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EFB201 Lecture 5 – Public Debt Markets Reading – Viney chapters 2 and 6 Tutorial Questions – Viney chapter 6 Essay Questions 8-12 Additional Questions on Blackboard Site. Outline Short Term Instruments Background Commercial Bills Promissory Notes Negotiable Certificates of Deposit

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Efb201 lecture 5 public debt markets reading viney chapters 2 and 6 tutorial questions

EFB201 Lecture 5 –

Public Debt Markets

Reading –

Viney chapters 2 and 6

Tutorial Questions –

Viney chapter 6 Essay Questions 8-12

Additional Questions on Blackboard Site


Efb201 lecture 5 public debt markets reading viney chapters 2 and 6 tutorial questions

Outline

Short Term Instruments

Background

Commercial Bills

Promissory Notes

Negotiable Certificates of Deposit

Valuation of Securities

Long Term Instruments

Background

Valuation


Efb201 lecture 5 public debt markets reading viney chapters 2 and 6 tutorial questions

Corporate debt instruments can be broadly split into

two categories :-

Short Term – less than one year to maturity

Long Term – greater than one year to maturity

Key characteristics in both markets are creditworthiness

and liquidity


Efb201 lecture 5 public debt markets reading viney chapters 2 and 6 tutorial questions

Short Term Instruments – Background

Bills of Exchange

A bill of exchange is a short-term money market

security that pays the face value at maturity.

It may be categorised as a trade bill which is used to

finance specific international trade transactions or a

commercial bill which is a method of borrowing.


Efb201 lecture 5 public debt markets reading viney chapters 2 and 6 tutorial questions

  • Commercial Bills

  • Bank-accepted bills where a bank places its name

    • on the face of the bill which will increase the bill’s

    • credit worthiness

    • Bank-endorsed bills where the bank, as a previous

    • owner of the bill, signs (endorses) the reverse of the

    • bill when selling it. These days endorsements are by

    • way of electronic record of transactions which

    • creates a legal chain of ownership

    • Anon-bank bill


Efb201 lecture 5 public debt markets reading viney chapters 2 and 6 tutorial questions

  • A commercial bill is a discount security as it is issued

  • at a price less than its face value. There are several

  • parties involved in the issue:

    • The drawer is the issuer. With a bank-accepted

    • bill the drawer has a liability to repay the face

    • value to the bank acceptor.

    • The acceptor is the party to whom the bill is

    • addressed and who undertakes to pay the bill’s

    • face value to the person presenting the bill at the

    • maturity date. They will charge the borrower fees

    • for doing this.


Efb201 lecture 5 public debt markets reading viney chapters 2 and 6 tutorial questions

  • The payee is the party to whom the bill is specified

  • to be paid. The payee is typically the drawer

  • although the drawer can specify some other entity

  • as the payee.

  • The discounter (lender) is the party that discounts

  • the bill’s face value and purchases the bill.


Efb201 lecture 5 public debt markets reading viney chapters 2 and 6 tutorial questions

Repay acceptor ($100,000 plus fee and margin)

Drawer (borrower)

Borrowing Corporation Ltd

Drawer

Bill accepted

Bill discounted

Funds lent ($95,800)

Present mature bill

Acceptor

Acceptor

ABC Bank Ltd

Discounter

Discounter

(current holder of bill)

Bill discharged (holder receives $100,000)

On the issue date a discount price will be paid:

At the maturity date the face value will be paid:


Efb201 lecture 5 public debt markets reading viney chapters 2 and 6 tutorial questions

The primary liability to exchange the bill at maturity

falls on the acceptor, not the drawer.

In the short-term money market there is an active

market in bank-accepted bills.

In an efficient market transactions will be recorded

electronically through an authorised central securities

depository.

Austraclear, which is part of the Australian Securities

Exchange, is the main central securities depository in

Australia.

Once a bill is drawn and discounted, the bill is physically

lodged with the depository and each successive

rediscounting and change of ownership is recorded

electronically by the depository.


Efb201 lecture 5 public debt markets reading viney chapters 2 and 6 tutorial questions

Commercial bills typically have a maximum maturity of

up to 180 days and a minimum face value of $100,000.

In reality a business may require funding for a longer

period of time.

A bank-accepted bill facility can be set up to extend the

overall term of a bill financing arrangement.

This involves a rollover facility being set up with the bank.

Under this facility the bank agrees to accept and discount

new commercial bills for the borrower at each maturity

date.


Efb201 lecture 5 public debt markets reading viney chapters 2 and 6 tutorial questions

On each rollover date the borrower will pay the bank

the difference between the face value on the maturing

bill and the discount price of the new bill.


Efb201 lecture 5 public debt markets reading viney chapters 2 and 6 tutorial questions

Promissory Notes

Promissory notes (P-notes) are discount securities

normally with a minimum face value of $100,000

and a term to maturity of up to 180 days.

The cost to the borrower is the difference between the

amount raised on the issue date and the face value payable

at maturity.


Efb201 lecture 5 public debt markets reading viney chapters 2 and 6 tutorial questions

It is market convention to refer to the P-notes as

commercial paper.

P-notes are similar to bills of exchange except

there is no acceptor involved.

There is also no need for the seller to endorse the bill.

Typically, only large companies with excellent credit

reputations in the market are able to attract investors

willing to discount P-notes.


Efb201 lecture 5 public debt markets reading viney chapters 2 and 6 tutorial questions

Negotiable Certificate of Deposit (CD)

A CD is short-term discount security issued by a bank,

typically with an initial maturity of up to 180 days.

CDs are an investment product offered by banks in the

money market to attract institutional investors.

Banks issue CDs, in part, to manage their liabilities and

liquidity.

