Fixed-Income Markets for Corporate Issuers

Fixed Income

Short-Term Funding Alternatives

Learning Outcome Statement:

compare short-term funding alternatives available to corporations and financial institutions

Summary:

This LOS explores various short-term funding alternatives for both non-financial corporations and financial institutions. It covers external loan financing, security-based financing, and specific funding mechanisms for financial institutions, detailing the characteristics, uses, and reliability of different funding sources such as lines of credit, commercial paper, and asset-backed commercial paper.

Key Concepts:

External Loan Financing

Non-financial corporations often rely on financial intermediaries for short-term financing through uncommitted bank lines of credit, committed bank lines of credit, and revolving credit agreements. These can be either secured or unsecured based on the company's financial strength and credit situation.

Security-Based Financing

Corporations can issue short-term, unsecured notes known as commercial paper to fund working capital or provide bridge financing. Financial institutions also issue commercial paper, often backed by a line of credit to minimize rollover risk.

Short-Term Funding for Financial Institutions

Financial institutions use various sources like deposits, interbank market loans, and commercial paper to meet short-term funding needs. These institutions also engage in repurchase agreements and may issue asset-backed commercial paper through special purpose entities.

Repurchase Agreements

Learning Outcome Statement:

describe repurchase agreements (repos), their uses, and their benefits and risks

Summary:

Repurchase agreements (repos) are secured short-term lending and borrowing mechanisms where a security is sold with an agreement to repurchase it at a future date for a specified price. Repos are used for financing security ownership, earning short-term income, and borrowing securities for short selling. They offer benefits like low borrowing costs and minimal liquidity or default risk but also carry risks such as default, collateral, margining, legal, and settlement risks.

Key Concepts:

Repurchase Agreement Mechanics

In a repurchase agreement, a security seller (cash borrower) sells a security to a buyer (cash lender) with a commitment to repurchase the same or similar security at a future date for a predetermined price, effectively securing a loan with the security.

Repo Rate

The repo rate is the interest rate applied to the cash lent in a repo transaction. It is determined by factors such as money market rates, collateral quality, repo term, collateral uniqueness, and delivery conditions.

Initial Margin and Haircut

Initial margin in a repo is the ratio of the security price to the purchase price, providing a buffer against price fluctuations. A haircut is the difference between the security price and the purchase price, expressed as a percentage of the security price, reflecting the risk of the loan.

Variation Margin

Variation margin is the additional collateral required if the value of the original collateral falls or if the value of the collateral increases, allowing for the release of excess collateral. It ensures the loan remains adequately secured throughout its term.

Reverse Repo

A reverse repo is a repo transaction from the perspective of the cash lender (security buyer). It involves lending cash and receiving a security as collateral, with the agreement to return the security and receive cash plus interest at a future date.

Formulas:

Repurchase Price

P_{\text{repurchase}} = P_{\text{initial}} \times \left[1 + \left(\text{repo rate} \times \frac{\text{days}}{360}\right)\right]

Calculates the future price at which the security will be repurchased, including interest.

Variables:

$P_{\text{repurchase}}$ :: Repurchase price
$P_{\text{initial}}$ :: Initial purchase price
$\text{repo rate}$ :: Annual interest rate of the repo
$\text{days}$ :: Number of days the repo is held

Units: currency

Initial Margin

\text{Initial Margin} = \frac{\text{Security Price}_0}{\text{Purchase Price}_0}

Represents the ratio of the security's initial price to the amount financed, indicating the level of over-collateralization.

Variables:

$\text{Initial Margin}$ :: Initial margin ratio
$\text{Security Price}_0$ :: Price of the security at the start
$\text{Purchase Price}_0$ :: Amount paid for the security at the start

Units: ratio

Haircut

\text{Haircut} = \frac{\text{Security Price}_0 - \text{Purchase Price}_0}{\text{Security Price}_0}

Measures the percentage by which the loan is under-collateralized relative to the initial market value of the security.

Variables:

$\text{Haircut}$ :: Percentage reduction of the loan relative to the collateral value
$\text{Security Price}_0$ :: Initial market price of the security
$\text{Purchase Price}_0$ :: Initial amount financed for the security

Units: percentage

Variation Margin

\text{Variation Margin} = (\text{Initial Margin} \times \text{Purchase Price}_t) - \text{Security Price}_t

Calculates the additional collateral required or excess collateral that can be returned based on the change in the value of the security.

Variables:

$\text{Variation Margin}$ :: Additional collateral required or excess to be returned
$\text{Initial Margin}$ :: Original margin ratio agreed upon
$\text{Purchase Price}_t$ :: Adjusted purchase price at time t
$\text{Security Price}_t$ :: Market price of the security at time t

Units: currency

Long-Term Corporate Debt

Learning Outcome Statement:

contrast the long-term funding of investment-grade versus high-yield corporate issuers

Summary:

The content discusses the differences and similarities in long-term funding strategies between investment-grade (IG) and high-yield (HY) corporate issuers. It covers how these issuers manage their debt, the impact of their credit ratings on their funding options, and the specific risks and benefits associated with each type of debt.

Key Concepts:

Similarities between IG and HY Issuance

Both IG and HY issuers face trade-offs between maturity and yield-to-maturity (YTM), where longer maturities typically offer higher YTMs but also come with increased risks such as price risk and reinvestment risk.

Differences between IG and HY Issuance

IG issuers generally have stronger credit ratings, allowing them to issue debt with fewer restrictions and lower YTMs attributed to credit spreads. HY issuers, due to a higher likelihood of default, face more restrictions and have a higher proportion of their YTM attributed to issuer-specific credit spreads.

Fallen Angels

These are formerly IG issuers whose credit ratings have deteriorated, making them HY issuers. Their outstanding debt still carries IG features, which can lead to significant market price impacts when they are forced to sell due to the new high-yield status.

Formulas:

Repo Haircut Calculation

\text{Repo Haircut} = \frac{(\text{Face Value} - \text{Loan Amount})}{\text{Face Value}} \times 100\%

This formula calculates the percentage difference between the face value of a bond and the loan amount, which is adjusted for the initial margin in a repo transaction.

Variables:

$Face Value$ :: The original value of the bond
$Loan Amount$ :: The amount borrowed against the bond

Units: percentage

Repurchase Price Calculation

\text{Repurchase Price} = \text{Loan Amount} \times \left[1 + \left(\frac{\text{Annual Interest Rate} \times \text{Repo Term (days)}}{360}\right)\right]

This formula calculates the total amount that must be repaid to repurchase the security at the end of the repo term, including interest.

Variables:

$Loan Amount$ :: The initial amount borrowed in the repo transaction
$Annual Interest Rate$ :: The annual interest rate agreed upon for the repo
$Repo Term (days)$ :: The duration of the repo agreement in days

Units: currency (e.g., USD)

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