoupon bondSuch issues are called trademarks
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The issue of trademarks has now ceasedBecause investment banks can now createsuch instruments
In concert with the Treasury itselfThese ZCBs are known as STRIPS ndash
Separate Trading of Registered Interest andPrincipal of Securities
These are not issued or sold by the Treasury
The market is made by investment banks
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What is the motivation to create suchproductsIn practice arbitrage is possible when a
coupon security is purchased at a priceThat is lower than what could be obtained byselling each cash flow separately
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Coupon stripping reflects a case of financialengineering
Creating a risk-return profile that is nototherwise available
An investment bank would buy a largequantity of a Treasury security
The securities would be placed with an SPV
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The SPV is a single-purpose dedicated trustIt has the powers to own the bonds andcollect payments
It cannot sell or lend the bondsIt cannot write options on the bondsOr use them as collateral for borrowing
The SPV is empowered to issue zero coupon
bondsWhere each security represents the ownership ofa single cash flow from the mother bond
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Assume that 100MM USD of 15 year bondswith a coupon of 8 are placed with the SPV
The SPV can issue 6M 12M 18M extending up to14 frac12 year zeroes with a total face value of 4MM
USD eachAnd 15 year zeroes with a total face value of104MM
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The Treasury launched this program in 1985to facilitate the stripping of designatedsecurities
All new T-bonds and notes with a maturity of 10years or more are eligibleThe zeroes created in the process are directobligations of the US government
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The mechanism is as followsA dealer who owns a bond or note can ask theFRB where it is held
To replace it with an equivalent set of STRIPS
representing each payment as a separate securityEach of these securities can be traded independentlyof others
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In 1987 the Treasury started to allow dealersto reverse the process
This is called STRIPS RECONSTUTUTION If a dealer owns STRIPS representing all thecoupon and principal payments of a bond
The FED can on request convert these holdings into asingle position in the corresponding bond
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Each coupon and principal cash flow from aTreasury security is assigned a CUSIP
The mother bond is also assigned a CUSIPThe stripped coupons are known as C-STRIPSThe stripped principal is known as P-STRIPSSupply of a C-STRIP increases over time
because a C-STRIP maturing on a day like 15 FEB
2020 will have the same CUSIP irrespective ofwhich mother bond it has come fromThe original coupon rate is irrelevant
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P-STRIPS always correspond to the originalsecurityThey have a unique CUSIPTheir supply is fixed at the time of issuanceIn practice the prices of long-dated P-STRIPSare a bit higher than those of C-STRIPS withthe same maturity date
One reason is that P-STRIPS are more liquid due
to greater availabilityA $100 face value bond with a coupon of 8 willgenerate C-STRIPS with a face value of $4 but P-STRIPS with a face value of $100
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Another reason why P-STRIPS are in higherdemand is that they allow reconstitutionactivities more easily
Assume that the sum of the STRIPS is cheaper than
the mother bondIf a dealer already has the P-STRIPS only the C-STRIPSneed to be acquiredHowever if he owns some of the C-STRIPS he needs toacquire the P-STRIPS and the remaining C-STRIPSThe facility to reconstitute when profitable is pricedinto the P-STRIPSNote Buy and hold investors will prefer C-STRIPSsince they are priced lower and give a higher yield
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For Plain Vanilla bonds the specifiedcoupon rate is valid for the life of thebond
In the case of Floaters the rate is reset atthe beginning of every periodThe rate will vary directly with thebenchmark
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The rate on a Floater is specified as LIBOR+ 50 bp
The spread is positiveIf it were specified as LIBOR ndash 30bp
The spread will be negativeIf LIBOR rises the rate will increasewhereas if LIBOR falls it will decrease
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In the case of a default risk-free floater theprice will reset to par on a coupon date
It may sell at a premium or discount betweencoupon dates
Consider a floater with a coupon = 5-year T-Bond rate
Assume there are two periods left to maturity
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The price at the end of the first coupon period willbe given by
cT-1 is the coupon one period before maturityyT-1 is the YTM one period before maturity
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On a coupon reset date the YTM = couponBecause we have assumed there is no default riskAny change in the required yield as reflected inthe prevailing YTM
Will also be reflected in the coupon being setIf coupon = yield the bond should sell at par
Thus P T-1 = M
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Once again at T-2 c T-2 = yT-2 and P T-2 = MThis logic can be applied to a bond with anytime remaining till maturityHowever between two coupon dates theprice may not be equal to par
Consider the valuation at T-2+k
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Although c T-2 was set at T-2 and is equal toyT-2
yT-2+k is determined at T-2+k and will reflect theyield prevailing at that time
Thus yT-2+k need not equal c T-2 and may behigher or lower
Hence between two coupon dates a floater maysell at a premium or discount
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Now consider a floater characterized bydefault risk
The risk premium required by the market neednot be constant over time
Assume that at the time of issue YTM = 5-year T-note rate + 75bp
The coupon would have been set equal to thisrate and the bond would have been issued at par
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Six months hence the issue may be perceivedas more risky
YTM = 5-year T-note rate + 95 bpThe coupon will however be set equal to theprevailing 5-year rate + 75 bpIf so the issue will not reset to par at the nextcoupon date
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Floaters may come with a CAP or a FLOOR orBOTH
The CAP is a maximum coupon rateProtects issuers against rising rates
The FLOOR is a minimum coupon rateProtects investors against falling rates
When there is a spread over LIBORThere is a natural floorLIBOR cannot be less than zero
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A plain vanilla or Bullet Bond pays the entireface value at maturity in a lump sumAmortizing bonds pay the principal in
installmentsThe first payment occurs before maturityThe last payment is made at maturity
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Consider a 5 year amortizing bond with aface value of $1000 and an annual coupon of8
The annual cash flows are depicted below
8282014 40
Time Cash Flow
1 802 803 3304 3105 540
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The first two cash flows represent interest ona principal of $1000The third cash flow is interest on $1000 plus
a principal payment of $250The outstanding principal is $750The fourth cash flow is interest on $750 plusa principal payment of $250
The outstanding principal is $500The final cash flow is interest on $500 plusthe remaining principal of $500
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Some companies issue such bonds becausethe assets being funded have a similar cashflow profile
Second the coupon on such a bond may belower than that of a bullet bondIn the case of a bullet bond the entire principalis due at a single point in timeThere is greater default risk
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Microsoft is issuing zeroes with 5 years tomaturity and a face value of $10000
The required yield is 10 per annumWhat should be the price
Price is the PV of the face valueIn practice we discount on a semi-annual basis
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This is to facilitate comparisons withconventional bonds
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A zero coupon bond can never sell at apremium
It will always trade at a discount prior tomaturityAt maturity it will trade at par
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If held to maturity a ZCB will always give riseto a capital gainIf sold prior to maturity there may be a
capital gain or a capital lossConsider a bond with 10 years to maturityThe YTM at the time of purchase was 10The cost was $37690
A year later it is sold at a YTM of 12The corresponding price is $35035
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A newly established issuerOr an issuer with a relatively virgin productor service
Or a restructured company due to a mergeror following a bankruptcyWill be perceived as more riskyInvestors will demand a high coupon
Such firms are unlikely to have high earningsRevenues will peak only after theproductservice is established
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They can ill afford high couponsThey may consider a step-up coupon bond
Where the coupon increases as the bond ages
Assume a company can issue a plain vanillaat a coupon of 8 with a maturity of 5 yearsInstead it may opt for a bond
With a coupon of 6 for the first three years
And a coupon of 10 for the last two yearsThis is a Deferred Interest Security
Provides the issuer with breathing room in theearlier years
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These pay coupons in the form of additionalsecurities and not cash
This offers the issuer time to prepare for cashoutlays
They are used as Mezzanine FinanceThey rank between senior debt and equity in thecapital structureInvestors take more risk as compared to buyersof regular bonds ndash but get higher returnsIssuers can conserve cash in earlier years when itis at a premium
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Fully backed by the federal government ofthe issuing nationConsequently they are virtually devoid ofcredit risk or the risk of defaultThe yield on such securities is a benchmarkfor setting rates on other kinds of debt
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Treasury securities are issuedTo finance expenses in excess of currentrevenuesTo pay interest on debt accumulated in earlieryears due to deficits in those yearsTo repay past debt issues that are currentlymaturing
The US Treasuries marketIs the largest bond market in the worldIs the most liquid bond market in the world
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The Treasury issues three categories ofmarketable securities
T-bills are discount securitiesThey are zero coupon securitiesT-notes and T-bonds are sold at face value andpay interest periodically
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T-bills are issued with a original time tomaturity of one year or less
They are Money market instrumentsThey have maturities of either 1 3 6 or 12months at the time of issue
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T-notes and T-bonds have a time to maturityexceeding one year at the time of issue
They are capital market instrumentsT-notes have maturities ranging from 1-10 yearsT-bonds have an original maturity in excess of 10years extending up to 30 years
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An issue may be followed later by a furtherissue
With the same remaining time to maturity andthe same couponThe issuance of further tranches is termed as aRe-opening
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Six months ago a 10-year note was issuedwith a coupon of 8 per annumToday if a note with 9 frac12 years to maturityand a coupon of 8 issued it will add to thepool that is already trading in the marketThus it is a re-opening of an existing issue
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Who is a primary dealerA PD is a dealer who is authorized to dealdirectly with the Central Bank of the countryIn the US a PD is a bank or securities broker-dealer that directly deals with the FRBNY
Importance of FRBNYIn India a PD deals directly with the RBI
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The Treasury sells bills notes and bonds byway of a competitive auction process
Most of the treasury securities are bought byprimary dealers
Individual investors submit non-competitive bidsand participate on a much smaller scale
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Bids may beCompetitive
Indicate price amp quantity or yield amp quantityNon-competitive
Indicate only quantity
Small investors and individualsgenerally submit non-competitive bids
A non-competitive bidder may not bid for more than$5MM worth of securities in a bill or bond auction
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Primary dealers bid for their accounts andon behalf of their clientsThey usually submit large competitive
bidsBids indicate the maximum price that the bidderis prepared to pay if it is a price based auctionOr the minimum yield that the bidder is
prepared to accept if it is a yield based auction
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The Treasury will net out the totalamount of non-competitive bids
The balance will be allocated to competitivebidders
There are two ways in which securitiescan be allotted
The multiple priceyield auction mechanism
French AuctionsThe uniform priceyield auction mechanism
Dutch Auctions
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Assume that the Treasury is offering 25billion dollars worth of T-bonds
2 billion dollars worth of non-competitive bidshave been receivedSo 23 billion dollars worth of bonds are availableto be offered to the competitive bidders
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There are six competitive bidders who havesubmitted the following yields
The bids have been arranged in ascending orderof yieldIn a price based auction the bids would havebeen arranged in descending order of price
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Bidder Bid Yield Bid Amount
Aggregate Amount
Alpha 5370 30 bn 30 bnBeta 5372 50 bn 80 bn
Gamma 5373 40 bn 12 bn
Delta 5375 80 bn 20 bnCharlie 5375 120 bn 32 bn
Tango 5380 30 bn 35 bn8282014 69
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The aggregate demand equals the amount onoffer at a yield of 5375A multiple yield auction will lead to thefollowing allocation
Alpha will get 3 bn at a yield of 5370Beta will get 5 bn at 5372Gamma will get 4 bn at 5373
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At a yield of 5375 we have only 11 bn left toallocateThere is a demand of 20 bn at this yield
8 bn from Delta and 12 bn from CharlieThus we will allocate 1120 = 55 to eachbidder at this yield
There will be pro-rata allocation
055 of 8 bn or 440 bn will go to Delta055 of 12 bn or 66 bn will go to Charlie
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The highest accepted yield is called the StopYield or High Yield
In this case it is 5375The ratio of bids received to the amountawarded is known as the bid to cover ratio
The higher the ratio the stronger is the auction
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Those who bid more than 5375 will getnothing and are said to be shutout of theauctionSince 1999 the US Treasury has beenconducting only uniform yield auctions
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WI stands for ndash When As and If IssuedThe when issued market is a market forforward trading of a bond
Which has been announced but not yet issuedTrades take place from the date ofannouncement until the actual issue date
Helps bidders to gauge the marketrsquos interestbefore the actual auction
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WI trading has ramifications for the biddingstrategies of market participantsTraders can take both long and shortpositions
Settlement is scheduled for the issue date
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It has a bearing on the outcome of theauction
It affects the strategy used by a bidder becauseit has an impact on his prior positionBidders who are long in the WI market enter theauction with a Long PositionThose who are short in the WI market enter theauction with a short position
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The WI market helps in price discoveryIt provides important information on
The strength of demand for the securityAnd on the disparity of biddersrsquo views
This help potential bidders to formulate theirstrategiesAt times a dealer may believe that he hasvery important private information
If so he may not participate in the WI market andwill directly enter the auction with bids based onhis knowledge
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On or before the date of the auction theissues trade on a yield basis
The actual price can be established only afterthe coupon is set
Starting with the day after the auctionSecurities are quoted on a price basis becausethe coupon is known
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In a coupon roll a dealer will purchase themost recently issued security from a clientAnd simultaneously sell the same amount ofthe recently announced new security
The first leg with settle on the following dayThe second leg is a forward contract
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There can be a Reverse RollThe dealer will sell the most recent issue fornext day settlementAnd buy the newly announced security forforward settlement
The forward leg in a RollReverse Roll is a WItrade
It will settle on the new issue settlement date
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The roll is the spread between the yield onthe new security and that on the outstandingissue in the same maturity segmentA GIVE in the Roll means that
The WI security provides a higher yield than theoutstanding issue
A Take in the Roll means thatThe WI security provides a lower yield
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On March 17 20XX the Treasury announcedthe auction of a 2-year note
The auction was scheduled for March 24The settlement date was March 31
Trading of the roll began as soon as the issuewas announcedA Give of 5 bp means that the dealer proposes tobuy the current issue at the prevailing yieldAnd sell the new issue at a yield that is 5 bpmoreA Take of 5 bp means that the dealer proposes tosell the new issue at a yield that is 5bp lower
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The roll achieves the followingHe acquires the outstanding issue for next daysettlementHe sells the to be issued security with the samepar value for forward delivery on 31 March
The customer is rolling over the investmentfrom the current issue to the new issue
This extends the maturity of the investment byone month
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The client can invest the funds received tillthe new issue settlesHowever he loses the accrued interest thathe would have earned had he held on to theissue
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The Treasury per se does not issue zerocoupon securitiesBut zero coupon securities can be created
which are backed by conventional bondsTake a large quantity of a T-note or bond andseparate all the cash flows from each otherSell the entitlement to each cash flowseparately
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Take the case of a two-year T-noteIt can be separated into five zero couponsecurities maturing after
6 months12 months18 months24 months
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Earlier investment banks used to buy bondsfrom the Treasury and separate the cashflows
Each cash flow was then sold separately as a zerocoupon bondSuch issues are called trademarks
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The issue of trademarks has now ceasedBecause investment banks can now createsuch instruments
In concert with the Treasury itselfThese ZCBs are known as STRIPS ndash
Separate Trading of Registered Interest andPrincipal of Securities
These are not issued or sold by the Treasury
The market is made by investment banks
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What is the motivation to create suchproductsIn practice arbitrage is possible when a
coupon security is purchased at a priceThat is lower than what could be obtained byselling each cash flow separately
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Coupon stripping reflects a case of financialengineering
Creating a risk-return profile that is nototherwise available
An investment bank would buy a largequantity of a Treasury security
The securities would be placed with an SPV
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The SPV is a single-purpose dedicated trustIt has the powers to own the bonds andcollect payments
It cannot sell or lend the bondsIt cannot write options on the bondsOr use them as collateral for borrowing
The SPV is empowered to issue zero coupon
bondsWhere each security represents the ownership ofa single cash flow from the mother bond
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Assume that 100MM USD of 15 year bondswith a coupon of 8 are placed with the SPV
The SPV can issue 6M 12M 18M extending up to14 frac12 year zeroes with a total face value of 4MM
USD eachAnd 15 year zeroes with a total face value of104MM
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The Treasury launched this program in 1985to facilitate the stripping of designatedsecurities
All new T-bonds and notes with a maturity of 10years or more are eligibleThe zeroes created in the process are directobligations of the US government
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The mechanism is as followsA dealer who owns a bond or note can ask theFRB where it is held
To replace it with an equivalent set of STRIPS
representing each payment as a separate securityEach of these securities can be traded independentlyof others
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In 1987 the Treasury started to allow dealersto reverse the process
This is called STRIPS RECONSTUTUTION If a dealer owns STRIPS representing all thecoupon and principal payments of a bond
The FED can on request convert these holdings into asingle position in the corresponding bond
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Each coupon and principal cash flow from aTreasury security is assigned a CUSIP
The mother bond is also assigned a CUSIPThe stripped coupons are known as C-STRIPSThe stripped principal is known as P-STRIPSSupply of a C-STRIP increases over time
because a C-STRIP maturing on a day like 15 FEB
2020 will have the same CUSIP irrespective ofwhich mother bond it has come fromThe original coupon rate is irrelevant
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P-STRIPS always correspond to the originalsecurityThey have a unique CUSIPTheir supply is fixed at the time of issuanceIn practice the prices of long-dated P-STRIPSare a bit higher than those of C-STRIPS withthe same maturity date
One reason is that P-STRIPS are more liquid due
to greater availabilityA $100 face value bond with a coupon of 8 willgenerate C-STRIPS with a face value of $4 but P-STRIPS with a face value of $100
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Another reason why P-STRIPS are in higherdemand is that they allow reconstitutionactivities more easily
Assume that the sum of the STRIPS is cheaper than
the mother bondIf a dealer already has the P-STRIPS only the C-STRIPSneed to be acquiredHowever if he owns some of the C-STRIPS he needs toacquire the P-STRIPS and the remaining C-STRIPSThe facility to reconstitute when profitable is pricedinto the P-STRIPSNote Buy and hold investors will prefer C-STRIPSsince they are priced lower and give a higher yield
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For Plain Vanilla bonds the specifiedcoupon rate is valid for the life of thebond
In the case of Floaters the rate is reset atthe beginning of every periodThe rate will vary directly with thebenchmark
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The rate on a Floater is specified as LIBOR+ 50 bp
The spread is positiveIf it were specified as LIBOR ndash 30bp
The spread will be negativeIf LIBOR rises the rate will increasewhereas if LIBOR falls it will decrease
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In the case of a default risk-free floater theprice will reset to par on a coupon date
It may sell at a premium or discount betweencoupon dates
Consider a floater with a coupon = 5-year T-Bond rate
Assume there are two periods left to maturity
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The price at the end of the first coupon period willbe given by
cT-1 is the coupon one period before maturityyT-1 is the YTM one period before maturity
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On a coupon reset date the YTM = couponBecause we have assumed there is no default riskAny change in the required yield as reflected inthe prevailing YTM
Will also be reflected in the coupon being setIf coupon = yield the bond should sell at par
Thus P T-1 = M
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Once again at T-2 c T-2 = yT-2 and P T-2 = MThis logic can be applied to a bond with anytime remaining till maturityHowever between two coupon dates theprice may not be equal to par
Consider the valuation at T-2+k
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Although c T-2 was set at T-2 and is equal toyT-2
yT-2+k is determined at T-2+k and will reflect theyield prevailing at that time
Thus yT-2+k need not equal c T-2 and may behigher or lower
Hence between two coupon dates a floater maysell at a premium or discount
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Now consider a floater characterized bydefault risk
The risk premium required by the market neednot be constant over time
Assume that at the time of issue YTM = 5-year T-note rate + 75bp
The coupon would have been set equal to thisrate and the bond would have been issued at par
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Six months hence the issue may be perceivedas more risky
YTM = 5-year T-note rate + 95 bpThe coupon will however be set equal to theprevailing 5-year rate + 75 bpIf so the issue will not reset to par at the nextcoupon date
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Floaters may come with a CAP or a FLOOR orBOTH
The CAP is a maximum coupon rateProtects issuers against rising rates
The FLOOR is a minimum coupon rateProtects investors against falling rates
When there is a spread over LIBORThere is a natural floorLIBOR cannot be less than zero
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Consider a 5 year amortizing bond with aface value of $1000 and an annual coupon of8
The annual cash flows are depicted below
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Time Cash Flow
1 802 803 3304 3105 540
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The first two cash flows represent interest ona principal of $1000The third cash flow is interest on $1000 plus
a principal payment of $250The outstanding principal is $750The fourth cash flow is interest on $750 plusa principal payment of $250
The outstanding principal is $500The final cash flow is interest on $500 plusthe remaining principal of $500
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Some companies issue such bonds becausethe assets being funded have a similar cashflow profile
Second the coupon on such a bond may belower than that of a bullet bondIn the case of a bullet bond the entire principalis due at a single point in timeThere is greater default risk
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Microsoft is issuing zeroes with 5 years tomaturity and a face value of $10000
The required yield is 10 per annumWhat should be the price
Price is the PV of the face valueIn practice we discount on a semi-annual basis
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This is to facilitate comparisons withconventional bonds
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A zero coupon bond can never sell at apremium
It will always trade at a discount prior tomaturityAt maturity it will trade at par
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If held to maturity a ZCB will always give riseto a capital gainIf sold prior to maturity there may be a
capital gain or a capital lossConsider a bond with 10 years to maturityThe YTM at the time of purchase was 10The cost was $37690
A year later it is sold at a YTM of 12The corresponding price is $35035
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A newly established issuerOr an issuer with a relatively virgin productor service
Or a restructured company due to a mergeror following a bankruptcyWill be perceived as more riskyInvestors will demand a high coupon
Such firms are unlikely to have high earningsRevenues will peak only after theproductservice is established
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They can ill afford high couponsThey may consider a step-up coupon bond
Where the coupon increases as the bond ages
Assume a company can issue a plain vanillaat a coupon of 8 with a maturity of 5 yearsInstead it may opt for a bond
With a coupon of 6 for the first three years
And a coupon of 10 for the last two yearsThis is a Deferred Interest Security
Provides the issuer with breathing room in theearlier years
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These pay coupons in the form of additionalsecurities and not cash
This offers the issuer time to prepare for cashoutlays
They are used as Mezzanine FinanceThey rank between senior debt and equity in thecapital structureInvestors take more risk as compared to buyersof regular bonds ndash but get higher returnsIssuers can conserve cash in earlier years when itis at a premium
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Fully backed by the federal government ofthe issuing nationConsequently they are virtually devoid ofcredit risk or the risk of defaultThe yield on such securities is a benchmarkfor setting rates on other kinds of debt
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Treasury securities are issuedTo finance expenses in excess of currentrevenuesTo pay interest on debt accumulated in earlieryears due to deficits in those yearsTo repay past debt issues that are currentlymaturing
The US Treasuries marketIs the largest bond market in the worldIs the most liquid bond market in the world
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The Treasury issues three categories ofmarketable securities
T-bills are discount securitiesThey are zero coupon securitiesT-notes and T-bonds are sold at face value andpay interest periodically
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T-bills are issued with a original time tomaturity of one year or less
They are Money market instrumentsThey have maturities of either 1 3 6 or 12months at the time of issue
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T-notes and T-bonds have a time to maturityexceeding one year at the time of issue
They are capital market instrumentsT-notes have maturities ranging from 1-10 yearsT-bonds have an original maturity in excess of 10years extending up to 30 years
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An issue may be followed later by a furtherissue
With the same remaining time to maturity andthe same couponThe issuance of further tranches is termed as aRe-opening
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Six months ago a 10-year note was issuedwith a coupon of 8 per annumToday if a note with 9 frac12 years to maturityand a coupon of 8 issued it will add to thepool that is already trading in the marketThus it is a re-opening of an existing issue
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Who is a primary dealerA PD is a dealer who is authorized to dealdirectly with the Central Bank of the countryIn the US a PD is a bank or securities broker-dealer that directly deals with the FRBNY
Importance of FRBNYIn India a PD deals directly with the RBI
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The Treasury sells bills notes and bonds byway of a competitive auction process
Most of the treasury securities are bought byprimary dealers
Individual investors submit non-competitive bidsand participate on a much smaller scale
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Bids may beCompetitive
Indicate price amp quantity or yield amp quantityNon-competitive
Indicate only quantity
Small investors and individualsgenerally submit non-competitive bids
A non-competitive bidder may not bid for more than$5MM worth of securities in a bill or bond auction
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Primary dealers bid for their accounts andon behalf of their clientsThey usually submit large competitive
bidsBids indicate the maximum price that the bidderis prepared to pay if it is a price based auctionOr the minimum yield that the bidder is
prepared to accept if it is a yield based auction
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The Treasury will net out the totalamount of non-competitive bids
The balance will be allocated to competitivebidders
There are two ways in which securitiescan be allotted
The multiple priceyield auction mechanism
French AuctionsThe uniform priceyield auction mechanism
Dutch Auctions
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Assume that the Treasury is offering 25billion dollars worth of T-bonds
2 billion dollars worth of non-competitive bidshave been receivedSo 23 billion dollars worth of bonds are availableto be offered to the competitive bidders
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There are six competitive bidders who havesubmitted the following yields
The bids have been arranged in ascending orderof yieldIn a price based auction the bids would havebeen arranged in descending order of price
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Bidder Bid Yield Bid Amount
Aggregate Amount
Alpha 5370 30 bn 30 bnBeta 5372 50 bn 80 bn
Gamma 5373 40 bn 12 bn
Delta 5375 80 bn 20 bnCharlie 5375 120 bn 32 bn
Tango 5380 30 bn 35 bn8282014 69
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The aggregate demand equals the amount onoffer at a yield of 5375A multiple yield auction will lead to thefollowing allocation
Alpha will get 3 bn at a yield of 5370Beta will get 5 bn at 5372Gamma will get 4 bn at 5373
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At a yield of 5375 we have only 11 bn left toallocateThere is a demand of 20 bn at this yield
8 bn from Delta and 12 bn from CharlieThus we will allocate 1120 = 55 to eachbidder at this yield
There will be pro-rata allocation
055 of 8 bn or 440 bn will go to Delta055 of 12 bn or 66 bn will go to Charlie
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The highest accepted yield is called the StopYield or High Yield
In this case it is 5375The ratio of bids received to the amountawarded is known as the bid to cover ratio
The higher the ratio the stronger is the auction
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Those who bid more than 5375 will getnothing and are said to be shutout of theauctionSince 1999 the US Treasury has beenconducting only uniform yield auctions
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WI stands for ndash When As and If IssuedThe when issued market is a market forforward trading of a bond
Which has been announced but not yet issuedTrades take place from the date ofannouncement until the actual issue date
Helps bidders to gauge the marketrsquos interestbefore the actual auction
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WI trading has ramifications for the biddingstrategies of market participantsTraders can take both long and shortpositions
Settlement is scheduled for the issue date
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It has a bearing on the outcome of theauction
It affects the strategy used by a bidder becauseit has an impact on his prior positionBidders who are long in the WI market enter theauction with a Long PositionThose who are short in the WI market enter theauction with a short position
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The WI market helps in price discoveryIt provides important information on
The strength of demand for the securityAnd on the disparity of biddersrsquo views
This help potential bidders to formulate theirstrategiesAt times a dealer may believe that he hasvery important private information
If so he may not participate in the WI market andwill directly enter the auction with bids based onhis knowledge
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On or before the date of the auction theissues trade on a yield basis
The actual price can be established only afterthe coupon is set
Starting with the day after the auctionSecurities are quoted on a price basis becausethe coupon is known
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In a coupon roll a dealer will purchase themost recently issued security from a clientAnd simultaneously sell the same amount ofthe recently announced new security
The first leg with settle on the following dayThe second leg is a forward contract
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There can be a Reverse RollThe dealer will sell the most recent issue fornext day settlementAnd buy the newly announced security forforward settlement
The forward leg in a RollReverse Roll is a WItrade
It will settle on the new issue settlement date
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The roll is the spread between the yield onthe new security and that on the outstandingissue in the same maturity segmentA GIVE in the Roll means that
The WI security provides a higher yield than theoutstanding issue
A Take in the Roll means thatThe WI security provides a lower yield
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On March 17 20XX the Treasury announcedthe auction of a 2-year note
The auction was scheduled for March 24The settlement date was March 31
Trading of the roll began as soon as the issuewas announcedA Give of 5 bp means that the dealer proposes tobuy the current issue at the prevailing yieldAnd sell the new issue at a yield that is 5 bpmoreA Take of 5 bp means that the dealer proposes tosell the new issue at a yield that is 5bp lower
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The roll achieves the followingHe acquires the outstanding issue for next daysettlementHe sells the to be issued security with the samepar value for forward delivery on 31 March
The customer is rolling over the investmentfrom the current issue to the new issue
This extends the maturity of the investment byone month
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The client can invest the funds received tillthe new issue settlesHowever he loses the accrued interest thathe would have earned had he held on to theissue
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The Treasury per se does not issue zerocoupon securitiesBut zero coupon securities can be created
which are backed by conventional bondsTake a large quantity of a T-note or bond andseparate all the cash flows from each otherSell the entitlement to each cash flowseparately
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Take the case of a two-year T-noteIt can be separated into five zero couponsecurities maturing after
6 months12 months18 months24 months
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Earlier investment banks used to buy bondsfrom the Treasury and separate the cashflows
Each cash flow was then sold separately as a zerocoupon bondSuch issues are called trademarks
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The issue of trademarks has now ceasedBecause investment banks can now createsuch instruments
In concert with the Treasury itselfThese ZCBs are known as STRIPS ndash
Separate Trading of Registered Interest andPrincipal of Securities
These are not issued or sold by the Treasury
The market is made by investment banks
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What is the motivation to create suchproductsIn practice arbitrage is possible when a
coupon security is purchased at a priceThat is lower than what could be obtained byselling each cash flow separately
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Coupon stripping reflects a case of financialengineering
Creating a risk-return profile that is nototherwise available
An investment bank would buy a largequantity of a Treasury security
The securities would be placed with an SPV
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The SPV is a single-purpose dedicated trustIt has the powers to own the bonds andcollect payments
It cannot sell or lend the bondsIt cannot write options on the bondsOr use them as collateral for borrowing
The SPV is empowered to issue zero coupon
bondsWhere each security represents the ownership ofa single cash flow from the mother bond
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Assume that 100MM USD of 15 year bondswith a coupon of 8 are placed with the SPV
The SPV can issue 6M 12M 18M extending up to14 frac12 year zeroes with a total face value of 4MM
USD eachAnd 15 year zeroes with a total face value of104MM
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The Treasury launched this program in 1985to facilitate the stripping of designatedsecurities
All new T-bonds and notes with a maturity of 10years or more are eligibleThe zeroes created in the process are directobligations of the US government
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The mechanism is as followsA dealer who owns a bond or note can ask theFRB where it is held
To replace it with an equivalent set of STRIPS
representing each payment as a separate securityEach of these securities can be traded independentlyof others
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In 1987 the Treasury started to allow dealersto reverse the process
This is called STRIPS RECONSTUTUTION If a dealer owns STRIPS representing all thecoupon and principal payments of a bond
The FED can on request convert these holdings into asingle position in the corresponding bond
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Each coupon and principal cash flow from aTreasury security is assigned a CUSIP
The mother bond is also assigned a CUSIPThe stripped coupons are known as C-STRIPSThe stripped principal is known as P-STRIPSSupply of a C-STRIP increases over time
because a C-STRIP maturing on a day like 15 FEB
2020 will have the same CUSIP irrespective ofwhich mother bond it has come fromThe original coupon rate is irrelevant
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P-STRIPS always correspond to the originalsecurityThey have a unique CUSIPTheir supply is fixed at the time of issuanceIn practice the prices of long-dated P-STRIPSare a bit higher than those of C-STRIPS withthe same maturity date
One reason is that P-STRIPS are more liquid due
to greater availabilityA $100 face value bond with a coupon of 8 willgenerate C-STRIPS with a face value of $4 but P-STRIPS with a face value of $100
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Another reason why P-STRIPS are in higherdemand is that they allow reconstitutionactivities more easily
Assume that the sum of the STRIPS is cheaper than
the mother bondIf a dealer already has the P-STRIPS only the C-STRIPSneed to be acquiredHowever if he owns some of the C-STRIPS he needs toacquire the P-STRIPS and the remaining C-STRIPSThe facility to reconstitute when profitable is pricedinto the P-STRIPSNote Buy and hold investors will prefer C-STRIPSsince they are priced lower and give a higher yield
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For Plain Vanilla bonds the specifiedcoupon rate is valid for the life of thebond
In the case of Floaters the rate is reset atthe beginning of every periodThe rate will vary directly with thebenchmark
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The rate on a Floater is specified as LIBOR+ 50 bp
The spread is positiveIf it were specified as LIBOR ndash 30bp
The spread will be negativeIf LIBOR rises the rate will increasewhereas if LIBOR falls it will decrease
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In the case of a default risk-free floater theprice will reset to par on a coupon date
It may sell at a premium or discount betweencoupon dates
Consider a floater with a coupon = 5-year T-Bond rate
Assume there are two periods left to maturity
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The price at the end of the first coupon period willbe given by
cT-1 is the coupon one period before maturityyT-1 is the YTM one period before maturity
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On a coupon reset date the YTM = couponBecause we have assumed there is no default riskAny change in the required yield as reflected inthe prevailing YTM
Will also be reflected in the coupon being setIf coupon = yield the bond should sell at par
Thus P T-1 = M
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Once again at T-2 c T-2 = yT-2 and P T-2 = MThis logic can be applied to a bond with anytime remaining till maturityHowever between two coupon dates theprice may not be equal to par
Consider the valuation at T-2+k
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Although c T-2 was set at T-2 and is equal toyT-2
yT-2+k is determined at T-2+k and will reflect theyield prevailing at that time
Thus yT-2+k need not equal c T-2 and may behigher or lower
Hence between two coupon dates a floater maysell at a premium or discount
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Now consider a floater characterized bydefault risk
The risk premium required by the market neednot be constant over time
Assume that at the time of issue YTM = 5-year T-note rate + 75bp
The coupon would have been set equal to thisrate and the bond would have been issued at par
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Six months hence the issue may be perceivedas more risky
YTM = 5-year T-note rate + 95 bpThe coupon will however be set equal to theprevailing 5-year rate + 75 bpIf so the issue will not reset to par at the nextcoupon date
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Floaters may come with a CAP or a FLOOR orBOTH
The CAP is a maximum coupon rateProtects issuers against rising rates
The FLOOR is a minimum coupon rateProtects investors against falling rates
When there is a spread over LIBORThere is a natural floorLIBOR cannot be less than zero
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The first two cash flows represent interest ona principal of $1000The third cash flow is interest on $1000 plus
a principal payment of $250The outstanding principal is $750The fourth cash flow is interest on $750 plusa principal payment of $250
The outstanding principal is $500The final cash flow is interest on $500 plusthe remaining principal of $500
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Some companies issue such bonds becausethe assets being funded have a similar cashflow profile
Second the coupon on such a bond may belower than that of a bullet bondIn the case of a bullet bond the entire principalis due at a single point in timeThere is greater default risk
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Microsoft is issuing zeroes with 5 years tomaturity and a face value of $10000
The required yield is 10 per annumWhat should be the price
Price is the PV of the face valueIn practice we discount on a semi-annual basis
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This is to facilitate comparisons withconventional bonds
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A zero coupon bond can never sell at apremium
It will always trade at a discount prior tomaturityAt maturity it will trade at par
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If held to maturity a ZCB will always give riseto a capital gainIf sold prior to maturity there may be a
capital gain or a capital lossConsider a bond with 10 years to maturityThe YTM at the time of purchase was 10The cost was $37690
A year later it is sold at a YTM of 12The corresponding price is $35035
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A newly established issuerOr an issuer with a relatively virgin productor service
Or a restructured company due to a mergeror following a bankruptcyWill be perceived as more riskyInvestors will demand a high coupon
Such firms are unlikely to have high earningsRevenues will peak only after theproductservice is established
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They can ill afford high couponsThey may consider a step-up coupon bond
Where the coupon increases as the bond ages
Assume a company can issue a plain vanillaat a coupon of 8 with a maturity of 5 yearsInstead it may opt for a bond
With a coupon of 6 for the first three years
And a coupon of 10 for the last two yearsThis is a Deferred Interest Security
Provides the issuer with breathing room in theearlier years
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These pay coupons in the form of additionalsecurities and not cash
This offers the issuer time to prepare for cashoutlays
They are used as Mezzanine FinanceThey rank between senior debt and equity in thecapital structureInvestors take more risk as compared to buyersof regular bonds ndash but get higher returnsIssuers can conserve cash in earlier years when itis at a premium
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Fully backed by the federal government ofthe issuing nationConsequently they are virtually devoid ofcredit risk or the risk of defaultThe yield on such securities is a benchmarkfor setting rates on other kinds of debt
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Treasury securities are issuedTo finance expenses in excess of currentrevenuesTo pay interest on debt accumulated in earlieryears due to deficits in those yearsTo repay past debt issues that are currentlymaturing
The US Treasuries marketIs the largest bond market in the worldIs the most liquid bond market in the world
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The Treasury issues three categories ofmarketable securities
T-bills are discount securitiesThey are zero coupon securitiesT-notes and T-bonds are sold at face value andpay interest periodically
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T-bills are issued with a original time tomaturity of one year or less
They are Money market instrumentsThey have maturities of either 1 3 6 or 12months at the time of issue
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T-notes and T-bonds have a time to maturityexceeding one year at the time of issue
They are capital market instrumentsT-notes have maturities ranging from 1-10 yearsT-bonds have an original maturity in excess of 10years extending up to 30 years
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An issue may be followed later by a furtherissue
With the same remaining time to maturity andthe same couponThe issuance of further tranches is termed as aRe-opening
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Six months ago a 10-year note was issuedwith a coupon of 8 per annumToday if a note with 9 frac12 years to maturityand a coupon of 8 issued it will add to thepool that is already trading in the marketThus it is a re-opening of an existing issue
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Who is a primary dealerA PD is a dealer who is authorized to dealdirectly with the Central Bank of the countryIn the US a PD is a bank or securities broker-dealer that directly deals with the FRBNY
Importance of FRBNYIn India a PD deals directly with the RBI
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The Treasury sells bills notes and bonds byway of a competitive auction process
Most of the treasury securities are bought byprimary dealers
Individual investors submit non-competitive bidsand participate on a much smaller scale
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Bids may beCompetitive
Indicate price amp quantity or yield amp quantityNon-competitive
Indicate only quantity
Small investors and individualsgenerally submit non-competitive bids
A non-competitive bidder may not bid for more than$5MM worth of securities in a bill or bond auction
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Primary dealers bid for their accounts andon behalf of their clientsThey usually submit large competitive
bidsBids indicate the maximum price that the bidderis prepared to pay if it is a price based auctionOr the minimum yield that the bidder is
prepared to accept if it is a yield based auction
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The Treasury will net out the totalamount of non-competitive bids
The balance will be allocated to competitivebidders
There are two ways in which securitiescan be allotted
The multiple priceyield auction mechanism
French AuctionsThe uniform priceyield auction mechanism
Dutch Auctions
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Assume that the Treasury is offering 25billion dollars worth of T-bonds
2 billion dollars worth of non-competitive bidshave been receivedSo 23 billion dollars worth of bonds are availableto be offered to the competitive bidders
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There are six competitive bidders who havesubmitted the following yields
The bids have been arranged in ascending orderof yieldIn a price based auction the bids would havebeen arranged in descending order of price
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Bidder Bid Yield Bid Amount
Aggregate Amount
Alpha 5370 30 bn 30 bnBeta 5372 50 bn 80 bn
Gamma 5373 40 bn 12 bn
Delta 5375 80 bn 20 bnCharlie 5375 120 bn 32 bn
Tango 5380 30 bn 35 bn8282014 69
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The aggregate demand equals the amount onoffer at a yield of 5375A multiple yield auction will lead to thefollowing allocation
Alpha will get 3 bn at a yield of 5370Beta will get 5 bn at 5372Gamma will get 4 bn at 5373
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At a yield of 5375 we have only 11 bn left toallocateThere is a demand of 20 bn at this yield
8 bn from Delta and 12 bn from CharlieThus we will allocate 1120 = 55 to eachbidder at this yield
There will be pro-rata allocation
055 of 8 bn or 440 bn will go to Delta055 of 12 bn or 66 bn will go to Charlie
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The highest accepted yield is called the StopYield or High Yield
In this case it is 5375The ratio of bids received to the amountawarded is known as the bid to cover ratio
The higher the ratio the stronger is the auction
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Those who bid more than 5375 will getnothing and are said to be shutout of theauctionSince 1999 the US Treasury has beenconducting only uniform yield auctions
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WI stands for ndash When As and If IssuedThe when issued market is a market forforward trading of a bond
Which has been announced but not yet issuedTrades take place from the date ofannouncement until the actual issue date
Helps bidders to gauge the marketrsquos interestbefore the actual auction
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WI trading has ramifications for the biddingstrategies of market participantsTraders can take both long and shortpositions
Settlement is scheduled for the issue date
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It has a bearing on the outcome of theauction
It affects the strategy used by a bidder becauseit has an impact on his prior positionBidders who are long in the WI market enter theauction with a Long PositionThose who are short in the WI market enter theauction with a short position
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The WI market helps in price discoveryIt provides important information on
The strength of demand for the securityAnd on the disparity of biddersrsquo views
This help potential bidders to formulate theirstrategiesAt times a dealer may believe that he hasvery important private information
If so he may not participate in the WI market andwill directly enter the auction with bids based onhis knowledge
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On or before the date of the auction theissues trade on a yield basis
The actual price can be established only afterthe coupon is set
Starting with the day after the auctionSecurities are quoted on a price basis becausethe coupon is known
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In a coupon roll a dealer will purchase themost recently issued security from a clientAnd simultaneously sell the same amount ofthe recently announced new security
The first leg with settle on the following dayThe second leg is a forward contract
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There can be a Reverse RollThe dealer will sell the most recent issue fornext day settlementAnd buy the newly announced security forforward settlement
The forward leg in a RollReverse Roll is a WItrade
It will settle on the new issue settlement date
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The roll is the spread between the yield onthe new security and that on the outstandingissue in the same maturity segmentA GIVE in the Roll means that
The WI security provides a higher yield than theoutstanding issue
A Take in the Roll means thatThe WI security provides a lower yield
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On March 17 20XX the Treasury announcedthe auction of a 2-year note
The auction was scheduled for March 24The settlement date was March 31
Trading of the roll began as soon as the issuewas announcedA Give of 5 bp means that the dealer proposes tobuy the current issue at the prevailing yieldAnd sell the new issue at a yield that is 5 bpmoreA Take of 5 bp means that the dealer proposes tosell the new issue at a yield that is 5bp lower
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The roll achieves the followingHe acquires the outstanding issue for next daysettlementHe sells the to be issued security with the samepar value for forward delivery on 31 March
The customer is rolling over the investmentfrom the current issue to the new issue
This extends the maturity of the investment byone month
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The client can invest the funds received tillthe new issue settlesHowever he loses the accrued interest thathe would have earned had he held on to theissue
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The Treasury per se does not issue zerocoupon securitiesBut zero coupon securities can be created
which are backed by conventional bondsTake a large quantity of a T-note or bond andseparate all the cash flows from each otherSell the entitlement to each cash flowseparately
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Take the case of a two-year T-noteIt can be separated into five zero couponsecurities maturing after
6 months12 months18 months24 months
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Earlier investment banks used to buy bondsfrom the Treasury and separate the cashflows
Each cash flow was then sold separately as a zerocoupon bondSuch issues are called trademarks
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The issue of trademarks has now ceasedBecause investment banks can now createsuch instruments
In concert with the Treasury itselfThese ZCBs are known as STRIPS ndash
Separate Trading of Registered Interest andPrincipal of Securities
These are not issued or sold by the Treasury
The market is made by investment banks
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What is the motivation to create suchproductsIn practice arbitrage is possible when a
coupon security is purchased at a priceThat is lower than what could be obtained byselling each cash flow separately
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Coupon stripping reflects a case of financialengineering
Creating a risk-return profile that is nototherwise available
An investment bank would buy a largequantity of a Treasury security
The securities would be placed with an SPV
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The SPV is a single-purpose dedicated trustIt has the powers to own the bonds andcollect payments
It cannot sell or lend the bondsIt cannot write options on the bondsOr use them as collateral for borrowing
The SPV is empowered to issue zero coupon
bondsWhere each security represents the ownership ofa single cash flow from the mother bond
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Assume that 100MM USD of 15 year bondswith a coupon of 8 are placed with the SPV
The SPV can issue 6M 12M 18M extending up to14 frac12 year zeroes with a total face value of 4MM
USD eachAnd 15 year zeroes with a total face value of104MM
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The Treasury launched this program in 1985to facilitate the stripping of designatedsecurities
All new T-bonds and notes with a maturity of 10years or more are eligibleThe zeroes created in the process are directobligations of the US government
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The mechanism is as followsA dealer who owns a bond or note can ask theFRB where it is held
To replace it with an equivalent set of STRIPS
representing each payment as a separate securityEach of these securities can be traded independentlyof others
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In 1987 the Treasury started to allow dealersto reverse the process
This is called STRIPS RECONSTUTUTION If a dealer owns STRIPS representing all thecoupon and principal payments of a bond
The FED can on request convert these holdings into asingle position in the corresponding bond
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Each coupon and principal cash flow from aTreasury security is assigned a CUSIP
The mother bond is also assigned a CUSIPThe stripped coupons are known as C-STRIPSThe stripped principal is known as P-STRIPSSupply of a C-STRIP increases over time
because a C-STRIP maturing on a day like 15 FEB
2020 will have the same CUSIP irrespective ofwhich mother bond it has come fromThe original coupon rate is irrelevant
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P-STRIPS always correspond to the originalsecurityThey have a unique CUSIPTheir supply is fixed at the time of issuanceIn practice the prices of long-dated P-STRIPSare a bit higher than those of C-STRIPS withthe same maturity date
One reason is that P-STRIPS are more liquid due
to greater availabilityA $100 face value bond with a coupon of 8 willgenerate C-STRIPS with a face value of $4 but P-STRIPS with a face value of $100
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Another reason why P-STRIPS are in higherdemand is that they allow reconstitutionactivities more easily
Assume that the sum of the STRIPS is cheaper than
the mother bondIf a dealer already has the P-STRIPS only the C-STRIPSneed to be acquiredHowever if he owns some of the C-STRIPS he needs toacquire the P-STRIPS and the remaining C-STRIPSThe facility to reconstitute when profitable is pricedinto the P-STRIPSNote Buy and hold investors will prefer C-STRIPSsince they are priced lower and give a higher yield
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For Plain Vanilla bonds the specifiedcoupon rate is valid for the life of thebond
In the case of Floaters the rate is reset atthe beginning of every periodThe rate will vary directly with thebenchmark
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The rate on a Floater is specified as LIBOR+ 50 bp
The spread is positiveIf it were specified as LIBOR ndash 30bp
The spread will be negativeIf LIBOR rises the rate will increasewhereas if LIBOR falls it will decrease
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In the case of a default risk-free floater theprice will reset to par on a coupon date
It may sell at a premium or discount betweencoupon dates
Consider a floater with a coupon = 5-year T-Bond rate
Assume there are two periods left to maturity
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The price at the end of the first coupon period willbe given by
cT-1 is the coupon one period before maturityyT-1 is the YTM one period before maturity
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On a coupon reset date the YTM = couponBecause we have assumed there is no default riskAny change in the required yield as reflected inthe prevailing YTM
Will also be reflected in the coupon being setIf coupon = yield the bond should sell at par
Thus P T-1 = M
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Once again at T-2 c T-2 = yT-2 and P T-2 = MThis logic can be applied to a bond with anytime remaining till maturityHowever between two coupon dates theprice may not be equal to par
Consider the valuation at T-2+k
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Although c T-2 was set at T-2 and is equal toyT-2
yT-2+k is determined at T-2+k and will reflect theyield prevailing at that time
Thus yT-2+k need not equal c T-2 and may behigher or lower
Hence between two coupon dates a floater maysell at a premium or discount
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Now consider a floater characterized bydefault risk
The risk premium required by the market neednot be constant over time
Assume that at the time of issue YTM = 5-year T-note rate + 75bp
The coupon would have been set equal to thisrate and the bond would have been issued at par
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Six months hence the issue may be perceivedas more risky
YTM = 5-year T-note rate + 95 bpThe coupon will however be set equal to theprevailing 5-year rate + 75 bpIf so the issue will not reset to par at the nextcoupon date
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Floaters may come with a CAP or a FLOOR orBOTH
The CAP is a maximum coupon rateProtects issuers against rising rates
The FLOOR is a minimum coupon rateProtects investors against falling rates
When there is a spread over LIBORThere is a natural floorLIBOR cannot be less than zero
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Some companies issue such bonds becausethe assets being funded have a similar cashflow profile
Second the coupon on such a bond may belower than that of a bullet bondIn the case of a bullet bond the entire principalis due at a single point in timeThere is greater default risk
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Microsoft is issuing zeroes with 5 years tomaturity and a face value of $10000
The required yield is 10 per annumWhat should be the price
Price is the PV of the face valueIn practice we discount on a semi-annual basis
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This is to facilitate comparisons withconventional bonds
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A zero coupon bond can never sell at apremium
It will always trade at a discount prior tomaturityAt maturity it will trade at par
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If held to maturity a ZCB will always give riseto a capital gainIf sold prior to maturity there may be a
capital gain or a capital lossConsider a bond with 10 years to maturityThe YTM at the time of purchase was 10The cost was $37690
A year later it is sold at a YTM of 12The corresponding price is $35035
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A newly established issuerOr an issuer with a relatively virgin productor service
Or a restructured company due to a mergeror following a bankruptcyWill be perceived as more riskyInvestors will demand a high coupon
Such firms are unlikely to have high earningsRevenues will peak only after theproductservice is established
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They can ill afford high couponsThey may consider a step-up coupon bond
Where the coupon increases as the bond ages
Assume a company can issue a plain vanillaat a coupon of 8 with a maturity of 5 yearsInstead it may opt for a bond
With a coupon of 6 for the first three years
And a coupon of 10 for the last two yearsThis is a Deferred Interest Security
Provides the issuer with breathing room in theearlier years
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These pay coupons in the form of additionalsecurities and not cash
This offers the issuer time to prepare for cashoutlays
They are used as Mezzanine FinanceThey rank between senior debt and equity in thecapital structureInvestors take more risk as compared to buyersof regular bonds ndash but get higher returnsIssuers can conserve cash in earlier years when itis at a premium
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Fully backed by the federal government ofthe issuing nationConsequently they are virtually devoid ofcredit risk or the risk of defaultThe yield on such securities is a benchmarkfor setting rates on other kinds of debt
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Treasury securities are issuedTo finance expenses in excess of currentrevenuesTo pay interest on debt accumulated in earlieryears due to deficits in those yearsTo repay past debt issues that are currentlymaturing
The US Treasuries marketIs the largest bond market in the worldIs the most liquid bond market in the world
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The Treasury issues three categories ofmarketable securities
T-bills are discount securitiesThey are zero coupon securitiesT-notes and T-bonds are sold at face value andpay interest periodically
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T-bills are issued with a original time tomaturity of one year or less
They are Money market instrumentsThey have maturities of either 1 3 6 or 12months at the time of issue
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T-notes and T-bonds have a time to maturityexceeding one year at the time of issue
They are capital market instrumentsT-notes have maturities ranging from 1-10 yearsT-bonds have an original maturity in excess of 10years extending up to 30 years
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An issue may be followed later by a furtherissue
With the same remaining time to maturity andthe same couponThe issuance of further tranches is termed as aRe-opening
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Six months ago a 10-year note was issuedwith a coupon of 8 per annumToday if a note with 9 frac12 years to maturityand a coupon of 8 issued it will add to thepool that is already trading in the marketThus it is a re-opening of an existing issue
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Who is a primary dealerA PD is a dealer who is authorized to dealdirectly with the Central Bank of the countryIn the US a PD is a bank or securities broker-dealer that directly deals with the FRBNY
Importance of FRBNYIn India a PD deals directly with the RBI
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The Treasury sells bills notes and bonds byway of a competitive auction process
Most of the treasury securities are bought byprimary dealers
Individual investors submit non-competitive bidsand participate on a much smaller scale
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Bids may beCompetitive
Indicate price amp quantity or yield amp quantityNon-competitive
Indicate only quantity
Small investors and individualsgenerally submit non-competitive bids
A non-competitive bidder may not bid for more than$5MM worth of securities in a bill or bond auction
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Primary dealers bid for their accounts andon behalf of their clientsThey usually submit large competitive
bidsBids indicate the maximum price that the bidderis prepared to pay if it is a price based auctionOr the minimum yield that the bidder is
prepared to accept if it is a yield based auction
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The Treasury will net out the totalamount of non-competitive bids
The balance will be allocated to competitivebidders
There are two ways in which securitiescan be allotted
The multiple priceyield auction mechanism
French AuctionsThe uniform priceyield auction mechanism
Dutch Auctions
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Assume that the Treasury is offering 25billion dollars worth of T-bonds
2 billion dollars worth of non-competitive bidshave been receivedSo 23 billion dollars worth of bonds are availableto be offered to the competitive bidders
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There are six competitive bidders who havesubmitted the following yields
The bids have been arranged in ascending orderof yieldIn a price based auction the bids would havebeen arranged in descending order of price
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Bidder Bid Yield Bid Amount
Aggregate Amount
Alpha 5370 30 bn 30 bnBeta 5372 50 bn 80 bn
Gamma 5373 40 bn 12 bn
Delta 5375 80 bn 20 bnCharlie 5375 120 bn 32 bn
Tango 5380 30 bn 35 bn8282014 69
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The aggregate demand equals the amount onoffer at a yield of 5375A multiple yield auction will lead to thefollowing allocation
Alpha will get 3 bn at a yield of 5370Beta will get 5 bn at 5372Gamma will get 4 bn at 5373
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At a yield of 5375 we have only 11 bn left toallocateThere is a demand of 20 bn at this yield
8 bn from Delta and 12 bn from CharlieThus we will allocate 1120 = 55 to eachbidder at this yield
There will be pro-rata allocation
055 of 8 bn or 440 bn will go to Delta055 of 12 bn or 66 bn will go to Charlie
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The highest accepted yield is called the StopYield or High Yield
In this case it is 5375The ratio of bids received to the amountawarded is known as the bid to cover ratio
The higher the ratio the stronger is the auction
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Those who bid more than 5375 will getnothing and are said to be shutout of theauctionSince 1999 the US Treasury has beenconducting only uniform yield auctions
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WI stands for ndash When As and If IssuedThe when issued market is a market forforward trading of a bond
Which has been announced but not yet issuedTrades take place from the date ofannouncement until the actual issue date
Helps bidders to gauge the marketrsquos interestbefore the actual auction
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WI trading has ramifications for the biddingstrategies of market participantsTraders can take both long and shortpositions
Settlement is scheduled for the issue date
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It has a bearing on the outcome of theauction
It affects the strategy used by a bidder becauseit has an impact on his prior positionBidders who are long in the WI market enter theauction with a Long PositionThose who are short in the WI market enter theauction with a short position
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The WI market helps in price discoveryIt provides important information on
The strength of demand for the securityAnd on the disparity of biddersrsquo views
This help potential bidders to formulate theirstrategiesAt times a dealer may believe that he hasvery important private information
If so he may not participate in the WI market andwill directly enter the auction with bids based onhis knowledge
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On or before the date of the auction theissues trade on a yield basis
The actual price can be established only afterthe coupon is set
Starting with the day after the auctionSecurities are quoted on a price basis becausethe coupon is known
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In a coupon roll a dealer will purchase themost recently issued security from a clientAnd simultaneously sell the same amount ofthe recently announced new security
The first leg with settle on the following dayThe second leg is a forward contract
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There can be a Reverse RollThe dealer will sell the most recent issue fornext day settlementAnd buy the newly announced security forforward settlement
The forward leg in a RollReverse Roll is a WItrade
It will settle on the new issue settlement date
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The roll is the spread between the yield onthe new security and that on the outstandingissue in the same maturity segmentA GIVE in the Roll means that
The WI security provides a higher yield than theoutstanding issue
A Take in the Roll means thatThe WI security provides a lower yield
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On March 17 20XX the Treasury announcedthe auction of a 2-year note
The auction was scheduled for March 24The settlement date was March 31
Trading of the roll began as soon as the issuewas announcedA Give of 5 bp means that the dealer proposes tobuy the current issue at the prevailing yieldAnd sell the new issue at a yield that is 5 bpmoreA Take of 5 bp means that the dealer proposes tosell the new issue at a yield that is 5bp lower
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The roll achieves the followingHe acquires the outstanding issue for next daysettlementHe sells the to be issued security with the samepar value for forward delivery on 31 March
The customer is rolling over the investmentfrom the current issue to the new issue
This extends the maturity of the investment byone month
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The client can invest the funds received tillthe new issue settlesHowever he loses the accrued interest thathe would have earned had he held on to theissue
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The Treasury per se does not issue zerocoupon securitiesBut zero coupon securities can be created
which are backed by conventional bondsTake a large quantity of a T-note or bond andseparate all the cash flows from each otherSell the entitlement to each cash flowseparately
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Take the case of a two-year T-noteIt can be separated into five zero couponsecurities maturing after
6 months12 months18 months24 months
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Earlier investment banks used to buy bondsfrom the Treasury and separate the cashflows
Each cash flow was then sold separately as a zerocoupon bondSuch issues are called trademarks
8282014 89
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The issue of trademarks has now ceasedBecause investment banks can now createsuch instruments
In concert with the Treasury itselfThese ZCBs are known as STRIPS ndash
Separate Trading of Registered Interest andPrincipal of Securities
These are not issued or sold by the Treasury
The market is made by investment banks
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What is the motivation to create suchproductsIn practice arbitrage is possible when a
coupon security is purchased at a priceThat is lower than what could be obtained byselling each cash flow separately
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Coupon stripping reflects a case of financialengineering
Creating a risk-return profile that is nototherwise available
An investment bank would buy a largequantity of a Treasury security
The securities would be placed with an SPV
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The SPV is a single-purpose dedicated trustIt has the powers to own the bonds andcollect payments
It cannot sell or lend the bondsIt cannot write options on the bondsOr use them as collateral for borrowing
The SPV is empowered to issue zero coupon
bondsWhere each security represents the ownership ofa single cash flow from the mother bond
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Assume that 100MM USD of 15 year bondswith a coupon of 8 are placed with the SPV
The SPV can issue 6M 12M 18M extending up to14 frac12 year zeroes with a total face value of 4MM
USD eachAnd 15 year zeroes with a total face value of104MM
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The Treasury launched this program in 1985to facilitate the stripping of designatedsecurities
All new T-bonds and notes with a maturity of 10years or more are eligibleThe zeroes created in the process are directobligations of the US government
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The mechanism is as followsA dealer who owns a bond or note can ask theFRB where it is held
To replace it with an equivalent set of STRIPS
representing each payment as a separate securityEach of these securities can be traded independentlyof others
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In 1987 the Treasury started to allow dealersto reverse the process
This is called STRIPS RECONSTUTUTION If a dealer owns STRIPS representing all thecoupon and principal payments of a bond
The FED can on request convert these holdings into asingle position in the corresponding bond
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Each coupon and principal cash flow from aTreasury security is assigned a CUSIP
The mother bond is also assigned a CUSIPThe stripped coupons are known as C-STRIPSThe stripped principal is known as P-STRIPSSupply of a C-STRIP increases over time
because a C-STRIP maturing on a day like 15 FEB
2020 will have the same CUSIP irrespective ofwhich mother bond it has come fromThe original coupon rate is irrelevant
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P-STRIPS always correspond to the originalsecurityThey have a unique CUSIPTheir supply is fixed at the time of issuanceIn practice the prices of long-dated P-STRIPSare a bit higher than those of C-STRIPS withthe same maturity date
One reason is that P-STRIPS are more liquid due
to greater availabilityA $100 face value bond with a coupon of 8 willgenerate C-STRIPS with a face value of $4 but P-STRIPS with a face value of $100
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Another reason why P-STRIPS are in higherdemand is that they allow reconstitutionactivities more easily
Assume that the sum of the STRIPS is cheaper than
the mother bondIf a dealer already has the P-STRIPS only the C-STRIPSneed to be acquiredHowever if he owns some of the C-STRIPS he needs toacquire the P-STRIPS and the remaining C-STRIPSThe facility to reconstitute when profitable is pricedinto the P-STRIPSNote Buy and hold investors will prefer C-STRIPSsince they are priced lower and give a higher yield
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For Plain Vanilla bonds the specifiedcoupon rate is valid for the life of thebond
In the case of Floaters the rate is reset atthe beginning of every periodThe rate will vary directly with thebenchmark
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The rate on a Floater is specified as LIBOR+ 50 bp
The spread is positiveIf it were specified as LIBOR ndash 30bp
The spread will be negativeIf LIBOR rises the rate will increasewhereas if LIBOR falls it will decrease
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In the case of a default risk-free floater theprice will reset to par on a coupon date
It may sell at a premium or discount betweencoupon dates
Consider a floater with a coupon = 5-year T-Bond rate
Assume there are two periods left to maturity
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The price at the end of the first coupon period willbe given by
cT-1 is the coupon one period before maturityyT-1 is the YTM one period before maturity
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On a coupon reset date the YTM = couponBecause we have assumed there is no default riskAny change in the required yield as reflected inthe prevailing YTM
Will also be reflected in the coupon being setIf coupon = yield the bond should sell at par
Thus P T-1 = M
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Once again at T-2 c T-2 = yT-2 and P T-2 = MThis logic can be applied to a bond with anytime remaining till maturityHowever between two coupon dates theprice may not be equal to par
Consider the valuation at T-2+k
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Although c T-2 was set at T-2 and is equal toyT-2
yT-2+k is determined at T-2+k and will reflect theyield prevailing at that time
Thus yT-2+k need not equal c T-2 and may behigher or lower
Hence between two coupon dates a floater maysell at a premium or discount
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Now consider a floater characterized bydefault risk
The risk premium required by the market neednot be constant over time
Assume that at the time of issue YTM = 5-year T-note rate + 75bp
The coupon would have been set equal to thisrate and the bond would have been issued at par
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Six months hence the issue may be perceivedas more risky
YTM = 5-year T-note rate + 95 bpThe coupon will however be set equal to theprevailing 5-year rate + 75 bpIf so the issue will not reset to par at the nextcoupon date
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Floaters may come with a CAP or a FLOOR orBOTH
The CAP is a maximum coupon rateProtects issuers against rising rates
The FLOOR is a minimum coupon rateProtects investors against falling rates
When there is a spread over LIBORThere is a natural floorLIBOR cannot be less than zero
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Microsoft is issuing zeroes with 5 years tomaturity and a face value of $10000
The required yield is 10 per annumWhat should be the price
Price is the PV of the face valueIn practice we discount on a semi-annual basis
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This is to facilitate comparisons withconventional bonds
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A zero coupon bond can never sell at apremium
It will always trade at a discount prior tomaturityAt maturity it will trade at par
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If held to maturity a ZCB will always give riseto a capital gainIf sold prior to maturity there may be a
capital gain or a capital lossConsider a bond with 10 years to maturityThe YTM at the time of purchase was 10The cost was $37690
A year later it is sold at a YTM of 12The corresponding price is $35035
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A newly established issuerOr an issuer with a relatively virgin productor service
Or a restructured company due to a mergeror following a bankruptcyWill be perceived as more riskyInvestors will demand a high coupon
Such firms are unlikely to have high earningsRevenues will peak only after theproductservice is established
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They can ill afford high couponsThey may consider a step-up coupon bond
Where the coupon increases as the bond ages
Assume a company can issue a plain vanillaat a coupon of 8 with a maturity of 5 yearsInstead it may opt for a bond
With a coupon of 6 for the first three years
And a coupon of 10 for the last two yearsThis is a Deferred Interest Security
Provides the issuer with breathing room in theearlier years
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These pay coupons in the form of additionalsecurities and not cash
This offers the issuer time to prepare for cashoutlays
They are used as Mezzanine FinanceThey rank between senior debt and equity in thecapital structureInvestors take more risk as compared to buyersof regular bonds ndash but get higher returnsIssuers can conserve cash in earlier years when itis at a premium
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Fully backed by the federal government ofthe issuing nationConsequently they are virtually devoid ofcredit risk or the risk of defaultThe yield on such securities is a benchmarkfor setting rates on other kinds of debt
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Treasury securities are issuedTo finance expenses in excess of currentrevenuesTo pay interest on debt accumulated in earlieryears due to deficits in those yearsTo repay past debt issues that are currentlymaturing
The US Treasuries marketIs the largest bond market in the worldIs the most liquid bond market in the world
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The Treasury issues three categories ofmarketable securities
T-bills are discount securitiesThey are zero coupon securitiesT-notes and T-bonds are sold at face value andpay interest periodically
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T-bills are issued with a original time tomaturity of one year or less
They are Money market instrumentsThey have maturities of either 1 3 6 or 12months at the time of issue
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T-notes and T-bonds have a time to maturityexceeding one year at the time of issue
They are capital market instrumentsT-notes have maturities ranging from 1-10 yearsT-bonds have an original maturity in excess of 10years extending up to 30 years
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An issue may be followed later by a furtherissue
With the same remaining time to maturity andthe same couponThe issuance of further tranches is termed as aRe-opening
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Six months ago a 10-year note was issuedwith a coupon of 8 per annumToday if a note with 9 frac12 years to maturityand a coupon of 8 issued it will add to thepool that is already trading in the marketThus it is a re-opening of an existing issue
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Who is a primary dealerA PD is a dealer who is authorized to dealdirectly with the Central Bank of the countryIn the US a PD is a bank or securities broker-dealer that directly deals with the FRBNY
Importance of FRBNYIn India a PD deals directly with the RBI
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The Treasury sells bills notes and bonds byway of a competitive auction process
Most of the treasury securities are bought byprimary dealers
Individual investors submit non-competitive bidsand participate on a much smaller scale
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Bids may beCompetitive
Indicate price amp quantity or yield amp quantityNon-competitive
Indicate only quantity
Small investors and individualsgenerally submit non-competitive bids
A non-competitive bidder may not bid for more than$5MM worth of securities in a bill or bond auction
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Primary dealers bid for their accounts andon behalf of their clientsThey usually submit large competitive
bidsBids indicate the maximum price that the bidderis prepared to pay if it is a price based auctionOr the minimum yield that the bidder is
prepared to accept if it is a yield based auction
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The Treasury will net out the totalamount of non-competitive bids
The balance will be allocated to competitivebidders
There are two ways in which securitiescan be allotted
The multiple priceyield auction mechanism
French AuctionsThe uniform priceyield auction mechanism
Dutch Auctions
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Assume that the Treasury is offering 25billion dollars worth of T-bonds
2 billion dollars worth of non-competitive bidshave been receivedSo 23 billion dollars worth of bonds are availableto be offered to the competitive bidders
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There are six competitive bidders who havesubmitted the following yields
The bids have been arranged in ascending orderof yieldIn a price based auction the bids would havebeen arranged in descending order of price
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Bidder Bid Yield Bid Amount
Aggregate Amount
Alpha 5370 30 bn 30 bnBeta 5372 50 bn 80 bn
Gamma 5373 40 bn 12 bn
Delta 5375 80 bn 20 bnCharlie 5375 120 bn 32 bn
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The aggregate demand equals the amount onoffer at a yield of 5375A multiple yield auction will lead to thefollowing allocation
Alpha will get 3 bn at a yield of 5370Beta will get 5 bn at 5372Gamma will get 4 bn at 5373
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At a yield of 5375 we have only 11 bn left toallocateThere is a demand of 20 bn at this yield
8 bn from Delta and 12 bn from CharlieThus we will allocate 1120 = 55 to eachbidder at this yield
There will be pro-rata allocation
055 of 8 bn or 440 bn will go to Delta055 of 12 bn or 66 bn will go to Charlie
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The highest accepted yield is called the StopYield or High Yield
In this case it is 5375The ratio of bids received to the amountawarded is known as the bid to cover ratio
The higher the ratio the stronger is the auction
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Those who bid more than 5375 will getnothing and are said to be shutout of theauctionSince 1999 the US Treasury has beenconducting only uniform yield auctions
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WI stands for ndash When As and If IssuedThe when issued market is a market forforward trading of a bond
Which has been announced but not yet issuedTrades take place from the date ofannouncement until the actual issue date
Helps bidders to gauge the marketrsquos interestbefore the actual auction
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WI trading has ramifications for the biddingstrategies of market participantsTraders can take both long and shortpositions
Settlement is scheduled for the issue date
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It has a bearing on the outcome of theauction
It affects the strategy used by a bidder becauseit has an impact on his prior positionBidders who are long in the WI market enter theauction with a Long PositionThose who are short in the WI market enter theauction with a short position
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The WI market helps in price discoveryIt provides important information on
The strength of demand for the securityAnd on the disparity of biddersrsquo views
This help potential bidders to formulate theirstrategiesAt times a dealer may believe that he hasvery important private information
If so he may not participate in the WI market andwill directly enter the auction with bids based onhis knowledge
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On or before the date of the auction theissues trade on a yield basis
The actual price can be established only afterthe coupon is set
Starting with the day after the auctionSecurities are quoted on a price basis becausethe coupon is known
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In a coupon roll a dealer will purchase themost recently issued security from a clientAnd simultaneously sell the same amount ofthe recently announced new security
The first leg with settle on the following dayThe second leg is a forward contract
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There can be a Reverse RollThe dealer will sell the most recent issue fornext day settlementAnd buy the newly announced security forforward settlement
The forward leg in a RollReverse Roll is a WItrade
It will settle on the new issue settlement date
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The roll is the spread between the yield onthe new security and that on the outstandingissue in the same maturity segmentA GIVE in the Roll means that
The WI security provides a higher yield than theoutstanding issue
A Take in the Roll means thatThe WI security provides a lower yield
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On March 17 20XX the Treasury announcedthe auction of a 2-year note
The auction was scheduled for March 24The settlement date was March 31
Trading of the roll began as soon as the issuewas announcedA Give of 5 bp means that the dealer proposes tobuy the current issue at the prevailing yieldAnd sell the new issue at a yield that is 5 bpmoreA Take of 5 bp means that the dealer proposes tosell the new issue at a yield that is 5bp lower
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The roll achieves the followingHe acquires the outstanding issue for next daysettlementHe sells the to be issued security with the samepar value for forward delivery on 31 March
The customer is rolling over the investmentfrom the current issue to the new issue
This extends the maturity of the investment byone month
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The client can invest the funds received tillthe new issue settlesHowever he loses the accrued interest thathe would have earned had he held on to theissue
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The Treasury per se does not issue zerocoupon securitiesBut zero coupon securities can be created
which are backed by conventional bondsTake a large quantity of a T-note or bond andseparate all the cash flows from each otherSell the entitlement to each cash flowseparately
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Take the case of a two-year T-noteIt can be separated into five zero couponsecurities maturing after
6 months12 months18 months24 months
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Earlier investment banks used to buy bondsfrom the Treasury and separate the cashflows
Each cash flow was then sold separately as a zerocoupon bondSuch issues are called trademarks
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The issue of trademarks has now ceasedBecause investment banks can now createsuch instruments
In concert with the Treasury itselfThese ZCBs are known as STRIPS ndash
Separate Trading of Registered Interest andPrincipal of Securities
These are not issued or sold by the Treasury
The market is made by investment banks
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What is the motivation to create suchproductsIn practice arbitrage is possible when a
coupon security is purchased at a priceThat is lower than what could be obtained byselling each cash flow separately
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Coupon stripping reflects a case of financialengineering
Creating a risk-return profile that is nototherwise available
An investment bank would buy a largequantity of a Treasury security
The securities would be placed with an SPV
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The SPV is a single-purpose dedicated trustIt has the powers to own the bonds andcollect payments
It cannot sell or lend the bondsIt cannot write options on the bondsOr use them as collateral for borrowing
The SPV is empowered to issue zero coupon
bondsWhere each security represents the ownership ofa single cash flow from the mother bond
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Assume that 100MM USD of 15 year bondswith a coupon of 8 are placed with the SPV
The SPV can issue 6M 12M 18M extending up to14 frac12 year zeroes with a total face value of 4MM
USD eachAnd 15 year zeroes with a total face value of104MM
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The Treasury launched this program in 1985to facilitate the stripping of designatedsecurities
All new T-bonds and notes with a maturity of 10years or more are eligibleThe zeroes created in the process are directobligations of the US government
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The mechanism is as followsA dealer who owns a bond or note can ask theFRB where it is held
To replace it with an equivalent set of STRIPS
representing each payment as a separate securityEach of these securities can be traded independentlyof others
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In 1987 the Treasury started to allow dealersto reverse the process
This is called STRIPS RECONSTUTUTION If a dealer owns STRIPS representing all thecoupon and principal payments of a bond
The FED can on request convert these holdings into asingle position in the corresponding bond
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Each coupon and principal cash flow from aTreasury security is assigned a CUSIP
The mother bond is also assigned a CUSIPThe stripped coupons are known as C-STRIPSThe stripped principal is known as P-STRIPSSupply of a C-STRIP increases over time
because a C-STRIP maturing on a day like 15 FEB
2020 will have the same CUSIP irrespective ofwhich mother bond it has come fromThe original coupon rate is irrelevant
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P-STRIPS always correspond to the originalsecurityThey have a unique CUSIPTheir supply is fixed at the time of issuanceIn practice the prices of long-dated P-STRIPSare a bit higher than those of C-STRIPS withthe same maturity date
One reason is that P-STRIPS are more liquid due
to greater availabilityA $100 face value bond with a coupon of 8 willgenerate C-STRIPS with a face value of $4 but P-STRIPS with a face value of $100
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Another reason why P-STRIPS are in higherdemand is that they allow reconstitutionactivities more easily
Assume that the sum of the STRIPS is cheaper than
the mother bondIf a dealer already has the P-STRIPS only the C-STRIPSneed to be acquiredHowever if he owns some of the C-STRIPS he needs toacquire the P-STRIPS and the remaining C-STRIPSThe facility to reconstitute when profitable is pricedinto the P-STRIPSNote Buy and hold investors will prefer C-STRIPSsince they are priced lower and give a higher yield
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For Plain Vanilla bonds the specifiedcoupon rate is valid for the life of thebond
In the case of Floaters the rate is reset atthe beginning of every periodThe rate will vary directly with thebenchmark
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The rate on a Floater is specified as LIBOR+ 50 bp
The spread is positiveIf it were specified as LIBOR ndash 30bp
The spread will be negativeIf LIBOR rises the rate will increasewhereas if LIBOR falls it will decrease
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In the case of a default risk-free floater theprice will reset to par on a coupon date
It may sell at a premium or discount betweencoupon dates
Consider a floater with a coupon = 5-year T-Bond rate
Assume there are two periods left to maturity
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The price at the end of the first coupon period willbe given by
cT-1 is the coupon one period before maturityyT-1 is the YTM one period before maturity
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On a coupon reset date the YTM = couponBecause we have assumed there is no default riskAny change in the required yield as reflected inthe prevailing YTM
Will also be reflected in the coupon being setIf coupon = yield the bond should sell at par
Thus P T-1 = M
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Once again at T-2 c T-2 = yT-2 and P T-2 = MThis logic can be applied to a bond with anytime remaining till maturityHowever between two coupon dates theprice may not be equal to par
Consider the valuation at T-2+k
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Although c T-2 was set at T-2 and is equal toyT-2
yT-2+k is determined at T-2+k and will reflect theyield prevailing at that time
Thus yT-2+k need not equal c T-2 and may behigher or lower
Hence between two coupon dates a floater maysell at a premium or discount
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Now consider a floater characterized bydefault risk
The risk premium required by the market neednot be constant over time
Assume that at the time of issue YTM = 5-year T-note rate + 75bp
The coupon would have been set equal to thisrate and the bond would have been issued at par
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Six months hence the issue may be perceivedas more risky
YTM = 5-year T-note rate + 95 bpThe coupon will however be set equal to theprevailing 5-year rate + 75 bpIf so the issue will not reset to par at the nextcoupon date
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Floaters may come with a CAP or a FLOOR orBOTH
The CAP is a maximum coupon rateProtects issuers against rising rates
The FLOOR is a minimum coupon rateProtects investors against falling rates
When there is a spread over LIBORThere is a natural floorLIBOR cannot be less than zero
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8112019 FISD-02-A
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8112019 FISD-02-A
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Microsoft is issuing zeroes with 5 years tomaturity and a face value of $10000
The required yield is 10 per annumWhat should be the price
Price is the PV of the face valueIn practice we discount on a semi-annual basis
8282014 45
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This is to facilitate comparisons withconventional bonds
8282014 46
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A zero coupon bond can never sell at apremium
It will always trade at a discount prior tomaturityAt maturity it will trade at par
8282014 47
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If held to maturity a ZCB will always give riseto a capital gainIf sold prior to maturity there may be a
capital gain or a capital lossConsider a bond with 10 years to maturityThe YTM at the time of purchase was 10The cost was $37690
A year later it is sold at a YTM of 12The corresponding price is $35035
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8112019 FISD-02-A
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A newly established issuerOr an issuer with a relatively virgin productor service
Or a restructured company due to a mergeror following a bankruptcyWill be perceived as more riskyInvestors will demand a high coupon
Such firms are unlikely to have high earningsRevenues will peak only after theproductservice is established
8282014 50
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They can ill afford high couponsThey may consider a step-up coupon bond
Where the coupon increases as the bond ages
Assume a company can issue a plain vanillaat a coupon of 8 with a maturity of 5 yearsInstead it may opt for a bond
With a coupon of 6 for the first three years
And a coupon of 10 for the last two yearsThis is a Deferred Interest Security
Provides the issuer with breathing room in theearlier years
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These pay coupons in the form of additionalsecurities and not cash
This offers the issuer time to prepare for cashoutlays
They are used as Mezzanine FinanceThey rank between senior debt and equity in thecapital structureInvestors take more risk as compared to buyersof regular bonds ndash but get higher returnsIssuers can conserve cash in earlier years when itis at a premium
8282014 52
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Fully backed by the federal government ofthe issuing nationConsequently they are virtually devoid ofcredit risk or the risk of defaultThe yield on such securities is a benchmarkfor setting rates on other kinds of debt
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Treasury securities are issuedTo finance expenses in excess of currentrevenuesTo pay interest on debt accumulated in earlieryears due to deficits in those yearsTo repay past debt issues that are currentlymaturing
The US Treasuries marketIs the largest bond market in the worldIs the most liquid bond market in the world
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The Treasury issues three categories ofmarketable securities
T-bills are discount securitiesThey are zero coupon securitiesT-notes and T-bonds are sold at face value andpay interest periodically
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T-bills are issued with a original time tomaturity of one year or less
They are Money market instrumentsThey have maturities of either 1 3 6 or 12months at the time of issue
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T-notes and T-bonds have a time to maturityexceeding one year at the time of issue
They are capital market instrumentsT-notes have maturities ranging from 1-10 yearsT-bonds have an original maturity in excess of 10years extending up to 30 years
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An issue may be followed later by a furtherissue
With the same remaining time to maturity andthe same couponThe issuance of further tranches is termed as aRe-opening
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Six months ago a 10-year note was issuedwith a coupon of 8 per annumToday if a note with 9 frac12 years to maturityand a coupon of 8 issued it will add to thepool that is already trading in the marketThus it is a re-opening of an existing issue
8282014 60
8112019 FISD-02-A
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Who is a primary dealerA PD is a dealer who is authorized to dealdirectly with the Central Bank of the countryIn the US a PD is a bank or securities broker-dealer that directly deals with the FRBNY
Importance of FRBNYIn India a PD deals directly with the RBI
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The Treasury sells bills notes and bonds byway of a competitive auction process
Most of the treasury securities are bought byprimary dealers
Individual investors submit non-competitive bidsand participate on a much smaller scale
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Bids may beCompetitive
Indicate price amp quantity or yield amp quantityNon-competitive
Indicate only quantity
Small investors and individualsgenerally submit non-competitive bids
A non-competitive bidder may not bid for more than$5MM worth of securities in a bill or bond auction
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Primary dealers bid for their accounts andon behalf of their clientsThey usually submit large competitive
bidsBids indicate the maximum price that the bidderis prepared to pay if it is a price based auctionOr the minimum yield that the bidder is
prepared to accept if it is a yield based auction
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The Treasury will net out the totalamount of non-competitive bids
The balance will be allocated to competitivebidders
There are two ways in which securitiescan be allotted
The multiple priceyield auction mechanism
French AuctionsThe uniform priceyield auction mechanism
Dutch Auctions
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Assume that the Treasury is offering 25billion dollars worth of T-bonds
2 billion dollars worth of non-competitive bidshave been receivedSo 23 billion dollars worth of bonds are availableto be offered to the competitive bidders
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There are six competitive bidders who havesubmitted the following yields
The bids have been arranged in ascending orderof yieldIn a price based auction the bids would havebeen arranged in descending order of price
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Bidder Bid Yield Bid Amount
Aggregate Amount
Alpha 5370 30 bn 30 bnBeta 5372 50 bn 80 bn
Gamma 5373 40 bn 12 bn
Delta 5375 80 bn 20 bnCharlie 5375 120 bn 32 bn
Tango 5380 30 bn 35 bn8282014 69
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The aggregate demand equals the amount onoffer at a yield of 5375A multiple yield auction will lead to thefollowing allocation
Alpha will get 3 bn at a yield of 5370Beta will get 5 bn at 5372Gamma will get 4 bn at 5373
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At a yield of 5375 we have only 11 bn left toallocateThere is a demand of 20 bn at this yield
8 bn from Delta and 12 bn from CharlieThus we will allocate 1120 = 55 to eachbidder at this yield
There will be pro-rata allocation
055 of 8 bn or 440 bn will go to Delta055 of 12 bn or 66 bn will go to Charlie
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The highest accepted yield is called the StopYield or High Yield
In this case it is 5375The ratio of bids received to the amountawarded is known as the bid to cover ratio
The higher the ratio the stronger is the auction
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Those who bid more than 5375 will getnothing and are said to be shutout of theauctionSince 1999 the US Treasury has beenconducting only uniform yield auctions
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WI stands for ndash When As and If IssuedThe when issued market is a market forforward trading of a bond
Which has been announced but not yet issuedTrades take place from the date ofannouncement until the actual issue date
Helps bidders to gauge the marketrsquos interestbefore the actual auction
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WI trading has ramifications for the biddingstrategies of market participantsTraders can take both long and shortpositions
Settlement is scheduled for the issue date
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It has a bearing on the outcome of theauction
It affects the strategy used by a bidder becauseit has an impact on his prior positionBidders who are long in the WI market enter theauction with a Long PositionThose who are short in the WI market enter theauction with a short position
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The WI market helps in price discoveryIt provides important information on
The strength of demand for the securityAnd on the disparity of biddersrsquo views
This help potential bidders to formulate theirstrategiesAt times a dealer may believe that he hasvery important private information
If so he may not participate in the WI market andwill directly enter the auction with bids based onhis knowledge
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On or before the date of the auction theissues trade on a yield basis
The actual price can be established only afterthe coupon is set
Starting with the day after the auctionSecurities are quoted on a price basis becausethe coupon is known
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In a coupon roll a dealer will purchase themost recently issued security from a clientAnd simultaneously sell the same amount ofthe recently announced new security
The first leg with settle on the following dayThe second leg is a forward contract
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There can be a Reverse RollThe dealer will sell the most recent issue fornext day settlementAnd buy the newly announced security forforward settlement
The forward leg in a RollReverse Roll is a WItrade
It will settle on the new issue settlement date
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The roll is the spread between the yield onthe new security and that on the outstandingissue in the same maturity segmentA GIVE in the Roll means that
The WI security provides a higher yield than theoutstanding issue
A Take in the Roll means thatThe WI security provides a lower yield
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On March 17 20XX the Treasury announcedthe auction of a 2-year note
The auction was scheduled for March 24The settlement date was March 31
Trading of the roll began as soon as the issuewas announcedA Give of 5 bp means that the dealer proposes tobuy the current issue at the prevailing yieldAnd sell the new issue at a yield that is 5 bpmoreA Take of 5 bp means that the dealer proposes tosell the new issue at a yield that is 5bp lower
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The roll achieves the followingHe acquires the outstanding issue for next daysettlementHe sells the to be issued security with the samepar value for forward delivery on 31 March
The customer is rolling over the investmentfrom the current issue to the new issue
This extends the maturity of the investment byone month
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The client can invest the funds received tillthe new issue settlesHowever he loses the accrued interest thathe would have earned had he held on to theissue
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The Treasury per se does not issue zerocoupon securitiesBut zero coupon securities can be created
which are backed by conventional bondsTake a large quantity of a T-note or bond andseparate all the cash flows from each otherSell the entitlement to each cash flowseparately
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Take the case of a two-year T-noteIt can be separated into five zero couponsecurities maturing after
6 months12 months18 months24 months
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Earlier investment banks used to buy bondsfrom the Treasury and separate the cashflows
Each cash flow was then sold separately as a zerocoupon bondSuch issues are called trademarks
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The issue of trademarks has now ceasedBecause investment banks can now createsuch instruments
In concert with the Treasury itselfThese ZCBs are known as STRIPS ndash
Separate Trading of Registered Interest andPrincipal of Securities
These are not issued or sold by the Treasury
The market is made by investment banks
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What is the motivation to create suchproductsIn practice arbitrage is possible when a
coupon security is purchased at a priceThat is lower than what could be obtained byselling each cash flow separately
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Coupon stripping reflects a case of financialengineering
Creating a risk-return profile that is nototherwise available
An investment bank would buy a largequantity of a Treasury security
The securities would be placed with an SPV
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The SPV is a single-purpose dedicated trustIt has the powers to own the bonds andcollect payments
It cannot sell or lend the bondsIt cannot write options on the bondsOr use them as collateral for borrowing
The SPV is empowered to issue zero coupon
bondsWhere each security represents the ownership ofa single cash flow from the mother bond
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Assume that 100MM USD of 15 year bondswith a coupon of 8 are placed with the SPV
The SPV can issue 6M 12M 18M extending up to14 frac12 year zeroes with a total face value of 4MM
USD eachAnd 15 year zeroes with a total face value of104MM
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The Treasury launched this program in 1985to facilitate the stripping of designatedsecurities
All new T-bonds and notes with a maturity of 10years or more are eligibleThe zeroes created in the process are directobligations of the US government
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The mechanism is as followsA dealer who owns a bond or note can ask theFRB where it is held
To replace it with an equivalent set of STRIPS
representing each payment as a separate securityEach of these securities can be traded independentlyof others
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In 1987 the Treasury started to allow dealersto reverse the process
This is called STRIPS RECONSTUTUTION If a dealer owns STRIPS representing all thecoupon and principal payments of a bond
The FED can on request convert these holdings into asingle position in the corresponding bond
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Each coupon and principal cash flow from aTreasury security is assigned a CUSIP
The mother bond is also assigned a CUSIPThe stripped coupons are known as C-STRIPSThe stripped principal is known as P-STRIPSSupply of a C-STRIP increases over time
because a C-STRIP maturing on a day like 15 FEB
2020 will have the same CUSIP irrespective ofwhich mother bond it has come fromThe original coupon rate is irrelevant
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P-STRIPS always correspond to the originalsecurityThey have a unique CUSIPTheir supply is fixed at the time of issuanceIn practice the prices of long-dated P-STRIPSare a bit higher than those of C-STRIPS withthe same maturity date
One reason is that P-STRIPS are more liquid due
to greater availabilityA $100 face value bond with a coupon of 8 willgenerate C-STRIPS with a face value of $4 but P-STRIPS with a face value of $100
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Another reason why P-STRIPS are in higherdemand is that they allow reconstitutionactivities more easily
Assume that the sum of the STRIPS is cheaper than
the mother bondIf a dealer already has the P-STRIPS only the C-STRIPSneed to be acquiredHowever if he owns some of the C-STRIPS he needs toacquire the P-STRIPS and the remaining C-STRIPSThe facility to reconstitute when profitable is pricedinto the P-STRIPSNote Buy and hold investors will prefer C-STRIPSsince they are priced lower and give a higher yield
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For Plain Vanilla bonds the specifiedcoupon rate is valid for the life of thebond
In the case of Floaters the rate is reset atthe beginning of every periodThe rate will vary directly with thebenchmark
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The rate on a Floater is specified as LIBOR+ 50 bp
The spread is positiveIf it were specified as LIBOR ndash 30bp
The spread will be negativeIf LIBOR rises the rate will increasewhereas if LIBOR falls it will decrease
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In the case of a default risk-free floater theprice will reset to par on a coupon date
It may sell at a premium or discount betweencoupon dates
Consider a floater with a coupon = 5-year T-Bond rate
Assume there are two periods left to maturity
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The price at the end of the first coupon period willbe given by
cT-1 is the coupon one period before maturityyT-1 is the YTM one period before maturity
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On a coupon reset date the YTM = couponBecause we have assumed there is no default riskAny change in the required yield as reflected inthe prevailing YTM
Will also be reflected in the coupon being setIf coupon = yield the bond should sell at par
Thus P T-1 = M
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Once again at T-2 c T-2 = yT-2 and P T-2 = MThis logic can be applied to a bond with anytime remaining till maturityHowever between two coupon dates theprice may not be equal to par
Consider the valuation at T-2+k
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Although c T-2 was set at T-2 and is equal toyT-2
yT-2+k is determined at T-2+k and will reflect theyield prevailing at that time
Thus yT-2+k need not equal c T-2 and may behigher or lower
Hence between two coupon dates a floater maysell at a premium or discount
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Now consider a floater characterized bydefault risk
The risk premium required by the market neednot be constant over time
Assume that at the time of issue YTM = 5-year T-note rate + 75bp
The coupon would have been set equal to thisrate and the bond would have been issued at par
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Six months hence the issue may be perceivedas more risky
YTM = 5-year T-note rate + 95 bpThe coupon will however be set equal to theprevailing 5-year rate + 75 bpIf so the issue will not reset to par at the nextcoupon date
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Floaters may come with a CAP or a FLOOR orBOTH
The CAP is a maximum coupon rateProtects issuers against rising rates
The FLOOR is a minimum coupon rateProtects investors against falling rates
When there is a spread over LIBORThere is a natural floorLIBOR cannot be less than zero
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Microsoft is issuing zeroes with 5 years tomaturity and a face value of $10000
The required yield is 10 per annumWhat should be the price
Price is the PV of the face valueIn practice we discount on a semi-annual basis
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This is to facilitate comparisons withconventional bonds
8282014 46
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A zero coupon bond can never sell at apremium
It will always trade at a discount prior tomaturityAt maturity it will trade at par
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If held to maturity a ZCB will always give riseto a capital gainIf sold prior to maturity there may be a
capital gain or a capital lossConsider a bond with 10 years to maturityThe YTM at the time of purchase was 10The cost was $37690
A year later it is sold at a YTM of 12The corresponding price is $35035
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8112019 FISD-02-A
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A newly established issuerOr an issuer with a relatively virgin productor service
Or a restructured company due to a mergeror following a bankruptcyWill be perceived as more riskyInvestors will demand a high coupon
Such firms are unlikely to have high earningsRevenues will peak only after theproductservice is established
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They can ill afford high couponsThey may consider a step-up coupon bond
Where the coupon increases as the bond ages
Assume a company can issue a plain vanillaat a coupon of 8 with a maturity of 5 yearsInstead it may opt for a bond
With a coupon of 6 for the first three years
And a coupon of 10 for the last two yearsThis is a Deferred Interest Security
Provides the issuer with breathing room in theearlier years
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These pay coupons in the form of additionalsecurities and not cash
This offers the issuer time to prepare for cashoutlays
They are used as Mezzanine FinanceThey rank between senior debt and equity in thecapital structureInvestors take more risk as compared to buyersof regular bonds ndash but get higher returnsIssuers can conserve cash in earlier years when itis at a premium
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Fully backed by the federal government ofthe issuing nationConsequently they are virtually devoid ofcredit risk or the risk of defaultThe yield on such securities is a benchmarkfor setting rates on other kinds of debt
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Treasury securities are issuedTo finance expenses in excess of currentrevenuesTo pay interest on debt accumulated in earlieryears due to deficits in those yearsTo repay past debt issues that are currentlymaturing
The US Treasuries marketIs the largest bond market in the worldIs the most liquid bond market in the world
8282014 55
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The Treasury issues three categories ofmarketable securities
T-bills are discount securitiesThey are zero coupon securitiesT-notes and T-bonds are sold at face value andpay interest periodically
8282014 56
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httpslidepdfcomreaderfullfisd-02-a 57115
T-bills are issued with a original time tomaturity of one year or less
They are Money market instrumentsThey have maturities of either 1 3 6 or 12months at the time of issue
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T-notes and T-bonds have a time to maturityexceeding one year at the time of issue
They are capital market instrumentsT-notes have maturities ranging from 1-10 yearsT-bonds have an original maturity in excess of 10years extending up to 30 years
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An issue may be followed later by a furtherissue
With the same remaining time to maturity andthe same couponThe issuance of further tranches is termed as aRe-opening
8282014 59
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Six months ago a 10-year note was issuedwith a coupon of 8 per annumToday if a note with 9 frac12 years to maturityand a coupon of 8 issued it will add to thepool that is already trading in the marketThus it is a re-opening of an existing issue
8282014 60
8112019 FISD-02-A
httpslidepdfcomreaderfullfisd-02-a 61115
Who is a primary dealerA PD is a dealer who is authorized to dealdirectly with the Central Bank of the countryIn the US a PD is a bank or securities broker-dealer that directly deals with the FRBNY
Importance of FRBNYIn India a PD deals directly with the RBI
8282014 61
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The Treasury sells bills notes and bonds byway of a competitive auction process
Most of the treasury securities are bought byprimary dealers
Individual investors submit non-competitive bidsand participate on a much smaller scale
8282014 63
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Bids may beCompetitive
Indicate price amp quantity or yield amp quantityNon-competitive
Indicate only quantity
Small investors and individualsgenerally submit non-competitive bids
A non-competitive bidder may not bid for more than$5MM worth of securities in a bill or bond auction
8282014 64
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Primary dealers bid for their accounts andon behalf of their clientsThey usually submit large competitive
bidsBids indicate the maximum price that the bidderis prepared to pay if it is a price based auctionOr the minimum yield that the bidder is
prepared to accept if it is a yield based auction
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The Treasury will net out the totalamount of non-competitive bids
The balance will be allocated to competitivebidders
There are two ways in which securitiescan be allotted
The multiple priceyield auction mechanism
French AuctionsThe uniform priceyield auction mechanism
Dutch Auctions
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Assume that the Treasury is offering 25billion dollars worth of T-bonds
2 billion dollars worth of non-competitive bidshave been receivedSo 23 billion dollars worth of bonds are availableto be offered to the competitive bidders
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There are six competitive bidders who havesubmitted the following yields
The bids have been arranged in ascending orderof yieldIn a price based auction the bids would havebeen arranged in descending order of price
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Bidder Bid Yield Bid Amount
Aggregate Amount
Alpha 5370 30 bn 30 bnBeta 5372 50 bn 80 bn
Gamma 5373 40 bn 12 bn
Delta 5375 80 bn 20 bnCharlie 5375 120 bn 32 bn
Tango 5380 30 bn 35 bn8282014 69
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The aggregate demand equals the amount onoffer at a yield of 5375A multiple yield auction will lead to thefollowing allocation
Alpha will get 3 bn at a yield of 5370Beta will get 5 bn at 5372Gamma will get 4 bn at 5373
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At a yield of 5375 we have only 11 bn left toallocateThere is a demand of 20 bn at this yield
8 bn from Delta and 12 bn from CharlieThus we will allocate 1120 = 55 to eachbidder at this yield
There will be pro-rata allocation
055 of 8 bn or 440 bn will go to Delta055 of 12 bn or 66 bn will go to Charlie
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The highest accepted yield is called the StopYield or High Yield
In this case it is 5375The ratio of bids received to the amountawarded is known as the bid to cover ratio
The higher the ratio the stronger is the auction
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Those who bid more than 5375 will getnothing and are said to be shutout of theauctionSince 1999 the US Treasury has beenconducting only uniform yield auctions
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WI stands for ndash When As and If IssuedThe when issued market is a market forforward trading of a bond
Which has been announced but not yet issuedTrades take place from the date ofannouncement until the actual issue date
Helps bidders to gauge the marketrsquos interestbefore the actual auction
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WI trading has ramifications for the biddingstrategies of market participantsTraders can take both long and shortpositions
Settlement is scheduled for the issue date
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It has a bearing on the outcome of theauction
It affects the strategy used by a bidder becauseit has an impact on his prior positionBidders who are long in the WI market enter theauction with a Long PositionThose who are short in the WI market enter theauction with a short position
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The WI market helps in price discoveryIt provides important information on
The strength of demand for the securityAnd on the disparity of biddersrsquo views
This help potential bidders to formulate theirstrategiesAt times a dealer may believe that he hasvery important private information
If so he may not participate in the WI market andwill directly enter the auction with bids based onhis knowledge
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On or before the date of the auction theissues trade on a yield basis
The actual price can be established only afterthe coupon is set
Starting with the day after the auctionSecurities are quoted on a price basis becausethe coupon is known
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In a coupon roll a dealer will purchase themost recently issued security from a clientAnd simultaneously sell the same amount ofthe recently announced new security
The first leg with settle on the following dayThe second leg is a forward contract
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There can be a Reverse RollThe dealer will sell the most recent issue fornext day settlementAnd buy the newly announced security forforward settlement
The forward leg in a RollReverse Roll is a WItrade
It will settle on the new issue settlement date
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The roll is the spread between the yield onthe new security and that on the outstandingissue in the same maturity segmentA GIVE in the Roll means that
The WI security provides a higher yield than theoutstanding issue
A Take in the Roll means thatThe WI security provides a lower yield
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8112019 FISD-02-A
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On March 17 20XX the Treasury announcedthe auction of a 2-year note
The auction was scheduled for March 24The settlement date was March 31
Trading of the roll began as soon as the issuewas announcedA Give of 5 bp means that the dealer proposes tobuy the current issue at the prevailing yieldAnd sell the new issue at a yield that is 5 bpmoreA Take of 5 bp means that the dealer proposes tosell the new issue at a yield that is 5bp lower
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The roll achieves the followingHe acquires the outstanding issue for next daysettlementHe sells the to be issued security with the samepar value for forward delivery on 31 March
The customer is rolling over the investmentfrom the current issue to the new issue
This extends the maturity of the investment byone month
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The client can invest the funds received tillthe new issue settlesHowever he loses the accrued interest thathe would have earned had he held on to theissue
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The Treasury per se does not issue zerocoupon securitiesBut zero coupon securities can be created
which are backed by conventional bondsTake a large quantity of a T-note or bond andseparate all the cash flows from each otherSell the entitlement to each cash flowseparately
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Take the case of a two-year T-noteIt can be separated into five zero couponsecurities maturing after
6 months12 months18 months24 months
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Earlier investment banks used to buy bondsfrom the Treasury and separate the cashflows
Each cash flow was then sold separately as a zerocoupon bondSuch issues are called trademarks
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The issue of trademarks has now ceasedBecause investment banks can now createsuch instruments
In concert with the Treasury itselfThese ZCBs are known as STRIPS ndash
Separate Trading of Registered Interest andPrincipal of Securities
These are not issued or sold by the Treasury
The market is made by investment banks
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What is the motivation to create suchproductsIn practice arbitrage is possible when a
coupon security is purchased at a priceThat is lower than what could be obtained byselling each cash flow separately
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Coupon stripping reflects a case of financialengineering
Creating a risk-return profile that is nototherwise available
An investment bank would buy a largequantity of a Treasury security
The securities would be placed with an SPV
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The SPV is a single-purpose dedicated trustIt has the powers to own the bonds andcollect payments
It cannot sell or lend the bondsIt cannot write options on the bondsOr use them as collateral for borrowing
The SPV is empowered to issue zero coupon
bondsWhere each security represents the ownership ofa single cash flow from the mother bond
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Assume that 100MM USD of 15 year bondswith a coupon of 8 are placed with the SPV
The SPV can issue 6M 12M 18M extending up to14 frac12 year zeroes with a total face value of 4MM
USD eachAnd 15 year zeroes with a total face value of104MM
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The Treasury launched this program in 1985to facilitate the stripping of designatedsecurities
All new T-bonds and notes with a maturity of 10years or more are eligibleThe zeroes created in the process are directobligations of the US government
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The mechanism is as followsA dealer who owns a bond or note can ask theFRB where it is held
To replace it with an equivalent set of STRIPS
representing each payment as a separate securityEach of these securities can be traded independentlyof others
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In 1987 the Treasury started to allow dealersto reverse the process
This is called STRIPS RECONSTUTUTION If a dealer owns STRIPS representing all thecoupon and principal payments of a bond
The FED can on request convert these holdings into asingle position in the corresponding bond
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Each coupon and principal cash flow from aTreasury security is assigned a CUSIP
The mother bond is also assigned a CUSIPThe stripped coupons are known as C-STRIPSThe stripped principal is known as P-STRIPSSupply of a C-STRIP increases over time
because a C-STRIP maturing on a day like 15 FEB
2020 will have the same CUSIP irrespective ofwhich mother bond it has come fromThe original coupon rate is irrelevant
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P-STRIPS always correspond to the originalsecurityThey have a unique CUSIPTheir supply is fixed at the time of issuanceIn practice the prices of long-dated P-STRIPSare a bit higher than those of C-STRIPS withthe same maturity date
One reason is that P-STRIPS are more liquid due
to greater availabilityA $100 face value bond with a coupon of 8 willgenerate C-STRIPS with a face value of $4 but P-STRIPS with a face value of $100
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Another reason why P-STRIPS are in higherdemand is that they allow reconstitutionactivities more easily
Assume that the sum of the STRIPS is cheaper than
the mother bondIf a dealer already has the P-STRIPS only the C-STRIPSneed to be acquiredHowever if he owns some of the C-STRIPS he needs toacquire the P-STRIPS and the remaining C-STRIPSThe facility to reconstitute when profitable is pricedinto the P-STRIPSNote Buy and hold investors will prefer C-STRIPSsince they are priced lower and give a higher yield
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For Plain Vanilla bonds the specifiedcoupon rate is valid for the life of thebond
In the case of Floaters the rate is reset atthe beginning of every periodThe rate will vary directly with thebenchmark
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The rate on a Floater is specified as LIBOR+ 50 bp
The spread is positiveIf it were specified as LIBOR ndash 30bp
The spread will be negativeIf LIBOR rises the rate will increasewhereas if LIBOR falls it will decrease
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In the case of a default risk-free floater theprice will reset to par on a coupon date
It may sell at a premium or discount betweencoupon dates
Consider a floater with a coupon = 5-year T-Bond rate
Assume there are two periods left to maturity
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The price at the end of the first coupon period willbe given by
cT-1 is the coupon one period before maturityyT-1 is the YTM one period before maturity
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On a coupon reset date the YTM = couponBecause we have assumed there is no default riskAny change in the required yield as reflected inthe prevailing YTM
Will also be reflected in the coupon being setIf coupon = yield the bond should sell at par
Thus P T-1 = M
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Once again at T-2 c T-2 = yT-2 and P T-2 = MThis logic can be applied to a bond with anytime remaining till maturityHowever between two coupon dates theprice may not be equal to par
Consider the valuation at T-2+k
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Although c T-2 was set at T-2 and is equal toyT-2
yT-2+k is determined at T-2+k and will reflect theyield prevailing at that time
Thus yT-2+k need not equal c T-2 and may behigher or lower
Hence between two coupon dates a floater maysell at a premium or discount
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Now consider a floater characterized bydefault risk
The risk premium required by the market neednot be constant over time
Assume that at the time of issue YTM = 5-year T-note rate + 75bp
The coupon would have been set equal to thisrate and the bond would have been issued at par
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Six months hence the issue may be perceivedas more risky
YTM = 5-year T-note rate + 95 bpThe coupon will however be set equal to theprevailing 5-year rate + 75 bpIf so the issue will not reset to par at the nextcoupon date
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Floaters may come with a CAP or a FLOOR orBOTH
The CAP is a maximum coupon rateProtects issuers against rising rates
The FLOOR is a minimum coupon rateProtects investors against falling rates
When there is a spread over LIBORThere is a natural floorLIBOR cannot be less than zero
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This is to facilitate comparisons withconventional bonds
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A zero coupon bond can never sell at apremium
It will always trade at a discount prior tomaturityAt maturity it will trade at par
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If held to maturity a ZCB will always give riseto a capital gainIf sold prior to maturity there may be a
capital gain or a capital lossConsider a bond with 10 years to maturityThe YTM at the time of purchase was 10The cost was $37690
A year later it is sold at a YTM of 12The corresponding price is $35035
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A newly established issuerOr an issuer with a relatively virgin productor service
Or a restructured company due to a mergeror following a bankruptcyWill be perceived as more riskyInvestors will demand a high coupon
Such firms are unlikely to have high earningsRevenues will peak only after theproductservice is established
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They can ill afford high couponsThey may consider a step-up coupon bond
Where the coupon increases as the bond ages
Assume a company can issue a plain vanillaat a coupon of 8 with a maturity of 5 yearsInstead it may opt for a bond
With a coupon of 6 for the first three years
And a coupon of 10 for the last two yearsThis is a Deferred Interest Security
Provides the issuer with breathing room in theearlier years
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These pay coupons in the form of additionalsecurities and not cash
This offers the issuer time to prepare for cashoutlays
They are used as Mezzanine FinanceThey rank between senior debt and equity in thecapital structureInvestors take more risk as compared to buyersof regular bonds ndash but get higher returnsIssuers can conserve cash in earlier years when itis at a premium
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Fully backed by the federal government ofthe issuing nationConsequently they are virtually devoid ofcredit risk or the risk of defaultThe yield on such securities is a benchmarkfor setting rates on other kinds of debt
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Treasury securities are issuedTo finance expenses in excess of currentrevenuesTo pay interest on debt accumulated in earlieryears due to deficits in those yearsTo repay past debt issues that are currentlymaturing
The US Treasuries marketIs the largest bond market in the worldIs the most liquid bond market in the world
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The Treasury issues three categories ofmarketable securities
T-bills are discount securitiesThey are zero coupon securitiesT-notes and T-bonds are sold at face value andpay interest periodically
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T-bills are issued with a original time tomaturity of one year or less
They are Money market instrumentsThey have maturities of either 1 3 6 or 12months at the time of issue
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T-notes and T-bonds have a time to maturityexceeding one year at the time of issue
They are capital market instrumentsT-notes have maturities ranging from 1-10 yearsT-bonds have an original maturity in excess of 10years extending up to 30 years
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An issue may be followed later by a furtherissue
With the same remaining time to maturity andthe same couponThe issuance of further tranches is termed as aRe-opening
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Six months ago a 10-year note was issuedwith a coupon of 8 per annumToday if a note with 9 frac12 years to maturityand a coupon of 8 issued it will add to thepool that is already trading in the marketThus it is a re-opening of an existing issue
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Who is a primary dealerA PD is a dealer who is authorized to dealdirectly with the Central Bank of the countryIn the US a PD is a bank or securities broker-dealer that directly deals with the FRBNY
Importance of FRBNYIn India a PD deals directly with the RBI
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The Treasury sells bills notes and bonds byway of a competitive auction process
Most of the treasury securities are bought byprimary dealers
Individual investors submit non-competitive bidsand participate on a much smaller scale
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Bids may beCompetitive
Indicate price amp quantity or yield amp quantityNon-competitive
Indicate only quantity
Small investors and individualsgenerally submit non-competitive bids
A non-competitive bidder may not bid for more than$5MM worth of securities in a bill or bond auction
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Primary dealers bid for their accounts andon behalf of their clientsThey usually submit large competitive
bidsBids indicate the maximum price that the bidderis prepared to pay if it is a price based auctionOr the minimum yield that the bidder is
prepared to accept if it is a yield based auction
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The Treasury will net out the totalamount of non-competitive bids
The balance will be allocated to competitivebidders
There are two ways in which securitiescan be allotted
The multiple priceyield auction mechanism
French AuctionsThe uniform priceyield auction mechanism
Dutch Auctions
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Assume that the Treasury is offering 25billion dollars worth of T-bonds
2 billion dollars worth of non-competitive bidshave been receivedSo 23 billion dollars worth of bonds are availableto be offered to the competitive bidders
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There are six competitive bidders who havesubmitted the following yields
The bids have been arranged in ascending orderof yieldIn a price based auction the bids would havebeen arranged in descending order of price
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Bidder Bid Yield Bid Amount
Aggregate Amount
Alpha 5370 30 bn 30 bnBeta 5372 50 bn 80 bn
Gamma 5373 40 bn 12 bn
Delta 5375 80 bn 20 bnCharlie 5375 120 bn 32 bn
Tango 5380 30 bn 35 bn8282014 69
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The aggregate demand equals the amount onoffer at a yield of 5375A multiple yield auction will lead to thefollowing allocation
Alpha will get 3 bn at a yield of 5370Beta will get 5 bn at 5372Gamma will get 4 bn at 5373
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At a yield of 5375 we have only 11 bn left toallocateThere is a demand of 20 bn at this yield
8 bn from Delta and 12 bn from CharlieThus we will allocate 1120 = 55 to eachbidder at this yield
There will be pro-rata allocation
055 of 8 bn or 440 bn will go to Delta055 of 12 bn or 66 bn will go to Charlie
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The highest accepted yield is called the StopYield or High Yield
In this case it is 5375The ratio of bids received to the amountawarded is known as the bid to cover ratio
The higher the ratio the stronger is the auction
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Those who bid more than 5375 will getnothing and are said to be shutout of theauctionSince 1999 the US Treasury has beenconducting only uniform yield auctions
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WI stands for ndash When As and If IssuedThe when issued market is a market forforward trading of a bond
Which has been announced but not yet issuedTrades take place from the date ofannouncement until the actual issue date
Helps bidders to gauge the marketrsquos interestbefore the actual auction
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WI trading has ramifications for the biddingstrategies of market participantsTraders can take both long and shortpositions
Settlement is scheduled for the issue date
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It has a bearing on the outcome of theauction
It affects the strategy used by a bidder becauseit has an impact on his prior positionBidders who are long in the WI market enter theauction with a Long PositionThose who are short in the WI market enter theauction with a short position
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The WI market helps in price discoveryIt provides important information on
The strength of demand for the securityAnd on the disparity of biddersrsquo views
This help potential bidders to formulate theirstrategiesAt times a dealer may believe that he hasvery important private information
If so he may not participate in the WI market andwill directly enter the auction with bids based onhis knowledge
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On or before the date of the auction theissues trade on a yield basis
The actual price can be established only afterthe coupon is set
Starting with the day after the auctionSecurities are quoted on a price basis becausethe coupon is known
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In a coupon roll a dealer will purchase themost recently issued security from a clientAnd simultaneously sell the same amount ofthe recently announced new security
The first leg with settle on the following dayThe second leg is a forward contract
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There can be a Reverse RollThe dealer will sell the most recent issue fornext day settlementAnd buy the newly announced security forforward settlement
The forward leg in a RollReverse Roll is a WItrade
It will settle on the new issue settlement date
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The roll is the spread between the yield onthe new security and that on the outstandingissue in the same maturity segmentA GIVE in the Roll means that
The WI security provides a higher yield than theoutstanding issue
A Take in the Roll means thatThe WI security provides a lower yield
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On March 17 20XX the Treasury announcedthe auction of a 2-year note
The auction was scheduled for March 24The settlement date was March 31
Trading of the roll began as soon as the issuewas announcedA Give of 5 bp means that the dealer proposes tobuy the current issue at the prevailing yieldAnd sell the new issue at a yield that is 5 bpmoreA Take of 5 bp means that the dealer proposes tosell the new issue at a yield that is 5bp lower
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The roll achieves the followingHe acquires the outstanding issue for next daysettlementHe sells the to be issued security with the samepar value for forward delivery on 31 March
The customer is rolling over the investmentfrom the current issue to the new issue
This extends the maturity of the investment byone month
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The client can invest the funds received tillthe new issue settlesHowever he loses the accrued interest thathe would have earned had he held on to theissue
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The Treasury per se does not issue zerocoupon securitiesBut zero coupon securities can be created
which are backed by conventional bondsTake a large quantity of a T-note or bond andseparate all the cash flows from each otherSell the entitlement to each cash flowseparately
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Take the case of a two-year T-noteIt can be separated into five zero couponsecurities maturing after
6 months12 months18 months24 months
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Earlier investment banks used to buy bondsfrom the Treasury and separate the cashflows
Each cash flow was then sold separately as a zerocoupon bondSuch issues are called trademarks
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The issue of trademarks has now ceasedBecause investment banks can now createsuch instruments
In concert with the Treasury itselfThese ZCBs are known as STRIPS ndash
Separate Trading of Registered Interest andPrincipal of Securities
These are not issued or sold by the Treasury
The market is made by investment banks
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What is the motivation to create suchproductsIn practice arbitrage is possible when a
coupon security is purchased at a priceThat is lower than what could be obtained byselling each cash flow separately
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Coupon stripping reflects a case of financialengineering
Creating a risk-return profile that is nototherwise available
An investment bank would buy a largequantity of a Treasury security
The securities would be placed with an SPV
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The SPV is a single-purpose dedicated trustIt has the powers to own the bonds andcollect payments
It cannot sell or lend the bondsIt cannot write options on the bondsOr use them as collateral for borrowing
The SPV is empowered to issue zero coupon
bondsWhere each security represents the ownership ofa single cash flow from the mother bond
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Assume that 100MM USD of 15 year bondswith a coupon of 8 are placed with the SPV
The SPV can issue 6M 12M 18M extending up to14 frac12 year zeroes with a total face value of 4MM
USD eachAnd 15 year zeroes with a total face value of104MM
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8112019 FISD-02-A
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The Treasury launched this program in 1985to facilitate the stripping of designatedsecurities
All new T-bonds and notes with a maturity of 10years or more are eligibleThe zeroes created in the process are directobligations of the US government
8282014 97
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The mechanism is as followsA dealer who owns a bond or note can ask theFRB where it is held
To replace it with an equivalent set of STRIPS
representing each payment as a separate securityEach of these securities can be traded independentlyof others
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In 1987 the Treasury started to allow dealersto reverse the process
This is called STRIPS RECONSTUTUTION If a dealer owns STRIPS representing all thecoupon and principal payments of a bond
The FED can on request convert these holdings into asingle position in the corresponding bond
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Each coupon and principal cash flow from aTreasury security is assigned a CUSIP
The mother bond is also assigned a CUSIPThe stripped coupons are known as C-STRIPSThe stripped principal is known as P-STRIPSSupply of a C-STRIP increases over time
because a C-STRIP maturing on a day like 15 FEB
2020 will have the same CUSIP irrespective ofwhich mother bond it has come fromThe original coupon rate is irrelevant
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P-STRIPS always correspond to the originalsecurityThey have a unique CUSIPTheir supply is fixed at the time of issuanceIn practice the prices of long-dated P-STRIPSare a bit higher than those of C-STRIPS withthe same maturity date
One reason is that P-STRIPS are more liquid due
to greater availabilityA $100 face value bond with a coupon of 8 willgenerate C-STRIPS with a face value of $4 but P-STRIPS with a face value of $100
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Another reason why P-STRIPS are in higherdemand is that they allow reconstitutionactivities more easily
Assume that the sum of the STRIPS is cheaper than
the mother bondIf a dealer already has the P-STRIPS only the C-STRIPSneed to be acquiredHowever if he owns some of the C-STRIPS he needs toacquire the P-STRIPS and the remaining C-STRIPSThe facility to reconstitute when profitable is pricedinto the P-STRIPSNote Buy and hold investors will prefer C-STRIPSsince they are priced lower and give a higher yield
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For Plain Vanilla bonds the specifiedcoupon rate is valid for the life of thebond
In the case of Floaters the rate is reset atthe beginning of every periodThe rate will vary directly with thebenchmark
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The rate on a Floater is specified as LIBOR+ 50 bp
The spread is positiveIf it were specified as LIBOR ndash 30bp
The spread will be negativeIf LIBOR rises the rate will increasewhereas if LIBOR falls it will decrease
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In the case of a default risk-free floater theprice will reset to par on a coupon date
It may sell at a premium or discount betweencoupon dates
Consider a floater with a coupon = 5-year T-Bond rate
Assume there are two periods left to maturity
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The price at the end of the first coupon period willbe given by
cT-1 is the coupon one period before maturityyT-1 is the YTM one period before maturity
8112019 FISD-02-A
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On a coupon reset date the YTM = couponBecause we have assumed there is no default riskAny change in the required yield as reflected inthe prevailing YTM
Will also be reflected in the coupon being setIf coupon = yield the bond should sell at par
Thus P T-1 = M
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Once again at T-2 c T-2 = yT-2 and P T-2 = MThis logic can be applied to a bond with anytime remaining till maturityHowever between two coupon dates theprice may not be equal to par
Consider the valuation at T-2+k
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Although c T-2 was set at T-2 and is equal toyT-2
yT-2+k is determined at T-2+k and will reflect theyield prevailing at that time
Thus yT-2+k need not equal c T-2 and may behigher or lower
Hence between two coupon dates a floater maysell at a premium or discount
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Now consider a floater characterized bydefault risk
The risk premium required by the market neednot be constant over time
Assume that at the time of issue YTM = 5-year T-note rate + 75bp
The coupon would have been set equal to thisrate and the bond would have been issued at par
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Six months hence the issue may be perceivedas more risky
YTM = 5-year T-note rate + 95 bpThe coupon will however be set equal to theprevailing 5-year rate + 75 bpIf so the issue will not reset to par at the nextcoupon date
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Floaters may come with a CAP or a FLOOR orBOTH
The CAP is a maximum coupon rateProtects issuers against rising rates
The FLOOR is a minimum coupon rateProtects investors against falling rates
When there is a spread over LIBORThere is a natural floorLIBOR cannot be less than zero
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A zero coupon bond can never sell at apremium
It will always trade at a discount prior tomaturityAt maturity it will trade at par
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If held to maturity a ZCB will always give riseto a capital gainIf sold prior to maturity there may be a
capital gain or a capital lossConsider a bond with 10 years to maturityThe YTM at the time of purchase was 10The cost was $37690
A year later it is sold at a YTM of 12The corresponding price is $35035
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A newly established issuerOr an issuer with a relatively virgin productor service
Or a restructured company due to a mergeror following a bankruptcyWill be perceived as more riskyInvestors will demand a high coupon
Such firms are unlikely to have high earningsRevenues will peak only after theproductservice is established
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They can ill afford high couponsThey may consider a step-up coupon bond
Where the coupon increases as the bond ages
Assume a company can issue a plain vanillaat a coupon of 8 with a maturity of 5 yearsInstead it may opt for a bond
With a coupon of 6 for the first three years
And a coupon of 10 for the last two yearsThis is a Deferred Interest Security
Provides the issuer with breathing room in theearlier years
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These pay coupons in the form of additionalsecurities and not cash
This offers the issuer time to prepare for cashoutlays
They are used as Mezzanine FinanceThey rank between senior debt and equity in thecapital structureInvestors take more risk as compared to buyersof regular bonds ndash but get higher returnsIssuers can conserve cash in earlier years when itis at a premium
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Fully backed by the federal government ofthe issuing nationConsequently they are virtually devoid ofcredit risk or the risk of defaultThe yield on such securities is a benchmarkfor setting rates on other kinds of debt
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Treasury securities are issuedTo finance expenses in excess of currentrevenuesTo pay interest on debt accumulated in earlieryears due to deficits in those yearsTo repay past debt issues that are currentlymaturing
The US Treasuries marketIs the largest bond market in the worldIs the most liquid bond market in the world
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The Treasury issues three categories ofmarketable securities
T-bills are discount securitiesThey are zero coupon securitiesT-notes and T-bonds are sold at face value andpay interest periodically
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T-bills are issued with a original time tomaturity of one year or less
They are Money market instrumentsThey have maturities of either 1 3 6 or 12months at the time of issue
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T-notes and T-bonds have a time to maturityexceeding one year at the time of issue
They are capital market instrumentsT-notes have maturities ranging from 1-10 yearsT-bonds have an original maturity in excess of 10years extending up to 30 years
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An issue may be followed later by a furtherissue
With the same remaining time to maturity andthe same couponThe issuance of further tranches is termed as aRe-opening
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Six months ago a 10-year note was issuedwith a coupon of 8 per annumToday if a note with 9 frac12 years to maturityand a coupon of 8 issued it will add to thepool that is already trading in the marketThus it is a re-opening of an existing issue
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Who is a primary dealerA PD is a dealer who is authorized to dealdirectly with the Central Bank of the countryIn the US a PD is a bank or securities broker-dealer that directly deals with the FRBNY
Importance of FRBNYIn India a PD deals directly with the RBI
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The Treasury sells bills notes and bonds byway of a competitive auction process
Most of the treasury securities are bought byprimary dealers
Individual investors submit non-competitive bidsand participate on a much smaller scale
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Bids may beCompetitive
Indicate price amp quantity or yield amp quantityNon-competitive
Indicate only quantity
Small investors and individualsgenerally submit non-competitive bids
A non-competitive bidder may not bid for more than$5MM worth of securities in a bill or bond auction
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Primary dealers bid for their accounts andon behalf of their clientsThey usually submit large competitive
bidsBids indicate the maximum price that the bidderis prepared to pay if it is a price based auctionOr the minimum yield that the bidder is
prepared to accept if it is a yield based auction
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The Treasury will net out the totalamount of non-competitive bids
The balance will be allocated to competitivebidders
There are two ways in which securitiescan be allotted
The multiple priceyield auction mechanism
French AuctionsThe uniform priceyield auction mechanism
Dutch Auctions
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Assume that the Treasury is offering 25billion dollars worth of T-bonds
2 billion dollars worth of non-competitive bidshave been receivedSo 23 billion dollars worth of bonds are availableto be offered to the competitive bidders
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There are six competitive bidders who havesubmitted the following yields
The bids have been arranged in ascending orderof yieldIn a price based auction the bids would havebeen arranged in descending order of price
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Bidder Bid Yield Bid Amount
Aggregate Amount
Alpha 5370 30 bn 30 bnBeta 5372 50 bn 80 bn
Gamma 5373 40 bn 12 bn
Delta 5375 80 bn 20 bnCharlie 5375 120 bn 32 bn
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The aggregate demand equals the amount onoffer at a yield of 5375A multiple yield auction will lead to thefollowing allocation
Alpha will get 3 bn at a yield of 5370Beta will get 5 bn at 5372Gamma will get 4 bn at 5373
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At a yield of 5375 we have only 11 bn left toallocateThere is a demand of 20 bn at this yield
8 bn from Delta and 12 bn from CharlieThus we will allocate 1120 = 55 to eachbidder at this yield
There will be pro-rata allocation
055 of 8 bn or 440 bn will go to Delta055 of 12 bn or 66 bn will go to Charlie
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The highest accepted yield is called the StopYield or High Yield
In this case it is 5375The ratio of bids received to the amountawarded is known as the bid to cover ratio
The higher the ratio the stronger is the auction
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Those who bid more than 5375 will getnothing and are said to be shutout of theauctionSince 1999 the US Treasury has beenconducting only uniform yield auctions
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WI stands for ndash When As and If IssuedThe when issued market is a market forforward trading of a bond
Which has been announced but not yet issuedTrades take place from the date ofannouncement until the actual issue date
Helps bidders to gauge the marketrsquos interestbefore the actual auction
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WI trading has ramifications for the biddingstrategies of market participantsTraders can take both long and shortpositions
Settlement is scheduled for the issue date
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It has a bearing on the outcome of theauction
It affects the strategy used by a bidder becauseit has an impact on his prior positionBidders who are long in the WI market enter theauction with a Long PositionThose who are short in the WI market enter theauction with a short position
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The WI market helps in price discoveryIt provides important information on
The strength of demand for the securityAnd on the disparity of biddersrsquo views
This help potential bidders to formulate theirstrategiesAt times a dealer may believe that he hasvery important private information
If so he may not participate in the WI market andwill directly enter the auction with bids based onhis knowledge
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On or before the date of the auction theissues trade on a yield basis
The actual price can be established only afterthe coupon is set
Starting with the day after the auctionSecurities are quoted on a price basis becausethe coupon is known
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In a coupon roll a dealer will purchase themost recently issued security from a clientAnd simultaneously sell the same amount ofthe recently announced new security
The first leg with settle on the following dayThe second leg is a forward contract
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There can be a Reverse RollThe dealer will sell the most recent issue fornext day settlementAnd buy the newly announced security forforward settlement
The forward leg in a RollReverse Roll is a WItrade
It will settle on the new issue settlement date
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The roll is the spread between the yield onthe new security and that on the outstandingissue in the same maturity segmentA GIVE in the Roll means that
The WI security provides a higher yield than theoutstanding issue
A Take in the Roll means thatThe WI security provides a lower yield
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On March 17 20XX the Treasury announcedthe auction of a 2-year note
The auction was scheduled for March 24The settlement date was March 31
Trading of the roll began as soon as the issuewas announcedA Give of 5 bp means that the dealer proposes tobuy the current issue at the prevailing yieldAnd sell the new issue at a yield that is 5 bpmoreA Take of 5 bp means that the dealer proposes tosell the new issue at a yield that is 5bp lower
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The roll achieves the followingHe acquires the outstanding issue for next daysettlementHe sells the to be issued security with the samepar value for forward delivery on 31 March
The customer is rolling over the investmentfrom the current issue to the new issue
This extends the maturity of the investment byone month
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The client can invest the funds received tillthe new issue settlesHowever he loses the accrued interest thathe would have earned had he held on to theissue
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The Treasury per se does not issue zerocoupon securitiesBut zero coupon securities can be created
which are backed by conventional bondsTake a large quantity of a T-note or bond andseparate all the cash flows from each otherSell the entitlement to each cash flowseparately
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Take the case of a two-year T-noteIt can be separated into five zero couponsecurities maturing after
6 months12 months18 months24 months
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Earlier investment banks used to buy bondsfrom the Treasury and separate the cashflows
Each cash flow was then sold separately as a zerocoupon bondSuch issues are called trademarks
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The issue of trademarks has now ceasedBecause investment banks can now createsuch instruments
In concert with the Treasury itselfThese ZCBs are known as STRIPS ndash
Separate Trading of Registered Interest andPrincipal of Securities
These are not issued or sold by the Treasury
The market is made by investment banks
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What is the motivation to create suchproductsIn practice arbitrage is possible when a
coupon security is purchased at a priceThat is lower than what could be obtained byselling each cash flow separately
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Coupon stripping reflects a case of financialengineering
Creating a risk-return profile that is nototherwise available
An investment bank would buy a largequantity of a Treasury security
The securities would be placed with an SPV
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The SPV is a single-purpose dedicated trustIt has the powers to own the bonds andcollect payments
It cannot sell or lend the bondsIt cannot write options on the bondsOr use them as collateral for borrowing
The SPV is empowered to issue zero coupon
bondsWhere each security represents the ownership ofa single cash flow from the mother bond
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Assume that 100MM USD of 15 year bondswith a coupon of 8 are placed with the SPV
The SPV can issue 6M 12M 18M extending up to14 frac12 year zeroes with a total face value of 4MM
USD eachAnd 15 year zeroes with a total face value of104MM
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The Treasury launched this program in 1985to facilitate the stripping of designatedsecurities
All new T-bonds and notes with a maturity of 10years or more are eligibleThe zeroes created in the process are directobligations of the US government
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The mechanism is as followsA dealer who owns a bond or note can ask theFRB where it is held
To replace it with an equivalent set of STRIPS
representing each payment as a separate securityEach of these securities can be traded independentlyof others
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In 1987 the Treasury started to allow dealersto reverse the process
This is called STRIPS RECONSTUTUTION If a dealer owns STRIPS representing all thecoupon and principal payments of a bond
The FED can on request convert these holdings into asingle position in the corresponding bond
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Each coupon and principal cash flow from aTreasury security is assigned a CUSIP
The mother bond is also assigned a CUSIPThe stripped coupons are known as C-STRIPSThe stripped principal is known as P-STRIPSSupply of a C-STRIP increases over time
because a C-STRIP maturing on a day like 15 FEB
2020 will have the same CUSIP irrespective ofwhich mother bond it has come fromThe original coupon rate is irrelevant
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P-STRIPS always correspond to the originalsecurityThey have a unique CUSIPTheir supply is fixed at the time of issuanceIn practice the prices of long-dated P-STRIPSare a bit higher than those of C-STRIPS withthe same maturity date
One reason is that P-STRIPS are more liquid due
to greater availabilityA $100 face value bond with a coupon of 8 willgenerate C-STRIPS with a face value of $4 but P-STRIPS with a face value of $100
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Another reason why P-STRIPS are in higherdemand is that they allow reconstitutionactivities more easily
Assume that the sum of the STRIPS is cheaper than
the mother bondIf a dealer already has the P-STRIPS only the C-STRIPSneed to be acquiredHowever if he owns some of the C-STRIPS he needs toacquire the P-STRIPS and the remaining C-STRIPSThe facility to reconstitute when profitable is pricedinto the P-STRIPSNote Buy and hold investors will prefer C-STRIPSsince they are priced lower and give a higher yield
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For Plain Vanilla bonds the specifiedcoupon rate is valid for the life of thebond
In the case of Floaters the rate is reset atthe beginning of every periodThe rate will vary directly with thebenchmark
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The rate on a Floater is specified as LIBOR+ 50 bp
The spread is positiveIf it were specified as LIBOR ndash 30bp
The spread will be negativeIf LIBOR rises the rate will increasewhereas if LIBOR falls it will decrease
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In the case of a default risk-free floater theprice will reset to par on a coupon date
It may sell at a premium or discount betweencoupon dates
Consider a floater with a coupon = 5-year T-Bond rate
Assume there are two periods left to maturity
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The price at the end of the first coupon period willbe given by
cT-1 is the coupon one period before maturityyT-1 is the YTM one period before maturity
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On a coupon reset date the YTM = couponBecause we have assumed there is no default riskAny change in the required yield as reflected inthe prevailing YTM
Will also be reflected in the coupon being setIf coupon = yield the bond should sell at par
Thus P T-1 = M
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Once again at T-2 c T-2 = yT-2 and P T-2 = MThis logic can be applied to a bond with anytime remaining till maturityHowever between two coupon dates theprice may not be equal to par
Consider the valuation at T-2+k
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Although c T-2 was set at T-2 and is equal toyT-2
yT-2+k is determined at T-2+k and will reflect theyield prevailing at that time
Thus yT-2+k need not equal c T-2 and may behigher or lower
Hence between two coupon dates a floater maysell at a premium or discount
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Now consider a floater characterized bydefault risk
The risk premium required by the market neednot be constant over time
Assume that at the time of issue YTM = 5-year T-note rate + 75bp
The coupon would have been set equal to thisrate and the bond would have been issued at par
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Six months hence the issue may be perceivedas more risky
YTM = 5-year T-note rate + 95 bpThe coupon will however be set equal to theprevailing 5-year rate + 75 bpIf so the issue will not reset to par at the nextcoupon date
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Floaters may come with a CAP or a FLOOR orBOTH
The CAP is a maximum coupon rateProtects issuers against rising rates
The FLOOR is a minimum coupon rateProtects investors against falling rates
When there is a spread over LIBORThere is a natural floorLIBOR cannot be less than zero
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If held to maturity a ZCB will always give riseto a capital gainIf sold prior to maturity there may be a
capital gain or a capital lossConsider a bond with 10 years to maturityThe YTM at the time of purchase was 10The cost was $37690
A year later it is sold at a YTM of 12The corresponding price is $35035
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A newly established issuerOr an issuer with a relatively virgin productor service
Or a restructured company due to a mergeror following a bankruptcyWill be perceived as more riskyInvestors will demand a high coupon
Such firms are unlikely to have high earningsRevenues will peak only after theproductservice is established
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They can ill afford high couponsThey may consider a step-up coupon bond
Where the coupon increases as the bond ages
Assume a company can issue a plain vanillaat a coupon of 8 with a maturity of 5 yearsInstead it may opt for a bond
With a coupon of 6 for the first three years
And a coupon of 10 for the last two yearsThis is a Deferred Interest Security
Provides the issuer with breathing room in theearlier years
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These pay coupons in the form of additionalsecurities and not cash
This offers the issuer time to prepare for cashoutlays
They are used as Mezzanine FinanceThey rank between senior debt and equity in thecapital structureInvestors take more risk as compared to buyersof regular bonds ndash but get higher returnsIssuers can conserve cash in earlier years when itis at a premium
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Fully backed by the federal government ofthe issuing nationConsequently they are virtually devoid ofcredit risk or the risk of defaultThe yield on such securities is a benchmarkfor setting rates on other kinds of debt
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Treasury securities are issuedTo finance expenses in excess of currentrevenuesTo pay interest on debt accumulated in earlieryears due to deficits in those yearsTo repay past debt issues that are currentlymaturing
The US Treasuries marketIs the largest bond market in the worldIs the most liquid bond market in the world
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The Treasury issues three categories ofmarketable securities
T-bills are discount securitiesThey are zero coupon securitiesT-notes and T-bonds are sold at face value andpay interest periodically
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T-bills are issued with a original time tomaturity of one year or less
They are Money market instrumentsThey have maturities of either 1 3 6 or 12months at the time of issue
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T-notes and T-bonds have a time to maturityexceeding one year at the time of issue
They are capital market instrumentsT-notes have maturities ranging from 1-10 yearsT-bonds have an original maturity in excess of 10years extending up to 30 years
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An issue may be followed later by a furtherissue
With the same remaining time to maturity andthe same couponThe issuance of further tranches is termed as aRe-opening
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Six months ago a 10-year note was issuedwith a coupon of 8 per annumToday if a note with 9 frac12 years to maturityand a coupon of 8 issued it will add to thepool that is already trading in the marketThus it is a re-opening of an existing issue
8282014 60
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Who is a primary dealerA PD is a dealer who is authorized to dealdirectly with the Central Bank of the countryIn the US a PD is a bank or securities broker-dealer that directly deals with the FRBNY
Importance of FRBNYIn India a PD deals directly with the RBI
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The Treasury sells bills notes and bonds byway of a competitive auction process
Most of the treasury securities are bought byprimary dealers
Individual investors submit non-competitive bidsand participate on a much smaller scale
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Bids may beCompetitive
Indicate price amp quantity or yield amp quantityNon-competitive
Indicate only quantity
Small investors and individualsgenerally submit non-competitive bids
A non-competitive bidder may not bid for more than$5MM worth of securities in a bill or bond auction
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Primary dealers bid for their accounts andon behalf of their clientsThey usually submit large competitive
bidsBids indicate the maximum price that the bidderis prepared to pay if it is a price based auctionOr the minimum yield that the bidder is
prepared to accept if it is a yield based auction
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The Treasury will net out the totalamount of non-competitive bids
The balance will be allocated to competitivebidders
There are two ways in which securitiescan be allotted
The multiple priceyield auction mechanism
French AuctionsThe uniform priceyield auction mechanism
Dutch Auctions
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Assume that the Treasury is offering 25billion dollars worth of T-bonds
2 billion dollars worth of non-competitive bidshave been receivedSo 23 billion dollars worth of bonds are availableto be offered to the competitive bidders
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There are six competitive bidders who havesubmitted the following yields
The bids have been arranged in ascending orderof yieldIn a price based auction the bids would havebeen arranged in descending order of price
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Bidder Bid Yield Bid Amount
Aggregate Amount
Alpha 5370 30 bn 30 bnBeta 5372 50 bn 80 bn
Gamma 5373 40 bn 12 bn
Delta 5375 80 bn 20 bnCharlie 5375 120 bn 32 bn
Tango 5380 30 bn 35 bn8282014 69
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The aggregate demand equals the amount onoffer at a yield of 5375A multiple yield auction will lead to thefollowing allocation
Alpha will get 3 bn at a yield of 5370Beta will get 5 bn at 5372Gamma will get 4 bn at 5373
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At a yield of 5375 we have only 11 bn left toallocateThere is a demand of 20 bn at this yield
8 bn from Delta and 12 bn from CharlieThus we will allocate 1120 = 55 to eachbidder at this yield
There will be pro-rata allocation
055 of 8 bn or 440 bn will go to Delta055 of 12 bn or 66 bn will go to Charlie
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The highest accepted yield is called the StopYield or High Yield
In this case it is 5375The ratio of bids received to the amountawarded is known as the bid to cover ratio
The higher the ratio the stronger is the auction
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Those who bid more than 5375 will getnothing and are said to be shutout of theauctionSince 1999 the US Treasury has beenconducting only uniform yield auctions
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WI stands for ndash When As and If IssuedThe when issued market is a market forforward trading of a bond
Which has been announced but not yet issuedTrades take place from the date ofannouncement until the actual issue date
Helps bidders to gauge the marketrsquos interestbefore the actual auction
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WI trading has ramifications for the biddingstrategies of market participantsTraders can take both long and shortpositions
Settlement is scheduled for the issue date
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It has a bearing on the outcome of theauction
It affects the strategy used by a bidder becauseit has an impact on his prior positionBidders who are long in the WI market enter theauction with a Long PositionThose who are short in the WI market enter theauction with a short position
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The WI market helps in price discoveryIt provides important information on
The strength of demand for the securityAnd on the disparity of biddersrsquo views
This help potential bidders to formulate theirstrategiesAt times a dealer may believe that he hasvery important private information
If so he may not participate in the WI market andwill directly enter the auction with bids based onhis knowledge
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On or before the date of the auction theissues trade on a yield basis
The actual price can be established only afterthe coupon is set
Starting with the day after the auctionSecurities are quoted on a price basis becausethe coupon is known
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In a coupon roll a dealer will purchase themost recently issued security from a clientAnd simultaneously sell the same amount ofthe recently announced new security
The first leg with settle on the following dayThe second leg is a forward contract
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There can be a Reverse RollThe dealer will sell the most recent issue fornext day settlementAnd buy the newly announced security forforward settlement
The forward leg in a RollReverse Roll is a WItrade
It will settle on the new issue settlement date
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The roll is the spread between the yield onthe new security and that on the outstandingissue in the same maturity segmentA GIVE in the Roll means that
The WI security provides a higher yield than theoutstanding issue
A Take in the Roll means thatThe WI security provides a lower yield
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On March 17 20XX the Treasury announcedthe auction of a 2-year note
The auction was scheduled for March 24The settlement date was March 31
Trading of the roll began as soon as the issuewas announcedA Give of 5 bp means that the dealer proposes tobuy the current issue at the prevailing yieldAnd sell the new issue at a yield that is 5 bpmoreA Take of 5 bp means that the dealer proposes tosell the new issue at a yield that is 5bp lower
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The roll achieves the followingHe acquires the outstanding issue for next daysettlementHe sells the to be issued security with the samepar value for forward delivery on 31 March
The customer is rolling over the investmentfrom the current issue to the new issue
This extends the maturity of the investment byone month
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The client can invest the funds received tillthe new issue settlesHowever he loses the accrued interest thathe would have earned had he held on to theissue
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The Treasury per se does not issue zerocoupon securitiesBut zero coupon securities can be created
which are backed by conventional bondsTake a large quantity of a T-note or bond andseparate all the cash flows from each otherSell the entitlement to each cash flowseparately
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Take the case of a two-year T-noteIt can be separated into five zero couponsecurities maturing after
6 months12 months18 months24 months
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Earlier investment banks used to buy bondsfrom the Treasury and separate the cashflows
Each cash flow was then sold separately as a zerocoupon bondSuch issues are called trademarks
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The issue of trademarks has now ceasedBecause investment banks can now createsuch instruments
In concert with the Treasury itselfThese ZCBs are known as STRIPS ndash
Separate Trading of Registered Interest andPrincipal of Securities
These are not issued or sold by the Treasury
The market is made by investment banks
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What is the motivation to create suchproductsIn practice arbitrage is possible when a
coupon security is purchased at a priceThat is lower than what could be obtained byselling each cash flow separately
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Coupon stripping reflects a case of financialengineering
Creating a risk-return profile that is nototherwise available
An investment bank would buy a largequantity of a Treasury security
The securities would be placed with an SPV
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The SPV is a single-purpose dedicated trustIt has the powers to own the bonds andcollect payments
It cannot sell or lend the bondsIt cannot write options on the bondsOr use them as collateral for borrowing
The SPV is empowered to issue zero coupon
bondsWhere each security represents the ownership ofa single cash flow from the mother bond
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Assume that 100MM USD of 15 year bondswith a coupon of 8 are placed with the SPV
The SPV can issue 6M 12M 18M extending up to14 frac12 year zeroes with a total face value of 4MM
USD eachAnd 15 year zeroes with a total face value of104MM
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The Treasury launched this program in 1985to facilitate the stripping of designatedsecurities
All new T-bonds and notes with a maturity of 10years or more are eligibleThe zeroes created in the process are directobligations of the US government
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The mechanism is as followsA dealer who owns a bond or note can ask theFRB where it is held
To replace it with an equivalent set of STRIPS
representing each payment as a separate securityEach of these securities can be traded independentlyof others
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In 1987 the Treasury started to allow dealersto reverse the process
This is called STRIPS RECONSTUTUTION If a dealer owns STRIPS representing all thecoupon and principal payments of a bond
The FED can on request convert these holdings into asingle position in the corresponding bond
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Each coupon and principal cash flow from aTreasury security is assigned a CUSIP
The mother bond is also assigned a CUSIPThe stripped coupons are known as C-STRIPSThe stripped principal is known as P-STRIPSSupply of a C-STRIP increases over time
because a C-STRIP maturing on a day like 15 FEB
2020 will have the same CUSIP irrespective ofwhich mother bond it has come fromThe original coupon rate is irrelevant
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P-STRIPS always correspond to the originalsecurityThey have a unique CUSIPTheir supply is fixed at the time of issuanceIn practice the prices of long-dated P-STRIPSare a bit higher than those of C-STRIPS withthe same maturity date
One reason is that P-STRIPS are more liquid due
to greater availabilityA $100 face value bond with a coupon of 8 willgenerate C-STRIPS with a face value of $4 but P-STRIPS with a face value of $100
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Another reason why P-STRIPS are in higherdemand is that they allow reconstitutionactivities more easily
Assume that the sum of the STRIPS is cheaper than
the mother bondIf a dealer already has the P-STRIPS only the C-STRIPSneed to be acquiredHowever if he owns some of the C-STRIPS he needs toacquire the P-STRIPS and the remaining C-STRIPSThe facility to reconstitute when profitable is pricedinto the P-STRIPSNote Buy and hold investors will prefer C-STRIPSsince they are priced lower and give a higher yield
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For Plain Vanilla bonds the specifiedcoupon rate is valid for the life of thebond
In the case of Floaters the rate is reset atthe beginning of every periodThe rate will vary directly with thebenchmark
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The rate on a Floater is specified as LIBOR+ 50 bp
The spread is positiveIf it were specified as LIBOR ndash 30bp
The spread will be negativeIf LIBOR rises the rate will increasewhereas if LIBOR falls it will decrease
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In the case of a default risk-free floater theprice will reset to par on a coupon date
It may sell at a premium or discount betweencoupon dates
Consider a floater with a coupon = 5-year T-Bond rate
Assume there are two periods left to maturity
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The price at the end of the first coupon period willbe given by
cT-1 is the coupon one period before maturityyT-1 is the YTM one period before maturity
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On a coupon reset date the YTM = couponBecause we have assumed there is no default riskAny change in the required yield as reflected inthe prevailing YTM
Will also be reflected in the coupon being setIf coupon = yield the bond should sell at par
Thus P T-1 = M
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Once again at T-2 c T-2 = yT-2 and P T-2 = MThis logic can be applied to a bond with anytime remaining till maturityHowever between two coupon dates theprice may not be equal to par
Consider the valuation at T-2+k
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Although c T-2 was set at T-2 and is equal toyT-2
yT-2+k is determined at T-2+k and will reflect theyield prevailing at that time
Thus yT-2+k need not equal c T-2 and may behigher or lower
Hence between two coupon dates a floater maysell at a premium or discount
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Now consider a floater characterized bydefault risk
The risk premium required by the market neednot be constant over time
Assume that at the time of issue YTM = 5-year T-note rate + 75bp
The coupon would have been set equal to thisrate and the bond would have been issued at par
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Six months hence the issue may be perceivedas more risky
YTM = 5-year T-note rate + 95 bpThe coupon will however be set equal to theprevailing 5-year rate + 75 bpIf so the issue will not reset to par at the nextcoupon date
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Floaters may come with a CAP or a FLOOR orBOTH
The CAP is a maximum coupon rateProtects issuers against rising rates
The FLOOR is a minimum coupon rateProtects investors against falling rates
When there is a spread over LIBORThere is a natural floorLIBOR cannot be less than zero
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A newly established issuerOr an issuer with a relatively virgin productor service
Or a restructured company due to a mergeror following a bankruptcyWill be perceived as more riskyInvestors will demand a high coupon
Such firms are unlikely to have high earningsRevenues will peak only after theproductservice is established
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They can ill afford high couponsThey may consider a step-up coupon bond
Where the coupon increases as the bond ages
Assume a company can issue a plain vanillaat a coupon of 8 with a maturity of 5 yearsInstead it may opt for a bond
With a coupon of 6 for the first three years
And a coupon of 10 for the last two yearsThis is a Deferred Interest Security
Provides the issuer with breathing room in theearlier years
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These pay coupons in the form of additionalsecurities and not cash
This offers the issuer time to prepare for cashoutlays
They are used as Mezzanine FinanceThey rank between senior debt and equity in thecapital structureInvestors take more risk as compared to buyersof regular bonds ndash but get higher returnsIssuers can conserve cash in earlier years when itis at a premium
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Fully backed by the federal government ofthe issuing nationConsequently they are virtually devoid ofcredit risk or the risk of defaultThe yield on such securities is a benchmarkfor setting rates on other kinds of debt
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Treasury securities are issuedTo finance expenses in excess of currentrevenuesTo pay interest on debt accumulated in earlieryears due to deficits in those yearsTo repay past debt issues that are currentlymaturing
The US Treasuries marketIs the largest bond market in the worldIs the most liquid bond market in the world
8282014 55
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The Treasury issues three categories ofmarketable securities
T-bills are discount securitiesThey are zero coupon securitiesT-notes and T-bonds are sold at face value andpay interest periodically
8282014 56
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T-bills are issued with a original time tomaturity of one year or less
They are Money market instrumentsThey have maturities of either 1 3 6 or 12months at the time of issue
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T-notes and T-bonds have a time to maturityexceeding one year at the time of issue
They are capital market instrumentsT-notes have maturities ranging from 1-10 yearsT-bonds have an original maturity in excess of 10years extending up to 30 years
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An issue may be followed later by a furtherissue
With the same remaining time to maturity andthe same couponThe issuance of further tranches is termed as aRe-opening
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Six months ago a 10-year note was issuedwith a coupon of 8 per annumToday if a note with 9 frac12 years to maturityand a coupon of 8 issued it will add to thepool that is already trading in the marketThus it is a re-opening of an existing issue
8282014 60
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Who is a primary dealerA PD is a dealer who is authorized to dealdirectly with the Central Bank of the countryIn the US a PD is a bank or securities broker-dealer that directly deals with the FRBNY
Importance of FRBNYIn India a PD deals directly with the RBI
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The Treasury sells bills notes and bonds byway of a competitive auction process
Most of the treasury securities are bought byprimary dealers
Individual investors submit non-competitive bidsand participate on a much smaller scale
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Bids may beCompetitive
Indicate price amp quantity or yield amp quantityNon-competitive
Indicate only quantity
Small investors and individualsgenerally submit non-competitive bids
A non-competitive bidder may not bid for more than$5MM worth of securities in a bill or bond auction
8282014 64
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Primary dealers bid for their accounts andon behalf of their clientsThey usually submit large competitive
bidsBids indicate the maximum price that the bidderis prepared to pay if it is a price based auctionOr the minimum yield that the bidder is
prepared to accept if it is a yield based auction
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The Treasury will net out the totalamount of non-competitive bids
The balance will be allocated to competitivebidders
There are two ways in which securitiescan be allotted
The multiple priceyield auction mechanism
French AuctionsThe uniform priceyield auction mechanism
Dutch Auctions
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Assume that the Treasury is offering 25billion dollars worth of T-bonds
2 billion dollars worth of non-competitive bidshave been receivedSo 23 billion dollars worth of bonds are availableto be offered to the competitive bidders
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There are six competitive bidders who havesubmitted the following yields
The bids have been arranged in ascending orderof yieldIn a price based auction the bids would havebeen arranged in descending order of price
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Bidder Bid Yield Bid Amount
Aggregate Amount
Alpha 5370 30 bn 30 bnBeta 5372 50 bn 80 bn
Gamma 5373 40 bn 12 bn
Delta 5375 80 bn 20 bnCharlie 5375 120 bn 32 bn
Tango 5380 30 bn 35 bn8282014 69
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The aggregate demand equals the amount onoffer at a yield of 5375A multiple yield auction will lead to thefollowing allocation
Alpha will get 3 bn at a yield of 5370Beta will get 5 bn at 5372Gamma will get 4 bn at 5373
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At a yield of 5375 we have only 11 bn left toallocateThere is a demand of 20 bn at this yield
8 bn from Delta and 12 bn from CharlieThus we will allocate 1120 = 55 to eachbidder at this yield
There will be pro-rata allocation
055 of 8 bn or 440 bn will go to Delta055 of 12 bn or 66 bn will go to Charlie
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The highest accepted yield is called the StopYield or High Yield
In this case it is 5375The ratio of bids received to the amountawarded is known as the bid to cover ratio
The higher the ratio the stronger is the auction
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Those who bid more than 5375 will getnothing and are said to be shutout of theauctionSince 1999 the US Treasury has beenconducting only uniform yield auctions
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WI stands for ndash When As and If IssuedThe when issued market is a market forforward trading of a bond
Which has been announced but not yet issuedTrades take place from the date ofannouncement until the actual issue date
Helps bidders to gauge the marketrsquos interestbefore the actual auction
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WI trading has ramifications for the biddingstrategies of market participantsTraders can take both long and shortpositions
Settlement is scheduled for the issue date
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It has a bearing on the outcome of theauction
It affects the strategy used by a bidder becauseit has an impact on his prior positionBidders who are long in the WI market enter theauction with a Long PositionThose who are short in the WI market enter theauction with a short position
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The WI market helps in price discoveryIt provides important information on
The strength of demand for the securityAnd on the disparity of biddersrsquo views
This help potential bidders to formulate theirstrategiesAt times a dealer may believe that he hasvery important private information
If so he may not participate in the WI market andwill directly enter the auction with bids based onhis knowledge
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On or before the date of the auction theissues trade on a yield basis
The actual price can be established only afterthe coupon is set
Starting with the day after the auctionSecurities are quoted on a price basis becausethe coupon is known
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In a coupon roll a dealer will purchase themost recently issued security from a clientAnd simultaneously sell the same amount ofthe recently announced new security
The first leg with settle on the following dayThe second leg is a forward contract
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There can be a Reverse RollThe dealer will sell the most recent issue fornext day settlementAnd buy the newly announced security forforward settlement
The forward leg in a RollReverse Roll is a WItrade
It will settle on the new issue settlement date
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The roll is the spread between the yield onthe new security and that on the outstandingissue in the same maturity segmentA GIVE in the Roll means that
The WI security provides a higher yield than theoutstanding issue
A Take in the Roll means thatThe WI security provides a lower yield
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8112019 FISD-02-A
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On March 17 20XX the Treasury announcedthe auction of a 2-year note
The auction was scheduled for March 24The settlement date was March 31
Trading of the roll began as soon as the issuewas announcedA Give of 5 bp means that the dealer proposes tobuy the current issue at the prevailing yieldAnd sell the new issue at a yield that is 5 bpmoreA Take of 5 bp means that the dealer proposes tosell the new issue at a yield that is 5bp lower
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The roll achieves the followingHe acquires the outstanding issue for next daysettlementHe sells the to be issued security with the samepar value for forward delivery on 31 March
The customer is rolling over the investmentfrom the current issue to the new issue
This extends the maturity of the investment byone month
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The client can invest the funds received tillthe new issue settlesHowever he loses the accrued interest thathe would have earned had he held on to theissue
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The Treasury per se does not issue zerocoupon securitiesBut zero coupon securities can be created
which are backed by conventional bondsTake a large quantity of a T-note or bond andseparate all the cash flows from each otherSell the entitlement to each cash flowseparately
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Take the case of a two-year T-noteIt can be separated into five zero couponsecurities maturing after
6 months12 months18 months24 months
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Earlier investment banks used to buy bondsfrom the Treasury and separate the cashflows
Each cash flow was then sold separately as a zerocoupon bondSuch issues are called trademarks
8282014 89
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The issue of trademarks has now ceasedBecause investment banks can now createsuch instruments
In concert with the Treasury itselfThese ZCBs are known as STRIPS ndash
Separate Trading of Registered Interest andPrincipal of Securities
These are not issued or sold by the Treasury
The market is made by investment banks
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What is the motivation to create suchproductsIn practice arbitrage is possible when a
coupon security is purchased at a priceThat is lower than what could be obtained byselling each cash flow separately
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Coupon stripping reflects a case of financialengineering
Creating a risk-return profile that is nototherwise available
An investment bank would buy a largequantity of a Treasury security
The securities would be placed with an SPV
8282014 92
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The SPV is a single-purpose dedicated trustIt has the powers to own the bonds andcollect payments
It cannot sell or lend the bondsIt cannot write options on the bondsOr use them as collateral for borrowing
The SPV is empowered to issue zero coupon
bondsWhere each security represents the ownership ofa single cash flow from the mother bond
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Assume that 100MM USD of 15 year bondswith a coupon of 8 are placed with the SPV
The SPV can issue 6M 12M 18M extending up to14 frac12 year zeroes with a total face value of 4MM
USD eachAnd 15 year zeroes with a total face value of104MM
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The Treasury launched this program in 1985to facilitate the stripping of designatedsecurities
All new T-bonds and notes with a maturity of 10years or more are eligibleThe zeroes created in the process are directobligations of the US government
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The mechanism is as followsA dealer who owns a bond or note can ask theFRB where it is held
To replace it with an equivalent set of STRIPS
representing each payment as a separate securityEach of these securities can be traded independentlyof others
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In 1987 the Treasury started to allow dealersto reverse the process
This is called STRIPS RECONSTUTUTION If a dealer owns STRIPS representing all thecoupon and principal payments of a bond
The FED can on request convert these holdings into asingle position in the corresponding bond
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Each coupon and principal cash flow from aTreasury security is assigned a CUSIP
The mother bond is also assigned a CUSIPThe stripped coupons are known as C-STRIPSThe stripped principal is known as P-STRIPSSupply of a C-STRIP increases over time
because a C-STRIP maturing on a day like 15 FEB
2020 will have the same CUSIP irrespective ofwhich mother bond it has come fromThe original coupon rate is irrelevant
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P-STRIPS always correspond to the originalsecurityThey have a unique CUSIPTheir supply is fixed at the time of issuanceIn practice the prices of long-dated P-STRIPSare a bit higher than those of C-STRIPS withthe same maturity date
One reason is that P-STRIPS are more liquid due
to greater availabilityA $100 face value bond with a coupon of 8 willgenerate C-STRIPS with a face value of $4 but P-STRIPS with a face value of $100
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Another reason why P-STRIPS are in higherdemand is that they allow reconstitutionactivities more easily
Assume that the sum of the STRIPS is cheaper than
the mother bondIf a dealer already has the P-STRIPS only the C-STRIPSneed to be acquiredHowever if he owns some of the C-STRIPS he needs toacquire the P-STRIPS and the remaining C-STRIPSThe facility to reconstitute when profitable is pricedinto the P-STRIPSNote Buy and hold investors will prefer C-STRIPSsince they are priced lower and give a higher yield
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For Plain Vanilla bonds the specifiedcoupon rate is valid for the life of thebond
In the case of Floaters the rate is reset atthe beginning of every periodThe rate will vary directly with thebenchmark
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The rate on a Floater is specified as LIBOR+ 50 bp
The spread is positiveIf it were specified as LIBOR ndash 30bp
The spread will be negativeIf LIBOR rises the rate will increasewhereas if LIBOR falls it will decrease
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In the case of a default risk-free floater theprice will reset to par on a coupon date
It may sell at a premium or discount betweencoupon dates
Consider a floater with a coupon = 5-year T-Bond rate
Assume there are two periods left to maturity
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The price at the end of the first coupon period willbe given by
cT-1 is the coupon one period before maturityyT-1 is the YTM one period before maturity
8112019 FISD-02-A
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On a coupon reset date the YTM = couponBecause we have assumed there is no default riskAny change in the required yield as reflected inthe prevailing YTM
Will also be reflected in the coupon being setIf coupon = yield the bond should sell at par
Thus P T-1 = M
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Once again at T-2 c T-2 = yT-2 and P T-2 = MThis logic can be applied to a bond with anytime remaining till maturityHowever between two coupon dates theprice may not be equal to par
Consider the valuation at T-2+k
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Although c T-2 was set at T-2 and is equal toyT-2
yT-2+k is determined at T-2+k and will reflect theyield prevailing at that time
Thus yT-2+k need not equal c T-2 and may behigher or lower
Hence between two coupon dates a floater maysell at a premium or discount
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Now consider a floater characterized bydefault risk
The risk premium required by the market neednot be constant over time
Assume that at the time of issue YTM = 5-year T-note rate + 75bp
The coupon would have been set equal to thisrate and the bond would have been issued at par
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Six months hence the issue may be perceivedas more risky
YTM = 5-year T-note rate + 95 bpThe coupon will however be set equal to theprevailing 5-year rate + 75 bpIf so the issue will not reset to par at the nextcoupon date
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Floaters may come with a CAP or a FLOOR orBOTH
The CAP is a maximum coupon rateProtects issuers against rising rates
The FLOOR is a minimum coupon rateProtects investors against falling rates
When there is a spread over LIBORThere is a natural floorLIBOR cannot be less than zero
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A newly established issuerOr an issuer with a relatively virgin productor service
Or a restructured company due to a mergeror following a bankruptcyWill be perceived as more riskyInvestors will demand a high coupon
Such firms are unlikely to have high earningsRevenues will peak only after theproductservice is established
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They can ill afford high couponsThey may consider a step-up coupon bond
Where the coupon increases as the bond ages
Assume a company can issue a plain vanillaat a coupon of 8 with a maturity of 5 yearsInstead it may opt for a bond
With a coupon of 6 for the first three years
And a coupon of 10 for the last two yearsThis is a Deferred Interest Security
Provides the issuer with breathing room in theearlier years
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These pay coupons in the form of additionalsecurities and not cash
This offers the issuer time to prepare for cashoutlays
They are used as Mezzanine FinanceThey rank between senior debt and equity in thecapital structureInvestors take more risk as compared to buyersof regular bonds ndash but get higher returnsIssuers can conserve cash in earlier years when itis at a premium
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Fully backed by the federal government ofthe issuing nationConsequently they are virtually devoid ofcredit risk or the risk of defaultThe yield on such securities is a benchmarkfor setting rates on other kinds of debt
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Treasury securities are issuedTo finance expenses in excess of currentrevenuesTo pay interest on debt accumulated in earlieryears due to deficits in those yearsTo repay past debt issues that are currentlymaturing
The US Treasuries marketIs the largest bond market in the worldIs the most liquid bond market in the world
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The Treasury issues three categories ofmarketable securities
T-bills are discount securitiesThey are zero coupon securitiesT-notes and T-bonds are sold at face value andpay interest periodically
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T-bills are issued with a original time tomaturity of one year or less
They are Money market instrumentsThey have maturities of either 1 3 6 or 12months at the time of issue
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T-notes and T-bonds have a time to maturityexceeding one year at the time of issue
They are capital market instrumentsT-notes have maturities ranging from 1-10 yearsT-bonds have an original maturity in excess of 10years extending up to 30 years
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An issue may be followed later by a furtherissue
With the same remaining time to maturity andthe same couponThe issuance of further tranches is termed as aRe-opening
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Six months ago a 10-year note was issuedwith a coupon of 8 per annumToday if a note with 9 frac12 years to maturityand a coupon of 8 issued it will add to thepool that is already trading in the marketThus it is a re-opening of an existing issue
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Who is a primary dealerA PD is a dealer who is authorized to dealdirectly with the Central Bank of the countryIn the US a PD is a bank or securities broker-dealer that directly deals with the FRBNY
Importance of FRBNYIn India a PD deals directly with the RBI
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The Treasury sells bills notes and bonds byway of a competitive auction process
Most of the treasury securities are bought byprimary dealers
Individual investors submit non-competitive bidsand participate on a much smaller scale
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Bids may beCompetitive
Indicate price amp quantity or yield amp quantityNon-competitive
Indicate only quantity
Small investors and individualsgenerally submit non-competitive bids
A non-competitive bidder may not bid for more than$5MM worth of securities in a bill or bond auction
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Primary dealers bid for their accounts andon behalf of their clientsThey usually submit large competitive
bidsBids indicate the maximum price that the bidderis prepared to pay if it is a price based auctionOr the minimum yield that the bidder is
prepared to accept if it is a yield based auction
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The Treasury will net out the totalamount of non-competitive bids
The balance will be allocated to competitivebidders
There are two ways in which securitiescan be allotted
The multiple priceyield auction mechanism
French AuctionsThe uniform priceyield auction mechanism
Dutch Auctions
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Assume that the Treasury is offering 25billion dollars worth of T-bonds
2 billion dollars worth of non-competitive bidshave been receivedSo 23 billion dollars worth of bonds are availableto be offered to the competitive bidders
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There are six competitive bidders who havesubmitted the following yields
The bids have been arranged in ascending orderof yieldIn a price based auction the bids would havebeen arranged in descending order of price
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Bidder Bid Yield Bid Amount
Aggregate Amount
Alpha 5370 30 bn 30 bnBeta 5372 50 bn 80 bn
Gamma 5373 40 bn 12 bn
Delta 5375 80 bn 20 bnCharlie 5375 120 bn 32 bn
Tango 5380 30 bn 35 bn8282014 69
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The aggregate demand equals the amount onoffer at a yield of 5375A multiple yield auction will lead to thefollowing allocation
Alpha will get 3 bn at a yield of 5370Beta will get 5 bn at 5372Gamma will get 4 bn at 5373
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At a yield of 5375 we have only 11 bn left toallocateThere is a demand of 20 bn at this yield
8 bn from Delta and 12 bn from CharlieThus we will allocate 1120 = 55 to eachbidder at this yield
There will be pro-rata allocation
055 of 8 bn or 440 bn will go to Delta055 of 12 bn or 66 bn will go to Charlie
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The highest accepted yield is called the StopYield or High Yield
In this case it is 5375The ratio of bids received to the amountawarded is known as the bid to cover ratio
The higher the ratio the stronger is the auction
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Those who bid more than 5375 will getnothing and are said to be shutout of theauctionSince 1999 the US Treasury has beenconducting only uniform yield auctions
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WI stands for ndash When As and If IssuedThe when issued market is a market forforward trading of a bond
Which has been announced but not yet issuedTrades take place from the date ofannouncement until the actual issue date
Helps bidders to gauge the marketrsquos interestbefore the actual auction
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WI trading has ramifications for the biddingstrategies of market participantsTraders can take both long and shortpositions
Settlement is scheduled for the issue date
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It has a bearing on the outcome of theauction
It affects the strategy used by a bidder becauseit has an impact on his prior positionBidders who are long in the WI market enter theauction with a Long PositionThose who are short in the WI market enter theauction with a short position
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The WI market helps in price discoveryIt provides important information on
The strength of demand for the securityAnd on the disparity of biddersrsquo views
This help potential bidders to formulate theirstrategiesAt times a dealer may believe that he hasvery important private information
If so he may not participate in the WI market andwill directly enter the auction with bids based onhis knowledge
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On or before the date of the auction theissues trade on a yield basis
The actual price can be established only afterthe coupon is set
Starting with the day after the auctionSecurities are quoted on a price basis becausethe coupon is known
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In a coupon roll a dealer will purchase themost recently issued security from a clientAnd simultaneously sell the same amount ofthe recently announced new security
The first leg with settle on the following dayThe second leg is a forward contract
8282014 80
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There can be a Reverse RollThe dealer will sell the most recent issue fornext day settlementAnd buy the newly announced security forforward settlement
The forward leg in a RollReverse Roll is a WItrade
It will settle on the new issue settlement date
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The roll is the spread between the yield onthe new security and that on the outstandingissue in the same maturity segmentA GIVE in the Roll means that
The WI security provides a higher yield than theoutstanding issue
A Take in the Roll means thatThe WI security provides a lower yield
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On March 17 20XX the Treasury announcedthe auction of a 2-year note
The auction was scheduled for March 24The settlement date was March 31
Trading of the roll began as soon as the issuewas announcedA Give of 5 bp means that the dealer proposes tobuy the current issue at the prevailing yieldAnd sell the new issue at a yield that is 5 bpmoreA Take of 5 bp means that the dealer proposes tosell the new issue at a yield that is 5bp lower
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The roll achieves the followingHe acquires the outstanding issue for next daysettlementHe sells the to be issued security with the samepar value for forward delivery on 31 March
The customer is rolling over the investmentfrom the current issue to the new issue
This extends the maturity of the investment byone month
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The client can invest the funds received tillthe new issue settlesHowever he loses the accrued interest thathe would have earned had he held on to theissue
8282014 86
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The Treasury per se does not issue zerocoupon securitiesBut zero coupon securities can be created
which are backed by conventional bondsTake a large quantity of a T-note or bond andseparate all the cash flows from each otherSell the entitlement to each cash flowseparately
8282014 87
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Take the case of a two-year T-noteIt can be separated into five zero couponsecurities maturing after
6 months12 months18 months24 months
8282014 88
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httpslidepdfcomreaderfullfisd-02-a 89115
Earlier investment banks used to buy bondsfrom the Treasury and separate the cashflows
Each cash flow was then sold separately as a zerocoupon bondSuch issues are called trademarks
8282014 89
8112019 FISD-02-A
httpslidepdfcomreaderfullfisd-02-a 90115
The issue of trademarks has now ceasedBecause investment banks can now createsuch instruments
In concert with the Treasury itselfThese ZCBs are known as STRIPS ndash
Separate Trading of Registered Interest andPrincipal of Securities
These are not issued or sold by the Treasury
The market is made by investment banks
8282014 90
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What is the motivation to create suchproductsIn practice arbitrage is possible when a
coupon security is purchased at a priceThat is lower than what could be obtained byselling each cash flow separately
8282014 91
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Coupon stripping reflects a case of financialengineering
Creating a risk-return profile that is nototherwise available
An investment bank would buy a largequantity of a Treasury security
The securities would be placed with an SPV
8282014 92
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httpslidepdfcomreaderfullfisd-02-a 93115
The SPV is a single-purpose dedicated trustIt has the powers to own the bonds andcollect payments
It cannot sell or lend the bondsIt cannot write options on the bondsOr use them as collateral for borrowing
The SPV is empowered to issue zero coupon
bondsWhere each security represents the ownership ofa single cash flow from the mother bond
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Assume that 100MM USD of 15 year bondswith a coupon of 8 are placed with the SPV
The SPV can issue 6M 12M 18M extending up to14 frac12 year zeroes with a total face value of 4MM
USD eachAnd 15 year zeroes with a total face value of104MM
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8112019 FISD-02-A
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The Treasury launched this program in 1985to facilitate the stripping of designatedsecurities
All new T-bonds and notes with a maturity of 10years or more are eligibleThe zeroes created in the process are directobligations of the US government
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The mechanism is as followsA dealer who owns a bond or note can ask theFRB where it is held
To replace it with an equivalent set of STRIPS
representing each payment as a separate securityEach of these securities can be traded independentlyof others
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In 1987 the Treasury started to allow dealersto reverse the process
This is called STRIPS RECONSTUTUTION If a dealer owns STRIPS representing all thecoupon and principal payments of a bond
The FED can on request convert these holdings into asingle position in the corresponding bond
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Each coupon and principal cash flow from aTreasury security is assigned a CUSIP
The mother bond is also assigned a CUSIPThe stripped coupons are known as C-STRIPSThe stripped principal is known as P-STRIPSSupply of a C-STRIP increases over time
because a C-STRIP maturing on a day like 15 FEB
2020 will have the same CUSIP irrespective ofwhich mother bond it has come fromThe original coupon rate is irrelevant
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P-STRIPS always correspond to the originalsecurityThey have a unique CUSIPTheir supply is fixed at the time of issuanceIn practice the prices of long-dated P-STRIPSare a bit higher than those of C-STRIPS withthe same maturity date
One reason is that P-STRIPS are more liquid due
to greater availabilityA $100 face value bond with a coupon of 8 willgenerate C-STRIPS with a face value of $4 but P-STRIPS with a face value of $100
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Another reason why P-STRIPS are in higherdemand is that they allow reconstitutionactivities more easily
Assume that the sum of the STRIPS is cheaper than
the mother bondIf a dealer already has the P-STRIPS only the C-STRIPSneed to be acquiredHowever if he owns some of the C-STRIPS he needs toacquire the P-STRIPS and the remaining C-STRIPSThe facility to reconstitute when profitable is pricedinto the P-STRIPSNote Buy and hold investors will prefer C-STRIPSsince they are priced lower and give a higher yield
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For Plain Vanilla bonds the specifiedcoupon rate is valid for the life of thebond
In the case of Floaters the rate is reset atthe beginning of every periodThe rate will vary directly with thebenchmark
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The rate on a Floater is specified as LIBOR+ 50 bp
The spread is positiveIf it were specified as LIBOR ndash 30bp
The spread will be negativeIf LIBOR rises the rate will increasewhereas if LIBOR falls it will decrease
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In the case of a default risk-free floater theprice will reset to par on a coupon date
It may sell at a premium or discount betweencoupon dates
Consider a floater with a coupon = 5-year T-Bond rate
Assume there are two periods left to maturity
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The price at the end of the first coupon period willbe given by
cT-1 is the coupon one period before maturityyT-1 is the YTM one period before maturity
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On a coupon reset date the YTM = couponBecause we have assumed there is no default riskAny change in the required yield as reflected inthe prevailing YTM
Will also be reflected in the coupon being setIf coupon = yield the bond should sell at par
Thus P T-1 = M
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Once again at T-2 c T-2 = yT-2 and P T-2 = MThis logic can be applied to a bond with anytime remaining till maturityHowever between two coupon dates theprice may not be equal to par
Consider the valuation at T-2+k
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Although c T-2 was set at T-2 and is equal toyT-2
yT-2+k is determined at T-2+k and will reflect theyield prevailing at that time
Thus yT-2+k need not equal c T-2 and may behigher or lower
Hence between two coupon dates a floater maysell at a premium or discount
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Now consider a floater characterized bydefault risk
The risk premium required by the market neednot be constant over time
Assume that at the time of issue YTM = 5-year T-note rate + 75bp
The coupon would have been set equal to thisrate and the bond would have been issued at par
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Six months hence the issue may be perceivedas more risky
YTM = 5-year T-note rate + 95 bpThe coupon will however be set equal to theprevailing 5-year rate + 75 bpIf so the issue will not reset to par at the nextcoupon date
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Floaters may come with a CAP or a FLOOR orBOTH
The CAP is a maximum coupon rateProtects issuers against rising rates
The FLOOR is a minimum coupon rateProtects investors against falling rates
When there is a spread over LIBORThere is a natural floorLIBOR cannot be less than zero
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They can ill afford high couponsThey may consider a step-up coupon bond
Where the coupon increases as the bond ages
Assume a company can issue a plain vanillaat a coupon of 8 with a maturity of 5 yearsInstead it may opt for a bond
With a coupon of 6 for the first three years
And a coupon of 10 for the last two yearsThis is a Deferred Interest Security
Provides the issuer with breathing room in theearlier years
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These pay coupons in the form of additionalsecurities and not cash
This offers the issuer time to prepare for cashoutlays
They are used as Mezzanine FinanceThey rank between senior debt and equity in thecapital structureInvestors take more risk as compared to buyersof regular bonds ndash but get higher returnsIssuers can conserve cash in earlier years when itis at a premium
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Fully backed by the federal government ofthe issuing nationConsequently they are virtually devoid ofcredit risk or the risk of defaultThe yield on such securities is a benchmarkfor setting rates on other kinds of debt
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Treasury securities are issuedTo finance expenses in excess of currentrevenuesTo pay interest on debt accumulated in earlieryears due to deficits in those yearsTo repay past debt issues that are currentlymaturing
The US Treasuries marketIs the largest bond market in the worldIs the most liquid bond market in the world
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The Treasury issues three categories ofmarketable securities
T-bills are discount securitiesThey are zero coupon securitiesT-notes and T-bonds are sold at face value andpay interest periodically
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T-bills are issued with a original time tomaturity of one year or less
They are Money market instrumentsThey have maturities of either 1 3 6 or 12months at the time of issue
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T-notes and T-bonds have a time to maturityexceeding one year at the time of issue
They are capital market instrumentsT-notes have maturities ranging from 1-10 yearsT-bonds have an original maturity in excess of 10years extending up to 30 years
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An issue may be followed later by a furtherissue
With the same remaining time to maturity andthe same couponThe issuance of further tranches is termed as aRe-opening
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Six months ago a 10-year note was issuedwith a coupon of 8 per annumToday if a note with 9 frac12 years to maturityand a coupon of 8 issued it will add to thepool that is already trading in the marketThus it is a re-opening of an existing issue
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Who is a primary dealerA PD is a dealer who is authorized to dealdirectly with the Central Bank of the countryIn the US a PD is a bank or securities broker-dealer that directly deals with the FRBNY
Importance of FRBNYIn India a PD deals directly with the RBI
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The Treasury sells bills notes and bonds byway of a competitive auction process
Most of the treasury securities are bought byprimary dealers
Individual investors submit non-competitive bidsand participate on a much smaller scale
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Bids may beCompetitive
Indicate price amp quantity or yield amp quantityNon-competitive
Indicate only quantity
Small investors and individualsgenerally submit non-competitive bids
A non-competitive bidder may not bid for more than$5MM worth of securities in a bill or bond auction
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Primary dealers bid for their accounts andon behalf of their clientsThey usually submit large competitive
bidsBids indicate the maximum price that the bidderis prepared to pay if it is a price based auctionOr the minimum yield that the bidder is
prepared to accept if it is a yield based auction
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The Treasury will net out the totalamount of non-competitive bids
The balance will be allocated to competitivebidders
There are two ways in which securitiescan be allotted
The multiple priceyield auction mechanism
French AuctionsThe uniform priceyield auction mechanism
Dutch Auctions
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Assume that the Treasury is offering 25billion dollars worth of T-bonds
2 billion dollars worth of non-competitive bidshave been receivedSo 23 billion dollars worth of bonds are availableto be offered to the competitive bidders
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There are six competitive bidders who havesubmitted the following yields
The bids have been arranged in ascending orderof yieldIn a price based auction the bids would havebeen arranged in descending order of price
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Bidder Bid Yield Bid Amount
Aggregate Amount
Alpha 5370 30 bn 30 bnBeta 5372 50 bn 80 bn
Gamma 5373 40 bn 12 bn
Delta 5375 80 bn 20 bnCharlie 5375 120 bn 32 bn
Tango 5380 30 bn 35 bn8282014 69
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The aggregate demand equals the amount onoffer at a yield of 5375A multiple yield auction will lead to thefollowing allocation
Alpha will get 3 bn at a yield of 5370Beta will get 5 bn at 5372Gamma will get 4 bn at 5373
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At a yield of 5375 we have only 11 bn left toallocateThere is a demand of 20 bn at this yield
8 bn from Delta and 12 bn from CharlieThus we will allocate 1120 = 55 to eachbidder at this yield
There will be pro-rata allocation
055 of 8 bn or 440 bn will go to Delta055 of 12 bn or 66 bn will go to Charlie
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The highest accepted yield is called the StopYield or High Yield
In this case it is 5375The ratio of bids received to the amountawarded is known as the bid to cover ratio
The higher the ratio the stronger is the auction
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Those who bid more than 5375 will getnothing and are said to be shutout of theauctionSince 1999 the US Treasury has beenconducting only uniform yield auctions
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WI stands for ndash When As and If IssuedThe when issued market is a market forforward trading of a bond
Which has been announced but not yet issuedTrades take place from the date ofannouncement until the actual issue date
Helps bidders to gauge the marketrsquos interestbefore the actual auction
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WI trading has ramifications for the biddingstrategies of market participantsTraders can take both long and shortpositions
Settlement is scheduled for the issue date
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It has a bearing on the outcome of theauction
It affects the strategy used by a bidder becauseit has an impact on his prior positionBidders who are long in the WI market enter theauction with a Long PositionThose who are short in the WI market enter theauction with a short position
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The WI market helps in price discoveryIt provides important information on
The strength of demand for the securityAnd on the disparity of biddersrsquo views
This help potential bidders to formulate theirstrategiesAt times a dealer may believe that he hasvery important private information
If so he may not participate in the WI market andwill directly enter the auction with bids based onhis knowledge
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On or before the date of the auction theissues trade on a yield basis
The actual price can be established only afterthe coupon is set
Starting with the day after the auctionSecurities are quoted on a price basis becausethe coupon is known
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In a coupon roll a dealer will purchase themost recently issued security from a clientAnd simultaneously sell the same amount ofthe recently announced new security
The first leg with settle on the following dayThe second leg is a forward contract
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There can be a Reverse RollThe dealer will sell the most recent issue fornext day settlementAnd buy the newly announced security forforward settlement
The forward leg in a RollReverse Roll is a WItrade
It will settle on the new issue settlement date
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The roll is the spread between the yield onthe new security and that on the outstandingissue in the same maturity segmentA GIVE in the Roll means that
The WI security provides a higher yield than theoutstanding issue
A Take in the Roll means thatThe WI security provides a lower yield
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On March 17 20XX the Treasury announcedthe auction of a 2-year note
The auction was scheduled for March 24The settlement date was March 31
Trading of the roll began as soon as the issuewas announcedA Give of 5 bp means that the dealer proposes tobuy the current issue at the prevailing yieldAnd sell the new issue at a yield that is 5 bpmoreA Take of 5 bp means that the dealer proposes tosell the new issue at a yield that is 5bp lower
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The roll achieves the followingHe acquires the outstanding issue for next daysettlementHe sells the to be issued security with the samepar value for forward delivery on 31 March
The customer is rolling over the investmentfrom the current issue to the new issue
This extends the maturity of the investment byone month
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The client can invest the funds received tillthe new issue settlesHowever he loses the accrued interest thathe would have earned had he held on to theissue
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The Treasury per se does not issue zerocoupon securitiesBut zero coupon securities can be created
which are backed by conventional bondsTake a large quantity of a T-note or bond andseparate all the cash flows from each otherSell the entitlement to each cash flowseparately
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Take the case of a two-year T-noteIt can be separated into five zero couponsecurities maturing after
6 months12 months18 months24 months
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Earlier investment banks used to buy bondsfrom the Treasury and separate the cashflows
Each cash flow was then sold separately as a zerocoupon bondSuch issues are called trademarks
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The issue of trademarks has now ceasedBecause investment banks can now createsuch instruments
In concert with the Treasury itselfThese ZCBs are known as STRIPS ndash
Separate Trading of Registered Interest andPrincipal of Securities
These are not issued or sold by the Treasury
The market is made by investment banks
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What is the motivation to create suchproductsIn practice arbitrage is possible when a
coupon security is purchased at a priceThat is lower than what could be obtained byselling each cash flow separately
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Coupon stripping reflects a case of financialengineering
Creating a risk-return profile that is nototherwise available
An investment bank would buy a largequantity of a Treasury security
The securities would be placed with an SPV
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The SPV is a single-purpose dedicated trustIt has the powers to own the bonds andcollect payments
It cannot sell or lend the bondsIt cannot write options on the bondsOr use them as collateral for borrowing
The SPV is empowered to issue zero coupon
bondsWhere each security represents the ownership ofa single cash flow from the mother bond
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Assume that 100MM USD of 15 year bondswith a coupon of 8 are placed with the SPV
The SPV can issue 6M 12M 18M extending up to14 frac12 year zeroes with a total face value of 4MM
USD eachAnd 15 year zeroes with a total face value of104MM
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The Treasury launched this program in 1985to facilitate the stripping of designatedsecurities
All new T-bonds and notes with a maturity of 10years or more are eligibleThe zeroes created in the process are directobligations of the US government
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The mechanism is as followsA dealer who owns a bond or note can ask theFRB where it is held
To replace it with an equivalent set of STRIPS
representing each payment as a separate securityEach of these securities can be traded independentlyof others
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In 1987 the Treasury started to allow dealersto reverse the process
This is called STRIPS RECONSTUTUTION If a dealer owns STRIPS representing all thecoupon and principal payments of a bond
The FED can on request convert these holdings into asingle position in the corresponding bond
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Each coupon and principal cash flow from aTreasury security is assigned a CUSIP
The mother bond is also assigned a CUSIPThe stripped coupons are known as C-STRIPSThe stripped principal is known as P-STRIPSSupply of a C-STRIP increases over time
because a C-STRIP maturing on a day like 15 FEB
2020 will have the same CUSIP irrespective ofwhich mother bond it has come fromThe original coupon rate is irrelevant
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P-STRIPS always correspond to the originalsecurityThey have a unique CUSIPTheir supply is fixed at the time of issuanceIn practice the prices of long-dated P-STRIPSare a bit higher than those of C-STRIPS withthe same maturity date
One reason is that P-STRIPS are more liquid due
to greater availabilityA $100 face value bond with a coupon of 8 willgenerate C-STRIPS with a face value of $4 but P-STRIPS with a face value of $100
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Another reason why P-STRIPS are in higherdemand is that they allow reconstitutionactivities more easily
Assume that the sum of the STRIPS is cheaper than
the mother bondIf a dealer already has the P-STRIPS only the C-STRIPSneed to be acquiredHowever if he owns some of the C-STRIPS he needs toacquire the P-STRIPS and the remaining C-STRIPSThe facility to reconstitute when profitable is pricedinto the P-STRIPSNote Buy and hold investors will prefer C-STRIPSsince they are priced lower and give a higher yield
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For Plain Vanilla bonds the specifiedcoupon rate is valid for the life of thebond
In the case of Floaters the rate is reset atthe beginning of every periodThe rate will vary directly with thebenchmark
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The rate on a Floater is specified as LIBOR+ 50 bp
The spread is positiveIf it were specified as LIBOR ndash 30bp
The spread will be negativeIf LIBOR rises the rate will increasewhereas if LIBOR falls it will decrease
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In the case of a default risk-free floater theprice will reset to par on a coupon date
It may sell at a premium or discount betweencoupon dates
Consider a floater with a coupon = 5-year T-Bond rate
Assume there are two periods left to maturity
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The price at the end of the first coupon period willbe given by
cT-1 is the coupon one period before maturityyT-1 is the YTM one period before maturity
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On a coupon reset date the YTM = couponBecause we have assumed there is no default riskAny change in the required yield as reflected inthe prevailing YTM
Will also be reflected in the coupon being setIf coupon = yield the bond should sell at par
Thus P T-1 = M
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Once again at T-2 c T-2 = yT-2 and P T-2 = MThis logic can be applied to a bond with anytime remaining till maturityHowever between two coupon dates theprice may not be equal to par
Consider the valuation at T-2+k
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Although c T-2 was set at T-2 and is equal toyT-2
yT-2+k is determined at T-2+k and will reflect theyield prevailing at that time
Thus yT-2+k need not equal c T-2 and may behigher or lower
Hence between two coupon dates a floater maysell at a premium or discount
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Now consider a floater characterized bydefault risk
The risk premium required by the market neednot be constant over time
Assume that at the time of issue YTM = 5-year T-note rate + 75bp
The coupon would have been set equal to thisrate and the bond would have been issued at par
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Six months hence the issue may be perceivedas more risky
YTM = 5-year T-note rate + 95 bpThe coupon will however be set equal to theprevailing 5-year rate + 75 bpIf so the issue will not reset to par at the nextcoupon date
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Floaters may come with a CAP or a FLOOR orBOTH
The CAP is a maximum coupon rateProtects issuers against rising rates
The FLOOR is a minimum coupon rateProtects investors against falling rates
When there is a spread over LIBORThere is a natural floorLIBOR cannot be less than zero
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These pay coupons in the form of additionalsecurities and not cash
This offers the issuer time to prepare for cashoutlays
They are used as Mezzanine FinanceThey rank between senior debt and equity in thecapital structureInvestors take more risk as compared to buyersof regular bonds ndash but get higher returnsIssuers can conserve cash in earlier years when itis at a premium
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Fully backed by the federal government ofthe issuing nationConsequently they are virtually devoid ofcredit risk or the risk of defaultThe yield on such securities is a benchmarkfor setting rates on other kinds of debt
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Treasury securities are issuedTo finance expenses in excess of currentrevenuesTo pay interest on debt accumulated in earlieryears due to deficits in those yearsTo repay past debt issues that are currentlymaturing
The US Treasuries marketIs the largest bond market in the worldIs the most liquid bond market in the world
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The Treasury issues three categories ofmarketable securities
T-bills are discount securitiesThey are zero coupon securitiesT-notes and T-bonds are sold at face value andpay interest periodically
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T-bills are issued with a original time tomaturity of one year or less
They are Money market instrumentsThey have maturities of either 1 3 6 or 12months at the time of issue
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T-notes and T-bonds have a time to maturityexceeding one year at the time of issue
They are capital market instrumentsT-notes have maturities ranging from 1-10 yearsT-bonds have an original maturity in excess of 10years extending up to 30 years
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An issue may be followed later by a furtherissue
With the same remaining time to maturity andthe same couponThe issuance of further tranches is termed as aRe-opening
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Six months ago a 10-year note was issuedwith a coupon of 8 per annumToday if a note with 9 frac12 years to maturityand a coupon of 8 issued it will add to thepool that is already trading in the marketThus it is a re-opening of an existing issue
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Who is a primary dealerA PD is a dealer who is authorized to dealdirectly with the Central Bank of the countryIn the US a PD is a bank or securities broker-dealer that directly deals with the FRBNY
Importance of FRBNYIn India a PD deals directly with the RBI
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The Treasury sells bills notes and bonds byway of a competitive auction process
Most of the treasury securities are bought byprimary dealers
Individual investors submit non-competitive bidsand participate on a much smaller scale
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Bids may beCompetitive
Indicate price amp quantity or yield amp quantityNon-competitive
Indicate only quantity
Small investors and individualsgenerally submit non-competitive bids
A non-competitive bidder may not bid for more than$5MM worth of securities in a bill or bond auction
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Primary dealers bid for their accounts andon behalf of their clientsThey usually submit large competitive
bidsBids indicate the maximum price that the bidderis prepared to pay if it is a price based auctionOr the minimum yield that the bidder is
prepared to accept if it is a yield based auction
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The Treasury will net out the totalamount of non-competitive bids
The balance will be allocated to competitivebidders
There are two ways in which securitiescan be allotted
The multiple priceyield auction mechanism
French AuctionsThe uniform priceyield auction mechanism
Dutch Auctions
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Assume that the Treasury is offering 25billion dollars worth of T-bonds
2 billion dollars worth of non-competitive bidshave been receivedSo 23 billion dollars worth of bonds are availableto be offered to the competitive bidders
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There are six competitive bidders who havesubmitted the following yields
The bids have been arranged in ascending orderof yieldIn a price based auction the bids would havebeen arranged in descending order of price
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Bidder Bid Yield Bid Amount
Aggregate Amount
Alpha 5370 30 bn 30 bnBeta 5372 50 bn 80 bn
Gamma 5373 40 bn 12 bn
Delta 5375 80 bn 20 bnCharlie 5375 120 bn 32 bn
Tango 5380 30 bn 35 bn8282014 69
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The aggregate demand equals the amount onoffer at a yield of 5375A multiple yield auction will lead to thefollowing allocation
Alpha will get 3 bn at a yield of 5370Beta will get 5 bn at 5372Gamma will get 4 bn at 5373
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At a yield of 5375 we have only 11 bn left toallocateThere is a demand of 20 bn at this yield
8 bn from Delta and 12 bn from CharlieThus we will allocate 1120 = 55 to eachbidder at this yield
There will be pro-rata allocation
055 of 8 bn or 440 bn will go to Delta055 of 12 bn or 66 bn will go to Charlie
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The highest accepted yield is called the StopYield or High Yield
In this case it is 5375The ratio of bids received to the amountawarded is known as the bid to cover ratio
The higher the ratio the stronger is the auction
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Those who bid more than 5375 will getnothing and are said to be shutout of theauctionSince 1999 the US Treasury has beenconducting only uniform yield auctions
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WI stands for ndash When As and If IssuedThe when issued market is a market forforward trading of a bond
Which has been announced but not yet issuedTrades take place from the date ofannouncement until the actual issue date
Helps bidders to gauge the marketrsquos interestbefore the actual auction
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WI trading has ramifications for the biddingstrategies of market participantsTraders can take both long and shortpositions
Settlement is scheduled for the issue date
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It has a bearing on the outcome of theauction
It affects the strategy used by a bidder becauseit has an impact on his prior positionBidders who are long in the WI market enter theauction with a Long PositionThose who are short in the WI market enter theauction with a short position
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The WI market helps in price discoveryIt provides important information on
The strength of demand for the securityAnd on the disparity of biddersrsquo views
This help potential bidders to formulate theirstrategiesAt times a dealer may believe that he hasvery important private information
If so he may not participate in the WI market andwill directly enter the auction with bids based onhis knowledge
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On or before the date of the auction theissues trade on a yield basis
The actual price can be established only afterthe coupon is set
Starting with the day after the auctionSecurities are quoted on a price basis becausethe coupon is known
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In a coupon roll a dealer will purchase themost recently issued security from a clientAnd simultaneously sell the same amount ofthe recently announced new security
The first leg with settle on the following dayThe second leg is a forward contract
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There can be a Reverse RollThe dealer will sell the most recent issue fornext day settlementAnd buy the newly announced security forforward settlement
The forward leg in a RollReverse Roll is a WItrade
It will settle on the new issue settlement date
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The roll is the spread between the yield onthe new security and that on the outstandingissue in the same maturity segmentA GIVE in the Roll means that
The WI security provides a higher yield than theoutstanding issue
A Take in the Roll means thatThe WI security provides a lower yield
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8112019 FISD-02-A
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On March 17 20XX the Treasury announcedthe auction of a 2-year note
The auction was scheduled for March 24The settlement date was March 31
Trading of the roll began as soon as the issuewas announcedA Give of 5 bp means that the dealer proposes tobuy the current issue at the prevailing yieldAnd sell the new issue at a yield that is 5 bpmoreA Take of 5 bp means that the dealer proposes tosell the new issue at a yield that is 5bp lower
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The roll achieves the followingHe acquires the outstanding issue for next daysettlementHe sells the to be issued security with the samepar value for forward delivery on 31 March
The customer is rolling over the investmentfrom the current issue to the new issue
This extends the maturity of the investment byone month
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The client can invest the funds received tillthe new issue settlesHowever he loses the accrued interest thathe would have earned had he held on to theissue
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The Treasury per se does not issue zerocoupon securitiesBut zero coupon securities can be created
which are backed by conventional bondsTake a large quantity of a T-note or bond andseparate all the cash flows from each otherSell the entitlement to each cash flowseparately
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Take the case of a two-year T-noteIt can be separated into five zero couponsecurities maturing after
6 months12 months18 months24 months
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Earlier investment banks used to buy bondsfrom the Treasury and separate the cashflows
Each cash flow was then sold separately as a zerocoupon bondSuch issues are called trademarks
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The issue of trademarks has now ceasedBecause investment banks can now createsuch instruments
In concert with the Treasury itselfThese ZCBs are known as STRIPS ndash
Separate Trading of Registered Interest andPrincipal of Securities
These are not issued or sold by the Treasury
The market is made by investment banks
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What is the motivation to create suchproductsIn practice arbitrage is possible when a
coupon security is purchased at a priceThat is lower than what could be obtained byselling each cash flow separately
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Coupon stripping reflects a case of financialengineering
Creating a risk-return profile that is nototherwise available
An investment bank would buy a largequantity of a Treasury security
The securities would be placed with an SPV
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The SPV is a single-purpose dedicated trustIt has the powers to own the bonds andcollect payments
It cannot sell or lend the bondsIt cannot write options on the bondsOr use them as collateral for borrowing
The SPV is empowered to issue zero coupon
bondsWhere each security represents the ownership ofa single cash flow from the mother bond
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Assume that 100MM USD of 15 year bondswith a coupon of 8 are placed with the SPV
The SPV can issue 6M 12M 18M extending up to14 frac12 year zeroes with a total face value of 4MM
USD eachAnd 15 year zeroes with a total face value of104MM
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The Treasury launched this program in 1985to facilitate the stripping of designatedsecurities
All new T-bonds and notes with a maturity of 10years or more are eligibleThe zeroes created in the process are directobligations of the US government
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The mechanism is as followsA dealer who owns a bond or note can ask theFRB where it is held
To replace it with an equivalent set of STRIPS
representing each payment as a separate securityEach of these securities can be traded independentlyof others
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In 1987 the Treasury started to allow dealersto reverse the process
This is called STRIPS RECONSTUTUTION If a dealer owns STRIPS representing all thecoupon and principal payments of a bond
The FED can on request convert these holdings into asingle position in the corresponding bond
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Each coupon and principal cash flow from aTreasury security is assigned a CUSIP
The mother bond is also assigned a CUSIPThe stripped coupons are known as C-STRIPSThe stripped principal is known as P-STRIPSSupply of a C-STRIP increases over time
because a C-STRIP maturing on a day like 15 FEB
2020 will have the same CUSIP irrespective ofwhich mother bond it has come fromThe original coupon rate is irrelevant
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P-STRIPS always correspond to the originalsecurityThey have a unique CUSIPTheir supply is fixed at the time of issuanceIn practice the prices of long-dated P-STRIPSare a bit higher than those of C-STRIPS withthe same maturity date
One reason is that P-STRIPS are more liquid due
to greater availabilityA $100 face value bond with a coupon of 8 willgenerate C-STRIPS with a face value of $4 but P-STRIPS with a face value of $100
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Another reason why P-STRIPS are in higherdemand is that they allow reconstitutionactivities more easily
Assume that the sum of the STRIPS is cheaper than
the mother bondIf a dealer already has the P-STRIPS only the C-STRIPSneed to be acquiredHowever if he owns some of the C-STRIPS he needs toacquire the P-STRIPS and the remaining C-STRIPSThe facility to reconstitute when profitable is pricedinto the P-STRIPSNote Buy and hold investors will prefer C-STRIPSsince they are priced lower and give a higher yield
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For Plain Vanilla bonds the specifiedcoupon rate is valid for the life of thebond
In the case of Floaters the rate is reset atthe beginning of every periodThe rate will vary directly with thebenchmark
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The rate on a Floater is specified as LIBOR+ 50 bp
The spread is positiveIf it were specified as LIBOR ndash 30bp
The spread will be negativeIf LIBOR rises the rate will increasewhereas if LIBOR falls it will decrease
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In the case of a default risk-free floater theprice will reset to par on a coupon date
It may sell at a premium or discount betweencoupon dates
Consider a floater with a coupon = 5-year T-Bond rate
Assume there are two periods left to maturity
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The price at the end of the first coupon period willbe given by
cT-1 is the coupon one period before maturityyT-1 is the YTM one period before maturity
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On a coupon reset date the YTM = couponBecause we have assumed there is no default riskAny change in the required yield as reflected inthe prevailing YTM
Will also be reflected in the coupon being setIf coupon = yield the bond should sell at par
Thus P T-1 = M
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Once again at T-2 c T-2 = yT-2 and P T-2 = MThis logic can be applied to a bond with anytime remaining till maturityHowever between two coupon dates theprice may not be equal to par
Consider the valuation at T-2+k
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Although c T-2 was set at T-2 and is equal toyT-2
yT-2+k is determined at T-2+k and will reflect theyield prevailing at that time
Thus yT-2+k need not equal c T-2 and may behigher or lower
Hence between two coupon dates a floater maysell at a premium or discount
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Now consider a floater characterized bydefault risk
The risk premium required by the market neednot be constant over time
Assume that at the time of issue YTM = 5-year T-note rate + 75bp
The coupon would have been set equal to thisrate and the bond would have been issued at par
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Six months hence the issue may be perceivedas more risky
YTM = 5-year T-note rate + 95 bpThe coupon will however be set equal to theprevailing 5-year rate + 75 bpIf so the issue will not reset to par at the nextcoupon date
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Floaters may come with a CAP or a FLOOR orBOTH
The CAP is a maximum coupon rateProtects issuers against rising rates
The FLOOR is a minimum coupon rateProtects investors against falling rates
When there is a spread over LIBORThere is a natural floorLIBOR cannot be less than zero
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Fully backed by the federal government ofthe issuing nationConsequently they are virtually devoid ofcredit risk or the risk of defaultThe yield on such securities is a benchmarkfor setting rates on other kinds of debt
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Treasury securities are issuedTo finance expenses in excess of currentrevenuesTo pay interest on debt accumulated in earlieryears due to deficits in those yearsTo repay past debt issues that are currentlymaturing
The US Treasuries marketIs the largest bond market in the worldIs the most liquid bond market in the world
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The Treasury issues three categories ofmarketable securities
T-bills are discount securitiesThey are zero coupon securitiesT-notes and T-bonds are sold at face value andpay interest periodically
8282014 56
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T-bills are issued with a original time tomaturity of one year or less
They are Money market instrumentsThey have maturities of either 1 3 6 or 12months at the time of issue
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T-notes and T-bonds have a time to maturityexceeding one year at the time of issue
They are capital market instrumentsT-notes have maturities ranging from 1-10 yearsT-bonds have an original maturity in excess of 10years extending up to 30 years
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An issue may be followed later by a furtherissue
With the same remaining time to maturity andthe same couponThe issuance of further tranches is termed as aRe-opening
8282014 59
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httpslidepdfcomreaderfullfisd-02-a 60115
Six months ago a 10-year note was issuedwith a coupon of 8 per annumToday if a note with 9 frac12 years to maturityand a coupon of 8 issued it will add to thepool that is already trading in the marketThus it is a re-opening of an existing issue
8282014 60
8112019 FISD-02-A
httpslidepdfcomreaderfullfisd-02-a 61115
Who is a primary dealerA PD is a dealer who is authorized to dealdirectly with the Central Bank of the countryIn the US a PD is a bank or securities broker-dealer that directly deals with the FRBNY
Importance of FRBNYIn India a PD deals directly with the RBI
8282014 61
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8282014 62
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The Treasury sells bills notes and bonds byway of a competitive auction process
Most of the treasury securities are bought byprimary dealers
Individual investors submit non-competitive bidsand participate on a much smaller scale
8282014 63
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Bids may beCompetitive
Indicate price amp quantity or yield amp quantityNon-competitive
Indicate only quantity
Small investors and individualsgenerally submit non-competitive bids
A non-competitive bidder may not bid for more than$5MM worth of securities in a bill or bond auction
8282014 64
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Primary dealers bid for their accounts andon behalf of their clientsThey usually submit large competitive
bidsBids indicate the maximum price that the bidderis prepared to pay if it is a price based auctionOr the minimum yield that the bidder is
prepared to accept if it is a yield based auction
8282014 65
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The Treasury will net out the totalamount of non-competitive bids
The balance will be allocated to competitivebidders
There are two ways in which securitiescan be allotted
The multiple priceyield auction mechanism
French AuctionsThe uniform priceyield auction mechanism
Dutch Auctions
8282014 66
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Assume that the Treasury is offering 25billion dollars worth of T-bonds
2 billion dollars worth of non-competitive bidshave been receivedSo 23 billion dollars worth of bonds are availableto be offered to the competitive bidders
8282014 67
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There are six competitive bidders who havesubmitted the following yields
The bids have been arranged in ascending orderof yieldIn a price based auction the bids would havebeen arranged in descending order of price
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Bidder Bid Yield Bid Amount
Aggregate Amount
Alpha 5370 30 bn 30 bnBeta 5372 50 bn 80 bn
Gamma 5373 40 bn 12 bn
Delta 5375 80 bn 20 bnCharlie 5375 120 bn 32 bn
Tango 5380 30 bn 35 bn8282014 69
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The aggregate demand equals the amount onoffer at a yield of 5375A multiple yield auction will lead to thefollowing allocation
Alpha will get 3 bn at a yield of 5370Beta will get 5 bn at 5372Gamma will get 4 bn at 5373
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At a yield of 5375 we have only 11 bn left toallocateThere is a demand of 20 bn at this yield
8 bn from Delta and 12 bn from CharlieThus we will allocate 1120 = 55 to eachbidder at this yield
There will be pro-rata allocation
055 of 8 bn or 440 bn will go to Delta055 of 12 bn or 66 bn will go to Charlie
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The highest accepted yield is called the StopYield or High Yield
In this case it is 5375The ratio of bids received to the amountawarded is known as the bid to cover ratio
The higher the ratio the stronger is the auction
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Those who bid more than 5375 will getnothing and are said to be shutout of theauctionSince 1999 the US Treasury has beenconducting only uniform yield auctions
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WI stands for ndash When As and If IssuedThe when issued market is a market forforward trading of a bond
Which has been announced but not yet issuedTrades take place from the date ofannouncement until the actual issue date
Helps bidders to gauge the marketrsquos interestbefore the actual auction
8282014 75
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WI trading has ramifications for the biddingstrategies of market participantsTraders can take both long and shortpositions
Settlement is scheduled for the issue date
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It has a bearing on the outcome of theauction
It affects the strategy used by a bidder becauseit has an impact on his prior positionBidders who are long in the WI market enter theauction with a Long PositionThose who are short in the WI market enter theauction with a short position
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The WI market helps in price discoveryIt provides important information on
The strength of demand for the securityAnd on the disparity of biddersrsquo views
This help potential bidders to formulate theirstrategiesAt times a dealer may believe that he hasvery important private information
If so he may not participate in the WI market andwill directly enter the auction with bids based onhis knowledge
8282014 78
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On or before the date of the auction theissues trade on a yield basis
The actual price can be established only afterthe coupon is set
Starting with the day after the auctionSecurities are quoted on a price basis becausethe coupon is known
8282014 79
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httpslidepdfcomreaderfullfisd-02-a 80115
In a coupon roll a dealer will purchase themost recently issued security from a clientAnd simultaneously sell the same amount ofthe recently announced new security
The first leg with settle on the following dayThe second leg is a forward contract
8282014 80
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httpslidepdfcomreaderfullfisd-02-a 81115
There can be a Reverse RollThe dealer will sell the most recent issue fornext day settlementAnd buy the newly announced security forforward settlement
The forward leg in a RollReverse Roll is a WItrade
It will settle on the new issue settlement date
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The roll is the spread between the yield onthe new security and that on the outstandingissue in the same maturity segmentA GIVE in the Roll means that
The WI security provides a higher yield than theoutstanding issue
A Take in the Roll means thatThe WI security provides a lower yield
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On March 17 20XX the Treasury announcedthe auction of a 2-year note
The auction was scheduled for March 24The settlement date was March 31
Trading of the roll began as soon as the issuewas announcedA Give of 5 bp means that the dealer proposes tobuy the current issue at the prevailing yieldAnd sell the new issue at a yield that is 5 bpmoreA Take of 5 bp means that the dealer proposes tosell the new issue at a yield that is 5bp lower
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The roll achieves the followingHe acquires the outstanding issue for next daysettlementHe sells the to be issued security with the samepar value for forward delivery on 31 March
The customer is rolling over the investmentfrom the current issue to the new issue
This extends the maturity of the investment byone month
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The client can invest the funds received tillthe new issue settlesHowever he loses the accrued interest thathe would have earned had he held on to theissue
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The Treasury per se does not issue zerocoupon securitiesBut zero coupon securities can be created
which are backed by conventional bondsTake a large quantity of a T-note or bond andseparate all the cash flows from each otherSell the entitlement to each cash flowseparately
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Take the case of a two-year T-noteIt can be separated into five zero couponsecurities maturing after
6 months12 months18 months24 months
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Earlier investment banks used to buy bondsfrom the Treasury and separate the cashflows
Each cash flow was then sold separately as a zerocoupon bondSuch issues are called trademarks
8282014 89
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The issue of trademarks has now ceasedBecause investment banks can now createsuch instruments
In concert with the Treasury itselfThese ZCBs are known as STRIPS ndash
Separate Trading of Registered Interest andPrincipal of Securities
These are not issued or sold by the Treasury
The market is made by investment banks
8282014 90
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What is the motivation to create suchproductsIn practice arbitrage is possible when a
coupon security is purchased at a priceThat is lower than what could be obtained byselling each cash flow separately
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Coupon stripping reflects a case of financialengineering
Creating a risk-return profile that is nototherwise available
An investment bank would buy a largequantity of a Treasury security
The securities would be placed with an SPV
8282014 92
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The SPV is a single-purpose dedicated trustIt has the powers to own the bonds andcollect payments
It cannot sell or lend the bondsIt cannot write options on the bondsOr use them as collateral for borrowing
The SPV is empowered to issue zero coupon
bondsWhere each security represents the ownership ofa single cash flow from the mother bond
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Assume that 100MM USD of 15 year bondswith a coupon of 8 are placed with the SPV
The SPV can issue 6M 12M 18M extending up to14 frac12 year zeroes with a total face value of 4MM
USD eachAnd 15 year zeroes with a total face value of104MM
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8112019 FISD-02-A
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The Treasury launched this program in 1985to facilitate the stripping of designatedsecurities
All new T-bonds and notes with a maturity of 10years or more are eligibleThe zeroes created in the process are directobligations of the US government
8282014 97
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The mechanism is as followsA dealer who owns a bond or note can ask theFRB where it is held
To replace it with an equivalent set of STRIPS
representing each payment as a separate securityEach of these securities can be traded independentlyof others
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In 1987 the Treasury started to allow dealersto reverse the process
This is called STRIPS RECONSTUTUTION If a dealer owns STRIPS representing all thecoupon and principal payments of a bond
The FED can on request convert these holdings into asingle position in the corresponding bond
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Each coupon and principal cash flow from aTreasury security is assigned a CUSIP
The mother bond is also assigned a CUSIPThe stripped coupons are known as C-STRIPSThe stripped principal is known as P-STRIPSSupply of a C-STRIP increases over time
because a C-STRIP maturing on a day like 15 FEB
2020 will have the same CUSIP irrespective ofwhich mother bond it has come fromThe original coupon rate is irrelevant
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P-STRIPS always correspond to the originalsecurityThey have a unique CUSIPTheir supply is fixed at the time of issuanceIn practice the prices of long-dated P-STRIPSare a bit higher than those of C-STRIPS withthe same maturity date
One reason is that P-STRIPS are more liquid due
to greater availabilityA $100 face value bond with a coupon of 8 willgenerate C-STRIPS with a face value of $4 but P-STRIPS with a face value of $100
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Another reason why P-STRIPS are in higherdemand is that they allow reconstitutionactivities more easily
Assume that the sum of the STRIPS is cheaper than
the mother bondIf a dealer already has the P-STRIPS only the C-STRIPSneed to be acquiredHowever if he owns some of the C-STRIPS he needs toacquire the P-STRIPS and the remaining C-STRIPSThe facility to reconstitute when profitable is pricedinto the P-STRIPSNote Buy and hold investors will prefer C-STRIPSsince they are priced lower and give a higher yield
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For Plain Vanilla bonds the specifiedcoupon rate is valid for the life of thebond
In the case of Floaters the rate is reset atthe beginning of every periodThe rate will vary directly with thebenchmark
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The rate on a Floater is specified as LIBOR+ 50 bp
The spread is positiveIf it were specified as LIBOR ndash 30bp
The spread will be negativeIf LIBOR rises the rate will increasewhereas if LIBOR falls it will decrease
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In the case of a default risk-free floater theprice will reset to par on a coupon date
It may sell at a premium or discount betweencoupon dates
Consider a floater with a coupon = 5-year T-Bond rate
Assume there are two periods left to maturity
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The price at the end of the first coupon period willbe given by
cT-1 is the coupon one period before maturityyT-1 is the YTM one period before maturity
8112019 FISD-02-A
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On a coupon reset date the YTM = couponBecause we have assumed there is no default riskAny change in the required yield as reflected inthe prevailing YTM
Will also be reflected in the coupon being setIf coupon = yield the bond should sell at par
Thus P T-1 = M
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Once again at T-2 c T-2 = yT-2 and P T-2 = MThis logic can be applied to a bond with anytime remaining till maturityHowever between two coupon dates theprice may not be equal to par
Consider the valuation at T-2+k
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Although c T-2 was set at T-2 and is equal toyT-2
yT-2+k is determined at T-2+k and will reflect theyield prevailing at that time
Thus yT-2+k need not equal c T-2 and may behigher or lower
Hence between two coupon dates a floater maysell at a premium or discount
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Now consider a floater characterized bydefault risk
The risk premium required by the market neednot be constant over time
Assume that at the time of issue YTM = 5-year T-note rate + 75bp
The coupon would have been set equal to thisrate and the bond would have been issued at par
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Six months hence the issue may be perceivedas more risky
YTM = 5-year T-note rate + 95 bpThe coupon will however be set equal to theprevailing 5-year rate + 75 bpIf so the issue will not reset to par at the nextcoupon date
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Floaters may come with a CAP or a FLOOR orBOTH
The CAP is a maximum coupon rateProtects issuers against rising rates
The FLOOR is a minimum coupon rateProtects investors against falling rates
When there is a spread over LIBORThere is a natural floorLIBOR cannot be less than zero
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Fully backed by the federal government ofthe issuing nationConsequently they are virtually devoid ofcredit risk or the risk of defaultThe yield on such securities is a benchmarkfor setting rates on other kinds of debt
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Treasury securities are issuedTo finance expenses in excess of currentrevenuesTo pay interest on debt accumulated in earlieryears due to deficits in those yearsTo repay past debt issues that are currentlymaturing
The US Treasuries marketIs the largest bond market in the worldIs the most liquid bond market in the world
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The Treasury issues three categories ofmarketable securities
T-bills are discount securitiesThey are zero coupon securitiesT-notes and T-bonds are sold at face value andpay interest periodically
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T-bills are issued with a original time tomaturity of one year or less
They are Money market instrumentsThey have maturities of either 1 3 6 or 12months at the time of issue
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T-notes and T-bonds have a time to maturityexceeding one year at the time of issue
They are capital market instrumentsT-notes have maturities ranging from 1-10 yearsT-bonds have an original maturity in excess of 10years extending up to 30 years
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An issue may be followed later by a furtherissue
With the same remaining time to maturity andthe same couponThe issuance of further tranches is termed as aRe-opening
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Six months ago a 10-year note was issuedwith a coupon of 8 per annumToday if a note with 9 frac12 years to maturityand a coupon of 8 issued it will add to thepool that is already trading in the marketThus it is a re-opening of an existing issue
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Who is a primary dealerA PD is a dealer who is authorized to dealdirectly with the Central Bank of the countryIn the US a PD is a bank or securities broker-dealer that directly deals with the FRBNY
Importance of FRBNYIn India a PD deals directly with the RBI
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The Treasury sells bills notes and bonds byway of a competitive auction process
Most of the treasury securities are bought byprimary dealers
Individual investors submit non-competitive bidsand participate on a much smaller scale
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Bids may beCompetitive
Indicate price amp quantity or yield amp quantityNon-competitive
Indicate only quantity
Small investors and individualsgenerally submit non-competitive bids
A non-competitive bidder may not bid for more than$5MM worth of securities in a bill or bond auction
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Primary dealers bid for their accounts andon behalf of their clientsThey usually submit large competitive
bidsBids indicate the maximum price that the bidderis prepared to pay if it is a price based auctionOr the minimum yield that the bidder is
prepared to accept if it is a yield based auction
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The Treasury will net out the totalamount of non-competitive bids
The balance will be allocated to competitivebidders
There are two ways in which securitiescan be allotted
The multiple priceyield auction mechanism
French AuctionsThe uniform priceyield auction mechanism
Dutch Auctions
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Assume that the Treasury is offering 25billion dollars worth of T-bonds
2 billion dollars worth of non-competitive bidshave been receivedSo 23 billion dollars worth of bonds are availableto be offered to the competitive bidders
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There are six competitive bidders who havesubmitted the following yields
The bids have been arranged in ascending orderof yieldIn a price based auction the bids would havebeen arranged in descending order of price
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Bidder Bid Yield Bid Amount
Aggregate Amount
Alpha 5370 30 bn 30 bnBeta 5372 50 bn 80 bn
Gamma 5373 40 bn 12 bn
Delta 5375 80 bn 20 bnCharlie 5375 120 bn 32 bn
Tango 5380 30 bn 35 bn8282014 69
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The aggregate demand equals the amount onoffer at a yield of 5375A multiple yield auction will lead to thefollowing allocation
Alpha will get 3 bn at a yield of 5370Beta will get 5 bn at 5372Gamma will get 4 bn at 5373
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At a yield of 5375 we have only 11 bn left toallocateThere is a demand of 20 bn at this yield
8 bn from Delta and 12 bn from CharlieThus we will allocate 1120 = 55 to eachbidder at this yield
There will be pro-rata allocation
055 of 8 bn or 440 bn will go to Delta055 of 12 bn or 66 bn will go to Charlie
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The highest accepted yield is called the StopYield or High Yield
In this case it is 5375The ratio of bids received to the amountawarded is known as the bid to cover ratio
The higher the ratio the stronger is the auction
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Those who bid more than 5375 will getnothing and are said to be shutout of theauctionSince 1999 the US Treasury has beenconducting only uniform yield auctions
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WI stands for ndash When As and If IssuedThe when issued market is a market forforward trading of a bond
Which has been announced but not yet issuedTrades take place from the date ofannouncement until the actual issue date
Helps bidders to gauge the marketrsquos interestbefore the actual auction
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WI trading has ramifications for the biddingstrategies of market participantsTraders can take both long and shortpositions
Settlement is scheduled for the issue date
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It has a bearing on the outcome of theauction
It affects the strategy used by a bidder becauseit has an impact on his prior positionBidders who are long in the WI market enter theauction with a Long PositionThose who are short in the WI market enter theauction with a short position
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The WI market helps in price discoveryIt provides important information on
The strength of demand for the securityAnd on the disparity of biddersrsquo views
This help potential bidders to formulate theirstrategiesAt times a dealer may believe that he hasvery important private information
If so he may not participate in the WI market andwill directly enter the auction with bids based onhis knowledge
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On or before the date of the auction theissues trade on a yield basis
The actual price can be established only afterthe coupon is set
Starting with the day after the auctionSecurities are quoted on a price basis becausethe coupon is known
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In a coupon roll a dealer will purchase themost recently issued security from a clientAnd simultaneously sell the same amount ofthe recently announced new security
The first leg with settle on the following dayThe second leg is a forward contract
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There can be a Reverse RollThe dealer will sell the most recent issue fornext day settlementAnd buy the newly announced security forforward settlement
The forward leg in a RollReverse Roll is a WItrade
It will settle on the new issue settlement date
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The roll is the spread between the yield onthe new security and that on the outstandingissue in the same maturity segmentA GIVE in the Roll means that
The WI security provides a higher yield than theoutstanding issue
A Take in the Roll means thatThe WI security provides a lower yield
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On March 17 20XX the Treasury announcedthe auction of a 2-year note
The auction was scheduled for March 24The settlement date was March 31
Trading of the roll began as soon as the issuewas announcedA Give of 5 bp means that the dealer proposes tobuy the current issue at the prevailing yieldAnd sell the new issue at a yield that is 5 bpmoreA Take of 5 bp means that the dealer proposes tosell the new issue at a yield that is 5bp lower
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The roll achieves the followingHe acquires the outstanding issue for next daysettlementHe sells the to be issued security with the samepar value for forward delivery on 31 March
The customer is rolling over the investmentfrom the current issue to the new issue
This extends the maturity of the investment byone month
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The client can invest the funds received tillthe new issue settlesHowever he loses the accrued interest thathe would have earned had he held on to theissue
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The Treasury per se does not issue zerocoupon securitiesBut zero coupon securities can be created
which are backed by conventional bondsTake a large quantity of a T-note or bond andseparate all the cash flows from each otherSell the entitlement to each cash flowseparately
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Take the case of a two-year T-noteIt can be separated into five zero couponsecurities maturing after
6 months12 months18 months24 months
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Earlier investment banks used to buy bondsfrom the Treasury and separate the cashflows
Each cash flow was then sold separately as a zerocoupon bondSuch issues are called trademarks
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The issue of trademarks has now ceasedBecause investment banks can now createsuch instruments
In concert with the Treasury itselfThese ZCBs are known as STRIPS ndash
Separate Trading of Registered Interest andPrincipal of Securities
These are not issued or sold by the Treasury
The market is made by investment banks
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What is the motivation to create suchproductsIn practice arbitrage is possible when a
coupon security is purchased at a priceThat is lower than what could be obtained byselling each cash flow separately
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Coupon stripping reflects a case of financialengineering
Creating a risk-return profile that is nototherwise available
An investment bank would buy a largequantity of a Treasury security
The securities would be placed with an SPV
8282014 92
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The SPV is a single-purpose dedicated trustIt has the powers to own the bonds andcollect payments
It cannot sell or lend the bondsIt cannot write options on the bondsOr use them as collateral for borrowing
The SPV is empowered to issue zero coupon
bondsWhere each security represents the ownership ofa single cash flow from the mother bond
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Assume that 100MM USD of 15 year bondswith a coupon of 8 are placed with the SPV
The SPV can issue 6M 12M 18M extending up to14 frac12 year zeroes with a total face value of 4MM
USD eachAnd 15 year zeroes with a total face value of104MM
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The Treasury launched this program in 1985to facilitate the stripping of designatedsecurities
All new T-bonds and notes with a maturity of 10years or more are eligibleThe zeroes created in the process are directobligations of the US government
8282014 97
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The mechanism is as followsA dealer who owns a bond or note can ask theFRB where it is held
To replace it with an equivalent set of STRIPS
representing each payment as a separate securityEach of these securities can be traded independentlyof others
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In 1987 the Treasury started to allow dealersto reverse the process
This is called STRIPS RECONSTUTUTION If a dealer owns STRIPS representing all thecoupon and principal payments of a bond
The FED can on request convert these holdings into asingle position in the corresponding bond
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Each coupon and principal cash flow from aTreasury security is assigned a CUSIP
The mother bond is also assigned a CUSIPThe stripped coupons are known as C-STRIPSThe stripped principal is known as P-STRIPSSupply of a C-STRIP increases over time
because a C-STRIP maturing on a day like 15 FEB
2020 will have the same CUSIP irrespective ofwhich mother bond it has come fromThe original coupon rate is irrelevant
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P-STRIPS always correspond to the originalsecurityThey have a unique CUSIPTheir supply is fixed at the time of issuanceIn practice the prices of long-dated P-STRIPSare a bit higher than those of C-STRIPS withthe same maturity date
One reason is that P-STRIPS are more liquid due
to greater availabilityA $100 face value bond with a coupon of 8 willgenerate C-STRIPS with a face value of $4 but P-STRIPS with a face value of $100
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Another reason why P-STRIPS are in higherdemand is that they allow reconstitutionactivities more easily
Assume that the sum of the STRIPS is cheaper than
the mother bondIf a dealer already has the P-STRIPS only the C-STRIPSneed to be acquiredHowever if he owns some of the C-STRIPS he needs toacquire the P-STRIPS and the remaining C-STRIPSThe facility to reconstitute when profitable is pricedinto the P-STRIPSNote Buy and hold investors will prefer C-STRIPSsince they are priced lower and give a higher yield
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For Plain Vanilla bonds the specifiedcoupon rate is valid for the life of thebond
In the case of Floaters the rate is reset atthe beginning of every periodThe rate will vary directly with thebenchmark
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The rate on a Floater is specified as LIBOR+ 50 bp
The spread is positiveIf it were specified as LIBOR ndash 30bp
The spread will be negativeIf LIBOR rises the rate will increasewhereas if LIBOR falls it will decrease
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In the case of a default risk-free floater theprice will reset to par on a coupon date
It may sell at a premium or discount betweencoupon dates
Consider a floater with a coupon = 5-year T-Bond rate
Assume there are two periods left to maturity
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The price at the end of the first coupon period willbe given by
cT-1 is the coupon one period before maturityyT-1 is the YTM one period before maturity
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On a coupon reset date the YTM = couponBecause we have assumed there is no default riskAny change in the required yield as reflected inthe prevailing YTM
Will also be reflected in the coupon being setIf coupon = yield the bond should sell at par
Thus P T-1 = M
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Once again at T-2 c T-2 = yT-2 and P T-2 = MThis logic can be applied to a bond with anytime remaining till maturityHowever between two coupon dates theprice may not be equal to par
Consider the valuation at T-2+k
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Although c T-2 was set at T-2 and is equal toyT-2
yT-2+k is determined at T-2+k and will reflect theyield prevailing at that time
Thus yT-2+k need not equal c T-2 and may behigher or lower
Hence between two coupon dates a floater maysell at a premium or discount
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Now consider a floater characterized bydefault risk
The risk premium required by the market neednot be constant over time
Assume that at the time of issue YTM = 5-year T-note rate + 75bp
The coupon would have been set equal to thisrate and the bond would have been issued at par
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Six months hence the issue may be perceivedas more risky
YTM = 5-year T-note rate + 95 bpThe coupon will however be set equal to theprevailing 5-year rate + 75 bpIf so the issue will not reset to par at the nextcoupon date
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Floaters may come with a CAP or a FLOOR orBOTH
The CAP is a maximum coupon rateProtects issuers against rising rates
The FLOOR is a minimum coupon rateProtects investors against falling rates
When there is a spread over LIBORThere is a natural floorLIBOR cannot be less than zero
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Treasury securities are issuedTo finance expenses in excess of currentrevenuesTo pay interest on debt accumulated in earlieryears due to deficits in those yearsTo repay past debt issues that are currentlymaturing
The US Treasuries marketIs the largest bond market in the worldIs the most liquid bond market in the world
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The Treasury issues three categories ofmarketable securities
T-bills are discount securitiesThey are zero coupon securitiesT-notes and T-bonds are sold at face value andpay interest periodically
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T-bills are issued with a original time tomaturity of one year or less
They are Money market instrumentsThey have maturities of either 1 3 6 or 12months at the time of issue
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T-notes and T-bonds have a time to maturityexceeding one year at the time of issue
They are capital market instrumentsT-notes have maturities ranging from 1-10 yearsT-bonds have an original maturity in excess of 10years extending up to 30 years
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An issue may be followed later by a furtherissue
With the same remaining time to maturity andthe same couponThe issuance of further tranches is termed as aRe-opening
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Six months ago a 10-year note was issuedwith a coupon of 8 per annumToday if a note with 9 frac12 years to maturityand a coupon of 8 issued it will add to thepool that is already trading in the marketThus it is a re-opening of an existing issue
8282014 60
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Who is a primary dealerA PD is a dealer who is authorized to dealdirectly with the Central Bank of the countryIn the US a PD is a bank or securities broker-dealer that directly deals with the FRBNY
Importance of FRBNYIn India a PD deals directly with the RBI
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The Treasury sells bills notes and bonds byway of a competitive auction process
Most of the treasury securities are bought byprimary dealers
Individual investors submit non-competitive bidsand participate on a much smaller scale
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Bids may beCompetitive
Indicate price amp quantity or yield amp quantityNon-competitive
Indicate only quantity
Small investors and individualsgenerally submit non-competitive bids
A non-competitive bidder may not bid for more than$5MM worth of securities in a bill or bond auction
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Primary dealers bid for their accounts andon behalf of their clientsThey usually submit large competitive
bidsBids indicate the maximum price that the bidderis prepared to pay if it is a price based auctionOr the minimum yield that the bidder is
prepared to accept if it is a yield based auction
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The Treasury will net out the totalamount of non-competitive bids
The balance will be allocated to competitivebidders
There are two ways in which securitiescan be allotted
The multiple priceyield auction mechanism
French AuctionsThe uniform priceyield auction mechanism
Dutch Auctions
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Assume that the Treasury is offering 25billion dollars worth of T-bonds
2 billion dollars worth of non-competitive bidshave been receivedSo 23 billion dollars worth of bonds are availableto be offered to the competitive bidders
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There are six competitive bidders who havesubmitted the following yields
The bids have been arranged in ascending orderof yieldIn a price based auction the bids would havebeen arranged in descending order of price
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Bidder Bid Yield Bid Amount
Aggregate Amount
Alpha 5370 30 bn 30 bnBeta 5372 50 bn 80 bn
Gamma 5373 40 bn 12 bn
Delta 5375 80 bn 20 bnCharlie 5375 120 bn 32 bn
Tango 5380 30 bn 35 bn8282014 69
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The aggregate demand equals the amount onoffer at a yield of 5375A multiple yield auction will lead to thefollowing allocation
Alpha will get 3 bn at a yield of 5370Beta will get 5 bn at 5372Gamma will get 4 bn at 5373
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At a yield of 5375 we have only 11 bn left toallocateThere is a demand of 20 bn at this yield
8 bn from Delta and 12 bn from CharlieThus we will allocate 1120 = 55 to eachbidder at this yield
There will be pro-rata allocation
055 of 8 bn or 440 bn will go to Delta055 of 12 bn or 66 bn will go to Charlie
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The highest accepted yield is called the StopYield or High Yield
In this case it is 5375The ratio of bids received to the amountawarded is known as the bid to cover ratio
The higher the ratio the stronger is the auction
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Those who bid more than 5375 will getnothing and are said to be shutout of theauctionSince 1999 the US Treasury has beenconducting only uniform yield auctions
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WI stands for ndash When As and If IssuedThe when issued market is a market forforward trading of a bond
Which has been announced but not yet issuedTrades take place from the date ofannouncement until the actual issue date
Helps bidders to gauge the marketrsquos interestbefore the actual auction
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WI trading has ramifications for the biddingstrategies of market participantsTraders can take both long and shortpositions
Settlement is scheduled for the issue date
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It has a bearing on the outcome of theauction
It affects the strategy used by a bidder becauseit has an impact on his prior positionBidders who are long in the WI market enter theauction with a Long PositionThose who are short in the WI market enter theauction with a short position
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The WI market helps in price discoveryIt provides important information on
The strength of demand for the securityAnd on the disparity of biddersrsquo views
This help potential bidders to formulate theirstrategiesAt times a dealer may believe that he hasvery important private information
If so he may not participate in the WI market andwill directly enter the auction with bids based onhis knowledge
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On or before the date of the auction theissues trade on a yield basis
The actual price can be established only afterthe coupon is set
Starting with the day after the auctionSecurities are quoted on a price basis becausethe coupon is known
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In a coupon roll a dealer will purchase themost recently issued security from a clientAnd simultaneously sell the same amount ofthe recently announced new security
The first leg with settle on the following dayThe second leg is a forward contract
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There can be a Reverse RollThe dealer will sell the most recent issue fornext day settlementAnd buy the newly announced security forforward settlement
The forward leg in a RollReverse Roll is a WItrade
It will settle on the new issue settlement date
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The roll is the spread between the yield onthe new security and that on the outstandingissue in the same maturity segmentA GIVE in the Roll means that
The WI security provides a higher yield than theoutstanding issue
A Take in the Roll means thatThe WI security provides a lower yield
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8112019 FISD-02-A
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On March 17 20XX the Treasury announcedthe auction of a 2-year note
The auction was scheduled for March 24The settlement date was March 31
Trading of the roll began as soon as the issuewas announcedA Give of 5 bp means that the dealer proposes tobuy the current issue at the prevailing yieldAnd sell the new issue at a yield that is 5 bpmoreA Take of 5 bp means that the dealer proposes tosell the new issue at a yield that is 5bp lower
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The roll achieves the followingHe acquires the outstanding issue for next daysettlementHe sells the to be issued security with the samepar value for forward delivery on 31 March
The customer is rolling over the investmentfrom the current issue to the new issue
This extends the maturity of the investment byone month
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The client can invest the funds received tillthe new issue settlesHowever he loses the accrued interest thathe would have earned had he held on to theissue
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The Treasury per se does not issue zerocoupon securitiesBut zero coupon securities can be created
which are backed by conventional bondsTake a large quantity of a T-note or bond andseparate all the cash flows from each otherSell the entitlement to each cash flowseparately
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Take the case of a two-year T-noteIt can be separated into five zero couponsecurities maturing after
6 months12 months18 months24 months
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Earlier investment banks used to buy bondsfrom the Treasury and separate the cashflows
Each cash flow was then sold separately as a zerocoupon bondSuch issues are called trademarks
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The issue of trademarks has now ceasedBecause investment banks can now createsuch instruments
In concert with the Treasury itselfThese ZCBs are known as STRIPS ndash
Separate Trading of Registered Interest andPrincipal of Securities
These are not issued or sold by the Treasury
The market is made by investment banks
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What is the motivation to create suchproductsIn practice arbitrage is possible when a
coupon security is purchased at a priceThat is lower than what could be obtained byselling each cash flow separately
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Coupon stripping reflects a case of financialengineering
Creating a risk-return profile that is nototherwise available
An investment bank would buy a largequantity of a Treasury security
The securities would be placed with an SPV
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The SPV is a single-purpose dedicated trustIt has the powers to own the bonds andcollect payments
It cannot sell or lend the bondsIt cannot write options on the bondsOr use them as collateral for borrowing
The SPV is empowered to issue zero coupon
bondsWhere each security represents the ownership ofa single cash flow from the mother bond
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Assume that 100MM USD of 15 year bondswith a coupon of 8 are placed with the SPV
The SPV can issue 6M 12M 18M extending up to14 frac12 year zeroes with a total face value of 4MM
USD eachAnd 15 year zeroes with a total face value of104MM
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The Treasury launched this program in 1985to facilitate the stripping of designatedsecurities
All new T-bonds and notes with a maturity of 10years or more are eligibleThe zeroes created in the process are directobligations of the US government
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The mechanism is as followsA dealer who owns a bond or note can ask theFRB where it is held
To replace it with an equivalent set of STRIPS
representing each payment as a separate securityEach of these securities can be traded independentlyof others
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In 1987 the Treasury started to allow dealersto reverse the process
This is called STRIPS RECONSTUTUTION If a dealer owns STRIPS representing all thecoupon and principal payments of a bond
The FED can on request convert these holdings into asingle position in the corresponding bond
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Each coupon and principal cash flow from aTreasury security is assigned a CUSIP
The mother bond is also assigned a CUSIPThe stripped coupons are known as C-STRIPSThe stripped principal is known as P-STRIPSSupply of a C-STRIP increases over time
because a C-STRIP maturing on a day like 15 FEB
2020 will have the same CUSIP irrespective ofwhich mother bond it has come fromThe original coupon rate is irrelevant
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P-STRIPS always correspond to the originalsecurityThey have a unique CUSIPTheir supply is fixed at the time of issuanceIn practice the prices of long-dated P-STRIPSare a bit higher than those of C-STRIPS withthe same maturity date
One reason is that P-STRIPS are more liquid due
to greater availabilityA $100 face value bond with a coupon of 8 willgenerate C-STRIPS with a face value of $4 but P-STRIPS with a face value of $100
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Another reason why P-STRIPS are in higherdemand is that they allow reconstitutionactivities more easily
Assume that the sum of the STRIPS is cheaper than
the mother bondIf a dealer already has the P-STRIPS only the C-STRIPSneed to be acquiredHowever if he owns some of the C-STRIPS he needs toacquire the P-STRIPS and the remaining C-STRIPSThe facility to reconstitute when profitable is pricedinto the P-STRIPSNote Buy and hold investors will prefer C-STRIPSsince they are priced lower and give a higher yield
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For Plain Vanilla bonds the specifiedcoupon rate is valid for the life of thebond
In the case of Floaters the rate is reset atthe beginning of every periodThe rate will vary directly with thebenchmark
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The rate on a Floater is specified as LIBOR+ 50 bp
The spread is positiveIf it were specified as LIBOR ndash 30bp
The spread will be negativeIf LIBOR rises the rate will increasewhereas if LIBOR falls it will decrease
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In the case of a default risk-free floater theprice will reset to par on a coupon date
It may sell at a premium or discount betweencoupon dates
Consider a floater with a coupon = 5-year T-Bond rate
Assume there are two periods left to maturity
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The price at the end of the first coupon period willbe given by
cT-1 is the coupon one period before maturityyT-1 is the YTM one period before maturity
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On a coupon reset date the YTM = couponBecause we have assumed there is no default riskAny change in the required yield as reflected inthe prevailing YTM
Will also be reflected in the coupon being setIf coupon = yield the bond should sell at par
Thus P T-1 = M
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Once again at T-2 c T-2 = yT-2 and P T-2 = MThis logic can be applied to a bond with anytime remaining till maturityHowever between two coupon dates theprice may not be equal to par
Consider the valuation at T-2+k
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Although c T-2 was set at T-2 and is equal toyT-2
yT-2+k is determined at T-2+k and will reflect theyield prevailing at that time
Thus yT-2+k need not equal c T-2 and may behigher or lower
Hence between two coupon dates a floater maysell at a premium or discount
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Now consider a floater characterized bydefault risk
The risk premium required by the market neednot be constant over time
Assume that at the time of issue YTM = 5-year T-note rate + 75bp
The coupon would have been set equal to thisrate and the bond would have been issued at par
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Six months hence the issue may be perceivedas more risky
YTM = 5-year T-note rate + 95 bpThe coupon will however be set equal to theprevailing 5-year rate + 75 bpIf so the issue will not reset to par at the nextcoupon date
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Floaters may come with a CAP or a FLOOR orBOTH
The CAP is a maximum coupon rateProtects issuers against rising rates
The FLOOR is a minimum coupon rateProtects investors against falling rates
When there is a spread over LIBORThere is a natural floorLIBOR cannot be less than zero
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The Treasury issues three categories ofmarketable securities
T-bills are discount securitiesThey are zero coupon securitiesT-notes and T-bonds are sold at face value andpay interest periodically
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T-bills are issued with a original time tomaturity of one year or less
They are Money market instrumentsThey have maturities of either 1 3 6 or 12months at the time of issue
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T-notes and T-bonds have a time to maturityexceeding one year at the time of issue
They are capital market instrumentsT-notes have maturities ranging from 1-10 yearsT-bonds have an original maturity in excess of 10years extending up to 30 years
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An issue may be followed later by a furtherissue
With the same remaining time to maturity andthe same couponThe issuance of further tranches is termed as aRe-opening
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Six months ago a 10-year note was issuedwith a coupon of 8 per annumToday if a note with 9 frac12 years to maturityand a coupon of 8 issued it will add to thepool that is already trading in the marketThus it is a re-opening of an existing issue
8282014 60
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Who is a primary dealerA PD is a dealer who is authorized to dealdirectly with the Central Bank of the countryIn the US a PD is a bank or securities broker-dealer that directly deals with the FRBNY
Importance of FRBNYIn India a PD deals directly with the RBI
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The Treasury sells bills notes and bonds byway of a competitive auction process
Most of the treasury securities are bought byprimary dealers
Individual investors submit non-competitive bidsand participate on a much smaller scale
8282014 63
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Bids may beCompetitive
Indicate price amp quantity or yield amp quantityNon-competitive
Indicate only quantity
Small investors and individualsgenerally submit non-competitive bids
A non-competitive bidder may not bid for more than$5MM worth of securities in a bill or bond auction
8282014 64
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Primary dealers bid for their accounts andon behalf of their clientsThey usually submit large competitive
bidsBids indicate the maximum price that the bidderis prepared to pay if it is a price based auctionOr the minimum yield that the bidder is
prepared to accept if it is a yield based auction
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The Treasury will net out the totalamount of non-competitive bids
The balance will be allocated to competitivebidders
There are two ways in which securitiescan be allotted
The multiple priceyield auction mechanism
French AuctionsThe uniform priceyield auction mechanism
Dutch Auctions
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Assume that the Treasury is offering 25billion dollars worth of T-bonds
2 billion dollars worth of non-competitive bidshave been receivedSo 23 billion dollars worth of bonds are availableto be offered to the competitive bidders
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There are six competitive bidders who havesubmitted the following yields
The bids have been arranged in ascending orderof yieldIn a price based auction the bids would havebeen arranged in descending order of price
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Bidder Bid Yield Bid Amount
Aggregate Amount
Alpha 5370 30 bn 30 bnBeta 5372 50 bn 80 bn
Gamma 5373 40 bn 12 bn
Delta 5375 80 bn 20 bnCharlie 5375 120 bn 32 bn
Tango 5380 30 bn 35 bn8282014 69
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The aggregate demand equals the amount onoffer at a yield of 5375A multiple yield auction will lead to thefollowing allocation
Alpha will get 3 bn at a yield of 5370Beta will get 5 bn at 5372Gamma will get 4 bn at 5373
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At a yield of 5375 we have only 11 bn left toallocateThere is a demand of 20 bn at this yield
8 bn from Delta and 12 bn from CharlieThus we will allocate 1120 = 55 to eachbidder at this yield
There will be pro-rata allocation
055 of 8 bn or 440 bn will go to Delta055 of 12 bn or 66 bn will go to Charlie
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The highest accepted yield is called the StopYield or High Yield
In this case it is 5375The ratio of bids received to the amountawarded is known as the bid to cover ratio
The higher the ratio the stronger is the auction
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Those who bid more than 5375 will getnothing and are said to be shutout of theauctionSince 1999 the US Treasury has beenconducting only uniform yield auctions
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WI stands for ndash When As and If IssuedThe when issued market is a market forforward trading of a bond
Which has been announced but not yet issuedTrades take place from the date ofannouncement until the actual issue date
Helps bidders to gauge the marketrsquos interestbefore the actual auction
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WI trading has ramifications for the biddingstrategies of market participantsTraders can take both long and shortpositions
Settlement is scheduled for the issue date
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It has a bearing on the outcome of theauction
It affects the strategy used by a bidder becauseit has an impact on his prior positionBidders who are long in the WI market enter theauction with a Long PositionThose who are short in the WI market enter theauction with a short position
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The WI market helps in price discoveryIt provides important information on
The strength of demand for the securityAnd on the disparity of biddersrsquo views
This help potential bidders to formulate theirstrategiesAt times a dealer may believe that he hasvery important private information
If so he may not participate in the WI market andwill directly enter the auction with bids based onhis knowledge
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On or before the date of the auction theissues trade on a yield basis
The actual price can be established only afterthe coupon is set
Starting with the day after the auctionSecurities are quoted on a price basis becausethe coupon is known
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In a coupon roll a dealer will purchase themost recently issued security from a clientAnd simultaneously sell the same amount ofthe recently announced new security
The first leg with settle on the following dayThe second leg is a forward contract
8282014 80
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There can be a Reverse RollThe dealer will sell the most recent issue fornext day settlementAnd buy the newly announced security forforward settlement
The forward leg in a RollReverse Roll is a WItrade
It will settle on the new issue settlement date
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The roll is the spread between the yield onthe new security and that on the outstandingissue in the same maturity segmentA GIVE in the Roll means that
The WI security provides a higher yield than theoutstanding issue
A Take in the Roll means thatThe WI security provides a lower yield
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On March 17 20XX the Treasury announcedthe auction of a 2-year note
The auction was scheduled for March 24The settlement date was March 31
Trading of the roll began as soon as the issuewas announcedA Give of 5 bp means that the dealer proposes tobuy the current issue at the prevailing yieldAnd sell the new issue at a yield that is 5 bpmoreA Take of 5 bp means that the dealer proposes tosell the new issue at a yield that is 5bp lower
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The roll achieves the followingHe acquires the outstanding issue for next daysettlementHe sells the to be issued security with the samepar value for forward delivery on 31 March
The customer is rolling over the investmentfrom the current issue to the new issue
This extends the maturity of the investment byone month
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The client can invest the funds received tillthe new issue settlesHowever he loses the accrued interest thathe would have earned had he held on to theissue
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The Treasury per se does not issue zerocoupon securitiesBut zero coupon securities can be created
which are backed by conventional bondsTake a large quantity of a T-note or bond andseparate all the cash flows from each otherSell the entitlement to each cash flowseparately
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Take the case of a two-year T-noteIt can be separated into five zero couponsecurities maturing after
6 months12 months18 months24 months
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Earlier investment banks used to buy bondsfrom the Treasury and separate the cashflows
Each cash flow was then sold separately as a zerocoupon bondSuch issues are called trademarks
8282014 89
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The issue of trademarks has now ceasedBecause investment banks can now createsuch instruments
In concert with the Treasury itselfThese ZCBs are known as STRIPS ndash
Separate Trading of Registered Interest andPrincipal of Securities
These are not issued or sold by the Treasury
The market is made by investment banks
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What is the motivation to create suchproductsIn practice arbitrage is possible when a
coupon security is purchased at a priceThat is lower than what could be obtained byselling each cash flow separately
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Coupon stripping reflects a case of financialengineering
Creating a risk-return profile that is nototherwise available
An investment bank would buy a largequantity of a Treasury security
The securities would be placed with an SPV
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The SPV is a single-purpose dedicated trustIt has the powers to own the bonds andcollect payments
It cannot sell or lend the bondsIt cannot write options on the bondsOr use them as collateral for borrowing
The SPV is empowered to issue zero coupon
bondsWhere each security represents the ownership ofa single cash flow from the mother bond
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Assume that 100MM USD of 15 year bondswith a coupon of 8 are placed with the SPV
The SPV can issue 6M 12M 18M extending up to14 frac12 year zeroes with a total face value of 4MM
USD eachAnd 15 year zeroes with a total face value of104MM
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8112019 FISD-02-A
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The Treasury launched this program in 1985to facilitate the stripping of designatedsecurities
All new T-bonds and notes with a maturity of 10years or more are eligibleThe zeroes created in the process are directobligations of the US government
8282014 97
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The mechanism is as followsA dealer who owns a bond or note can ask theFRB where it is held
To replace it with an equivalent set of STRIPS
representing each payment as a separate securityEach of these securities can be traded independentlyof others
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In 1987 the Treasury started to allow dealersto reverse the process
This is called STRIPS RECONSTUTUTION If a dealer owns STRIPS representing all thecoupon and principal payments of a bond
The FED can on request convert these holdings into asingle position in the corresponding bond
8282014 99
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Each coupon and principal cash flow from aTreasury security is assigned a CUSIP
The mother bond is also assigned a CUSIPThe stripped coupons are known as C-STRIPSThe stripped principal is known as P-STRIPSSupply of a C-STRIP increases over time
because a C-STRIP maturing on a day like 15 FEB
2020 will have the same CUSIP irrespective ofwhich mother bond it has come fromThe original coupon rate is irrelevant
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P-STRIPS always correspond to the originalsecurityThey have a unique CUSIPTheir supply is fixed at the time of issuanceIn practice the prices of long-dated P-STRIPSare a bit higher than those of C-STRIPS withthe same maturity date
One reason is that P-STRIPS are more liquid due
to greater availabilityA $100 face value bond with a coupon of 8 willgenerate C-STRIPS with a face value of $4 but P-STRIPS with a face value of $100
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Another reason why P-STRIPS are in higherdemand is that they allow reconstitutionactivities more easily
Assume that the sum of the STRIPS is cheaper than
the mother bondIf a dealer already has the P-STRIPS only the C-STRIPSneed to be acquiredHowever if he owns some of the C-STRIPS he needs toacquire the P-STRIPS and the remaining C-STRIPSThe facility to reconstitute when profitable is pricedinto the P-STRIPSNote Buy and hold investors will prefer C-STRIPSsince they are priced lower and give a higher yield
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For Plain Vanilla bonds the specifiedcoupon rate is valid for the life of thebond
In the case of Floaters the rate is reset atthe beginning of every periodThe rate will vary directly with thebenchmark
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The rate on a Floater is specified as LIBOR+ 50 bp
The spread is positiveIf it were specified as LIBOR ndash 30bp
The spread will be negativeIf LIBOR rises the rate will increasewhereas if LIBOR falls it will decrease
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In the case of a default risk-free floater theprice will reset to par on a coupon date
It may sell at a premium or discount betweencoupon dates
Consider a floater with a coupon = 5-year T-Bond rate
Assume there are two periods left to maturity
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The price at the end of the first coupon period willbe given by
cT-1 is the coupon one period before maturityyT-1 is the YTM one period before maturity
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On a coupon reset date the YTM = couponBecause we have assumed there is no default riskAny change in the required yield as reflected inthe prevailing YTM
Will also be reflected in the coupon being setIf coupon = yield the bond should sell at par
Thus P T-1 = M
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Once again at T-2 c T-2 = yT-2 and P T-2 = MThis logic can be applied to a bond with anytime remaining till maturityHowever between two coupon dates theprice may not be equal to par
Consider the valuation at T-2+k
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Although c T-2 was set at T-2 and is equal toyT-2
yT-2+k is determined at T-2+k and will reflect theyield prevailing at that time
Thus yT-2+k need not equal c T-2 and may behigher or lower
Hence between two coupon dates a floater maysell at a premium or discount
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Now consider a floater characterized bydefault risk
The risk premium required by the market neednot be constant over time
Assume that at the time of issue YTM = 5-year T-note rate + 75bp
The coupon would have been set equal to thisrate and the bond would have been issued at par
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Six months hence the issue may be perceivedas more risky
YTM = 5-year T-note rate + 95 bpThe coupon will however be set equal to theprevailing 5-year rate + 75 bpIf so the issue will not reset to par at the nextcoupon date
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Floaters may come with a CAP or a FLOOR orBOTH
The CAP is a maximum coupon rateProtects issuers against rising rates
The FLOOR is a minimum coupon rateProtects investors against falling rates
When there is a spread over LIBORThere is a natural floorLIBOR cannot be less than zero
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T-bills are issued with a original time tomaturity of one year or less
They are Money market instrumentsThey have maturities of either 1 3 6 or 12months at the time of issue
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T-notes and T-bonds have a time to maturityexceeding one year at the time of issue
They are capital market instrumentsT-notes have maturities ranging from 1-10 yearsT-bonds have an original maturity in excess of 10years extending up to 30 years
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An issue may be followed later by a furtherissue
With the same remaining time to maturity andthe same couponThe issuance of further tranches is termed as aRe-opening
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Six months ago a 10-year note was issuedwith a coupon of 8 per annumToday if a note with 9 frac12 years to maturityand a coupon of 8 issued it will add to thepool that is already trading in the marketThus it is a re-opening of an existing issue
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Who is a primary dealerA PD is a dealer who is authorized to dealdirectly with the Central Bank of the countryIn the US a PD is a bank or securities broker-dealer that directly deals with the FRBNY
Importance of FRBNYIn India a PD deals directly with the RBI
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The Treasury sells bills notes and bonds byway of a competitive auction process
Most of the treasury securities are bought byprimary dealers
Individual investors submit non-competitive bidsand participate on a much smaller scale
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Bids may beCompetitive
Indicate price amp quantity or yield amp quantityNon-competitive
Indicate only quantity
Small investors and individualsgenerally submit non-competitive bids
A non-competitive bidder may not bid for more than$5MM worth of securities in a bill or bond auction
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Primary dealers bid for their accounts andon behalf of their clientsThey usually submit large competitive
bidsBids indicate the maximum price that the bidderis prepared to pay if it is a price based auctionOr the minimum yield that the bidder is
prepared to accept if it is a yield based auction
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The Treasury will net out the totalamount of non-competitive bids
The balance will be allocated to competitivebidders
There are two ways in which securitiescan be allotted
The multiple priceyield auction mechanism
French AuctionsThe uniform priceyield auction mechanism
Dutch Auctions
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Assume that the Treasury is offering 25billion dollars worth of T-bonds
2 billion dollars worth of non-competitive bidshave been receivedSo 23 billion dollars worth of bonds are availableto be offered to the competitive bidders
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There are six competitive bidders who havesubmitted the following yields
The bids have been arranged in ascending orderof yieldIn a price based auction the bids would havebeen arranged in descending order of price
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Bidder Bid Yield Bid Amount
Aggregate Amount
Alpha 5370 30 bn 30 bnBeta 5372 50 bn 80 bn
Gamma 5373 40 bn 12 bn
Delta 5375 80 bn 20 bnCharlie 5375 120 bn 32 bn
Tango 5380 30 bn 35 bn8282014 69
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The aggregate demand equals the amount onoffer at a yield of 5375A multiple yield auction will lead to thefollowing allocation
Alpha will get 3 bn at a yield of 5370Beta will get 5 bn at 5372Gamma will get 4 bn at 5373
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At a yield of 5375 we have only 11 bn left toallocateThere is a demand of 20 bn at this yield
8 bn from Delta and 12 bn from CharlieThus we will allocate 1120 = 55 to eachbidder at this yield
There will be pro-rata allocation
055 of 8 bn or 440 bn will go to Delta055 of 12 bn or 66 bn will go to Charlie
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The highest accepted yield is called the StopYield or High Yield
In this case it is 5375The ratio of bids received to the amountawarded is known as the bid to cover ratio
The higher the ratio the stronger is the auction
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Those who bid more than 5375 will getnothing and are said to be shutout of theauctionSince 1999 the US Treasury has beenconducting only uniform yield auctions
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WI stands for ndash When As and If IssuedThe when issued market is a market forforward trading of a bond
Which has been announced but not yet issuedTrades take place from the date ofannouncement until the actual issue date
Helps bidders to gauge the marketrsquos interestbefore the actual auction
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WI trading has ramifications for the biddingstrategies of market participantsTraders can take both long and shortpositions
Settlement is scheduled for the issue date
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It has a bearing on the outcome of theauction
It affects the strategy used by a bidder becauseit has an impact on his prior positionBidders who are long in the WI market enter theauction with a Long PositionThose who are short in the WI market enter theauction with a short position
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The WI market helps in price discoveryIt provides important information on
The strength of demand for the securityAnd on the disparity of biddersrsquo views
This help potential bidders to formulate theirstrategiesAt times a dealer may believe that he hasvery important private information
If so he may not participate in the WI market andwill directly enter the auction with bids based onhis knowledge
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On or before the date of the auction theissues trade on a yield basis
The actual price can be established only afterthe coupon is set
Starting with the day after the auctionSecurities are quoted on a price basis becausethe coupon is known
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In a coupon roll a dealer will purchase themost recently issued security from a clientAnd simultaneously sell the same amount ofthe recently announced new security
The first leg with settle on the following dayThe second leg is a forward contract
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There can be a Reverse RollThe dealer will sell the most recent issue fornext day settlementAnd buy the newly announced security forforward settlement
The forward leg in a RollReverse Roll is a WItrade
It will settle on the new issue settlement date
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The roll is the spread between the yield onthe new security and that on the outstandingissue in the same maturity segmentA GIVE in the Roll means that
The WI security provides a higher yield than theoutstanding issue
A Take in the Roll means thatThe WI security provides a lower yield
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On March 17 20XX the Treasury announcedthe auction of a 2-year note
The auction was scheduled for March 24The settlement date was March 31
Trading of the roll began as soon as the issuewas announcedA Give of 5 bp means that the dealer proposes tobuy the current issue at the prevailing yieldAnd sell the new issue at a yield that is 5 bpmoreA Take of 5 bp means that the dealer proposes tosell the new issue at a yield that is 5bp lower
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The roll achieves the followingHe acquires the outstanding issue for next daysettlementHe sells the to be issued security with the samepar value for forward delivery on 31 March
The customer is rolling over the investmentfrom the current issue to the new issue
This extends the maturity of the investment byone month
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The client can invest the funds received tillthe new issue settlesHowever he loses the accrued interest thathe would have earned had he held on to theissue
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The Treasury per se does not issue zerocoupon securitiesBut zero coupon securities can be created
which are backed by conventional bondsTake a large quantity of a T-note or bond andseparate all the cash flows from each otherSell the entitlement to each cash flowseparately
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Take the case of a two-year T-noteIt can be separated into five zero couponsecurities maturing after
6 months12 months18 months24 months
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Earlier investment banks used to buy bondsfrom the Treasury and separate the cashflows
Each cash flow was then sold separately as a zerocoupon bondSuch issues are called trademarks
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The issue of trademarks has now ceasedBecause investment banks can now createsuch instruments
In concert with the Treasury itselfThese ZCBs are known as STRIPS ndash
Separate Trading of Registered Interest andPrincipal of Securities
These are not issued or sold by the Treasury
The market is made by investment banks
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What is the motivation to create suchproductsIn practice arbitrage is possible when a
coupon security is purchased at a priceThat is lower than what could be obtained byselling each cash flow separately
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Coupon stripping reflects a case of financialengineering
Creating a risk-return profile that is nototherwise available
An investment bank would buy a largequantity of a Treasury security
The securities would be placed with an SPV
8282014 92
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The SPV is a single-purpose dedicated trustIt has the powers to own the bonds andcollect payments
It cannot sell or lend the bondsIt cannot write options on the bondsOr use them as collateral for borrowing
The SPV is empowered to issue zero coupon
bondsWhere each security represents the ownership ofa single cash flow from the mother bond
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Assume that 100MM USD of 15 year bondswith a coupon of 8 are placed with the SPV
The SPV can issue 6M 12M 18M extending up to14 frac12 year zeroes with a total face value of 4MM
USD eachAnd 15 year zeroes with a total face value of104MM
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8112019 FISD-02-A
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The Treasury launched this program in 1985to facilitate the stripping of designatedsecurities
All new T-bonds and notes with a maturity of 10years or more are eligibleThe zeroes created in the process are directobligations of the US government
8282014 97
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The mechanism is as followsA dealer who owns a bond or note can ask theFRB where it is held
To replace it with an equivalent set of STRIPS
representing each payment as a separate securityEach of these securities can be traded independentlyof others
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In 1987 the Treasury started to allow dealersto reverse the process
This is called STRIPS RECONSTUTUTION If a dealer owns STRIPS representing all thecoupon and principal payments of a bond
The FED can on request convert these holdings into asingle position in the corresponding bond
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Each coupon and principal cash flow from aTreasury security is assigned a CUSIP
The mother bond is also assigned a CUSIPThe stripped coupons are known as C-STRIPSThe stripped principal is known as P-STRIPSSupply of a C-STRIP increases over time
because a C-STRIP maturing on a day like 15 FEB
2020 will have the same CUSIP irrespective ofwhich mother bond it has come fromThe original coupon rate is irrelevant
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P-STRIPS always correspond to the originalsecurityThey have a unique CUSIPTheir supply is fixed at the time of issuanceIn practice the prices of long-dated P-STRIPSare a bit higher than those of C-STRIPS withthe same maturity date
One reason is that P-STRIPS are more liquid due
to greater availabilityA $100 face value bond with a coupon of 8 willgenerate C-STRIPS with a face value of $4 but P-STRIPS with a face value of $100
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Another reason why P-STRIPS are in higherdemand is that they allow reconstitutionactivities more easily
Assume that the sum of the STRIPS is cheaper than
the mother bondIf a dealer already has the P-STRIPS only the C-STRIPSneed to be acquiredHowever if he owns some of the C-STRIPS he needs toacquire the P-STRIPS and the remaining C-STRIPSThe facility to reconstitute when profitable is pricedinto the P-STRIPSNote Buy and hold investors will prefer C-STRIPSsince they are priced lower and give a higher yield
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For Plain Vanilla bonds the specifiedcoupon rate is valid for the life of thebond
In the case of Floaters the rate is reset atthe beginning of every periodThe rate will vary directly with thebenchmark
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The rate on a Floater is specified as LIBOR+ 50 bp
The spread is positiveIf it were specified as LIBOR ndash 30bp
The spread will be negativeIf LIBOR rises the rate will increasewhereas if LIBOR falls it will decrease
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In the case of a default risk-free floater theprice will reset to par on a coupon date
It may sell at a premium or discount betweencoupon dates
Consider a floater with a coupon = 5-year T-Bond rate
Assume there are two periods left to maturity
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The price at the end of the first coupon period willbe given by
cT-1 is the coupon one period before maturityyT-1 is the YTM one period before maturity
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On a coupon reset date the YTM = couponBecause we have assumed there is no default riskAny change in the required yield as reflected inthe prevailing YTM
Will also be reflected in the coupon being setIf coupon = yield the bond should sell at par
Thus P T-1 = M
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Once again at T-2 c T-2 = yT-2 and P T-2 = MThis logic can be applied to a bond with anytime remaining till maturityHowever between two coupon dates theprice may not be equal to par
Consider the valuation at T-2+k
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Although c T-2 was set at T-2 and is equal toyT-2
yT-2+k is determined at T-2+k and will reflect theyield prevailing at that time
Thus yT-2+k need not equal c T-2 and may behigher or lower
Hence between two coupon dates a floater maysell at a premium or discount
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Now consider a floater characterized bydefault risk
The risk premium required by the market neednot be constant over time
Assume that at the time of issue YTM = 5-year T-note rate + 75bp
The coupon would have been set equal to thisrate and the bond would have been issued at par
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Six months hence the issue may be perceivedas more risky
YTM = 5-year T-note rate + 95 bpThe coupon will however be set equal to theprevailing 5-year rate + 75 bpIf so the issue will not reset to par at the nextcoupon date
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Floaters may come with a CAP or a FLOOR orBOTH
The CAP is a maximum coupon rateProtects issuers against rising rates
The FLOOR is a minimum coupon rateProtects investors against falling rates
When there is a spread over LIBORThere is a natural floorLIBOR cannot be less than zero
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T-notes and T-bonds have a time to maturityexceeding one year at the time of issue
They are capital market instrumentsT-notes have maturities ranging from 1-10 yearsT-bonds have an original maturity in excess of 10years extending up to 30 years
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An issue may be followed later by a furtherissue
With the same remaining time to maturity andthe same couponThe issuance of further tranches is termed as aRe-opening
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Six months ago a 10-year note was issuedwith a coupon of 8 per annumToday if a note with 9 frac12 years to maturityand a coupon of 8 issued it will add to thepool that is already trading in the marketThus it is a re-opening of an existing issue
8282014 60
8112019 FISD-02-A
httpslidepdfcomreaderfullfisd-02-a 61115
Who is a primary dealerA PD is a dealer who is authorized to dealdirectly with the Central Bank of the countryIn the US a PD is a bank or securities broker-dealer that directly deals with the FRBNY
Importance of FRBNYIn India a PD deals directly with the RBI
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The Treasury sells bills notes and bonds byway of a competitive auction process
Most of the treasury securities are bought byprimary dealers
Individual investors submit non-competitive bidsand participate on a much smaller scale
8282014 63
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httpslidepdfcomreaderfullfisd-02-a 64115
Bids may beCompetitive
Indicate price amp quantity or yield amp quantityNon-competitive
Indicate only quantity
Small investors and individualsgenerally submit non-competitive bids
A non-competitive bidder may not bid for more than$5MM worth of securities in a bill or bond auction
8282014 64
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Primary dealers bid for their accounts andon behalf of their clientsThey usually submit large competitive
bidsBids indicate the maximum price that the bidderis prepared to pay if it is a price based auctionOr the minimum yield that the bidder is
prepared to accept if it is a yield based auction
8282014 65
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The Treasury will net out the totalamount of non-competitive bids
The balance will be allocated to competitivebidders
There are two ways in which securitiescan be allotted
The multiple priceyield auction mechanism
French AuctionsThe uniform priceyield auction mechanism
Dutch Auctions
8282014 66
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Assume that the Treasury is offering 25billion dollars worth of T-bonds
2 billion dollars worth of non-competitive bidshave been receivedSo 23 billion dollars worth of bonds are availableto be offered to the competitive bidders
8282014 67
8112019 FISD-02-A
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There are six competitive bidders who havesubmitted the following yields
The bids have been arranged in ascending orderof yieldIn a price based auction the bids would havebeen arranged in descending order of price
8282014 68
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Bidder Bid Yield Bid Amount
Aggregate Amount
Alpha 5370 30 bn 30 bnBeta 5372 50 bn 80 bn
Gamma 5373 40 bn 12 bn
Delta 5375 80 bn 20 bnCharlie 5375 120 bn 32 bn
Tango 5380 30 bn 35 bn8282014 69
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The aggregate demand equals the amount onoffer at a yield of 5375A multiple yield auction will lead to thefollowing allocation
Alpha will get 3 bn at a yield of 5370Beta will get 5 bn at 5372Gamma will get 4 bn at 5373
8282014 70
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At a yield of 5375 we have only 11 bn left toallocateThere is a demand of 20 bn at this yield
8 bn from Delta and 12 bn from CharlieThus we will allocate 1120 = 55 to eachbidder at this yield
There will be pro-rata allocation
055 of 8 bn or 440 bn will go to Delta055 of 12 bn or 66 bn will go to Charlie
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The highest accepted yield is called the StopYield or High Yield
In this case it is 5375The ratio of bids received to the amountawarded is known as the bid to cover ratio
The higher the ratio the stronger is the auction
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8112019 FISD-02-A
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Those who bid more than 5375 will getnothing and are said to be shutout of theauctionSince 1999 the US Treasury has beenconducting only uniform yield auctions
8282014 74
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WI stands for ndash When As and If IssuedThe when issued market is a market forforward trading of a bond
Which has been announced but not yet issuedTrades take place from the date ofannouncement until the actual issue date
Helps bidders to gauge the marketrsquos interestbefore the actual auction
8282014 75
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WI trading has ramifications for the biddingstrategies of market participantsTraders can take both long and shortpositions
Settlement is scheduled for the issue date
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It has a bearing on the outcome of theauction
It affects the strategy used by a bidder becauseit has an impact on his prior positionBidders who are long in the WI market enter theauction with a Long PositionThose who are short in the WI market enter theauction with a short position
8282014 77
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The WI market helps in price discoveryIt provides important information on
The strength of demand for the securityAnd on the disparity of biddersrsquo views
This help potential bidders to formulate theirstrategiesAt times a dealer may believe that he hasvery important private information
If so he may not participate in the WI market andwill directly enter the auction with bids based onhis knowledge
8282014 78
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On or before the date of the auction theissues trade on a yield basis
The actual price can be established only afterthe coupon is set
Starting with the day after the auctionSecurities are quoted on a price basis becausethe coupon is known
8282014 79
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In a coupon roll a dealer will purchase themost recently issued security from a clientAnd simultaneously sell the same amount ofthe recently announced new security
The first leg with settle on the following dayThe second leg is a forward contract
8282014 80
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httpslidepdfcomreaderfullfisd-02-a 81115
There can be a Reverse RollThe dealer will sell the most recent issue fornext day settlementAnd buy the newly announced security forforward settlement
The forward leg in a RollReverse Roll is a WItrade
It will settle on the new issue settlement date
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The roll is the spread between the yield onthe new security and that on the outstandingissue in the same maturity segmentA GIVE in the Roll means that
The WI security provides a higher yield than theoutstanding issue
A Take in the Roll means thatThe WI security provides a lower yield
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8112019 FISD-02-A
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On March 17 20XX the Treasury announcedthe auction of a 2-year note
The auction was scheduled for March 24The settlement date was March 31
Trading of the roll began as soon as the issuewas announcedA Give of 5 bp means that the dealer proposes tobuy the current issue at the prevailing yieldAnd sell the new issue at a yield that is 5 bpmoreA Take of 5 bp means that the dealer proposes tosell the new issue at a yield that is 5bp lower
8282014 84
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The roll achieves the followingHe acquires the outstanding issue for next daysettlementHe sells the to be issued security with the samepar value for forward delivery on 31 March
The customer is rolling over the investmentfrom the current issue to the new issue
This extends the maturity of the investment byone month
8282014 85
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The client can invest the funds received tillthe new issue settlesHowever he loses the accrued interest thathe would have earned had he held on to theissue
8282014 86
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httpslidepdfcomreaderfullfisd-02-a 87115
The Treasury per se does not issue zerocoupon securitiesBut zero coupon securities can be created
which are backed by conventional bondsTake a large quantity of a T-note or bond andseparate all the cash flows from each otherSell the entitlement to each cash flowseparately
8282014 87
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Take the case of a two-year T-noteIt can be separated into five zero couponsecurities maturing after
6 months12 months18 months24 months
8282014 88
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httpslidepdfcomreaderfullfisd-02-a 89115
Earlier investment banks used to buy bondsfrom the Treasury and separate the cashflows
Each cash flow was then sold separately as a zerocoupon bondSuch issues are called trademarks
8282014 89
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httpslidepdfcomreaderfullfisd-02-a 90115
The issue of trademarks has now ceasedBecause investment banks can now createsuch instruments
In concert with the Treasury itselfThese ZCBs are known as STRIPS ndash
Separate Trading of Registered Interest andPrincipal of Securities
These are not issued or sold by the Treasury
The market is made by investment banks
8282014 90
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What is the motivation to create suchproductsIn practice arbitrage is possible when a
coupon security is purchased at a priceThat is lower than what could be obtained byselling each cash flow separately
8282014 91
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Coupon stripping reflects a case of financialengineering
Creating a risk-return profile that is nototherwise available
An investment bank would buy a largequantity of a Treasury security
The securities would be placed with an SPV
8282014 92
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httpslidepdfcomreaderfullfisd-02-a 93115
The SPV is a single-purpose dedicated trustIt has the powers to own the bonds andcollect payments
It cannot sell or lend the bondsIt cannot write options on the bondsOr use them as collateral for borrowing
The SPV is empowered to issue zero coupon
bondsWhere each security represents the ownership ofa single cash flow from the mother bond
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Assume that 100MM USD of 15 year bondswith a coupon of 8 are placed with the SPV
The SPV can issue 6M 12M 18M extending up to14 frac12 year zeroes with a total face value of 4MM
USD eachAnd 15 year zeroes with a total face value of104MM
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8112019 FISD-02-A
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The Treasury launched this program in 1985to facilitate the stripping of designatedsecurities
All new T-bonds and notes with a maturity of 10years or more are eligibleThe zeroes created in the process are directobligations of the US government
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The mechanism is as followsA dealer who owns a bond or note can ask theFRB where it is held
To replace it with an equivalent set of STRIPS
representing each payment as a separate securityEach of these securities can be traded independentlyof others
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In 1987 the Treasury started to allow dealersto reverse the process
This is called STRIPS RECONSTUTUTION If a dealer owns STRIPS representing all thecoupon and principal payments of a bond
The FED can on request convert these holdings into asingle position in the corresponding bond
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Each coupon and principal cash flow from aTreasury security is assigned a CUSIP
The mother bond is also assigned a CUSIPThe stripped coupons are known as C-STRIPSThe stripped principal is known as P-STRIPSSupply of a C-STRIP increases over time
because a C-STRIP maturing on a day like 15 FEB
2020 will have the same CUSIP irrespective ofwhich mother bond it has come fromThe original coupon rate is irrelevant
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P-STRIPS always correspond to the originalsecurityThey have a unique CUSIPTheir supply is fixed at the time of issuanceIn practice the prices of long-dated P-STRIPSare a bit higher than those of C-STRIPS withthe same maturity date
One reason is that P-STRIPS are more liquid due
to greater availabilityA $100 face value bond with a coupon of 8 willgenerate C-STRIPS with a face value of $4 but P-STRIPS with a face value of $100
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Another reason why P-STRIPS are in higherdemand is that they allow reconstitutionactivities more easily
Assume that the sum of the STRIPS is cheaper than
the mother bondIf a dealer already has the P-STRIPS only the C-STRIPSneed to be acquiredHowever if he owns some of the C-STRIPS he needs toacquire the P-STRIPS and the remaining C-STRIPSThe facility to reconstitute when profitable is pricedinto the P-STRIPSNote Buy and hold investors will prefer C-STRIPSsince they are priced lower and give a higher yield
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For Plain Vanilla bonds the specifiedcoupon rate is valid for the life of thebond
In the case of Floaters the rate is reset atthe beginning of every periodThe rate will vary directly with thebenchmark
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The rate on a Floater is specified as LIBOR+ 50 bp
The spread is positiveIf it were specified as LIBOR ndash 30bp
The spread will be negativeIf LIBOR rises the rate will increasewhereas if LIBOR falls it will decrease
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In the case of a default risk-free floater theprice will reset to par on a coupon date
It may sell at a premium or discount betweencoupon dates
Consider a floater with a coupon = 5-year T-Bond rate
Assume there are two periods left to maturity
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The price at the end of the first coupon period willbe given by
cT-1 is the coupon one period before maturityyT-1 is the YTM one period before maturity
8112019 FISD-02-A
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On a coupon reset date the YTM = couponBecause we have assumed there is no default riskAny change in the required yield as reflected inthe prevailing YTM
Will also be reflected in the coupon being setIf coupon = yield the bond should sell at par
Thus P T-1 = M
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Once again at T-2 c T-2 = yT-2 and P T-2 = MThis logic can be applied to a bond with anytime remaining till maturityHowever between two coupon dates theprice may not be equal to par
Consider the valuation at T-2+k
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Although c T-2 was set at T-2 and is equal toyT-2
yT-2+k is determined at T-2+k and will reflect theyield prevailing at that time
Thus yT-2+k need not equal c T-2 and may behigher or lower
Hence between two coupon dates a floater maysell at a premium or discount
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Now consider a floater characterized bydefault risk
The risk premium required by the market neednot be constant over time
Assume that at the time of issue YTM = 5-year T-note rate + 75bp
The coupon would have been set equal to thisrate and the bond would have been issued at par
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Six months hence the issue may be perceivedas more risky
YTM = 5-year T-note rate + 95 bpThe coupon will however be set equal to theprevailing 5-year rate + 75 bpIf so the issue will not reset to par at the nextcoupon date
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Floaters may come with a CAP or a FLOOR orBOTH
The CAP is a maximum coupon rateProtects issuers against rising rates
The FLOOR is a minimum coupon rateProtects investors against falling rates
When there is a spread over LIBORThere is a natural floorLIBOR cannot be less than zero
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An issue may be followed later by a furtherissue
With the same remaining time to maturity andthe same couponThe issuance of further tranches is termed as aRe-opening
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Six months ago a 10-year note was issuedwith a coupon of 8 per annumToday if a note with 9 frac12 years to maturityand a coupon of 8 issued it will add to thepool that is already trading in the marketThus it is a re-opening of an existing issue
8282014 60
8112019 FISD-02-A
httpslidepdfcomreaderfullfisd-02-a 61115
Who is a primary dealerA PD is a dealer who is authorized to dealdirectly with the Central Bank of the countryIn the US a PD is a bank or securities broker-dealer that directly deals with the FRBNY
Importance of FRBNYIn India a PD deals directly with the RBI
8282014 61
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8282014 62
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The Treasury sells bills notes and bonds byway of a competitive auction process
Most of the treasury securities are bought byprimary dealers
Individual investors submit non-competitive bidsand participate on a much smaller scale
8282014 63
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httpslidepdfcomreaderfullfisd-02-a 64115
Bids may beCompetitive
Indicate price amp quantity or yield amp quantityNon-competitive
Indicate only quantity
Small investors and individualsgenerally submit non-competitive bids
A non-competitive bidder may not bid for more than$5MM worth of securities in a bill or bond auction
8282014 64
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httpslidepdfcomreaderfullfisd-02-a 65115
Primary dealers bid for their accounts andon behalf of their clientsThey usually submit large competitive
bidsBids indicate the maximum price that the bidderis prepared to pay if it is a price based auctionOr the minimum yield that the bidder is
prepared to accept if it is a yield based auction
8282014 65
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httpslidepdfcomreaderfullfisd-02-a 66115
The Treasury will net out the totalamount of non-competitive bids
The balance will be allocated to competitivebidders
There are two ways in which securitiescan be allotted
The multiple priceyield auction mechanism
French AuctionsThe uniform priceyield auction mechanism
Dutch Auctions
8282014 66
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Assume that the Treasury is offering 25billion dollars worth of T-bonds
2 billion dollars worth of non-competitive bidshave been receivedSo 23 billion dollars worth of bonds are availableto be offered to the competitive bidders
8282014 67
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There are six competitive bidders who havesubmitted the following yields
The bids have been arranged in ascending orderof yieldIn a price based auction the bids would havebeen arranged in descending order of price
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Bidder Bid Yield Bid Amount
Aggregate Amount
Alpha 5370 30 bn 30 bnBeta 5372 50 bn 80 bn
Gamma 5373 40 bn 12 bn
Delta 5375 80 bn 20 bnCharlie 5375 120 bn 32 bn
Tango 5380 30 bn 35 bn8282014 69
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The aggregate demand equals the amount onoffer at a yield of 5375A multiple yield auction will lead to thefollowing allocation
Alpha will get 3 bn at a yield of 5370Beta will get 5 bn at 5372Gamma will get 4 bn at 5373
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At a yield of 5375 we have only 11 bn left toallocateThere is a demand of 20 bn at this yield
8 bn from Delta and 12 bn from CharlieThus we will allocate 1120 = 55 to eachbidder at this yield
There will be pro-rata allocation
055 of 8 bn or 440 bn will go to Delta055 of 12 bn or 66 bn will go to Charlie
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The highest accepted yield is called the StopYield or High Yield
In this case it is 5375The ratio of bids received to the amountawarded is known as the bid to cover ratio
The higher the ratio the stronger is the auction
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8112019 FISD-02-A
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Those who bid more than 5375 will getnothing and are said to be shutout of theauctionSince 1999 the US Treasury has beenconducting only uniform yield auctions
8282014 74
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WI stands for ndash When As and If IssuedThe when issued market is a market forforward trading of a bond
Which has been announced but not yet issuedTrades take place from the date ofannouncement until the actual issue date
Helps bidders to gauge the marketrsquos interestbefore the actual auction
8282014 75
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httpslidepdfcomreaderfullfisd-02-a 76115
WI trading has ramifications for the biddingstrategies of market participantsTraders can take both long and shortpositions
Settlement is scheduled for the issue date
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It has a bearing on the outcome of theauction
It affects the strategy used by a bidder becauseit has an impact on his prior positionBidders who are long in the WI market enter theauction with a Long PositionThose who are short in the WI market enter theauction with a short position
8282014 77
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The WI market helps in price discoveryIt provides important information on
The strength of demand for the securityAnd on the disparity of biddersrsquo views
This help potential bidders to formulate theirstrategiesAt times a dealer may believe that he hasvery important private information
If so he may not participate in the WI market andwill directly enter the auction with bids based onhis knowledge
8282014 78
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On or before the date of the auction theissues trade on a yield basis
The actual price can be established only afterthe coupon is set
Starting with the day after the auctionSecurities are quoted on a price basis becausethe coupon is known
8282014 79
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httpslidepdfcomreaderfullfisd-02-a 80115
In a coupon roll a dealer will purchase themost recently issued security from a clientAnd simultaneously sell the same amount ofthe recently announced new security
The first leg with settle on the following dayThe second leg is a forward contract
8282014 80
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httpslidepdfcomreaderfullfisd-02-a 81115
There can be a Reverse RollThe dealer will sell the most recent issue fornext day settlementAnd buy the newly announced security forforward settlement
The forward leg in a RollReverse Roll is a WItrade
It will settle on the new issue settlement date
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The roll is the spread between the yield onthe new security and that on the outstandingissue in the same maturity segmentA GIVE in the Roll means that
The WI security provides a higher yield than theoutstanding issue
A Take in the Roll means thatThe WI security provides a lower yield
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8112019 FISD-02-A
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On March 17 20XX the Treasury announcedthe auction of a 2-year note
The auction was scheduled for March 24The settlement date was March 31
Trading of the roll began as soon as the issuewas announcedA Give of 5 bp means that the dealer proposes tobuy the current issue at the prevailing yieldAnd sell the new issue at a yield that is 5 bpmoreA Take of 5 bp means that the dealer proposes tosell the new issue at a yield that is 5bp lower
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The roll achieves the followingHe acquires the outstanding issue for next daysettlementHe sells the to be issued security with the samepar value for forward delivery on 31 March
The customer is rolling over the investmentfrom the current issue to the new issue
This extends the maturity of the investment byone month
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The client can invest the funds received tillthe new issue settlesHowever he loses the accrued interest thathe would have earned had he held on to theissue
8282014 86
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The Treasury per se does not issue zerocoupon securitiesBut zero coupon securities can be created
which are backed by conventional bondsTake a large quantity of a T-note or bond andseparate all the cash flows from each otherSell the entitlement to each cash flowseparately
8282014 87
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Take the case of a two-year T-noteIt can be separated into five zero couponsecurities maturing after
6 months12 months18 months24 months
8282014 88
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httpslidepdfcomreaderfullfisd-02-a 89115
Earlier investment banks used to buy bondsfrom the Treasury and separate the cashflows
Each cash flow was then sold separately as a zerocoupon bondSuch issues are called trademarks
8282014 89
8112019 FISD-02-A
httpslidepdfcomreaderfullfisd-02-a 90115
The issue of trademarks has now ceasedBecause investment banks can now createsuch instruments
In concert with the Treasury itselfThese ZCBs are known as STRIPS ndash
Separate Trading of Registered Interest andPrincipal of Securities
These are not issued or sold by the Treasury
The market is made by investment banks
8282014 90
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What is the motivation to create suchproductsIn practice arbitrage is possible when a
coupon security is purchased at a priceThat is lower than what could be obtained byselling each cash flow separately
8282014 91
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Coupon stripping reflects a case of financialengineering
Creating a risk-return profile that is nototherwise available
An investment bank would buy a largequantity of a Treasury security
The securities would be placed with an SPV
8282014 92
8112019 FISD-02-A
httpslidepdfcomreaderfullfisd-02-a 93115
The SPV is a single-purpose dedicated trustIt has the powers to own the bonds andcollect payments
It cannot sell or lend the bondsIt cannot write options on the bondsOr use them as collateral for borrowing
The SPV is empowered to issue zero coupon
bondsWhere each security represents the ownership ofa single cash flow from the mother bond
8282014 93
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Assume that 100MM USD of 15 year bondswith a coupon of 8 are placed with the SPV
The SPV can issue 6M 12M 18M extending up to14 frac12 year zeroes with a total face value of 4MM
USD eachAnd 15 year zeroes with a total face value of104MM
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The Treasury launched this program in 1985to facilitate the stripping of designatedsecurities
All new T-bonds and notes with a maturity of 10years or more are eligibleThe zeroes created in the process are directobligations of the US government
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The mechanism is as followsA dealer who owns a bond or note can ask theFRB where it is held
To replace it with an equivalent set of STRIPS
representing each payment as a separate securityEach of these securities can be traded independentlyof others
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In 1987 the Treasury started to allow dealersto reverse the process
This is called STRIPS RECONSTUTUTION If a dealer owns STRIPS representing all thecoupon and principal payments of a bond
The FED can on request convert these holdings into asingle position in the corresponding bond
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Each coupon and principal cash flow from aTreasury security is assigned a CUSIP
The mother bond is also assigned a CUSIPThe stripped coupons are known as C-STRIPSThe stripped principal is known as P-STRIPSSupply of a C-STRIP increases over time
because a C-STRIP maturing on a day like 15 FEB
2020 will have the same CUSIP irrespective ofwhich mother bond it has come fromThe original coupon rate is irrelevant
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P-STRIPS always correspond to the originalsecurityThey have a unique CUSIPTheir supply is fixed at the time of issuanceIn practice the prices of long-dated P-STRIPSare a bit higher than those of C-STRIPS withthe same maturity date
One reason is that P-STRIPS are more liquid due
to greater availabilityA $100 face value bond with a coupon of 8 willgenerate C-STRIPS with a face value of $4 but P-STRIPS with a face value of $100
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Another reason why P-STRIPS are in higherdemand is that they allow reconstitutionactivities more easily
Assume that the sum of the STRIPS is cheaper than
the mother bondIf a dealer already has the P-STRIPS only the C-STRIPSneed to be acquiredHowever if he owns some of the C-STRIPS he needs toacquire the P-STRIPS and the remaining C-STRIPSThe facility to reconstitute when profitable is pricedinto the P-STRIPSNote Buy and hold investors will prefer C-STRIPSsince they are priced lower and give a higher yield
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For Plain Vanilla bonds the specifiedcoupon rate is valid for the life of thebond
In the case of Floaters the rate is reset atthe beginning of every periodThe rate will vary directly with thebenchmark
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The rate on a Floater is specified as LIBOR+ 50 bp
The spread is positiveIf it were specified as LIBOR ndash 30bp
The spread will be negativeIf LIBOR rises the rate will increasewhereas if LIBOR falls it will decrease
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In the case of a default risk-free floater theprice will reset to par on a coupon date
It may sell at a premium or discount betweencoupon dates
Consider a floater with a coupon = 5-year T-Bond rate
Assume there are two periods left to maturity
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The price at the end of the first coupon period willbe given by
cT-1 is the coupon one period before maturityyT-1 is the YTM one period before maturity
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On a coupon reset date the YTM = couponBecause we have assumed there is no default riskAny change in the required yield as reflected inthe prevailing YTM
Will also be reflected in the coupon being setIf coupon = yield the bond should sell at par
Thus P T-1 = M
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Once again at T-2 c T-2 = yT-2 and P T-2 = MThis logic can be applied to a bond with anytime remaining till maturityHowever between two coupon dates theprice may not be equal to par
Consider the valuation at T-2+k
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Although c T-2 was set at T-2 and is equal toyT-2
yT-2+k is determined at T-2+k and will reflect theyield prevailing at that time
Thus yT-2+k need not equal c T-2 and may behigher or lower
Hence between two coupon dates a floater maysell at a premium or discount
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Now consider a floater characterized bydefault risk
The risk premium required by the market neednot be constant over time
Assume that at the time of issue YTM = 5-year T-note rate + 75bp
The coupon would have been set equal to thisrate and the bond would have been issued at par
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Six months hence the issue may be perceivedas more risky
YTM = 5-year T-note rate + 95 bpThe coupon will however be set equal to theprevailing 5-year rate + 75 bpIf so the issue will not reset to par at the nextcoupon date
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Floaters may come with a CAP or a FLOOR orBOTH
The CAP is a maximum coupon rateProtects issuers against rising rates
The FLOOR is a minimum coupon rateProtects investors against falling rates
When there is a spread over LIBORThere is a natural floorLIBOR cannot be less than zero
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Six months ago a 10-year note was issuedwith a coupon of 8 per annumToday if a note with 9 frac12 years to maturityand a coupon of 8 issued it will add to thepool that is already trading in the marketThus it is a re-opening of an existing issue
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Who is a primary dealerA PD is a dealer who is authorized to dealdirectly with the Central Bank of the countryIn the US a PD is a bank or securities broker-dealer that directly deals with the FRBNY
Importance of FRBNYIn India a PD deals directly with the RBI
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The Treasury sells bills notes and bonds byway of a competitive auction process
Most of the treasury securities are bought byprimary dealers
Individual investors submit non-competitive bidsand participate on a much smaller scale
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Bids may beCompetitive
Indicate price amp quantity or yield amp quantityNon-competitive
Indicate only quantity
Small investors and individualsgenerally submit non-competitive bids
A non-competitive bidder may not bid for more than$5MM worth of securities in a bill or bond auction
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Primary dealers bid for their accounts andon behalf of their clientsThey usually submit large competitive
bidsBids indicate the maximum price that the bidderis prepared to pay if it is a price based auctionOr the minimum yield that the bidder is
prepared to accept if it is a yield based auction
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The Treasury will net out the totalamount of non-competitive bids
The balance will be allocated to competitivebidders
There are two ways in which securitiescan be allotted
The multiple priceyield auction mechanism
French AuctionsThe uniform priceyield auction mechanism
Dutch Auctions
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Assume that the Treasury is offering 25billion dollars worth of T-bonds
2 billion dollars worth of non-competitive bidshave been receivedSo 23 billion dollars worth of bonds are availableto be offered to the competitive bidders
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There are six competitive bidders who havesubmitted the following yields
The bids have been arranged in ascending orderof yieldIn a price based auction the bids would havebeen arranged in descending order of price
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Bidder Bid Yield Bid Amount
Aggregate Amount
Alpha 5370 30 bn 30 bnBeta 5372 50 bn 80 bn
Gamma 5373 40 bn 12 bn
Delta 5375 80 bn 20 bnCharlie 5375 120 bn 32 bn
Tango 5380 30 bn 35 bn8282014 69
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The aggregate demand equals the amount onoffer at a yield of 5375A multiple yield auction will lead to thefollowing allocation
Alpha will get 3 bn at a yield of 5370Beta will get 5 bn at 5372Gamma will get 4 bn at 5373
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At a yield of 5375 we have only 11 bn left toallocateThere is a demand of 20 bn at this yield
8 bn from Delta and 12 bn from CharlieThus we will allocate 1120 = 55 to eachbidder at this yield
There will be pro-rata allocation
055 of 8 bn or 440 bn will go to Delta055 of 12 bn or 66 bn will go to Charlie
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The highest accepted yield is called the StopYield or High Yield
In this case it is 5375The ratio of bids received to the amountawarded is known as the bid to cover ratio
The higher the ratio the stronger is the auction
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Those who bid more than 5375 will getnothing and are said to be shutout of theauctionSince 1999 the US Treasury has beenconducting only uniform yield auctions
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WI stands for ndash When As and If IssuedThe when issued market is a market forforward trading of a bond
Which has been announced but not yet issuedTrades take place from the date ofannouncement until the actual issue date
Helps bidders to gauge the marketrsquos interestbefore the actual auction
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WI trading has ramifications for the biddingstrategies of market participantsTraders can take both long and shortpositions
Settlement is scheduled for the issue date
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It has a bearing on the outcome of theauction
It affects the strategy used by a bidder becauseit has an impact on his prior positionBidders who are long in the WI market enter theauction with a Long PositionThose who are short in the WI market enter theauction with a short position
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The WI market helps in price discoveryIt provides important information on
The strength of demand for the securityAnd on the disparity of biddersrsquo views
This help potential bidders to formulate theirstrategiesAt times a dealer may believe that he hasvery important private information
If so he may not participate in the WI market andwill directly enter the auction with bids based onhis knowledge
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On or before the date of the auction theissues trade on a yield basis
The actual price can be established only afterthe coupon is set
Starting with the day after the auctionSecurities are quoted on a price basis becausethe coupon is known
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In a coupon roll a dealer will purchase themost recently issued security from a clientAnd simultaneously sell the same amount ofthe recently announced new security
The first leg with settle on the following dayThe second leg is a forward contract
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There can be a Reverse RollThe dealer will sell the most recent issue fornext day settlementAnd buy the newly announced security forforward settlement
The forward leg in a RollReverse Roll is a WItrade
It will settle on the new issue settlement date
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The roll is the spread between the yield onthe new security and that on the outstandingissue in the same maturity segmentA GIVE in the Roll means that
The WI security provides a higher yield than theoutstanding issue
A Take in the Roll means thatThe WI security provides a lower yield
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On March 17 20XX the Treasury announcedthe auction of a 2-year note
The auction was scheduled for March 24The settlement date was March 31
Trading of the roll began as soon as the issuewas announcedA Give of 5 bp means that the dealer proposes tobuy the current issue at the prevailing yieldAnd sell the new issue at a yield that is 5 bpmoreA Take of 5 bp means that the dealer proposes tosell the new issue at a yield that is 5bp lower
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The roll achieves the followingHe acquires the outstanding issue for next daysettlementHe sells the to be issued security with the samepar value for forward delivery on 31 March
The customer is rolling over the investmentfrom the current issue to the new issue
This extends the maturity of the investment byone month
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The client can invest the funds received tillthe new issue settlesHowever he loses the accrued interest thathe would have earned had he held on to theissue
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The Treasury per se does not issue zerocoupon securitiesBut zero coupon securities can be created
which are backed by conventional bondsTake a large quantity of a T-note or bond andseparate all the cash flows from each otherSell the entitlement to each cash flowseparately
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Take the case of a two-year T-noteIt can be separated into five zero couponsecurities maturing after
6 months12 months18 months24 months
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Earlier investment banks used to buy bondsfrom the Treasury and separate the cashflows
Each cash flow was then sold separately as a zerocoupon bondSuch issues are called trademarks
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The issue of trademarks has now ceasedBecause investment banks can now createsuch instruments
In concert with the Treasury itselfThese ZCBs are known as STRIPS ndash
Separate Trading of Registered Interest andPrincipal of Securities
These are not issued or sold by the Treasury
The market is made by investment banks
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What is the motivation to create suchproductsIn practice arbitrage is possible when a
coupon security is purchased at a priceThat is lower than what could be obtained byselling each cash flow separately
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Coupon stripping reflects a case of financialengineering
Creating a risk-return profile that is nototherwise available
An investment bank would buy a largequantity of a Treasury security
The securities would be placed with an SPV
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The SPV is a single-purpose dedicated trustIt has the powers to own the bonds andcollect payments
It cannot sell or lend the bondsIt cannot write options on the bondsOr use them as collateral for borrowing
The SPV is empowered to issue zero coupon
bondsWhere each security represents the ownership ofa single cash flow from the mother bond
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Assume that 100MM USD of 15 year bondswith a coupon of 8 are placed with the SPV
The SPV can issue 6M 12M 18M extending up to14 frac12 year zeroes with a total face value of 4MM
USD eachAnd 15 year zeroes with a total face value of104MM
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The Treasury launched this program in 1985to facilitate the stripping of designatedsecurities
All new T-bonds and notes with a maturity of 10years or more are eligibleThe zeroes created in the process are directobligations of the US government
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The mechanism is as followsA dealer who owns a bond or note can ask theFRB where it is held
To replace it with an equivalent set of STRIPS
representing each payment as a separate securityEach of these securities can be traded independentlyof others
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In 1987 the Treasury started to allow dealersto reverse the process
This is called STRIPS RECONSTUTUTION If a dealer owns STRIPS representing all thecoupon and principal payments of a bond
The FED can on request convert these holdings into asingle position in the corresponding bond
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Each coupon and principal cash flow from aTreasury security is assigned a CUSIP
The mother bond is also assigned a CUSIPThe stripped coupons are known as C-STRIPSThe stripped principal is known as P-STRIPSSupply of a C-STRIP increases over time
because a C-STRIP maturing on a day like 15 FEB
2020 will have the same CUSIP irrespective ofwhich mother bond it has come fromThe original coupon rate is irrelevant
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P-STRIPS always correspond to the originalsecurityThey have a unique CUSIPTheir supply is fixed at the time of issuanceIn practice the prices of long-dated P-STRIPSare a bit higher than those of C-STRIPS withthe same maturity date
One reason is that P-STRIPS are more liquid due
to greater availabilityA $100 face value bond with a coupon of 8 willgenerate C-STRIPS with a face value of $4 but P-STRIPS with a face value of $100
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Another reason why P-STRIPS are in higherdemand is that they allow reconstitutionactivities more easily
Assume that the sum of the STRIPS is cheaper than
the mother bondIf a dealer already has the P-STRIPS only the C-STRIPSneed to be acquiredHowever if he owns some of the C-STRIPS he needs toacquire the P-STRIPS and the remaining C-STRIPSThe facility to reconstitute when profitable is pricedinto the P-STRIPSNote Buy and hold investors will prefer C-STRIPSsince they are priced lower and give a higher yield
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For Plain Vanilla bonds the specifiedcoupon rate is valid for the life of thebond
In the case of Floaters the rate is reset atthe beginning of every periodThe rate will vary directly with thebenchmark
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The rate on a Floater is specified as LIBOR+ 50 bp
The spread is positiveIf it were specified as LIBOR ndash 30bp
The spread will be negativeIf LIBOR rises the rate will increasewhereas if LIBOR falls it will decrease
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In the case of a default risk-free floater theprice will reset to par on a coupon date
It may sell at a premium or discount betweencoupon dates
Consider a floater with a coupon = 5-year T-Bond rate
Assume there are two periods left to maturity
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The price at the end of the first coupon period willbe given by
cT-1 is the coupon one period before maturityyT-1 is the YTM one period before maturity
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On a coupon reset date the YTM = couponBecause we have assumed there is no default riskAny change in the required yield as reflected inthe prevailing YTM
Will also be reflected in the coupon being setIf coupon = yield the bond should sell at par
Thus P T-1 = M
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Once again at T-2 c T-2 = yT-2 and P T-2 = MThis logic can be applied to a bond with anytime remaining till maturityHowever between two coupon dates theprice may not be equal to par
Consider the valuation at T-2+k
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Although c T-2 was set at T-2 and is equal toyT-2
yT-2+k is determined at T-2+k and will reflect theyield prevailing at that time
Thus yT-2+k need not equal c T-2 and may behigher or lower
Hence between two coupon dates a floater maysell at a premium or discount
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Now consider a floater characterized bydefault risk
The risk premium required by the market neednot be constant over time
Assume that at the time of issue YTM = 5-year T-note rate + 75bp
The coupon would have been set equal to thisrate and the bond would have been issued at par
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Six months hence the issue may be perceivedas more risky
YTM = 5-year T-note rate + 95 bpThe coupon will however be set equal to theprevailing 5-year rate + 75 bpIf so the issue will not reset to par at the nextcoupon date
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Floaters may come with a CAP or a FLOOR orBOTH
The CAP is a maximum coupon rateProtects issuers against rising rates
The FLOOR is a minimum coupon rateProtects investors against falling rates
When there is a spread over LIBORThere is a natural floorLIBOR cannot be less than zero
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Who is a primary dealerA PD is a dealer who is authorized to dealdirectly with the Central Bank of the countryIn the US a PD is a bank or securities broker-dealer that directly deals with the FRBNY
Importance of FRBNYIn India a PD deals directly with the RBI
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The Treasury sells bills notes and bonds byway of a competitive auction process
Most of the treasury securities are bought byprimary dealers
Individual investors submit non-competitive bidsand participate on a much smaller scale
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Bids may beCompetitive
Indicate price amp quantity or yield amp quantityNon-competitive
Indicate only quantity
Small investors and individualsgenerally submit non-competitive bids
A non-competitive bidder may not bid for more than$5MM worth of securities in a bill or bond auction
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Primary dealers bid for their accounts andon behalf of their clientsThey usually submit large competitive
bidsBids indicate the maximum price that the bidderis prepared to pay if it is a price based auctionOr the minimum yield that the bidder is
prepared to accept if it is a yield based auction
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The Treasury will net out the totalamount of non-competitive bids
The balance will be allocated to competitivebidders
There are two ways in which securitiescan be allotted
The multiple priceyield auction mechanism
French AuctionsThe uniform priceyield auction mechanism
Dutch Auctions
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Assume that the Treasury is offering 25billion dollars worth of T-bonds
2 billion dollars worth of non-competitive bidshave been receivedSo 23 billion dollars worth of bonds are availableto be offered to the competitive bidders
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There are six competitive bidders who havesubmitted the following yields
The bids have been arranged in ascending orderof yieldIn a price based auction the bids would havebeen arranged in descending order of price
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Bidder Bid Yield Bid Amount
Aggregate Amount
Alpha 5370 30 bn 30 bnBeta 5372 50 bn 80 bn
Gamma 5373 40 bn 12 bn
Delta 5375 80 bn 20 bnCharlie 5375 120 bn 32 bn
Tango 5380 30 bn 35 bn8282014 69
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The aggregate demand equals the amount onoffer at a yield of 5375A multiple yield auction will lead to thefollowing allocation
Alpha will get 3 bn at a yield of 5370Beta will get 5 bn at 5372Gamma will get 4 bn at 5373
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At a yield of 5375 we have only 11 bn left toallocateThere is a demand of 20 bn at this yield
8 bn from Delta and 12 bn from CharlieThus we will allocate 1120 = 55 to eachbidder at this yield
There will be pro-rata allocation
055 of 8 bn or 440 bn will go to Delta055 of 12 bn or 66 bn will go to Charlie
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The highest accepted yield is called the StopYield or High Yield
In this case it is 5375The ratio of bids received to the amountawarded is known as the bid to cover ratio
The higher the ratio the stronger is the auction
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Those who bid more than 5375 will getnothing and are said to be shutout of theauctionSince 1999 the US Treasury has beenconducting only uniform yield auctions
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WI stands for ndash When As and If IssuedThe when issued market is a market forforward trading of a bond
Which has been announced but not yet issuedTrades take place from the date ofannouncement until the actual issue date
Helps bidders to gauge the marketrsquos interestbefore the actual auction
8282014 75
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WI trading has ramifications for the biddingstrategies of market participantsTraders can take both long and shortpositions
Settlement is scheduled for the issue date
8282014 76
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httpslidepdfcomreaderfullfisd-02-a 77115
It has a bearing on the outcome of theauction
It affects the strategy used by a bidder becauseit has an impact on his prior positionBidders who are long in the WI market enter theauction with a Long PositionThose who are short in the WI market enter theauction with a short position
8282014 77
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httpslidepdfcomreaderfullfisd-02-a 78115
The WI market helps in price discoveryIt provides important information on
The strength of demand for the securityAnd on the disparity of biddersrsquo views
This help potential bidders to formulate theirstrategiesAt times a dealer may believe that he hasvery important private information
If so he may not participate in the WI market andwill directly enter the auction with bids based onhis knowledge
8282014 78
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httpslidepdfcomreaderfullfisd-02-a 79115
On or before the date of the auction theissues trade on a yield basis
The actual price can be established only afterthe coupon is set
Starting with the day after the auctionSecurities are quoted on a price basis becausethe coupon is known
8282014 79
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httpslidepdfcomreaderfullfisd-02-a 80115
In a coupon roll a dealer will purchase themost recently issued security from a clientAnd simultaneously sell the same amount ofthe recently announced new security
The first leg with settle on the following dayThe second leg is a forward contract
8282014 80
8112019 FISD-02-A
httpslidepdfcomreaderfullfisd-02-a 81115
There can be a Reverse RollThe dealer will sell the most recent issue fornext day settlementAnd buy the newly announced security forforward settlement
The forward leg in a RollReverse Roll is a WItrade
It will settle on the new issue settlement date
8282014 81
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The roll is the spread between the yield onthe new security and that on the outstandingissue in the same maturity segmentA GIVE in the Roll means that
The WI security provides a higher yield than theoutstanding issue
A Take in the Roll means thatThe WI security provides a lower yield
8282014 82
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httpslidepdfcomreaderfullfisd-02-a 83115
8112019 FISD-02-A
httpslidepdfcomreaderfullfisd-02-a 84115
On March 17 20XX the Treasury announcedthe auction of a 2-year note
The auction was scheduled for March 24The settlement date was March 31
Trading of the roll began as soon as the issuewas announcedA Give of 5 bp means that the dealer proposes tobuy the current issue at the prevailing yieldAnd sell the new issue at a yield that is 5 bpmoreA Take of 5 bp means that the dealer proposes tosell the new issue at a yield that is 5bp lower
8282014 84
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httpslidepdfcomreaderfullfisd-02-a 85115
The roll achieves the followingHe acquires the outstanding issue for next daysettlementHe sells the to be issued security with the samepar value for forward delivery on 31 March
The customer is rolling over the investmentfrom the current issue to the new issue
This extends the maturity of the investment byone month
8282014 85
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The client can invest the funds received tillthe new issue settlesHowever he loses the accrued interest thathe would have earned had he held on to theissue
8282014 86
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httpslidepdfcomreaderfullfisd-02-a 87115
The Treasury per se does not issue zerocoupon securitiesBut zero coupon securities can be created
which are backed by conventional bondsTake a large quantity of a T-note or bond andseparate all the cash flows from each otherSell the entitlement to each cash flowseparately
8282014 87
8112019 FISD-02-A
httpslidepdfcomreaderfullfisd-02-a 88115
Take the case of a two-year T-noteIt can be separated into five zero couponsecurities maturing after
6 months12 months18 months24 months
8282014 88
8112019 FISD-02-A
httpslidepdfcomreaderfullfisd-02-a 89115
Earlier investment banks used to buy bondsfrom the Treasury and separate the cashflows
Each cash flow was then sold separately as a zerocoupon bondSuch issues are called trademarks
8282014 89
8112019 FISD-02-A
httpslidepdfcomreaderfullfisd-02-a 90115
The issue of trademarks has now ceasedBecause investment banks can now createsuch instruments
In concert with the Treasury itselfThese ZCBs are known as STRIPS ndash
Separate Trading of Registered Interest andPrincipal of Securities
These are not issued or sold by the Treasury
The market is made by investment banks
8282014 90
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httpslidepdfcomreaderfullfisd-02-a 91115
What is the motivation to create suchproductsIn practice arbitrage is possible when a
coupon security is purchased at a priceThat is lower than what could be obtained byselling each cash flow separately
8282014 91
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httpslidepdfcomreaderfullfisd-02-a 92115
Coupon stripping reflects a case of financialengineering
Creating a risk-return profile that is nototherwise available
An investment bank would buy a largequantity of a Treasury security
The securities would be placed with an SPV
8282014 92
8112019 FISD-02-A
httpslidepdfcomreaderfullfisd-02-a 93115
The SPV is a single-purpose dedicated trustIt has the powers to own the bonds andcollect payments
It cannot sell or lend the bondsIt cannot write options on the bondsOr use them as collateral for borrowing
The SPV is empowered to issue zero coupon
bondsWhere each security represents the ownership ofa single cash flow from the mother bond
8282014 93
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httpslidepdfcomreaderfullfisd-02-a 94115
Assume that 100MM USD of 15 year bondswith a coupon of 8 are placed with the SPV
The SPV can issue 6M 12M 18M extending up to14 frac12 year zeroes with a total face value of 4MM
USD eachAnd 15 year zeroes with a total face value of104MM
8282014 94
8112019 FISD-02-A
httpslidepdfcomreaderfullfisd-02-a 95115
8112019 FISD-02-A
httpslidepdfcomreaderfullfisd-02-a 96115
8282014 96
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The Treasury launched this program in 1985to facilitate the stripping of designatedsecurities
All new T-bonds and notes with a maturity of 10years or more are eligibleThe zeroes created in the process are directobligations of the US government
8282014 97
8112019 FISD-02-A
httpslidepdfcomreaderfullfisd-02-a 98115
The mechanism is as followsA dealer who owns a bond or note can ask theFRB where it is held
To replace it with an equivalent set of STRIPS
representing each payment as a separate securityEach of these securities can be traded independentlyof others
8282014 98
8112019 FISD-02-A
httpslidepdfcomreaderfullfisd-02-a 99115
In 1987 the Treasury started to allow dealersto reverse the process
This is called STRIPS RECONSTUTUTION If a dealer owns STRIPS representing all thecoupon and principal payments of a bond
The FED can on request convert these holdings into asingle position in the corresponding bond
8282014 99
8112019 FISD-02-A
httpslidepdfcomreaderfullfisd-02-a 100115
Each coupon and principal cash flow from aTreasury security is assigned a CUSIP
The mother bond is also assigned a CUSIPThe stripped coupons are known as C-STRIPSThe stripped principal is known as P-STRIPSSupply of a C-STRIP increases over time
because a C-STRIP maturing on a day like 15 FEB
2020 will have the same CUSIP irrespective ofwhich mother bond it has come fromThe original coupon rate is irrelevant
8282014 100
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P-STRIPS always correspond to the originalsecurityThey have a unique CUSIPTheir supply is fixed at the time of issuanceIn practice the prices of long-dated P-STRIPSare a bit higher than those of C-STRIPS withthe same maturity date
One reason is that P-STRIPS are more liquid due
to greater availabilityA $100 face value bond with a coupon of 8 willgenerate C-STRIPS with a face value of $4 but P-STRIPS with a face value of $100
8282014 101
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Another reason why P-STRIPS are in higherdemand is that they allow reconstitutionactivities more easily
Assume that the sum of the STRIPS is cheaper than
the mother bondIf a dealer already has the P-STRIPS only the C-STRIPSneed to be acquiredHowever if he owns some of the C-STRIPS he needs toacquire the P-STRIPS and the remaining C-STRIPSThe facility to reconstitute when profitable is pricedinto the P-STRIPSNote Buy and hold investors will prefer C-STRIPSsince they are priced lower and give a higher yield
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For Plain Vanilla bonds the specifiedcoupon rate is valid for the life of thebond
In the case of Floaters the rate is reset atthe beginning of every periodThe rate will vary directly with thebenchmark
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The rate on a Floater is specified as LIBOR+ 50 bp
The spread is positiveIf it were specified as LIBOR ndash 30bp
The spread will be negativeIf LIBOR rises the rate will increasewhereas if LIBOR falls it will decrease
8282014 104
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In the case of a default risk-free floater theprice will reset to par on a coupon date
It may sell at a premium or discount betweencoupon dates
Consider a floater with a coupon = 5-year T-Bond rate
Assume there are two periods left to maturity
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8282014 106
The price at the end of the first coupon period willbe given by
cT-1 is the coupon one period before maturityyT-1 is the YTM one period before maturity
8112019 FISD-02-A
httpslidepdfcomreaderfullfisd-02-a 107115
On a coupon reset date the YTM = couponBecause we have assumed there is no default riskAny change in the required yield as reflected inthe prevailing YTM
Will also be reflected in the coupon being setIf coupon = yield the bond should sell at par
Thus P T-1 = M
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8282014 108
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Once again at T-2 c T-2 = yT-2 and P T-2 = MThis logic can be applied to a bond with anytime remaining till maturityHowever between two coupon dates theprice may not be equal to par
Consider the valuation at T-2+k
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Although c T-2 was set at T-2 and is equal toyT-2
yT-2+k is determined at T-2+k and will reflect theyield prevailing at that time
Thus yT-2+k need not equal c T-2 and may behigher or lower
Hence between two coupon dates a floater maysell at a premium or discount
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Now consider a floater characterized bydefault risk
The risk premium required by the market neednot be constant over time
Assume that at the time of issue YTM = 5-year T-note rate + 75bp
The coupon would have been set equal to thisrate and the bond would have been issued at par
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Six months hence the issue may be perceivedas more risky
YTM = 5-year T-note rate + 95 bpThe coupon will however be set equal to theprevailing 5-year rate + 75 bpIf so the issue will not reset to par at the nextcoupon date
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Floaters may come with a CAP or a FLOOR orBOTH
The CAP is a maximum coupon rateProtects issuers against rising rates
The FLOOR is a minimum coupon rateProtects investors against falling rates
When there is a spread over LIBORThere is a natural floorLIBOR cannot be less than zero
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8112019 FISD-02-A
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The Treasury sells bills notes and bonds byway of a competitive auction process
Most of the treasury securities are bought byprimary dealers
Individual investors submit non-competitive bidsand participate on a much smaller scale
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Bids may beCompetitive
Indicate price amp quantity or yield amp quantityNon-competitive
Indicate only quantity
Small investors and individualsgenerally submit non-competitive bids
A non-competitive bidder may not bid for more than$5MM worth of securities in a bill or bond auction
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Primary dealers bid for their accounts andon behalf of their clientsThey usually submit large competitive
bidsBids indicate the maximum price that the bidderis prepared to pay if it is a price based auctionOr the minimum yield that the bidder is
prepared to accept if it is a yield based auction
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The Treasury will net out the totalamount of non-competitive bids
The balance will be allocated to competitivebidders
There are two ways in which securitiescan be allotted
The multiple priceyield auction mechanism
French AuctionsThe uniform priceyield auction mechanism
Dutch Auctions
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Assume that the Treasury is offering 25billion dollars worth of T-bonds
2 billion dollars worth of non-competitive bidshave been receivedSo 23 billion dollars worth of bonds are availableto be offered to the competitive bidders
8282014 67
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There are six competitive bidders who havesubmitted the following yields
The bids have been arranged in ascending orderof yieldIn a price based auction the bids would havebeen arranged in descending order of price
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Bidder Bid Yield Bid Amount
Aggregate Amount
Alpha 5370 30 bn 30 bnBeta 5372 50 bn 80 bn
Gamma 5373 40 bn 12 bn
Delta 5375 80 bn 20 bnCharlie 5375 120 bn 32 bn
Tango 5380 30 bn 35 bn8282014 69
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The aggregate demand equals the amount onoffer at a yield of 5375A multiple yield auction will lead to thefollowing allocation
Alpha will get 3 bn at a yield of 5370Beta will get 5 bn at 5372Gamma will get 4 bn at 5373
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At a yield of 5375 we have only 11 bn left toallocateThere is a demand of 20 bn at this yield
8 bn from Delta and 12 bn from CharlieThus we will allocate 1120 = 55 to eachbidder at this yield
There will be pro-rata allocation
055 of 8 bn or 440 bn will go to Delta055 of 12 bn or 66 bn will go to Charlie
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The highest accepted yield is called the StopYield or High Yield
In this case it is 5375The ratio of bids received to the amountawarded is known as the bid to cover ratio
The higher the ratio the stronger is the auction
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8112019 FISD-02-A
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Those who bid more than 5375 will getnothing and are said to be shutout of theauctionSince 1999 the US Treasury has beenconducting only uniform yield auctions
8282014 74
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httpslidepdfcomreaderfullfisd-02-a 75115
WI stands for ndash When As and If IssuedThe when issued market is a market forforward trading of a bond
Which has been announced but not yet issuedTrades take place from the date ofannouncement until the actual issue date
Helps bidders to gauge the marketrsquos interestbefore the actual auction
8282014 75
8112019 FISD-02-A
httpslidepdfcomreaderfullfisd-02-a 76115
WI trading has ramifications for the biddingstrategies of market participantsTraders can take both long and shortpositions
Settlement is scheduled for the issue date
8282014 76
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httpslidepdfcomreaderfullfisd-02-a 77115
It has a bearing on the outcome of theauction
It affects the strategy used by a bidder becauseit has an impact on his prior positionBidders who are long in the WI market enter theauction with a Long PositionThose who are short in the WI market enter theauction with a short position
8282014 77
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httpslidepdfcomreaderfullfisd-02-a 78115
The WI market helps in price discoveryIt provides important information on
The strength of demand for the securityAnd on the disparity of biddersrsquo views
This help potential bidders to formulate theirstrategiesAt times a dealer may believe that he hasvery important private information
If so he may not participate in the WI market andwill directly enter the auction with bids based onhis knowledge
8282014 78
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httpslidepdfcomreaderfullfisd-02-a 79115
On or before the date of the auction theissues trade on a yield basis
The actual price can be established only afterthe coupon is set
Starting with the day after the auctionSecurities are quoted on a price basis becausethe coupon is known
8282014 79
8112019 FISD-02-A
httpslidepdfcomreaderfullfisd-02-a 80115
In a coupon roll a dealer will purchase themost recently issued security from a clientAnd simultaneously sell the same amount ofthe recently announced new security
The first leg with settle on the following dayThe second leg is a forward contract
8282014 80
8112019 FISD-02-A
httpslidepdfcomreaderfullfisd-02-a 81115
There can be a Reverse RollThe dealer will sell the most recent issue fornext day settlementAnd buy the newly announced security forforward settlement
The forward leg in a RollReverse Roll is a WItrade
It will settle on the new issue settlement date
8282014 81
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The roll is the spread between the yield onthe new security and that on the outstandingissue in the same maturity segmentA GIVE in the Roll means that
The WI security provides a higher yield than theoutstanding issue
A Take in the Roll means thatThe WI security provides a lower yield
8282014 82
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httpslidepdfcomreaderfullfisd-02-a 83115
8112019 FISD-02-A
httpslidepdfcomreaderfullfisd-02-a 84115
On March 17 20XX the Treasury announcedthe auction of a 2-year note
The auction was scheduled for March 24The settlement date was March 31
Trading of the roll began as soon as the issuewas announcedA Give of 5 bp means that the dealer proposes tobuy the current issue at the prevailing yieldAnd sell the new issue at a yield that is 5 bpmoreA Take of 5 bp means that the dealer proposes tosell the new issue at a yield that is 5bp lower
8282014 84
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The roll achieves the followingHe acquires the outstanding issue for next daysettlementHe sells the to be issued security with the samepar value for forward delivery on 31 March
The customer is rolling over the investmentfrom the current issue to the new issue
This extends the maturity of the investment byone month
8282014 85
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The client can invest the funds received tillthe new issue settlesHowever he loses the accrued interest thathe would have earned had he held on to theissue
8282014 86
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httpslidepdfcomreaderfullfisd-02-a 87115
The Treasury per se does not issue zerocoupon securitiesBut zero coupon securities can be created
which are backed by conventional bondsTake a large quantity of a T-note or bond andseparate all the cash flows from each otherSell the entitlement to each cash flowseparately
8282014 87
8112019 FISD-02-A
httpslidepdfcomreaderfullfisd-02-a 88115
Take the case of a two-year T-noteIt can be separated into five zero couponsecurities maturing after
6 months12 months18 months24 months
8282014 88
8112019 FISD-02-A
httpslidepdfcomreaderfullfisd-02-a 89115
Earlier investment banks used to buy bondsfrom the Treasury and separate the cashflows
Each cash flow was then sold separately as a zerocoupon bondSuch issues are called trademarks
8282014 89
8112019 FISD-02-A
httpslidepdfcomreaderfullfisd-02-a 90115
The issue of trademarks has now ceasedBecause investment banks can now createsuch instruments
In concert with the Treasury itselfThese ZCBs are known as STRIPS ndash
Separate Trading of Registered Interest andPrincipal of Securities
These are not issued or sold by the Treasury
The market is made by investment banks
8282014 90
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httpslidepdfcomreaderfullfisd-02-a 91115
What is the motivation to create suchproductsIn practice arbitrage is possible when a
coupon security is purchased at a priceThat is lower than what could be obtained byselling each cash flow separately
8282014 91
8112019 FISD-02-A
httpslidepdfcomreaderfullfisd-02-a 92115
Coupon stripping reflects a case of financialengineering
Creating a risk-return profile that is nototherwise available
An investment bank would buy a largequantity of a Treasury security
The securities would be placed with an SPV
8282014 92
8112019 FISD-02-A
httpslidepdfcomreaderfullfisd-02-a 93115
The SPV is a single-purpose dedicated trustIt has the powers to own the bonds andcollect payments
It cannot sell or lend the bondsIt cannot write options on the bondsOr use them as collateral for borrowing
The SPV is empowered to issue zero coupon
bondsWhere each security represents the ownership ofa single cash flow from the mother bond
8282014 93
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Assume that 100MM USD of 15 year bondswith a coupon of 8 are placed with the SPV
The SPV can issue 6M 12M 18M extending up to14 frac12 year zeroes with a total face value of 4MM
USD eachAnd 15 year zeroes with a total face value of104MM
8282014 94
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8112019 FISD-02-A
httpslidepdfcomreaderfullfisd-02-a 96115
8282014 96
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The Treasury launched this program in 1985to facilitate the stripping of designatedsecurities
All new T-bonds and notes with a maturity of 10years or more are eligibleThe zeroes created in the process are directobligations of the US government
8282014 97
8112019 FISD-02-A
httpslidepdfcomreaderfullfisd-02-a 98115
The mechanism is as followsA dealer who owns a bond or note can ask theFRB where it is held
To replace it with an equivalent set of STRIPS
representing each payment as a separate securityEach of these securities can be traded independentlyof others
8282014 98
8112019 FISD-02-A
httpslidepdfcomreaderfullfisd-02-a 99115
In 1987 the Treasury started to allow dealersto reverse the process
This is called STRIPS RECONSTUTUTION If a dealer owns STRIPS representing all thecoupon and principal payments of a bond
The FED can on request convert these holdings into asingle position in the corresponding bond
8282014 99
8112019 FISD-02-A
httpslidepdfcomreaderfullfisd-02-a 100115
Each coupon and principal cash flow from aTreasury security is assigned a CUSIP
The mother bond is also assigned a CUSIPThe stripped coupons are known as C-STRIPSThe stripped principal is known as P-STRIPSSupply of a C-STRIP increases over time
because a C-STRIP maturing on a day like 15 FEB
2020 will have the same CUSIP irrespective ofwhich mother bond it has come fromThe original coupon rate is irrelevant
8282014 100
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P-STRIPS always correspond to the originalsecurityThey have a unique CUSIPTheir supply is fixed at the time of issuanceIn practice the prices of long-dated P-STRIPSare a bit higher than those of C-STRIPS withthe same maturity date
One reason is that P-STRIPS are more liquid due
to greater availabilityA $100 face value bond with a coupon of 8 willgenerate C-STRIPS with a face value of $4 but P-STRIPS with a face value of $100
8282014 101
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Another reason why P-STRIPS are in higherdemand is that they allow reconstitutionactivities more easily
Assume that the sum of the STRIPS is cheaper than
the mother bondIf a dealer already has the P-STRIPS only the C-STRIPSneed to be acquiredHowever if he owns some of the C-STRIPS he needs toacquire the P-STRIPS and the remaining C-STRIPSThe facility to reconstitute when profitable is pricedinto the P-STRIPSNote Buy and hold investors will prefer C-STRIPSsince they are priced lower and give a higher yield
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For Plain Vanilla bonds the specifiedcoupon rate is valid for the life of thebond
In the case of Floaters the rate is reset atthe beginning of every periodThe rate will vary directly with thebenchmark
8282014 103
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The rate on a Floater is specified as LIBOR+ 50 bp
The spread is positiveIf it were specified as LIBOR ndash 30bp
The spread will be negativeIf LIBOR rises the rate will increasewhereas if LIBOR falls it will decrease
8282014 104
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In the case of a default risk-free floater theprice will reset to par on a coupon date
It may sell at a premium or discount betweencoupon dates
Consider a floater with a coupon = 5-year T-Bond rate
Assume there are two periods left to maturity
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8282014 106
The price at the end of the first coupon period willbe given by
cT-1 is the coupon one period before maturityyT-1 is the YTM one period before maturity
8112019 FISD-02-A
httpslidepdfcomreaderfullfisd-02-a 107115
On a coupon reset date the YTM = couponBecause we have assumed there is no default riskAny change in the required yield as reflected inthe prevailing YTM
Will also be reflected in the coupon being setIf coupon = yield the bond should sell at par
Thus P T-1 = M
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Once again at T-2 c T-2 = yT-2 and P T-2 = MThis logic can be applied to a bond with anytime remaining till maturityHowever between two coupon dates theprice may not be equal to par
Consider the valuation at T-2+k
8282014 109
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8282014 110
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Although c T-2 was set at T-2 and is equal toyT-2
yT-2+k is determined at T-2+k and will reflect theyield prevailing at that time
Thus yT-2+k need not equal c T-2 and may behigher or lower
Hence between two coupon dates a floater maysell at a premium or discount
8282014 111
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Now consider a floater characterized bydefault risk
The risk premium required by the market neednot be constant over time
Assume that at the time of issue YTM = 5-year T-note rate + 75bp
The coupon would have been set equal to thisrate and the bond would have been issued at par
8282014 112
8112019 FISD-02-A
httpslidepdfcomreaderfullfisd-02-a 113115
Six months hence the issue may be perceivedas more risky
YTM = 5-year T-note rate + 95 bpThe coupon will however be set equal to theprevailing 5-year rate + 75 bpIf so the issue will not reset to par at the nextcoupon date
8282014 113
8112019 FISD-02-A
httpslidepdfcomreaderfullfisd-02-a 114115
Floaters may come with a CAP or a FLOOR orBOTH
The CAP is a maximum coupon rateProtects issuers against rising rates
The FLOOR is a minimum coupon rateProtects investors against falling rates
When there is a spread over LIBORThere is a natural floorLIBOR cannot be less than zero
8282014 114
8112019 FISD-02-A
httpslidepdfcomreaderfullfisd-02-a 115115
8112019 FISD-02-A
httpslidepdfcomreaderfullfisd-02-a 63115
The Treasury sells bills notes and bonds byway of a competitive auction process
Most of the treasury securities are bought byprimary dealers
Individual investors submit non-competitive bidsand participate on a much smaller scale
8282014 63
8112019 FISD-02-A
httpslidepdfcomreaderfullfisd-02-a 64115
Bids may beCompetitive
Indicate price amp quantity or yield amp quantityNon-competitive
Indicate only quantity
Small investors and individualsgenerally submit non-competitive bids
A non-competitive bidder may not bid for more than$5MM worth of securities in a bill or bond auction
8282014 64
8112019 FISD-02-A
httpslidepdfcomreaderfullfisd-02-a 65115
Primary dealers bid for their accounts andon behalf of their clientsThey usually submit large competitive
bidsBids indicate the maximum price that the bidderis prepared to pay if it is a price based auctionOr the minimum yield that the bidder is
prepared to accept if it is a yield based auction
8282014 65
8112019 FISD-02-A
httpslidepdfcomreaderfullfisd-02-a 66115
The Treasury will net out the totalamount of non-competitive bids
The balance will be allocated to competitivebidders
There are two ways in which securitiescan be allotted
The multiple priceyield auction mechanism
French AuctionsThe uniform priceyield auction mechanism
Dutch Auctions
8282014 66
8112019 FISD-02-A
httpslidepdfcomreaderfullfisd-02-a 67115
Assume that the Treasury is offering 25billion dollars worth of T-bonds
2 billion dollars worth of non-competitive bidshave been receivedSo 23 billion dollars worth of bonds are availableto be offered to the competitive bidders
8282014 67
8112019 FISD-02-A
httpslidepdfcomreaderfullfisd-02-a 68115
There are six competitive bidders who havesubmitted the following yields
The bids have been arranged in ascending orderof yieldIn a price based auction the bids would havebeen arranged in descending order of price
8282014 68
8112019 FISD-02-A
httpslidepdfcomreaderfullfisd-02-a 69115
Bidder Bid Yield Bid Amount
Aggregate Amount
Alpha 5370 30 bn 30 bnBeta 5372 50 bn 80 bn
Gamma 5373 40 bn 12 bn
Delta 5375 80 bn 20 bnCharlie 5375 120 bn 32 bn
Tango 5380 30 bn 35 bn8282014 69
8112019 FISD-02-A
httpslidepdfcomreaderfullfisd-02-a 70115
The aggregate demand equals the amount onoffer at a yield of 5375A multiple yield auction will lead to thefollowing allocation
Alpha will get 3 bn at a yield of 5370Beta will get 5 bn at 5372Gamma will get 4 bn at 5373
8282014 70
8112019 FISD-02-A
httpslidepdfcomreaderfullfisd-02-a 71115
At a yield of 5375 we have only 11 bn left toallocateThere is a demand of 20 bn at this yield
8 bn from Delta and 12 bn from CharlieThus we will allocate 1120 = 55 to eachbidder at this yield
There will be pro-rata allocation
055 of 8 bn or 440 bn will go to Delta055 of 12 bn or 66 bn will go to Charlie
8282014 71
8112019 FISD-02-A
httpslidepdfcomreaderfullfisd-02-a 72115
The highest accepted yield is called the StopYield or High Yield
In this case it is 5375The ratio of bids received to the amountawarded is known as the bid to cover ratio
The higher the ratio the stronger is the auction
8282014 72
8112019 FISD-02-A
httpslidepdfcomreaderfullfisd-02-a 73115
8112019 FISD-02-A
httpslidepdfcomreaderfullfisd-02-a 74115
Those who bid more than 5375 will getnothing and are said to be shutout of theauctionSince 1999 the US Treasury has beenconducting only uniform yield auctions
8282014 74
8112019 FISD-02-A
httpslidepdfcomreaderfullfisd-02-a 75115
WI stands for ndash When As and If IssuedThe when issued market is a market forforward trading of a bond
Which has been announced but not yet issuedTrades take place from the date ofannouncement until the actual issue date
Helps bidders to gauge the marketrsquos interestbefore the actual auction
8282014 75
8112019 FISD-02-A
httpslidepdfcomreaderfullfisd-02-a 76115
WI trading has ramifications for the biddingstrategies of market participantsTraders can take both long and shortpositions
Settlement is scheduled for the issue date
8282014 76
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httpslidepdfcomreaderfullfisd-02-a 77115
It has a bearing on the outcome of theauction
It affects the strategy used by a bidder becauseit has an impact on his prior positionBidders who are long in the WI market enter theauction with a Long PositionThose who are short in the WI market enter theauction with a short position
8282014 77
8112019 FISD-02-A
httpslidepdfcomreaderfullfisd-02-a 78115
The WI market helps in price discoveryIt provides important information on
The strength of demand for the securityAnd on the disparity of biddersrsquo views
This help potential bidders to formulate theirstrategiesAt times a dealer may believe that he hasvery important private information
If so he may not participate in the WI market andwill directly enter the auction with bids based onhis knowledge
8282014 78
8112019 FISD-02-A
httpslidepdfcomreaderfullfisd-02-a 79115
On or before the date of the auction theissues trade on a yield basis
The actual price can be established only afterthe coupon is set
Starting with the day after the auctionSecurities are quoted on a price basis becausethe coupon is known
8282014 79
8112019 FISD-02-A
httpslidepdfcomreaderfullfisd-02-a 80115
In a coupon roll a dealer will purchase themost recently issued security from a clientAnd simultaneously sell the same amount ofthe recently announced new security
The first leg with settle on the following dayThe second leg is a forward contract
8282014 80
8112019 FISD-02-A
httpslidepdfcomreaderfullfisd-02-a 81115
There can be a Reverse RollThe dealer will sell the most recent issue fornext day settlementAnd buy the newly announced security forforward settlement
The forward leg in a RollReverse Roll is a WItrade
It will settle on the new issue settlement date
8282014 81
8112019 FISD-02-A
httpslidepdfcomreaderfullfisd-02-a 82115
The roll is the spread between the yield onthe new security and that on the outstandingissue in the same maturity segmentA GIVE in the Roll means that
The WI security provides a higher yield than theoutstanding issue
A Take in the Roll means thatThe WI security provides a lower yield
8282014 82
8112019 FISD-02-A
httpslidepdfcomreaderfullfisd-02-a 83115
8112019 FISD-02-A
httpslidepdfcomreaderfullfisd-02-a 84115
On March 17 20XX the Treasury announcedthe auction of a 2-year note
The auction was scheduled for March 24The settlement date was March 31
Trading of the roll began as soon as the issuewas announcedA Give of 5 bp means that the dealer proposes tobuy the current issue at the prevailing yieldAnd sell the new issue at a yield that is 5 bpmoreA Take of 5 bp means that the dealer proposes tosell the new issue at a yield that is 5bp lower
8282014 84
8112019 FISD-02-A
httpslidepdfcomreaderfullfisd-02-a 85115
The roll achieves the followingHe acquires the outstanding issue for next daysettlementHe sells the to be issued security with the samepar value for forward delivery on 31 March
The customer is rolling over the investmentfrom the current issue to the new issue
This extends the maturity of the investment byone month
8282014 85
8112019 FISD-02-A
httpslidepdfcomreaderfullfisd-02-a 86115
The client can invest the funds received tillthe new issue settlesHowever he loses the accrued interest thathe would have earned had he held on to theissue
8282014 86
8112019 FISD-02-A
httpslidepdfcomreaderfullfisd-02-a 87115
The Treasury per se does not issue zerocoupon securitiesBut zero coupon securities can be created
which are backed by conventional bondsTake a large quantity of a T-note or bond andseparate all the cash flows from each otherSell the entitlement to each cash flowseparately
8282014 87
8112019 FISD-02-A
httpslidepdfcomreaderfullfisd-02-a 88115
Take the case of a two-year T-noteIt can be separated into five zero couponsecurities maturing after
6 months12 months18 months24 months
8282014 88
8112019 FISD-02-A
httpslidepdfcomreaderfullfisd-02-a 89115
Earlier investment banks used to buy bondsfrom the Treasury and separate the cashflows
Each cash flow was then sold separately as a zerocoupon bondSuch issues are called trademarks
8282014 89
8112019 FISD-02-A
httpslidepdfcomreaderfullfisd-02-a 90115
The issue of trademarks has now ceasedBecause investment banks can now createsuch instruments
In concert with the Treasury itselfThese ZCBs are known as STRIPS ndash
Separate Trading of Registered Interest andPrincipal of Securities
These are not issued or sold by the Treasury
The market is made by investment banks
8282014 90
8112019 FISD-02-A
httpslidepdfcomreaderfullfisd-02-a 91115
What is the motivation to create suchproductsIn practice arbitrage is possible when a
coupon security is purchased at a priceThat is lower than what could be obtained byselling each cash flow separately
8282014 91
8112019 FISD-02-A
httpslidepdfcomreaderfullfisd-02-a 92115
Coupon stripping reflects a case of financialengineering
Creating a risk-return profile that is nototherwise available
An investment bank would buy a largequantity of a Treasury security
The securities would be placed with an SPV
8282014 92
8112019 FISD-02-A
httpslidepdfcomreaderfullfisd-02-a 93115
The SPV is a single-purpose dedicated trustIt has the powers to own the bonds andcollect payments
It cannot sell or lend the bondsIt cannot write options on the bondsOr use them as collateral for borrowing
The SPV is empowered to issue zero coupon
bondsWhere each security represents the ownership ofa single cash flow from the mother bond
8282014 93
8112019 FISD-02-A
httpslidepdfcomreaderfullfisd-02-a 94115
Assume that 100MM USD of 15 year bondswith a coupon of 8 are placed with the SPV
The SPV can issue 6M 12M 18M extending up to14 frac12 year zeroes with a total face value of 4MM
USD eachAnd 15 year zeroes with a total face value of104MM
8282014 94
8112019 FISD-02-A
httpslidepdfcomreaderfullfisd-02-a 95115
8112019 FISD-02-A
httpslidepdfcomreaderfullfisd-02-a 96115
8282014 96
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The Treasury launched this program in 1985to facilitate the stripping of designatedsecurities
All new T-bonds and notes with a maturity of 10years or more are eligibleThe zeroes created in the process are directobligations of the US government
8282014 97
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httpslidepdfcomreaderfullfisd-02-a 98115
The mechanism is as followsA dealer who owns a bond or note can ask theFRB where it is held
To replace it with an equivalent set of STRIPS
representing each payment as a separate securityEach of these securities can be traded independentlyof others
8282014 98
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In 1987 the Treasury started to allow dealersto reverse the process
This is called STRIPS RECONSTUTUTION If a dealer owns STRIPS representing all thecoupon and principal payments of a bond
The FED can on request convert these holdings into asingle position in the corresponding bond
8282014 99
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Each coupon and principal cash flow from aTreasury security is assigned a CUSIP
The mother bond is also assigned a CUSIPThe stripped coupons are known as C-STRIPSThe stripped principal is known as P-STRIPSSupply of a C-STRIP increases over time
because a C-STRIP maturing on a day like 15 FEB
2020 will have the same CUSIP irrespective ofwhich mother bond it has come fromThe original coupon rate is irrelevant
8282014 100
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P-STRIPS always correspond to the originalsecurityThey have a unique CUSIPTheir supply is fixed at the time of issuanceIn practice the prices of long-dated P-STRIPSare a bit higher than those of C-STRIPS withthe same maturity date
One reason is that P-STRIPS are more liquid due
to greater availabilityA $100 face value bond with a coupon of 8 willgenerate C-STRIPS with a face value of $4 but P-STRIPS with a face value of $100
8282014 101
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Another reason why P-STRIPS are in higherdemand is that they allow reconstitutionactivities more easily
Assume that the sum of the STRIPS is cheaper than
the mother bondIf a dealer already has the P-STRIPS only the C-STRIPSneed to be acquiredHowever if he owns some of the C-STRIPS he needs toacquire the P-STRIPS and the remaining C-STRIPSThe facility to reconstitute when profitable is pricedinto the P-STRIPSNote Buy and hold investors will prefer C-STRIPSsince they are priced lower and give a higher yield
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For Plain Vanilla bonds the specifiedcoupon rate is valid for the life of thebond
In the case of Floaters the rate is reset atthe beginning of every periodThe rate will vary directly with thebenchmark
8282014 103
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The rate on a Floater is specified as LIBOR+ 50 bp
The spread is positiveIf it were specified as LIBOR ndash 30bp
The spread will be negativeIf LIBOR rises the rate will increasewhereas if LIBOR falls it will decrease
8282014 104
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In the case of a default risk-free floater theprice will reset to par on a coupon date
It may sell at a premium or discount betweencoupon dates
Consider a floater with a coupon = 5-year T-Bond rate
Assume there are two periods left to maturity
8282014 105
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8282014 106
The price at the end of the first coupon period willbe given by
cT-1 is the coupon one period before maturityyT-1 is the YTM one period before maturity
8112019 FISD-02-A
httpslidepdfcomreaderfullfisd-02-a 107115
On a coupon reset date the YTM = couponBecause we have assumed there is no default riskAny change in the required yield as reflected inthe prevailing YTM
Will also be reflected in the coupon being setIf coupon = yield the bond should sell at par
Thus P T-1 = M
8282014 107
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8282014 108
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Once again at T-2 c T-2 = yT-2 and P T-2 = MThis logic can be applied to a bond with anytime remaining till maturityHowever between two coupon dates theprice may not be equal to par
Consider the valuation at T-2+k
8282014 109
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8282014 110
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Although c T-2 was set at T-2 and is equal toyT-2
yT-2+k is determined at T-2+k and will reflect theyield prevailing at that time
Thus yT-2+k need not equal c T-2 and may behigher or lower
Hence between two coupon dates a floater maysell at a premium or discount
8282014 111
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httpslidepdfcomreaderfullfisd-02-a 112115
Now consider a floater characterized bydefault risk
The risk premium required by the market neednot be constant over time
Assume that at the time of issue YTM = 5-year T-note rate + 75bp
The coupon would have been set equal to thisrate and the bond would have been issued at par
8282014 112
8112019 FISD-02-A
httpslidepdfcomreaderfullfisd-02-a 113115
Six months hence the issue may be perceivedas more risky
YTM = 5-year T-note rate + 95 bpThe coupon will however be set equal to theprevailing 5-year rate + 75 bpIf so the issue will not reset to par at the nextcoupon date
8282014 113
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httpslidepdfcomreaderfullfisd-02-a 114115
Floaters may come with a CAP or a FLOOR orBOTH
The CAP is a maximum coupon rateProtects issuers against rising rates
The FLOOR is a minimum coupon rateProtects investors against falling rates
When there is a spread over LIBORThere is a natural floorLIBOR cannot be less than zero
8282014 114
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httpslidepdfcomreaderfullfisd-02-a 115115
8112019 FISD-02-A
httpslidepdfcomreaderfullfisd-02-a 64115
Bids may beCompetitive
Indicate price amp quantity or yield amp quantityNon-competitive
Indicate only quantity
Small investors and individualsgenerally submit non-competitive bids
A non-competitive bidder may not bid for more than$5MM worth of securities in a bill or bond auction
8282014 64
8112019 FISD-02-A
httpslidepdfcomreaderfullfisd-02-a 65115
Primary dealers bid for their accounts andon behalf of their clientsThey usually submit large competitive
bidsBids indicate the maximum price that the bidderis prepared to pay if it is a price based auctionOr the minimum yield that the bidder is
prepared to accept if it is a yield based auction
8282014 65
8112019 FISD-02-A
httpslidepdfcomreaderfullfisd-02-a 66115
The Treasury will net out the totalamount of non-competitive bids
The balance will be allocated to competitivebidders
There are two ways in which securitiescan be allotted
The multiple priceyield auction mechanism
French AuctionsThe uniform priceyield auction mechanism
Dutch Auctions
8282014 66
8112019 FISD-02-A
httpslidepdfcomreaderfullfisd-02-a 67115
Assume that the Treasury is offering 25billion dollars worth of T-bonds
2 billion dollars worth of non-competitive bidshave been receivedSo 23 billion dollars worth of bonds are availableto be offered to the competitive bidders
8282014 67
8112019 FISD-02-A
httpslidepdfcomreaderfullfisd-02-a 68115
There are six competitive bidders who havesubmitted the following yields
The bids have been arranged in ascending orderof yieldIn a price based auction the bids would havebeen arranged in descending order of price
8282014 68
8112019 FISD-02-A
httpslidepdfcomreaderfullfisd-02-a 69115
Bidder Bid Yield Bid Amount
Aggregate Amount
Alpha 5370 30 bn 30 bnBeta 5372 50 bn 80 bn
Gamma 5373 40 bn 12 bn
Delta 5375 80 bn 20 bnCharlie 5375 120 bn 32 bn
Tango 5380 30 bn 35 bn8282014 69
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httpslidepdfcomreaderfullfisd-02-a 70115
The aggregate demand equals the amount onoffer at a yield of 5375A multiple yield auction will lead to thefollowing allocation
Alpha will get 3 bn at a yield of 5370Beta will get 5 bn at 5372Gamma will get 4 bn at 5373
8282014 70
8112019 FISD-02-A
httpslidepdfcomreaderfullfisd-02-a 71115
At a yield of 5375 we have only 11 bn left toallocateThere is a demand of 20 bn at this yield
8 bn from Delta and 12 bn from CharlieThus we will allocate 1120 = 55 to eachbidder at this yield
There will be pro-rata allocation
055 of 8 bn or 440 bn will go to Delta055 of 12 bn or 66 bn will go to Charlie
8282014 71
8112019 FISD-02-A
httpslidepdfcomreaderfullfisd-02-a 72115
The highest accepted yield is called the StopYield or High Yield
In this case it is 5375The ratio of bids received to the amountawarded is known as the bid to cover ratio
The higher the ratio the stronger is the auction
8282014 72
8112019 FISD-02-A
httpslidepdfcomreaderfullfisd-02-a 73115
8112019 FISD-02-A
httpslidepdfcomreaderfullfisd-02-a 74115
Those who bid more than 5375 will getnothing and are said to be shutout of theauctionSince 1999 the US Treasury has beenconducting only uniform yield auctions
8282014 74
8112019 FISD-02-A
httpslidepdfcomreaderfullfisd-02-a 75115
WI stands for ndash When As and If IssuedThe when issued market is a market forforward trading of a bond
Which has been announced but not yet issuedTrades take place from the date ofannouncement until the actual issue date
Helps bidders to gauge the marketrsquos interestbefore the actual auction
8282014 75
8112019 FISD-02-A
httpslidepdfcomreaderfullfisd-02-a 76115
WI trading has ramifications for the biddingstrategies of market participantsTraders can take both long and shortpositions
Settlement is scheduled for the issue date
8282014 76
8112019 FISD-02-A
httpslidepdfcomreaderfullfisd-02-a 77115
It has a bearing on the outcome of theauction
It affects the strategy used by a bidder becauseit has an impact on his prior positionBidders who are long in the WI market enter theauction with a Long PositionThose who are short in the WI market enter theauction with a short position
8282014 77
8112019 FISD-02-A
httpslidepdfcomreaderfullfisd-02-a 78115
The WI market helps in price discoveryIt provides important information on
The strength of demand for the securityAnd on the disparity of biddersrsquo views
This help potential bidders to formulate theirstrategiesAt times a dealer may believe that he hasvery important private information
If so he may not participate in the WI market andwill directly enter the auction with bids based onhis knowledge
8282014 78
8112019 FISD-02-A
httpslidepdfcomreaderfullfisd-02-a 79115
On or before the date of the auction theissues trade on a yield basis
The actual price can be established only afterthe coupon is set
Starting with the day after the auctionSecurities are quoted on a price basis becausethe coupon is known
8282014 79
8112019 FISD-02-A
httpslidepdfcomreaderfullfisd-02-a 80115
In a coupon roll a dealer will purchase themost recently issued security from a clientAnd simultaneously sell the same amount ofthe recently announced new security
The first leg with settle on the following dayThe second leg is a forward contract
8282014 80
8112019 FISD-02-A
httpslidepdfcomreaderfullfisd-02-a 81115
There can be a Reverse RollThe dealer will sell the most recent issue fornext day settlementAnd buy the newly announced security forforward settlement
The forward leg in a RollReverse Roll is a WItrade
It will settle on the new issue settlement date
8282014 81
8112019 FISD-02-A
httpslidepdfcomreaderfullfisd-02-a 82115
The roll is the spread between the yield onthe new security and that on the outstandingissue in the same maturity segmentA GIVE in the Roll means that
The WI security provides a higher yield than theoutstanding issue
A Take in the Roll means thatThe WI security provides a lower yield
8282014 82
8112019 FISD-02-A
httpslidepdfcomreaderfullfisd-02-a 83115
8112019 FISD-02-A
httpslidepdfcomreaderfullfisd-02-a 84115
On March 17 20XX the Treasury announcedthe auction of a 2-year note
The auction was scheduled for March 24The settlement date was March 31
Trading of the roll began as soon as the issuewas announcedA Give of 5 bp means that the dealer proposes tobuy the current issue at the prevailing yieldAnd sell the new issue at a yield that is 5 bpmoreA Take of 5 bp means that the dealer proposes tosell the new issue at a yield that is 5bp lower
8282014 84
8112019 FISD-02-A
httpslidepdfcomreaderfullfisd-02-a 85115
The roll achieves the followingHe acquires the outstanding issue for next daysettlementHe sells the to be issued security with the samepar value for forward delivery on 31 March
The customer is rolling over the investmentfrom the current issue to the new issue
This extends the maturity of the investment byone month
8282014 85
8112019 FISD-02-A
httpslidepdfcomreaderfullfisd-02-a 86115
The client can invest the funds received tillthe new issue settlesHowever he loses the accrued interest thathe would have earned had he held on to theissue
8282014 86
8112019 FISD-02-A
httpslidepdfcomreaderfullfisd-02-a 87115
The Treasury per se does not issue zerocoupon securitiesBut zero coupon securities can be created
which are backed by conventional bondsTake a large quantity of a T-note or bond andseparate all the cash flows from each otherSell the entitlement to each cash flowseparately
8282014 87
8112019 FISD-02-A
httpslidepdfcomreaderfullfisd-02-a 88115
Take the case of a two-year T-noteIt can be separated into five zero couponsecurities maturing after
6 months12 months18 months24 months
8282014 88
8112019 FISD-02-A
httpslidepdfcomreaderfullfisd-02-a 89115
Earlier investment banks used to buy bondsfrom the Treasury and separate the cashflows
Each cash flow was then sold separately as a zerocoupon bondSuch issues are called trademarks
8282014 89
8112019 FISD-02-A
httpslidepdfcomreaderfullfisd-02-a 90115
The issue of trademarks has now ceasedBecause investment banks can now createsuch instruments
In concert with the Treasury itselfThese ZCBs are known as STRIPS ndash
Separate Trading of Registered Interest andPrincipal of Securities
These are not issued or sold by the Treasury
The market is made by investment banks
8282014 90
8112019 FISD-02-A
httpslidepdfcomreaderfullfisd-02-a 91115
What is the motivation to create suchproductsIn practice arbitrage is possible when a
coupon security is purchased at a priceThat is lower than what could be obtained byselling each cash flow separately
8282014 91
8112019 FISD-02-A
httpslidepdfcomreaderfullfisd-02-a 92115
Coupon stripping reflects a case of financialengineering
Creating a risk-return profile that is nototherwise available
An investment bank would buy a largequantity of a Treasury security
The securities would be placed with an SPV
8282014 92
8112019 FISD-02-A
httpslidepdfcomreaderfullfisd-02-a 93115
The SPV is a single-purpose dedicated trustIt has the powers to own the bonds andcollect payments
It cannot sell or lend the bondsIt cannot write options on the bondsOr use them as collateral for borrowing
The SPV is empowered to issue zero coupon
bondsWhere each security represents the ownership ofa single cash flow from the mother bond
8282014 93
8112019 FISD-02-A
httpslidepdfcomreaderfullfisd-02-a 94115
Assume that 100MM USD of 15 year bondswith a coupon of 8 are placed with the SPV
The SPV can issue 6M 12M 18M extending up to14 frac12 year zeroes with a total face value of 4MM
USD eachAnd 15 year zeroes with a total face value of104MM
8282014 94
8112019 FISD-02-A
httpslidepdfcomreaderfullfisd-02-a 95115
8112019 FISD-02-A
httpslidepdfcomreaderfullfisd-02-a 96115
8282014 96
8112019 FISD-02-A
httpslidepdfcomreaderfullfisd-02-a 97115
The Treasury launched this program in 1985to facilitate the stripping of designatedsecurities
All new T-bonds and notes with a maturity of 10years or more are eligibleThe zeroes created in the process are directobligations of the US government
8282014 97
8112019 FISD-02-A
httpslidepdfcomreaderfullfisd-02-a 98115
The mechanism is as followsA dealer who owns a bond or note can ask theFRB where it is held
To replace it with an equivalent set of STRIPS
representing each payment as a separate securityEach of these securities can be traded independentlyof others
8282014 98
8112019 FISD-02-A
httpslidepdfcomreaderfullfisd-02-a 99115
In 1987 the Treasury started to allow dealersto reverse the process
This is called STRIPS RECONSTUTUTION If a dealer owns STRIPS representing all thecoupon and principal payments of a bond
The FED can on request convert these holdings into asingle position in the corresponding bond
8282014 99
8112019 FISD-02-A
httpslidepdfcomreaderfullfisd-02-a 100115
Each coupon and principal cash flow from aTreasury security is assigned a CUSIP
The mother bond is also assigned a CUSIPThe stripped coupons are known as C-STRIPSThe stripped principal is known as P-STRIPSSupply of a C-STRIP increases over time
because a C-STRIP maturing on a day like 15 FEB
2020 will have the same CUSIP irrespective ofwhich mother bond it has come fromThe original coupon rate is irrelevant
8282014 100
8112019 FISD-02-A
httpslidepdfcomreaderfullfisd-02-a 101115
P-STRIPS always correspond to the originalsecurityThey have a unique CUSIPTheir supply is fixed at the time of issuanceIn practice the prices of long-dated P-STRIPSare a bit higher than those of C-STRIPS withthe same maturity date
One reason is that P-STRIPS are more liquid due
to greater availabilityA $100 face value bond with a coupon of 8 willgenerate C-STRIPS with a face value of $4 but P-STRIPS with a face value of $100
8282014 101
8112019 FISD-02-A
httpslidepdfcomreaderfullfisd-02-a 102115
Another reason why P-STRIPS are in higherdemand is that they allow reconstitutionactivities more easily
Assume that the sum of the STRIPS is cheaper than
the mother bondIf a dealer already has the P-STRIPS only the C-STRIPSneed to be acquiredHowever if he owns some of the C-STRIPS he needs toacquire the P-STRIPS and the remaining C-STRIPSThe facility to reconstitute when profitable is pricedinto the P-STRIPSNote Buy and hold investors will prefer C-STRIPSsince they are priced lower and give a higher yield
8282014 102
8112019 FISD-02-A
httpslidepdfcomreaderfullfisd-02-a 103115
For Plain Vanilla bonds the specifiedcoupon rate is valid for the life of thebond
In the case of Floaters the rate is reset atthe beginning of every periodThe rate will vary directly with thebenchmark
8282014 103
8112019 FISD-02-A
httpslidepdfcomreaderfullfisd-02-a 104115
The rate on a Floater is specified as LIBOR+ 50 bp
The spread is positiveIf it were specified as LIBOR ndash 30bp
The spread will be negativeIf LIBOR rises the rate will increasewhereas if LIBOR falls it will decrease
8282014 104
8112019 FISD-02-A
httpslidepdfcomreaderfullfisd-02-a 105115
In the case of a default risk-free floater theprice will reset to par on a coupon date
It may sell at a premium or discount betweencoupon dates
Consider a floater with a coupon = 5-year T-Bond rate
Assume there are two periods left to maturity
8282014 105
8112019 FISD-02-A
httpslidepdfcomreaderfullfisd-02-a 106115
8282014 106
The price at the end of the first coupon period willbe given by
cT-1 is the coupon one period before maturityyT-1 is the YTM one period before maturity
8112019 FISD-02-A
httpslidepdfcomreaderfullfisd-02-a 107115
On a coupon reset date the YTM = couponBecause we have assumed there is no default riskAny change in the required yield as reflected inthe prevailing YTM
Will also be reflected in the coupon being setIf coupon = yield the bond should sell at par
Thus P T-1 = M
8282014 107
8112019 FISD-02-A
httpslidepdfcomreaderfullfisd-02-a 108115
8282014 108
8112019 FISD-02-A
httpslidepdfcomreaderfullfisd-02-a 109115
Once again at T-2 c T-2 = yT-2 and P T-2 = MThis logic can be applied to a bond with anytime remaining till maturityHowever between two coupon dates theprice may not be equal to par
Consider the valuation at T-2+k
8282014 109
8112019 FISD-02-A
httpslidepdfcomreaderfullfisd-02-a 110115
8282014 110
8112019 FISD-02-A
httpslidepdfcomreaderfullfisd-02-a 111115
Although c T-2 was set at T-2 and is equal toyT-2
yT-2+k is determined at T-2+k and will reflect theyield prevailing at that time
Thus yT-2+k need not equal c T-2 and may behigher or lower
Hence between two coupon dates a floater maysell at a premium or discount
8282014 111
8112019 FISD-02-A
httpslidepdfcomreaderfullfisd-02-a 112115
Now consider a floater characterized bydefault risk
The risk premium required by the market neednot be constant over time
Assume that at the time of issue YTM = 5-year T-note rate + 75bp
The coupon would have been set equal to thisrate and the bond would have been issued at par
8282014 112
8112019 FISD-02-A
httpslidepdfcomreaderfullfisd-02-a 113115
Six months hence the issue may be perceivedas more risky
YTM = 5-year T-note rate + 95 bpThe coupon will however be set equal to theprevailing 5-year rate + 75 bpIf so the issue will not reset to par at the nextcoupon date
8282014 113
8112019 FISD-02-A
httpslidepdfcomreaderfullfisd-02-a 114115
Floaters may come with a CAP or a FLOOR orBOTH
The CAP is a maximum coupon rateProtects issuers against rising rates
The FLOOR is a minimum coupon rateProtects investors against falling rates
When there is a spread over LIBORThere is a natural floorLIBOR cannot be less than zero
8282014 114
8112019 FISD-02-A
httpslidepdfcomreaderfullfisd-02-a 115115
8112019 FISD-02-A
httpslidepdfcomreaderfullfisd-02-a 65115
Primary dealers bid for their accounts andon behalf of their clientsThey usually submit large competitive
bidsBids indicate the maximum price that the bidderis prepared to pay if it is a price based auctionOr the minimum yield that the bidder is
prepared to accept if it is a yield based auction
8282014 65
8112019 FISD-02-A
httpslidepdfcomreaderfullfisd-02-a 66115
The Treasury will net out the totalamount of non-competitive bids
The balance will be allocated to competitivebidders
There are two ways in which securitiescan be allotted
The multiple priceyield auction mechanism
French AuctionsThe uniform priceyield auction mechanism
Dutch Auctions
8282014 66
8112019 FISD-02-A
httpslidepdfcomreaderfullfisd-02-a 67115
Assume that the Treasury is offering 25billion dollars worth of T-bonds
2 billion dollars worth of non-competitive bidshave been receivedSo 23 billion dollars worth of bonds are availableto be offered to the competitive bidders
8282014 67
8112019 FISD-02-A
httpslidepdfcomreaderfullfisd-02-a 68115
There are six competitive bidders who havesubmitted the following yields
The bids have been arranged in ascending orderof yieldIn a price based auction the bids would havebeen arranged in descending order of price
8282014 68
8112019 FISD-02-A
httpslidepdfcomreaderfullfisd-02-a 69115
Bidder Bid Yield Bid Amount
Aggregate Amount
Alpha 5370 30 bn 30 bnBeta 5372 50 bn 80 bn
Gamma 5373 40 bn 12 bn
Delta 5375 80 bn 20 bnCharlie 5375 120 bn 32 bn
Tango 5380 30 bn 35 bn8282014 69
8112019 FISD-02-A
httpslidepdfcomreaderfullfisd-02-a 70115
The aggregate demand equals the amount onoffer at a yield of 5375A multiple yield auction will lead to thefollowing allocation
Alpha will get 3 bn at a yield of 5370Beta will get 5 bn at 5372Gamma will get 4 bn at 5373
8282014 70
8112019 FISD-02-A
httpslidepdfcomreaderfullfisd-02-a 71115
At a yield of 5375 we have only 11 bn left toallocateThere is a demand of 20 bn at this yield
8 bn from Delta and 12 bn from CharlieThus we will allocate 1120 = 55 to eachbidder at this yield
There will be pro-rata allocation
055 of 8 bn or 440 bn will go to Delta055 of 12 bn or 66 bn will go to Charlie
8282014 71
8112019 FISD-02-A
httpslidepdfcomreaderfullfisd-02-a 72115
The highest accepted yield is called the StopYield or High Yield
In this case it is 5375The ratio of bids received to the amountawarded is known as the bid to cover ratio
The higher the ratio the stronger is the auction
8282014 72
8112019 FISD-02-A
httpslidepdfcomreaderfullfisd-02-a 73115
8112019 FISD-02-A
httpslidepdfcomreaderfullfisd-02-a 74115
Those who bid more than 5375 will getnothing and are said to be shutout of theauctionSince 1999 the US Treasury has beenconducting only uniform yield auctions
8282014 74
8112019 FISD-02-A
httpslidepdfcomreaderfullfisd-02-a 75115
WI stands for ndash When As and If IssuedThe when issued market is a market forforward trading of a bond
Which has been announced but not yet issuedTrades take place from the date ofannouncement until the actual issue date
Helps bidders to gauge the marketrsquos interestbefore the actual auction
8282014 75
8112019 FISD-02-A
httpslidepdfcomreaderfullfisd-02-a 76115
WI trading has ramifications for the biddingstrategies of market participantsTraders can take both long and shortpositions
Settlement is scheduled for the issue date
8282014 76
8112019 FISD-02-A
httpslidepdfcomreaderfullfisd-02-a 77115
It has a bearing on the outcome of theauction
It affects the strategy used by a bidder becauseit has an impact on his prior positionBidders who are long in the WI market enter theauction with a Long PositionThose who are short in the WI market enter theauction with a short position
8282014 77
8112019 FISD-02-A
httpslidepdfcomreaderfullfisd-02-a 78115
The WI market helps in price discoveryIt provides important information on
The strength of demand for the securityAnd on the disparity of biddersrsquo views
This help potential bidders to formulate theirstrategiesAt times a dealer may believe that he hasvery important private information
If so he may not participate in the WI market andwill directly enter the auction with bids based onhis knowledge
8282014 78
8112019 FISD-02-A
httpslidepdfcomreaderfullfisd-02-a 79115
On or before the date of the auction theissues trade on a yield basis
The actual price can be established only afterthe coupon is set
Starting with the day after the auctionSecurities are quoted on a price basis becausethe coupon is known
8282014 79
8112019 FISD-02-A
httpslidepdfcomreaderfullfisd-02-a 80115
In a coupon roll a dealer will purchase themost recently issued security from a clientAnd simultaneously sell the same amount ofthe recently announced new security
The first leg with settle on the following dayThe second leg is a forward contract
8282014 80
8112019 FISD-02-A
httpslidepdfcomreaderfullfisd-02-a 81115
There can be a Reverse RollThe dealer will sell the most recent issue fornext day settlementAnd buy the newly announced security forforward settlement
The forward leg in a RollReverse Roll is a WItrade
It will settle on the new issue settlement date
8282014 81
8112019 FISD-02-A
httpslidepdfcomreaderfullfisd-02-a 82115
The roll is the spread between the yield onthe new security and that on the outstandingissue in the same maturity segmentA GIVE in the Roll means that
The WI security provides a higher yield than theoutstanding issue
A Take in the Roll means thatThe WI security provides a lower yield
8282014 82
8112019 FISD-02-A
httpslidepdfcomreaderfullfisd-02-a 83115
8112019 FISD-02-A
httpslidepdfcomreaderfullfisd-02-a 84115
On March 17 20XX the Treasury announcedthe auction of a 2-year note
The auction was scheduled for March 24The settlement date was March 31
Trading of the roll began as soon as the issuewas announcedA Give of 5 bp means that the dealer proposes tobuy the current issue at the prevailing yieldAnd sell the new issue at a yield that is 5 bpmoreA Take of 5 bp means that the dealer proposes tosell the new issue at a yield that is 5bp lower
8282014 84
8112019 FISD-02-A
httpslidepdfcomreaderfullfisd-02-a 85115
The roll achieves the followingHe acquires the outstanding issue for next daysettlementHe sells the to be issued security with the samepar value for forward delivery on 31 March
The customer is rolling over the investmentfrom the current issue to the new issue
This extends the maturity of the investment byone month
8282014 85
8112019 FISD-02-A
httpslidepdfcomreaderfullfisd-02-a 86115
The client can invest the funds received tillthe new issue settlesHowever he loses the accrued interest thathe would have earned had he held on to theissue
8282014 86
8112019 FISD-02-A
httpslidepdfcomreaderfullfisd-02-a 87115
The Treasury per se does not issue zerocoupon securitiesBut zero coupon securities can be created
which are backed by conventional bondsTake a large quantity of a T-note or bond andseparate all the cash flows from each otherSell the entitlement to each cash flowseparately
8282014 87
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httpslidepdfcomreaderfullfisd-02-a 88115
Take the case of a two-year T-noteIt can be separated into five zero couponsecurities maturing after
6 months12 months18 months24 months
8282014 88
8112019 FISD-02-A
httpslidepdfcomreaderfullfisd-02-a 89115
Earlier investment banks used to buy bondsfrom the Treasury and separate the cashflows
Each cash flow was then sold separately as a zerocoupon bondSuch issues are called trademarks
8282014 89
8112019 FISD-02-A
httpslidepdfcomreaderfullfisd-02-a 90115
The issue of trademarks has now ceasedBecause investment banks can now createsuch instruments
In concert with the Treasury itselfThese ZCBs are known as STRIPS ndash
Separate Trading of Registered Interest andPrincipal of Securities
These are not issued or sold by the Treasury
The market is made by investment banks
8282014 90
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httpslidepdfcomreaderfullfisd-02-a 91115
What is the motivation to create suchproductsIn practice arbitrage is possible when a
coupon security is purchased at a priceThat is lower than what could be obtained byselling each cash flow separately
8282014 91
8112019 FISD-02-A
httpslidepdfcomreaderfullfisd-02-a 92115
Coupon stripping reflects a case of financialengineering
Creating a risk-return profile that is nototherwise available
An investment bank would buy a largequantity of a Treasury security
The securities would be placed with an SPV
8282014 92
8112019 FISD-02-A
httpslidepdfcomreaderfullfisd-02-a 93115
The SPV is a single-purpose dedicated trustIt has the powers to own the bonds andcollect payments
It cannot sell or lend the bondsIt cannot write options on the bondsOr use them as collateral for borrowing
The SPV is empowered to issue zero coupon
bondsWhere each security represents the ownership ofa single cash flow from the mother bond
8282014 93
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httpslidepdfcomreaderfullfisd-02-a 94115
Assume that 100MM USD of 15 year bondswith a coupon of 8 are placed with the SPV
The SPV can issue 6M 12M 18M extending up to14 frac12 year zeroes with a total face value of 4MM
USD eachAnd 15 year zeroes with a total face value of104MM
8282014 94
8112019 FISD-02-A
httpslidepdfcomreaderfullfisd-02-a 95115
8112019 FISD-02-A
httpslidepdfcomreaderfullfisd-02-a 96115
8282014 96
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The Treasury launched this program in 1985to facilitate the stripping of designatedsecurities
All new T-bonds and notes with a maturity of 10years or more are eligibleThe zeroes created in the process are directobligations of the US government
8282014 97
8112019 FISD-02-A
httpslidepdfcomreaderfullfisd-02-a 98115
The mechanism is as followsA dealer who owns a bond or note can ask theFRB where it is held
To replace it with an equivalent set of STRIPS
representing each payment as a separate securityEach of these securities can be traded independentlyof others
8282014 98
8112019 FISD-02-A
httpslidepdfcomreaderfullfisd-02-a 99115
In 1987 the Treasury started to allow dealersto reverse the process
This is called STRIPS RECONSTUTUTION If a dealer owns STRIPS representing all thecoupon and principal payments of a bond
The FED can on request convert these holdings into asingle position in the corresponding bond
8282014 99
8112019 FISD-02-A
httpslidepdfcomreaderfullfisd-02-a 100115
Each coupon and principal cash flow from aTreasury security is assigned a CUSIP
The mother bond is also assigned a CUSIPThe stripped coupons are known as C-STRIPSThe stripped principal is known as P-STRIPSSupply of a C-STRIP increases over time
because a C-STRIP maturing on a day like 15 FEB
2020 will have the same CUSIP irrespective ofwhich mother bond it has come fromThe original coupon rate is irrelevant
8282014 100
8112019 FISD-02-A
httpslidepdfcomreaderfullfisd-02-a 101115
P-STRIPS always correspond to the originalsecurityThey have a unique CUSIPTheir supply is fixed at the time of issuanceIn practice the prices of long-dated P-STRIPSare a bit higher than those of C-STRIPS withthe same maturity date
One reason is that P-STRIPS are more liquid due
to greater availabilityA $100 face value bond with a coupon of 8 willgenerate C-STRIPS with a face value of $4 but P-STRIPS with a face value of $100
8282014 101
8112019 FISD-02-A
httpslidepdfcomreaderfullfisd-02-a 102115
Another reason why P-STRIPS are in higherdemand is that they allow reconstitutionactivities more easily
Assume that the sum of the STRIPS is cheaper than
the mother bondIf a dealer already has the P-STRIPS only the C-STRIPSneed to be acquiredHowever if he owns some of the C-STRIPS he needs toacquire the P-STRIPS and the remaining C-STRIPSThe facility to reconstitute when profitable is pricedinto the P-STRIPSNote Buy and hold investors will prefer C-STRIPSsince they are priced lower and give a higher yield
8282014 102
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httpslidepdfcomreaderfullfisd-02-a 103115
For Plain Vanilla bonds the specifiedcoupon rate is valid for the life of thebond
In the case of Floaters the rate is reset atthe beginning of every periodThe rate will vary directly with thebenchmark
8282014 103
8112019 FISD-02-A
httpslidepdfcomreaderfullfisd-02-a 104115
The rate on a Floater is specified as LIBOR+ 50 bp
The spread is positiveIf it were specified as LIBOR ndash 30bp
The spread will be negativeIf LIBOR rises the rate will increasewhereas if LIBOR falls it will decrease
8282014 104
8112019 FISD-02-A
httpslidepdfcomreaderfullfisd-02-a 105115
In the case of a default risk-free floater theprice will reset to par on a coupon date
It may sell at a premium or discount betweencoupon dates
Consider a floater with a coupon = 5-year T-Bond rate
Assume there are two periods left to maturity
8282014 105
8112019 FISD-02-A
httpslidepdfcomreaderfullfisd-02-a 106115
8282014 106
The price at the end of the first coupon period willbe given by
cT-1 is the coupon one period before maturityyT-1 is the YTM one period before maturity
8112019 FISD-02-A
httpslidepdfcomreaderfullfisd-02-a 107115
On a coupon reset date the YTM = couponBecause we have assumed there is no default riskAny change in the required yield as reflected inthe prevailing YTM
Will also be reflected in the coupon being setIf coupon = yield the bond should sell at par
Thus P T-1 = M
8282014 107
8112019 FISD-02-A
httpslidepdfcomreaderfullfisd-02-a 108115
8282014 108
8112019 FISD-02-A
httpslidepdfcomreaderfullfisd-02-a 109115
Once again at T-2 c T-2 = yT-2 and P T-2 = MThis logic can be applied to a bond with anytime remaining till maturityHowever between two coupon dates theprice may not be equal to par
Consider the valuation at T-2+k
8282014 109
8112019 FISD-02-A
httpslidepdfcomreaderfullfisd-02-a 110115
8282014 110
8112019 FISD-02-A
httpslidepdfcomreaderfullfisd-02-a 111115
Although c T-2 was set at T-2 and is equal toyT-2
yT-2+k is determined at T-2+k and will reflect theyield prevailing at that time
Thus yT-2+k need not equal c T-2 and may behigher or lower
Hence between two coupon dates a floater maysell at a premium or discount
8282014 111
8112019 FISD-02-A
httpslidepdfcomreaderfullfisd-02-a 112115
Now consider a floater characterized bydefault risk
The risk premium required by the market neednot be constant over time
Assume that at the time of issue YTM = 5-year T-note rate + 75bp
The coupon would have been set equal to thisrate and the bond would have been issued at par
8282014 112
8112019 FISD-02-A
httpslidepdfcomreaderfullfisd-02-a 113115
Six months hence the issue may be perceivedas more risky
YTM = 5-year T-note rate + 95 bpThe coupon will however be set equal to theprevailing 5-year rate + 75 bpIf so the issue will not reset to par at the nextcoupon date
8282014 113
8112019 FISD-02-A
httpslidepdfcomreaderfullfisd-02-a 114115
Floaters may come with a CAP or a FLOOR orBOTH
The CAP is a maximum coupon rateProtects issuers against rising rates
The FLOOR is a minimum coupon rateProtects investors against falling rates
When there is a spread over LIBORThere is a natural floorLIBOR cannot be less than zero
8282014 114
8112019 FISD-02-A
httpslidepdfcomreaderfullfisd-02-a 115115
8112019 FISD-02-A
httpslidepdfcomreaderfullfisd-02-a 66115
The Treasury will net out the totalamount of non-competitive bids
The balance will be allocated to competitivebidders
There are two ways in which securitiescan be allotted
The multiple priceyield auction mechanism
French AuctionsThe uniform priceyield auction mechanism
Dutch Auctions
8282014 66
8112019 FISD-02-A
httpslidepdfcomreaderfullfisd-02-a 67115
Assume that the Treasury is offering 25billion dollars worth of T-bonds
2 billion dollars worth of non-competitive bidshave been receivedSo 23 billion dollars worth of bonds are availableto be offered to the competitive bidders
8282014 67
8112019 FISD-02-A
httpslidepdfcomreaderfullfisd-02-a 68115
There are six competitive bidders who havesubmitted the following yields
The bids have been arranged in ascending orderof yieldIn a price based auction the bids would havebeen arranged in descending order of price
8282014 68
8112019 FISD-02-A
httpslidepdfcomreaderfullfisd-02-a 69115
Bidder Bid Yield Bid Amount
Aggregate Amount
Alpha 5370 30 bn 30 bnBeta 5372 50 bn 80 bn
Gamma 5373 40 bn 12 bn
Delta 5375 80 bn 20 bnCharlie 5375 120 bn 32 bn
Tango 5380 30 bn 35 bn8282014 69
8112019 FISD-02-A
httpslidepdfcomreaderfullfisd-02-a 70115
The aggregate demand equals the amount onoffer at a yield of 5375A multiple yield auction will lead to thefollowing allocation
Alpha will get 3 bn at a yield of 5370Beta will get 5 bn at 5372Gamma will get 4 bn at 5373
8282014 70
8112019 FISD-02-A
httpslidepdfcomreaderfullfisd-02-a 71115
At a yield of 5375 we have only 11 bn left toallocateThere is a demand of 20 bn at this yield
8 bn from Delta and 12 bn from CharlieThus we will allocate 1120 = 55 to eachbidder at this yield
There will be pro-rata allocation
055 of 8 bn or 440 bn will go to Delta055 of 12 bn or 66 bn will go to Charlie
8282014 71
8112019 FISD-02-A
httpslidepdfcomreaderfullfisd-02-a 72115
The highest accepted yield is called the StopYield or High Yield
In this case it is 5375The ratio of bids received to the amountawarded is known as the bid to cover ratio
The higher the ratio the stronger is the auction
8282014 72
8112019 FISD-02-A
httpslidepdfcomreaderfullfisd-02-a 73115
8112019 FISD-02-A
httpslidepdfcomreaderfullfisd-02-a 74115
Those who bid more than 5375 will getnothing and are said to be shutout of theauctionSince 1999 the US Treasury has beenconducting only uniform yield auctions
8282014 74
8112019 FISD-02-A
httpslidepdfcomreaderfullfisd-02-a 75115
WI stands for ndash When As and If IssuedThe when issued market is a market forforward trading of a bond
Which has been announced but not yet issuedTrades take place from the date ofannouncement until the actual issue date
Helps bidders to gauge the marketrsquos interestbefore the actual auction
8282014 75
8112019 FISD-02-A
httpslidepdfcomreaderfullfisd-02-a 76115
WI trading has ramifications for the biddingstrategies of market participantsTraders can take both long and shortpositions
Settlement is scheduled for the issue date
8282014 76
8112019 FISD-02-A
httpslidepdfcomreaderfullfisd-02-a 77115
It has a bearing on the outcome of theauction
It affects the strategy used by a bidder becauseit has an impact on his prior positionBidders who are long in the WI market enter theauction with a Long PositionThose who are short in the WI market enter theauction with a short position
8282014 77
8112019 FISD-02-A
httpslidepdfcomreaderfullfisd-02-a 78115
The WI market helps in price discoveryIt provides important information on
The strength of demand for the securityAnd on the disparity of biddersrsquo views
This help potential bidders to formulate theirstrategiesAt times a dealer may believe that he hasvery important private information
If so he may not participate in the WI market andwill directly enter the auction with bids based onhis knowledge
8282014 78
8112019 FISD-02-A
httpslidepdfcomreaderfullfisd-02-a 79115
On or before the date of the auction theissues trade on a yield basis
The actual price can be established only afterthe coupon is set
Starting with the day after the auctionSecurities are quoted on a price basis becausethe coupon is known
8282014 79
8112019 FISD-02-A
httpslidepdfcomreaderfullfisd-02-a 80115
In a coupon roll a dealer will purchase themost recently issued security from a clientAnd simultaneously sell the same amount ofthe recently announced new security
The first leg with settle on the following dayThe second leg is a forward contract
8282014 80
8112019 FISD-02-A
httpslidepdfcomreaderfullfisd-02-a 81115
There can be a Reverse RollThe dealer will sell the most recent issue fornext day settlementAnd buy the newly announced security forforward settlement
The forward leg in a RollReverse Roll is a WItrade
It will settle on the new issue settlement date
8282014 81
8112019 FISD-02-A
httpslidepdfcomreaderfullfisd-02-a 82115
The roll is the spread between the yield onthe new security and that on the outstandingissue in the same maturity segmentA GIVE in the Roll means that
The WI security provides a higher yield than theoutstanding issue
A Take in the Roll means thatThe WI security provides a lower yield
8282014 82
8112019 FISD-02-A
httpslidepdfcomreaderfullfisd-02-a 83115
8112019 FISD-02-A
httpslidepdfcomreaderfullfisd-02-a 84115
On March 17 20XX the Treasury announcedthe auction of a 2-year note
The auction was scheduled for March 24The settlement date was March 31
Trading of the roll began as soon as the issuewas announcedA Give of 5 bp means that the dealer proposes tobuy the current issue at the prevailing yieldAnd sell the new issue at a yield that is 5 bpmoreA Take of 5 bp means that the dealer proposes tosell the new issue at a yield that is 5bp lower
8282014 84
8112019 FISD-02-A
httpslidepdfcomreaderfullfisd-02-a 85115
The roll achieves the followingHe acquires the outstanding issue for next daysettlementHe sells the to be issued security with the samepar value for forward delivery on 31 March
The customer is rolling over the investmentfrom the current issue to the new issue
This extends the maturity of the investment byone month
8282014 85
8112019 FISD-02-A
httpslidepdfcomreaderfullfisd-02-a 86115
The client can invest the funds received tillthe new issue settlesHowever he loses the accrued interest thathe would have earned had he held on to theissue
8282014 86
8112019 FISD-02-A
httpslidepdfcomreaderfullfisd-02-a 87115
The Treasury per se does not issue zerocoupon securitiesBut zero coupon securities can be created
which are backed by conventional bondsTake a large quantity of a T-note or bond andseparate all the cash flows from each otherSell the entitlement to each cash flowseparately
8282014 87
8112019 FISD-02-A
httpslidepdfcomreaderfullfisd-02-a 88115
Take the case of a two-year T-noteIt can be separated into five zero couponsecurities maturing after
6 months12 months18 months24 months
8282014 88
8112019 FISD-02-A
httpslidepdfcomreaderfullfisd-02-a 89115
Earlier investment banks used to buy bondsfrom the Treasury and separate the cashflows
Each cash flow was then sold separately as a zerocoupon bondSuch issues are called trademarks
8282014 89
8112019 FISD-02-A
httpslidepdfcomreaderfullfisd-02-a 90115
The issue of trademarks has now ceasedBecause investment banks can now createsuch instruments
In concert with the Treasury itselfThese ZCBs are known as STRIPS ndash
Separate Trading of Registered Interest andPrincipal of Securities
These are not issued or sold by the Treasury
The market is made by investment banks
8282014 90
8112019 FISD-02-A
httpslidepdfcomreaderfullfisd-02-a 91115
What is the motivation to create suchproductsIn practice arbitrage is possible when a
coupon security is purchased at a priceThat is lower than what could be obtained byselling each cash flow separately
8282014 91
8112019 FISD-02-A
httpslidepdfcomreaderfullfisd-02-a 92115
Coupon stripping reflects a case of financialengineering
Creating a risk-return profile that is nototherwise available
An investment bank would buy a largequantity of a Treasury security
The securities would be placed with an SPV
8282014 92
8112019 FISD-02-A
httpslidepdfcomreaderfullfisd-02-a 93115
The SPV is a single-purpose dedicated trustIt has the powers to own the bonds andcollect payments
It cannot sell or lend the bondsIt cannot write options on the bondsOr use them as collateral for borrowing
The SPV is empowered to issue zero coupon
bondsWhere each security represents the ownership ofa single cash flow from the mother bond
8282014 93
8112019 FISD-02-A
httpslidepdfcomreaderfullfisd-02-a 94115
Assume that 100MM USD of 15 year bondswith a coupon of 8 are placed with the SPV
The SPV can issue 6M 12M 18M extending up to14 frac12 year zeroes with a total face value of 4MM
USD eachAnd 15 year zeroes with a total face value of104MM
8282014 94
8112019 FISD-02-A
httpslidepdfcomreaderfullfisd-02-a 95115
8112019 FISD-02-A
httpslidepdfcomreaderfullfisd-02-a 96115
8282014 96
8112019 FISD-02-A
httpslidepdfcomreaderfullfisd-02-a 97115
The Treasury launched this program in 1985to facilitate the stripping of designatedsecurities
All new T-bonds and notes with a maturity of 10years or more are eligibleThe zeroes created in the process are directobligations of the US government
8282014 97
8112019 FISD-02-A
httpslidepdfcomreaderfullfisd-02-a 98115
The mechanism is as followsA dealer who owns a bond or note can ask theFRB where it is held
To replace it with an equivalent set of STRIPS
representing each payment as a separate securityEach of these securities can be traded independentlyof others
8282014 98
8112019 FISD-02-A
httpslidepdfcomreaderfullfisd-02-a 99115
In 1987 the Treasury started to allow dealersto reverse the process
This is called STRIPS RECONSTUTUTION If a dealer owns STRIPS representing all thecoupon and principal payments of a bond
The FED can on request convert these holdings into asingle position in the corresponding bond
8282014 99
8112019 FISD-02-A
httpslidepdfcomreaderfullfisd-02-a 100115
Each coupon and principal cash flow from aTreasury security is assigned a CUSIP
The mother bond is also assigned a CUSIPThe stripped coupons are known as C-STRIPSThe stripped principal is known as P-STRIPSSupply of a C-STRIP increases over time
because a C-STRIP maturing on a day like 15 FEB
2020 will have the same CUSIP irrespective ofwhich mother bond it has come fromThe original coupon rate is irrelevant
8282014 100
8112019 FISD-02-A
httpslidepdfcomreaderfullfisd-02-a 101115
P-STRIPS always correspond to the originalsecurityThey have a unique CUSIPTheir supply is fixed at the time of issuanceIn practice the prices of long-dated P-STRIPSare a bit higher than those of C-STRIPS withthe same maturity date
One reason is that P-STRIPS are more liquid due
to greater availabilityA $100 face value bond with a coupon of 8 willgenerate C-STRIPS with a face value of $4 but P-STRIPS with a face value of $100
8282014 101
8112019 FISD-02-A
httpslidepdfcomreaderfullfisd-02-a 102115
Another reason why P-STRIPS are in higherdemand is that they allow reconstitutionactivities more easily
Assume that the sum of the STRIPS is cheaper than
the mother bondIf a dealer already has the P-STRIPS only the C-STRIPSneed to be acquiredHowever if he owns some of the C-STRIPS he needs toacquire the P-STRIPS and the remaining C-STRIPSThe facility to reconstitute when profitable is pricedinto the P-STRIPSNote Buy and hold investors will prefer C-STRIPSsince they are priced lower and give a higher yield
8282014 102
8112019 FISD-02-A
httpslidepdfcomreaderfullfisd-02-a 103115
For Plain Vanilla bonds the specifiedcoupon rate is valid for the life of thebond
In the case of Floaters the rate is reset atthe beginning of every periodThe rate will vary directly with thebenchmark
8282014 103
8112019 FISD-02-A
httpslidepdfcomreaderfullfisd-02-a 104115
The rate on a Floater is specified as LIBOR+ 50 bp
The spread is positiveIf it were specified as LIBOR ndash 30bp
The spread will be negativeIf LIBOR rises the rate will increasewhereas if LIBOR falls it will decrease
8282014 104
8112019 FISD-02-A
httpslidepdfcomreaderfullfisd-02-a 105115
In the case of a default risk-free floater theprice will reset to par on a coupon date
It may sell at a premium or discount betweencoupon dates
Consider a floater with a coupon = 5-year T-Bond rate
Assume there are two periods left to maturity
8282014 105
8112019 FISD-02-A
httpslidepdfcomreaderfullfisd-02-a 106115
8282014 106
The price at the end of the first coupon period willbe given by
cT-1 is the coupon one period before maturityyT-1 is the YTM one period before maturity
8112019 FISD-02-A
httpslidepdfcomreaderfullfisd-02-a 107115
On a coupon reset date the YTM = couponBecause we have assumed there is no default riskAny change in the required yield as reflected inthe prevailing YTM
Will also be reflected in the coupon being setIf coupon = yield the bond should sell at par
Thus P T-1 = M
8282014 107
8112019 FISD-02-A
httpslidepdfcomreaderfullfisd-02-a 108115
8282014 108
8112019 FISD-02-A
httpslidepdfcomreaderfullfisd-02-a 109115
Once again at T-2 c T-2 = yT-2 and P T-2 = MThis logic can be applied to a bond with anytime remaining till maturityHowever between two coupon dates theprice may not be equal to par
Consider the valuation at T-2+k
8282014 109
8112019 FISD-02-A
httpslidepdfcomreaderfullfisd-02-a 110115
8282014 110
8112019 FISD-02-A
httpslidepdfcomreaderfullfisd-02-a 111115
Although c T-2 was set at T-2 and is equal toyT-2
yT-2+k is determined at T-2+k and will reflect theyield prevailing at that time
Thus yT-2+k need not equal c T-2 and may behigher or lower
Hence between two coupon dates a floater maysell at a premium or discount
8282014 111
8112019 FISD-02-A
httpslidepdfcomreaderfullfisd-02-a 112115
Now consider a floater characterized bydefault risk
The risk premium required by the market neednot be constant over time
Assume that at the time of issue YTM = 5-year T-note rate + 75bp
The coupon would have been set equal to thisrate and the bond would have been issued at par
8282014 112
8112019 FISD-02-A
httpslidepdfcomreaderfullfisd-02-a 113115
Six months hence the issue may be perceivedas more risky
YTM = 5-year T-note rate + 95 bpThe coupon will however be set equal to theprevailing 5-year rate + 75 bpIf so the issue will not reset to par at the nextcoupon date
8282014 113
8112019 FISD-02-A
httpslidepdfcomreaderfullfisd-02-a 114115
Floaters may come with a CAP or a FLOOR orBOTH
The CAP is a maximum coupon rateProtects issuers against rising rates
The FLOOR is a minimum coupon rateProtects investors against falling rates
When there is a spread over LIBORThere is a natural floorLIBOR cannot be less than zero
8282014 114
8112019 FISD-02-A
httpslidepdfcomreaderfullfisd-02-a 115115
8112019 FISD-02-A
httpslidepdfcomreaderfullfisd-02-a 67115
Assume that the Treasury is offering 25billion dollars worth of T-bonds
2 billion dollars worth of non-competitive bidshave been receivedSo 23 billion dollars worth of bonds are availableto be offered to the competitive bidders
8282014 67
8112019 FISD-02-A
httpslidepdfcomreaderfullfisd-02-a 68115
There are six competitive bidders who havesubmitted the following yields
The bids have been arranged in ascending orderof yieldIn a price based auction the bids would havebeen arranged in descending order of price
8282014 68
8112019 FISD-02-A
httpslidepdfcomreaderfullfisd-02-a 69115
Bidder Bid Yield Bid Amount
Aggregate Amount
Alpha 5370 30 bn 30 bnBeta 5372 50 bn 80 bn
Gamma 5373 40 bn 12 bn
Delta 5375 80 bn 20 bnCharlie 5375 120 bn 32 bn
Tango 5380 30 bn 35 bn8282014 69
8112019 FISD-02-A
httpslidepdfcomreaderfullfisd-02-a 70115
The aggregate demand equals the amount onoffer at a yield of 5375A multiple yield auction will lead to thefollowing allocation
Alpha will get 3 bn at a yield of 5370Beta will get 5 bn at 5372Gamma will get 4 bn at 5373
8282014 70
8112019 FISD-02-A
httpslidepdfcomreaderfullfisd-02-a 71115
At a yield of 5375 we have only 11 bn left toallocateThere is a demand of 20 bn at this yield
8 bn from Delta and 12 bn from CharlieThus we will allocate 1120 = 55 to eachbidder at this yield
There will be pro-rata allocation
055 of 8 bn or 440 bn will go to Delta055 of 12 bn or 66 bn will go to Charlie
8282014 71
8112019 FISD-02-A
httpslidepdfcomreaderfullfisd-02-a 72115
The highest accepted yield is called the StopYield or High Yield
In this case it is 5375The ratio of bids received to the amountawarded is known as the bid to cover ratio
The higher the ratio the stronger is the auction
8282014 72
8112019 FISD-02-A
httpslidepdfcomreaderfullfisd-02-a 73115
8112019 FISD-02-A
httpslidepdfcomreaderfullfisd-02-a 74115
Those who bid more than 5375 will getnothing and are said to be shutout of theauctionSince 1999 the US Treasury has beenconducting only uniform yield auctions
8282014 74
8112019 FISD-02-A
httpslidepdfcomreaderfullfisd-02-a 75115
WI stands for ndash When As and If IssuedThe when issued market is a market forforward trading of a bond
Which has been announced but not yet issuedTrades take place from the date ofannouncement until the actual issue date
Helps bidders to gauge the marketrsquos interestbefore the actual auction
8282014 75
8112019 FISD-02-A
httpslidepdfcomreaderfullfisd-02-a 76115
WI trading has ramifications for the biddingstrategies of market participantsTraders can take both long and shortpositions
Settlement is scheduled for the issue date
8282014 76
8112019 FISD-02-A
httpslidepdfcomreaderfullfisd-02-a 77115
It has a bearing on the outcome of theauction
It affects the strategy used by a bidder becauseit has an impact on his prior positionBidders who are long in the WI market enter theauction with a Long PositionThose who are short in the WI market enter theauction with a short position
8282014 77
8112019 FISD-02-A
httpslidepdfcomreaderfullfisd-02-a 78115
The WI market helps in price discoveryIt provides important information on
The strength of demand for the securityAnd on the disparity of biddersrsquo views
This help potential bidders to formulate theirstrategiesAt times a dealer may believe that he hasvery important private information
If so he may not participate in the WI market andwill directly enter the auction with bids based onhis knowledge
8282014 78
8112019 FISD-02-A
httpslidepdfcomreaderfullfisd-02-a 79115
On or before the date of the auction theissues trade on a yield basis
The actual price can be established only afterthe coupon is set
Starting with the day after the auctionSecurities are quoted on a price basis becausethe coupon is known
8282014 79
8112019 FISD-02-A
httpslidepdfcomreaderfullfisd-02-a 80115
In a coupon roll a dealer will purchase themost recently issued security from a clientAnd simultaneously sell the same amount ofthe recently announced new security
The first leg with settle on the following dayThe second leg is a forward contract
8282014 80
8112019 FISD-02-A
httpslidepdfcomreaderfullfisd-02-a 81115
There can be a Reverse RollThe dealer will sell the most recent issue fornext day settlementAnd buy the newly announced security forforward settlement
The forward leg in a RollReverse Roll is a WItrade
It will settle on the new issue settlement date
8282014 81
8112019 FISD-02-A
httpslidepdfcomreaderfullfisd-02-a 82115
The roll is the spread between the yield onthe new security and that on the outstandingissue in the same maturity segmentA GIVE in the Roll means that
The WI security provides a higher yield than theoutstanding issue
A Take in the Roll means thatThe WI security provides a lower yield
8282014 82
8112019 FISD-02-A
httpslidepdfcomreaderfullfisd-02-a 83115
8112019 FISD-02-A
httpslidepdfcomreaderfullfisd-02-a 84115
On March 17 20XX the Treasury announcedthe auction of a 2-year note
The auction was scheduled for March 24The settlement date was March 31
Trading of the roll began as soon as the issuewas announcedA Give of 5 bp means that the dealer proposes tobuy the current issue at the prevailing yieldAnd sell the new issue at a yield that is 5 bpmoreA Take of 5 bp means that the dealer proposes tosell the new issue at a yield that is 5bp lower
8282014 84
8112019 FISD-02-A
httpslidepdfcomreaderfullfisd-02-a 85115
The roll achieves the followingHe acquires the outstanding issue for next daysettlementHe sells the to be issued security with the samepar value for forward delivery on 31 March
The customer is rolling over the investmentfrom the current issue to the new issue
This extends the maturity of the investment byone month
8282014 85
8112019 FISD-02-A
httpslidepdfcomreaderfullfisd-02-a 86115
The client can invest the funds received tillthe new issue settlesHowever he loses the accrued interest thathe would have earned had he held on to theissue
8282014 86
8112019 FISD-02-A
httpslidepdfcomreaderfullfisd-02-a 87115
The Treasury per se does not issue zerocoupon securitiesBut zero coupon securities can be created
which are backed by conventional bondsTake a large quantity of a T-note or bond andseparate all the cash flows from each otherSell the entitlement to each cash flowseparately
8282014 87
8112019 FISD-02-A
httpslidepdfcomreaderfullfisd-02-a 88115
Take the case of a two-year T-noteIt can be separated into five zero couponsecurities maturing after
6 months12 months18 months24 months
8282014 88
8112019 FISD-02-A
httpslidepdfcomreaderfullfisd-02-a 89115
Earlier investment banks used to buy bondsfrom the Treasury and separate the cashflows
Each cash flow was then sold separately as a zerocoupon bondSuch issues are called trademarks
8282014 89
8112019 FISD-02-A
httpslidepdfcomreaderfullfisd-02-a 90115
The issue of trademarks has now ceasedBecause investment banks can now createsuch instruments
In concert with the Treasury itselfThese ZCBs are known as STRIPS ndash
Separate Trading of Registered Interest andPrincipal of Securities
These are not issued or sold by the Treasury
The market is made by investment banks
8282014 90
8112019 FISD-02-A
httpslidepdfcomreaderfullfisd-02-a 91115
What is the motivation to create suchproductsIn practice arbitrage is possible when a
coupon security is purchased at a priceThat is lower than what could be obtained byselling each cash flow separately
8282014 91
8112019 FISD-02-A
httpslidepdfcomreaderfullfisd-02-a 92115
Coupon stripping reflects a case of financialengineering
Creating a risk-return profile that is nototherwise available
An investment bank would buy a largequantity of a Treasury security
The securities would be placed with an SPV
8282014 92
8112019 FISD-02-A
httpslidepdfcomreaderfullfisd-02-a 93115
The SPV is a single-purpose dedicated trustIt has the powers to own the bonds andcollect payments
It cannot sell or lend the bondsIt cannot write options on the bondsOr use them as collateral for borrowing
The SPV is empowered to issue zero coupon
bondsWhere each security represents the ownership ofa single cash flow from the mother bond
8282014 93
8112019 FISD-02-A
httpslidepdfcomreaderfullfisd-02-a 94115
Assume that 100MM USD of 15 year bondswith a coupon of 8 are placed with the SPV
The SPV can issue 6M 12M 18M extending up to14 frac12 year zeroes with a total face value of 4MM
USD eachAnd 15 year zeroes with a total face value of104MM
8282014 94
8112019 FISD-02-A
httpslidepdfcomreaderfullfisd-02-a 95115
8112019 FISD-02-A
httpslidepdfcomreaderfullfisd-02-a 96115
8282014 96
8112019 FISD-02-A
httpslidepdfcomreaderfullfisd-02-a 97115
The Treasury launched this program in 1985to facilitate the stripping of designatedsecurities
All new T-bonds and notes with a maturity of 10years or more are eligibleThe zeroes created in the process are directobligations of the US government
8282014 97
8112019 FISD-02-A
httpslidepdfcomreaderfullfisd-02-a 98115
The mechanism is as followsA dealer who owns a bond or note can ask theFRB where it is held
To replace it with an equivalent set of STRIPS
representing each payment as a separate securityEach of these securities can be traded independentlyof others
8282014 98
8112019 FISD-02-A
httpslidepdfcomreaderfullfisd-02-a 99115
In 1987 the Treasury started to allow dealersto reverse the process
This is called STRIPS RECONSTUTUTION If a dealer owns STRIPS representing all thecoupon and principal payments of a bond
The FED can on request convert these holdings into asingle position in the corresponding bond
8282014 99
8112019 FISD-02-A
httpslidepdfcomreaderfullfisd-02-a 100115
Each coupon and principal cash flow from aTreasury security is assigned a CUSIP
The mother bond is also assigned a CUSIPThe stripped coupons are known as C-STRIPSThe stripped principal is known as P-STRIPSSupply of a C-STRIP increases over time
because a C-STRIP maturing on a day like 15 FEB
2020 will have the same CUSIP irrespective ofwhich mother bond it has come fromThe original coupon rate is irrelevant
8282014 100
8112019 FISD-02-A
httpslidepdfcomreaderfullfisd-02-a 101115
P-STRIPS always correspond to the originalsecurityThey have a unique CUSIPTheir supply is fixed at the time of issuanceIn practice the prices of long-dated P-STRIPSare a bit higher than those of C-STRIPS withthe same maturity date
One reason is that P-STRIPS are more liquid due
to greater availabilityA $100 face value bond with a coupon of 8 willgenerate C-STRIPS with a face value of $4 but P-STRIPS with a face value of $100
8282014 101
8112019 FISD-02-A
httpslidepdfcomreaderfullfisd-02-a 102115
Another reason why P-STRIPS are in higherdemand is that they allow reconstitutionactivities more easily
Assume that the sum of the STRIPS is cheaper than
the mother bondIf a dealer already has the P-STRIPS only the C-STRIPSneed to be acquiredHowever if he owns some of the C-STRIPS he needs toacquire the P-STRIPS and the remaining C-STRIPSThe facility to reconstitute when profitable is pricedinto the P-STRIPSNote Buy and hold investors will prefer C-STRIPSsince they are priced lower and give a higher yield
8282014 102
8112019 FISD-02-A
httpslidepdfcomreaderfullfisd-02-a 103115
For Plain Vanilla bonds the specifiedcoupon rate is valid for the life of thebond
In the case of Floaters the rate is reset atthe beginning of every periodThe rate will vary directly with thebenchmark
8282014 103
8112019 FISD-02-A
httpslidepdfcomreaderfullfisd-02-a 104115
The rate on a Floater is specified as LIBOR+ 50 bp
The spread is positiveIf it were specified as LIBOR ndash 30bp
The spread will be negativeIf LIBOR rises the rate will increasewhereas if LIBOR falls it will decrease
8282014 104
8112019 FISD-02-A
httpslidepdfcomreaderfullfisd-02-a 105115
In the case of a default risk-free floater theprice will reset to par on a coupon date
It may sell at a premium or discount betweencoupon dates
Consider a floater with a coupon = 5-year T-Bond rate
Assume there are two periods left to maturity
8282014 105
8112019 FISD-02-A
httpslidepdfcomreaderfullfisd-02-a 106115
8282014 106
The price at the end of the first coupon period willbe given by
cT-1 is the coupon one period before maturityyT-1 is the YTM one period before maturity
8112019 FISD-02-A
httpslidepdfcomreaderfullfisd-02-a 107115
On a coupon reset date the YTM = couponBecause we have assumed there is no default riskAny change in the required yield as reflected inthe prevailing YTM
Will also be reflected in the coupon being setIf coupon = yield the bond should sell at par
Thus P T-1 = M
8282014 107
8112019 FISD-02-A
httpslidepdfcomreaderfullfisd-02-a 108115
8282014 108
8112019 FISD-02-A
httpslidepdfcomreaderfullfisd-02-a 109115
Once again at T-2 c T-2 = yT-2 and P T-2 = MThis logic can be applied to a bond with anytime remaining till maturityHowever between two coupon dates theprice may not be equal to par
Consider the valuation at T-2+k
8282014 109
8112019 FISD-02-A
httpslidepdfcomreaderfullfisd-02-a 110115
8282014 110
8112019 FISD-02-A
httpslidepdfcomreaderfullfisd-02-a 111115
Although c T-2 was set at T-2 and is equal toyT-2
yT-2+k is determined at T-2+k and will reflect theyield prevailing at that time
Thus yT-2+k need not equal c T-2 and may behigher or lower
Hence between two coupon dates a floater maysell at a premium or discount
8282014 111
8112019 FISD-02-A
httpslidepdfcomreaderfullfisd-02-a 112115
Now consider a floater characterized bydefault risk
The risk premium required by the market neednot be constant over time
Assume that at the time of issue YTM = 5-year T-note rate + 75bp
The coupon would have been set equal to thisrate and the bond would have been issued at par
8282014 112
8112019 FISD-02-A
httpslidepdfcomreaderfullfisd-02-a 113115
Six months hence the issue may be perceivedas more risky
YTM = 5-year T-note rate + 95 bpThe coupon will however be set equal to theprevailing 5-year rate + 75 bpIf so the issue will not reset to par at the nextcoupon date
8282014 113
8112019 FISD-02-A
httpslidepdfcomreaderfullfisd-02-a 114115
Floaters may come with a CAP or a FLOOR orBOTH
The CAP is a maximum coupon rateProtects issuers against rising rates
The FLOOR is a minimum coupon rateProtects investors against falling rates
When there is a spread over LIBORThere is a natural floorLIBOR cannot be less than zero
8282014 114
8112019 FISD-02-A
httpslidepdfcomreaderfullfisd-02-a 115115
8112019 FISD-02-A
httpslidepdfcomreaderfullfisd-02-a 68115
There are six competitive bidders who havesubmitted the following yields
The bids have been arranged in ascending orderof yieldIn a price based auction the bids would havebeen arranged in descending order of price
8282014 68
8112019 FISD-02-A
httpslidepdfcomreaderfullfisd-02-a 69115
Bidder Bid Yield Bid Amount
Aggregate Amount
Alpha 5370 30 bn 30 bnBeta 5372 50 bn 80 bn
Gamma 5373 40 bn 12 bn
Delta 5375 80 bn 20 bnCharlie 5375 120 bn 32 bn
Tango 5380 30 bn 35 bn8282014 69
8112019 FISD-02-A
httpslidepdfcomreaderfullfisd-02-a 70115
The aggregate demand equals the amount onoffer at a yield of 5375A multiple yield auction will lead to thefollowing allocation
Alpha will get 3 bn at a yield of 5370Beta will get 5 bn at 5372Gamma will get 4 bn at 5373
8282014 70
8112019 FISD-02-A
httpslidepdfcomreaderfullfisd-02-a 71115
At a yield of 5375 we have only 11 bn left toallocateThere is a demand of 20 bn at this yield
8 bn from Delta and 12 bn from CharlieThus we will allocate 1120 = 55 to eachbidder at this yield
There will be pro-rata allocation
055 of 8 bn or 440 bn will go to Delta055 of 12 bn or 66 bn will go to Charlie
8282014 71
8112019 FISD-02-A
httpslidepdfcomreaderfullfisd-02-a 72115
The highest accepted yield is called the StopYield or High Yield
In this case it is 5375The ratio of bids received to the amountawarded is known as the bid to cover ratio
The higher the ratio the stronger is the auction
8282014 72
8112019 FISD-02-A
httpslidepdfcomreaderfullfisd-02-a 73115
8112019 FISD-02-A
httpslidepdfcomreaderfullfisd-02-a 74115
Those who bid more than 5375 will getnothing and are said to be shutout of theauctionSince 1999 the US Treasury has beenconducting only uniform yield auctions
8282014 74
8112019 FISD-02-A
httpslidepdfcomreaderfullfisd-02-a 75115
WI stands for ndash When As and If IssuedThe when issued market is a market forforward trading of a bond
Which has been announced but not yet issuedTrades take place from the date ofannouncement until the actual issue date
Helps bidders to gauge the marketrsquos interestbefore the actual auction
8282014 75
8112019 FISD-02-A
httpslidepdfcomreaderfullfisd-02-a 76115
WI trading has ramifications for the biddingstrategies of market participantsTraders can take both long and shortpositions
Settlement is scheduled for the issue date
8282014 76
8112019 FISD-02-A
httpslidepdfcomreaderfullfisd-02-a 77115
It has a bearing on the outcome of theauction
It affects the strategy used by a bidder becauseit has an impact on his prior positionBidders who are long in the WI market enter theauction with a Long PositionThose who are short in the WI market enter theauction with a short position
8282014 77
8112019 FISD-02-A
httpslidepdfcomreaderfullfisd-02-a 78115
The WI market helps in price discoveryIt provides important information on
The strength of demand for the securityAnd on the disparity of biddersrsquo views
This help potential bidders to formulate theirstrategiesAt times a dealer may believe that he hasvery important private information
If so he may not participate in the WI market andwill directly enter the auction with bids based onhis knowledge
8282014 78
8112019 FISD-02-A
httpslidepdfcomreaderfullfisd-02-a 79115
On or before the date of the auction theissues trade on a yield basis
The actual price can be established only afterthe coupon is set
Starting with the day after the auctionSecurities are quoted on a price basis becausethe coupon is known
8282014 79
8112019 FISD-02-A
httpslidepdfcomreaderfullfisd-02-a 80115
In a coupon roll a dealer will purchase themost recently issued security from a clientAnd simultaneously sell the same amount ofthe recently announced new security
The first leg with settle on the following dayThe second leg is a forward contract
8282014 80
8112019 FISD-02-A
httpslidepdfcomreaderfullfisd-02-a 81115
There can be a Reverse RollThe dealer will sell the most recent issue fornext day settlementAnd buy the newly announced security forforward settlement
The forward leg in a RollReverse Roll is a WItrade
It will settle on the new issue settlement date
8282014 81
8112019 FISD-02-A
httpslidepdfcomreaderfullfisd-02-a 82115
The roll is the spread between the yield onthe new security and that on the outstandingissue in the same maturity segmentA GIVE in the Roll means that
The WI security provides a higher yield than theoutstanding issue
A Take in the Roll means thatThe WI security provides a lower yield
8282014 82
8112019 FISD-02-A
httpslidepdfcomreaderfullfisd-02-a 83115
8112019 FISD-02-A
httpslidepdfcomreaderfullfisd-02-a 84115
On March 17 20XX the Treasury announcedthe auction of a 2-year note
The auction was scheduled for March 24The settlement date was March 31
Trading of the roll began as soon as the issuewas announcedA Give of 5 bp means that the dealer proposes tobuy the current issue at the prevailing yieldAnd sell the new issue at a yield that is 5 bpmoreA Take of 5 bp means that the dealer proposes tosell the new issue at a yield that is 5bp lower
8282014 84
8112019 FISD-02-A
httpslidepdfcomreaderfullfisd-02-a 85115
The roll achieves the followingHe acquires the outstanding issue for next daysettlementHe sells the to be issued security with the samepar value for forward delivery on 31 March
The customer is rolling over the investmentfrom the current issue to the new issue
This extends the maturity of the investment byone month
8282014 85
8112019 FISD-02-A
httpslidepdfcomreaderfullfisd-02-a 86115
The client can invest the funds received tillthe new issue settlesHowever he loses the accrued interest thathe would have earned had he held on to theissue
8282014 86
8112019 FISD-02-A
httpslidepdfcomreaderfullfisd-02-a 87115
The Treasury per se does not issue zerocoupon securitiesBut zero coupon securities can be created
which are backed by conventional bondsTake a large quantity of a T-note or bond andseparate all the cash flows from each otherSell the entitlement to each cash flowseparately
8282014 87
8112019 FISD-02-A
httpslidepdfcomreaderfullfisd-02-a 88115
Take the case of a two-year T-noteIt can be separated into five zero couponsecurities maturing after
6 months12 months18 months24 months
8282014 88
8112019 FISD-02-A
httpslidepdfcomreaderfullfisd-02-a 89115
Earlier investment banks used to buy bondsfrom the Treasury and separate the cashflows
Each cash flow was then sold separately as a zerocoupon bondSuch issues are called trademarks
8282014 89
8112019 FISD-02-A
httpslidepdfcomreaderfullfisd-02-a 90115
The issue of trademarks has now ceasedBecause investment banks can now createsuch instruments
In concert with the Treasury itselfThese ZCBs are known as STRIPS ndash
Separate Trading of Registered Interest andPrincipal of Securities
These are not issued or sold by the Treasury
The market is made by investment banks
8282014 90
8112019 FISD-02-A
httpslidepdfcomreaderfullfisd-02-a 91115
What is the motivation to create suchproductsIn practice arbitrage is possible when a
coupon security is purchased at a priceThat is lower than what could be obtained byselling each cash flow separately
8282014 91
8112019 FISD-02-A
httpslidepdfcomreaderfullfisd-02-a 92115
Coupon stripping reflects a case of financialengineering
Creating a risk-return profile that is nototherwise available
An investment bank would buy a largequantity of a Treasury security
The securities would be placed with an SPV
8282014 92
8112019 FISD-02-A
httpslidepdfcomreaderfullfisd-02-a 93115
The SPV is a single-purpose dedicated trustIt has the powers to own the bonds andcollect payments
It cannot sell or lend the bondsIt cannot write options on the bondsOr use them as collateral for borrowing
The SPV is empowered to issue zero coupon
bondsWhere each security represents the ownership ofa single cash flow from the mother bond
8282014 93
8112019 FISD-02-A
httpslidepdfcomreaderfullfisd-02-a 94115
Assume that 100MM USD of 15 year bondswith a coupon of 8 are placed with the SPV
The SPV can issue 6M 12M 18M extending up to14 frac12 year zeroes with a total face value of 4MM
USD eachAnd 15 year zeroes with a total face value of104MM
8282014 94
8112019 FISD-02-A
httpslidepdfcomreaderfullfisd-02-a 95115
8112019 FISD-02-A
httpslidepdfcomreaderfullfisd-02-a 96115
8282014 96
8112019 FISD-02-A
httpslidepdfcomreaderfullfisd-02-a 97115
The Treasury launched this program in 1985to facilitate the stripping of designatedsecurities
All new T-bonds and notes with a maturity of 10years or more are eligibleThe zeroes created in the process are directobligations of the US government
8282014 97
8112019 FISD-02-A
httpslidepdfcomreaderfullfisd-02-a 98115
The mechanism is as followsA dealer who owns a bond or note can ask theFRB where it is held
To replace it with an equivalent set of STRIPS
representing each payment as a separate securityEach of these securities can be traded independentlyof others
8282014 98
8112019 FISD-02-A
httpslidepdfcomreaderfullfisd-02-a 99115
In 1987 the Treasury started to allow dealersto reverse the process
This is called STRIPS RECONSTUTUTION If a dealer owns STRIPS representing all thecoupon and principal payments of a bond
The FED can on request convert these holdings into asingle position in the corresponding bond
8282014 99
8112019 FISD-02-A
httpslidepdfcomreaderfullfisd-02-a 100115
Each coupon and principal cash flow from aTreasury security is assigned a CUSIP
The mother bond is also assigned a CUSIPThe stripped coupons are known as C-STRIPSThe stripped principal is known as P-STRIPSSupply of a C-STRIP increases over time
because a C-STRIP maturing on a day like 15 FEB
2020 will have the same CUSIP irrespective ofwhich mother bond it has come fromThe original coupon rate is irrelevant
8282014 100
8112019 FISD-02-A
httpslidepdfcomreaderfullfisd-02-a 101115
P-STRIPS always correspond to the originalsecurityThey have a unique CUSIPTheir supply is fixed at the time of issuanceIn practice the prices of long-dated P-STRIPSare a bit higher than those of C-STRIPS withthe same maturity date
One reason is that P-STRIPS are more liquid due
to greater availabilityA $100 face value bond with a coupon of 8 willgenerate C-STRIPS with a face value of $4 but P-STRIPS with a face value of $100
8282014 101
8112019 FISD-02-A
httpslidepdfcomreaderfullfisd-02-a 102115
Another reason why P-STRIPS are in higherdemand is that they allow reconstitutionactivities more easily
Assume that the sum of the STRIPS is cheaper than
the mother bondIf a dealer already has the P-STRIPS only the C-STRIPSneed to be acquiredHowever if he owns some of the C-STRIPS he needs toacquire the P-STRIPS and the remaining C-STRIPSThe facility to reconstitute when profitable is pricedinto the P-STRIPSNote Buy and hold investors will prefer C-STRIPSsince they are priced lower and give a higher yield
8282014 102
8112019 FISD-02-A
httpslidepdfcomreaderfullfisd-02-a 103115
For Plain Vanilla bonds the specifiedcoupon rate is valid for the life of thebond
In the case of Floaters the rate is reset atthe beginning of every periodThe rate will vary directly with thebenchmark
8282014 103
8112019 FISD-02-A
httpslidepdfcomreaderfullfisd-02-a 104115
The rate on a Floater is specified as LIBOR+ 50 bp
The spread is positiveIf it were specified as LIBOR ndash 30bp
The spread will be negativeIf LIBOR rises the rate will increasewhereas if LIBOR falls it will decrease
8282014 104
8112019 FISD-02-A
httpslidepdfcomreaderfullfisd-02-a 105115
In the case of a default risk-free floater theprice will reset to par on a coupon date
It may sell at a premium or discount betweencoupon dates
Consider a floater with a coupon = 5-year T-Bond rate
Assume there are two periods left to maturity
8282014 105
8112019 FISD-02-A
httpslidepdfcomreaderfullfisd-02-a 106115
8282014 106
The price at the end of the first coupon period willbe given by
cT-1 is the coupon one period before maturityyT-1 is the YTM one period before maturity
8112019 FISD-02-A
httpslidepdfcomreaderfullfisd-02-a 107115
On a coupon reset date the YTM = couponBecause we have assumed there is no default riskAny change in the required yield as reflected inthe prevailing YTM
Will also be reflected in the coupon being setIf coupon = yield the bond should sell at par
Thus P T-1 = M
8282014 107
8112019 FISD-02-A
httpslidepdfcomreaderfullfisd-02-a 108115
8282014 108
8112019 FISD-02-A
httpslidepdfcomreaderfullfisd-02-a 109115
Once again at T-2 c T-2 = yT-2 and P T-2 = MThis logic can be applied to a bond with anytime remaining till maturityHowever between two coupon dates theprice may not be equal to par
Consider the valuation at T-2+k
8282014 109
8112019 FISD-02-A
httpslidepdfcomreaderfullfisd-02-a 110115
8282014 110
8112019 FISD-02-A
httpslidepdfcomreaderfullfisd-02-a 111115
Although c T-2 was set at T-2 and is equal toyT-2
yT-2+k is determined at T-2+k and will reflect theyield prevailing at that time
Thus yT-2+k need not equal c T-2 and may behigher or lower
Hence between two coupon dates a floater maysell at a premium or discount
8282014 111
8112019 FISD-02-A
httpslidepdfcomreaderfullfisd-02-a 112115
Now consider a floater characterized bydefault risk
The risk premium required by the market neednot be constant over time
Assume that at the time of issue YTM = 5-year T-note rate + 75bp
The coupon would have been set equal to thisrate and the bond would have been issued at par
8282014 112
8112019 FISD-02-A
httpslidepdfcomreaderfullfisd-02-a 113115
Six months hence the issue may be perceivedas more risky
YTM = 5-year T-note rate + 95 bpThe coupon will however be set equal to theprevailing 5-year rate + 75 bpIf so the issue will not reset to par at the nextcoupon date
8282014 113
8112019 FISD-02-A
httpslidepdfcomreaderfullfisd-02-a 114115
Floaters may come with a CAP or a FLOOR orBOTH
The CAP is a maximum coupon rateProtects issuers against rising rates
The FLOOR is a minimum coupon rateProtects investors against falling rates
When there is a spread over LIBORThere is a natural floorLIBOR cannot be less than zero
8282014 114
8112019 FISD-02-A
httpslidepdfcomreaderfullfisd-02-a 115115
8112019 FISD-02-A
httpslidepdfcomreaderfullfisd-02-a 69115
Bidder Bid Yield Bid Amount
Aggregate Amount
Alpha 5370 30 bn 30 bnBeta 5372 50 bn 80 bn
Gamma 5373 40 bn 12 bn
Delta 5375 80 bn 20 bnCharlie 5375 120 bn 32 bn
Tango 5380 30 bn 35 bn8282014 69
8112019 FISD-02-A
httpslidepdfcomreaderfullfisd-02-a 70115
The aggregate demand equals the amount onoffer at a yield of 5375A multiple yield auction will lead to thefollowing allocation
Alpha will get 3 bn at a yield of 5370Beta will get 5 bn at 5372Gamma will get 4 bn at 5373
8282014 70
8112019 FISD-02-A
httpslidepdfcomreaderfullfisd-02-a 71115
At a yield of 5375 we have only 11 bn left toallocateThere is a demand of 20 bn at this yield
8 bn from Delta and 12 bn from CharlieThus we will allocate 1120 = 55 to eachbidder at this yield
There will be pro-rata allocation
055 of 8 bn or 440 bn will go to Delta055 of 12 bn or 66 bn will go to Charlie
8282014 71
8112019 FISD-02-A
httpslidepdfcomreaderfullfisd-02-a 72115
The highest accepted yield is called the StopYield or High Yield
In this case it is 5375The ratio of bids received to the amountawarded is known as the bid to cover ratio
The higher the ratio the stronger is the auction
8282014 72
8112019 FISD-02-A
httpslidepdfcomreaderfullfisd-02-a 73115
8112019 FISD-02-A
httpslidepdfcomreaderfullfisd-02-a 74115
Those who bid more than 5375 will getnothing and are said to be shutout of theauctionSince 1999 the US Treasury has beenconducting only uniform yield auctions
8282014 74
8112019 FISD-02-A
httpslidepdfcomreaderfullfisd-02-a 75115
WI stands for ndash When As and If IssuedThe when issued market is a market forforward trading of a bond
Which has been announced but not yet issuedTrades take place from the date ofannouncement until the actual issue date
Helps bidders to gauge the marketrsquos interestbefore the actual auction
8282014 75
8112019 FISD-02-A
httpslidepdfcomreaderfullfisd-02-a 76115
WI trading has ramifications for the biddingstrategies of market participantsTraders can take both long and shortpositions
Settlement is scheduled for the issue date
8282014 76
8112019 FISD-02-A
httpslidepdfcomreaderfullfisd-02-a 77115
It has a bearing on the outcome of theauction
It affects the strategy used by a bidder becauseit has an impact on his prior positionBidders who are long in the WI market enter theauction with a Long PositionThose who are short in the WI market enter theauction with a short position
8282014 77
8112019 FISD-02-A
httpslidepdfcomreaderfullfisd-02-a 78115
The WI market helps in price discoveryIt provides important information on
The strength of demand for the securityAnd on the disparity of biddersrsquo views
This help potential bidders to formulate theirstrategiesAt times a dealer may believe that he hasvery important private information
If so he may not participate in the WI market andwill directly enter the auction with bids based onhis knowledge
8282014 78
8112019 FISD-02-A
httpslidepdfcomreaderfullfisd-02-a 79115
On or before the date of the auction theissues trade on a yield basis
The actual price can be established only afterthe coupon is set
Starting with the day after the auctionSecurities are quoted on a price basis becausethe coupon is known
8282014 79
8112019 FISD-02-A
httpslidepdfcomreaderfullfisd-02-a 80115
In a coupon roll a dealer will purchase themost recently issued security from a clientAnd simultaneously sell the same amount ofthe recently announced new security
The first leg with settle on the following dayThe second leg is a forward contract
8282014 80
8112019 FISD-02-A
httpslidepdfcomreaderfullfisd-02-a 81115
There can be a Reverse RollThe dealer will sell the most recent issue fornext day settlementAnd buy the newly announced security forforward settlement
The forward leg in a RollReverse Roll is a WItrade
It will settle on the new issue settlement date
8282014 81
8112019 FISD-02-A
httpslidepdfcomreaderfullfisd-02-a 82115
The roll is the spread between the yield onthe new security and that on the outstandingissue in the same maturity segmentA GIVE in the Roll means that
The WI security provides a higher yield than theoutstanding issue
A Take in the Roll means thatThe WI security provides a lower yield
8282014 82
8112019 FISD-02-A
httpslidepdfcomreaderfullfisd-02-a 83115
8112019 FISD-02-A
httpslidepdfcomreaderfullfisd-02-a 84115
On March 17 20XX the Treasury announcedthe auction of a 2-year note
The auction was scheduled for March 24The settlement date was March 31
Trading of the roll began as soon as the issuewas announcedA Give of 5 bp means that the dealer proposes tobuy the current issue at the prevailing yieldAnd sell the new issue at a yield that is 5 bpmoreA Take of 5 bp means that the dealer proposes tosell the new issue at a yield that is 5bp lower
8282014 84
8112019 FISD-02-A
httpslidepdfcomreaderfullfisd-02-a 85115
The roll achieves the followingHe acquires the outstanding issue for next daysettlementHe sells the to be issued security with the samepar value for forward delivery on 31 March
The customer is rolling over the investmentfrom the current issue to the new issue
This extends the maturity of the investment byone month
8282014 85
8112019 FISD-02-A
httpslidepdfcomreaderfullfisd-02-a 86115
The client can invest the funds received tillthe new issue settlesHowever he loses the accrued interest thathe would have earned had he held on to theissue
8282014 86
8112019 FISD-02-A
httpslidepdfcomreaderfullfisd-02-a 87115
The Treasury per se does not issue zerocoupon securitiesBut zero coupon securities can be created
which are backed by conventional bondsTake a large quantity of a T-note or bond andseparate all the cash flows from each otherSell the entitlement to each cash flowseparately
8282014 87
8112019 FISD-02-A
httpslidepdfcomreaderfullfisd-02-a 88115
Take the case of a two-year T-noteIt can be separated into five zero couponsecurities maturing after
6 months12 months18 months24 months
8282014 88
8112019 FISD-02-A
httpslidepdfcomreaderfullfisd-02-a 89115
Earlier investment banks used to buy bondsfrom the Treasury and separate the cashflows
Each cash flow was then sold separately as a zerocoupon bondSuch issues are called trademarks
8282014 89
8112019 FISD-02-A
httpslidepdfcomreaderfullfisd-02-a 90115
The issue of trademarks has now ceasedBecause investment banks can now createsuch instruments
In concert with the Treasury itselfThese ZCBs are known as STRIPS ndash
Separate Trading of Registered Interest andPrincipal of Securities
These are not issued or sold by the Treasury
The market is made by investment banks
8282014 90
8112019 FISD-02-A
httpslidepdfcomreaderfullfisd-02-a 91115
What is the motivation to create suchproductsIn practice arbitrage is possible when a
coupon security is purchased at a priceThat is lower than what could be obtained byselling each cash flow separately
8282014 91
8112019 FISD-02-A
httpslidepdfcomreaderfullfisd-02-a 92115
Coupon stripping reflects a case of financialengineering
Creating a risk-return profile that is nototherwise available
An investment bank would buy a largequantity of a Treasury security
The securities would be placed with an SPV
8282014 92
8112019 FISD-02-A
httpslidepdfcomreaderfullfisd-02-a 93115
The SPV is a single-purpose dedicated trustIt has the powers to own the bonds andcollect payments
It cannot sell or lend the bondsIt cannot write options on the bondsOr use them as collateral for borrowing
The SPV is empowered to issue zero coupon
bondsWhere each security represents the ownership ofa single cash flow from the mother bond
8282014 93
8112019 FISD-02-A
httpslidepdfcomreaderfullfisd-02-a 94115
Assume that 100MM USD of 15 year bondswith a coupon of 8 are placed with the SPV
The SPV can issue 6M 12M 18M extending up to14 frac12 year zeroes with a total face value of 4MM
USD eachAnd 15 year zeroes with a total face value of104MM
8282014 94
8112019 FISD-02-A
httpslidepdfcomreaderfullfisd-02-a 95115
8112019 FISD-02-A
httpslidepdfcomreaderfullfisd-02-a 96115
8282014 96
8112019 FISD-02-A
httpslidepdfcomreaderfullfisd-02-a 97115
The Treasury launched this program in 1985to facilitate the stripping of designatedsecurities
All new T-bonds and notes with a maturity of 10years or more are eligibleThe zeroes created in the process are directobligations of the US government
8282014 97
8112019 FISD-02-A
httpslidepdfcomreaderfullfisd-02-a 98115
The mechanism is as followsA dealer who owns a bond or note can ask theFRB where it is held
To replace it with an equivalent set of STRIPS
representing each payment as a separate securityEach of these securities can be traded independentlyof others
8282014 98
8112019 FISD-02-A
httpslidepdfcomreaderfullfisd-02-a 99115
In 1987 the Treasury started to allow dealersto reverse the process
This is called STRIPS RECONSTUTUTION If a dealer owns STRIPS representing all thecoupon and principal payments of a bond
The FED can on request convert these holdings into asingle position in the corresponding bond
8282014 99
8112019 FISD-02-A
httpslidepdfcomreaderfullfisd-02-a 100115
Each coupon and principal cash flow from aTreasury security is assigned a CUSIP
The mother bond is also assigned a CUSIPThe stripped coupons are known as C-STRIPSThe stripped principal is known as P-STRIPSSupply of a C-STRIP increases over time
because a C-STRIP maturing on a day like 15 FEB
2020 will have the same CUSIP irrespective ofwhich mother bond it has come fromThe original coupon rate is irrelevant
8282014 100
8112019 FISD-02-A
httpslidepdfcomreaderfullfisd-02-a 101115
P-STRIPS always correspond to the originalsecurityThey have a unique CUSIPTheir supply is fixed at the time of issuanceIn practice the prices of long-dated P-STRIPSare a bit higher than those of C-STRIPS withthe same maturity date
One reason is that P-STRIPS are more liquid due
to greater availabilityA $100 face value bond with a coupon of 8 willgenerate C-STRIPS with a face value of $4 but P-STRIPS with a face value of $100
8282014 101
8112019 FISD-02-A
httpslidepdfcomreaderfullfisd-02-a 102115
Another reason why P-STRIPS are in higherdemand is that they allow reconstitutionactivities more easily
Assume that the sum of the STRIPS is cheaper than
the mother bondIf a dealer already has the P-STRIPS only the C-STRIPSneed to be acquiredHowever if he owns some of the C-STRIPS he needs toacquire the P-STRIPS and the remaining C-STRIPSThe facility to reconstitute when profitable is pricedinto the P-STRIPSNote Buy and hold investors will prefer C-STRIPSsince they are priced lower and give a higher yield
8282014 102
8112019 FISD-02-A
httpslidepdfcomreaderfullfisd-02-a 103115
For Plain Vanilla bonds the specifiedcoupon rate is valid for the life of thebond
In the case of Floaters the rate is reset atthe beginning of every periodThe rate will vary directly with thebenchmark
8282014 103
8112019 FISD-02-A
httpslidepdfcomreaderfullfisd-02-a 104115
The rate on a Floater is specified as LIBOR+ 50 bp
The spread is positiveIf it were specified as LIBOR ndash 30bp
The spread will be negativeIf LIBOR rises the rate will increasewhereas if LIBOR falls it will decrease
8282014 104
8112019 FISD-02-A
httpslidepdfcomreaderfullfisd-02-a 105115
In the case of a default risk-free floater theprice will reset to par on a coupon date
It may sell at a premium or discount betweencoupon dates
Consider a floater with a coupon = 5-year T-Bond rate
Assume there are two periods left to maturity
8282014 105
8112019 FISD-02-A
httpslidepdfcomreaderfullfisd-02-a 106115
8282014 106
The price at the end of the first coupon period willbe given by
cT-1 is the coupon one period before maturityyT-1 is the YTM one period before maturity
8112019 FISD-02-A
httpslidepdfcomreaderfullfisd-02-a 107115
On a coupon reset date the YTM = couponBecause we have assumed there is no default riskAny change in the required yield as reflected inthe prevailing YTM
Will also be reflected in the coupon being setIf coupon = yield the bond should sell at par
Thus P T-1 = M
8282014 107
8112019 FISD-02-A
httpslidepdfcomreaderfullfisd-02-a 108115
8282014 108
8112019 FISD-02-A
httpslidepdfcomreaderfullfisd-02-a 109115
Once again at T-2 c T-2 = yT-2 and P T-2 = MThis logic can be applied to a bond with anytime remaining till maturityHowever between two coupon dates theprice may not be equal to par
Consider the valuation at T-2+k
8282014 109
8112019 FISD-02-A
httpslidepdfcomreaderfullfisd-02-a 110115
8282014 110
8112019 FISD-02-A
httpslidepdfcomreaderfullfisd-02-a 111115
Although c T-2 was set at T-2 and is equal toyT-2
yT-2+k is determined at T-2+k and will reflect theyield prevailing at that time
Thus yT-2+k need not equal c T-2 and may behigher or lower
Hence between two coupon dates a floater maysell at a premium or discount
8282014 111
8112019 FISD-02-A
httpslidepdfcomreaderfullfisd-02-a 112115
Now consider a floater characterized bydefault risk
The risk premium required by the market neednot be constant over time
Assume that at the time of issue YTM = 5-year T-note rate + 75bp
The coupon would have been set equal to thisrate and the bond would have been issued at par
8282014 112
8112019 FISD-02-A
httpslidepdfcomreaderfullfisd-02-a 113115
Six months hence the issue may be perceivedas more risky
YTM = 5-year T-note rate + 95 bpThe coupon will however be set equal to theprevailing 5-year rate + 75 bpIf so the issue will not reset to par at the nextcoupon date
8282014 113
8112019 FISD-02-A
httpslidepdfcomreaderfullfisd-02-a 114115
Floaters may come with a CAP or a FLOOR orBOTH
The CAP is a maximum coupon rateProtects issuers against rising rates
The FLOOR is a minimum coupon rateProtects investors against falling rates
When there is a spread over LIBORThere is a natural floorLIBOR cannot be less than zero
8282014 114
8112019 FISD-02-A
httpslidepdfcomreaderfullfisd-02-a 115115
8112019 FISD-02-A
httpslidepdfcomreaderfullfisd-02-a 70115
The aggregate demand equals the amount onoffer at a yield of 5375A multiple yield auction will lead to thefollowing allocation
Alpha will get 3 bn at a yield of 5370Beta will get 5 bn at 5372Gamma will get 4 bn at 5373
8282014 70
8112019 FISD-02-A
httpslidepdfcomreaderfullfisd-02-a 71115
At a yield of 5375 we have only 11 bn left toallocateThere is a demand of 20 bn at this yield
8 bn from Delta and 12 bn from CharlieThus we will allocate 1120 = 55 to eachbidder at this yield
There will be pro-rata allocation
055 of 8 bn or 440 bn will go to Delta055 of 12 bn or 66 bn will go to Charlie
8282014 71
8112019 FISD-02-A
httpslidepdfcomreaderfullfisd-02-a 72115
The highest accepted yield is called the StopYield or High Yield
In this case it is 5375The ratio of bids received to the amountawarded is known as the bid to cover ratio
The higher the ratio the stronger is the auction
8282014 72
8112019 FISD-02-A
httpslidepdfcomreaderfullfisd-02-a 73115
8112019 FISD-02-A
httpslidepdfcomreaderfullfisd-02-a 74115
Those who bid more than 5375 will getnothing and are said to be shutout of theauctionSince 1999 the US Treasury has beenconducting only uniform yield auctions
8282014 74
8112019 FISD-02-A
httpslidepdfcomreaderfullfisd-02-a 75115
WI stands for ndash When As and If IssuedThe when issued market is a market forforward trading of a bond
Which has been announced but not yet issuedTrades take place from the date ofannouncement until the actual issue date
Helps bidders to gauge the marketrsquos interestbefore the actual auction
8282014 75
8112019 FISD-02-A
httpslidepdfcomreaderfullfisd-02-a 76115
WI trading has ramifications for the biddingstrategies of market participantsTraders can take both long and shortpositions
Settlement is scheduled for the issue date
8282014 76
8112019 FISD-02-A
httpslidepdfcomreaderfullfisd-02-a 77115
It has a bearing on the outcome of theauction
It affects the strategy used by a bidder becauseit has an impact on his prior positionBidders who are long in the WI market enter theauction with a Long PositionThose who are short in the WI market enter theauction with a short position
8282014 77
8112019 FISD-02-A
httpslidepdfcomreaderfullfisd-02-a 78115
The WI market helps in price discoveryIt provides important information on
The strength of demand for the securityAnd on the disparity of biddersrsquo views
This help potential bidders to formulate theirstrategiesAt times a dealer may believe that he hasvery important private information
If so he may not participate in the WI market andwill directly enter the auction with bids based onhis knowledge
8282014 78
8112019 FISD-02-A
httpslidepdfcomreaderfullfisd-02-a 79115
On or before the date of the auction theissues trade on a yield basis
The actual price can be established only afterthe coupon is set
Starting with the day after the auctionSecurities are quoted on a price basis becausethe coupon is known
8282014 79
8112019 FISD-02-A
httpslidepdfcomreaderfullfisd-02-a 80115
In a coupon roll a dealer will purchase themost recently issued security from a clientAnd simultaneously sell the same amount ofthe recently announced new security
The first leg with settle on the following dayThe second leg is a forward contract
8282014 80
8112019 FISD-02-A
httpslidepdfcomreaderfullfisd-02-a 81115
There can be a Reverse RollThe dealer will sell the most recent issue fornext day settlementAnd buy the newly announced security forforward settlement
The forward leg in a RollReverse Roll is a WItrade
It will settle on the new issue settlement date
8282014 81
8112019 FISD-02-A
httpslidepdfcomreaderfullfisd-02-a 82115
The roll is the spread between the yield onthe new security and that on the outstandingissue in the same maturity segmentA GIVE in the Roll means that
The WI security provides a higher yield than theoutstanding issue
A Take in the Roll means thatThe WI security provides a lower yield
8282014 82
8112019 FISD-02-A
httpslidepdfcomreaderfullfisd-02-a 83115
8112019 FISD-02-A
httpslidepdfcomreaderfullfisd-02-a 84115
On March 17 20XX the Treasury announcedthe auction of a 2-year note
The auction was scheduled for March 24The settlement date was March 31
Trading of the roll began as soon as the issuewas announcedA Give of 5 bp means that the dealer proposes tobuy the current issue at the prevailing yieldAnd sell the new issue at a yield that is 5 bpmoreA Take of 5 bp means that the dealer proposes tosell the new issue at a yield that is 5bp lower
8282014 84
8112019 FISD-02-A
httpslidepdfcomreaderfullfisd-02-a 85115
The roll achieves the followingHe acquires the outstanding issue for next daysettlementHe sells the to be issued security with the samepar value for forward delivery on 31 March
The customer is rolling over the investmentfrom the current issue to the new issue
This extends the maturity of the investment byone month
8282014 85
8112019 FISD-02-A
httpslidepdfcomreaderfullfisd-02-a 86115
The client can invest the funds received tillthe new issue settlesHowever he loses the accrued interest thathe would have earned had he held on to theissue
8282014 86
8112019 FISD-02-A
httpslidepdfcomreaderfullfisd-02-a 87115
The Treasury per se does not issue zerocoupon securitiesBut zero coupon securities can be created
which are backed by conventional bondsTake a large quantity of a T-note or bond andseparate all the cash flows from each otherSell the entitlement to each cash flowseparately
8282014 87
8112019 FISD-02-A
httpslidepdfcomreaderfullfisd-02-a 88115
Take the case of a two-year T-noteIt can be separated into five zero couponsecurities maturing after
6 months12 months18 months24 months
8282014 88
8112019 FISD-02-A
httpslidepdfcomreaderfullfisd-02-a 89115
Earlier investment banks used to buy bondsfrom the Treasury and separate the cashflows
Each cash flow was then sold separately as a zerocoupon bondSuch issues are called trademarks
8282014 89
8112019 FISD-02-A
httpslidepdfcomreaderfullfisd-02-a 90115
The issue of trademarks has now ceasedBecause investment banks can now createsuch instruments
In concert with the Treasury itselfThese ZCBs are known as STRIPS ndash
Separate Trading of Registered Interest andPrincipal of Securities
These are not issued or sold by the Treasury
The market is made by investment banks
8282014 90
8112019 FISD-02-A
httpslidepdfcomreaderfullfisd-02-a 91115
What is the motivation to create suchproductsIn practice arbitrage is possible when a
coupon security is purchased at a priceThat is lower than what could be obtained byselling each cash flow separately
8282014 91
8112019 FISD-02-A
httpslidepdfcomreaderfullfisd-02-a 92115
Coupon stripping reflects a case of financialengineering
Creating a risk-return profile that is nototherwise available
An investment bank would buy a largequantity of a Treasury security
The securities would be placed with an SPV
8282014 92
8112019 FISD-02-A
httpslidepdfcomreaderfullfisd-02-a 93115
The SPV is a single-purpose dedicated trustIt has the powers to own the bonds andcollect payments
It cannot sell or lend the bondsIt cannot write options on the bondsOr use them as collateral for borrowing
The SPV is empowered to issue zero coupon
bondsWhere each security represents the ownership ofa single cash flow from the mother bond
8282014 93
8112019 FISD-02-A
httpslidepdfcomreaderfullfisd-02-a 94115
Assume that 100MM USD of 15 year bondswith a coupon of 8 are placed with the SPV
The SPV can issue 6M 12M 18M extending up to14 frac12 year zeroes with a total face value of 4MM
USD eachAnd 15 year zeroes with a total face value of104MM
8282014 94
8112019 FISD-02-A
httpslidepdfcomreaderfullfisd-02-a 95115
8112019 FISD-02-A
httpslidepdfcomreaderfullfisd-02-a 96115
8282014 96
8112019 FISD-02-A
httpslidepdfcomreaderfullfisd-02-a 97115
The Treasury launched this program in 1985to facilitate the stripping of designatedsecurities
All new T-bonds and notes with a maturity of 10years or more are eligibleThe zeroes created in the process are directobligations of the US government
8282014 97
8112019 FISD-02-A
httpslidepdfcomreaderfullfisd-02-a 98115
The mechanism is as followsA dealer who owns a bond or note can ask theFRB where it is held
To replace it with an equivalent set of STRIPS
representing each payment as a separate securityEach of these securities can be traded independentlyof others
8282014 98
8112019 FISD-02-A
httpslidepdfcomreaderfullfisd-02-a 99115
In 1987 the Treasury started to allow dealersto reverse the process
This is called STRIPS RECONSTUTUTION If a dealer owns STRIPS representing all thecoupon and principal payments of a bond
The FED can on request convert these holdings into asingle position in the corresponding bond
8282014 99
8112019 FISD-02-A
httpslidepdfcomreaderfullfisd-02-a 100115
Each coupon and principal cash flow from aTreasury security is assigned a CUSIP
The mother bond is also assigned a CUSIPThe stripped coupons are known as C-STRIPSThe stripped principal is known as P-STRIPSSupply of a C-STRIP increases over time
because a C-STRIP maturing on a day like 15 FEB
2020 will have the same CUSIP irrespective ofwhich mother bond it has come fromThe original coupon rate is irrelevant
8282014 100
8112019 FISD-02-A
httpslidepdfcomreaderfullfisd-02-a 101115
P-STRIPS always correspond to the originalsecurityThey have a unique CUSIPTheir supply is fixed at the time of issuanceIn practice the prices of long-dated P-STRIPSare a bit higher than those of C-STRIPS withthe same maturity date
One reason is that P-STRIPS are more liquid due
to greater availabilityA $100 face value bond with a coupon of 8 willgenerate C-STRIPS with a face value of $4 but P-STRIPS with a face value of $100
8282014 101
8112019 FISD-02-A
httpslidepdfcomreaderfullfisd-02-a 102115
Another reason why P-STRIPS are in higherdemand is that they allow reconstitutionactivities more easily
Assume that the sum of the STRIPS is cheaper than
the mother bondIf a dealer already has the P-STRIPS only the C-STRIPSneed to be acquiredHowever if he owns some of the C-STRIPS he needs toacquire the P-STRIPS and the remaining C-STRIPSThe facility to reconstitute when profitable is pricedinto the P-STRIPSNote Buy and hold investors will prefer C-STRIPSsince they are priced lower and give a higher yield
8282014 102
8112019 FISD-02-A
httpslidepdfcomreaderfullfisd-02-a 103115
For Plain Vanilla bonds the specifiedcoupon rate is valid for the life of thebond
In the case of Floaters the rate is reset atthe beginning of every periodThe rate will vary directly with thebenchmark
8282014 103
8112019 FISD-02-A
httpslidepdfcomreaderfullfisd-02-a 104115
The rate on a Floater is specified as LIBOR+ 50 bp
The spread is positiveIf it were specified as LIBOR ndash 30bp
The spread will be negativeIf LIBOR rises the rate will increasewhereas if LIBOR falls it will decrease
8282014 104
8112019 FISD-02-A
httpslidepdfcomreaderfullfisd-02-a 105115
In the case of a default risk-free floater theprice will reset to par on a coupon date
It may sell at a premium or discount betweencoupon dates
Consider a floater with a coupon = 5-year T-Bond rate
Assume there are two periods left to maturity
8282014 105
8112019 FISD-02-A
httpslidepdfcomreaderfullfisd-02-a 106115
8282014 106
The price at the end of the first coupon period willbe given by
cT-1 is the coupon one period before maturityyT-1 is the YTM one period before maturity
8112019 FISD-02-A
httpslidepdfcomreaderfullfisd-02-a 107115
On a coupon reset date the YTM = couponBecause we have assumed there is no default riskAny change in the required yield as reflected inthe prevailing YTM
Will also be reflected in the coupon being setIf coupon = yield the bond should sell at par
Thus P T-1 = M
8282014 107
8112019 FISD-02-A
httpslidepdfcomreaderfullfisd-02-a 108115
8282014 108
8112019 FISD-02-A
httpslidepdfcomreaderfullfisd-02-a 109115
Once again at T-2 c T-2 = yT-2 and P T-2 = MThis logic can be applied to a bond with anytime remaining till maturityHowever between two coupon dates theprice may not be equal to par
Consider the valuation at T-2+k
8282014 109
8112019 FISD-02-A
httpslidepdfcomreaderfullfisd-02-a 110115
8282014 110
8112019 FISD-02-A
httpslidepdfcomreaderfullfisd-02-a 111115
Although c T-2 was set at T-2 and is equal toyT-2
yT-2+k is determined at T-2+k and will reflect theyield prevailing at that time
Thus yT-2+k need not equal c T-2 and may behigher or lower
Hence between two coupon dates a floater maysell at a premium or discount
8282014 111
8112019 FISD-02-A
httpslidepdfcomreaderfullfisd-02-a 112115
Now consider a floater characterized bydefault risk
The risk premium required by the market neednot be constant over time
Assume that at the time of issue YTM = 5-year T-note rate + 75bp
The coupon would have been set equal to thisrate and the bond would have been issued at par
8282014 112
8112019 FISD-02-A
httpslidepdfcomreaderfullfisd-02-a 113115
Six months hence the issue may be perceivedas more risky
YTM = 5-year T-note rate + 95 bpThe coupon will however be set equal to theprevailing 5-year rate + 75 bpIf so the issue will not reset to par at the nextcoupon date
8282014 113
8112019 FISD-02-A
httpslidepdfcomreaderfullfisd-02-a 114115
Floaters may come with a CAP or a FLOOR orBOTH
The CAP is a maximum coupon rateProtects issuers against rising rates
The FLOOR is a minimum coupon rateProtects investors against falling rates
When there is a spread over LIBORThere is a natural floorLIBOR cannot be less than zero
8282014 114
8112019 FISD-02-A
httpslidepdfcomreaderfullfisd-02-a 115115
8112019 FISD-02-A
httpslidepdfcomreaderfullfisd-02-a 71115
At a yield of 5375 we have only 11 bn left toallocateThere is a demand of 20 bn at this yield
8 bn from Delta and 12 bn from CharlieThus we will allocate 1120 = 55 to eachbidder at this yield
There will be pro-rata allocation
055 of 8 bn or 440 bn will go to Delta055 of 12 bn or 66 bn will go to Charlie
8282014 71
8112019 FISD-02-A
httpslidepdfcomreaderfullfisd-02-a 72115
The highest accepted yield is called the StopYield or High Yield
In this case it is 5375The ratio of bids received to the amountawarded is known as the bid to cover ratio
The higher the ratio the stronger is the auction
8282014 72
8112019 FISD-02-A
httpslidepdfcomreaderfullfisd-02-a 73115
8112019 FISD-02-A
httpslidepdfcomreaderfullfisd-02-a 74115
Those who bid more than 5375 will getnothing and are said to be shutout of theauctionSince 1999 the US Treasury has beenconducting only uniform yield auctions
8282014 74
8112019 FISD-02-A
httpslidepdfcomreaderfullfisd-02-a 75115
WI stands for ndash When As and If IssuedThe when issued market is a market forforward trading of a bond
Which has been announced but not yet issuedTrades take place from the date ofannouncement until the actual issue date
Helps bidders to gauge the marketrsquos interestbefore the actual auction
8282014 75
8112019 FISD-02-A
httpslidepdfcomreaderfullfisd-02-a 76115
WI trading has ramifications for the biddingstrategies of market participantsTraders can take both long and shortpositions
Settlement is scheduled for the issue date
8282014 76
8112019 FISD-02-A
httpslidepdfcomreaderfullfisd-02-a 77115
It has a bearing on the outcome of theauction
It affects the strategy used by a bidder becauseit has an impact on his prior positionBidders who are long in the WI market enter theauction with a Long PositionThose who are short in the WI market enter theauction with a short position
8282014 77
8112019 FISD-02-A
httpslidepdfcomreaderfullfisd-02-a 78115
The WI market helps in price discoveryIt provides important information on
The strength of demand for the securityAnd on the disparity of biddersrsquo views
This help potential bidders to formulate theirstrategiesAt times a dealer may believe that he hasvery important private information
If so he may not participate in the WI market andwill directly enter the auction with bids based onhis knowledge
8282014 78
8112019 FISD-02-A
httpslidepdfcomreaderfullfisd-02-a 79115
On or before the date of the auction theissues trade on a yield basis
The actual price can be established only afterthe coupon is set
Starting with the day after the auctionSecurities are quoted on a price basis becausethe coupon is known
8282014 79
8112019 FISD-02-A
httpslidepdfcomreaderfullfisd-02-a 80115
In a coupon roll a dealer will purchase themost recently issued security from a clientAnd simultaneously sell the same amount ofthe recently announced new security
The first leg with settle on the following dayThe second leg is a forward contract
8282014 80
8112019 FISD-02-A
httpslidepdfcomreaderfullfisd-02-a 81115
There can be a Reverse RollThe dealer will sell the most recent issue fornext day settlementAnd buy the newly announced security forforward settlement
The forward leg in a RollReverse Roll is a WItrade
It will settle on the new issue settlement date
8282014 81
8112019 FISD-02-A
httpslidepdfcomreaderfullfisd-02-a 82115
The roll is the spread between the yield onthe new security and that on the outstandingissue in the same maturity segmentA GIVE in the Roll means that
The WI security provides a higher yield than theoutstanding issue
A Take in the Roll means thatThe WI security provides a lower yield
8282014 82
8112019 FISD-02-A
httpslidepdfcomreaderfullfisd-02-a 83115
8112019 FISD-02-A
httpslidepdfcomreaderfullfisd-02-a 84115
On March 17 20XX the Treasury announcedthe auction of a 2-year note
The auction was scheduled for March 24The settlement date was March 31
Trading of the roll began as soon as the issuewas announcedA Give of 5 bp means that the dealer proposes tobuy the current issue at the prevailing yieldAnd sell the new issue at a yield that is 5 bpmoreA Take of 5 bp means that the dealer proposes tosell the new issue at a yield that is 5bp lower
8282014 84
8112019 FISD-02-A
httpslidepdfcomreaderfullfisd-02-a 85115
The roll achieves the followingHe acquires the outstanding issue for next daysettlementHe sells the to be issued security with the samepar value for forward delivery on 31 March
The customer is rolling over the investmentfrom the current issue to the new issue
This extends the maturity of the investment byone month
8282014 85
8112019 FISD-02-A
httpslidepdfcomreaderfullfisd-02-a 86115
The client can invest the funds received tillthe new issue settlesHowever he loses the accrued interest thathe would have earned had he held on to theissue
8282014 86
8112019 FISD-02-A
httpslidepdfcomreaderfullfisd-02-a 87115
The Treasury per se does not issue zerocoupon securitiesBut zero coupon securities can be created
which are backed by conventional bondsTake a large quantity of a T-note or bond andseparate all the cash flows from each otherSell the entitlement to each cash flowseparately
8282014 87
8112019 FISD-02-A
httpslidepdfcomreaderfullfisd-02-a 88115
Take the case of a two-year T-noteIt can be separated into five zero couponsecurities maturing after
6 months12 months18 months24 months
8282014 88
8112019 FISD-02-A
httpslidepdfcomreaderfullfisd-02-a 89115
Earlier investment banks used to buy bondsfrom the Treasury and separate the cashflows
Each cash flow was then sold separately as a zerocoupon bondSuch issues are called trademarks
8282014 89
8112019 FISD-02-A
httpslidepdfcomreaderfullfisd-02-a 90115
The issue of trademarks has now ceasedBecause investment banks can now createsuch instruments
In concert with the Treasury itselfThese ZCBs are known as STRIPS ndash
Separate Trading of Registered Interest andPrincipal of Securities
These are not issued or sold by the Treasury
The market is made by investment banks
8282014 90
8112019 FISD-02-A
httpslidepdfcomreaderfullfisd-02-a 91115
What is the motivation to create suchproductsIn practice arbitrage is possible when a
coupon security is purchased at a priceThat is lower than what could be obtained byselling each cash flow separately
8282014 91
8112019 FISD-02-A
httpslidepdfcomreaderfullfisd-02-a 92115
Coupon stripping reflects a case of financialengineering
Creating a risk-return profile that is nototherwise available
An investment bank would buy a largequantity of a Treasury security
The securities would be placed with an SPV
8282014 92
8112019 FISD-02-A
httpslidepdfcomreaderfullfisd-02-a 93115
The SPV is a single-purpose dedicated trustIt has the powers to own the bonds andcollect payments
It cannot sell or lend the bondsIt cannot write options on the bondsOr use them as collateral for borrowing
The SPV is empowered to issue zero coupon
bondsWhere each security represents the ownership ofa single cash flow from the mother bond
8282014 93
8112019 FISD-02-A
httpslidepdfcomreaderfullfisd-02-a 94115
Assume that 100MM USD of 15 year bondswith a coupon of 8 are placed with the SPV
The SPV can issue 6M 12M 18M extending up to14 frac12 year zeroes with a total face value of 4MM
USD eachAnd 15 year zeroes with a total face value of104MM
8282014 94
8112019 FISD-02-A
httpslidepdfcomreaderfullfisd-02-a 95115
8112019 FISD-02-A
httpslidepdfcomreaderfullfisd-02-a 96115
8282014 96
8112019 FISD-02-A
httpslidepdfcomreaderfullfisd-02-a 97115
The Treasury launched this program in 1985to facilitate the stripping of designatedsecurities
All new T-bonds and notes with a maturity of 10years or more are eligibleThe zeroes created in the process are directobligations of the US government
8282014 97
8112019 FISD-02-A
httpslidepdfcomreaderfullfisd-02-a 98115
The mechanism is as followsA dealer who owns a bond or note can ask theFRB where it is held
To replace it with an equivalent set of STRIPS
representing each payment as a separate securityEach of these securities can be traded independentlyof others
8282014 98
8112019 FISD-02-A
httpslidepdfcomreaderfullfisd-02-a 99115
In 1987 the Treasury started to allow dealersto reverse the process
This is called STRIPS RECONSTUTUTION If a dealer owns STRIPS representing all thecoupon and principal payments of a bond
The FED can on request convert these holdings into asingle position in the corresponding bond
8282014 99
8112019 FISD-02-A
httpslidepdfcomreaderfullfisd-02-a 100115
Each coupon and principal cash flow from aTreasury security is assigned a CUSIP
The mother bond is also assigned a CUSIPThe stripped coupons are known as C-STRIPSThe stripped principal is known as P-STRIPSSupply of a C-STRIP increases over time
because a C-STRIP maturing on a day like 15 FEB
2020 will have the same CUSIP irrespective ofwhich mother bond it has come fromThe original coupon rate is irrelevant
8282014 100
8112019 FISD-02-A
httpslidepdfcomreaderfullfisd-02-a 101115
P-STRIPS always correspond to the originalsecurityThey have a unique CUSIPTheir supply is fixed at the time of issuanceIn practice the prices of long-dated P-STRIPSare a bit higher than those of C-STRIPS withthe same maturity date
One reason is that P-STRIPS are more liquid due
to greater availabilityA $100 face value bond with a coupon of 8 willgenerate C-STRIPS with a face value of $4 but P-STRIPS with a face value of $100
8282014 101
8112019 FISD-02-A
httpslidepdfcomreaderfullfisd-02-a 102115
Another reason why P-STRIPS are in higherdemand is that they allow reconstitutionactivities more easily
Assume that the sum of the STRIPS is cheaper than
the mother bondIf a dealer already has the P-STRIPS only the C-STRIPSneed to be acquiredHowever if he owns some of the C-STRIPS he needs toacquire the P-STRIPS and the remaining C-STRIPSThe facility to reconstitute when profitable is pricedinto the P-STRIPSNote Buy and hold investors will prefer C-STRIPSsince they are priced lower and give a higher yield
8282014 102
8112019 FISD-02-A
httpslidepdfcomreaderfullfisd-02-a 103115
For Plain Vanilla bonds the specifiedcoupon rate is valid for the life of thebond
In the case of Floaters the rate is reset atthe beginning of every periodThe rate will vary directly with thebenchmark
8282014 103
8112019 FISD-02-A
httpslidepdfcomreaderfullfisd-02-a 104115
The rate on a Floater is specified as LIBOR+ 50 bp
The spread is positiveIf it were specified as LIBOR ndash 30bp
The spread will be negativeIf LIBOR rises the rate will increasewhereas if LIBOR falls it will decrease
8282014 104
8112019 FISD-02-A
httpslidepdfcomreaderfullfisd-02-a 105115
In the case of a default risk-free floater theprice will reset to par on a coupon date
It may sell at a premium or discount betweencoupon dates
Consider a floater with a coupon = 5-year T-Bond rate
Assume there are two periods left to maturity
8282014 105
8112019 FISD-02-A
httpslidepdfcomreaderfullfisd-02-a 106115
8282014 106
The price at the end of the first coupon period willbe given by
cT-1 is the coupon one period before maturityyT-1 is the YTM one period before maturity
8112019 FISD-02-A
httpslidepdfcomreaderfullfisd-02-a 107115
On a coupon reset date the YTM = couponBecause we have assumed there is no default riskAny change in the required yield as reflected inthe prevailing YTM
Will also be reflected in the coupon being setIf coupon = yield the bond should sell at par
Thus P T-1 = M
8282014 107
8112019 FISD-02-A
httpslidepdfcomreaderfullfisd-02-a 108115
8282014 108
8112019 FISD-02-A
httpslidepdfcomreaderfullfisd-02-a 109115
Once again at T-2 c T-2 = yT-2 and P T-2 = MThis logic can be applied to a bond with anytime remaining till maturityHowever between two coupon dates theprice may not be equal to par
Consider the valuation at T-2+k
8282014 109
8112019 FISD-02-A
httpslidepdfcomreaderfullfisd-02-a 110115
8282014 110
8112019 FISD-02-A
httpslidepdfcomreaderfullfisd-02-a 111115
Although c T-2 was set at T-2 and is equal toyT-2
yT-2+k is determined at T-2+k and will reflect theyield prevailing at that time
Thus yT-2+k need not equal c T-2 and may behigher or lower
Hence between two coupon dates a floater maysell at a premium or discount
8282014 111
8112019 FISD-02-A
httpslidepdfcomreaderfullfisd-02-a 112115
Now consider a floater characterized bydefault risk
The risk premium required by the market neednot be constant over time
Assume that at the time of issue YTM = 5-year T-note rate + 75bp
The coupon would have been set equal to thisrate and the bond would have been issued at par
8282014 112
8112019 FISD-02-A
httpslidepdfcomreaderfullfisd-02-a 113115
Six months hence the issue may be perceivedas more risky
YTM = 5-year T-note rate + 95 bpThe coupon will however be set equal to theprevailing 5-year rate + 75 bpIf so the issue will not reset to par at the nextcoupon date
8282014 113
8112019 FISD-02-A
httpslidepdfcomreaderfullfisd-02-a 114115
Floaters may come with a CAP or a FLOOR orBOTH
The CAP is a maximum coupon rateProtects issuers against rising rates
The FLOOR is a minimum coupon rateProtects investors against falling rates
When there is a spread over LIBORThere is a natural floorLIBOR cannot be less than zero
8282014 114
8112019 FISD-02-A
httpslidepdfcomreaderfullfisd-02-a 115115
8112019 FISD-02-A
httpslidepdfcomreaderfullfisd-02-a 72115
The highest accepted yield is called the StopYield or High Yield
In this case it is 5375The ratio of bids received to the amountawarded is known as the bid to cover ratio
The higher the ratio the stronger is the auction
8282014 72
8112019 FISD-02-A
httpslidepdfcomreaderfullfisd-02-a 73115
8112019 FISD-02-A
httpslidepdfcomreaderfullfisd-02-a 74115
Those who bid more than 5375 will getnothing and are said to be shutout of theauctionSince 1999 the US Treasury has beenconducting only uniform yield auctions
8282014 74
8112019 FISD-02-A
httpslidepdfcomreaderfullfisd-02-a 75115
WI stands for ndash When As and If IssuedThe when issued market is a market forforward trading of a bond
Which has been announced but not yet issuedTrades take place from the date ofannouncement until the actual issue date
Helps bidders to gauge the marketrsquos interestbefore the actual auction
8282014 75
8112019 FISD-02-A
httpslidepdfcomreaderfullfisd-02-a 76115
WI trading has ramifications for the biddingstrategies of market participantsTraders can take both long and shortpositions
Settlement is scheduled for the issue date
8282014 76
8112019 FISD-02-A
httpslidepdfcomreaderfullfisd-02-a 77115
It has a bearing on the outcome of theauction
It affects the strategy used by a bidder becauseit has an impact on his prior positionBidders who are long in the WI market enter theauction with a Long PositionThose who are short in the WI market enter theauction with a short position
8282014 77
8112019 FISD-02-A
httpslidepdfcomreaderfullfisd-02-a 78115
The WI market helps in price discoveryIt provides important information on
The strength of demand for the securityAnd on the disparity of biddersrsquo views
This help potential bidders to formulate theirstrategiesAt times a dealer may believe that he hasvery important private information
If so he may not participate in the WI market andwill directly enter the auction with bids based onhis knowledge
8282014 78
8112019 FISD-02-A
httpslidepdfcomreaderfullfisd-02-a 79115
On or before the date of the auction theissues trade on a yield basis
The actual price can be established only afterthe coupon is set
Starting with the day after the auctionSecurities are quoted on a price basis becausethe coupon is known
8282014 79
8112019 FISD-02-A
httpslidepdfcomreaderfullfisd-02-a 80115
In a coupon roll a dealer will purchase themost recently issued security from a clientAnd simultaneously sell the same amount ofthe recently announced new security
The first leg with settle on the following dayThe second leg is a forward contract
8282014 80
8112019 FISD-02-A
httpslidepdfcomreaderfullfisd-02-a 81115
There can be a Reverse RollThe dealer will sell the most recent issue fornext day settlementAnd buy the newly announced security forforward settlement
The forward leg in a RollReverse Roll is a WItrade
It will settle on the new issue settlement date
8282014 81
8112019 FISD-02-A
httpslidepdfcomreaderfullfisd-02-a 82115
The roll is the spread between the yield onthe new security and that on the outstandingissue in the same maturity segmentA GIVE in the Roll means that
The WI security provides a higher yield than theoutstanding issue
A Take in the Roll means thatThe WI security provides a lower yield
8282014 82
8112019 FISD-02-A
httpslidepdfcomreaderfullfisd-02-a 83115
8112019 FISD-02-A
httpslidepdfcomreaderfullfisd-02-a 84115
On March 17 20XX the Treasury announcedthe auction of a 2-year note
The auction was scheduled for March 24The settlement date was March 31
Trading of the roll began as soon as the issuewas announcedA Give of 5 bp means that the dealer proposes tobuy the current issue at the prevailing yieldAnd sell the new issue at a yield that is 5 bpmoreA Take of 5 bp means that the dealer proposes tosell the new issue at a yield that is 5bp lower
8282014 84
8112019 FISD-02-A
httpslidepdfcomreaderfullfisd-02-a 85115
The roll achieves the followingHe acquires the outstanding issue for next daysettlementHe sells the to be issued security with the samepar value for forward delivery on 31 March
The customer is rolling over the investmentfrom the current issue to the new issue
This extends the maturity of the investment byone month
8282014 85
8112019 FISD-02-A
httpslidepdfcomreaderfullfisd-02-a 86115
The client can invest the funds received tillthe new issue settlesHowever he loses the accrued interest thathe would have earned had he held on to theissue
8282014 86
8112019 FISD-02-A
httpslidepdfcomreaderfullfisd-02-a 87115
The Treasury per se does not issue zerocoupon securitiesBut zero coupon securities can be created
which are backed by conventional bondsTake a large quantity of a T-note or bond andseparate all the cash flows from each otherSell the entitlement to each cash flowseparately
8282014 87
8112019 FISD-02-A
httpslidepdfcomreaderfullfisd-02-a 88115
Take the case of a two-year T-noteIt can be separated into five zero couponsecurities maturing after
6 months12 months18 months24 months
8282014 88
8112019 FISD-02-A
httpslidepdfcomreaderfullfisd-02-a 89115
Earlier investment banks used to buy bondsfrom the Treasury and separate the cashflows
Each cash flow was then sold separately as a zerocoupon bondSuch issues are called trademarks
8282014 89
8112019 FISD-02-A
httpslidepdfcomreaderfullfisd-02-a 90115
The issue of trademarks has now ceasedBecause investment banks can now createsuch instruments
In concert with the Treasury itselfThese ZCBs are known as STRIPS ndash
Separate Trading of Registered Interest andPrincipal of Securities
These are not issued or sold by the Treasury
The market is made by investment banks
8282014 90
8112019 FISD-02-A
httpslidepdfcomreaderfullfisd-02-a 91115
What is the motivation to create suchproductsIn practice arbitrage is possible when a
coupon security is purchased at a priceThat is lower than what could be obtained byselling each cash flow separately
8282014 91
8112019 FISD-02-A
httpslidepdfcomreaderfullfisd-02-a 92115
Coupon stripping reflects a case of financialengineering
Creating a risk-return profile that is nototherwise available
An investment bank would buy a largequantity of a Treasury security
The securities would be placed with an SPV
8282014 92
8112019 FISD-02-A
httpslidepdfcomreaderfullfisd-02-a 93115
The SPV is a single-purpose dedicated trustIt has the powers to own the bonds andcollect payments
It cannot sell or lend the bondsIt cannot write options on the bondsOr use them as collateral for borrowing
The SPV is empowered to issue zero coupon
bondsWhere each security represents the ownership ofa single cash flow from the mother bond
8282014 93
8112019 FISD-02-A
httpslidepdfcomreaderfullfisd-02-a 94115
Assume that 100MM USD of 15 year bondswith a coupon of 8 are placed with the SPV
The SPV can issue 6M 12M 18M extending up to14 frac12 year zeroes with a total face value of 4MM
USD eachAnd 15 year zeroes with a total face value of104MM
8282014 94
8112019 FISD-02-A
httpslidepdfcomreaderfullfisd-02-a 95115
8112019 FISD-02-A
httpslidepdfcomreaderfullfisd-02-a 96115
8282014 96
8112019 FISD-02-A
httpslidepdfcomreaderfullfisd-02-a 97115
The Treasury launched this program in 1985to facilitate the stripping of designatedsecurities
All new T-bonds and notes with a maturity of 10years or more are eligibleThe zeroes created in the process are directobligations of the US government
8282014 97
8112019 FISD-02-A
httpslidepdfcomreaderfullfisd-02-a 98115
The mechanism is as followsA dealer who owns a bond or note can ask theFRB where it is held
To replace it with an equivalent set of STRIPS
representing each payment as a separate securityEach of these securities can be traded independentlyof others
8282014 98
8112019 FISD-02-A
httpslidepdfcomreaderfullfisd-02-a 99115
In 1987 the Treasury started to allow dealersto reverse the process
This is called STRIPS RECONSTUTUTION If a dealer owns STRIPS representing all thecoupon and principal payments of a bond
The FED can on request convert these holdings into asingle position in the corresponding bond
8282014 99
8112019 FISD-02-A
httpslidepdfcomreaderfullfisd-02-a 100115
Each coupon and principal cash flow from aTreasury security is assigned a CUSIP
The mother bond is also assigned a CUSIPThe stripped coupons are known as C-STRIPSThe stripped principal is known as P-STRIPSSupply of a C-STRIP increases over time
because a C-STRIP maturing on a day like 15 FEB
2020 will have the same CUSIP irrespective ofwhich mother bond it has come fromThe original coupon rate is irrelevant
8282014 100
8112019 FISD-02-A
httpslidepdfcomreaderfullfisd-02-a 101115
P-STRIPS always correspond to the originalsecurityThey have a unique CUSIPTheir supply is fixed at the time of issuanceIn practice the prices of long-dated P-STRIPSare a bit higher than those of C-STRIPS withthe same maturity date
One reason is that P-STRIPS are more liquid due
to greater availabilityA $100 face value bond with a coupon of 8 willgenerate C-STRIPS with a face value of $4 but P-STRIPS with a face value of $100
8282014 101
8112019 FISD-02-A
httpslidepdfcomreaderfullfisd-02-a 102115
Another reason why P-STRIPS are in higherdemand is that they allow reconstitutionactivities more easily
Assume that the sum of the STRIPS is cheaper than
the mother bondIf a dealer already has the P-STRIPS only the C-STRIPSneed to be acquiredHowever if he owns some of the C-STRIPS he needs toacquire the P-STRIPS and the remaining C-STRIPSThe facility to reconstitute when profitable is pricedinto the P-STRIPSNote Buy and hold investors will prefer C-STRIPSsince they are priced lower and give a higher yield
8282014 102
8112019 FISD-02-A
httpslidepdfcomreaderfullfisd-02-a 103115
For Plain Vanilla bonds the specifiedcoupon rate is valid for the life of thebond
In the case of Floaters the rate is reset atthe beginning of every periodThe rate will vary directly with thebenchmark
8282014 103
8112019 FISD-02-A
httpslidepdfcomreaderfullfisd-02-a 104115
The rate on a Floater is specified as LIBOR+ 50 bp
The spread is positiveIf it were specified as LIBOR ndash 30bp
The spread will be negativeIf LIBOR rises the rate will increasewhereas if LIBOR falls it will decrease
8282014 104
8112019 FISD-02-A
httpslidepdfcomreaderfullfisd-02-a 105115
In the case of a default risk-free floater theprice will reset to par on a coupon date
It may sell at a premium or discount betweencoupon dates
Consider a floater with a coupon = 5-year T-Bond rate
Assume there are two periods left to maturity
8282014 105
8112019 FISD-02-A
httpslidepdfcomreaderfullfisd-02-a 106115
8282014 106
The price at the end of the first coupon period willbe given by
cT-1 is the coupon one period before maturityyT-1 is the YTM one period before maturity
8112019 FISD-02-A
httpslidepdfcomreaderfullfisd-02-a 107115
On a coupon reset date the YTM = couponBecause we have assumed there is no default riskAny change in the required yield as reflected inthe prevailing YTM
Will also be reflected in the coupon being setIf coupon = yield the bond should sell at par
Thus P T-1 = M
8282014 107
8112019 FISD-02-A
httpslidepdfcomreaderfullfisd-02-a 108115
8282014 108
8112019 FISD-02-A
httpslidepdfcomreaderfullfisd-02-a 109115
Once again at T-2 c T-2 = yT-2 and P T-2 = MThis logic can be applied to a bond with anytime remaining till maturityHowever between two coupon dates theprice may not be equal to par
Consider the valuation at T-2+k
8282014 109
8112019 FISD-02-A
httpslidepdfcomreaderfullfisd-02-a 110115
8282014 110
8112019 FISD-02-A
httpslidepdfcomreaderfullfisd-02-a 111115
Although c T-2 was set at T-2 and is equal toyT-2
yT-2+k is determined at T-2+k and will reflect theyield prevailing at that time
Thus yT-2+k need not equal c T-2 and may behigher or lower
Hence between two coupon dates a floater maysell at a premium or discount
8282014 111
8112019 FISD-02-A
httpslidepdfcomreaderfullfisd-02-a 112115
Now consider a floater characterized bydefault risk
The risk premium required by the market neednot be constant over time
Assume that at the time of issue YTM = 5-year T-note rate + 75bp
The coupon would have been set equal to thisrate and the bond would have been issued at par
8282014 112
8112019 FISD-02-A
httpslidepdfcomreaderfullfisd-02-a 113115
Six months hence the issue may be perceivedas more risky
YTM = 5-year T-note rate + 95 bpThe coupon will however be set equal to theprevailing 5-year rate + 75 bpIf so the issue will not reset to par at the nextcoupon date
8282014 113
8112019 FISD-02-A
httpslidepdfcomreaderfullfisd-02-a 114115
Floaters may come with a CAP or a FLOOR orBOTH
The CAP is a maximum coupon rateProtects issuers against rising rates
The FLOOR is a minimum coupon rateProtects investors against falling rates
When there is a spread over LIBORThere is a natural floorLIBOR cannot be less than zero
8282014 114
8112019 FISD-02-A
httpslidepdfcomreaderfullfisd-02-a 115115
8112019 FISD-02-A
httpslidepdfcomreaderfullfisd-02-a 73115
8112019 FISD-02-A
httpslidepdfcomreaderfullfisd-02-a 74115
Those who bid more than 5375 will getnothing and are said to be shutout of theauctionSince 1999 the US Treasury has beenconducting only uniform yield auctions
8282014 74
8112019 FISD-02-A
httpslidepdfcomreaderfullfisd-02-a 75115
WI stands for ndash When As and If IssuedThe when issued market is a market forforward trading of a bond
Which has been announced but not yet issuedTrades take place from the date ofannouncement until the actual issue date
Helps bidders to gauge the marketrsquos interestbefore the actual auction
8282014 75
8112019 FISD-02-A
httpslidepdfcomreaderfullfisd-02-a 76115
WI trading has ramifications for the biddingstrategies of market participantsTraders can take both long and shortpositions
Settlement is scheduled for the issue date
8282014 76
8112019 FISD-02-A
httpslidepdfcomreaderfullfisd-02-a 77115
It has a bearing on the outcome of theauction
It affects the strategy used by a bidder becauseit has an impact on his prior positionBidders who are long in the WI market enter theauction with a Long PositionThose who are short in the WI market enter theauction with a short position
8282014 77
8112019 FISD-02-A
httpslidepdfcomreaderfullfisd-02-a 78115
The WI market helps in price discoveryIt provides important information on
The strength of demand for the securityAnd on the disparity of biddersrsquo views
This help potential bidders to formulate theirstrategiesAt times a dealer may believe that he hasvery important private information
If so he may not participate in the WI market andwill directly enter the auction with bids based onhis knowledge
8282014 78
8112019 FISD-02-A
httpslidepdfcomreaderfullfisd-02-a 79115
On or before the date of the auction theissues trade on a yield basis
The actual price can be established only afterthe coupon is set
Starting with the day after the auctionSecurities are quoted on a price basis becausethe coupon is known
8282014 79
8112019 FISD-02-A
httpslidepdfcomreaderfullfisd-02-a 80115
In a coupon roll a dealer will purchase themost recently issued security from a clientAnd simultaneously sell the same amount ofthe recently announced new security
The first leg with settle on the following dayThe second leg is a forward contract
8282014 80
8112019 FISD-02-A
httpslidepdfcomreaderfullfisd-02-a 81115
There can be a Reverse RollThe dealer will sell the most recent issue fornext day settlementAnd buy the newly announced security forforward settlement
The forward leg in a RollReverse Roll is a WItrade
It will settle on the new issue settlement date
8282014 81
8112019 FISD-02-A
httpslidepdfcomreaderfullfisd-02-a 82115
The roll is the spread between the yield onthe new security and that on the outstandingissue in the same maturity segmentA GIVE in the Roll means that
The WI security provides a higher yield than theoutstanding issue
A Take in the Roll means thatThe WI security provides a lower yield
8282014 82
8112019 FISD-02-A
httpslidepdfcomreaderfullfisd-02-a 83115
8112019 FISD-02-A
httpslidepdfcomreaderfullfisd-02-a 84115
On March 17 20XX the Treasury announcedthe auction of a 2-year note
The auction was scheduled for March 24The settlement date was March 31
Trading of the roll began as soon as the issuewas announcedA Give of 5 bp means that the dealer proposes tobuy the current issue at the prevailing yieldAnd sell the new issue at a yield that is 5 bpmoreA Take of 5 bp means that the dealer proposes tosell the new issue at a yield that is 5bp lower
8282014 84
8112019 FISD-02-A
httpslidepdfcomreaderfullfisd-02-a 85115
The roll achieves the followingHe acquires the outstanding issue for next daysettlementHe sells the to be issued security with the samepar value for forward delivery on 31 March
The customer is rolling over the investmentfrom the current issue to the new issue
This extends the maturity of the investment byone month
8282014 85
8112019 FISD-02-A
httpslidepdfcomreaderfullfisd-02-a 86115
The client can invest the funds received tillthe new issue settlesHowever he loses the accrued interest thathe would have earned had he held on to theissue
8282014 86
8112019 FISD-02-A
httpslidepdfcomreaderfullfisd-02-a 87115
The Treasury per se does not issue zerocoupon securitiesBut zero coupon securities can be created
which are backed by conventional bondsTake a large quantity of a T-note or bond andseparate all the cash flows from each otherSell the entitlement to each cash flowseparately
8282014 87
8112019 FISD-02-A
httpslidepdfcomreaderfullfisd-02-a 88115
Take the case of a two-year T-noteIt can be separated into five zero couponsecurities maturing after
6 months12 months18 months24 months
8282014 88
8112019 FISD-02-A
httpslidepdfcomreaderfullfisd-02-a 89115
Earlier investment banks used to buy bondsfrom the Treasury and separate the cashflows
Each cash flow was then sold separately as a zerocoupon bondSuch issues are called trademarks
8282014 89
8112019 FISD-02-A
httpslidepdfcomreaderfullfisd-02-a 90115
The issue of trademarks has now ceasedBecause investment banks can now createsuch instruments
In concert with the Treasury itselfThese ZCBs are known as STRIPS ndash
Separate Trading of Registered Interest andPrincipal of Securities
These are not issued or sold by the Treasury
The market is made by investment banks
8282014 90
8112019 FISD-02-A
httpslidepdfcomreaderfullfisd-02-a 91115
What is the motivation to create suchproductsIn practice arbitrage is possible when a
coupon security is purchased at a priceThat is lower than what could be obtained byselling each cash flow separately
8282014 91
8112019 FISD-02-A
httpslidepdfcomreaderfullfisd-02-a 92115
Coupon stripping reflects a case of financialengineering
Creating a risk-return profile that is nototherwise available
An investment bank would buy a largequantity of a Treasury security
The securities would be placed with an SPV
8282014 92
8112019 FISD-02-A
httpslidepdfcomreaderfullfisd-02-a 93115
The SPV is a single-purpose dedicated trustIt has the powers to own the bonds andcollect payments
It cannot sell or lend the bondsIt cannot write options on the bondsOr use them as collateral for borrowing
The SPV is empowered to issue zero coupon
bondsWhere each security represents the ownership ofa single cash flow from the mother bond
8282014 93
8112019 FISD-02-A
httpslidepdfcomreaderfullfisd-02-a 94115
Assume that 100MM USD of 15 year bondswith a coupon of 8 are placed with the SPV
The SPV can issue 6M 12M 18M extending up to14 frac12 year zeroes with a total face value of 4MM
USD eachAnd 15 year zeroes with a total face value of104MM
8282014 94
8112019 FISD-02-A
httpslidepdfcomreaderfullfisd-02-a 95115
8112019 FISD-02-A
httpslidepdfcomreaderfullfisd-02-a 96115
8282014 96
8112019 FISD-02-A
httpslidepdfcomreaderfullfisd-02-a 97115
The Treasury launched this program in 1985to facilitate the stripping of designatedsecurities
All new T-bonds and notes with a maturity of 10years or more are eligibleThe zeroes created in the process are directobligations of the US government
8282014 97
8112019 FISD-02-A
httpslidepdfcomreaderfullfisd-02-a 98115
The mechanism is as followsA dealer who owns a bond or note can ask theFRB where it is held
To replace it with an equivalent set of STRIPS
representing each payment as a separate securityEach of these securities can be traded independentlyof others
8282014 98
8112019 FISD-02-A
httpslidepdfcomreaderfullfisd-02-a 99115
In 1987 the Treasury started to allow dealersto reverse the process
This is called STRIPS RECONSTUTUTION If a dealer owns STRIPS representing all thecoupon and principal payments of a bond
The FED can on request convert these holdings into asingle position in the corresponding bond
8282014 99
8112019 FISD-02-A
httpslidepdfcomreaderfullfisd-02-a 100115
Each coupon and principal cash flow from aTreasury security is assigned a CUSIP
The mother bond is also assigned a CUSIPThe stripped coupons are known as C-STRIPSThe stripped principal is known as P-STRIPSSupply of a C-STRIP increases over time
because a C-STRIP maturing on a day like 15 FEB
2020 will have the same CUSIP irrespective ofwhich mother bond it has come fromThe original coupon rate is irrelevant
8282014 100
8112019 FISD-02-A
httpslidepdfcomreaderfullfisd-02-a 101115
P-STRIPS always correspond to the originalsecurityThey have a unique CUSIPTheir supply is fixed at the time of issuanceIn practice the prices of long-dated P-STRIPSare a bit higher than those of C-STRIPS withthe same maturity date
One reason is that P-STRIPS are more liquid due
to greater availabilityA $100 face value bond with a coupon of 8 willgenerate C-STRIPS with a face value of $4 but P-STRIPS with a face value of $100
8282014 101
8112019 FISD-02-A
httpslidepdfcomreaderfullfisd-02-a 102115
Another reason why P-STRIPS are in higherdemand is that they allow reconstitutionactivities more easily
Assume that the sum of the STRIPS is cheaper than
the mother bondIf a dealer already has the P-STRIPS only the C-STRIPSneed to be acquiredHowever if he owns some of the C-STRIPS he needs toacquire the P-STRIPS and the remaining C-STRIPSThe facility to reconstitute when profitable is pricedinto the P-STRIPSNote Buy and hold investors will prefer C-STRIPSsince they are priced lower and give a higher yield
8282014 102
8112019 FISD-02-A
httpslidepdfcomreaderfullfisd-02-a 103115
For Plain Vanilla bonds the specifiedcoupon rate is valid for the life of thebond
In the case of Floaters the rate is reset atthe beginning of every periodThe rate will vary directly with thebenchmark
8282014 103
8112019 FISD-02-A
httpslidepdfcomreaderfullfisd-02-a 104115
The rate on a Floater is specified as LIBOR+ 50 bp
The spread is positiveIf it were specified as LIBOR ndash 30bp
The spread will be negativeIf LIBOR rises the rate will increasewhereas if LIBOR falls it will decrease
8282014 104
8112019 FISD-02-A
httpslidepdfcomreaderfullfisd-02-a 105115
In the case of a default risk-free floater theprice will reset to par on a coupon date
It may sell at a premium or discount betweencoupon dates
Consider a floater with a coupon = 5-year T-Bond rate
Assume there are two periods left to maturity
8282014 105
8112019 FISD-02-A
httpslidepdfcomreaderfullfisd-02-a 106115
8282014 106
The price at the end of the first coupon period willbe given by
cT-1 is the coupon one period before maturityyT-1 is the YTM one period before maturity
8112019 FISD-02-A
httpslidepdfcomreaderfullfisd-02-a 107115
On a coupon reset date the YTM = couponBecause we have assumed there is no default riskAny change in the required yield as reflected inthe prevailing YTM
Will also be reflected in the coupon being setIf coupon = yield the bond should sell at par
Thus P T-1 = M
8282014 107
8112019 FISD-02-A
httpslidepdfcomreaderfullfisd-02-a 108115
8282014 108
8112019 FISD-02-A
httpslidepdfcomreaderfullfisd-02-a 109115
Once again at T-2 c T-2 = yT-2 and P T-2 = MThis logic can be applied to a bond with anytime remaining till maturityHowever between two coupon dates theprice may not be equal to par
Consider the valuation at T-2+k
8282014 109
8112019 FISD-02-A
httpslidepdfcomreaderfullfisd-02-a 110115
8282014 110
8112019 FISD-02-A
httpslidepdfcomreaderfullfisd-02-a 111115
Although c T-2 was set at T-2 and is equal toyT-2
yT-2+k is determined at T-2+k and will reflect theyield prevailing at that time
Thus yT-2+k need not equal c T-2 and may behigher or lower
Hence between two coupon dates a floater maysell at a premium or discount
8282014 111
8112019 FISD-02-A
httpslidepdfcomreaderfullfisd-02-a 112115
Now consider a floater characterized bydefault risk
The risk premium required by the market neednot be constant over time
Assume that at the time of issue YTM = 5-year T-note rate + 75bp
The coupon would have been set equal to thisrate and the bond would have been issued at par
8282014 112
8112019 FISD-02-A
httpslidepdfcomreaderfullfisd-02-a 113115
Six months hence the issue may be perceivedas more risky
YTM = 5-year T-note rate + 95 bpThe coupon will however be set equal to theprevailing 5-year rate + 75 bpIf so the issue will not reset to par at the nextcoupon date
8282014 113
8112019 FISD-02-A
httpslidepdfcomreaderfullfisd-02-a 114115
Floaters may come with a CAP or a FLOOR orBOTH
The CAP is a maximum coupon rateProtects issuers against rising rates
The FLOOR is a minimum coupon rateProtects investors against falling rates
When there is a spread over LIBORThere is a natural floorLIBOR cannot be less than zero
8282014 114
8112019 FISD-02-A
httpslidepdfcomreaderfullfisd-02-a 115115
8112019 FISD-02-A
httpslidepdfcomreaderfullfisd-02-a 74115
Those who bid more than 5375 will getnothing and are said to be shutout of theauctionSince 1999 the US Treasury has beenconducting only uniform yield auctions
8282014 74
8112019 FISD-02-A
httpslidepdfcomreaderfullfisd-02-a 75115
WI stands for ndash When As and If IssuedThe when issued market is a market forforward trading of a bond
Which has been announced but not yet issuedTrades take place from the date ofannouncement until the actual issue date
Helps bidders to gauge the marketrsquos interestbefore the actual auction
8282014 75
8112019 FISD-02-A
httpslidepdfcomreaderfullfisd-02-a 76115
WI trading has ramifications for the biddingstrategies of market participantsTraders can take both long and shortpositions
Settlement is scheduled for the issue date
8282014 76
8112019 FISD-02-A
httpslidepdfcomreaderfullfisd-02-a 77115
It has a bearing on the outcome of theauction
It affects the strategy used by a bidder becauseit has an impact on his prior positionBidders who are long in the WI market enter theauction with a Long PositionThose who are short in the WI market enter theauction with a short position
8282014 77
8112019 FISD-02-A
httpslidepdfcomreaderfullfisd-02-a 78115
The WI market helps in price discoveryIt provides important information on
The strength of demand for the securityAnd on the disparity of biddersrsquo views
This help potential bidders to formulate theirstrategiesAt times a dealer may believe that he hasvery important private information
If so he may not participate in the WI market andwill directly enter the auction with bids based onhis knowledge
8282014 78
8112019 FISD-02-A
httpslidepdfcomreaderfullfisd-02-a 79115
On or before the date of the auction theissues trade on a yield basis
The actual price can be established only afterthe coupon is set
Starting with the day after the auctionSecurities are quoted on a price basis becausethe coupon is known
8282014 79
8112019 FISD-02-A
httpslidepdfcomreaderfullfisd-02-a 80115
In a coupon roll a dealer will purchase themost recently issued security from a clientAnd simultaneously sell the same amount ofthe recently announced new security
The first leg with settle on the following dayThe second leg is a forward contract
8282014 80
8112019 FISD-02-A
httpslidepdfcomreaderfullfisd-02-a 81115
There can be a Reverse RollThe dealer will sell the most recent issue fornext day settlementAnd buy the newly announced security forforward settlement
The forward leg in a RollReverse Roll is a WItrade
It will settle on the new issue settlement date
8282014 81
8112019 FISD-02-A
httpslidepdfcomreaderfullfisd-02-a 82115
The roll is the spread between the yield onthe new security and that on the outstandingissue in the same maturity segmentA GIVE in the Roll means that
The WI security provides a higher yield than theoutstanding issue
A Take in the Roll means thatThe WI security provides a lower yield
8282014 82
8112019 FISD-02-A
httpslidepdfcomreaderfullfisd-02-a 83115
8112019 FISD-02-A
httpslidepdfcomreaderfullfisd-02-a 84115
On March 17 20XX the Treasury announcedthe auction of a 2-year note
The auction was scheduled for March 24The settlement date was March 31
Trading of the roll began as soon as the issuewas announcedA Give of 5 bp means that the dealer proposes tobuy the current issue at the prevailing yieldAnd sell the new issue at a yield that is 5 bpmoreA Take of 5 bp means that the dealer proposes tosell the new issue at a yield that is 5bp lower
8282014 84
8112019 FISD-02-A
httpslidepdfcomreaderfullfisd-02-a 85115
The roll achieves the followingHe acquires the outstanding issue for next daysettlementHe sells the to be issued security with the samepar value for forward delivery on 31 March
The customer is rolling over the investmentfrom the current issue to the new issue
This extends the maturity of the investment byone month
8282014 85
8112019 FISD-02-A
httpslidepdfcomreaderfullfisd-02-a 86115
The client can invest the funds received tillthe new issue settlesHowever he loses the accrued interest thathe would have earned had he held on to theissue
8282014 86
8112019 FISD-02-A
httpslidepdfcomreaderfullfisd-02-a 87115
The Treasury per se does not issue zerocoupon securitiesBut zero coupon securities can be created
which are backed by conventional bondsTake a large quantity of a T-note or bond andseparate all the cash flows from each otherSell the entitlement to each cash flowseparately
8282014 87
8112019 FISD-02-A
httpslidepdfcomreaderfullfisd-02-a 88115
Take the case of a two-year T-noteIt can be separated into five zero couponsecurities maturing after
6 months12 months18 months24 months
8282014 88
8112019 FISD-02-A
httpslidepdfcomreaderfullfisd-02-a 89115
Earlier investment banks used to buy bondsfrom the Treasury and separate the cashflows
Each cash flow was then sold separately as a zerocoupon bondSuch issues are called trademarks
8282014 89
8112019 FISD-02-A
httpslidepdfcomreaderfullfisd-02-a 90115
The issue of trademarks has now ceasedBecause investment banks can now createsuch instruments
In concert with the Treasury itselfThese ZCBs are known as STRIPS ndash
Separate Trading of Registered Interest andPrincipal of Securities
These are not issued or sold by the Treasury
The market is made by investment banks
8282014 90
8112019 FISD-02-A
httpslidepdfcomreaderfullfisd-02-a 91115
What is the motivation to create suchproductsIn practice arbitrage is possible when a
coupon security is purchased at a priceThat is lower than what could be obtained byselling each cash flow separately
8282014 91
8112019 FISD-02-A
httpslidepdfcomreaderfullfisd-02-a 92115
Coupon stripping reflects a case of financialengineering
Creating a risk-return profile that is nototherwise available
An investment bank would buy a largequantity of a Treasury security
The securities would be placed with an SPV
8282014 92
8112019 FISD-02-A
httpslidepdfcomreaderfullfisd-02-a 93115
The SPV is a single-purpose dedicated trustIt has the powers to own the bonds andcollect payments
It cannot sell or lend the bondsIt cannot write options on the bondsOr use them as collateral for borrowing
The SPV is empowered to issue zero coupon
bondsWhere each security represents the ownership ofa single cash flow from the mother bond
8282014 93
8112019 FISD-02-A
httpslidepdfcomreaderfullfisd-02-a 94115
Assume that 100MM USD of 15 year bondswith a coupon of 8 are placed with the SPV
The SPV can issue 6M 12M 18M extending up to14 frac12 year zeroes with a total face value of 4MM
USD eachAnd 15 year zeroes with a total face value of104MM
8282014 94
8112019 FISD-02-A
httpslidepdfcomreaderfullfisd-02-a 95115
8112019 FISD-02-A
httpslidepdfcomreaderfullfisd-02-a 96115
8282014 96
8112019 FISD-02-A
httpslidepdfcomreaderfullfisd-02-a 97115
The Treasury launched this program in 1985to facilitate the stripping of designatedsecurities
All new T-bonds and notes with a maturity of 10years or more are eligibleThe zeroes created in the process are directobligations of the US government
8282014 97
8112019 FISD-02-A
httpslidepdfcomreaderfullfisd-02-a 98115
The mechanism is as followsA dealer who owns a bond or note can ask theFRB where it is held
To replace it with an equivalent set of STRIPS
representing each payment as a separate securityEach of these securities can be traded independentlyof others
8282014 98
8112019 FISD-02-A
httpslidepdfcomreaderfullfisd-02-a 99115
In 1987 the Treasury started to allow dealersto reverse the process
This is called STRIPS RECONSTUTUTION If a dealer owns STRIPS representing all thecoupon and principal payments of a bond
The FED can on request convert these holdings into asingle position in the corresponding bond
8282014 99
8112019 FISD-02-A
httpslidepdfcomreaderfullfisd-02-a 100115
Each coupon and principal cash flow from aTreasury security is assigned a CUSIP
The mother bond is also assigned a CUSIPThe stripped coupons are known as C-STRIPSThe stripped principal is known as P-STRIPSSupply of a C-STRIP increases over time
because a C-STRIP maturing on a day like 15 FEB
2020 will have the same CUSIP irrespective ofwhich mother bond it has come fromThe original coupon rate is irrelevant
8282014 100
8112019 FISD-02-A
httpslidepdfcomreaderfullfisd-02-a 101115
P-STRIPS always correspond to the originalsecurityThey have a unique CUSIPTheir supply is fixed at the time of issuanceIn practice the prices of long-dated P-STRIPSare a bit higher than those of C-STRIPS withthe same maturity date
One reason is that P-STRIPS are more liquid due
to greater availabilityA $100 face value bond with a coupon of 8 willgenerate C-STRIPS with a face value of $4 but P-STRIPS with a face value of $100
8282014 101
8112019 FISD-02-A
httpslidepdfcomreaderfullfisd-02-a 102115
Another reason why P-STRIPS are in higherdemand is that they allow reconstitutionactivities more easily
Assume that the sum of the STRIPS is cheaper than
the mother bondIf a dealer already has the P-STRIPS only the C-STRIPSneed to be acquiredHowever if he owns some of the C-STRIPS he needs toacquire the P-STRIPS and the remaining C-STRIPSThe facility to reconstitute when profitable is pricedinto the P-STRIPSNote Buy and hold investors will prefer C-STRIPSsince they are priced lower and give a higher yield
8282014 102
8112019 FISD-02-A
httpslidepdfcomreaderfullfisd-02-a 103115
For Plain Vanilla bonds the specifiedcoupon rate is valid for the life of thebond
In the case of Floaters the rate is reset atthe beginning of every periodThe rate will vary directly with thebenchmark
8282014 103
8112019 FISD-02-A
httpslidepdfcomreaderfullfisd-02-a 104115
The rate on a Floater is specified as LIBOR+ 50 bp
The spread is positiveIf it were specified as LIBOR ndash 30bp
The spread will be negativeIf LIBOR rises the rate will increasewhereas if LIBOR falls it will decrease
8282014 104
8112019 FISD-02-A
httpslidepdfcomreaderfullfisd-02-a 105115
In the case of a default risk-free floater theprice will reset to par on a coupon date
It may sell at a premium or discount betweencoupon dates
Consider a floater with a coupon = 5-year T-Bond rate
Assume there are two periods left to maturity
8282014 105
8112019 FISD-02-A
httpslidepdfcomreaderfullfisd-02-a 106115
8282014 106
The price at the end of the first coupon period willbe given by
cT-1 is the coupon one period before maturityyT-1 is the YTM one period before maturity
8112019 FISD-02-A
httpslidepdfcomreaderfullfisd-02-a 107115
On a coupon reset date the YTM = couponBecause we have assumed there is no default riskAny change in the required yield as reflected inthe prevailing YTM
Will also be reflected in the coupon being setIf coupon = yield the bond should sell at par
Thus P T-1 = M
8282014 107
8112019 FISD-02-A
httpslidepdfcomreaderfullfisd-02-a 108115
8282014 108
8112019 FISD-02-A
httpslidepdfcomreaderfullfisd-02-a 109115
Once again at T-2 c T-2 = yT-2 and P T-2 = MThis logic can be applied to a bond with anytime remaining till maturityHowever between two coupon dates theprice may not be equal to par
Consider the valuation at T-2+k
8282014 109
8112019 FISD-02-A
httpslidepdfcomreaderfullfisd-02-a 110115
8282014 110
8112019 FISD-02-A
httpslidepdfcomreaderfullfisd-02-a 111115
Although c T-2 was set at T-2 and is equal toyT-2
yT-2+k is determined at T-2+k and will reflect theyield prevailing at that time
Thus yT-2+k need not equal c T-2 and may behigher or lower
Hence between two coupon dates a floater maysell at a premium or discount
8282014 111
8112019 FISD-02-A
httpslidepdfcomreaderfullfisd-02-a 112115
Now consider a floater characterized bydefault risk
The risk premium required by the market neednot be constant over time
Assume that at the time of issue YTM = 5-year T-note rate + 75bp
The coupon would have been set equal to thisrate and the bond would have been issued at par
8282014 112
8112019 FISD-02-A
httpslidepdfcomreaderfullfisd-02-a 113115
Six months hence the issue may be perceivedas more risky
YTM = 5-year T-note rate + 95 bpThe coupon will however be set equal to theprevailing 5-year rate + 75 bpIf so the issue will not reset to par at the nextcoupon date
8282014 113
8112019 FISD-02-A
httpslidepdfcomreaderfullfisd-02-a 114115
Floaters may come with a CAP or a FLOOR orBOTH
The CAP is a maximum coupon rateProtects issuers against rising rates
The FLOOR is a minimum coupon rateProtects investors against falling rates
When there is a spread over LIBORThere is a natural floorLIBOR cannot be less than zero
8282014 114
8112019 FISD-02-A
httpslidepdfcomreaderfullfisd-02-a 115115
8112019 FISD-02-A
httpslidepdfcomreaderfullfisd-02-a 75115
WI stands for ndash When As and If IssuedThe when issued market is a market forforward trading of a bond
Which has been announced but not yet issuedTrades take place from the date ofannouncement until the actual issue date
Helps bidders to gauge the marketrsquos interestbefore the actual auction
8282014 75
8112019 FISD-02-A
httpslidepdfcomreaderfullfisd-02-a 76115
WI trading has ramifications for the biddingstrategies of market participantsTraders can take both long and shortpositions
Settlement is scheduled for the issue date
8282014 76
8112019 FISD-02-A
httpslidepdfcomreaderfullfisd-02-a 77115
It has a bearing on the outcome of theauction
It affects the strategy used by a bidder becauseit has an impact on his prior positionBidders who are long in the WI market enter theauction with a Long PositionThose who are short in the WI market enter theauction with a short position
8282014 77
8112019 FISD-02-A
httpslidepdfcomreaderfullfisd-02-a 78115
The WI market helps in price discoveryIt provides important information on
The strength of demand for the securityAnd on the disparity of biddersrsquo views
This help potential bidders to formulate theirstrategiesAt times a dealer may believe that he hasvery important private information
If so he may not participate in the WI market andwill directly enter the auction with bids based onhis knowledge
8282014 78
8112019 FISD-02-A
httpslidepdfcomreaderfullfisd-02-a 79115
On or before the date of the auction theissues trade on a yield basis
The actual price can be established only afterthe coupon is set
Starting with the day after the auctionSecurities are quoted on a price basis becausethe coupon is known
8282014 79
8112019 FISD-02-A
httpslidepdfcomreaderfullfisd-02-a 80115
In a coupon roll a dealer will purchase themost recently issued security from a clientAnd simultaneously sell the same amount ofthe recently announced new security
The first leg with settle on the following dayThe second leg is a forward contract
8282014 80
8112019 FISD-02-A
httpslidepdfcomreaderfullfisd-02-a 81115
There can be a Reverse RollThe dealer will sell the most recent issue fornext day settlementAnd buy the newly announced security forforward settlement
The forward leg in a RollReverse Roll is a WItrade
It will settle on the new issue settlement date
8282014 81
8112019 FISD-02-A
httpslidepdfcomreaderfullfisd-02-a 82115
The roll is the spread between the yield onthe new security and that on the outstandingissue in the same maturity segmentA GIVE in the Roll means that
The WI security provides a higher yield than theoutstanding issue
A Take in the Roll means thatThe WI security provides a lower yield
8282014 82
8112019 FISD-02-A
httpslidepdfcomreaderfullfisd-02-a 83115
8112019 FISD-02-A
httpslidepdfcomreaderfullfisd-02-a 84115
On March 17 20XX the Treasury announcedthe auction of a 2-year note
The auction was scheduled for March 24The settlement date was March 31
Trading of the roll began as soon as the issuewas announcedA Give of 5 bp means that the dealer proposes tobuy the current issue at the prevailing yieldAnd sell the new issue at a yield that is 5 bpmoreA Take of 5 bp means that the dealer proposes tosell the new issue at a yield that is 5bp lower
8282014 84
8112019 FISD-02-A
httpslidepdfcomreaderfullfisd-02-a 85115
The roll achieves the followingHe acquires the outstanding issue for next daysettlementHe sells the to be issued security with the samepar value for forward delivery on 31 March
The customer is rolling over the investmentfrom the current issue to the new issue
This extends the maturity of the investment byone month
8282014 85
8112019 FISD-02-A
httpslidepdfcomreaderfullfisd-02-a 86115
The client can invest the funds received tillthe new issue settlesHowever he loses the accrued interest thathe would have earned had he held on to theissue
8282014 86
8112019 FISD-02-A
httpslidepdfcomreaderfullfisd-02-a 87115
The Treasury per se does not issue zerocoupon securitiesBut zero coupon securities can be created
which are backed by conventional bondsTake a large quantity of a T-note or bond andseparate all the cash flows from each otherSell the entitlement to each cash flowseparately
8282014 87
8112019 FISD-02-A
httpslidepdfcomreaderfullfisd-02-a 88115
Take the case of a two-year T-noteIt can be separated into five zero couponsecurities maturing after
6 months12 months18 months24 months
8282014 88
8112019 FISD-02-A
httpslidepdfcomreaderfullfisd-02-a 89115
Earlier investment banks used to buy bondsfrom the Treasury and separate the cashflows
Each cash flow was then sold separately as a zerocoupon bondSuch issues are called trademarks
8282014 89
8112019 FISD-02-A
httpslidepdfcomreaderfullfisd-02-a 90115
The issue of trademarks has now ceasedBecause investment banks can now createsuch instruments
In concert with the Treasury itselfThese ZCBs are known as STRIPS ndash
Separate Trading of Registered Interest andPrincipal of Securities
These are not issued or sold by the Treasury
The market is made by investment banks
8282014 90
8112019 FISD-02-A
httpslidepdfcomreaderfullfisd-02-a 91115
What is the motivation to create suchproductsIn practice arbitrage is possible when a
coupon security is purchased at a priceThat is lower than what could be obtained byselling each cash flow separately
8282014 91
8112019 FISD-02-A
httpslidepdfcomreaderfullfisd-02-a 92115
Coupon stripping reflects a case of financialengineering
Creating a risk-return profile that is nototherwise available
An investment bank would buy a largequantity of a Treasury security
The securities would be placed with an SPV
8282014 92
8112019 FISD-02-A
httpslidepdfcomreaderfullfisd-02-a 93115
The SPV is a single-purpose dedicated trustIt has the powers to own the bonds andcollect payments
It cannot sell or lend the bondsIt cannot write options on the bondsOr use them as collateral for borrowing
The SPV is empowered to issue zero coupon
bondsWhere each security represents the ownership ofa single cash flow from the mother bond
8282014 93
8112019 FISD-02-A
httpslidepdfcomreaderfullfisd-02-a 94115
Assume that 100MM USD of 15 year bondswith a coupon of 8 are placed with the SPV
The SPV can issue 6M 12M 18M extending up to14 frac12 year zeroes with a total face value of 4MM
USD eachAnd 15 year zeroes with a total face value of104MM
8282014 94
8112019 FISD-02-A
httpslidepdfcomreaderfullfisd-02-a 95115
8112019 FISD-02-A
httpslidepdfcomreaderfullfisd-02-a 96115
8282014 96
8112019 FISD-02-A
httpslidepdfcomreaderfullfisd-02-a 97115
The Treasury launched this program in 1985to facilitate the stripping of designatedsecurities
All new T-bonds and notes with a maturity of 10years or more are eligibleThe zeroes created in the process are directobligations of the US government
8282014 97
8112019 FISD-02-A
httpslidepdfcomreaderfullfisd-02-a 98115
The mechanism is as followsA dealer who owns a bond or note can ask theFRB where it is held
To replace it with an equivalent set of STRIPS
representing each payment as a separate securityEach of these securities can be traded independentlyof others
8282014 98
8112019 FISD-02-A
httpslidepdfcomreaderfullfisd-02-a 99115
In 1987 the Treasury started to allow dealersto reverse the process
This is called STRIPS RECONSTUTUTION If a dealer owns STRIPS representing all thecoupon and principal payments of a bond
The FED can on request convert these holdings into asingle position in the corresponding bond
8282014 99
8112019 FISD-02-A
httpslidepdfcomreaderfullfisd-02-a 100115
Each coupon and principal cash flow from aTreasury security is assigned a CUSIP
The mother bond is also assigned a CUSIPThe stripped coupons are known as C-STRIPSThe stripped principal is known as P-STRIPSSupply of a C-STRIP increases over time
because a C-STRIP maturing on a day like 15 FEB
2020 will have the same CUSIP irrespective ofwhich mother bond it has come fromThe original coupon rate is irrelevant
8282014 100
8112019 FISD-02-A
httpslidepdfcomreaderfullfisd-02-a 101115
P-STRIPS always correspond to the originalsecurityThey have a unique CUSIPTheir supply is fixed at the time of issuanceIn practice the prices of long-dated P-STRIPSare a bit higher than those of C-STRIPS withthe same maturity date
One reason is that P-STRIPS are more liquid due
to greater availabilityA $100 face value bond with a coupon of 8 willgenerate C-STRIPS with a face value of $4 but P-STRIPS with a face value of $100
8282014 101
8112019 FISD-02-A
httpslidepdfcomreaderfullfisd-02-a 102115
Another reason why P-STRIPS are in higherdemand is that they allow reconstitutionactivities more easily
Assume that the sum of the STRIPS is cheaper than
the mother bondIf a dealer already has the P-STRIPS only the C-STRIPSneed to be acquiredHowever if he owns some of the C-STRIPS he needs toacquire the P-STRIPS and the remaining C-STRIPSThe facility to reconstitute when profitable is pricedinto the P-STRIPSNote Buy and hold investors will prefer C-STRIPSsince they are priced lower and give a higher yield
8282014 102
8112019 FISD-02-A
httpslidepdfcomreaderfullfisd-02-a 103115
For Plain Vanilla bonds the specifiedcoupon rate is valid for the life of thebond
In the case of Floaters the rate is reset atthe beginning of every periodThe rate will vary directly with thebenchmark
8282014 103
8112019 FISD-02-A
httpslidepdfcomreaderfullfisd-02-a 104115
The rate on a Floater is specified as LIBOR+ 50 bp
The spread is positiveIf it were specified as LIBOR ndash 30bp
The spread will be negativeIf LIBOR rises the rate will increasewhereas if LIBOR falls it will decrease
8282014 104
8112019 FISD-02-A
httpslidepdfcomreaderfullfisd-02-a 105115
In the case of a default risk-free floater theprice will reset to par on a coupon date
It may sell at a premium or discount betweencoupon dates
Consider a floater with a coupon = 5-year T-Bond rate
Assume there are two periods left to maturity
8282014 105
8112019 FISD-02-A
httpslidepdfcomreaderfullfisd-02-a 106115
8282014 106
The price at the end of the first coupon period willbe given by
cT-1 is the coupon one period before maturityyT-1 is the YTM one period before maturity
8112019 FISD-02-A
httpslidepdfcomreaderfullfisd-02-a 107115
On a coupon reset date the YTM = couponBecause we have assumed there is no default riskAny change in the required yield as reflected inthe prevailing YTM
Will also be reflected in the coupon being setIf coupon = yield the bond should sell at par
Thus P T-1 = M
8282014 107
8112019 FISD-02-A
httpslidepdfcomreaderfullfisd-02-a 108115
8282014 108
8112019 FISD-02-A
httpslidepdfcomreaderfullfisd-02-a 109115
Once again at T-2 c T-2 = yT-2 and P T-2 = MThis logic can be applied to a bond with anytime remaining till maturityHowever between two coupon dates theprice may not be equal to par
Consider the valuation at T-2+k
8282014 109
8112019 FISD-02-A
httpslidepdfcomreaderfullfisd-02-a 110115
8282014 110
8112019 FISD-02-A
httpslidepdfcomreaderfullfisd-02-a 111115
Although c T-2 was set at T-2 and is equal toyT-2
yT-2+k is determined at T-2+k and will reflect theyield prevailing at that time
Thus yT-2+k need not equal c T-2 and may behigher or lower
Hence between two coupon dates a floater maysell at a premium or discount
8282014 111
8112019 FISD-02-A
httpslidepdfcomreaderfullfisd-02-a 112115
Now consider a floater characterized bydefault risk
The risk premium required by the market neednot be constant over time
Assume that at the time of issue YTM = 5-year T-note rate + 75bp
The coupon would have been set equal to thisrate and the bond would have been issued at par
8282014 112
8112019 FISD-02-A
httpslidepdfcomreaderfullfisd-02-a 113115
Six months hence the issue may be perceivedas more risky
YTM = 5-year T-note rate + 95 bpThe coupon will however be set equal to theprevailing 5-year rate + 75 bpIf so the issue will not reset to par at the nextcoupon date
8282014 113
8112019 FISD-02-A
httpslidepdfcomreaderfullfisd-02-a 114115
Floaters may come with a CAP or a FLOOR orBOTH
The CAP is a maximum coupon rateProtects issuers against rising rates
The FLOOR is a minimum coupon rateProtects investors against falling rates
When there is a spread over LIBORThere is a natural floorLIBOR cannot be less than zero
8282014 114
8112019 FISD-02-A
httpslidepdfcomreaderfullfisd-02-a 115115
8112019 FISD-02-A
httpslidepdfcomreaderfullfisd-02-a 76115
WI trading has ramifications for the biddingstrategies of market participantsTraders can take both long and shortpositions
Settlement is scheduled for the issue date
8282014 76
8112019 FISD-02-A
httpslidepdfcomreaderfullfisd-02-a 77115
It has a bearing on the outcome of theauction
It affects the strategy used by a bidder becauseit has an impact on his prior positionBidders who are long in the WI market enter theauction with a Long PositionThose who are short in the WI market enter theauction with a short position
8282014 77
8112019 FISD-02-A
httpslidepdfcomreaderfullfisd-02-a 78115
The WI market helps in price discoveryIt provides important information on
The strength of demand for the securityAnd on the disparity of biddersrsquo views
This help potential bidders to formulate theirstrategiesAt times a dealer may believe that he hasvery important private information
If so he may not participate in the WI market andwill directly enter the auction with bids based onhis knowledge
8282014 78
8112019 FISD-02-A
httpslidepdfcomreaderfullfisd-02-a 79115
On or before the date of the auction theissues trade on a yield basis
The actual price can be established only afterthe coupon is set
Starting with the day after the auctionSecurities are quoted on a price basis becausethe coupon is known
8282014 79
8112019 FISD-02-A
httpslidepdfcomreaderfullfisd-02-a 80115
In a coupon roll a dealer will purchase themost recently issued security from a clientAnd simultaneously sell the same amount ofthe recently announced new security
The first leg with settle on the following dayThe second leg is a forward contract
8282014 80
8112019 FISD-02-A
httpslidepdfcomreaderfullfisd-02-a 81115
There can be a Reverse RollThe dealer will sell the most recent issue fornext day settlementAnd buy the newly announced security forforward settlement
The forward leg in a RollReverse Roll is a WItrade
It will settle on the new issue settlement date
8282014 81
8112019 FISD-02-A
httpslidepdfcomreaderfullfisd-02-a 82115
The roll is the spread between the yield onthe new security and that on the outstandingissue in the same maturity segmentA GIVE in the Roll means that
The WI security provides a higher yield than theoutstanding issue
A Take in the Roll means thatThe WI security provides a lower yield
8282014 82
8112019 FISD-02-A
httpslidepdfcomreaderfullfisd-02-a 83115
8112019 FISD-02-A
httpslidepdfcomreaderfullfisd-02-a 84115
On March 17 20XX the Treasury announcedthe auction of a 2-year note
The auction was scheduled for March 24The settlement date was March 31
Trading of the roll began as soon as the issuewas announcedA Give of 5 bp means that the dealer proposes tobuy the current issue at the prevailing yieldAnd sell the new issue at a yield that is 5 bpmoreA Take of 5 bp means that the dealer proposes tosell the new issue at a yield that is 5bp lower
8282014 84
8112019 FISD-02-A
httpslidepdfcomreaderfullfisd-02-a 85115
The roll achieves the followingHe acquires the outstanding issue for next daysettlementHe sells the to be issued security with the samepar value for forward delivery on 31 March
The customer is rolling over the investmentfrom the current issue to the new issue
This extends the maturity of the investment byone month
8282014 85
8112019 FISD-02-A
httpslidepdfcomreaderfullfisd-02-a 86115
The client can invest the funds received tillthe new issue settlesHowever he loses the accrued interest thathe would have earned had he held on to theissue
8282014 86
8112019 FISD-02-A
httpslidepdfcomreaderfullfisd-02-a 87115
The Treasury per se does not issue zerocoupon securitiesBut zero coupon securities can be created
which are backed by conventional bondsTake a large quantity of a T-note or bond andseparate all the cash flows from each otherSell the entitlement to each cash flowseparately
8282014 87
8112019 FISD-02-A
httpslidepdfcomreaderfullfisd-02-a 88115
Take the case of a two-year T-noteIt can be separated into five zero couponsecurities maturing after
6 months12 months18 months24 months
8282014 88
8112019 FISD-02-A
httpslidepdfcomreaderfullfisd-02-a 89115
Earlier investment banks used to buy bondsfrom the Treasury and separate the cashflows
Each cash flow was then sold separately as a zerocoupon bondSuch issues are called trademarks
8282014 89
8112019 FISD-02-A
httpslidepdfcomreaderfullfisd-02-a 90115
The issue of trademarks has now ceasedBecause investment banks can now createsuch instruments
In concert with the Treasury itselfThese ZCBs are known as STRIPS ndash
Separate Trading of Registered Interest andPrincipal of Securities
These are not issued or sold by the Treasury
The market is made by investment banks
8282014 90
8112019 FISD-02-A
httpslidepdfcomreaderfullfisd-02-a 91115
What is the motivation to create suchproductsIn practice arbitrage is possible when a
coupon security is purchased at a priceThat is lower than what could be obtained byselling each cash flow separately
8282014 91
8112019 FISD-02-A
httpslidepdfcomreaderfullfisd-02-a 92115
Coupon stripping reflects a case of financialengineering
Creating a risk-return profile that is nototherwise available
An investment bank would buy a largequantity of a Treasury security
The securities would be placed with an SPV
8282014 92
8112019 FISD-02-A
httpslidepdfcomreaderfullfisd-02-a 93115
The SPV is a single-purpose dedicated trustIt has the powers to own the bonds andcollect payments
It cannot sell or lend the bondsIt cannot write options on the bondsOr use them as collateral for borrowing
The SPV is empowered to issue zero coupon
bondsWhere each security represents the ownership ofa single cash flow from the mother bond
8282014 93
8112019 FISD-02-A
httpslidepdfcomreaderfullfisd-02-a 94115
Assume that 100MM USD of 15 year bondswith a coupon of 8 are placed with the SPV
The SPV can issue 6M 12M 18M extending up to14 frac12 year zeroes with a total face value of 4MM
USD eachAnd 15 year zeroes with a total face value of104MM
8282014 94
8112019 FISD-02-A
httpslidepdfcomreaderfullfisd-02-a 95115
8112019 FISD-02-A
httpslidepdfcomreaderfullfisd-02-a 96115
8282014 96
8112019 FISD-02-A
httpslidepdfcomreaderfullfisd-02-a 97115
The Treasury launched this program in 1985to facilitate the stripping of designatedsecurities
All new T-bonds and notes with a maturity of 10years or more are eligibleThe zeroes created in the process are directobligations of the US government
8282014 97
8112019 FISD-02-A
httpslidepdfcomreaderfullfisd-02-a 98115
The mechanism is as followsA dealer who owns a bond or note can ask theFRB where it is held
To replace it with an equivalent set of STRIPS
representing each payment as a separate securityEach of these securities can be traded independentlyof others
8282014 98
8112019 FISD-02-A
httpslidepdfcomreaderfullfisd-02-a 99115
In 1987 the Treasury started to allow dealersto reverse the process
This is called STRIPS RECONSTUTUTION If a dealer owns STRIPS representing all thecoupon and principal payments of a bond
The FED can on request convert these holdings into asingle position in the corresponding bond
8282014 99
8112019 FISD-02-A
httpslidepdfcomreaderfullfisd-02-a 100115
Each coupon and principal cash flow from aTreasury security is assigned a CUSIP
The mother bond is also assigned a CUSIPThe stripped coupons are known as C-STRIPSThe stripped principal is known as P-STRIPSSupply of a C-STRIP increases over time
because a C-STRIP maturing on a day like 15 FEB
2020 will have the same CUSIP irrespective ofwhich mother bond it has come fromThe original coupon rate is irrelevant
8282014 100
8112019 FISD-02-A
httpslidepdfcomreaderfullfisd-02-a 101115
P-STRIPS always correspond to the originalsecurityThey have a unique CUSIPTheir supply is fixed at the time of issuanceIn practice the prices of long-dated P-STRIPSare a bit higher than those of C-STRIPS withthe same maturity date
One reason is that P-STRIPS are more liquid due
to greater availabilityA $100 face value bond with a coupon of 8 willgenerate C-STRIPS with a face value of $4 but P-STRIPS with a face value of $100
8282014 101
8112019 FISD-02-A
httpslidepdfcomreaderfullfisd-02-a 102115
Another reason why P-STRIPS are in higherdemand is that they allow reconstitutionactivities more easily
Assume that the sum of the STRIPS is cheaper than
the mother bondIf a dealer already has the P-STRIPS only the C-STRIPSneed to be acquiredHowever if he owns some of the C-STRIPS he needs toacquire the P-STRIPS and the remaining C-STRIPSThe facility to reconstitute when profitable is pricedinto the P-STRIPSNote Buy and hold investors will prefer C-STRIPSsince they are priced lower and give a higher yield
8282014 102
8112019 FISD-02-A
httpslidepdfcomreaderfullfisd-02-a 103115
For Plain Vanilla bonds the specifiedcoupon rate is valid for the life of thebond
In the case of Floaters the rate is reset atthe beginning of every periodThe rate will vary directly with thebenchmark
8282014 103
8112019 FISD-02-A
httpslidepdfcomreaderfullfisd-02-a 104115
The rate on a Floater is specified as LIBOR+ 50 bp
The spread is positiveIf it were specified as LIBOR ndash 30bp
The spread will be negativeIf LIBOR rises the rate will increasewhereas if LIBOR falls it will decrease
8282014 104
8112019 FISD-02-A
httpslidepdfcomreaderfullfisd-02-a 105115
In the case of a default risk-free floater theprice will reset to par on a coupon date
It may sell at a premium or discount betweencoupon dates
Consider a floater with a coupon = 5-year T-Bond rate
Assume there are two periods left to maturity
8282014 105
8112019 FISD-02-A
httpslidepdfcomreaderfullfisd-02-a 106115
8282014 106
The price at the end of the first coupon period willbe given by
cT-1 is the coupon one period before maturityyT-1 is the YTM one period before maturity
8112019 FISD-02-A
httpslidepdfcomreaderfullfisd-02-a 107115
On a coupon reset date the YTM = couponBecause we have assumed there is no default riskAny change in the required yield as reflected inthe prevailing YTM
Will also be reflected in the coupon being setIf coupon = yield the bond should sell at par
Thus P T-1 = M
8282014 107
8112019 FISD-02-A
httpslidepdfcomreaderfullfisd-02-a 108115
8282014 108
8112019 FISD-02-A
httpslidepdfcomreaderfullfisd-02-a 109115
Once again at T-2 c T-2 = yT-2 and P T-2 = MThis logic can be applied to a bond with anytime remaining till maturityHowever between two coupon dates theprice may not be equal to par
Consider the valuation at T-2+k
8282014 109
8112019 FISD-02-A
httpslidepdfcomreaderfullfisd-02-a 110115
8282014 110
8112019 FISD-02-A
httpslidepdfcomreaderfullfisd-02-a 111115
Although c T-2 was set at T-2 and is equal toyT-2
yT-2+k is determined at T-2+k and will reflect theyield prevailing at that time
Thus yT-2+k need not equal c T-2 and may behigher or lower
Hence between two coupon dates a floater maysell at a premium or discount
8282014 111
8112019 FISD-02-A
httpslidepdfcomreaderfullfisd-02-a 112115
Now consider a floater characterized bydefault risk
The risk premium required by the market neednot be constant over time
Assume that at the time of issue YTM = 5-year T-note rate + 75bp
The coupon would have been set equal to thisrate and the bond would have been issued at par
8282014 112
8112019 FISD-02-A
httpslidepdfcomreaderfullfisd-02-a 113115
Six months hence the issue may be perceivedas more risky
YTM = 5-year T-note rate + 95 bpThe coupon will however be set equal to theprevailing 5-year rate + 75 bpIf so the issue will not reset to par at the nextcoupon date
8282014 113
8112019 FISD-02-A
httpslidepdfcomreaderfullfisd-02-a 114115
Floaters may come with a CAP or a FLOOR orBOTH
The CAP is a maximum coupon rateProtects issuers against rising rates
The FLOOR is a minimum coupon rateProtects investors against falling rates
When there is a spread over LIBORThere is a natural floorLIBOR cannot be less than zero
8282014 114
8112019 FISD-02-A
httpslidepdfcomreaderfullfisd-02-a 115115
8112019 FISD-02-A
httpslidepdfcomreaderfullfisd-02-a 77115
It has a bearing on the outcome of theauction
It affects the strategy used by a bidder becauseit has an impact on his prior positionBidders who are long in the WI market enter theauction with a Long PositionThose who are short in the WI market enter theauction with a short position
8282014 77
8112019 FISD-02-A
httpslidepdfcomreaderfullfisd-02-a 78115
The WI market helps in price discoveryIt provides important information on
The strength of demand for the securityAnd on the disparity of biddersrsquo views
This help potential bidders to formulate theirstrategiesAt times a dealer may believe that he hasvery important private information
If so he may not participate in the WI market andwill directly enter the auction with bids based onhis knowledge
8282014 78
8112019 FISD-02-A
httpslidepdfcomreaderfullfisd-02-a 79115
On or before the date of the auction theissues trade on a yield basis
The actual price can be established only afterthe coupon is set
Starting with the day after the auctionSecurities are quoted on a price basis becausethe coupon is known
8282014 79
8112019 FISD-02-A
httpslidepdfcomreaderfullfisd-02-a 80115
In a coupon roll a dealer will purchase themost recently issued security from a clientAnd simultaneously sell the same amount ofthe recently announced new security
The first leg with settle on the following dayThe second leg is a forward contract
8282014 80
8112019 FISD-02-A
httpslidepdfcomreaderfullfisd-02-a 81115
There can be a Reverse RollThe dealer will sell the most recent issue fornext day settlementAnd buy the newly announced security forforward settlement
The forward leg in a RollReverse Roll is a WItrade
It will settle on the new issue settlement date
8282014 81
8112019 FISD-02-A
httpslidepdfcomreaderfullfisd-02-a 82115
The roll is the spread between the yield onthe new security and that on the outstandingissue in the same maturity segmentA GIVE in the Roll means that
The WI security provides a higher yield than theoutstanding issue
A Take in the Roll means thatThe WI security provides a lower yield
8282014 82
8112019 FISD-02-A
httpslidepdfcomreaderfullfisd-02-a 83115
8112019 FISD-02-A
httpslidepdfcomreaderfullfisd-02-a 84115
On March 17 20XX the Treasury announcedthe auction of a 2-year note
The auction was scheduled for March 24The settlement date was March 31
Trading of the roll began as soon as the issuewas announcedA Give of 5 bp means that the dealer proposes tobuy the current issue at the prevailing yieldAnd sell the new issue at a yield that is 5 bpmoreA Take of 5 bp means that the dealer proposes tosell the new issue at a yield that is 5bp lower
8282014 84
8112019 FISD-02-A
httpslidepdfcomreaderfullfisd-02-a 85115
The roll achieves the followingHe acquires the outstanding issue for next daysettlementHe sells the to be issued security with the samepar value for forward delivery on 31 March
The customer is rolling over the investmentfrom the current issue to the new issue
This extends the maturity of the investment byone month
8282014 85
8112019 FISD-02-A
httpslidepdfcomreaderfullfisd-02-a 86115
The client can invest the funds received tillthe new issue settlesHowever he loses the accrued interest thathe would have earned had he held on to theissue
8282014 86
8112019 FISD-02-A
httpslidepdfcomreaderfullfisd-02-a 87115
The Treasury per se does not issue zerocoupon securitiesBut zero coupon securities can be created
which are backed by conventional bondsTake a large quantity of a T-note or bond andseparate all the cash flows from each otherSell the entitlement to each cash flowseparately
8282014 87
8112019 FISD-02-A
httpslidepdfcomreaderfullfisd-02-a 88115
Take the case of a two-year T-noteIt can be separated into five zero couponsecurities maturing after
6 months12 months18 months24 months
8282014 88
8112019 FISD-02-A
httpslidepdfcomreaderfullfisd-02-a 89115
Earlier investment banks used to buy bondsfrom the Treasury and separate the cashflows
Each cash flow was then sold separately as a zerocoupon bondSuch issues are called trademarks
8282014 89
8112019 FISD-02-A
httpslidepdfcomreaderfullfisd-02-a 90115
The issue of trademarks has now ceasedBecause investment banks can now createsuch instruments
In concert with the Treasury itselfThese ZCBs are known as STRIPS ndash
Separate Trading of Registered Interest andPrincipal of Securities
These are not issued or sold by the Treasury
The market is made by investment banks
8282014 90
8112019 FISD-02-A
httpslidepdfcomreaderfullfisd-02-a 91115
What is the motivation to create suchproductsIn practice arbitrage is possible when a
coupon security is purchased at a priceThat is lower than what could be obtained byselling each cash flow separately
8282014 91
8112019 FISD-02-A
httpslidepdfcomreaderfullfisd-02-a 92115
Coupon stripping reflects a case of financialengineering
Creating a risk-return profile that is nototherwise available
An investment bank would buy a largequantity of a Treasury security
The securities would be placed with an SPV
8282014 92
8112019 FISD-02-A
httpslidepdfcomreaderfullfisd-02-a 93115
The SPV is a single-purpose dedicated trustIt has the powers to own the bonds andcollect payments
It cannot sell or lend the bondsIt cannot write options on the bondsOr use them as collateral for borrowing
The SPV is empowered to issue zero coupon
bondsWhere each security represents the ownership ofa single cash flow from the mother bond
8282014 93
8112019 FISD-02-A
httpslidepdfcomreaderfullfisd-02-a 94115
Assume that 100MM USD of 15 year bondswith a coupon of 8 are placed with the SPV
The SPV can issue 6M 12M 18M extending up to14 frac12 year zeroes with a total face value of 4MM
USD eachAnd 15 year zeroes with a total face value of104MM
8282014 94
8112019 FISD-02-A
httpslidepdfcomreaderfullfisd-02-a 95115
8112019 FISD-02-A
httpslidepdfcomreaderfullfisd-02-a 96115
8282014 96
8112019 FISD-02-A
httpslidepdfcomreaderfullfisd-02-a 97115
The Treasury launched this program in 1985to facilitate the stripping of designatedsecurities
All new T-bonds and notes with a maturity of 10years or more are eligibleThe zeroes created in the process are directobligations of the US government
8282014 97
8112019 FISD-02-A
httpslidepdfcomreaderfullfisd-02-a 98115
The mechanism is as followsA dealer who owns a bond or note can ask theFRB where it is held
To replace it with an equivalent set of STRIPS
representing each payment as a separate securityEach of these securities can be traded independentlyof others
8282014 98
8112019 FISD-02-A
httpslidepdfcomreaderfullfisd-02-a 99115
In 1987 the Treasury started to allow dealersto reverse the process
This is called STRIPS RECONSTUTUTION If a dealer owns STRIPS representing all thecoupon and principal payments of a bond
The FED can on request convert these holdings into asingle position in the corresponding bond
8282014 99
8112019 FISD-02-A
httpslidepdfcomreaderfullfisd-02-a 100115
Each coupon and principal cash flow from aTreasury security is assigned a CUSIP
The mother bond is also assigned a CUSIPThe stripped coupons are known as C-STRIPSThe stripped principal is known as P-STRIPSSupply of a C-STRIP increases over time
because a C-STRIP maturing on a day like 15 FEB
2020 will have the same CUSIP irrespective ofwhich mother bond it has come fromThe original coupon rate is irrelevant
8282014 100
8112019 FISD-02-A
httpslidepdfcomreaderfullfisd-02-a 101115
P-STRIPS always correspond to the originalsecurityThey have a unique CUSIPTheir supply is fixed at the time of issuanceIn practice the prices of long-dated P-STRIPSare a bit higher than those of C-STRIPS withthe same maturity date
One reason is that P-STRIPS are more liquid due
to greater availabilityA $100 face value bond with a coupon of 8 willgenerate C-STRIPS with a face value of $4 but P-STRIPS with a face value of $100
8282014 101
8112019 FISD-02-A
httpslidepdfcomreaderfullfisd-02-a 102115
Another reason why P-STRIPS are in higherdemand is that they allow reconstitutionactivities more easily
Assume that the sum of the STRIPS is cheaper than
the mother bondIf a dealer already has the P-STRIPS only the C-STRIPSneed to be acquiredHowever if he owns some of the C-STRIPS he needs toacquire the P-STRIPS and the remaining C-STRIPSThe facility to reconstitute when profitable is pricedinto the P-STRIPSNote Buy and hold investors will prefer C-STRIPSsince they are priced lower and give a higher yield
8282014 102
8112019 FISD-02-A
httpslidepdfcomreaderfullfisd-02-a 103115
For Plain Vanilla bonds the specifiedcoupon rate is valid for the life of thebond
In the case of Floaters the rate is reset atthe beginning of every periodThe rate will vary directly with thebenchmark
8282014 103
8112019 FISD-02-A
httpslidepdfcomreaderfullfisd-02-a 104115
The rate on a Floater is specified as LIBOR+ 50 bp
The spread is positiveIf it were specified as LIBOR ndash 30bp
The spread will be negativeIf LIBOR rises the rate will increasewhereas if LIBOR falls it will decrease
8282014 104
8112019 FISD-02-A
httpslidepdfcomreaderfullfisd-02-a 105115
In the case of a default risk-free floater theprice will reset to par on a coupon date
It may sell at a premium or discount betweencoupon dates
Consider a floater with a coupon = 5-year T-Bond rate
Assume there are two periods left to maturity
8282014 105
8112019 FISD-02-A
httpslidepdfcomreaderfullfisd-02-a 106115
8282014 106
The price at the end of the first coupon period willbe given by
cT-1 is the coupon one period before maturityyT-1 is the YTM one period before maturity
8112019 FISD-02-A
httpslidepdfcomreaderfullfisd-02-a 107115
On a coupon reset date the YTM = couponBecause we have assumed there is no default riskAny change in the required yield as reflected inthe prevailing YTM
Will also be reflected in the coupon being setIf coupon = yield the bond should sell at par
Thus P T-1 = M
8282014 107
8112019 FISD-02-A
httpslidepdfcomreaderfullfisd-02-a 108115
8282014 108
8112019 FISD-02-A
httpslidepdfcomreaderfullfisd-02-a 109115
Once again at T-2 c T-2 = yT-2 and P T-2 = MThis logic can be applied to a bond with anytime remaining till maturityHowever between two coupon dates theprice may not be equal to par
Consider the valuation at T-2+k
8282014 109
8112019 FISD-02-A
httpslidepdfcomreaderfullfisd-02-a 110115
8282014 110
8112019 FISD-02-A
httpslidepdfcomreaderfullfisd-02-a 111115
Although c T-2 was set at T-2 and is equal toyT-2
yT-2+k is determined at T-2+k and will reflect theyield prevailing at that time
Thus yT-2+k need not equal c T-2 and may behigher or lower
Hence between two coupon dates a floater maysell at a premium or discount
8282014 111
8112019 FISD-02-A
httpslidepdfcomreaderfullfisd-02-a 112115
Now consider a floater characterized bydefault risk
The risk premium required by the market neednot be constant over time
Assume that at the time of issue YTM = 5-year T-note rate + 75bp
The coupon would have been set equal to thisrate and the bond would have been issued at par
8282014 112
8112019 FISD-02-A
httpslidepdfcomreaderfullfisd-02-a 113115
Six months hence the issue may be perceivedas more risky
YTM = 5-year T-note rate + 95 bpThe coupon will however be set equal to theprevailing 5-year rate + 75 bpIf so the issue will not reset to par at the nextcoupon date
8282014 113
8112019 FISD-02-A
httpslidepdfcomreaderfullfisd-02-a 114115
Floaters may come with a CAP or a FLOOR orBOTH
The CAP is a maximum coupon rateProtects issuers against rising rates
The FLOOR is a minimum coupon rateProtects investors against falling rates
When there is a spread over LIBORThere is a natural floorLIBOR cannot be less than zero
8282014 114
8112019 FISD-02-A
httpslidepdfcomreaderfullfisd-02-a 115115
8112019 FISD-02-A
httpslidepdfcomreaderfullfisd-02-a 78115
The WI market helps in price discoveryIt provides important information on
The strength of demand for the securityAnd on the disparity of biddersrsquo views
This help potential bidders to formulate theirstrategiesAt times a dealer may believe that he hasvery important private information
If so he may not participate in the WI market andwill directly enter the auction with bids based onhis knowledge
8282014 78
8112019 FISD-02-A
httpslidepdfcomreaderfullfisd-02-a 79115
On or before the date of the auction theissues trade on a yield basis
The actual price can be established only afterthe coupon is set
Starting with the day after the auctionSecurities are quoted on a price basis becausethe coupon is known
8282014 79
8112019 FISD-02-A
httpslidepdfcomreaderfullfisd-02-a 80115
In a coupon roll a dealer will purchase themost recently issued security from a clientAnd simultaneously sell the same amount ofthe recently announced new security
The first leg with settle on the following dayThe second leg is a forward contract
8282014 80
8112019 FISD-02-A
httpslidepdfcomreaderfullfisd-02-a 81115
There can be a Reverse RollThe dealer will sell the most recent issue fornext day settlementAnd buy the newly announced security forforward settlement
The forward leg in a RollReverse Roll is a WItrade
It will settle on the new issue settlement date
8282014 81
8112019 FISD-02-A
httpslidepdfcomreaderfullfisd-02-a 82115
The roll is the spread between the yield onthe new security and that on the outstandingissue in the same maturity segmentA GIVE in the Roll means that
The WI security provides a higher yield than theoutstanding issue
A Take in the Roll means thatThe WI security provides a lower yield
8282014 82
8112019 FISD-02-A
httpslidepdfcomreaderfullfisd-02-a 83115
8112019 FISD-02-A
httpslidepdfcomreaderfullfisd-02-a 84115
On March 17 20XX the Treasury announcedthe auction of a 2-year note
The auction was scheduled for March 24The settlement date was March 31
Trading of the roll began as soon as the issuewas announcedA Give of 5 bp means that the dealer proposes tobuy the current issue at the prevailing yieldAnd sell the new issue at a yield that is 5 bpmoreA Take of 5 bp means that the dealer proposes tosell the new issue at a yield that is 5bp lower
8282014 84
8112019 FISD-02-A
httpslidepdfcomreaderfullfisd-02-a 85115
The roll achieves the followingHe acquires the outstanding issue for next daysettlementHe sells the to be issued security with the samepar value for forward delivery on 31 March
The customer is rolling over the investmentfrom the current issue to the new issue
This extends the maturity of the investment byone month
8282014 85
8112019 FISD-02-A
httpslidepdfcomreaderfullfisd-02-a 86115
The client can invest the funds received tillthe new issue settlesHowever he loses the accrued interest thathe would have earned had he held on to theissue
8282014 86
8112019 FISD-02-A
httpslidepdfcomreaderfullfisd-02-a 87115
The Treasury per se does not issue zerocoupon securitiesBut zero coupon securities can be created
which are backed by conventional bondsTake a large quantity of a T-note or bond andseparate all the cash flows from each otherSell the entitlement to each cash flowseparately
8282014 87
8112019 FISD-02-A
httpslidepdfcomreaderfullfisd-02-a 88115
Take the case of a two-year T-noteIt can be separated into five zero couponsecurities maturing after
6 months12 months18 months24 months
8282014 88
8112019 FISD-02-A
httpslidepdfcomreaderfullfisd-02-a 89115
Earlier investment banks used to buy bondsfrom the Treasury and separate the cashflows
Each cash flow was then sold separately as a zerocoupon bondSuch issues are called trademarks
8282014 89
8112019 FISD-02-A
httpslidepdfcomreaderfullfisd-02-a 90115
The issue of trademarks has now ceasedBecause investment banks can now createsuch instruments
In concert with the Treasury itselfThese ZCBs are known as STRIPS ndash
Separate Trading of Registered Interest andPrincipal of Securities
These are not issued or sold by the Treasury
The market is made by investment banks
8282014 90
8112019 FISD-02-A
httpslidepdfcomreaderfullfisd-02-a 91115
What is the motivation to create suchproductsIn practice arbitrage is possible when a
coupon security is purchased at a priceThat is lower than what could be obtained byselling each cash flow separately
8282014 91
8112019 FISD-02-A
httpslidepdfcomreaderfullfisd-02-a 92115
Coupon stripping reflects a case of financialengineering
Creating a risk-return profile that is nototherwise available
An investment bank would buy a largequantity of a Treasury security
The securities would be placed with an SPV
8282014 92
8112019 FISD-02-A
httpslidepdfcomreaderfullfisd-02-a 93115
The SPV is a single-purpose dedicated trustIt has the powers to own the bonds andcollect payments
It cannot sell or lend the bondsIt cannot write options on the bondsOr use them as collateral for borrowing
The SPV is empowered to issue zero coupon
bondsWhere each security represents the ownership ofa single cash flow from the mother bond
8282014 93
8112019 FISD-02-A
httpslidepdfcomreaderfullfisd-02-a 94115
Assume that 100MM USD of 15 year bondswith a coupon of 8 are placed with the SPV
The SPV can issue 6M 12M 18M extending up to14 frac12 year zeroes with a total face value of 4MM
USD eachAnd 15 year zeroes with a total face value of104MM
8282014 94
8112019 FISD-02-A
httpslidepdfcomreaderfullfisd-02-a 95115
8112019 FISD-02-A
httpslidepdfcomreaderfullfisd-02-a 96115
8282014 96
8112019 FISD-02-A
httpslidepdfcomreaderfullfisd-02-a 97115
The Treasury launched this program in 1985to facilitate the stripping of designatedsecurities
All new T-bonds and notes with a maturity of 10years or more are eligibleThe zeroes created in the process are directobligations of the US government
8282014 97
8112019 FISD-02-A
httpslidepdfcomreaderfullfisd-02-a 98115
The mechanism is as followsA dealer who owns a bond or note can ask theFRB where it is held
To replace it with an equivalent set of STRIPS
representing each payment as a separate securityEach of these securities can be traded independentlyof others
8282014 98
8112019 FISD-02-A
httpslidepdfcomreaderfullfisd-02-a 99115
In 1987 the Treasury started to allow dealersto reverse the process
This is called STRIPS RECONSTUTUTION If a dealer owns STRIPS representing all thecoupon and principal payments of a bond
The FED can on request convert these holdings into asingle position in the corresponding bond
8282014 99
8112019 FISD-02-A
httpslidepdfcomreaderfullfisd-02-a 100115
Each coupon and principal cash flow from aTreasury security is assigned a CUSIP
The mother bond is also assigned a CUSIPThe stripped coupons are known as C-STRIPSThe stripped principal is known as P-STRIPSSupply of a C-STRIP increases over time
because a C-STRIP maturing on a day like 15 FEB
2020 will have the same CUSIP irrespective ofwhich mother bond it has come fromThe original coupon rate is irrelevant
8282014 100
8112019 FISD-02-A
httpslidepdfcomreaderfullfisd-02-a 101115
P-STRIPS always correspond to the originalsecurityThey have a unique CUSIPTheir supply is fixed at the time of issuanceIn practice the prices of long-dated P-STRIPSare a bit higher than those of C-STRIPS withthe same maturity date
One reason is that P-STRIPS are more liquid due
to greater availabilityA $100 face value bond with a coupon of 8 willgenerate C-STRIPS with a face value of $4 but P-STRIPS with a face value of $100
8282014 101
8112019 FISD-02-A
httpslidepdfcomreaderfullfisd-02-a 102115
Another reason why P-STRIPS are in higherdemand is that they allow reconstitutionactivities more easily
Assume that the sum of the STRIPS is cheaper than
the mother bondIf a dealer already has the P-STRIPS only the C-STRIPSneed to be acquiredHowever if he owns some of the C-STRIPS he needs toacquire the P-STRIPS and the remaining C-STRIPSThe facility to reconstitute when profitable is pricedinto the P-STRIPSNote Buy and hold investors will prefer C-STRIPSsince they are priced lower and give a higher yield
8282014 102
8112019 FISD-02-A
httpslidepdfcomreaderfullfisd-02-a 103115
For Plain Vanilla bonds the specifiedcoupon rate is valid for the life of thebond
In the case of Floaters the rate is reset atthe beginning of every periodThe rate will vary directly with thebenchmark
8282014 103
8112019 FISD-02-A
httpslidepdfcomreaderfullfisd-02-a 104115
The rate on a Floater is specified as LIBOR+ 50 bp
The spread is positiveIf it were specified as LIBOR ndash 30bp
The spread will be negativeIf LIBOR rises the rate will increasewhereas if LIBOR falls it will decrease
8282014 104
8112019 FISD-02-A
httpslidepdfcomreaderfullfisd-02-a 105115
In the case of a default risk-free floater theprice will reset to par on a coupon date
It may sell at a premium or discount betweencoupon dates
Consider a floater with a coupon = 5-year T-Bond rate
Assume there are two periods left to maturity
8282014 105
8112019 FISD-02-A
httpslidepdfcomreaderfullfisd-02-a 106115
8282014 106
The price at the end of the first coupon period willbe given by
cT-1 is the coupon one period before maturityyT-1 is the YTM one period before maturity
8112019 FISD-02-A
httpslidepdfcomreaderfullfisd-02-a 107115
On a coupon reset date the YTM = couponBecause we have assumed there is no default riskAny change in the required yield as reflected inthe prevailing YTM
Will also be reflected in the coupon being setIf coupon = yield the bond should sell at par
Thus P T-1 = M
8282014 107
8112019 FISD-02-A
httpslidepdfcomreaderfullfisd-02-a 108115
8282014 108
8112019 FISD-02-A
httpslidepdfcomreaderfullfisd-02-a 109115
Once again at T-2 c T-2 = yT-2 and P T-2 = MThis logic can be applied to a bond with anytime remaining till maturityHowever between two coupon dates theprice may not be equal to par
Consider the valuation at T-2+k
8282014 109
8112019 FISD-02-A
httpslidepdfcomreaderfullfisd-02-a 110115
8282014 110
8112019 FISD-02-A
httpslidepdfcomreaderfullfisd-02-a 111115
Although c T-2 was set at T-2 and is equal toyT-2
yT-2+k is determined at T-2+k and will reflect theyield prevailing at that time
Thus yT-2+k need not equal c T-2 and may behigher or lower
Hence between two coupon dates a floater maysell at a premium or discount
8282014 111
8112019 FISD-02-A
httpslidepdfcomreaderfullfisd-02-a 112115
Now consider a floater characterized bydefault risk
The risk premium required by the market neednot be constant over time
Assume that at the time of issue YTM = 5-year T-note rate + 75bp
The coupon would have been set equal to thisrate and the bond would have been issued at par
8282014 112
8112019 FISD-02-A
httpslidepdfcomreaderfullfisd-02-a 113115
Six months hence the issue may be perceivedas more risky
YTM = 5-year T-note rate + 95 bpThe coupon will however be set equal to theprevailing 5-year rate + 75 bpIf so the issue will not reset to par at the nextcoupon date
8282014 113
8112019 FISD-02-A
httpslidepdfcomreaderfullfisd-02-a 114115
Floaters may come with a CAP or a FLOOR orBOTH
The CAP is a maximum coupon rateProtects issuers against rising rates
The FLOOR is a minimum coupon rateProtects investors against falling rates
When there is a spread over LIBORThere is a natural floorLIBOR cannot be less than zero
8282014 114
8112019 FISD-02-A
httpslidepdfcomreaderfullfisd-02-a 115115
8112019 FISD-02-A
httpslidepdfcomreaderfullfisd-02-a 79115
On or before the date of the auction theissues trade on a yield basis
The actual price can be established only afterthe coupon is set
Starting with the day after the auctionSecurities are quoted on a price basis becausethe coupon is known
8282014 79
8112019 FISD-02-A
httpslidepdfcomreaderfullfisd-02-a 80115
In a coupon roll a dealer will purchase themost recently issued security from a clientAnd simultaneously sell the same amount ofthe recently announced new security
The first leg with settle on the following dayThe second leg is a forward contract
8282014 80
8112019 FISD-02-A
httpslidepdfcomreaderfullfisd-02-a 81115
There can be a Reverse RollThe dealer will sell the most recent issue fornext day settlementAnd buy the newly announced security forforward settlement
The forward leg in a RollReverse Roll is a WItrade
It will settle on the new issue settlement date
8282014 81
8112019 FISD-02-A
httpslidepdfcomreaderfullfisd-02-a 82115
The roll is the spread between the yield onthe new security and that on the outstandingissue in the same maturity segmentA GIVE in the Roll means that
The WI security provides a higher yield than theoutstanding issue
A Take in the Roll means thatThe WI security provides a lower yield
8282014 82
8112019 FISD-02-A
httpslidepdfcomreaderfullfisd-02-a 83115
8112019 FISD-02-A
httpslidepdfcomreaderfullfisd-02-a 84115
On March 17 20XX the Treasury announcedthe auction of a 2-year note
The auction was scheduled for March 24The settlement date was March 31
Trading of the roll began as soon as the issuewas announcedA Give of 5 bp means that the dealer proposes tobuy the current issue at the prevailing yieldAnd sell the new issue at a yield that is 5 bpmoreA Take of 5 bp means that the dealer proposes tosell the new issue at a yield that is 5bp lower
8282014 84
8112019 FISD-02-A
httpslidepdfcomreaderfullfisd-02-a 85115
The roll achieves the followingHe acquires the outstanding issue for next daysettlementHe sells the to be issued security with the samepar value for forward delivery on 31 March
The customer is rolling over the investmentfrom the current issue to the new issue
This extends the maturity of the investment byone month
8282014 85
8112019 FISD-02-A
httpslidepdfcomreaderfullfisd-02-a 86115
The client can invest the funds received tillthe new issue settlesHowever he loses the accrued interest thathe would have earned had he held on to theissue
8282014 86
8112019 FISD-02-A
httpslidepdfcomreaderfullfisd-02-a 87115
The Treasury per se does not issue zerocoupon securitiesBut zero coupon securities can be created
which are backed by conventional bondsTake a large quantity of a T-note or bond andseparate all the cash flows from each otherSell the entitlement to each cash flowseparately
8282014 87
8112019 FISD-02-A
httpslidepdfcomreaderfullfisd-02-a 88115
Take the case of a two-year T-noteIt can be separated into five zero couponsecurities maturing after
6 months12 months18 months24 months
8282014 88
8112019 FISD-02-A
httpslidepdfcomreaderfullfisd-02-a 89115
Earlier investment banks used to buy bondsfrom the Treasury and separate the cashflows
Each cash flow was then sold separately as a zerocoupon bondSuch issues are called trademarks
8282014 89
8112019 FISD-02-A
httpslidepdfcomreaderfullfisd-02-a 90115
The issue of trademarks has now ceasedBecause investment banks can now createsuch instruments
In concert with the Treasury itselfThese ZCBs are known as STRIPS ndash
Separate Trading of Registered Interest andPrincipal of Securities
These are not issued or sold by the Treasury
The market is made by investment banks
8282014 90
8112019 FISD-02-A
httpslidepdfcomreaderfullfisd-02-a 91115
What is the motivation to create suchproductsIn practice arbitrage is possible when a
coupon security is purchased at a priceThat is lower than what could be obtained byselling each cash flow separately
8282014 91
8112019 FISD-02-A
httpslidepdfcomreaderfullfisd-02-a 92115
Coupon stripping reflects a case of financialengineering
Creating a risk-return profile that is nototherwise available
An investment bank would buy a largequantity of a Treasury security
The securities would be placed with an SPV
8282014 92
8112019 FISD-02-A
httpslidepdfcomreaderfullfisd-02-a 93115
The SPV is a single-purpose dedicated trustIt has the powers to own the bonds andcollect payments
It cannot sell or lend the bondsIt cannot write options on the bondsOr use them as collateral for borrowing
The SPV is empowered to issue zero coupon
bondsWhere each security represents the ownership ofa single cash flow from the mother bond
8282014 93
8112019 FISD-02-A
httpslidepdfcomreaderfullfisd-02-a 94115
Assume that 100MM USD of 15 year bondswith a coupon of 8 are placed with the SPV
The SPV can issue 6M 12M 18M extending up to14 frac12 year zeroes with a total face value of 4MM
USD eachAnd 15 year zeroes with a total face value of104MM
8282014 94
8112019 FISD-02-A
httpslidepdfcomreaderfullfisd-02-a 95115
8112019 FISD-02-A
httpslidepdfcomreaderfullfisd-02-a 96115
8282014 96
8112019 FISD-02-A
httpslidepdfcomreaderfullfisd-02-a 97115
The Treasury launched this program in 1985to facilitate the stripping of designatedsecurities
All new T-bonds and notes with a maturity of 10years or more are eligibleThe zeroes created in the process are directobligations of the US government
8282014 97
8112019 FISD-02-A
httpslidepdfcomreaderfullfisd-02-a 98115
The mechanism is as followsA dealer who owns a bond or note can ask theFRB where it is held
To replace it with an equivalent set of STRIPS
representing each payment as a separate securityEach of these securities can be traded independentlyof others
8282014 98
8112019 FISD-02-A
httpslidepdfcomreaderfullfisd-02-a 99115
In 1987 the Treasury started to allow dealersto reverse the process
This is called STRIPS RECONSTUTUTION If a dealer owns STRIPS representing all thecoupon and principal payments of a bond
The FED can on request convert these holdings into asingle position in the corresponding bond
8282014 99
8112019 FISD-02-A
httpslidepdfcomreaderfullfisd-02-a 100115
Each coupon and principal cash flow from aTreasury security is assigned a CUSIP
The mother bond is also assigned a CUSIPThe stripped coupons are known as C-STRIPSThe stripped principal is known as P-STRIPSSupply of a C-STRIP increases over time
because a C-STRIP maturing on a day like 15 FEB
2020 will have the same CUSIP irrespective ofwhich mother bond it has come fromThe original coupon rate is irrelevant
8282014 100
8112019 FISD-02-A
httpslidepdfcomreaderfullfisd-02-a 101115
P-STRIPS always correspond to the originalsecurityThey have a unique CUSIPTheir supply is fixed at the time of issuanceIn practice the prices of long-dated P-STRIPSare a bit higher than those of C-STRIPS withthe same maturity date
One reason is that P-STRIPS are more liquid due
to greater availabilityA $100 face value bond with a coupon of 8 willgenerate C-STRIPS with a face value of $4 but P-STRIPS with a face value of $100
8282014 101
8112019 FISD-02-A
httpslidepdfcomreaderfullfisd-02-a 102115
Another reason why P-STRIPS are in higherdemand is that they allow reconstitutionactivities more easily
Assume that the sum of the STRIPS is cheaper than
the mother bondIf a dealer already has the P-STRIPS only the C-STRIPSneed to be acquiredHowever if he owns some of the C-STRIPS he needs toacquire the P-STRIPS and the remaining C-STRIPSThe facility to reconstitute when profitable is pricedinto the P-STRIPSNote Buy and hold investors will prefer C-STRIPSsince they are priced lower and give a higher yield
8282014 102
8112019 FISD-02-A
httpslidepdfcomreaderfullfisd-02-a 103115
For Plain Vanilla bonds the specifiedcoupon rate is valid for the life of thebond
In the case of Floaters the rate is reset atthe beginning of every periodThe rate will vary directly with thebenchmark
8282014 103
8112019 FISD-02-A
httpslidepdfcomreaderfullfisd-02-a 104115
The rate on a Floater is specified as LIBOR+ 50 bp
The spread is positiveIf it were specified as LIBOR ndash 30bp
The spread will be negativeIf LIBOR rises the rate will increasewhereas if LIBOR falls it will decrease
8282014 104
8112019 FISD-02-A
httpslidepdfcomreaderfullfisd-02-a 105115
In the case of a default risk-free floater theprice will reset to par on a coupon date
It may sell at a premium or discount betweencoupon dates
Consider a floater with a coupon = 5-year T-Bond rate
Assume there are two periods left to maturity
8282014 105
8112019 FISD-02-A
httpslidepdfcomreaderfullfisd-02-a 106115
8282014 106
The price at the end of the first coupon period willbe given by
cT-1 is the coupon one period before maturityyT-1 is the YTM one period before maturity
8112019 FISD-02-A
httpslidepdfcomreaderfullfisd-02-a 107115
On a coupon reset date the YTM = couponBecause we have assumed there is no default riskAny change in the required yield as reflected inthe prevailing YTM
Will also be reflected in the coupon being setIf coupon = yield the bond should sell at par
Thus P T-1 = M
8282014 107
8112019 FISD-02-A
httpslidepdfcomreaderfullfisd-02-a 108115
8282014 108
8112019 FISD-02-A
httpslidepdfcomreaderfullfisd-02-a 109115
Once again at T-2 c T-2 = yT-2 and P T-2 = MThis logic can be applied to a bond with anytime remaining till maturityHowever between two coupon dates theprice may not be equal to par
Consider the valuation at T-2+k
8282014 109
8112019 FISD-02-A
httpslidepdfcomreaderfullfisd-02-a 110115
8282014 110
8112019 FISD-02-A
httpslidepdfcomreaderfullfisd-02-a 111115
Although c T-2 was set at T-2 and is equal toyT-2
yT-2+k is determined at T-2+k and will reflect theyield prevailing at that time
Thus yT-2+k need not equal c T-2 and may behigher or lower
Hence between two coupon dates a floater maysell at a premium or discount
8282014 111
8112019 FISD-02-A
httpslidepdfcomreaderfullfisd-02-a 112115
Now consider a floater characterized bydefault risk
The risk premium required by the market neednot be constant over time
Assume that at the time of issue YTM = 5-year T-note rate + 75bp
The coupon would have been set equal to thisrate and the bond would have been issued at par
8282014 112
8112019 FISD-02-A
httpslidepdfcomreaderfullfisd-02-a 113115
Six months hence the issue may be perceivedas more risky
YTM = 5-year T-note rate + 95 bpThe coupon will however be set equal to theprevailing 5-year rate + 75 bpIf so the issue will not reset to par at the nextcoupon date
8282014 113
8112019 FISD-02-A
httpslidepdfcomreaderfullfisd-02-a 114115
Floaters may come with a CAP or a FLOOR orBOTH
The CAP is a maximum coupon rateProtects issuers against rising rates
The FLOOR is a minimum coupon rateProtects investors against falling rates
When there is a spread over LIBORThere is a natural floorLIBOR cannot be less than zero
8282014 114
8112019 FISD-02-A
httpslidepdfcomreaderfullfisd-02-a 115115
8112019 FISD-02-A
httpslidepdfcomreaderfullfisd-02-a 80115
In a coupon roll a dealer will purchase themost recently issued security from a clientAnd simultaneously sell the same amount ofthe recently announced new security
The first leg with settle on the following dayThe second leg is a forward contract
8282014 80
8112019 FISD-02-A
httpslidepdfcomreaderfullfisd-02-a 81115
There can be a Reverse RollThe dealer will sell the most recent issue fornext day settlementAnd buy the newly announced security forforward settlement
The forward leg in a RollReverse Roll is a WItrade
It will settle on the new issue settlement date
8282014 81
8112019 FISD-02-A
httpslidepdfcomreaderfullfisd-02-a 82115
The roll is the spread between the yield onthe new security and that on the outstandingissue in the same maturity segmentA GIVE in the Roll means that
The WI security provides a higher yield than theoutstanding issue
A Take in the Roll means thatThe WI security provides a lower yield
8282014 82
8112019 FISD-02-A
httpslidepdfcomreaderfullfisd-02-a 83115
8112019 FISD-02-A
httpslidepdfcomreaderfullfisd-02-a 84115
On March 17 20XX the Treasury announcedthe auction of a 2-year note
The auction was scheduled for March 24The settlement date was March 31
Trading of the roll began as soon as the issuewas announcedA Give of 5 bp means that the dealer proposes tobuy the current issue at the prevailing yieldAnd sell the new issue at a yield that is 5 bpmoreA Take of 5 bp means that the dealer proposes tosell the new issue at a yield that is 5bp lower
8282014 84
8112019 FISD-02-A
httpslidepdfcomreaderfullfisd-02-a 85115
The roll achieves the followingHe acquires the outstanding issue for next daysettlementHe sells the to be issued security with the samepar value for forward delivery on 31 March
The customer is rolling over the investmentfrom the current issue to the new issue
This extends the maturity of the investment byone month
8282014 85
8112019 FISD-02-A
httpslidepdfcomreaderfullfisd-02-a 86115
The client can invest the funds received tillthe new issue settlesHowever he loses the accrued interest thathe would have earned had he held on to theissue
8282014 86
8112019 FISD-02-A
httpslidepdfcomreaderfullfisd-02-a 87115
The Treasury per se does not issue zerocoupon securitiesBut zero coupon securities can be created
which are backed by conventional bondsTake a large quantity of a T-note or bond andseparate all the cash flows from each otherSell the entitlement to each cash flowseparately
8282014 87
8112019 FISD-02-A
httpslidepdfcomreaderfullfisd-02-a 88115
Take the case of a two-year T-noteIt can be separated into five zero couponsecurities maturing after
6 months12 months18 months24 months
8282014 88
8112019 FISD-02-A
httpslidepdfcomreaderfullfisd-02-a 89115
Earlier investment banks used to buy bondsfrom the Treasury and separate the cashflows
Each cash flow was then sold separately as a zerocoupon bondSuch issues are called trademarks
8282014 89
8112019 FISD-02-A
httpslidepdfcomreaderfullfisd-02-a 90115
The issue of trademarks has now ceasedBecause investment banks can now createsuch instruments
In concert with the Treasury itselfThese ZCBs are known as STRIPS ndash
Separate Trading of Registered Interest andPrincipal of Securities
These are not issued or sold by the Treasury
The market is made by investment banks
8282014 90
8112019 FISD-02-A
httpslidepdfcomreaderfullfisd-02-a 91115
What is the motivation to create suchproductsIn practice arbitrage is possible when a
coupon security is purchased at a priceThat is lower than what could be obtained byselling each cash flow separately
8282014 91
8112019 FISD-02-A
httpslidepdfcomreaderfullfisd-02-a 92115
Coupon stripping reflects a case of financialengineering
Creating a risk-return profile that is nototherwise available
An investment bank would buy a largequantity of a Treasury security
The securities would be placed with an SPV
8282014 92
8112019 FISD-02-A
httpslidepdfcomreaderfullfisd-02-a 93115
The SPV is a single-purpose dedicated trustIt has the powers to own the bonds andcollect payments
It cannot sell or lend the bondsIt cannot write options on the bondsOr use them as collateral for borrowing
The SPV is empowered to issue zero coupon
bondsWhere each security represents the ownership ofa single cash flow from the mother bond
8282014 93
8112019 FISD-02-A
httpslidepdfcomreaderfullfisd-02-a 94115
Assume that 100MM USD of 15 year bondswith a coupon of 8 are placed with the SPV
The SPV can issue 6M 12M 18M extending up to14 frac12 year zeroes with a total face value of 4MM
USD eachAnd 15 year zeroes with a total face value of104MM
8282014 94
8112019 FISD-02-A
httpslidepdfcomreaderfullfisd-02-a 95115
8112019 FISD-02-A
httpslidepdfcomreaderfullfisd-02-a 96115
8282014 96
8112019 FISD-02-A
httpslidepdfcomreaderfullfisd-02-a 97115
The Treasury launched this program in 1985to facilitate the stripping of designatedsecurities
All new T-bonds and notes with a maturity of 10years or more are eligibleThe zeroes created in the process are directobligations of the US government
8282014 97
8112019 FISD-02-A
httpslidepdfcomreaderfullfisd-02-a 98115
The mechanism is as followsA dealer who owns a bond or note can ask theFRB where it is held
To replace it with an equivalent set of STRIPS
representing each payment as a separate securityEach of these securities can be traded independentlyof others
8282014 98
8112019 FISD-02-A
httpslidepdfcomreaderfullfisd-02-a 99115
In 1987 the Treasury started to allow dealersto reverse the process
This is called STRIPS RECONSTUTUTION If a dealer owns STRIPS representing all thecoupon and principal payments of a bond
The FED can on request convert these holdings into asingle position in the corresponding bond
8282014 99
8112019 FISD-02-A
httpslidepdfcomreaderfullfisd-02-a 100115
Each coupon and principal cash flow from aTreasury security is assigned a CUSIP
The mother bond is also assigned a CUSIPThe stripped coupons are known as C-STRIPSThe stripped principal is known as P-STRIPSSupply of a C-STRIP increases over time
because a C-STRIP maturing on a day like 15 FEB
2020 will have the same CUSIP irrespective ofwhich mother bond it has come fromThe original coupon rate is irrelevant
8282014 100
8112019 FISD-02-A
httpslidepdfcomreaderfullfisd-02-a 101115
P-STRIPS always correspond to the originalsecurityThey have a unique CUSIPTheir supply is fixed at the time of issuanceIn practice the prices of long-dated P-STRIPSare a bit higher than those of C-STRIPS withthe same maturity date
One reason is that P-STRIPS are more liquid due
to greater availabilityA $100 face value bond with a coupon of 8 willgenerate C-STRIPS with a face value of $4 but P-STRIPS with a face value of $100
8282014 101
8112019 FISD-02-A
httpslidepdfcomreaderfullfisd-02-a 102115
Another reason why P-STRIPS are in higherdemand is that they allow reconstitutionactivities more easily
Assume that the sum of the STRIPS is cheaper than
the mother bondIf a dealer already has the P-STRIPS only the C-STRIPSneed to be acquiredHowever if he owns some of the C-STRIPS he needs toacquire the P-STRIPS and the remaining C-STRIPSThe facility to reconstitute when profitable is pricedinto the P-STRIPSNote Buy and hold investors will prefer C-STRIPSsince they are priced lower and give a higher yield
8282014 102
8112019 FISD-02-A
httpslidepdfcomreaderfullfisd-02-a 103115
For Plain Vanilla bonds the specifiedcoupon rate is valid for the life of thebond
In the case of Floaters the rate is reset atthe beginning of every periodThe rate will vary directly with thebenchmark
8282014 103
8112019 FISD-02-A
httpslidepdfcomreaderfullfisd-02-a 104115
The rate on a Floater is specified as LIBOR+ 50 bp
The spread is positiveIf it were specified as LIBOR ndash 30bp
The spread will be negativeIf LIBOR rises the rate will increasewhereas if LIBOR falls it will decrease
8282014 104
8112019 FISD-02-A
httpslidepdfcomreaderfullfisd-02-a 105115
In the case of a default risk-free floater theprice will reset to par on a coupon date
It may sell at a premium or discount betweencoupon dates
Consider a floater with a coupon = 5-year T-Bond rate
Assume there are two periods left to maturity
8282014 105
8112019 FISD-02-A
httpslidepdfcomreaderfullfisd-02-a 106115
8282014 106
The price at the end of the first coupon period willbe given by
cT-1 is the coupon one period before maturityyT-1 is the YTM one period before maturity
8112019 FISD-02-A
httpslidepdfcomreaderfullfisd-02-a 107115
On a coupon reset date the YTM = couponBecause we have assumed there is no default riskAny change in the required yield as reflected inthe prevailing YTM
Will also be reflected in the coupon being setIf coupon = yield the bond should sell at par
Thus P T-1 = M
8282014 107
8112019 FISD-02-A
httpslidepdfcomreaderfullfisd-02-a 108115
8282014 108
8112019 FISD-02-A
httpslidepdfcomreaderfullfisd-02-a 109115
Once again at T-2 c T-2 = yT-2 and P T-2 = MThis logic can be applied to a bond with anytime remaining till maturityHowever between two coupon dates theprice may not be equal to par
Consider the valuation at T-2+k
8282014 109
8112019 FISD-02-A
httpslidepdfcomreaderfullfisd-02-a 110115
8282014 110
8112019 FISD-02-A
httpslidepdfcomreaderfullfisd-02-a 111115
Although c T-2 was set at T-2 and is equal toyT-2
yT-2+k is determined at T-2+k and will reflect theyield prevailing at that time
Thus yT-2+k need not equal c T-2 and may behigher or lower
Hence between two coupon dates a floater maysell at a premium or discount
8282014 111
8112019 FISD-02-A
httpslidepdfcomreaderfullfisd-02-a 112115
Now consider a floater characterized bydefault risk
The risk premium required by the market neednot be constant over time
Assume that at the time of issue YTM = 5-year T-note rate + 75bp
The coupon would have been set equal to thisrate and the bond would have been issued at par
8282014 112
8112019 FISD-02-A
httpslidepdfcomreaderfullfisd-02-a 113115
Six months hence the issue may be perceivedas more risky
YTM = 5-year T-note rate + 95 bpThe coupon will however be set equal to theprevailing 5-year rate + 75 bpIf so the issue will not reset to par at the nextcoupon date
8282014 113
8112019 FISD-02-A
httpslidepdfcomreaderfullfisd-02-a 114115
Floaters may come with a CAP or a FLOOR orBOTH
The CAP is a maximum coupon rateProtects issuers against rising rates
The FLOOR is a minimum coupon rateProtects investors against falling rates
When there is a spread over LIBORThere is a natural floorLIBOR cannot be less than zero
8282014 114
8112019 FISD-02-A
httpslidepdfcomreaderfullfisd-02-a 115115
8112019 FISD-02-A
httpslidepdfcomreaderfullfisd-02-a 81115
There can be a Reverse RollThe dealer will sell the most recent issue fornext day settlementAnd buy the newly announced security forforward settlement
The forward leg in a RollReverse Roll is a WItrade
It will settle on the new issue settlement date
8282014 81
8112019 FISD-02-A
httpslidepdfcomreaderfullfisd-02-a 82115
The roll is the spread between the yield onthe new security and that on the outstandingissue in the same maturity segmentA GIVE in the Roll means that
The WI security provides a higher yield than theoutstanding issue
A Take in the Roll means thatThe WI security provides a lower yield
8282014 82
8112019 FISD-02-A
httpslidepdfcomreaderfullfisd-02-a 83115
8112019 FISD-02-A
httpslidepdfcomreaderfullfisd-02-a 84115
On March 17 20XX the Treasury announcedthe auction of a 2-year note
The auction was scheduled for March 24The settlement date was March 31
Trading of the roll began as soon as the issuewas announcedA Give of 5 bp means that the dealer proposes tobuy the current issue at the prevailing yieldAnd sell the new issue at a yield that is 5 bpmoreA Take of 5 bp means that the dealer proposes tosell the new issue at a yield that is 5bp lower
8282014 84
8112019 FISD-02-A
httpslidepdfcomreaderfullfisd-02-a 85115
The roll achieves the followingHe acquires the outstanding issue for next daysettlementHe sells the to be issued security with the samepar value for forward delivery on 31 March
The customer is rolling over the investmentfrom the current issue to the new issue
This extends the maturity of the investment byone month
8282014 85
8112019 FISD-02-A
httpslidepdfcomreaderfullfisd-02-a 86115
The client can invest the funds received tillthe new issue settlesHowever he loses the accrued interest thathe would have earned had he held on to theissue
8282014 86
8112019 FISD-02-A
httpslidepdfcomreaderfullfisd-02-a 87115
The Treasury per se does not issue zerocoupon securitiesBut zero coupon securities can be created
which are backed by conventional bondsTake a large quantity of a T-note or bond andseparate all the cash flows from each otherSell the entitlement to each cash flowseparately
8282014 87
8112019 FISD-02-A
httpslidepdfcomreaderfullfisd-02-a 88115
Take the case of a two-year T-noteIt can be separated into five zero couponsecurities maturing after
6 months12 months18 months24 months
8282014 88
8112019 FISD-02-A
httpslidepdfcomreaderfullfisd-02-a 89115
Earlier investment banks used to buy bondsfrom the Treasury and separate the cashflows
Each cash flow was then sold separately as a zerocoupon bondSuch issues are called trademarks
8282014 89
8112019 FISD-02-A
httpslidepdfcomreaderfullfisd-02-a 90115
The issue of trademarks has now ceasedBecause investment banks can now createsuch instruments
In concert with the Treasury itselfThese ZCBs are known as STRIPS ndash
Separate Trading of Registered Interest andPrincipal of Securities
These are not issued or sold by the Treasury
The market is made by investment banks
8282014 90
8112019 FISD-02-A
httpslidepdfcomreaderfullfisd-02-a 91115
What is the motivation to create suchproductsIn practice arbitrage is possible when a
coupon security is purchased at a priceThat is lower than what could be obtained byselling each cash flow separately
8282014 91
8112019 FISD-02-A
httpslidepdfcomreaderfullfisd-02-a 92115
Coupon stripping reflects a case of financialengineering
Creating a risk-return profile that is nototherwise available
An investment bank would buy a largequantity of a Treasury security
The securities would be placed with an SPV
8282014 92
8112019 FISD-02-A
httpslidepdfcomreaderfullfisd-02-a 93115
The SPV is a single-purpose dedicated trustIt has the powers to own the bonds andcollect payments
It cannot sell or lend the bondsIt cannot write options on the bondsOr use them as collateral for borrowing
The SPV is empowered to issue zero coupon
bondsWhere each security represents the ownership ofa single cash flow from the mother bond
8282014 93
8112019 FISD-02-A
httpslidepdfcomreaderfullfisd-02-a 94115
Assume that 100MM USD of 15 year bondswith a coupon of 8 are placed with the SPV
The SPV can issue 6M 12M 18M extending up to14 frac12 year zeroes with a total face value of 4MM
USD eachAnd 15 year zeroes with a total face value of104MM
8282014 94
8112019 FISD-02-A
httpslidepdfcomreaderfullfisd-02-a 95115
8112019 FISD-02-A
httpslidepdfcomreaderfullfisd-02-a 96115
8282014 96
8112019 FISD-02-A
httpslidepdfcomreaderfullfisd-02-a 97115
The Treasury launched this program in 1985to facilitate the stripping of designatedsecurities
All new T-bonds and notes with a maturity of 10years or more are eligibleThe zeroes created in the process are directobligations of the US government
8282014 97
8112019 FISD-02-A
httpslidepdfcomreaderfullfisd-02-a 98115
The mechanism is as followsA dealer who owns a bond or note can ask theFRB where it is held
To replace it with an equivalent set of STRIPS
representing each payment as a separate securityEach of these securities can be traded independentlyof others
8282014 98
8112019 FISD-02-A
httpslidepdfcomreaderfullfisd-02-a 99115
In 1987 the Treasury started to allow dealersto reverse the process
This is called STRIPS RECONSTUTUTION If a dealer owns STRIPS representing all thecoupon and principal payments of a bond
The FED can on request convert these holdings into asingle position in the corresponding bond
8282014 99
8112019 FISD-02-A
httpslidepdfcomreaderfullfisd-02-a 100115
Each coupon and principal cash flow from aTreasury security is assigned a CUSIP
The mother bond is also assigned a CUSIPThe stripped coupons are known as C-STRIPSThe stripped principal is known as P-STRIPSSupply of a C-STRIP increases over time
because a C-STRIP maturing on a day like 15 FEB
2020 will have the same CUSIP irrespective ofwhich mother bond it has come fromThe original coupon rate is irrelevant
8282014 100
8112019 FISD-02-A
httpslidepdfcomreaderfullfisd-02-a 101115
P-STRIPS always correspond to the originalsecurityThey have a unique CUSIPTheir supply is fixed at the time of issuanceIn practice the prices of long-dated P-STRIPSare a bit higher than those of C-STRIPS withthe same maturity date
One reason is that P-STRIPS are more liquid due
to greater availabilityA $100 face value bond with a coupon of 8 willgenerate C-STRIPS with a face value of $4 but P-STRIPS with a face value of $100
8282014 101
8112019 FISD-02-A
httpslidepdfcomreaderfullfisd-02-a 102115
Another reason why P-STRIPS are in higherdemand is that they allow reconstitutionactivities more easily
Assume that the sum of the STRIPS is cheaper than
the mother bondIf a dealer already has the P-STRIPS only the C-STRIPSneed to be acquiredHowever if he owns some of the C-STRIPS he needs toacquire the P-STRIPS and the remaining C-STRIPSThe facility to reconstitute when profitable is pricedinto the P-STRIPSNote Buy and hold investors will prefer C-STRIPSsince they are priced lower and give a higher yield
8282014 102
8112019 FISD-02-A
httpslidepdfcomreaderfullfisd-02-a 103115
For Plain Vanilla bonds the specifiedcoupon rate is valid for the life of thebond
In the case of Floaters the rate is reset atthe beginning of every periodThe rate will vary directly with thebenchmark
8282014 103
8112019 FISD-02-A
httpslidepdfcomreaderfullfisd-02-a 104115
The rate on a Floater is specified as LIBOR+ 50 bp
The spread is positiveIf it were specified as LIBOR ndash 30bp
The spread will be negativeIf LIBOR rises the rate will increasewhereas if LIBOR falls it will decrease
8282014 104
8112019 FISD-02-A
httpslidepdfcomreaderfullfisd-02-a 105115
In the case of a default risk-free floater theprice will reset to par on a coupon date
It may sell at a premium or discount betweencoupon dates
Consider a floater with a coupon = 5-year T-Bond rate
Assume there are two periods left to maturity
8282014 105
8112019 FISD-02-A
httpslidepdfcomreaderfullfisd-02-a 106115
8282014 106
The price at the end of the first coupon period willbe given by
cT-1 is the coupon one period before maturityyT-1 is the YTM one period before maturity
8112019 FISD-02-A
httpslidepdfcomreaderfullfisd-02-a 107115
On a coupon reset date the YTM = couponBecause we have assumed there is no default riskAny change in the required yield as reflected inthe prevailing YTM
Will also be reflected in the coupon being setIf coupon = yield the bond should sell at par
Thus P T-1 = M
8282014 107
8112019 FISD-02-A
httpslidepdfcomreaderfullfisd-02-a 108115
8282014 108
8112019 FISD-02-A
httpslidepdfcomreaderfullfisd-02-a 109115
Once again at T-2 c T-2 = yT-2 and P T-2 = MThis logic can be applied to a bond with anytime remaining till maturityHowever between two coupon dates theprice may not be equal to par
Consider the valuation at T-2+k
8282014 109
8112019 FISD-02-A
httpslidepdfcomreaderfullfisd-02-a 110115
8282014 110
8112019 FISD-02-A
httpslidepdfcomreaderfullfisd-02-a 111115
Although c T-2 was set at T-2 and is equal toyT-2
yT-2+k is determined at T-2+k and will reflect theyield prevailing at that time
Thus yT-2+k need not equal c T-2 and may behigher or lower
Hence between two coupon dates a floater maysell at a premium or discount
8282014 111
8112019 FISD-02-A
httpslidepdfcomreaderfullfisd-02-a 112115
Now consider a floater characterized bydefault risk
The risk premium required by the market neednot be constant over time
Assume that at the time of issue YTM = 5-year T-note rate + 75bp
The coupon would have been set equal to thisrate and the bond would have been issued at par
8282014 112
8112019 FISD-02-A
httpslidepdfcomreaderfullfisd-02-a 113115
Six months hence the issue may be perceivedas more risky
YTM = 5-year T-note rate + 95 bpThe coupon will however be set equal to theprevailing 5-year rate + 75 bpIf so the issue will not reset to par at the nextcoupon date
8282014 113
8112019 FISD-02-A
httpslidepdfcomreaderfullfisd-02-a 114115
Floaters may come with a CAP or a FLOOR orBOTH
The CAP is a maximum coupon rateProtects issuers against rising rates
The FLOOR is a minimum coupon rateProtects investors against falling rates
When there is a spread over LIBORThere is a natural floorLIBOR cannot be less than zero
8282014 114
8112019 FISD-02-A
httpslidepdfcomreaderfullfisd-02-a 115115
8112019 FISD-02-A
httpslidepdfcomreaderfullfisd-02-a 82115
The roll is the spread between the yield onthe new security and that on the outstandingissue in the same maturity segmentA GIVE in the Roll means that
The WI security provides a higher yield than theoutstanding issue
A Take in the Roll means thatThe WI security provides a lower yield
8282014 82
8112019 FISD-02-A
httpslidepdfcomreaderfullfisd-02-a 83115
8112019 FISD-02-A
httpslidepdfcomreaderfullfisd-02-a 84115
On March 17 20XX the Treasury announcedthe auction of a 2-year note
The auction was scheduled for March 24The settlement date was March 31
Trading of the roll began as soon as the issuewas announcedA Give of 5 bp means that the dealer proposes tobuy the current issue at the prevailing yieldAnd sell the new issue at a yield that is 5 bpmoreA Take of 5 bp means that the dealer proposes tosell the new issue at a yield that is 5bp lower
8282014 84
8112019 FISD-02-A
httpslidepdfcomreaderfullfisd-02-a 85115
The roll achieves the followingHe acquires the outstanding issue for next daysettlementHe sells the to be issued security with the samepar value for forward delivery on 31 March
The customer is rolling over the investmentfrom the current issue to the new issue
This extends the maturity of the investment byone month
8282014 85
8112019 FISD-02-A
httpslidepdfcomreaderfullfisd-02-a 86115
The client can invest the funds received tillthe new issue settlesHowever he loses the accrued interest thathe would have earned had he held on to theissue
8282014 86
8112019 FISD-02-A
httpslidepdfcomreaderfullfisd-02-a 87115
The Treasury per se does not issue zerocoupon securitiesBut zero coupon securities can be created
which are backed by conventional bondsTake a large quantity of a T-note or bond andseparate all the cash flows from each otherSell the entitlement to each cash flowseparately
8282014 87
8112019 FISD-02-A
httpslidepdfcomreaderfullfisd-02-a 88115
Take the case of a two-year T-noteIt can be separated into five zero couponsecurities maturing after
6 months12 months18 months24 months
8282014 88
8112019 FISD-02-A
httpslidepdfcomreaderfullfisd-02-a 89115
Earlier investment banks used to buy bondsfrom the Treasury and separate the cashflows
Each cash flow was then sold separately as a zerocoupon bondSuch issues are called trademarks
8282014 89
8112019 FISD-02-A
httpslidepdfcomreaderfullfisd-02-a 90115
The issue of trademarks has now ceasedBecause investment banks can now createsuch instruments
In concert with the Treasury itselfThese ZCBs are known as STRIPS ndash
Separate Trading of Registered Interest andPrincipal of Securities
These are not issued or sold by the Treasury
The market is made by investment banks
8282014 90
8112019 FISD-02-A
httpslidepdfcomreaderfullfisd-02-a 91115
What is the motivation to create suchproductsIn practice arbitrage is possible when a
coupon security is purchased at a priceThat is lower than what could be obtained byselling each cash flow separately
8282014 91
8112019 FISD-02-A
httpslidepdfcomreaderfullfisd-02-a 92115
Coupon stripping reflects a case of financialengineering
Creating a risk-return profile that is nototherwise available
An investment bank would buy a largequantity of a Treasury security
The securities would be placed with an SPV
8282014 92
8112019 FISD-02-A
httpslidepdfcomreaderfullfisd-02-a 93115
The SPV is a single-purpose dedicated trustIt has the powers to own the bonds andcollect payments
It cannot sell or lend the bondsIt cannot write options on the bondsOr use them as collateral for borrowing
The SPV is empowered to issue zero coupon
bondsWhere each security represents the ownership ofa single cash flow from the mother bond
8282014 93
8112019 FISD-02-A
httpslidepdfcomreaderfullfisd-02-a 94115
Assume that 100MM USD of 15 year bondswith a coupon of 8 are placed with the SPV
The SPV can issue 6M 12M 18M extending up to14 frac12 year zeroes with a total face value of 4MM
USD eachAnd 15 year zeroes with a total face value of104MM
8282014 94
8112019 FISD-02-A
httpslidepdfcomreaderfullfisd-02-a 95115
8112019 FISD-02-A
httpslidepdfcomreaderfullfisd-02-a 96115
8282014 96
8112019 FISD-02-A
httpslidepdfcomreaderfullfisd-02-a 97115
The Treasury launched this program in 1985to facilitate the stripping of designatedsecurities
All new T-bonds and notes with a maturity of 10years or more are eligibleThe zeroes created in the process are directobligations of the US government
8282014 97
8112019 FISD-02-A
httpslidepdfcomreaderfullfisd-02-a 98115
The mechanism is as followsA dealer who owns a bond or note can ask theFRB where it is held
To replace it with an equivalent set of STRIPS
representing each payment as a separate securityEach of these securities can be traded independentlyof others
8282014 98
8112019 FISD-02-A
httpslidepdfcomreaderfullfisd-02-a 99115
In 1987 the Treasury started to allow dealersto reverse the process
This is called STRIPS RECONSTUTUTION If a dealer owns STRIPS representing all thecoupon and principal payments of a bond
The FED can on request convert these holdings into asingle position in the corresponding bond
8282014 99
8112019 FISD-02-A
httpslidepdfcomreaderfullfisd-02-a 100115
Each coupon and principal cash flow from aTreasury security is assigned a CUSIP
The mother bond is also assigned a CUSIPThe stripped coupons are known as C-STRIPSThe stripped principal is known as P-STRIPSSupply of a C-STRIP increases over time
because a C-STRIP maturing on a day like 15 FEB
2020 will have the same CUSIP irrespective ofwhich mother bond it has come fromThe original coupon rate is irrelevant
8282014 100
8112019 FISD-02-A
httpslidepdfcomreaderfullfisd-02-a 101115
P-STRIPS always correspond to the originalsecurityThey have a unique CUSIPTheir supply is fixed at the time of issuanceIn practice the prices of long-dated P-STRIPSare a bit higher than those of C-STRIPS withthe same maturity date
One reason is that P-STRIPS are more liquid due
to greater availabilityA $100 face value bond with a coupon of 8 willgenerate C-STRIPS with a face value of $4 but P-STRIPS with a face value of $100
8282014 101
8112019 FISD-02-A
httpslidepdfcomreaderfullfisd-02-a 102115
Another reason why P-STRIPS are in higherdemand is that they allow reconstitutionactivities more easily
Assume that the sum of the STRIPS is cheaper than
the mother bondIf a dealer already has the P-STRIPS only the C-STRIPSneed to be acquiredHowever if he owns some of the C-STRIPS he needs toacquire the P-STRIPS and the remaining C-STRIPSThe facility to reconstitute when profitable is pricedinto the P-STRIPSNote Buy and hold investors will prefer C-STRIPSsince they are priced lower and give a higher yield
8282014 102
8112019 FISD-02-A
httpslidepdfcomreaderfullfisd-02-a 103115
For Plain Vanilla bonds the specifiedcoupon rate is valid for the life of thebond
In the case of Floaters the rate is reset atthe beginning of every periodThe rate will vary directly with thebenchmark
8282014 103
8112019 FISD-02-A
httpslidepdfcomreaderfullfisd-02-a 104115
The rate on a Floater is specified as LIBOR+ 50 bp
The spread is positiveIf it were specified as LIBOR ndash 30bp
The spread will be negativeIf LIBOR rises the rate will increasewhereas if LIBOR falls it will decrease
8282014 104
8112019 FISD-02-A
httpslidepdfcomreaderfullfisd-02-a 105115
In the case of a default risk-free floater theprice will reset to par on a coupon date
It may sell at a premium or discount betweencoupon dates
Consider a floater with a coupon = 5-year T-Bond rate
Assume there are two periods left to maturity
8282014 105
8112019 FISD-02-A
httpslidepdfcomreaderfullfisd-02-a 106115
8282014 106
The price at the end of the first coupon period willbe given by
cT-1 is the coupon one period before maturityyT-1 is the YTM one period before maturity
8112019 FISD-02-A
httpslidepdfcomreaderfullfisd-02-a 107115
On a coupon reset date the YTM = couponBecause we have assumed there is no default riskAny change in the required yield as reflected inthe prevailing YTM
Will also be reflected in the coupon being setIf coupon = yield the bond should sell at par
Thus P T-1 = M
8282014 107
8112019 FISD-02-A
httpslidepdfcomreaderfullfisd-02-a 108115
8282014 108
8112019 FISD-02-A
httpslidepdfcomreaderfullfisd-02-a 109115
Once again at T-2 c T-2 = yT-2 and P T-2 = MThis logic can be applied to a bond with anytime remaining till maturityHowever between two coupon dates theprice may not be equal to par
Consider the valuation at T-2+k
8282014 109
8112019 FISD-02-A
httpslidepdfcomreaderfullfisd-02-a 110115
8282014 110
8112019 FISD-02-A
httpslidepdfcomreaderfullfisd-02-a 111115
Although c T-2 was set at T-2 and is equal toyT-2
yT-2+k is determined at T-2+k and will reflect theyield prevailing at that time
Thus yT-2+k need not equal c T-2 and may behigher or lower
Hence between two coupon dates a floater maysell at a premium or discount
8282014 111
8112019 FISD-02-A
httpslidepdfcomreaderfullfisd-02-a 112115
Now consider a floater characterized bydefault risk
The risk premium required by the market neednot be constant over time
Assume that at the time of issue YTM = 5-year T-note rate + 75bp
The coupon would have been set equal to thisrate and the bond would have been issued at par
8282014 112
8112019 FISD-02-A
httpslidepdfcomreaderfullfisd-02-a 113115
Six months hence the issue may be perceivedas more risky
YTM = 5-year T-note rate + 95 bpThe coupon will however be set equal to theprevailing 5-year rate + 75 bpIf so the issue will not reset to par at the nextcoupon date
8282014 113
8112019 FISD-02-A
httpslidepdfcomreaderfullfisd-02-a 114115
Floaters may come with a CAP or a FLOOR orBOTH
The CAP is a maximum coupon rateProtects issuers against rising rates
The FLOOR is a minimum coupon rateProtects investors against falling rates
When there is a spread over LIBORThere is a natural floorLIBOR cannot be less than zero
8282014 114
8112019 FISD-02-A
httpslidepdfcomreaderfullfisd-02-a 115115
8112019 FISD-02-A
httpslidepdfcomreaderfullfisd-02-a 83115
8112019 FISD-02-A
httpslidepdfcomreaderfullfisd-02-a 84115
On March 17 20XX the Treasury announcedthe auction of a 2-year note
The auction was scheduled for March 24The settlement date was March 31
Trading of the roll began as soon as the issuewas announcedA Give of 5 bp means that the dealer proposes tobuy the current issue at the prevailing yieldAnd sell the new issue at a yield that is 5 bpmoreA Take of 5 bp means that the dealer proposes tosell the new issue at a yield that is 5bp lower
8282014 84
8112019 FISD-02-A
httpslidepdfcomreaderfullfisd-02-a 85115
The roll achieves the followingHe acquires the outstanding issue for next daysettlementHe sells the to be issued security with the samepar value for forward delivery on 31 March
The customer is rolling over the investmentfrom the current issue to the new issue
This extends the maturity of the investment byone month
8282014 85
8112019 FISD-02-A
httpslidepdfcomreaderfullfisd-02-a 86115
The client can invest the funds received tillthe new issue settlesHowever he loses the accrued interest thathe would have earned had he held on to theissue
8282014 86
8112019 FISD-02-A
httpslidepdfcomreaderfullfisd-02-a 87115
The Treasury per se does not issue zerocoupon securitiesBut zero coupon securities can be created
which are backed by conventional bondsTake a large quantity of a T-note or bond andseparate all the cash flows from each otherSell the entitlement to each cash flowseparately
8282014 87
8112019 FISD-02-A
httpslidepdfcomreaderfullfisd-02-a 88115
Take the case of a two-year T-noteIt can be separated into five zero couponsecurities maturing after
6 months12 months18 months24 months
8282014 88
8112019 FISD-02-A
httpslidepdfcomreaderfullfisd-02-a 89115
Earlier investment banks used to buy bondsfrom the Treasury and separate the cashflows
Each cash flow was then sold separately as a zerocoupon bondSuch issues are called trademarks
8282014 89
8112019 FISD-02-A
httpslidepdfcomreaderfullfisd-02-a 90115
The issue of trademarks has now ceasedBecause investment banks can now createsuch instruments
In concert with the Treasury itselfThese ZCBs are known as STRIPS ndash
Separate Trading of Registered Interest andPrincipal of Securities
These are not issued or sold by the Treasury
The market is made by investment banks
8282014 90
8112019 FISD-02-A
httpslidepdfcomreaderfullfisd-02-a 91115
What is the motivation to create suchproductsIn practice arbitrage is possible when a
coupon security is purchased at a priceThat is lower than what could be obtained byselling each cash flow separately
8282014 91
8112019 FISD-02-A
httpslidepdfcomreaderfullfisd-02-a 92115
Coupon stripping reflects a case of financialengineering
Creating a risk-return profile that is nototherwise available
An investment bank would buy a largequantity of a Treasury security
The securities would be placed with an SPV
8282014 92
8112019 FISD-02-A
httpslidepdfcomreaderfullfisd-02-a 93115
The SPV is a single-purpose dedicated trustIt has the powers to own the bonds andcollect payments
It cannot sell or lend the bondsIt cannot write options on the bondsOr use them as collateral for borrowing
The SPV is empowered to issue zero coupon
bondsWhere each security represents the ownership ofa single cash flow from the mother bond
8282014 93
8112019 FISD-02-A
httpslidepdfcomreaderfullfisd-02-a 94115
Assume that 100MM USD of 15 year bondswith a coupon of 8 are placed with the SPV
The SPV can issue 6M 12M 18M extending up to14 frac12 year zeroes with a total face value of 4MM
USD eachAnd 15 year zeroes with a total face value of104MM
8282014 94
8112019 FISD-02-A
httpslidepdfcomreaderfullfisd-02-a 95115
8112019 FISD-02-A
httpslidepdfcomreaderfullfisd-02-a 96115
8282014 96
8112019 FISD-02-A
httpslidepdfcomreaderfullfisd-02-a 97115
The Treasury launched this program in 1985to facilitate the stripping of designatedsecurities
All new T-bonds and notes with a maturity of 10years or more are eligibleThe zeroes created in the process are directobligations of the US government
8282014 97
8112019 FISD-02-A
httpslidepdfcomreaderfullfisd-02-a 98115
The mechanism is as followsA dealer who owns a bond or note can ask theFRB where it is held
To replace it with an equivalent set of STRIPS
representing each payment as a separate securityEach of these securities can be traded independentlyof others
8282014 98
8112019 FISD-02-A
httpslidepdfcomreaderfullfisd-02-a 99115
In 1987 the Treasury started to allow dealersto reverse the process
This is called STRIPS RECONSTUTUTION If a dealer owns STRIPS representing all thecoupon and principal payments of a bond
The FED can on request convert these holdings into asingle position in the corresponding bond
8282014 99
8112019 FISD-02-A
httpslidepdfcomreaderfullfisd-02-a 100115
Each coupon and principal cash flow from aTreasury security is assigned a CUSIP
The mother bond is also assigned a CUSIPThe stripped coupons are known as C-STRIPSThe stripped principal is known as P-STRIPSSupply of a C-STRIP increases over time
because a C-STRIP maturing on a day like 15 FEB
2020 will have the same CUSIP irrespective ofwhich mother bond it has come fromThe original coupon rate is irrelevant
8282014 100
8112019 FISD-02-A
httpslidepdfcomreaderfullfisd-02-a 101115
P-STRIPS always correspond to the originalsecurityThey have a unique CUSIPTheir supply is fixed at the time of issuanceIn practice the prices of long-dated P-STRIPSare a bit higher than those of C-STRIPS withthe same maturity date
One reason is that P-STRIPS are more liquid due
to greater availabilityA $100 face value bond with a coupon of 8 willgenerate C-STRIPS with a face value of $4 but P-STRIPS with a face value of $100
8282014 101
8112019 FISD-02-A
httpslidepdfcomreaderfullfisd-02-a 102115
Another reason why P-STRIPS are in higherdemand is that they allow reconstitutionactivities more easily
Assume that the sum of the STRIPS is cheaper than
the mother bondIf a dealer already has the P-STRIPS only the C-STRIPSneed to be acquiredHowever if he owns some of the C-STRIPS he needs toacquire the P-STRIPS and the remaining C-STRIPSThe facility to reconstitute when profitable is pricedinto the P-STRIPSNote Buy and hold investors will prefer C-STRIPSsince they are priced lower and give a higher yield
8282014 102
8112019 FISD-02-A
httpslidepdfcomreaderfullfisd-02-a 103115
For Plain Vanilla bonds the specifiedcoupon rate is valid for the life of thebond
In the case of Floaters the rate is reset atthe beginning of every periodThe rate will vary directly with thebenchmark
8282014 103
8112019 FISD-02-A
httpslidepdfcomreaderfullfisd-02-a 104115
The rate on a Floater is specified as LIBOR+ 50 bp
The spread is positiveIf it were specified as LIBOR ndash 30bp
The spread will be negativeIf LIBOR rises the rate will increasewhereas if LIBOR falls it will decrease
8282014 104
8112019 FISD-02-A
httpslidepdfcomreaderfullfisd-02-a 105115
In the case of a default risk-free floater theprice will reset to par on a coupon date
It may sell at a premium or discount betweencoupon dates
Consider a floater with a coupon = 5-year T-Bond rate
Assume there are two periods left to maturity
8282014 105
8112019 FISD-02-A
httpslidepdfcomreaderfullfisd-02-a 106115
8282014 106
The price at the end of the first coupon period willbe given by
cT-1 is the coupon one period before maturityyT-1 is the YTM one period before maturity
8112019 FISD-02-A
httpslidepdfcomreaderfullfisd-02-a 107115
On a coupon reset date the YTM = couponBecause we have assumed there is no default riskAny change in the required yield as reflected inthe prevailing YTM
Will also be reflected in the coupon being setIf coupon = yield the bond should sell at par
Thus P T-1 = M
8282014 107
8112019 FISD-02-A
httpslidepdfcomreaderfullfisd-02-a 108115
8282014 108
8112019 FISD-02-A
httpslidepdfcomreaderfullfisd-02-a 109115
Once again at T-2 c T-2 = yT-2 and P T-2 = MThis logic can be applied to a bond with anytime remaining till maturityHowever between two coupon dates theprice may not be equal to par
Consider the valuation at T-2+k
8282014 109
8112019 FISD-02-A
httpslidepdfcomreaderfullfisd-02-a 110115
8282014 110
8112019 FISD-02-A
httpslidepdfcomreaderfullfisd-02-a 111115
Although c T-2 was set at T-2 and is equal toyT-2
yT-2+k is determined at T-2+k and will reflect theyield prevailing at that time
Thus yT-2+k need not equal c T-2 and may behigher or lower
Hence between two coupon dates a floater maysell at a premium or discount
8282014 111
8112019 FISD-02-A
httpslidepdfcomreaderfullfisd-02-a 112115
Now consider a floater characterized bydefault risk
The risk premium required by the market neednot be constant over time
Assume that at the time of issue YTM = 5-year T-note rate + 75bp
The coupon would have been set equal to thisrate and the bond would have been issued at par
8282014 112
8112019 FISD-02-A
httpslidepdfcomreaderfullfisd-02-a 113115
Six months hence the issue may be perceivedas more risky
YTM = 5-year T-note rate + 95 bpThe coupon will however be set equal to theprevailing 5-year rate + 75 bpIf so the issue will not reset to par at the nextcoupon date
8282014 113
8112019 FISD-02-A
httpslidepdfcomreaderfullfisd-02-a 114115
Floaters may come with a CAP or a FLOOR orBOTH
The CAP is a maximum coupon rateProtects issuers against rising rates
The FLOOR is a minimum coupon rateProtects investors against falling rates
When there is a spread over LIBORThere is a natural floorLIBOR cannot be less than zero
8282014 114
8112019 FISD-02-A
httpslidepdfcomreaderfullfisd-02-a 115115
8112019 FISD-02-A
httpslidepdfcomreaderfullfisd-02-a 84115
On March 17 20XX the Treasury announcedthe auction of a 2-year note
The auction was scheduled for March 24The settlement date was March 31
Trading of the roll began as soon as the issuewas announcedA Give of 5 bp means that the dealer proposes tobuy the current issue at the prevailing yieldAnd sell the new issue at a yield that is 5 bpmoreA Take of 5 bp means that the dealer proposes tosell the new issue at a yield that is 5bp lower
8282014 84
8112019 FISD-02-A
httpslidepdfcomreaderfullfisd-02-a 85115
The roll achieves the followingHe acquires the outstanding issue for next daysettlementHe sells the to be issued security with the samepar value for forward delivery on 31 March
The customer is rolling over the investmentfrom the current issue to the new issue
This extends the maturity of the investment byone month
8282014 85
8112019 FISD-02-A
httpslidepdfcomreaderfullfisd-02-a 86115
The client can invest the funds received tillthe new issue settlesHowever he loses the accrued interest thathe would have earned had he held on to theissue
8282014 86
8112019 FISD-02-A
httpslidepdfcomreaderfullfisd-02-a 87115
The Treasury per se does not issue zerocoupon securitiesBut zero coupon securities can be created
which are backed by conventional bondsTake a large quantity of a T-note or bond andseparate all the cash flows from each otherSell the entitlement to each cash flowseparately
8282014 87
8112019 FISD-02-A
httpslidepdfcomreaderfullfisd-02-a 88115
Take the case of a two-year T-noteIt can be separated into five zero couponsecurities maturing after
6 months12 months18 months24 months
8282014 88
8112019 FISD-02-A
httpslidepdfcomreaderfullfisd-02-a 89115
Earlier investment banks used to buy bondsfrom the Treasury and separate the cashflows
Each cash flow was then sold separately as a zerocoupon bondSuch issues are called trademarks
8282014 89
8112019 FISD-02-A
httpslidepdfcomreaderfullfisd-02-a 90115
The issue of trademarks has now ceasedBecause investment banks can now createsuch instruments
In concert with the Treasury itselfThese ZCBs are known as STRIPS ndash
Separate Trading of Registered Interest andPrincipal of Securities
These are not issued or sold by the Treasury
The market is made by investment banks
8282014 90
8112019 FISD-02-A
httpslidepdfcomreaderfullfisd-02-a 91115
What is the motivation to create suchproductsIn practice arbitrage is possible when a
coupon security is purchased at a priceThat is lower than what could be obtained byselling each cash flow separately
8282014 91
8112019 FISD-02-A
httpslidepdfcomreaderfullfisd-02-a 92115
Coupon stripping reflects a case of financialengineering
Creating a risk-return profile that is nototherwise available
An investment bank would buy a largequantity of a Treasury security
The securities would be placed with an SPV
8282014 92
8112019 FISD-02-A
httpslidepdfcomreaderfullfisd-02-a 93115
The SPV is a single-purpose dedicated trustIt has the powers to own the bonds andcollect payments
It cannot sell or lend the bondsIt cannot write options on the bondsOr use them as collateral for borrowing
The SPV is empowered to issue zero coupon
bondsWhere each security represents the ownership ofa single cash flow from the mother bond
8282014 93
8112019 FISD-02-A
httpslidepdfcomreaderfullfisd-02-a 94115
Assume that 100MM USD of 15 year bondswith a coupon of 8 are placed with the SPV
The SPV can issue 6M 12M 18M extending up to14 frac12 year zeroes with a total face value of 4MM
USD eachAnd 15 year zeroes with a total face value of104MM
8282014 94
8112019 FISD-02-A
httpslidepdfcomreaderfullfisd-02-a 95115
8112019 FISD-02-A
httpslidepdfcomreaderfullfisd-02-a 96115
8282014 96
8112019 FISD-02-A
httpslidepdfcomreaderfullfisd-02-a 97115
The Treasury launched this program in 1985to facilitate the stripping of designatedsecurities
All new T-bonds and notes with a maturity of 10years or more are eligibleThe zeroes created in the process are directobligations of the US government
8282014 97
8112019 FISD-02-A
httpslidepdfcomreaderfullfisd-02-a 98115
The mechanism is as followsA dealer who owns a bond or note can ask theFRB where it is held
To replace it with an equivalent set of STRIPS
representing each payment as a separate securityEach of these securities can be traded independentlyof others
8282014 98
8112019 FISD-02-A
httpslidepdfcomreaderfullfisd-02-a 99115
In 1987 the Treasury started to allow dealersto reverse the process
This is called STRIPS RECONSTUTUTION If a dealer owns STRIPS representing all thecoupon and principal payments of a bond
The FED can on request convert these holdings into asingle position in the corresponding bond
8282014 99
8112019 FISD-02-A
httpslidepdfcomreaderfullfisd-02-a 100115
Each coupon and principal cash flow from aTreasury security is assigned a CUSIP
The mother bond is also assigned a CUSIPThe stripped coupons are known as C-STRIPSThe stripped principal is known as P-STRIPSSupply of a C-STRIP increases over time
because a C-STRIP maturing on a day like 15 FEB
2020 will have the same CUSIP irrespective ofwhich mother bond it has come fromThe original coupon rate is irrelevant
8282014 100
8112019 FISD-02-A
httpslidepdfcomreaderfullfisd-02-a 101115
P-STRIPS always correspond to the originalsecurityThey have a unique CUSIPTheir supply is fixed at the time of issuanceIn practice the prices of long-dated P-STRIPSare a bit higher than those of C-STRIPS withthe same maturity date
One reason is that P-STRIPS are more liquid due
to greater availabilityA $100 face value bond with a coupon of 8 willgenerate C-STRIPS with a face value of $4 but P-STRIPS with a face value of $100
8282014 101
8112019 FISD-02-A
httpslidepdfcomreaderfullfisd-02-a 102115
Another reason why P-STRIPS are in higherdemand is that they allow reconstitutionactivities more easily
Assume that the sum of the STRIPS is cheaper than
the mother bondIf a dealer already has the P-STRIPS only the C-STRIPSneed to be acquiredHowever if he owns some of the C-STRIPS he needs toacquire the P-STRIPS and the remaining C-STRIPSThe facility to reconstitute when profitable is pricedinto the P-STRIPSNote Buy and hold investors will prefer C-STRIPSsince they are priced lower and give a higher yield
8282014 102
8112019 FISD-02-A
httpslidepdfcomreaderfullfisd-02-a 103115
For Plain Vanilla bonds the specifiedcoupon rate is valid for the life of thebond
In the case of Floaters the rate is reset atthe beginning of every periodThe rate will vary directly with thebenchmark
8282014 103
8112019 FISD-02-A
httpslidepdfcomreaderfullfisd-02-a 104115
The rate on a Floater is specified as LIBOR+ 50 bp
The spread is positiveIf it were specified as LIBOR ndash 30bp
The spread will be negativeIf LIBOR rises the rate will increasewhereas if LIBOR falls it will decrease
8282014 104
8112019 FISD-02-A
httpslidepdfcomreaderfullfisd-02-a 105115
In the case of a default risk-free floater theprice will reset to par on a coupon date
It may sell at a premium or discount betweencoupon dates
Consider a floater with a coupon = 5-year T-Bond rate
Assume there are two periods left to maturity
8282014 105
8112019 FISD-02-A
httpslidepdfcomreaderfullfisd-02-a 106115
8282014 106
The price at the end of the first coupon period willbe given by
cT-1 is the coupon one period before maturityyT-1 is the YTM one period before maturity
8112019 FISD-02-A
httpslidepdfcomreaderfullfisd-02-a 107115
On a coupon reset date the YTM = couponBecause we have assumed there is no default riskAny change in the required yield as reflected inthe prevailing YTM
Will also be reflected in the coupon being setIf coupon = yield the bond should sell at par
Thus P T-1 = M
8282014 107
8112019 FISD-02-A
httpslidepdfcomreaderfullfisd-02-a 108115
8282014 108
8112019 FISD-02-A
httpslidepdfcomreaderfullfisd-02-a 109115
Once again at T-2 c T-2 = yT-2 and P T-2 = MThis logic can be applied to a bond with anytime remaining till maturityHowever between two coupon dates theprice may not be equal to par
Consider the valuation at T-2+k
8282014 109
8112019 FISD-02-A
httpslidepdfcomreaderfullfisd-02-a 110115
8282014 110
8112019 FISD-02-A
httpslidepdfcomreaderfullfisd-02-a 111115
Although c T-2 was set at T-2 and is equal toyT-2
yT-2+k is determined at T-2+k and will reflect theyield prevailing at that time
Thus yT-2+k need not equal c T-2 and may behigher or lower
Hence between two coupon dates a floater maysell at a premium or discount
8282014 111
8112019 FISD-02-A
httpslidepdfcomreaderfullfisd-02-a 112115
Now consider a floater characterized bydefault risk
The risk premium required by the market neednot be constant over time
Assume that at the time of issue YTM = 5-year T-note rate + 75bp
The coupon would have been set equal to thisrate and the bond would have been issued at par
8282014 112
8112019 FISD-02-A
httpslidepdfcomreaderfullfisd-02-a 113115
Six months hence the issue may be perceivedas more risky
YTM = 5-year T-note rate + 95 bpThe coupon will however be set equal to theprevailing 5-year rate + 75 bpIf so the issue will not reset to par at the nextcoupon date
8282014 113
8112019 FISD-02-A
httpslidepdfcomreaderfullfisd-02-a 114115
Floaters may come with a CAP or a FLOOR orBOTH
The CAP is a maximum coupon rateProtects issuers against rising rates
The FLOOR is a minimum coupon rateProtects investors against falling rates
When there is a spread over LIBORThere is a natural floorLIBOR cannot be less than zero
8282014 114
8112019 FISD-02-A
httpslidepdfcomreaderfullfisd-02-a 115115
8112019 FISD-02-A
httpslidepdfcomreaderfullfisd-02-a 85115
The roll achieves the followingHe acquires the outstanding issue for next daysettlementHe sells the to be issued security with the samepar value for forward delivery on 31 March
The customer is rolling over the investmentfrom the current issue to the new issue
This extends the maturity of the investment byone month
8282014 85
8112019 FISD-02-A
httpslidepdfcomreaderfullfisd-02-a 86115
The client can invest the funds received tillthe new issue settlesHowever he loses the accrued interest thathe would have earned had he held on to theissue
8282014 86
8112019 FISD-02-A
httpslidepdfcomreaderfullfisd-02-a 87115
The Treasury per se does not issue zerocoupon securitiesBut zero coupon securities can be created
which are backed by conventional bondsTake a large quantity of a T-note or bond andseparate all the cash flows from each otherSell the entitlement to each cash flowseparately
8282014 87
8112019 FISD-02-A
httpslidepdfcomreaderfullfisd-02-a 88115
Take the case of a two-year T-noteIt can be separated into five zero couponsecurities maturing after
6 months12 months18 months24 months
8282014 88
8112019 FISD-02-A
httpslidepdfcomreaderfullfisd-02-a 89115
Earlier investment banks used to buy bondsfrom the Treasury and separate the cashflows
Each cash flow was then sold separately as a zerocoupon bondSuch issues are called trademarks
8282014 89
8112019 FISD-02-A
httpslidepdfcomreaderfullfisd-02-a 90115
The issue of trademarks has now ceasedBecause investment banks can now createsuch instruments
In concert with the Treasury itselfThese ZCBs are known as STRIPS ndash
Separate Trading of Registered Interest andPrincipal of Securities
These are not issued or sold by the Treasury
The market is made by investment banks
8282014 90
8112019 FISD-02-A
httpslidepdfcomreaderfullfisd-02-a 91115
What is the motivation to create suchproductsIn practice arbitrage is possible when a
coupon security is purchased at a priceThat is lower than what could be obtained byselling each cash flow separately
8282014 91
8112019 FISD-02-A
httpslidepdfcomreaderfullfisd-02-a 92115
Coupon stripping reflects a case of financialengineering
Creating a risk-return profile that is nototherwise available
An investment bank would buy a largequantity of a Treasury security
The securities would be placed with an SPV
8282014 92
8112019 FISD-02-A
httpslidepdfcomreaderfullfisd-02-a 93115
The SPV is a single-purpose dedicated trustIt has the powers to own the bonds andcollect payments
It cannot sell or lend the bondsIt cannot write options on the bondsOr use them as collateral for borrowing
The SPV is empowered to issue zero coupon
bondsWhere each security represents the ownership ofa single cash flow from the mother bond
8282014 93
8112019 FISD-02-A
httpslidepdfcomreaderfullfisd-02-a 94115
Assume that 100MM USD of 15 year bondswith a coupon of 8 are placed with the SPV
The SPV can issue 6M 12M 18M extending up to14 frac12 year zeroes with a total face value of 4MM
USD eachAnd 15 year zeroes with a total face value of104MM
8282014 94
8112019 FISD-02-A
httpslidepdfcomreaderfullfisd-02-a 95115
8112019 FISD-02-A
httpslidepdfcomreaderfullfisd-02-a 96115
8282014 96
8112019 FISD-02-A
httpslidepdfcomreaderfullfisd-02-a 97115
The Treasury launched this program in 1985to facilitate the stripping of designatedsecurities
All new T-bonds and notes with a maturity of 10years or more are eligibleThe zeroes created in the process are directobligations of the US government
8282014 97
8112019 FISD-02-A
httpslidepdfcomreaderfullfisd-02-a 98115
The mechanism is as followsA dealer who owns a bond or note can ask theFRB where it is held
To replace it with an equivalent set of STRIPS
representing each payment as a separate securityEach of these securities can be traded independentlyof others
8282014 98
8112019 FISD-02-A
httpslidepdfcomreaderfullfisd-02-a 99115
In 1987 the Treasury started to allow dealersto reverse the process
This is called STRIPS RECONSTUTUTION If a dealer owns STRIPS representing all thecoupon and principal payments of a bond
The FED can on request convert these holdings into asingle position in the corresponding bond
8282014 99
8112019 FISD-02-A
httpslidepdfcomreaderfullfisd-02-a 100115
Each coupon and principal cash flow from aTreasury security is assigned a CUSIP
The mother bond is also assigned a CUSIPThe stripped coupons are known as C-STRIPSThe stripped principal is known as P-STRIPSSupply of a C-STRIP increases over time
because a C-STRIP maturing on a day like 15 FEB
2020 will have the same CUSIP irrespective ofwhich mother bond it has come fromThe original coupon rate is irrelevant
8282014 100
8112019 FISD-02-A
httpslidepdfcomreaderfullfisd-02-a 101115
P-STRIPS always correspond to the originalsecurityThey have a unique CUSIPTheir supply is fixed at the time of issuanceIn practice the prices of long-dated P-STRIPSare a bit higher than those of C-STRIPS withthe same maturity date
One reason is that P-STRIPS are more liquid due
to greater availabilityA $100 face value bond with a coupon of 8 willgenerate C-STRIPS with a face value of $4 but P-STRIPS with a face value of $100
8282014 101
8112019 FISD-02-A
httpslidepdfcomreaderfullfisd-02-a 102115
Another reason why P-STRIPS are in higherdemand is that they allow reconstitutionactivities more easily
Assume that the sum of the STRIPS is cheaper than
the mother bondIf a dealer already has the P-STRIPS only the C-STRIPSneed to be acquiredHowever if he owns some of the C-STRIPS he needs toacquire the P-STRIPS and the remaining C-STRIPSThe facility to reconstitute when profitable is pricedinto the P-STRIPSNote Buy and hold investors will prefer C-STRIPSsince they are priced lower and give a higher yield
8282014 102
8112019 FISD-02-A
httpslidepdfcomreaderfullfisd-02-a 103115
For Plain Vanilla bonds the specifiedcoupon rate is valid for the life of thebond
In the case of Floaters the rate is reset atthe beginning of every periodThe rate will vary directly with thebenchmark
8282014 103
8112019 FISD-02-A
httpslidepdfcomreaderfullfisd-02-a 104115
The rate on a Floater is specified as LIBOR+ 50 bp
The spread is positiveIf it were specified as LIBOR ndash 30bp
The spread will be negativeIf LIBOR rises the rate will increasewhereas if LIBOR falls it will decrease
8282014 104
8112019 FISD-02-A
httpslidepdfcomreaderfullfisd-02-a 105115
In the case of a default risk-free floater theprice will reset to par on a coupon date
It may sell at a premium or discount betweencoupon dates
Consider a floater with a coupon = 5-year T-Bond rate
Assume there are two periods left to maturity
8282014 105
8112019 FISD-02-A
httpslidepdfcomreaderfullfisd-02-a 106115
8282014 106
The price at the end of the first coupon period willbe given by
cT-1 is the coupon one period before maturityyT-1 is the YTM one period before maturity
8112019 FISD-02-A
httpslidepdfcomreaderfullfisd-02-a 107115
On a coupon reset date the YTM = couponBecause we have assumed there is no default riskAny change in the required yield as reflected inthe prevailing YTM
Will also be reflected in the coupon being setIf coupon = yield the bond should sell at par
Thus P T-1 = M
8282014 107
8112019 FISD-02-A
httpslidepdfcomreaderfullfisd-02-a 108115
8282014 108
8112019 FISD-02-A
httpslidepdfcomreaderfullfisd-02-a 109115
Once again at T-2 c T-2 = yT-2 and P T-2 = MThis logic can be applied to a bond with anytime remaining till maturityHowever between two coupon dates theprice may not be equal to par
Consider the valuation at T-2+k
8282014 109
8112019 FISD-02-A
httpslidepdfcomreaderfullfisd-02-a 110115
8282014 110
8112019 FISD-02-A
httpslidepdfcomreaderfullfisd-02-a 111115
Although c T-2 was set at T-2 and is equal toyT-2
yT-2+k is determined at T-2+k and will reflect theyield prevailing at that time
Thus yT-2+k need not equal c T-2 and may behigher or lower
Hence between two coupon dates a floater maysell at a premium or discount
8282014 111
8112019 FISD-02-A
httpslidepdfcomreaderfullfisd-02-a 112115
Now consider a floater characterized bydefault risk
The risk premium required by the market neednot be constant over time
Assume that at the time of issue YTM = 5-year T-note rate + 75bp
The coupon would have been set equal to thisrate and the bond would have been issued at par
8282014 112
8112019 FISD-02-A
httpslidepdfcomreaderfullfisd-02-a 113115
Six months hence the issue may be perceivedas more risky
YTM = 5-year T-note rate + 95 bpThe coupon will however be set equal to theprevailing 5-year rate + 75 bpIf so the issue will not reset to par at the nextcoupon date
8282014 113
8112019 FISD-02-A
httpslidepdfcomreaderfullfisd-02-a 114115
Floaters may come with a CAP or a FLOOR orBOTH
The CAP is a maximum coupon rateProtects issuers against rising rates
The FLOOR is a minimum coupon rateProtects investors against falling rates
When there is a spread over LIBORThere is a natural floorLIBOR cannot be less than zero
8282014 114
8112019 FISD-02-A
httpslidepdfcomreaderfullfisd-02-a 115115
8112019 FISD-02-A
httpslidepdfcomreaderfullfisd-02-a 86115
The client can invest the funds received tillthe new issue settlesHowever he loses the accrued interest thathe would have earned had he held on to theissue
8282014 86
8112019 FISD-02-A
httpslidepdfcomreaderfullfisd-02-a 87115
The Treasury per se does not issue zerocoupon securitiesBut zero coupon securities can be created
which are backed by conventional bondsTake a large quantity of a T-note or bond andseparate all the cash flows from each otherSell the entitlement to each cash flowseparately
8282014 87
8112019 FISD-02-A
httpslidepdfcomreaderfullfisd-02-a 88115
Take the case of a two-year T-noteIt can be separated into five zero couponsecurities maturing after
6 months12 months18 months24 months
8282014 88
8112019 FISD-02-A
httpslidepdfcomreaderfullfisd-02-a 89115
Earlier investment banks used to buy bondsfrom the Treasury and separate the cashflows
Each cash flow was then sold separately as a zerocoupon bondSuch issues are called trademarks
8282014 89
8112019 FISD-02-A
httpslidepdfcomreaderfullfisd-02-a 90115
The issue of trademarks has now ceasedBecause investment banks can now createsuch instruments
In concert with the Treasury itselfThese ZCBs are known as STRIPS ndash
Separate Trading of Registered Interest andPrincipal of Securities
These are not issued or sold by the Treasury
The market is made by investment banks
8282014 90
8112019 FISD-02-A
httpslidepdfcomreaderfullfisd-02-a 91115
What is the motivation to create suchproductsIn practice arbitrage is possible when a
coupon security is purchased at a priceThat is lower than what could be obtained byselling each cash flow separately
8282014 91
8112019 FISD-02-A
httpslidepdfcomreaderfullfisd-02-a 92115
Coupon stripping reflects a case of financialengineering
Creating a risk-return profile that is nototherwise available
An investment bank would buy a largequantity of a Treasury security
The securities would be placed with an SPV
8282014 92
8112019 FISD-02-A
httpslidepdfcomreaderfullfisd-02-a 93115
The SPV is a single-purpose dedicated trustIt has the powers to own the bonds andcollect payments
It cannot sell or lend the bondsIt cannot write options on the bondsOr use them as collateral for borrowing
The SPV is empowered to issue zero coupon
bondsWhere each security represents the ownership ofa single cash flow from the mother bond
8282014 93
8112019 FISD-02-A
httpslidepdfcomreaderfullfisd-02-a 94115
Assume that 100MM USD of 15 year bondswith a coupon of 8 are placed with the SPV
The SPV can issue 6M 12M 18M extending up to14 frac12 year zeroes with a total face value of 4MM
USD eachAnd 15 year zeroes with a total face value of104MM
8282014 94
8112019 FISD-02-A
httpslidepdfcomreaderfullfisd-02-a 95115
8112019 FISD-02-A
httpslidepdfcomreaderfullfisd-02-a 96115
8282014 96
8112019 FISD-02-A
httpslidepdfcomreaderfullfisd-02-a 97115
The Treasury launched this program in 1985to facilitate the stripping of designatedsecurities
All new T-bonds and notes with a maturity of 10years or more are eligibleThe zeroes created in the process are directobligations of the US government
8282014 97
8112019 FISD-02-A
httpslidepdfcomreaderfullfisd-02-a 98115
The mechanism is as followsA dealer who owns a bond or note can ask theFRB where it is held
To replace it with an equivalent set of STRIPS
representing each payment as a separate securityEach of these securities can be traded independentlyof others
8282014 98
8112019 FISD-02-A
httpslidepdfcomreaderfullfisd-02-a 99115
In 1987 the Treasury started to allow dealersto reverse the process
This is called STRIPS RECONSTUTUTION If a dealer owns STRIPS representing all thecoupon and principal payments of a bond
The FED can on request convert these holdings into asingle position in the corresponding bond
8282014 99
8112019 FISD-02-A
httpslidepdfcomreaderfullfisd-02-a 100115
Each coupon and principal cash flow from aTreasury security is assigned a CUSIP
The mother bond is also assigned a CUSIPThe stripped coupons are known as C-STRIPSThe stripped principal is known as P-STRIPSSupply of a C-STRIP increases over time
because a C-STRIP maturing on a day like 15 FEB
2020 will have the same CUSIP irrespective ofwhich mother bond it has come fromThe original coupon rate is irrelevant
8282014 100
8112019 FISD-02-A
httpslidepdfcomreaderfullfisd-02-a 101115
P-STRIPS always correspond to the originalsecurityThey have a unique CUSIPTheir supply is fixed at the time of issuanceIn practice the prices of long-dated P-STRIPSare a bit higher than those of C-STRIPS withthe same maturity date
One reason is that P-STRIPS are more liquid due
to greater availabilityA $100 face value bond with a coupon of 8 willgenerate C-STRIPS with a face value of $4 but P-STRIPS with a face value of $100
8282014 101
8112019 FISD-02-A
httpslidepdfcomreaderfullfisd-02-a 102115
Another reason why P-STRIPS are in higherdemand is that they allow reconstitutionactivities more easily
Assume that the sum of the STRIPS is cheaper than
the mother bondIf a dealer already has the P-STRIPS only the C-STRIPSneed to be acquiredHowever if he owns some of the C-STRIPS he needs toacquire the P-STRIPS and the remaining C-STRIPSThe facility to reconstitute when profitable is pricedinto the P-STRIPSNote Buy and hold investors will prefer C-STRIPSsince they are priced lower and give a higher yield
8282014 102
8112019 FISD-02-A
httpslidepdfcomreaderfullfisd-02-a 103115
For Plain Vanilla bonds the specifiedcoupon rate is valid for the life of thebond
In the case of Floaters the rate is reset atthe beginning of every periodThe rate will vary directly with thebenchmark
8282014 103
8112019 FISD-02-A
httpslidepdfcomreaderfullfisd-02-a 104115
The rate on a Floater is specified as LIBOR+ 50 bp
The spread is positiveIf it were specified as LIBOR ndash 30bp
The spread will be negativeIf LIBOR rises the rate will increasewhereas if LIBOR falls it will decrease
8282014 104
8112019 FISD-02-A
httpslidepdfcomreaderfullfisd-02-a 105115
In the case of a default risk-free floater theprice will reset to par on a coupon date
It may sell at a premium or discount betweencoupon dates
Consider a floater with a coupon = 5-year T-Bond rate
Assume there are two periods left to maturity
8282014 105
8112019 FISD-02-A
httpslidepdfcomreaderfullfisd-02-a 106115
8282014 106
The price at the end of the first coupon period willbe given by
cT-1 is the coupon one period before maturityyT-1 is the YTM one period before maturity
8112019 FISD-02-A
httpslidepdfcomreaderfullfisd-02-a 107115
On a coupon reset date the YTM = couponBecause we have assumed there is no default riskAny change in the required yield as reflected inthe prevailing YTM
Will also be reflected in the coupon being setIf coupon = yield the bond should sell at par
Thus P T-1 = M
8282014 107
8112019 FISD-02-A
httpslidepdfcomreaderfullfisd-02-a 108115
8282014 108
8112019 FISD-02-A
httpslidepdfcomreaderfullfisd-02-a 109115
Once again at T-2 c T-2 = yT-2 and P T-2 = MThis logic can be applied to a bond with anytime remaining till maturityHowever between two coupon dates theprice may not be equal to par
Consider the valuation at T-2+k
8282014 109
8112019 FISD-02-A
httpslidepdfcomreaderfullfisd-02-a 110115
8282014 110
8112019 FISD-02-A
httpslidepdfcomreaderfullfisd-02-a 111115
Although c T-2 was set at T-2 and is equal toyT-2
yT-2+k is determined at T-2+k and will reflect theyield prevailing at that time
Thus yT-2+k need not equal c T-2 and may behigher or lower
Hence between two coupon dates a floater maysell at a premium or discount
8282014 111
8112019 FISD-02-A
httpslidepdfcomreaderfullfisd-02-a 112115
Now consider a floater characterized bydefault risk
The risk premium required by the market neednot be constant over time
Assume that at the time of issue YTM = 5-year T-note rate + 75bp
The coupon would have been set equal to thisrate and the bond would have been issued at par
8282014 112
8112019 FISD-02-A
httpslidepdfcomreaderfullfisd-02-a 113115
Six months hence the issue may be perceivedas more risky
YTM = 5-year T-note rate + 95 bpThe coupon will however be set equal to theprevailing 5-year rate + 75 bpIf so the issue will not reset to par at the nextcoupon date
8282014 113
8112019 FISD-02-A
httpslidepdfcomreaderfullfisd-02-a 114115
Floaters may come with a CAP or a FLOOR orBOTH
The CAP is a maximum coupon rateProtects issuers against rising rates
The FLOOR is a minimum coupon rateProtects investors against falling rates
When there is a spread over LIBORThere is a natural floorLIBOR cannot be less than zero
8282014 114
8112019 FISD-02-A
httpslidepdfcomreaderfullfisd-02-a 115115
8112019 FISD-02-A
httpslidepdfcomreaderfullfisd-02-a 87115
The Treasury per se does not issue zerocoupon securitiesBut zero coupon securities can be created
which are backed by conventional bondsTake a large quantity of a T-note or bond andseparate all the cash flows from each otherSell the entitlement to each cash flowseparately
8282014 87
8112019 FISD-02-A
httpslidepdfcomreaderfullfisd-02-a 88115
Take the case of a two-year T-noteIt can be separated into five zero couponsecurities maturing after
6 months12 months18 months24 months
8282014 88
8112019 FISD-02-A
httpslidepdfcomreaderfullfisd-02-a 89115
Earlier investment banks used to buy bondsfrom the Treasury and separate the cashflows
Each cash flow was then sold separately as a zerocoupon bondSuch issues are called trademarks
8282014 89
8112019 FISD-02-A
httpslidepdfcomreaderfullfisd-02-a 90115
The issue of trademarks has now ceasedBecause investment banks can now createsuch instruments
In concert with the Treasury itselfThese ZCBs are known as STRIPS ndash
Separate Trading of Registered Interest andPrincipal of Securities
These are not issued or sold by the Treasury
The market is made by investment banks
8282014 90
8112019 FISD-02-A
httpslidepdfcomreaderfullfisd-02-a 91115
What is the motivation to create suchproductsIn practice arbitrage is possible when a
coupon security is purchased at a priceThat is lower than what could be obtained byselling each cash flow separately
8282014 91
8112019 FISD-02-A
httpslidepdfcomreaderfullfisd-02-a 92115
Coupon stripping reflects a case of financialengineering
Creating a risk-return profile that is nototherwise available
An investment bank would buy a largequantity of a Treasury security
The securities would be placed with an SPV
8282014 92
8112019 FISD-02-A
httpslidepdfcomreaderfullfisd-02-a 93115
The SPV is a single-purpose dedicated trustIt has the powers to own the bonds andcollect payments
It cannot sell or lend the bondsIt cannot write options on the bondsOr use them as collateral for borrowing
The SPV is empowered to issue zero coupon
bondsWhere each security represents the ownership ofa single cash flow from the mother bond
8282014 93
8112019 FISD-02-A
httpslidepdfcomreaderfullfisd-02-a 94115
Assume that 100MM USD of 15 year bondswith a coupon of 8 are placed with the SPV
The SPV can issue 6M 12M 18M extending up to14 frac12 year zeroes with a total face value of 4MM
USD eachAnd 15 year zeroes with a total face value of104MM
8282014 94
8112019 FISD-02-A
httpslidepdfcomreaderfullfisd-02-a 95115
8112019 FISD-02-A
httpslidepdfcomreaderfullfisd-02-a 96115
8282014 96
8112019 FISD-02-A
httpslidepdfcomreaderfullfisd-02-a 97115
The Treasury launched this program in 1985to facilitate the stripping of designatedsecurities
All new T-bonds and notes with a maturity of 10years or more are eligibleThe zeroes created in the process are directobligations of the US government
8282014 97
8112019 FISD-02-A
httpslidepdfcomreaderfullfisd-02-a 98115
The mechanism is as followsA dealer who owns a bond or note can ask theFRB where it is held
To replace it with an equivalent set of STRIPS
representing each payment as a separate securityEach of these securities can be traded independentlyof others
8282014 98
8112019 FISD-02-A
httpslidepdfcomreaderfullfisd-02-a 99115
In 1987 the Treasury started to allow dealersto reverse the process
This is called STRIPS RECONSTUTUTION If a dealer owns STRIPS representing all thecoupon and principal payments of a bond
The FED can on request convert these holdings into asingle position in the corresponding bond
8282014 99
8112019 FISD-02-A
httpslidepdfcomreaderfullfisd-02-a 100115
Each coupon and principal cash flow from aTreasury security is assigned a CUSIP
The mother bond is also assigned a CUSIPThe stripped coupons are known as C-STRIPSThe stripped principal is known as P-STRIPSSupply of a C-STRIP increases over time
because a C-STRIP maturing on a day like 15 FEB
2020 will have the same CUSIP irrespective ofwhich mother bond it has come fromThe original coupon rate is irrelevant
8282014 100
8112019 FISD-02-A
httpslidepdfcomreaderfullfisd-02-a 101115
P-STRIPS always correspond to the originalsecurityThey have a unique CUSIPTheir supply is fixed at the time of issuanceIn practice the prices of long-dated P-STRIPSare a bit higher than those of C-STRIPS withthe same maturity date
One reason is that P-STRIPS are more liquid due
to greater availabilityA $100 face value bond with a coupon of 8 willgenerate C-STRIPS with a face value of $4 but P-STRIPS with a face value of $100
8282014 101
8112019 FISD-02-A
httpslidepdfcomreaderfullfisd-02-a 102115
Another reason why P-STRIPS are in higherdemand is that they allow reconstitutionactivities more easily
Assume that the sum of the STRIPS is cheaper than
the mother bondIf a dealer already has the P-STRIPS only the C-STRIPSneed to be acquiredHowever if he owns some of the C-STRIPS he needs toacquire the P-STRIPS and the remaining C-STRIPSThe facility to reconstitute when profitable is pricedinto the P-STRIPSNote Buy and hold investors will prefer C-STRIPSsince they are priced lower and give a higher yield
8282014 102
8112019 FISD-02-A
httpslidepdfcomreaderfullfisd-02-a 103115
For Plain Vanilla bonds the specifiedcoupon rate is valid for the life of thebond
In the case of Floaters the rate is reset atthe beginning of every periodThe rate will vary directly with thebenchmark
8282014 103
8112019 FISD-02-A
httpslidepdfcomreaderfullfisd-02-a 104115
The rate on a Floater is specified as LIBOR+ 50 bp
The spread is positiveIf it were specified as LIBOR ndash 30bp
The spread will be negativeIf LIBOR rises the rate will increasewhereas if LIBOR falls it will decrease
8282014 104
8112019 FISD-02-A
httpslidepdfcomreaderfullfisd-02-a 105115
In the case of a default risk-free floater theprice will reset to par on a coupon date
It may sell at a premium or discount betweencoupon dates
Consider a floater with a coupon = 5-year T-Bond rate
Assume there are two periods left to maturity
8282014 105
8112019 FISD-02-A
httpslidepdfcomreaderfullfisd-02-a 106115
8282014 106
The price at the end of the first coupon period willbe given by
cT-1 is the coupon one period before maturityyT-1 is the YTM one period before maturity
8112019 FISD-02-A
httpslidepdfcomreaderfullfisd-02-a 107115
On a coupon reset date the YTM = couponBecause we have assumed there is no default riskAny change in the required yield as reflected inthe prevailing YTM
Will also be reflected in the coupon being setIf coupon = yield the bond should sell at par
Thus P T-1 = M
8282014 107
8112019 FISD-02-A
httpslidepdfcomreaderfullfisd-02-a 108115
8282014 108
8112019 FISD-02-A
httpslidepdfcomreaderfullfisd-02-a 109115
Once again at T-2 c T-2 = yT-2 and P T-2 = MThis logic can be applied to a bond with anytime remaining till maturityHowever between two coupon dates theprice may not be equal to par
Consider the valuation at T-2+k
8282014 109
8112019 FISD-02-A
httpslidepdfcomreaderfullfisd-02-a 110115
8282014 110
8112019 FISD-02-A
httpslidepdfcomreaderfullfisd-02-a 111115
Although c T-2 was set at T-2 and is equal toyT-2
yT-2+k is determined at T-2+k and will reflect theyield prevailing at that time
Thus yT-2+k need not equal c T-2 and may behigher or lower
Hence between two coupon dates a floater maysell at a premium or discount
8282014 111
8112019 FISD-02-A
httpslidepdfcomreaderfullfisd-02-a 112115
Now consider a floater characterized bydefault risk
The risk premium required by the market neednot be constant over time
Assume that at the time of issue YTM = 5-year T-note rate + 75bp
The coupon would have been set equal to thisrate and the bond would have been issued at par
8282014 112
8112019 FISD-02-A
httpslidepdfcomreaderfullfisd-02-a 113115
Six months hence the issue may be perceivedas more risky
YTM = 5-year T-note rate + 95 bpThe coupon will however be set equal to theprevailing 5-year rate + 75 bpIf so the issue will not reset to par at the nextcoupon date
8282014 113
8112019 FISD-02-A
httpslidepdfcomreaderfullfisd-02-a 114115
Floaters may come with a CAP or a FLOOR orBOTH
The CAP is a maximum coupon rateProtects issuers against rising rates
The FLOOR is a minimum coupon rateProtects investors against falling rates
When there is a spread over LIBORThere is a natural floorLIBOR cannot be less than zero
8282014 114
8112019 FISD-02-A
httpslidepdfcomreaderfullfisd-02-a 115115
8112019 FISD-02-A
httpslidepdfcomreaderfullfisd-02-a 88115
Take the case of a two-year T-noteIt can be separated into five zero couponsecurities maturing after
6 months12 months18 months24 months
8282014 88
8112019 FISD-02-A
httpslidepdfcomreaderfullfisd-02-a 89115
Earlier investment banks used to buy bondsfrom the Treasury and separate the cashflows
Each cash flow was then sold separately as a zerocoupon bondSuch issues are called trademarks
8282014 89
8112019 FISD-02-A
httpslidepdfcomreaderfullfisd-02-a 90115
The issue of trademarks has now ceasedBecause investment banks can now createsuch instruments
In concert with the Treasury itselfThese ZCBs are known as STRIPS ndash
Separate Trading of Registered Interest andPrincipal of Securities
These are not issued or sold by the Treasury
The market is made by investment banks
8282014 90
8112019 FISD-02-A
httpslidepdfcomreaderfullfisd-02-a 91115
What is the motivation to create suchproductsIn practice arbitrage is possible when a
coupon security is purchased at a priceThat is lower than what could be obtained byselling each cash flow separately
8282014 91
8112019 FISD-02-A
httpslidepdfcomreaderfullfisd-02-a 92115
Coupon stripping reflects a case of financialengineering
Creating a risk-return profile that is nototherwise available
An investment bank would buy a largequantity of a Treasury security
The securities would be placed with an SPV
8282014 92
8112019 FISD-02-A
httpslidepdfcomreaderfullfisd-02-a 93115
The SPV is a single-purpose dedicated trustIt has the powers to own the bonds andcollect payments
It cannot sell or lend the bondsIt cannot write options on the bondsOr use them as collateral for borrowing
The SPV is empowered to issue zero coupon
bondsWhere each security represents the ownership ofa single cash flow from the mother bond
8282014 93
8112019 FISD-02-A
httpslidepdfcomreaderfullfisd-02-a 94115
Assume that 100MM USD of 15 year bondswith a coupon of 8 are placed with the SPV
The SPV can issue 6M 12M 18M extending up to14 frac12 year zeroes with a total face value of 4MM
USD eachAnd 15 year zeroes with a total face value of104MM
8282014 94
8112019 FISD-02-A
httpslidepdfcomreaderfullfisd-02-a 95115
8112019 FISD-02-A
httpslidepdfcomreaderfullfisd-02-a 96115
8282014 96
8112019 FISD-02-A
httpslidepdfcomreaderfullfisd-02-a 97115
The Treasury launched this program in 1985to facilitate the stripping of designatedsecurities
All new T-bonds and notes with a maturity of 10years or more are eligibleThe zeroes created in the process are directobligations of the US government
8282014 97
8112019 FISD-02-A
httpslidepdfcomreaderfullfisd-02-a 98115
The mechanism is as followsA dealer who owns a bond or note can ask theFRB where it is held
To replace it with an equivalent set of STRIPS
representing each payment as a separate securityEach of these securities can be traded independentlyof others
8282014 98
8112019 FISD-02-A
httpslidepdfcomreaderfullfisd-02-a 99115
In 1987 the Treasury started to allow dealersto reverse the process
This is called STRIPS RECONSTUTUTION If a dealer owns STRIPS representing all thecoupon and principal payments of a bond
The FED can on request convert these holdings into asingle position in the corresponding bond
8282014 99
8112019 FISD-02-A
httpslidepdfcomreaderfullfisd-02-a 100115
Each coupon and principal cash flow from aTreasury security is assigned a CUSIP
The mother bond is also assigned a CUSIPThe stripped coupons are known as C-STRIPSThe stripped principal is known as P-STRIPSSupply of a C-STRIP increases over time
because a C-STRIP maturing on a day like 15 FEB
2020 will have the same CUSIP irrespective ofwhich mother bond it has come fromThe original coupon rate is irrelevant
8282014 100
8112019 FISD-02-A
httpslidepdfcomreaderfullfisd-02-a 101115
P-STRIPS always correspond to the originalsecurityThey have a unique CUSIPTheir supply is fixed at the time of issuanceIn practice the prices of long-dated P-STRIPSare a bit higher than those of C-STRIPS withthe same maturity date
One reason is that P-STRIPS are more liquid due
to greater availabilityA $100 face value bond with a coupon of 8 willgenerate C-STRIPS with a face value of $4 but P-STRIPS with a face value of $100
8282014 101
8112019 FISD-02-A
httpslidepdfcomreaderfullfisd-02-a 102115
Another reason why P-STRIPS are in higherdemand is that they allow reconstitutionactivities more easily
Assume that the sum of the STRIPS is cheaper than
the mother bondIf a dealer already has the P-STRIPS only the C-STRIPSneed to be acquiredHowever if he owns some of the C-STRIPS he needs toacquire the P-STRIPS and the remaining C-STRIPSThe facility to reconstitute when profitable is pricedinto the P-STRIPSNote Buy and hold investors will prefer C-STRIPSsince they are priced lower and give a higher yield
8282014 102
8112019 FISD-02-A
httpslidepdfcomreaderfullfisd-02-a 103115
For Plain Vanilla bonds the specifiedcoupon rate is valid for the life of thebond
In the case of Floaters the rate is reset atthe beginning of every periodThe rate will vary directly with thebenchmark
8282014 103
8112019 FISD-02-A
httpslidepdfcomreaderfullfisd-02-a 104115
The rate on a Floater is specified as LIBOR+ 50 bp
The spread is positiveIf it were specified as LIBOR ndash 30bp
The spread will be negativeIf LIBOR rises the rate will increasewhereas if LIBOR falls it will decrease
8282014 104
8112019 FISD-02-A
httpslidepdfcomreaderfullfisd-02-a 105115
In the case of a default risk-free floater theprice will reset to par on a coupon date
It may sell at a premium or discount betweencoupon dates
Consider a floater with a coupon = 5-year T-Bond rate
Assume there are two periods left to maturity
8282014 105
8112019 FISD-02-A
httpslidepdfcomreaderfullfisd-02-a 106115
8282014 106
The price at the end of the first coupon period willbe given by
cT-1 is the coupon one period before maturityyT-1 is the YTM one period before maturity
8112019 FISD-02-A
httpslidepdfcomreaderfullfisd-02-a 107115
On a coupon reset date the YTM = couponBecause we have assumed there is no default riskAny change in the required yield as reflected inthe prevailing YTM
Will also be reflected in the coupon being setIf coupon = yield the bond should sell at par
Thus P T-1 = M
8282014 107
8112019 FISD-02-A
httpslidepdfcomreaderfullfisd-02-a 108115
8282014 108
8112019 FISD-02-A
httpslidepdfcomreaderfullfisd-02-a 109115
Once again at T-2 c T-2 = yT-2 and P T-2 = MThis logic can be applied to a bond with anytime remaining till maturityHowever between two coupon dates theprice may not be equal to par
Consider the valuation at T-2+k
8282014 109
8112019 FISD-02-A
httpslidepdfcomreaderfullfisd-02-a 110115
8282014 110
8112019 FISD-02-A
httpslidepdfcomreaderfullfisd-02-a 111115
Although c T-2 was set at T-2 and is equal toyT-2
yT-2+k is determined at T-2+k and will reflect theyield prevailing at that time
Thus yT-2+k need not equal c T-2 and may behigher or lower
Hence between two coupon dates a floater maysell at a premium or discount
8282014 111
8112019 FISD-02-A
httpslidepdfcomreaderfullfisd-02-a 112115
Now consider a floater characterized bydefault risk
The risk premium required by the market neednot be constant over time
Assume that at the time of issue YTM = 5-year T-note rate + 75bp
The coupon would have been set equal to thisrate and the bond would have been issued at par
8282014 112
8112019 FISD-02-A
httpslidepdfcomreaderfullfisd-02-a 113115
Six months hence the issue may be perceivedas more risky
YTM = 5-year T-note rate + 95 bpThe coupon will however be set equal to theprevailing 5-year rate + 75 bpIf so the issue will not reset to par at the nextcoupon date
8282014 113
8112019 FISD-02-A
httpslidepdfcomreaderfullfisd-02-a 114115
Floaters may come with a CAP or a FLOOR orBOTH
The CAP is a maximum coupon rateProtects issuers against rising rates
The FLOOR is a minimum coupon rateProtects investors against falling rates
When there is a spread over LIBORThere is a natural floorLIBOR cannot be less than zero
8282014 114
8112019 FISD-02-A
httpslidepdfcomreaderfullfisd-02-a 115115
8112019 FISD-02-A
httpslidepdfcomreaderfullfisd-02-a 89115
Earlier investment banks used to buy bondsfrom the Treasury and separate the cashflows
Each cash flow was then sold separately as a zerocoupon bondSuch issues are called trademarks
8282014 89
8112019 FISD-02-A
httpslidepdfcomreaderfullfisd-02-a 90115
The issue of trademarks has now ceasedBecause investment banks can now createsuch instruments
In concert with the Treasury itselfThese ZCBs are known as STRIPS ndash
Separate Trading of Registered Interest andPrincipal of Securities
These are not issued or sold by the Treasury
The market is made by investment banks
8282014 90
8112019 FISD-02-A
httpslidepdfcomreaderfullfisd-02-a 91115
What is the motivation to create suchproductsIn practice arbitrage is possible when a
coupon security is purchased at a priceThat is lower than what could be obtained byselling each cash flow separately
8282014 91
8112019 FISD-02-A
httpslidepdfcomreaderfullfisd-02-a 92115
Coupon stripping reflects a case of financialengineering
Creating a risk-return profile that is nototherwise available
An investment bank would buy a largequantity of a Treasury security
The securities would be placed with an SPV
8282014 92
8112019 FISD-02-A
httpslidepdfcomreaderfullfisd-02-a 93115
The SPV is a single-purpose dedicated trustIt has the powers to own the bonds andcollect payments
It cannot sell or lend the bondsIt cannot write options on the bondsOr use them as collateral for borrowing
The SPV is empowered to issue zero coupon
bondsWhere each security represents the ownership ofa single cash flow from the mother bond
8282014 93
8112019 FISD-02-A
httpslidepdfcomreaderfullfisd-02-a 94115
Assume that 100MM USD of 15 year bondswith a coupon of 8 are placed with the SPV
The SPV can issue 6M 12M 18M extending up to14 frac12 year zeroes with a total face value of 4MM
USD eachAnd 15 year zeroes with a total face value of104MM
8282014 94
8112019 FISD-02-A
httpslidepdfcomreaderfullfisd-02-a 95115
8112019 FISD-02-A
httpslidepdfcomreaderfullfisd-02-a 96115
8282014 96
8112019 FISD-02-A
httpslidepdfcomreaderfullfisd-02-a 97115
The Treasury launched this program in 1985to facilitate the stripping of designatedsecurities
All new T-bonds and notes with a maturity of 10years or more are eligibleThe zeroes created in the process are directobligations of the US government
8282014 97
8112019 FISD-02-A
httpslidepdfcomreaderfullfisd-02-a 98115
The mechanism is as followsA dealer who owns a bond or note can ask theFRB where it is held
To replace it with an equivalent set of STRIPS
representing each payment as a separate securityEach of these securities can be traded independentlyof others
8282014 98
8112019 FISD-02-A
httpslidepdfcomreaderfullfisd-02-a 99115
In 1987 the Treasury started to allow dealersto reverse the process
This is called STRIPS RECONSTUTUTION If a dealer owns STRIPS representing all thecoupon and principal payments of a bond
The FED can on request convert these holdings into asingle position in the corresponding bond
8282014 99
8112019 FISD-02-A
httpslidepdfcomreaderfullfisd-02-a 100115
Each coupon and principal cash flow from aTreasury security is assigned a CUSIP
The mother bond is also assigned a CUSIPThe stripped coupons are known as C-STRIPSThe stripped principal is known as P-STRIPSSupply of a C-STRIP increases over time
because a C-STRIP maturing on a day like 15 FEB
2020 will have the same CUSIP irrespective ofwhich mother bond it has come fromThe original coupon rate is irrelevant
8282014 100
8112019 FISD-02-A
httpslidepdfcomreaderfullfisd-02-a 101115
P-STRIPS always correspond to the originalsecurityThey have a unique CUSIPTheir supply is fixed at the time of issuanceIn practice the prices of long-dated P-STRIPSare a bit higher than those of C-STRIPS withthe same maturity date
One reason is that P-STRIPS are more liquid due
to greater availabilityA $100 face value bond with a coupon of 8 willgenerate C-STRIPS with a face value of $4 but P-STRIPS with a face value of $100
8282014 101
8112019 FISD-02-A
httpslidepdfcomreaderfullfisd-02-a 102115
Another reason why P-STRIPS are in higherdemand is that they allow reconstitutionactivities more easily
Assume that the sum of the STRIPS is cheaper than
the mother bondIf a dealer already has the P-STRIPS only the C-STRIPSneed to be acquiredHowever if he owns some of the C-STRIPS he needs toacquire the P-STRIPS and the remaining C-STRIPSThe facility to reconstitute when profitable is pricedinto the P-STRIPSNote Buy and hold investors will prefer C-STRIPSsince they are priced lower and give a higher yield
8282014 102
8112019 FISD-02-A
httpslidepdfcomreaderfullfisd-02-a 103115
For Plain Vanilla bonds the specifiedcoupon rate is valid for the life of thebond
In the case of Floaters the rate is reset atthe beginning of every periodThe rate will vary directly with thebenchmark
8282014 103
8112019 FISD-02-A
httpslidepdfcomreaderfullfisd-02-a 104115
The rate on a Floater is specified as LIBOR+ 50 bp
The spread is positiveIf it were specified as LIBOR ndash 30bp
The spread will be negativeIf LIBOR rises the rate will increasewhereas if LIBOR falls it will decrease
8282014 104
8112019 FISD-02-A
httpslidepdfcomreaderfullfisd-02-a 105115
In the case of a default risk-free floater theprice will reset to par on a coupon date
It may sell at a premium or discount betweencoupon dates
Consider a floater with a coupon = 5-year T-Bond rate
Assume there are two periods left to maturity
8282014 105
8112019 FISD-02-A
httpslidepdfcomreaderfullfisd-02-a 106115
8282014 106
The price at the end of the first coupon period willbe given by
cT-1 is the coupon one period before maturityyT-1 is the YTM one period before maturity
8112019 FISD-02-A
httpslidepdfcomreaderfullfisd-02-a 107115
On a coupon reset date the YTM = couponBecause we have assumed there is no default riskAny change in the required yield as reflected inthe prevailing YTM
Will also be reflected in the coupon being setIf coupon = yield the bond should sell at par
Thus P T-1 = M
8282014 107
8112019 FISD-02-A
httpslidepdfcomreaderfullfisd-02-a 108115
8282014 108
8112019 FISD-02-A
httpslidepdfcomreaderfullfisd-02-a 109115
Once again at T-2 c T-2 = yT-2 and P T-2 = MThis logic can be applied to a bond with anytime remaining till maturityHowever between two coupon dates theprice may not be equal to par
Consider the valuation at T-2+k
8282014 109
8112019 FISD-02-A
httpslidepdfcomreaderfullfisd-02-a 110115
8282014 110
8112019 FISD-02-A
httpslidepdfcomreaderfullfisd-02-a 111115
Although c T-2 was set at T-2 and is equal toyT-2
yT-2+k is determined at T-2+k and will reflect theyield prevailing at that time
Thus yT-2+k need not equal c T-2 and may behigher or lower
Hence between two coupon dates a floater maysell at a premium or discount
8282014 111
8112019 FISD-02-A
httpslidepdfcomreaderfullfisd-02-a 112115
Now consider a floater characterized bydefault risk
The risk premium required by the market neednot be constant over time
Assume that at the time of issue YTM = 5-year T-note rate + 75bp
The coupon would have been set equal to thisrate and the bond would have been issued at par
8282014 112
8112019 FISD-02-A
httpslidepdfcomreaderfullfisd-02-a 113115
Six months hence the issue may be perceivedas more risky
YTM = 5-year T-note rate + 95 bpThe coupon will however be set equal to theprevailing 5-year rate + 75 bpIf so the issue will not reset to par at the nextcoupon date
8282014 113
8112019 FISD-02-A
httpslidepdfcomreaderfullfisd-02-a 114115
Floaters may come with a CAP or a FLOOR orBOTH
The CAP is a maximum coupon rateProtects issuers against rising rates
The FLOOR is a minimum coupon rateProtects investors against falling rates
When there is a spread over LIBORThere is a natural floorLIBOR cannot be less than zero
8282014 114
8112019 FISD-02-A
httpslidepdfcomreaderfullfisd-02-a 115115
8112019 FISD-02-A
httpslidepdfcomreaderfullfisd-02-a 90115
The issue of trademarks has now ceasedBecause investment banks can now createsuch instruments
In concert with the Treasury itselfThese ZCBs are known as STRIPS ndash
Separate Trading of Registered Interest andPrincipal of Securities
These are not issued or sold by the Treasury
The market is made by investment banks
8282014 90
8112019 FISD-02-A
httpslidepdfcomreaderfullfisd-02-a 91115
What is the motivation to create suchproductsIn practice arbitrage is possible when a
coupon security is purchased at a priceThat is lower than what could be obtained byselling each cash flow separately
8282014 91
8112019 FISD-02-A
httpslidepdfcomreaderfullfisd-02-a 92115
Coupon stripping reflects a case of financialengineering
Creating a risk-return profile that is nototherwise available
An investment bank would buy a largequantity of a Treasury security
The securities would be placed with an SPV
8282014 92
8112019 FISD-02-A
httpslidepdfcomreaderfullfisd-02-a 93115
The SPV is a single-purpose dedicated trustIt has the powers to own the bonds andcollect payments
It cannot sell or lend the bondsIt cannot write options on the bondsOr use them as collateral for borrowing
The SPV is empowered to issue zero coupon
bondsWhere each security represents the ownership ofa single cash flow from the mother bond
8282014 93
8112019 FISD-02-A
httpslidepdfcomreaderfullfisd-02-a 94115
Assume that 100MM USD of 15 year bondswith a coupon of 8 are placed with the SPV
The SPV can issue 6M 12M 18M extending up to14 frac12 year zeroes with a total face value of 4MM
USD eachAnd 15 year zeroes with a total face value of104MM
8282014 94
8112019 FISD-02-A
httpslidepdfcomreaderfullfisd-02-a 95115
8112019 FISD-02-A
httpslidepdfcomreaderfullfisd-02-a 96115
8282014 96
8112019 FISD-02-A
httpslidepdfcomreaderfullfisd-02-a 97115
The Treasury launched this program in 1985to facilitate the stripping of designatedsecurities
All new T-bonds and notes with a maturity of 10years or more are eligibleThe zeroes created in the process are directobligations of the US government
8282014 97
8112019 FISD-02-A
httpslidepdfcomreaderfullfisd-02-a 98115
The mechanism is as followsA dealer who owns a bond or note can ask theFRB where it is held
To replace it with an equivalent set of STRIPS
representing each payment as a separate securityEach of these securities can be traded independentlyof others
8282014 98
8112019 FISD-02-A
httpslidepdfcomreaderfullfisd-02-a 99115
In 1987 the Treasury started to allow dealersto reverse the process
This is called STRIPS RECONSTUTUTION If a dealer owns STRIPS representing all thecoupon and principal payments of a bond
The FED can on request convert these holdings into asingle position in the corresponding bond
8282014 99
8112019 FISD-02-A
httpslidepdfcomreaderfullfisd-02-a 100115
Each coupon and principal cash flow from aTreasury security is assigned a CUSIP
The mother bond is also assigned a CUSIPThe stripped coupons are known as C-STRIPSThe stripped principal is known as P-STRIPSSupply of a C-STRIP increases over time
because a C-STRIP maturing on a day like 15 FEB
2020 will have the same CUSIP irrespective ofwhich mother bond it has come fromThe original coupon rate is irrelevant
8282014 100
8112019 FISD-02-A
httpslidepdfcomreaderfullfisd-02-a 101115
P-STRIPS always correspond to the originalsecurityThey have a unique CUSIPTheir supply is fixed at the time of issuanceIn practice the prices of long-dated P-STRIPSare a bit higher than those of C-STRIPS withthe same maturity date
One reason is that P-STRIPS are more liquid due
to greater availabilityA $100 face value bond with a coupon of 8 willgenerate C-STRIPS with a face value of $4 but P-STRIPS with a face value of $100
8282014 101
8112019 FISD-02-A
httpslidepdfcomreaderfullfisd-02-a 102115
Another reason why P-STRIPS are in higherdemand is that they allow reconstitutionactivities more easily
Assume that the sum of the STRIPS is cheaper than
the mother bondIf a dealer already has the P-STRIPS only the C-STRIPSneed to be acquiredHowever if he owns some of the C-STRIPS he needs toacquire the P-STRIPS and the remaining C-STRIPSThe facility to reconstitute when profitable is pricedinto the P-STRIPSNote Buy and hold investors will prefer C-STRIPSsince they are priced lower and give a higher yield
8282014 102
8112019 FISD-02-A
httpslidepdfcomreaderfullfisd-02-a 103115
For Plain Vanilla bonds the specifiedcoupon rate is valid for the life of thebond
In the case of Floaters the rate is reset atthe beginning of every periodThe rate will vary directly with thebenchmark
8282014 103
8112019 FISD-02-A
httpslidepdfcomreaderfullfisd-02-a 104115
The rate on a Floater is specified as LIBOR+ 50 bp
The spread is positiveIf it were specified as LIBOR ndash 30bp
The spread will be negativeIf LIBOR rises the rate will increasewhereas if LIBOR falls it will decrease
8282014 104
8112019 FISD-02-A
httpslidepdfcomreaderfullfisd-02-a 105115
In the case of a default risk-free floater theprice will reset to par on a coupon date
It may sell at a premium or discount betweencoupon dates
Consider a floater with a coupon = 5-year T-Bond rate
Assume there are two periods left to maturity
8282014 105
8112019 FISD-02-A
httpslidepdfcomreaderfullfisd-02-a 106115
8282014 106
The price at the end of the first coupon period willbe given by
cT-1 is the coupon one period before maturityyT-1 is the YTM one period before maturity
8112019 FISD-02-A
httpslidepdfcomreaderfullfisd-02-a 107115
On a coupon reset date the YTM = couponBecause we have assumed there is no default riskAny change in the required yield as reflected inthe prevailing YTM
Will also be reflected in the coupon being setIf coupon = yield the bond should sell at par
Thus P T-1 = M
8282014 107
8112019 FISD-02-A
httpslidepdfcomreaderfullfisd-02-a 108115
8282014 108
8112019 FISD-02-A
httpslidepdfcomreaderfullfisd-02-a 109115
Once again at T-2 c T-2 = yT-2 and P T-2 = MThis logic can be applied to a bond with anytime remaining till maturityHowever between two coupon dates theprice may not be equal to par
Consider the valuation at T-2+k
8282014 109
8112019 FISD-02-A
httpslidepdfcomreaderfullfisd-02-a 110115
8282014 110
8112019 FISD-02-A
httpslidepdfcomreaderfullfisd-02-a 111115
Although c T-2 was set at T-2 and is equal toyT-2
yT-2+k is determined at T-2+k and will reflect theyield prevailing at that time
Thus yT-2+k need not equal c T-2 and may behigher or lower
Hence between two coupon dates a floater maysell at a premium or discount
8282014 111
8112019 FISD-02-A
httpslidepdfcomreaderfullfisd-02-a 112115
Now consider a floater characterized bydefault risk
The risk premium required by the market neednot be constant over time
Assume that at the time of issue YTM = 5-year T-note rate + 75bp
The coupon would have been set equal to thisrate and the bond would have been issued at par
8282014 112
8112019 FISD-02-A
httpslidepdfcomreaderfullfisd-02-a 113115
Six months hence the issue may be perceivedas more risky
YTM = 5-year T-note rate + 95 bpThe coupon will however be set equal to theprevailing 5-year rate + 75 bpIf so the issue will not reset to par at the nextcoupon date
8282014 113
8112019 FISD-02-A
httpslidepdfcomreaderfullfisd-02-a 114115
Floaters may come with a CAP or a FLOOR orBOTH
The CAP is a maximum coupon rateProtects issuers against rising rates
The FLOOR is a minimum coupon rateProtects investors against falling rates
When there is a spread over LIBORThere is a natural floorLIBOR cannot be less than zero
8282014 114
8112019 FISD-02-A
httpslidepdfcomreaderfullfisd-02-a 115115
8112019 FISD-02-A
httpslidepdfcomreaderfullfisd-02-a 91115
What is the motivation to create suchproductsIn practice arbitrage is possible when a
coupon security is purchased at a priceThat is lower than what could be obtained byselling each cash flow separately
8282014 91
8112019 FISD-02-A
httpslidepdfcomreaderfullfisd-02-a 92115
Coupon stripping reflects a case of financialengineering
Creating a risk-return profile that is nototherwise available
An investment bank would buy a largequantity of a Treasury security
The securities would be placed with an SPV
8282014 92
8112019 FISD-02-A
httpslidepdfcomreaderfullfisd-02-a 93115
The SPV is a single-purpose dedicated trustIt has the powers to own the bonds andcollect payments
It cannot sell or lend the bondsIt cannot write options on the bondsOr use them as collateral for borrowing
The SPV is empowered to issue zero coupon
bondsWhere each security represents the ownership ofa single cash flow from the mother bond
8282014 93
8112019 FISD-02-A
httpslidepdfcomreaderfullfisd-02-a 94115
Assume that 100MM USD of 15 year bondswith a coupon of 8 are placed with the SPV
The SPV can issue 6M 12M 18M extending up to14 frac12 year zeroes with a total face value of 4MM
USD eachAnd 15 year zeroes with a total face value of104MM
8282014 94
8112019 FISD-02-A
httpslidepdfcomreaderfullfisd-02-a 95115
8112019 FISD-02-A
httpslidepdfcomreaderfullfisd-02-a 96115
8282014 96
8112019 FISD-02-A
httpslidepdfcomreaderfullfisd-02-a 97115
The Treasury launched this program in 1985to facilitate the stripping of designatedsecurities
All new T-bonds and notes with a maturity of 10years or more are eligibleThe zeroes created in the process are directobligations of the US government
8282014 97
8112019 FISD-02-A
httpslidepdfcomreaderfullfisd-02-a 98115
The mechanism is as followsA dealer who owns a bond or note can ask theFRB where it is held
To replace it with an equivalent set of STRIPS
representing each payment as a separate securityEach of these securities can be traded independentlyof others
8282014 98
8112019 FISD-02-A
httpslidepdfcomreaderfullfisd-02-a 99115
In 1987 the Treasury started to allow dealersto reverse the process
This is called STRIPS RECONSTUTUTION If a dealer owns STRIPS representing all thecoupon and principal payments of a bond
The FED can on request convert these holdings into asingle position in the corresponding bond
8282014 99
8112019 FISD-02-A
httpslidepdfcomreaderfullfisd-02-a 100115
Each coupon and principal cash flow from aTreasury security is assigned a CUSIP
The mother bond is also assigned a CUSIPThe stripped coupons are known as C-STRIPSThe stripped principal is known as P-STRIPSSupply of a C-STRIP increases over time
because a C-STRIP maturing on a day like 15 FEB
2020 will have the same CUSIP irrespective ofwhich mother bond it has come fromThe original coupon rate is irrelevant
8282014 100
8112019 FISD-02-A
httpslidepdfcomreaderfullfisd-02-a 101115
P-STRIPS always correspond to the originalsecurityThey have a unique CUSIPTheir supply is fixed at the time of issuanceIn practice the prices of long-dated P-STRIPSare a bit higher than those of C-STRIPS withthe same maturity date
One reason is that P-STRIPS are more liquid due
to greater availabilityA $100 face value bond with a coupon of 8 willgenerate C-STRIPS with a face value of $4 but P-STRIPS with a face value of $100
8282014 101
8112019 FISD-02-A
httpslidepdfcomreaderfullfisd-02-a 102115
Another reason why P-STRIPS are in higherdemand is that they allow reconstitutionactivities more easily
Assume that the sum of the STRIPS is cheaper than
the mother bondIf a dealer already has the P-STRIPS only the C-STRIPSneed to be acquiredHowever if he owns some of the C-STRIPS he needs toacquire the P-STRIPS and the remaining C-STRIPSThe facility to reconstitute when profitable is pricedinto the P-STRIPSNote Buy and hold investors will prefer C-STRIPSsince they are priced lower and give a higher yield
8282014 102
8112019 FISD-02-A
httpslidepdfcomreaderfullfisd-02-a 103115
For Plain Vanilla bonds the specifiedcoupon rate is valid for the life of thebond
In the case of Floaters the rate is reset atthe beginning of every periodThe rate will vary directly with thebenchmark
8282014 103
8112019 FISD-02-A
httpslidepdfcomreaderfullfisd-02-a 104115
The rate on a Floater is specified as LIBOR+ 50 bp
The spread is positiveIf it were specified as LIBOR ndash 30bp
The spread will be negativeIf LIBOR rises the rate will increasewhereas if LIBOR falls it will decrease
8282014 104
8112019 FISD-02-A
httpslidepdfcomreaderfullfisd-02-a 105115
In the case of a default risk-free floater theprice will reset to par on a coupon date
It may sell at a premium or discount betweencoupon dates
Consider a floater with a coupon = 5-year T-Bond rate
Assume there are two periods left to maturity
8282014 105
8112019 FISD-02-A
httpslidepdfcomreaderfullfisd-02-a 106115
8282014 106
The price at the end of the first coupon period willbe given by
cT-1 is the coupon one period before maturityyT-1 is the YTM one period before maturity
8112019 FISD-02-A
httpslidepdfcomreaderfullfisd-02-a 107115
On a coupon reset date the YTM = couponBecause we have assumed there is no default riskAny change in the required yield as reflected inthe prevailing YTM
Will also be reflected in the coupon being setIf coupon = yield the bond should sell at par
Thus P T-1 = M
8282014 107
8112019 FISD-02-A
httpslidepdfcomreaderfullfisd-02-a 108115
8282014 108
8112019 FISD-02-A
httpslidepdfcomreaderfullfisd-02-a 109115
Once again at T-2 c T-2 = yT-2 and P T-2 = MThis logic can be applied to a bond with anytime remaining till maturityHowever between two coupon dates theprice may not be equal to par
Consider the valuation at T-2+k
8282014 109
8112019 FISD-02-A
httpslidepdfcomreaderfullfisd-02-a 110115
8282014 110
8112019 FISD-02-A
httpslidepdfcomreaderfullfisd-02-a 111115
Although c T-2 was set at T-2 and is equal toyT-2
yT-2+k is determined at T-2+k and will reflect theyield prevailing at that time
Thus yT-2+k need not equal c T-2 and may behigher or lower
Hence between two coupon dates a floater maysell at a premium or discount
8282014 111
8112019 FISD-02-A
httpslidepdfcomreaderfullfisd-02-a 112115
Now consider a floater characterized bydefault risk
The risk premium required by the market neednot be constant over time
Assume that at the time of issue YTM = 5-year T-note rate + 75bp
The coupon would have been set equal to thisrate and the bond would have been issued at par
8282014 112
8112019 FISD-02-A
httpslidepdfcomreaderfullfisd-02-a 113115
Six months hence the issue may be perceivedas more risky
YTM = 5-year T-note rate + 95 bpThe coupon will however be set equal to theprevailing 5-year rate + 75 bpIf so the issue will not reset to par at the nextcoupon date
8282014 113
8112019 FISD-02-A
httpslidepdfcomreaderfullfisd-02-a 114115
Floaters may come with a CAP or a FLOOR orBOTH
The CAP is a maximum coupon rateProtects issuers against rising rates
The FLOOR is a minimum coupon rateProtects investors against falling rates
When there is a spread over LIBORThere is a natural floorLIBOR cannot be less than zero
8282014 114
8112019 FISD-02-A
httpslidepdfcomreaderfullfisd-02-a 115115
8112019 FISD-02-A
httpslidepdfcomreaderfullfisd-02-a 92115
Coupon stripping reflects a case of financialengineering
Creating a risk-return profile that is nototherwise available
An investment bank would buy a largequantity of a Treasury security
The securities would be placed with an SPV
8282014 92
8112019 FISD-02-A
httpslidepdfcomreaderfullfisd-02-a 93115
The SPV is a single-purpose dedicated trustIt has the powers to own the bonds andcollect payments
It cannot sell or lend the bondsIt cannot write options on the bondsOr use them as collateral for borrowing
The SPV is empowered to issue zero coupon
bondsWhere each security represents the ownership ofa single cash flow from the mother bond
8282014 93
8112019 FISD-02-A
httpslidepdfcomreaderfullfisd-02-a 94115
Assume that 100MM USD of 15 year bondswith a coupon of 8 are placed with the SPV
The SPV can issue 6M 12M 18M extending up to14 frac12 year zeroes with a total face value of 4MM
USD eachAnd 15 year zeroes with a total face value of104MM
8282014 94
8112019 FISD-02-A
httpslidepdfcomreaderfullfisd-02-a 95115
8112019 FISD-02-A
httpslidepdfcomreaderfullfisd-02-a 96115
8282014 96
8112019 FISD-02-A
httpslidepdfcomreaderfullfisd-02-a 97115
The Treasury launched this program in 1985to facilitate the stripping of designatedsecurities
All new T-bonds and notes with a maturity of 10years or more are eligibleThe zeroes created in the process are directobligations of the US government
8282014 97
8112019 FISD-02-A
httpslidepdfcomreaderfullfisd-02-a 98115
The mechanism is as followsA dealer who owns a bond or note can ask theFRB where it is held
To replace it with an equivalent set of STRIPS
representing each payment as a separate securityEach of these securities can be traded independentlyof others
8282014 98
8112019 FISD-02-A
httpslidepdfcomreaderfullfisd-02-a 99115
In 1987 the Treasury started to allow dealersto reverse the process
This is called STRIPS RECONSTUTUTION If a dealer owns STRIPS representing all thecoupon and principal payments of a bond
The FED can on request convert these holdings into asingle position in the corresponding bond
8282014 99
8112019 FISD-02-A
httpslidepdfcomreaderfullfisd-02-a 100115
Each coupon and principal cash flow from aTreasury security is assigned a CUSIP
The mother bond is also assigned a CUSIPThe stripped coupons are known as C-STRIPSThe stripped principal is known as P-STRIPSSupply of a C-STRIP increases over time
because a C-STRIP maturing on a day like 15 FEB
2020 will have the same CUSIP irrespective ofwhich mother bond it has come fromThe original coupon rate is irrelevant
8282014 100
8112019 FISD-02-A
httpslidepdfcomreaderfullfisd-02-a 101115
P-STRIPS always correspond to the originalsecurityThey have a unique CUSIPTheir supply is fixed at the time of issuanceIn practice the prices of long-dated P-STRIPSare a bit higher than those of C-STRIPS withthe same maturity date
One reason is that P-STRIPS are more liquid due
to greater availabilityA $100 face value bond with a coupon of 8 willgenerate C-STRIPS with a face value of $4 but P-STRIPS with a face value of $100
8282014 101
8112019 FISD-02-A
httpslidepdfcomreaderfullfisd-02-a 102115
Another reason why P-STRIPS are in higherdemand is that they allow reconstitutionactivities more easily
Assume that the sum of the STRIPS is cheaper than
the mother bondIf a dealer already has the P-STRIPS only the C-STRIPSneed to be acquiredHowever if he owns some of the C-STRIPS he needs toacquire the P-STRIPS and the remaining C-STRIPSThe facility to reconstitute when profitable is pricedinto the P-STRIPSNote Buy and hold investors will prefer C-STRIPSsince they are priced lower and give a higher yield
8282014 102
8112019 FISD-02-A
httpslidepdfcomreaderfullfisd-02-a 103115
For Plain Vanilla bonds the specifiedcoupon rate is valid for the life of thebond
In the case of Floaters the rate is reset atthe beginning of every periodThe rate will vary directly with thebenchmark
8282014 103
8112019 FISD-02-A
httpslidepdfcomreaderfullfisd-02-a 104115
The rate on a Floater is specified as LIBOR+ 50 bp
The spread is positiveIf it were specified as LIBOR ndash 30bp
The spread will be negativeIf LIBOR rises the rate will increasewhereas if LIBOR falls it will decrease
8282014 104
8112019 FISD-02-A
httpslidepdfcomreaderfullfisd-02-a 105115
In the case of a default risk-free floater theprice will reset to par on a coupon date
It may sell at a premium or discount betweencoupon dates
Consider a floater with a coupon = 5-year T-Bond rate
Assume there are two periods left to maturity
8282014 105
8112019 FISD-02-A
httpslidepdfcomreaderfullfisd-02-a 106115
8282014 106
The price at the end of the first coupon period willbe given by
cT-1 is the coupon one period before maturityyT-1 is the YTM one period before maturity
8112019 FISD-02-A
httpslidepdfcomreaderfullfisd-02-a 107115
On a coupon reset date the YTM = couponBecause we have assumed there is no default riskAny change in the required yield as reflected inthe prevailing YTM
Will also be reflected in the coupon being setIf coupon = yield the bond should sell at par
Thus P T-1 = M
8282014 107
8112019 FISD-02-A
httpslidepdfcomreaderfullfisd-02-a 108115
8282014 108
8112019 FISD-02-A
httpslidepdfcomreaderfullfisd-02-a 109115
Once again at T-2 c T-2 = yT-2 and P T-2 = MThis logic can be applied to a bond with anytime remaining till maturityHowever between two coupon dates theprice may not be equal to par
Consider the valuation at T-2+k
8282014 109
8112019 FISD-02-A
httpslidepdfcomreaderfullfisd-02-a 110115
8282014 110
8112019 FISD-02-A
httpslidepdfcomreaderfullfisd-02-a 111115
Although c T-2 was set at T-2 and is equal toyT-2
yT-2+k is determined at T-2+k and will reflect theyield prevailing at that time
Thus yT-2+k need not equal c T-2 and may behigher or lower
Hence between two coupon dates a floater maysell at a premium or discount
8282014 111
8112019 FISD-02-A
httpslidepdfcomreaderfullfisd-02-a 112115
Now consider a floater characterized bydefault risk
The risk premium required by the market neednot be constant over time
Assume that at the time of issue YTM = 5-year T-note rate + 75bp
The coupon would have been set equal to thisrate and the bond would have been issued at par
8282014 112
8112019 FISD-02-A
httpslidepdfcomreaderfullfisd-02-a 113115
Six months hence the issue may be perceivedas more risky
YTM = 5-year T-note rate + 95 bpThe coupon will however be set equal to theprevailing 5-year rate + 75 bpIf so the issue will not reset to par at the nextcoupon date
8282014 113
8112019 FISD-02-A
httpslidepdfcomreaderfullfisd-02-a 114115
Floaters may come with a CAP or a FLOOR orBOTH
The CAP is a maximum coupon rateProtects issuers against rising rates
The FLOOR is a minimum coupon rateProtects investors against falling rates
When there is a spread over LIBORThere is a natural floorLIBOR cannot be less than zero
8282014 114
8112019 FISD-02-A
httpslidepdfcomreaderfullfisd-02-a 115115
8112019 FISD-02-A
httpslidepdfcomreaderfullfisd-02-a 93115
The SPV is a single-purpose dedicated trustIt has the powers to own the bonds andcollect payments
It cannot sell or lend the bondsIt cannot write options on the bondsOr use them as collateral for borrowing
The SPV is empowered to issue zero coupon
bondsWhere each security represents the ownership ofa single cash flow from the mother bond
8282014 93
8112019 FISD-02-A
httpslidepdfcomreaderfullfisd-02-a 94115
Assume that 100MM USD of 15 year bondswith a coupon of 8 are placed with the SPV
The SPV can issue 6M 12M 18M extending up to14 frac12 year zeroes with a total face value of 4MM
USD eachAnd 15 year zeroes with a total face value of104MM
8282014 94
8112019 FISD-02-A
httpslidepdfcomreaderfullfisd-02-a 95115
8112019 FISD-02-A
httpslidepdfcomreaderfullfisd-02-a 96115
8282014 96
8112019 FISD-02-A
httpslidepdfcomreaderfullfisd-02-a 97115
The Treasury launched this program in 1985to facilitate the stripping of designatedsecurities
All new T-bonds and notes with a maturity of 10years or more are eligibleThe zeroes created in the process are directobligations of the US government
8282014 97
8112019 FISD-02-A
httpslidepdfcomreaderfullfisd-02-a 98115
The mechanism is as followsA dealer who owns a bond or note can ask theFRB where it is held
To replace it with an equivalent set of STRIPS
representing each payment as a separate securityEach of these securities can be traded independentlyof others
8282014 98
8112019 FISD-02-A
httpslidepdfcomreaderfullfisd-02-a 99115
In 1987 the Treasury started to allow dealersto reverse the process
This is called STRIPS RECONSTUTUTION If a dealer owns STRIPS representing all thecoupon and principal payments of a bond
The FED can on request convert these holdings into asingle position in the corresponding bond
8282014 99
8112019 FISD-02-A
httpslidepdfcomreaderfullfisd-02-a 100115
Each coupon and principal cash flow from aTreasury security is assigned a CUSIP
The mother bond is also assigned a CUSIPThe stripped coupons are known as C-STRIPSThe stripped principal is known as P-STRIPSSupply of a C-STRIP increases over time
because a C-STRIP maturing on a day like 15 FEB
2020 will have the same CUSIP irrespective ofwhich mother bond it has come fromThe original coupon rate is irrelevant
8282014 100
8112019 FISD-02-A
httpslidepdfcomreaderfullfisd-02-a 101115
P-STRIPS always correspond to the originalsecurityThey have a unique CUSIPTheir supply is fixed at the time of issuanceIn practice the prices of long-dated P-STRIPSare a bit higher than those of C-STRIPS withthe same maturity date
One reason is that P-STRIPS are more liquid due
to greater availabilityA $100 face value bond with a coupon of 8 willgenerate C-STRIPS with a face value of $4 but P-STRIPS with a face value of $100
8282014 101
8112019 FISD-02-A
httpslidepdfcomreaderfullfisd-02-a 102115
Another reason why P-STRIPS are in higherdemand is that they allow reconstitutionactivities more easily
Assume that the sum of the STRIPS is cheaper than
the mother bondIf a dealer already has the P-STRIPS only the C-STRIPSneed to be acquiredHowever if he owns some of the C-STRIPS he needs toacquire the P-STRIPS and the remaining C-STRIPSThe facility to reconstitute when profitable is pricedinto the P-STRIPSNote Buy and hold investors will prefer C-STRIPSsince they are priced lower and give a higher yield
8282014 102
8112019 FISD-02-A
httpslidepdfcomreaderfullfisd-02-a 103115
For Plain Vanilla bonds the specifiedcoupon rate is valid for the life of thebond
In the case of Floaters the rate is reset atthe beginning of every periodThe rate will vary directly with thebenchmark
8282014 103
8112019 FISD-02-A
httpslidepdfcomreaderfullfisd-02-a 104115
The rate on a Floater is specified as LIBOR+ 50 bp
The spread is positiveIf it were specified as LIBOR ndash 30bp
The spread will be negativeIf LIBOR rises the rate will increasewhereas if LIBOR falls it will decrease
8282014 104
8112019 FISD-02-A
httpslidepdfcomreaderfullfisd-02-a 105115
In the case of a default risk-free floater theprice will reset to par on a coupon date
It may sell at a premium or discount betweencoupon dates
Consider a floater with a coupon = 5-year T-Bond rate
Assume there are two periods left to maturity
8282014 105
8112019 FISD-02-A
httpslidepdfcomreaderfullfisd-02-a 106115
8282014 106
The price at the end of the first coupon period willbe given by
cT-1 is the coupon one period before maturityyT-1 is the YTM one period before maturity
8112019 FISD-02-A
httpslidepdfcomreaderfullfisd-02-a 107115
On a coupon reset date the YTM = couponBecause we have assumed there is no default riskAny change in the required yield as reflected inthe prevailing YTM
Will also be reflected in the coupon being setIf coupon = yield the bond should sell at par
Thus P T-1 = M
8282014 107
8112019 FISD-02-A
httpslidepdfcomreaderfullfisd-02-a 108115
8282014 108
8112019 FISD-02-A
httpslidepdfcomreaderfullfisd-02-a 109115
Once again at T-2 c T-2 = yT-2 and P T-2 = MThis logic can be applied to a bond with anytime remaining till maturityHowever between two coupon dates theprice may not be equal to par
Consider the valuation at T-2+k
8282014 109
8112019 FISD-02-A
httpslidepdfcomreaderfullfisd-02-a 110115
8282014 110
8112019 FISD-02-A
httpslidepdfcomreaderfullfisd-02-a 111115
Although c T-2 was set at T-2 and is equal toyT-2
yT-2+k is determined at T-2+k and will reflect theyield prevailing at that time
Thus yT-2+k need not equal c T-2 and may behigher or lower
Hence between two coupon dates a floater maysell at a premium or discount
8282014 111
8112019 FISD-02-A
httpslidepdfcomreaderfullfisd-02-a 112115
Now consider a floater characterized bydefault risk
The risk premium required by the market neednot be constant over time
Assume that at the time of issue YTM = 5-year T-note rate + 75bp
The coupon would have been set equal to thisrate and the bond would have been issued at par
8282014 112
8112019 FISD-02-A
httpslidepdfcomreaderfullfisd-02-a 113115
Six months hence the issue may be perceivedas more risky
YTM = 5-year T-note rate + 95 bpThe coupon will however be set equal to theprevailing 5-year rate + 75 bpIf so the issue will not reset to par at the nextcoupon date
8282014 113
8112019 FISD-02-A
httpslidepdfcomreaderfullfisd-02-a 114115
Floaters may come with a CAP or a FLOOR orBOTH
The CAP is a maximum coupon rateProtects issuers against rising rates
The FLOOR is a minimum coupon rateProtects investors against falling rates
When there is a spread over LIBORThere is a natural floorLIBOR cannot be less than zero
8282014 114
8112019 FISD-02-A
httpslidepdfcomreaderfullfisd-02-a 115115
8112019 FISD-02-A
httpslidepdfcomreaderfullfisd-02-a 94115
Assume that 100MM USD of 15 year bondswith a coupon of 8 are placed with the SPV
The SPV can issue 6M 12M 18M extending up to14 frac12 year zeroes with a total face value of 4MM
USD eachAnd 15 year zeroes with a total face value of104MM
8282014 94
8112019 FISD-02-A
httpslidepdfcomreaderfullfisd-02-a 95115
8112019 FISD-02-A
httpslidepdfcomreaderfullfisd-02-a 96115
8282014 96
8112019 FISD-02-A
httpslidepdfcomreaderfullfisd-02-a 97115
The Treasury launched this program in 1985to facilitate the stripping of designatedsecurities
All new T-bonds and notes with a maturity of 10years or more are eligibleThe zeroes created in the process are directobligations of the US government
8282014 97
8112019 FISD-02-A
httpslidepdfcomreaderfullfisd-02-a 98115
The mechanism is as followsA dealer who owns a bond or note can ask theFRB where it is held
To replace it with an equivalent set of STRIPS
representing each payment as a separate securityEach of these securities can be traded independentlyof others
8282014 98
8112019 FISD-02-A
httpslidepdfcomreaderfullfisd-02-a 99115
In 1987 the Treasury started to allow dealersto reverse the process
This is called STRIPS RECONSTUTUTION If a dealer owns STRIPS representing all thecoupon and principal payments of a bond
The FED can on request convert these holdings into asingle position in the corresponding bond
8282014 99
8112019 FISD-02-A
httpslidepdfcomreaderfullfisd-02-a 100115
Each coupon and principal cash flow from aTreasury security is assigned a CUSIP
The mother bond is also assigned a CUSIPThe stripped coupons are known as C-STRIPSThe stripped principal is known as P-STRIPSSupply of a C-STRIP increases over time
because a C-STRIP maturing on a day like 15 FEB
2020 will have the same CUSIP irrespective ofwhich mother bond it has come fromThe original coupon rate is irrelevant
8282014 100
8112019 FISD-02-A
httpslidepdfcomreaderfullfisd-02-a 101115
P-STRIPS always correspond to the originalsecurityThey have a unique CUSIPTheir supply is fixed at the time of issuanceIn practice the prices of long-dated P-STRIPSare a bit higher than those of C-STRIPS withthe same maturity date
One reason is that P-STRIPS are more liquid due
to greater availabilityA $100 face value bond with a coupon of 8 willgenerate C-STRIPS with a face value of $4 but P-STRIPS with a face value of $100
8282014 101
8112019 FISD-02-A
httpslidepdfcomreaderfullfisd-02-a 102115
Another reason why P-STRIPS are in higherdemand is that they allow reconstitutionactivities more easily
Assume that the sum of the STRIPS is cheaper than
the mother bondIf a dealer already has the P-STRIPS only the C-STRIPSneed to be acquiredHowever if he owns some of the C-STRIPS he needs toacquire the P-STRIPS and the remaining C-STRIPSThe facility to reconstitute when profitable is pricedinto the P-STRIPSNote Buy and hold investors will prefer C-STRIPSsince they are priced lower and give a higher yield
8282014 102
8112019 FISD-02-A
httpslidepdfcomreaderfullfisd-02-a 103115
For Plain Vanilla bonds the specifiedcoupon rate is valid for the life of thebond
In the case of Floaters the rate is reset atthe beginning of every periodThe rate will vary directly with thebenchmark
8282014 103
8112019 FISD-02-A
httpslidepdfcomreaderfullfisd-02-a 104115
The rate on a Floater is specified as LIBOR+ 50 bp
The spread is positiveIf it were specified as LIBOR ndash 30bp
The spread will be negativeIf LIBOR rises the rate will increasewhereas if LIBOR falls it will decrease
8282014 104
8112019 FISD-02-A
httpslidepdfcomreaderfullfisd-02-a 105115
In the case of a default risk-free floater theprice will reset to par on a coupon date
It may sell at a premium or discount betweencoupon dates
Consider a floater with a coupon = 5-year T-Bond rate
Assume there are two periods left to maturity
8282014 105
8112019 FISD-02-A
httpslidepdfcomreaderfullfisd-02-a 106115
8282014 106
The price at the end of the first coupon period willbe given by
cT-1 is the coupon one period before maturityyT-1 is the YTM one period before maturity
8112019 FISD-02-A
httpslidepdfcomreaderfullfisd-02-a 107115
On a coupon reset date the YTM = couponBecause we have assumed there is no default riskAny change in the required yield as reflected inthe prevailing YTM
Will also be reflected in the coupon being setIf coupon = yield the bond should sell at par
Thus P T-1 = M
8282014 107
8112019 FISD-02-A
httpslidepdfcomreaderfullfisd-02-a 108115
8282014 108
8112019 FISD-02-A
httpslidepdfcomreaderfullfisd-02-a 109115
Once again at T-2 c T-2 = yT-2 and P T-2 = MThis logic can be applied to a bond with anytime remaining till maturityHowever between two coupon dates theprice may not be equal to par
Consider the valuation at T-2+k
8282014 109
8112019 FISD-02-A
httpslidepdfcomreaderfullfisd-02-a 110115
8282014 110
8112019 FISD-02-A
httpslidepdfcomreaderfullfisd-02-a 111115
Although c T-2 was set at T-2 and is equal toyT-2
yT-2+k is determined at T-2+k and will reflect theyield prevailing at that time
Thus yT-2+k need not equal c T-2 and may behigher or lower
Hence between two coupon dates a floater maysell at a premium or discount
8282014 111
8112019 FISD-02-A
httpslidepdfcomreaderfullfisd-02-a 112115
Now consider a floater characterized bydefault risk
The risk premium required by the market neednot be constant over time
Assume that at the time of issue YTM = 5-year T-note rate + 75bp
The coupon would have been set equal to thisrate and the bond would have been issued at par
8282014 112
8112019 FISD-02-A
httpslidepdfcomreaderfullfisd-02-a 113115
Six months hence the issue may be perceivedas more risky
YTM = 5-year T-note rate + 95 bpThe coupon will however be set equal to theprevailing 5-year rate + 75 bpIf so the issue will not reset to par at the nextcoupon date
8282014 113
8112019 FISD-02-A
httpslidepdfcomreaderfullfisd-02-a 114115
Floaters may come with a CAP or a FLOOR orBOTH
The CAP is a maximum coupon rateProtects issuers against rising rates
The FLOOR is a minimum coupon rateProtects investors against falling rates
When there is a spread over LIBORThere is a natural floorLIBOR cannot be less than zero
8282014 114
8112019 FISD-02-A
httpslidepdfcomreaderfullfisd-02-a 115115
8112019 FISD-02-A
httpslidepdfcomreaderfullfisd-02-a 95115
8112019 FISD-02-A
httpslidepdfcomreaderfullfisd-02-a 96115
8282014 96
8112019 FISD-02-A
httpslidepdfcomreaderfullfisd-02-a 97115
The Treasury launched this program in 1985to facilitate the stripping of designatedsecurities
All new T-bonds and notes with a maturity of 10years or more are eligibleThe zeroes created in the process are directobligations of the US government
8282014 97
8112019 FISD-02-A
httpslidepdfcomreaderfullfisd-02-a 98115
The mechanism is as followsA dealer who owns a bond or note can ask theFRB where it is held
To replace it with an equivalent set of STRIPS
representing each payment as a separate securityEach of these securities can be traded independentlyof others
8282014 98
8112019 FISD-02-A
httpslidepdfcomreaderfullfisd-02-a 99115
In 1987 the Treasury started to allow dealersto reverse the process
This is called STRIPS RECONSTUTUTION If a dealer owns STRIPS representing all thecoupon and principal payments of a bond
The FED can on request convert these holdings into asingle position in the corresponding bond
8282014 99
8112019 FISD-02-A
httpslidepdfcomreaderfullfisd-02-a 100115
Each coupon and principal cash flow from aTreasury security is assigned a CUSIP
The mother bond is also assigned a CUSIPThe stripped coupons are known as C-STRIPSThe stripped principal is known as P-STRIPSSupply of a C-STRIP increases over time
because a C-STRIP maturing on a day like 15 FEB
2020 will have the same CUSIP irrespective ofwhich mother bond it has come fromThe original coupon rate is irrelevant
8282014 100
8112019 FISD-02-A
httpslidepdfcomreaderfullfisd-02-a 101115
P-STRIPS always correspond to the originalsecurityThey have a unique CUSIPTheir supply is fixed at the time of issuanceIn practice the prices of long-dated P-STRIPSare a bit higher than those of C-STRIPS withthe same maturity date
One reason is that P-STRIPS are more liquid due
to greater availabilityA $100 face value bond with a coupon of 8 willgenerate C-STRIPS with a face value of $4 but P-STRIPS with a face value of $100
8282014 101
8112019 FISD-02-A
httpslidepdfcomreaderfullfisd-02-a 102115
Another reason why P-STRIPS are in higherdemand is that they allow reconstitutionactivities more easily
Assume that the sum of the STRIPS is cheaper than
the mother bondIf a dealer already has the P-STRIPS only the C-STRIPSneed to be acquiredHowever if he owns some of the C-STRIPS he needs toacquire the P-STRIPS and the remaining C-STRIPSThe facility to reconstitute when profitable is pricedinto the P-STRIPSNote Buy and hold investors will prefer C-STRIPSsince they are priced lower and give a higher yield
8282014 102
8112019 FISD-02-A
httpslidepdfcomreaderfullfisd-02-a 103115
For Plain Vanilla bonds the specifiedcoupon rate is valid for the life of thebond
In the case of Floaters the rate is reset atthe beginning of every periodThe rate will vary directly with thebenchmark
8282014 103
8112019 FISD-02-A
httpslidepdfcomreaderfullfisd-02-a 104115
The rate on a Floater is specified as LIBOR+ 50 bp
The spread is positiveIf it were specified as LIBOR ndash 30bp
The spread will be negativeIf LIBOR rises the rate will increasewhereas if LIBOR falls it will decrease
8282014 104
8112019 FISD-02-A
httpslidepdfcomreaderfullfisd-02-a 105115
In the case of a default risk-free floater theprice will reset to par on a coupon date
It may sell at a premium or discount betweencoupon dates
Consider a floater with a coupon = 5-year T-Bond rate
Assume there are two periods left to maturity
8282014 105
8112019 FISD-02-A
httpslidepdfcomreaderfullfisd-02-a 106115
8282014 106
The price at the end of the first coupon period willbe given by
cT-1 is the coupon one period before maturityyT-1 is the YTM one period before maturity
8112019 FISD-02-A
httpslidepdfcomreaderfullfisd-02-a 107115
On a coupon reset date the YTM = couponBecause we have assumed there is no default riskAny change in the required yield as reflected inthe prevailing YTM
Will also be reflected in the coupon being setIf coupon = yield the bond should sell at par
Thus P T-1 = M
8282014 107
8112019 FISD-02-A
httpslidepdfcomreaderfullfisd-02-a 108115
8282014 108
8112019 FISD-02-A
httpslidepdfcomreaderfullfisd-02-a 109115
Once again at T-2 c T-2 = yT-2 and P T-2 = MThis logic can be applied to a bond with anytime remaining till maturityHowever between two coupon dates theprice may not be equal to par
Consider the valuation at T-2+k
8282014 109
8112019 FISD-02-A
httpslidepdfcomreaderfullfisd-02-a 110115
8282014 110
8112019 FISD-02-A
httpslidepdfcomreaderfullfisd-02-a 111115
Although c T-2 was set at T-2 and is equal toyT-2
yT-2+k is determined at T-2+k and will reflect theyield prevailing at that time
Thus yT-2+k need not equal c T-2 and may behigher or lower
Hence between two coupon dates a floater maysell at a premium or discount
8282014 111
8112019 FISD-02-A
httpslidepdfcomreaderfullfisd-02-a 112115
Now consider a floater characterized bydefault risk
The risk premium required by the market neednot be constant over time
Assume that at the time of issue YTM = 5-year T-note rate + 75bp
The coupon would have been set equal to thisrate and the bond would have been issued at par
8282014 112
8112019 FISD-02-A
httpslidepdfcomreaderfullfisd-02-a 113115
Six months hence the issue may be perceivedas more risky
YTM = 5-year T-note rate + 95 bpThe coupon will however be set equal to theprevailing 5-year rate + 75 bpIf so the issue will not reset to par at the nextcoupon date
8282014 113
8112019 FISD-02-A
httpslidepdfcomreaderfullfisd-02-a 114115
Floaters may come with a CAP or a FLOOR orBOTH
The CAP is a maximum coupon rateProtects issuers against rising rates
The FLOOR is a minimum coupon rateProtects investors against falling rates
When there is a spread over LIBORThere is a natural floorLIBOR cannot be less than zero
8282014 114
8112019 FISD-02-A
httpslidepdfcomreaderfullfisd-02-a 115115
8112019 FISD-02-A
httpslidepdfcomreaderfullfisd-02-a 96115
8282014 96
8112019 FISD-02-A
httpslidepdfcomreaderfullfisd-02-a 97115
The Treasury launched this program in 1985to facilitate the stripping of designatedsecurities
All new T-bonds and notes with a maturity of 10years or more are eligibleThe zeroes created in the process are directobligations of the US government
8282014 97
8112019 FISD-02-A
httpslidepdfcomreaderfullfisd-02-a 98115
The mechanism is as followsA dealer who owns a bond or note can ask theFRB where it is held
To replace it with an equivalent set of STRIPS
representing each payment as a separate securityEach of these securities can be traded independentlyof others
8282014 98
8112019 FISD-02-A
httpslidepdfcomreaderfullfisd-02-a 99115
In 1987 the Treasury started to allow dealersto reverse the process
This is called STRIPS RECONSTUTUTION If a dealer owns STRIPS representing all thecoupon and principal payments of a bond
The FED can on request convert these holdings into asingle position in the corresponding bond
8282014 99
8112019 FISD-02-A
httpslidepdfcomreaderfullfisd-02-a 100115
Each coupon and principal cash flow from aTreasury security is assigned a CUSIP
The mother bond is also assigned a CUSIPThe stripped coupons are known as C-STRIPSThe stripped principal is known as P-STRIPSSupply of a C-STRIP increases over time
because a C-STRIP maturing on a day like 15 FEB
2020 will have the same CUSIP irrespective ofwhich mother bond it has come fromThe original coupon rate is irrelevant
8282014 100
8112019 FISD-02-A
httpslidepdfcomreaderfullfisd-02-a 101115
P-STRIPS always correspond to the originalsecurityThey have a unique CUSIPTheir supply is fixed at the time of issuanceIn practice the prices of long-dated P-STRIPSare a bit higher than those of C-STRIPS withthe same maturity date
One reason is that P-STRIPS are more liquid due
to greater availabilityA $100 face value bond with a coupon of 8 willgenerate C-STRIPS with a face value of $4 but P-STRIPS with a face value of $100
8282014 101
8112019 FISD-02-A
httpslidepdfcomreaderfullfisd-02-a 102115
Another reason why P-STRIPS are in higherdemand is that they allow reconstitutionactivities more easily
Assume that the sum of the STRIPS is cheaper than
the mother bondIf a dealer already has the P-STRIPS only the C-STRIPSneed to be acquiredHowever if he owns some of the C-STRIPS he needs toacquire the P-STRIPS and the remaining C-STRIPSThe facility to reconstitute when profitable is pricedinto the P-STRIPSNote Buy and hold investors will prefer C-STRIPSsince they are priced lower and give a higher yield
8282014 102
8112019 FISD-02-A
httpslidepdfcomreaderfullfisd-02-a 103115
For Plain Vanilla bonds the specifiedcoupon rate is valid for the life of thebond
In the case of Floaters the rate is reset atthe beginning of every periodThe rate will vary directly with thebenchmark
8282014 103
8112019 FISD-02-A
httpslidepdfcomreaderfullfisd-02-a 104115
The rate on a Floater is specified as LIBOR+ 50 bp
The spread is positiveIf it were specified as LIBOR ndash 30bp
The spread will be negativeIf LIBOR rises the rate will increasewhereas if LIBOR falls it will decrease
8282014 104
8112019 FISD-02-A
httpslidepdfcomreaderfullfisd-02-a 105115
In the case of a default risk-free floater theprice will reset to par on a coupon date
It may sell at a premium or discount betweencoupon dates
Consider a floater with a coupon = 5-year T-Bond rate
Assume there are two periods left to maturity
8282014 105
8112019 FISD-02-A
httpslidepdfcomreaderfullfisd-02-a 106115
8282014 106
The price at the end of the first coupon period willbe given by
cT-1 is the coupon one period before maturityyT-1 is the YTM one period before maturity
8112019 FISD-02-A
httpslidepdfcomreaderfullfisd-02-a 107115
On a coupon reset date the YTM = couponBecause we have assumed there is no default riskAny change in the required yield as reflected inthe prevailing YTM
Will also be reflected in the coupon being setIf coupon = yield the bond should sell at par
Thus P T-1 = M
8282014 107
8112019 FISD-02-A
httpslidepdfcomreaderfullfisd-02-a 108115
8282014 108
8112019 FISD-02-A
httpslidepdfcomreaderfullfisd-02-a 109115
Once again at T-2 c T-2 = yT-2 and P T-2 = MThis logic can be applied to a bond with anytime remaining till maturityHowever between two coupon dates theprice may not be equal to par
Consider the valuation at T-2+k
8282014 109
8112019 FISD-02-A
httpslidepdfcomreaderfullfisd-02-a 110115
8282014 110
8112019 FISD-02-A
httpslidepdfcomreaderfullfisd-02-a 111115
Although c T-2 was set at T-2 and is equal toyT-2
yT-2+k is determined at T-2+k and will reflect theyield prevailing at that time
Thus yT-2+k need not equal c T-2 and may behigher or lower
Hence between two coupon dates a floater maysell at a premium or discount
8282014 111
8112019 FISD-02-A
httpslidepdfcomreaderfullfisd-02-a 112115
Now consider a floater characterized bydefault risk
The risk premium required by the market neednot be constant over time
Assume that at the time of issue YTM = 5-year T-note rate + 75bp
The coupon would have been set equal to thisrate and the bond would have been issued at par
8282014 112
8112019 FISD-02-A
httpslidepdfcomreaderfullfisd-02-a 113115
Six months hence the issue may be perceivedas more risky
YTM = 5-year T-note rate + 95 bpThe coupon will however be set equal to theprevailing 5-year rate + 75 bpIf so the issue will not reset to par at the nextcoupon date
8282014 113
8112019 FISD-02-A
httpslidepdfcomreaderfullfisd-02-a 114115
Floaters may come with a CAP or a FLOOR orBOTH
The CAP is a maximum coupon rateProtects issuers against rising rates
The FLOOR is a minimum coupon rateProtects investors against falling rates
When there is a spread over LIBORThere is a natural floorLIBOR cannot be less than zero
8282014 114
8112019 FISD-02-A
httpslidepdfcomreaderfullfisd-02-a 115115
8112019 FISD-02-A
httpslidepdfcomreaderfullfisd-02-a 97115
The Treasury launched this program in 1985to facilitate the stripping of designatedsecurities
All new T-bonds and notes with a maturity of 10years or more are eligibleThe zeroes created in the process are directobligations of the US government
8282014 97
8112019 FISD-02-A
httpslidepdfcomreaderfullfisd-02-a 98115
The mechanism is as followsA dealer who owns a bond or note can ask theFRB where it is held
To replace it with an equivalent set of STRIPS
representing each payment as a separate securityEach of these securities can be traded independentlyof others
8282014 98
8112019 FISD-02-A
httpslidepdfcomreaderfullfisd-02-a 99115
In 1987 the Treasury started to allow dealersto reverse the process
This is called STRIPS RECONSTUTUTION If a dealer owns STRIPS representing all thecoupon and principal payments of a bond
The FED can on request convert these holdings into asingle position in the corresponding bond
8282014 99
8112019 FISD-02-A
httpslidepdfcomreaderfullfisd-02-a 100115
Each coupon and principal cash flow from aTreasury security is assigned a CUSIP
The mother bond is also assigned a CUSIPThe stripped coupons are known as C-STRIPSThe stripped principal is known as P-STRIPSSupply of a C-STRIP increases over time
because a C-STRIP maturing on a day like 15 FEB
2020 will have the same CUSIP irrespective ofwhich mother bond it has come fromThe original coupon rate is irrelevant
8282014 100
8112019 FISD-02-A
httpslidepdfcomreaderfullfisd-02-a 101115
P-STRIPS always correspond to the originalsecurityThey have a unique CUSIPTheir supply is fixed at the time of issuanceIn practice the prices of long-dated P-STRIPSare a bit higher than those of C-STRIPS withthe same maturity date
One reason is that P-STRIPS are more liquid due
to greater availabilityA $100 face value bond with a coupon of 8 willgenerate C-STRIPS with a face value of $4 but P-STRIPS with a face value of $100
8282014 101
8112019 FISD-02-A
httpslidepdfcomreaderfullfisd-02-a 102115
Another reason why P-STRIPS are in higherdemand is that they allow reconstitutionactivities more easily
Assume that the sum of the STRIPS is cheaper than
the mother bondIf a dealer already has the P-STRIPS only the C-STRIPSneed to be acquiredHowever if he owns some of the C-STRIPS he needs toacquire the P-STRIPS and the remaining C-STRIPSThe facility to reconstitute when profitable is pricedinto the P-STRIPSNote Buy and hold investors will prefer C-STRIPSsince they are priced lower and give a higher yield
8282014 102
8112019 FISD-02-A
httpslidepdfcomreaderfullfisd-02-a 103115
For Plain Vanilla bonds the specifiedcoupon rate is valid for the life of thebond
In the case of Floaters the rate is reset atthe beginning of every periodThe rate will vary directly with thebenchmark
8282014 103
8112019 FISD-02-A
httpslidepdfcomreaderfullfisd-02-a 104115
The rate on a Floater is specified as LIBOR+ 50 bp
The spread is positiveIf it were specified as LIBOR ndash 30bp
The spread will be negativeIf LIBOR rises the rate will increasewhereas if LIBOR falls it will decrease
8282014 104
8112019 FISD-02-A
httpslidepdfcomreaderfullfisd-02-a 105115
In the case of a default risk-free floater theprice will reset to par on a coupon date
It may sell at a premium or discount betweencoupon dates
Consider a floater with a coupon = 5-year T-Bond rate
Assume there are two periods left to maturity
8282014 105
8112019 FISD-02-A
httpslidepdfcomreaderfullfisd-02-a 106115
8282014 106
The price at the end of the first coupon period willbe given by
cT-1 is the coupon one period before maturityyT-1 is the YTM one period before maturity
8112019 FISD-02-A
httpslidepdfcomreaderfullfisd-02-a 107115
On a coupon reset date the YTM = couponBecause we have assumed there is no default riskAny change in the required yield as reflected inthe prevailing YTM
Will also be reflected in the coupon being setIf coupon = yield the bond should sell at par
Thus P T-1 = M
8282014 107
8112019 FISD-02-A
httpslidepdfcomreaderfullfisd-02-a 108115
8282014 108
8112019 FISD-02-A
httpslidepdfcomreaderfullfisd-02-a 109115
Once again at T-2 c T-2 = yT-2 and P T-2 = MThis logic can be applied to a bond with anytime remaining till maturityHowever between two coupon dates theprice may not be equal to par
Consider the valuation at T-2+k
8282014 109
8112019 FISD-02-A
httpslidepdfcomreaderfullfisd-02-a 110115
8282014 110
8112019 FISD-02-A
httpslidepdfcomreaderfullfisd-02-a 111115
Although c T-2 was set at T-2 and is equal toyT-2
yT-2+k is determined at T-2+k and will reflect theyield prevailing at that time
Thus yT-2+k need not equal c T-2 and may behigher or lower
Hence between two coupon dates a floater maysell at a premium or discount
8282014 111
8112019 FISD-02-A
httpslidepdfcomreaderfullfisd-02-a 112115
Now consider a floater characterized bydefault risk
The risk premium required by the market neednot be constant over time
Assume that at the time of issue YTM = 5-year T-note rate + 75bp
The coupon would have been set equal to thisrate and the bond would have been issued at par
8282014 112
8112019 FISD-02-A
httpslidepdfcomreaderfullfisd-02-a 113115
Six months hence the issue may be perceivedas more risky
YTM = 5-year T-note rate + 95 bpThe coupon will however be set equal to theprevailing 5-year rate + 75 bpIf so the issue will not reset to par at the nextcoupon date
8282014 113
8112019 FISD-02-A
httpslidepdfcomreaderfullfisd-02-a 114115
Floaters may come with a CAP or a FLOOR orBOTH
The CAP is a maximum coupon rateProtects issuers against rising rates
The FLOOR is a minimum coupon rateProtects investors against falling rates
When there is a spread over LIBORThere is a natural floorLIBOR cannot be less than zero
8282014 114
8112019 FISD-02-A
httpslidepdfcomreaderfullfisd-02-a 115115
8112019 FISD-02-A
httpslidepdfcomreaderfullfisd-02-a 98115
The mechanism is as followsA dealer who owns a bond or note can ask theFRB where it is held
To replace it with an equivalent set of STRIPS
representing each payment as a separate securityEach of these securities can be traded independentlyof others
8282014 98
8112019 FISD-02-A
httpslidepdfcomreaderfullfisd-02-a 99115
In 1987 the Treasury started to allow dealersto reverse the process
This is called STRIPS RECONSTUTUTION If a dealer owns STRIPS representing all thecoupon and principal payments of a bond
The FED can on request convert these holdings into asingle position in the corresponding bond
8282014 99
8112019 FISD-02-A
httpslidepdfcomreaderfullfisd-02-a 100115
Each coupon and principal cash flow from aTreasury security is assigned a CUSIP
The mother bond is also assigned a CUSIPThe stripped coupons are known as C-STRIPSThe stripped principal is known as P-STRIPSSupply of a C-STRIP increases over time
because a C-STRIP maturing on a day like 15 FEB
2020 will have the same CUSIP irrespective ofwhich mother bond it has come fromThe original coupon rate is irrelevant
8282014 100
8112019 FISD-02-A
httpslidepdfcomreaderfullfisd-02-a 101115
P-STRIPS always correspond to the originalsecurityThey have a unique CUSIPTheir supply is fixed at the time of issuanceIn practice the prices of long-dated P-STRIPSare a bit higher than those of C-STRIPS withthe same maturity date
One reason is that P-STRIPS are more liquid due
to greater availabilityA $100 face value bond with a coupon of 8 willgenerate C-STRIPS with a face value of $4 but P-STRIPS with a face value of $100
8282014 101
8112019 FISD-02-A
httpslidepdfcomreaderfullfisd-02-a 102115
Another reason why P-STRIPS are in higherdemand is that they allow reconstitutionactivities more easily
Assume that the sum of the STRIPS is cheaper than
the mother bondIf a dealer already has the P-STRIPS only the C-STRIPSneed to be acquiredHowever if he owns some of the C-STRIPS he needs toacquire the P-STRIPS and the remaining C-STRIPSThe facility to reconstitute when profitable is pricedinto the P-STRIPSNote Buy and hold investors will prefer C-STRIPSsince they are priced lower and give a higher yield
8282014 102
8112019 FISD-02-A
httpslidepdfcomreaderfullfisd-02-a 103115
For Plain Vanilla bonds the specifiedcoupon rate is valid for the life of thebond
In the case of Floaters the rate is reset atthe beginning of every periodThe rate will vary directly with thebenchmark
8282014 103
8112019 FISD-02-A
httpslidepdfcomreaderfullfisd-02-a 104115
The rate on a Floater is specified as LIBOR+ 50 bp
The spread is positiveIf it were specified as LIBOR ndash 30bp
The spread will be negativeIf LIBOR rises the rate will increasewhereas if LIBOR falls it will decrease
8282014 104
8112019 FISD-02-A
httpslidepdfcomreaderfullfisd-02-a 105115
In the case of a default risk-free floater theprice will reset to par on a coupon date
It may sell at a premium or discount betweencoupon dates
Consider a floater with a coupon = 5-year T-Bond rate
Assume there are two periods left to maturity
8282014 105
8112019 FISD-02-A
httpslidepdfcomreaderfullfisd-02-a 106115
8282014 106
The price at the end of the first coupon period willbe given by
cT-1 is the coupon one period before maturityyT-1 is the YTM one period before maturity
8112019 FISD-02-A
httpslidepdfcomreaderfullfisd-02-a 107115
On a coupon reset date the YTM = couponBecause we have assumed there is no default riskAny change in the required yield as reflected inthe prevailing YTM
Will also be reflected in the coupon being setIf coupon = yield the bond should sell at par
Thus P T-1 = M
8282014 107
8112019 FISD-02-A
httpslidepdfcomreaderfullfisd-02-a 108115
8282014 108
8112019 FISD-02-A
httpslidepdfcomreaderfullfisd-02-a 109115
Once again at T-2 c T-2 = yT-2 and P T-2 = MThis logic can be applied to a bond with anytime remaining till maturityHowever between two coupon dates theprice may not be equal to par
Consider the valuation at T-2+k
8282014 109
8112019 FISD-02-A
httpslidepdfcomreaderfullfisd-02-a 110115
8282014 110
8112019 FISD-02-A
httpslidepdfcomreaderfullfisd-02-a 111115
Although c T-2 was set at T-2 and is equal toyT-2
yT-2+k is determined at T-2+k and will reflect theyield prevailing at that time
Thus yT-2+k need not equal c T-2 and may behigher or lower
Hence between two coupon dates a floater maysell at a premium or discount
8282014 111
8112019 FISD-02-A
httpslidepdfcomreaderfullfisd-02-a 112115
Now consider a floater characterized bydefault risk
The risk premium required by the market neednot be constant over time
Assume that at the time of issue YTM = 5-year T-note rate + 75bp
The coupon would have been set equal to thisrate and the bond would have been issued at par
8282014 112
8112019 FISD-02-A
httpslidepdfcomreaderfullfisd-02-a 113115
Six months hence the issue may be perceivedas more risky
YTM = 5-year T-note rate + 95 bpThe coupon will however be set equal to theprevailing 5-year rate + 75 bpIf so the issue will not reset to par at the nextcoupon date
8282014 113
8112019 FISD-02-A
httpslidepdfcomreaderfullfisd-02-a 114115
Floaters may come with a CAP or a FLOOR orBOTH
The CAP is a maximum coupon rateProtects issuers against rising rates
The FLOOR is a minimum coupon rateProtects investors against falling rates
When there is a spread over LIBORThere is a natural floorLIBOR cannot be less than zero
8282014 114
8112019 FISD-02-A
httpslidepdfcomreaderfullfisd-02-a 115115
8112019 FISD-02-A
httpslidepdfcomreaderfullfisd-02-a 99115
In 1987 the Treasury started to allow dealersto reverse the process
This is called STRIPS RECONSTUTUTION If a dealer owns STRIPS representing all thecoupon and principal payments of a bond
The FED can on request convert these holdings into asingle position in the corresponding bond
8282014 99
8112019 FISD-02-A
httpslidepdfcomreaderfullfisd-02-a 100115
Each coupon and principal cash flow from aTreasury security is assigned a CUSIP
The mother bond is also assigned a CUSIPThe stripped coupons are known as C-STRIPSThe stripped principal is known as P-STRIPSSupply of a C-STRIP increases over time
because a C-STRIP maturing on a day like 15 FEB
2020 will have the same CUSIP irrespective ofwhich mother bond it has come fromThe original coupon rate is irrelevant
8282014 100
8112019 FISD-02-A
httpslidepdfcomreaderfullfisd-02-a 101115
P-STRIPS always correspond to the originalsecurityThey have a unique CUSIPTheir supply is fixed at the time of issuanceIn practice the prices of long-dated P-STRIPSare a bit higher than those of C-STRIPS withthe same maturity date
One reason is that P-STRIPS are more liquid due
to greater availabilityA $100 face value bond with a coupon of 8 willgenerate C-STRIPS with a face value of $4 but P-STRIPS with a face value of $100
8282014 101
8112019 FISD-02-A
httpslidepdfcomreaderfullfisd-02-a 102115
Another reason why P-STRIPS are in higherdemand is that they allow reconstitutionactivities more easily
Assume that the sum of the STRIPS is cheaper than
the mother bondIf a dealer already has the P-STRIPS only the C-STRIPSneed to be acquiredHowever if he owns some of the C-STRIPS he needs toacquire the P-STRIPS and the remaining C-STRIPSThe facility to reconstitute when profitable is pricedinto the P-STRIPSNote Buy and hold investors will prefer C-STRIPSsince they are priced lower and give a higher yield
8282014 102
8112019 FISD-02-A
httpslidepdfcomreaderfullfisd-02-a 103115
For Plain Vanilla bonds the specifiedcoupon rate is valid for the life of thebond
In the case of Floaters the rate is reset atthe beginning of every periodThe rate will vary directly with thebenchmark
8282014 103
8112019 FISD-02-A
httpslidepdfcomreaderfullfisd-02-a 104115
The rate on a Floater is specified as LIBOR+ 50 bp
The spread is positiveIf it were specified as LIBOR ndash 30bp
The spread will be negativeIf LIBOR rises the rate will increasewhereas if LIBOR falls it will decrease
8282014 104
8112019 FISD-02-A
httpslidepdfcomreaderfullfisd-02-a 105115
In the case of a default risk-free floater theprice will reset to par on a coupon date
It may sell at a premium or discount betweencoupon dates
Consider a floater with a coupon = 5-year T-Bond rate
Assume there are two periods left to maturity
8282014 105
8112019 FISD-02-A
httpslidepdfcomreaderfullfisd-02-a 106115
8282014 106
The price at the end of the first coupon period willbe given by
cT-1 is the coupon one period before maturityyT-1 is the YTM one period before maturity
8112019 FISD-02-A
httpslidepdfcomreaderfullfisd-02-a 107115
On a coupon reset date the YTM = couponBecause we have assumed there is no default riskAny change in the required yield as reflected inthe prevailing YTM
Will also be reflected in the coupon being setIf coupon = yield the bond should sell at par
Thus P T-1 = M
8282014 107
8112019 FISD-02-A
httpslidepdfcomreaderfullfisd-02-a 108115
8282014 108
8112019 FISD-02-A
httpslidepdfcomreaderfullfisd-02-a 109115
Once again at T-2 c T-2 = yT-2 and P T-2 = MThis logic can be applied to a bond with anytime remaining till maturityHowever between two coupon dates theprice may not be equal to par
Consider the valuation at T-2+k
8282014 109
8112019 FISD-02-A
httpslidepdfcomreaderfullfisd-02-a 110115
8282014 110
8112019 FISD-02-A
httpslidepdfcomreaderfullfisd-02-a 111115
Although c T-2 was set at T-2 and is equal toyT-2
yT-2+k is determined at T-2+k and will reflect theyield prevailing at that time
Thus yT-2+k need not equal c T-2 and may behigher or lower
Hence between two coupon dates a floater maysell at a premium or discount
8282014 111
8112019 FISD-02-A
httpslidepdfcomreaderfullfisd-02-a 112115
Now consider a floater characterized bydefault risk
The risk premium required by the market neednot be constant over time
Assume that at the time of issue YTM = 5-year T-note rate + 75bp
The coupon would have been set equal to thisrate and the bond would have been issued at par
8282014 112
8112019 FISD-02-A
httpslidepdfcomreaderfullfisd-02-a 113115
Six months hence the issue may be perceivedas more risky
YTM = 5-year T-note rate + 95 bpThe coupon will however be set equal to theprevailing 5-year rate + 75 bpIf so the issue will not reset to par at the nextcoupon date
8282014 113
8112019 FISD-02-A
httpslidepdfcomreaderfullfisd-02-a 114115
Floaters may come with a CAP or a FLOOR orBOTH
The CAP is a maximum coupon rateProtects issuers against rising rates
The FLOOR is a minimum coupon rateProtects investors against falling rates
When there is a spread over LIBORThere is a natural floorLIBOR cannot be less than zero
8282014 114
8112019 FISD-02-A
httpslidepdfcomreaderfullfisd-02-a 115115
8112019 FISD-02-A
httpslidepdfcomreaderfullfisd-02-a 100115
Each coupon and principal cash flow from aTreasury security is assigned a CUSIP
The mother bond is also assigned a CUSIPThe stripped coupons are known as C-STRIPSThe stripped principal is known as P-STRIPSSupply of a C-STRIP increases over time
because a C-STRIP maturing on a day like 15 FEB
2020 will have the same CUSIP irrespective ofwhich mother bond it has come fromThe original coupon rate is irrelevant
8282014 100
8112019 FISD-02-A
httpslidepdfcomreaderfullfisd-02-a 101115
P-STRIPS always correspond to the originalsecurityThey have a unique CUSIPTheir supply is fixed at the time of issuanceIn practice the prices of long-dated P-STRIPSare a bit higher than those of C-STRIPS withthe same maturity date
One reason is that P-STRIPS are more liquid due
to greater availabilityA $100 face value bond with a coupon of 8 willgenerate C-STRIPS with a face value of $4 but P-STRIPS with a face value of $100
8282014 101
8112019 FISD-02-A
httpslidepdfcomreaderfullfisd-02-a 102115
Another reason why P-STRIPS are in higherdemand is that they allow reconstitutionactivities more easily
Assume that the sum of the STRIPS is cheaper than
the mother bondIf a dealer already has the P-STRIPS only the C-STRIPSneed to be acquiredHowever if he owns some of the C-STRIPS he needs toacquire the P-STRIPS and the remaining C-STRIPSThe facility to reconstitute when profitable is pricedinto the P-STRIPSNote Buy and hold investors will prefer C-STRIPSsince they are priced lower and give a higher yield
8282014 102
8112019 FISD-02-A
httpslidepdfcomreaderfullfisd-02-a 103115
For Plain Vanilla bonds the specifiedcoupon rate is valid for the life of thebond
In the case of Floaters the rate is reset atthe beginning of every periodThe rate will vary directly with thebenchmark
8282014 103
8112019 FISD-02-A
httpslidepdfcomreaderfullfisd-02-a 104115
The rate on a Floater is specified as LIBOR+ 50 bp
The spread is positiveIf it were specified as LIBOR ndash 30bp
The spread will be negativeIf LIBOR rises the rate will increasewhereas if LIBOR falls it will decrease
8282014 104
8112019 FISD-02-A
httpslidepdfcomreaderfullfisd-02-a 105115
In the case of a default risk-free floater theprice will reset to par on a coupon date
It may sell at a premium or discount betweencoupon dates
Consider a floater with a coupon = 5-year T-Bond rate
Assume there are two periods left to maturity
8282014 105
8112019 FISD-02-A
httpslidepdfcomreaderfullfisd-02-a 106115
8282014 106
The price at the end of the first coupon period willbe given by
cT-1 is the coupon one period before maturityyT-1 is the YTM one period before maturity
8112019 FISD-02-A
httpslidepdfcomreaderfullfisd-02-a 107115
On a coupon reset date the YTM = couponBecause we have assumed there is no default riskAny change in the required yield as reflected inthe prevailing YTM
Will also be reflected in the coupon being setIf coupon = yield the bond should sell at par
Thus P T-1 = M
8282014 107
8112019 FISD-02-A
httpslidepdfcomreaderfullfisd-02-a 108115
8282014 108
8112019 FISD-02-A
httpslidepdfcomreaderfullfisd-02-a 109115
Once again at T-2 c T-2 = yT-2 and P T-2 = MThis logic can be applied to a bond with anytime remaining till maturityHowever between two coupon dates theprice may not be equal to par
Consider the valuation at T-2+k
8282014 109
8112019 FISD-02-A
httpslidepdfcomreaderfullfisd-02-a 110115
8282014 110
8112019 FISD-02-A
httpslidepdfcomreaderfullfisd-02-a 111115
Although c T-2 was set at T-2 and is equal toyT-2
yT-2+k is determined at T-2+k and will reflect theyield prevailing at that time
Thus yT-2+k need not equal c T-2 and may behigher or lower
Hence between two coupon dates a floater maysell at a premium or discount
8282014 111
8112019 FISD-02-A
httpslidepdfcomreaderfullfisd-02-a 112115
Now consider a floater characterized bydefault risk
The risk premium required by the market neednot be constant over time
Assume that at the time of issue YTM = 5-year T-note rate + 75bp
The coupon would have been set equal to thisrate and the bond would have been issued at par
8282014 112
8112019 FISD-02-A
httpslidepdfcomreaderfullfisd-02-a 113115
Six months hence the issue may be perceivedas more risky
YTM = 5-year T-note rate + 95 bpThe coupon will however be set equal to theprevailing 5-year rate + 75 bpIf so the issue will not reset to par at the nextcoupon date
8282014 113
8112019 FISD-02-A
httpslidepdfcomreaderfullfisd-02-a 114115
Floaters may come with a CAP or a FLOOR orBOTH
The CAP is a maximum coupon rateProtects issuers against rising rates
The FLOOR is a minimum coupon rateProtects investors against falling rates
When there is a spread over LIBORThere is a natural floorLIBOR cannot be less than zero
8282014 114
8112019 FISD-02-A
httpslidepdfcomreaderfullfisd-02-a 115115
8112019 FISD-02-A
httpslidepdfcomreaderfullfisd-02-a 101115
P-STRIPS always correspond to the originalsecurityThey have a unique CUSIPTheir supply is fixed at the time of issuanceIn practice the prices of long-dated P-STRIPSare a bit higher than those of C-STRIPS withthe same maturity date
One reason is that P-STRIPS are more liquid due
to greater availabilityA $100 face value bond with a coupon of 8 willgenerate C-STRIPS with a face value of $4 but P-STRIPS with a face value of $100
8282014 101
8112019 FISD-02-A
httpslidepdfcomreaderfullfisd-02-a 102115
Another reason why P-STRIPS are in higherdemand is that they allow reconstitutionactivities more easily
Assume that the sum of the STRIPS is cheaper than
the mother bondIf a dealer already has the P-STRIPS only the C-STRIPSneed to be acquiredHowever if he owns some of the C-STRIPS he needs toacquire the P-STRIPS and the remaining C-STRIPSThe facility to reconstitute when profitable is pricedinto the P-STRIPSNote Buy and hold investors will prefer C-STRIPSsince they are priced lower and give a higher yield
8282014 102
8112019 FISD-02-A
httpslidepdfcomreaderfullfisd-02-a 103115
For Plain Vanilla bonds the specifiedcoupon rate is valid for the life of thebond
In the case of Floaters the rate is reset atthe beginning of every periodThe rate will vary directly with thebenchmark
8282014 103
8112019 FISD-02-A
httpslidepdfcomreaderfullfisd-02-a 104115
The rate on a Floater is specified as LIBOR+ 50 bp
The spread is positiveIf it were specified as LIBOR ndash 30bp
The spread will be negativeIf LIBOR rises the rate will increasewhereas if LIBOR falls it will decrease
8282014 104
8112019 FISD-02-A
httpslidepdfcomreaderfullfisd-02-a 105115
In the case of a default risk-free floater theprice will reset to par on a coupon date
It may sell at a premium or discount betweencoupon dates
Consider a floater with a coupon = 5-year T-Bond rate
Assume there are two periods left to maturity
8282014 105
8112019 FISD-02-A
httpslidepdfcomreaderfullfisd-02-a 106115
8282014 106
The price at the end of the first coupon period willbe given by
cT-1 is the coupon one period before maturityyT-1 is the YTM one period before maturity
8112019 FISD-02-A
httpslidepdfcomreaderfullfisd-02-a 107115
On a coupon reset date the YTM = couponBecause we have assumed there is no default riskAny change in the required yield as reflected inthe prevailing YTM
Will also be reflected in the coupon being setIf coupon = yield the bond should sell at par
Thus P T-1 = M
8282014 107
8112019 FISD-02-A
httpslidepdfcomreaderfullfisd-02-a 108115
8282014 108
8112019 FISD-02-A
httpslidepdfcomreaderfullfisd-02-a 109115
Once again at T-2 c T-2 = yT-2 and P T-2 = MThis logic can be applied to a bond with anytime remaining till maturityHowever between two coupon dates theprice may not be equal to par
Consider the valuation at T-2+k
8282014 109
8112019 FISD-02-A
httpslidepdfcomreaderfullfisd-02-a 110115
8282014 110
8112019 FISD-02-A
httpslidepdfcomreaderfullfisd-02-a 111115
Although c T-2 was set at T-2 and is equal toyT-2
yT-2+k is determined at T-2+k and will reflect theyield prevailing at that time
Thus yT-2+k need not equal c T-2 and may behigher or lower
Hence between two coupon dates a floater maysell at a premium or discount
8282014 111
8112019 FISD-02-A
httpslidepdfcomreaderfullfisd-02-a 112115
Now consider a floater characterized bydefault risk
The risk premium required by the market neednot be constant over time
Assume that at the time of issue YTM = 5-year T-note rate + 75bp
The coupon would have been set equal to thisrate and the bond would have been issued at par
8282014 112
8112019 FISD-02-A
httpslidepdfcomreaderfullfisd-02-a 113115
Six months hence the issue may be perceivedas more risky
YTM = 5-year T-note rate + 95 bpThe coupon will however be set equal to theprevailing 5-year rate + 75 bpIf so the issue will not reset to par at the nextcoupon date
8282014 113
8112019 FISD-02-A
httpslidepdfcomreaderfullfisd-02-a 114115
Floaters may come with a CAP or a FLOOR orBOTH
The CAP is a maximum coupon rateProtects issuers against rising rates
The FLOOR is a minimum coupon rateProtects investors against falling rates
When there is a spread over LIBORThere is a natural floorLIBOR cannot be less than zero
8282014 114
8112019 FISD-02-A
httpslidepdfcomreaderfullfisd-02-a 115115
8112019 FISD-02-A
httpslidepdfcomreaderfullfisd-02-a 102115
Another reason why P-STRIPS are in higherdemand is that they allow reconstitutionactivities more easily
Assume that the sum of the STRIPS is cheaper than
the mother bondIf a dealer already has the P-STRIPS only the C-STRIPSneed to be acquiredHowever if he owns some of the C-STRIPS he needs toacquire the P-STRIPS and the remaining C-STRIPSThe facility to reconstitute when profitable is pricedinto the P-STRIPSNote Buy and hold investors will prefer C-STRIPSsince they are priced lower and give a higher yield
8282014 102
8112019 FISD-02-A
httpslidepdfcomreaderfullfisd-02-a 103115
For Plain Vanilla bonds the specifiedcoupon rate is valid for the life of thebond
In the case of Floaters the rate is reset atthe beginning of every periodThe rate will vary directly with thebenchmark
8282014 103
8112019 FISD-02-A
httpslidepdfcomreaderfullfisd-02-a 104115
The rate on a Floater is specified as LIBOR+ 50 bp
The spread is positiveIf it were specified as LIBOR ndash 30bp
The spread will be negativeIf LIBOR rises the rate will increasewhereas if LIBOR falls it will decrease
8282014 104
8112019 FISD-02-A
httpslidepdfcomreaderfullfisd-02-a 105115
In the case of a default risk-free floater theprice will reset to par on a coupon date
It may sell at a premium or discount betweencoupon dates
Consider a floater with a coupon = 5-year T-Bond rate
Assume there are two periods left to maturity
8282014 105
8112019 FISD-02-A
httpslidepdfcomreaderfullfisd-02-a 106115
8282014 106
The price at the end of the first coupon period willbe given by
cT-1 is the coupon one period before maturityyT-1 is the YTM one period before maturity
8112019 FISD-02-A
httpslidepdfcomreaderfullfisd-02-a 107115
On a coupon reset date the YTM = couponBecause we have assumed there is no default riskAny change in the required yield as reflected inthe prevailing YTM
Will also be reflected in the coupon being setIf coupon = yield the bond should sell at par
Thus P T-1 = M
8282014 107
8112019 FISD-02-A
httpslidepdfcomreaderfullfisd-02-a 108115
8282014 108
8112019 FISD-02-A
httpslidepdfcomreaderfullfisd-02-a 109115
Once again at T-2 c T-2 = yT-2 and P T-2 = MThis logic can be applied to a bond with anytime remaining till maturityHowever between two coupon dates theprice may not be equal to par
Consider the valuation at T-2+k
8282014 109
8112019 FISD-02-A
httpslidepdfcomreaderfullfisd-02-a 110115
8282014 110
8112019 FISD-02-A
httpslidepdfcomreaderfullfisd-02-a 111115
Although c T-2 was set at T-2 and is equal toyT-2
yT-2+k is determined at T-2+k and will reflect theyield prevailing at that time
Thus yT-2+k need not equal c T-2 and may behigher or lower
Hence between two coupon dates a floater maysell at a premium or discount
8282014 111
8112019 FISD-02-A
httpslidepdfcomreaderfullfisd-02-a 112115
Now consider a floater characterized bydefault risk
The risk premium required by the market neednot be constant over time
Assume that at the time of issue YTM = 5-year T-note rate + 75bp
The coupon would have been set equal to thisrate and the bond would have been issued at par
8282014 112
8112019 FISD-02-A
httpslidepdfcomreaderfullfisd-02-a 113115
Six months hence the issue may be perceivedas more risky
YTM = 5-year T-note rate + 95 bpThe coupon will however be set equal to theprevailing 5-year rate + 75 bpIf so the issue will not reset to par at the nextcoupon date
8282014 113
8112019 FISD-02-A
httpslidepdfcomreaderfullfisd-02-a 114115
Floaters may come with a CAP or a FLOOR orBOTH
The CAP is a maximum coupon rateProtects issuers against rising rates
The FLOOR is a minimum coupon rateProtects investors against falling rates
When there is a spread over LIBORThere is a natural floorLIBOR cannot be less than zero
8282014 114
8112019 FISD-02-A
httpslidepdfcomreaderfullfisd-02-a 115115
8112019 FISD-02-A
httpslidepdfcomreaderfullfisd-02-a 103115
For Plain Vanilla bonds the specifiedcoupon rate is valid for the life of thebond
In the case of Floaters the rate is reset atthe beginning of every periodThe rate will vary directly with thebenchmark
8282014 103
8112019 FISD-02-A
httpslidepdfcomreaderfullfisd-02-a 104115
The rate on a Floater is specified as LIBOR+ 50 bp
The spread is positiveIf it were specified as LIBOR ndash 30bp
The spread will be negativeIf LIBOR rises the rate will increasewhereas if LIBOR falls it will decrease
8282014 104
8112019 FISD-02-A
httpslidepdfcomreaderfullfisd-02-a 105115
In the case of a default risk-free floater theprice will reset to par on a coupon date
It may sell at a premium or discount betweencoupon dates
Consider a floater with a coupon = 5-year T-Bond rate
Assume there are two periods left to maturity
8282014 105
8112019 FISD-02-A
httpslidepdfcomreaderfullfisd-02-a 106115
8282014 106
The price at the end of the first coupon period willbe given by
cT-1 is the coupon one period before maturityyT-1 is the YTM one period before maturity
8112019 FISD-02-A
httpslidepdfcomreaderfullfisd-02-a 107115
On a coupon reset date the YTM = couponBecause we have assumed there is no default riskAny change in the required yield as reflected inthe prevailing YTM
Will also be reflected in the coupon being setIf coupon = yield the bond should sell at par
Thus P T-1 = M
8282014 107
8112019 FISD-02-A
httpslidepdfcomreaderfullfisd-02-a 108115
8282014 108
8112019 FISD-02-A
httpslidepdfcomreaderfullfisd-02-a 109115
Once again at T-2 c T-2 = yT-2 and P T-2 = MThis logic can be applied to a bond with anytime remaining till maturityHowever between two coupon dates theprice may not be equal to par
Consider the valuation at T-2+k
8282014 109
8112019 FISD-02-A
httpslidepdfcomreaderfullfisd-02-a 110115
8282014 110
8112019 FISD-02-A
httpslidepdfcomreaderfullfisd-02-a 111115
Although c T-2 was set at T-2 and is equal toyT-2
yT-2+k is determined at T-2+k and will reflect theyield prevailing at that time
Thus yT-2+k need not equal c T-2 and may behigher or lower
Hence between two coupon dates a floater maysell at a premium or discount
8282014 111
8112019 FISD-02-A
httpslidepdfcomreaderfullfisd-02-a 112115
Now consider a floater characterized bydefault risk
The risk premium required by the market neednot be constant over time
Assume that at the time of issue YTM = 5-year T-note rate + 75bp
The coupon would have been set equal to thisrate and the bond would have been issued at par
8282014 112
8112019 FISD-02-A
httpslidepdfcomreaderfullfisd-02-a 113115
Six months hence the issue may be perceivedas more risky
YTM = 5-year T-note rate + 95 bpThe coupon will however be set equal to theprevailing 5-year rate + 75 bpIf so the issue will not reset to par at the nextcoupon date
8282014 113
8112019 FISD-02-A
httpslidepdfcomreaderfullfisd-02-a 114115
Floaters may come with a CAP or a FLOOR orBOTH
The CAP is a maximum coupon rateProtects issuers against rising rates
The FLOOR is a minimum coupon rateProtects investors against falling rates
When there is a spread over LIBORThere is a natural floorLIBOR cannot be less than zero
8282014 114
8112019 FISD-02-A
httpslidepdfcomreaderfullfisd-02-a 115115
8112019 FISD-02-A
httpslidepdfcomreaderfullfisd-02-a 104115
The rate on a Floater is specified as LIBOR+ 50 bp
The spread is positiveIf it were specified as LIBOR ndash 30bp
The spread will be negativeIf LIBOR rises the rate will increasewhereas if LIBOR falls it will decrease
8282014 104
8112019 FISD-02-A
httpslidepdfcomreaderfullfisd-02-a 105115
In the case of a default risk-free floater theprice will reset to par on a coupon date
It may sell at a premium or discount betweencoupon dates
Consider a floater with a coupon = 5-year T-Bond rate
Assume there are two periods left to maturity
8282014 105
8112019 FISD-02-A
httpslidepdfcomreaderfullfisd-02-a 106115
8282014 106
The price at the end of the first coupon period willbe given by
cT-1 is the coupon one period before maturityyT-1 is the YTM one period before maturity
8112019 FISD-02-A
httpslidepdfcomreaderfullfisd-02-a 107115
On a coupon reset date the YTM = couponBecause we have assumed there is no default riskAny change in the required yield as reflected inthe prevailing YTM
Will also be reflected in the coupon being setIf coupon = yield the bond should sell at par
Thus P T-1 = M
8282014 107
8112019 FISD-02-A
httpslidepdfcomreaderfullfisd-02-a 108115
8282014 108
8112019 FISD-02-A
httpslidepdfcomreaderfullfisd-02-a 109115
Once again at T-2 c T-2 = yT-2 and P T-2 = MThis logic can be applied to a bond with anytime remaining till maturityHowever between two coupon dates theprice may not be equal to par
Consider the valuation at T-2+k
8282014 109
8112019 FISD-02-A
httpslidepdfcomreaderfullfisd-02-a 110115
8282014 110
8112019 FISD-02-A
httpslidepdfcomreaderfullfisd-02-a 111115
Although c T-2 was set at T-2 and is equal toyT-2
yT-2+k is determined at T-2+k and will reflect theyield prevailing at that time
Thus yT-2+k need not equal c T-2 and may behigher or lower
Hence between two coupon dates a floater maysell at a premium or discount
8282014 111
8112019 FISD-02-A
httpslidepdfcomreaderfullfisd-02-a 112115
Now consider a floater characterized bydefault risk
The risk premium required by the market neednot be constant over time
Assume that at the time of issue YTM = 5-year T-note rate + 75bp
The coupon would have been set equal to thisrate and the bond would have been issued at par
8282014 112
8112019 FISD-02-A
httpslidepdfcomreaderfullfisd-02-a 113115
Six months hence the issue may be perceivedas more risky
YTM = 5-year T-note rate + 95 bpThe coupon will however be set equal to theprevailing 5-year rate + 75 bpIf so the issue will not reset to par at the nextcoupon date
8282014 113
8112019 FISD-02-A
httpslidepdfcomreaderfullfisd-02-a 114115
Floaters may come with a CAP or a FLOOR orBOTH
The CAP is a maximum coupon rateProtects issuers against rising rates
The FLOOR is a minimum coupon rateProtects investors against falling rates
When there is a spread over LIBORThere is a natural floorLIBOR cannot be less than zero
8282014 114
8112019 FISD-02-A
httpslidepdfcomreaderfullfisd-02-a 115115
8112019 FISD-02-A
httpslidepdfcomreaderfullfisd-02-a 105115
In the case of a default risk-free floater theprice will reset to par on a coupon date
It may sell at a premium or discount betweencoupon dates
Consider a floater with a coupon = 5-year T-Bond rate
Assume there are two periods left to maturity
8282014 105
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httpslidepdfcomreaderfullfisd-02-a 106115
8282014 106
The price at the end of the first coupon period willbe given by
cT-1 is the coupon one period before maturityyT-1 is the YTM one period before maturity
8112019 FISD-02-A
httpslidepdfcomreaderfullfisd-02-a 107115
On a coupon reset date the YTM = couponBecause we have assumed there is no default riskAny change in the required yield as reflected inthe prevailing YTM
Will also be reflected in the coupon being setIf coupon = yield the bond should sell at par
Thus P T-1 = M
8282014 107
8112019 FISD-02-A
httpslidepdfcomreaderfullfisd-02-a 108115
8282014 108
8112019 FISD-02-A
httpslidepdfcomreaderfullfisd-02-a 109115
Once again at T-2 c T-2 = yT-2 and P T-2 = MThis logic can be applied to a bond with anytime remaining till maturityHowever between two coupon dates theprice may not be equal to par
Consider the valuation at T-2+k
8282014 109
8112019 FISD-02-A
httpslidepdfcomreaderfullfisd-02-a 110115
8282014 110
8112019 FISD-02-A
httpslidepdfcomreaderfullfisd-02-a 111115
Although c T-2 was set at T-2 and is equal toyT-2
yT-2+k is determined at T-2+k and will reflect theyield prevailing at that time
Thus yT-2+k need not equal c T-2 and may behigher or lower
Hence between two coupon dates a floater maysell at a premium or discount
8282014 111
8112019 FISD-02-A
httpslidepdfcomreaderfullfisd-02-a 112115
Now consider a floater characterized bydefault risk
The risk premium required by the market neednot be constant over time
Assume that at the time of issue YTM = 5-year T-note rate + 75bp
The coupon would have been set equal to thisrate and the bond would have been issued at par
8282014 112
8112019 FISD-02-A
httpslidepdfcomreaderfullfisd-02-a 113115
Six months hence the issue may be perceivedas more risky
YTM = 5-year T-note rate + 95 bpThe coupon will however be set equal to theprevailing 5-year rate + 75 bpIf so the issue will not reset to par at the nextcoupon date
8282014 113
8112019 FISD-02-A
httpslidepdfcomreaderfullfisd-02-a 114115
Floaters may come with a CAP or a FLOOR orBOTH
The CAP is a maximum coupon rateProtects issuers against rising rates
The FLOOR is a minimum coupon rateProtects investors against falling rates
When there is a spread over LIBORThere is a natural floorLIBOR cannot be less than zero
8282014 114
8112019 FISD-02-A
httpslidepdfcomreaderfullfisd-02-a 115115
8112019 FISD-02-A
httpslidepdfcomreaderfullfisd-02-a 106115
8282014 106
The price at the end of the first coupon period willbe given by
cT-1 is the coupon one period before maturityyT-1 is the YTM one period before maturity
8112019 FISD-02-A
httpslidepdfcomreaderfullfisd-02-a 107115
On a coupon reset date the YTM = couponBecause we have assumed there is no default riskAny change in the required yield as reflected inthe prevailing YTM
Will also be reflected in the coupon being setIf coupon = yield the bond should sell at par
Thus P T-1 = M
8282014 107
8112019 FISD-02-A
httpslidepdfcomreaderfullfisd-02-a 108115
8282014 108
8112019 FISD-02-A
httpslidepdfcomreaderfullfisd-02-a 109115
Once again at T-2 c T-2 = yT-2 and P T-2 = MThis logic can be applied to a bond with anytime remaining till maturityHowever between two coupon dates theprice may not be equal to par
Consider the valuation at T-2+k
8282014 109
8112019 FISD-02-A
httpslidepdfcomreaderfullfisd-02-a 110115
8282014 110
8112019 FISD-02-A
httpslidepdfcomreaderfullfisd-02-a 111115
Although c T-2 was set at T-2 and is equal toyT-2
yT-2+k is determined at T-2+k and will reflect theyield prevailing at that time
Thus yT-2+k need not equal c T-2 and may behigher or lower
Hence between two coupon dates a floater maysell at a premium or discount
8282014 111
8112019 FISD-02-A
httpslidepdfcomreaderfullfisd-02-a 112115
Now consider a floater characterized bydefault risk
The risk premium required by the market neednot be constant over time
Assume that at the time of issue YTM = 5-year T-note rate + 75bp
The coupon would have been set equal to thisrate and the bond would have been issued at par
8282014 112
8112019 FISD-02-A
httpslidepdfcomreaderfullfisd-02-a 113115
Six months hence the issue may be perceivedas more risky
YTM = 5-year T-note rate + 95 bpThe coupon will however be set equal to theprevailing 5-year rate + 75 bpIf so the issue will not reset to par at the nextcoupon date
8282014 113
8112019 FISD-02-A
httpslidepdfcomreaderfullfisd-02-a 114115
Floaters may come with a CAP or a FLOOR orBOTH
The CAP is a maximum coupon rateProtects issuers against rising rates
The FLOOR is a minimum coupon rateProtects investors against falling rates
When there is a spread over LIBORThere is a natural floorLIBOR cannot be less than zero
8282014 114
8112019 FISD-02-A
httpslidepdfcomreaderfullfisd-02-a 115115
8112019 FISD-02-A
httpslidepdfcomreaderfullfisd-02-a 107115
On a coupon reset date the YTM = couponBecause we have assumed there is no default riskAny change in the required yield as reflected inthe prevailing YTM
Will also be reflected in the coupon being setIf coupon = yield the bond should sell at par
Thus P T-1 = M
8282014 107
8112019 FISD-02-A
httpslidepdfcomreaderfullfisd-02-a 108115
8282014 108
8112019 FISD-02-A
httpslidepdfcomreaderfullfisd-02-a 109115
Once again at T-2 c T-2 = yT-2 and P T-2 = MThis logic can be applied to a bond with anytime remaining till maturityHowever between two coupon dates theprice may not be equal to par
Consider the valuation at T-2+k
8282014 109
8112019 FISD-02-A
httpslidepdfcomreaderfullfisd-02-a 110115
8282014 110
8112019 FISD-02-A
httpslidepdfcomreaderfullfisd-02-a 111115
Although c T-2 was set at T-2 and is equal toyT-2
yT-2+k is determined at T-2+k and will reflect theyield prevailing at that time
Thus yT-2+k need not equal c T-2 and may behigher or lower
Hence between two coupon dates a floater maysell at a premium or discount
8282014 111
8112019 FISD-02-A
httpslidepdfcomreaderfullfisd-02-a 112115
Now consider a floater characterized bydefault risk
The risk premium required by the market neednot be constant over time
Assume that at the time of issue YTM = 5-year T-note rate + 75bp
The coupon would have been set equal to thisrate and the bond would have been issued at par
8282014 112
8112019 FISD-02-A
httpslidepdfcomreaderfullfisd-02-a 113115
Six months hence the issue may be perceivedas more risky
YTM = 5-year T-note rate + 95 bpThe coupon will however be set equal to theprevailing 5-year rate + 75 bpIf so the issue will not reset to par at the nextcoupon date
8282014 113
8112019 FISD-02-A
httpslidepdfcomreaderfullfisd-02-a 114115
Floaters may come with a CAP or a FLOOR orBOTH
The CAP is a maximum coupon rateProtects issuers against rising rates
The FLOOR is a minimum coupon rateProtects investors against falling rates
When there is a spread over LIBORThere is a natural floorLIBOR cannot be less than zero
8282014 114
8112019 FISD-02-A
httpslidepdfcomreaderfullfisd-02-a 115115
8112019 FISD-02-A
httpslidepdfcomreaderfullfisd-02-a 108115
8282014 108
8112019 FISD-02-A
httpslidepdfcomreaderfullfisd-02-a 109115
Once again at T-2 c T-2 = yT-2 and P T-2 = MThis logic can be applied to a bond with anytime remaining till maturityHowever between two coupon dates theprice may not be equal to par
Consider the valuation at T-2+k
8282014 109
8112019 FISD-02-A
httpslidepdfcomreaderfullfisd-02-a 110115
8282014 110
8112019 FISD-02-A
httpslidepdfcomreaderfullfisd-02-a 111115
Although c T-2 was set at T-2 and is equal toyT-2
yT-2+k is determined at T-2+k and will reflect theyield prevailing at that time
Thus yT-2+k need not equal c T-2 and may behigher or lower
Hence between two coupon dates a floater maysell at a premium or discount
8282014 111
8112019 FISD-02-A
httpslidepdfcomreaderfullfisd-02-a 112115
Now consider a floater characterized bydefault risk
The risk premium required by the market neednot be constant over time
Assume that at the time of issue YTM = 5-year T-note rate + 75bp
The coupon would have been set equal to thisrate and the bond would have been issued at par
8282014 112
8112019 FISD-02-A
httpslidepdfcomreaderfullfisd-02-a 113115
Six months hence the issue may be perceivedas more risky
YTM = 5-year T-note rate + 95 bpThe coupon will however be set equal to theprevailing 5-year rate + 75 bpIf so the issue will not reset to par at the nextcoupon date
8282014 113
8112019 FISD-02-A
httpslidepdfcomreaderfullfisd-02-a 114115
Floaters may come with a CAP or a FLOOR orBOTH
The CAP is a maximum coupon rateProtects issuers against rising rates
The FLOOR is a minimum coupon rateProtects investors against falling rates
When there is a spread over LIBORThere is a natural floorLIBOR cannot be less than zero
8282014 114
8112019 FISD-02-A
httpslidepdfcomreaderfullfisd-02-a 115115
8112019 FISD-02-A
httpslidepdfcomreaderfullfisd-02-a 109115
Once again at T-2 c T-2 = yT-2 and P T-2 = MThis logic can be applied to a bond with anytime remaining till maturityHowever between two coupon dates theprice may not be equal to par
Consider the valuation at T-2+k
8282014 109
8112019 FISD-02-A
httpslidepdfcomreaderfullfisd-02-a 110115
8282014 110
8112019 FISD-02-A
httpslidepdfcomreaderfullfisd-02-a 111115
Although c T-2 was set at T-2 and is equal toyT-2
yT-2+k is determined at T-2+k and will reflect theyield prevailing at that time
Thus yT-2+k need not equal c T-2 and may behigher or lower
Hence between two coupon dates a floater maysell at a premium or discount
8282014 111
8112019 FISD-02-A
httpslidepdfcomreaderfullfisd-02-a 112115
Now consider a floater characterized bydefault risk
The risk premium required by the market neednot be constant over time
Assume that at the time of issue YTM = 5-year T-note rate + 75bp
The coupon would have been set equal to thisrate and the bond would have been issued at par
8282014 112
8112019 FISD-02-A
httpslidepdfcomreaderfullfisd-02-a 113115
Six months hence the issue may be perceivedas more risky
YTM = 5-year T-note rate + 95 bpThe coupon will however be set equal to theprevailing 5-year rate + 75 bpIf so the issue will not reset to par at the nextcoupon date
8282014 113
8112019 FISD-02-A
httpslidepdfcomreaderfullfisd-02-a 114115
Floaters may come with a CAP or a FLOOR orBOTH
The CAP is a maximum coupon rateProtects issuers against rising rates
The FLOOR is a minimum coupon rateProtects investors against falling rates
When there is a spread over LIBORThere is a natural floorLIBOR cannot be less than zero
8282014 114
8112019 FISD-02-A
httpslidepdfcomreaderfullfisd-02-a 115115
8112019 FISD-02-A
httpslidepdfcomreaderfullfisd-02-a 110115
8282014 110
8112019 FISD-02-A
httpslidepdfcomreaderfullfisd-02-a 111115
Although c T-2 was set at T-2 and is equal toyT-2
yT-2+k is determined at T-2+k and will reflect theyield prevailing at that time
Thus yT-2+k need not equal c T-2 and may behigher or lower
Hence between two coupon dates a floater maysell at a premium or discount
8282014 111
8112019 FISD-02-A
httpslidepdfcomreaderfullfisd-02-a 112115
Now consider a floater characterized bydefault risk
The risk premium required by the market neednot be constant over time
Assume that at the time of issue YTM = 5-year T-note rate + 75bp
The coupon would have been set equal to thisrate and the bond would have been issued at par
8282014 112
8112019 FISD-02-A
httpslidepdfcomreaderfullfisd-02-a 113115
Six months hence the issue may be perceivedas more risky
YTM = 5-year T-note rate + 95 bpThe coupon will however be set equal to theprevailing 5-year rate + 75 bpIf so the issue will not reset to par at the nextcoupon date
8282014 113
8112019 FISD-02-A
httpslidepdfcomreaderfullfisd-02-a 114115
Floaters may come with a CAP or a FLOOR orBOTH
The CAP is a maximum coupon rateProtects issuers against rising rates
The FLOOR is a minimum coupon rateProtects investors against falling rates
When there is a spread over LIBORThere is a natural floorLIBOR cannot be less than zero
8282014 114
8112019 FISD-02-A
httpslidepdfcomreaderfullfisd-02-a 115115
8112019 FISD-02-A
httpslidepdfcomreaderfullfisd-02-a 111115
Although c T-2 was set at T-2 and is equal toyT-2
yT-2+k is determined at T-2+k and will reflect theyield prevailing at that time
Thus yT-2+k need not equal c T-2 and may behigher or lower
Hence between two coupon dates a floater maysell at a premium or discount
8282014 111
8112019 FISD-02-A
httpslidepdfcomreaderfullfisd-02-a 112115
Now consider a floater characterized bydefault risk
The risk premium required by the market neednot be constant over time
Assume that at the time of issue YTM = 5-year T-note rate + 75bp
The coupon would have been set equal to thisrate and the bond would have been issued at par
8282014 112
8112019 FISD-02-A
httpslidepdfcomreaderfullfisd-02-a 113115
Six months hence the issue may be perceivedas more risky
YTM = 5-year T-note rate + 95 bpThe coupon will however be set equal to theprevailing 5-year rate + 75 bpIf so the issue will not reset to par at the nextcoupon date
8282014 113
8112019 FISD-02-A
httpslidepdfcomreaderfullfisd-02-a 114115
Floaters may come with a CAP or a FLOOR orBOTH
The CAP is a maximum coupon rateProtects issuers against rising rates
The FLOOR is a minimum coupon rateProtects investors against falling rates
When there is a spread over LIBORThere is a natural floorLIBOR cannot be less than zero
8282014 114
8112019 FISD-02-A
httpslidepdfcomreaderfullfisd-02-a 115115
8112019 FISD-02-A
httpslidepdfcomreaderfullfisd-02-a 112115
Now consider a floater characterized bydefault risk
The risk premium required by the market neednot be constant over time
Assume that at the time of issue YTM = 5-year T-note rate + 75bp
The coupon would have been set equal to thisrate and the bond would have been issued at par
8282014 112
8112019 FISD-02-A
httpslidepdfcomreaderfullfisd-02-a 113115
Six months hence the issue may be perceivedas more risky
YTM = 5-year T-note rate + 95 bpThe coupon will however be set equal to theprevailing 5-year rate + 75 bpIf so the issue will not reset to par at the nextcoupon date
8282014 113
8112019 FISD-02-A
httpslidepdfcomreaderfullfisd-02-a 114115
Floaters may come with a CAP or a FLOOR orBOTH
The CAP is a maximum coupon rateProtects issuers against rising rates
The FLOOR is a minimum coupon rateProtects investors against falling rates
When there is a spread over LIBORThere is a natural floorLIBOR cannot be less than zero
8282014 114
8112019 FISD-02-A
httpslidepdfcomreaderfullfisd-02-a 115115
8112019 FISD-02-A
httpslidepdfcomreaderfullfisd-02-a 113115
Six months hence the issue may be perceivedas more risky
YTM = 5-year T-note rate + 95 bpThe coupon will however be set equal to theprevailing 5-year rate + 75 bpIf so the issue will not reset to par at the nextcoupon date
8282014 113
8112019 FISD-02-A
httpslidepdfcomreaderfullfisd-02-a 114115
Floaters may come with a CAP or a FLOOR orBOTH
The CAP is a maximum coupon rateProtects issuers against rising rates
The FLOOR is a minimum coupon rateProtects investors against falling rates
When there is a spread over LIBORThere is a natural floorLIBOR cannot be less than zero
8282014 114
8112019 FISD-02-A
httpslidepdfcomreaderfullfisd-02-a 115115
8112019 FISD-02-A
httpslidepdfcomreaderfullfisd-02-a 114115
Floaters may come with a CAP or a FLOOR orBOTH
The CAP is a maximum coupon rateProtects issuers against rising rates
The FLOOR is a minimum coupon rateProtects investors against falling rates
When there is a spread over LIBORThere is a natural floorLIBOR cannot be less than zero
8282014 114
8112019 FISD-02-A
httpslidepdfcomreaderfullfisd-02-a 115115
8112019 FISD-02-A
httpslidepdfcomreaderfullfisd-02-a 115115