Within the money market there is an active secondary

market in CDs.


Efb201 lecture 5 public debt markets reading viney chapters 2 and 6 tutorial questions

Valuation

PRICE = PRESENT VALUE

OF FUTURE CASH

FLOWS

REMEMBER

IF INTEREST RATES RISE, PV FALLS

IF INTEREST RATES FALL, PV RISES


Efb201 lecture 5 public debt markets reading viney chapters 2 and 6 tutorial questions

  • Discount securities are sold at a price that represents

  • a discount from the face value. Their price can be

  • calculated using:

  • P = FV/(1 + (yield × DTM/365))

    • where

    • P = price

    • FV = face value

    • DTM = days to maturity


Efb201 lecture 5 public debt markets reading viney chapters 2 and 6 tutorial questions

Example One

An investor buys a 180-day commercial bill with a

face value of $100,000 yielding 8.75%pa. They decide

to sell the bill 90 days later at a market yield of 7.8%pa.

Price paid for the 180-day commercial bill:

$95,864=$100,000/(1+0.0875×180/365)

Price received when the bill is sold 90 days later:

$98,113=$100,000/(1+0.078×90/365)


Efb201 lecture 5 public debt markets reading viney chapters 2 and 6 tutorial questions

Calculating Face Value

In many instances a company needs to raise a specific

amount of funds, the issue price, from a bill issue.

As the issue price and yield are known the face value

can be calculated using:

FV = P × (1 + (yield × DTM/365))

For example, a company issues a 60 day bank accepted

bill to raise $500,000. The bank agrees to discount the

bill at 8.75%pa so the bill’s face value will be:

$507,192 = 500,000 ×(1 + 0.0875 × 60/365)


Efb201 lecture 5 public debt markets reading viney chapters 2 and 6 tutorial questions

Calculating Yield

The yield is the rate of interest, expressed as per cent

per annum, on the amount outlaid to purchase the

discount security.

The yield can be calculated using:

(sell price – buy price)/buy price × (365/DTM)

At the maturity date the sell price will be the face value.

If the security is sold prior to the maturity date,

then DTM is replaced by days held.


Efb201 lecture 5 public debt markets reading viney chapters 2 and 6 tutorial questions

For example, an investor plans to purchase a 180-day

bill with a face value of $100,000 and a price of $95,000.

The yield on the investment will be:

($100,000 – $95,000)/$95,000 × 365/180

= 0.1067 = 10.67%pa


Efb201 lecture 5 public debt markets reading viney chapters 2 and 6 tutorial questions

Reconsider example 1 and calculate the

Holding Period Yield (HPY)

(sell price – buy price)/buy price × (365/Days Held)

HPY = ($98,113 – $95,864)/$95,864 × 365/90

= $2,249/$95864 x 365/90

= 0.02346 x 365/90

= 0.0951 = 9.51%pa


Efb201 lecture 5 public debt markets reading viney chapters 2 and 6 tutorial questions

Long Term Instruments

Background

The major long-term debt market in developed countries

is the bond market.

Again the key factors in the market are

1. Default Risk (Creditworthiness) and

2. Liquidity of the market


Efb201 lecture 5 public debt markets reading viney chapters 2 and 6 tutorial questions

The Australian bond market consists of:

1. Treasury bonds issued by the Commonwealth

Government

2. Semi-government bonds issued by state government

borrowing authorities

3. Corporate bonds issued by financial institutions and

other large listed corporations

4. Asset-backed securities

5. Australian-dollar-denominated bonds issued in

Australia by non-resident borrowers

(known as Kangaroo bonds).


Efb201 lecture 5 public debt markets reading viney chapters 2 and 6 tutorial questions

A bond pays a specified periodic interest rate for the

term of the bond and the principal is repaid at maturity.

The periodic interest payment made by a bond is

normally referred to as a coupon.

Typically the coupon is a fixed percentage of the face

value, but floating rate coupon bonds also exist.

It is cheaper for corporations to raise debt funds

directly from capital markets as it removes the cost

of the financial intermediary, such as a bank.


Efb201 lecture 5 public debt markets reading viney chapters 2 and 6 tutorial questions

Investors can obtain a higher return, although

at a higher risk, from buying corporate bonds

than if they placed their funds with a financial

institution.

A credit rating agency such as Standard & Poor’s

provides measures of an issuer’s credit risk.

In recent years managed funds have been the

major buyers of bonds.


Efb201 lecture 5 public debt markets reading viney chapters 2 and 6 tutorial questions

A corporate bond is a bond issued by a company and can be categorised as a debenture or

unsecured note.

A debenture is secured by a fixed and/or floating charge

over the issuing company's unpledged assets. These are

assets over which there is no charge or interest conveyed

to another party.

An unsecured note has no underlying

security attached.


Efb201 lecture 5 public debt markets reading viney chapters 2 and 6 tutorial questions

  • An issue of debentures is formalised through a debenture

  • trust deed. The deed will specify and protect the

  • underlying security attached to the debenture bond issue.

  • The three principal issue methods are:

  • public issues to the public at large

  • 2. holders of the company's securities, including

  • shareholders, bondholders and holders of convertible

  • notes

  • 3. private placements to institutions that regularly deal

  • in securities or other institutional investors such as fund

  • managers and insurance offices.


Efb201 lecture 5 public debt markets reading viney chapters 2 and 6 tutorial questions

For most corporate bond issues, the price paid on

subscription is the same as the face value of the security.

In most countries corporations law will require any

invitation to the public to deposit money with or lend

to a corporation to be accompanied by a prospectus

that has first been registered with the corporate regulator.

A prospectus will provide detailed information on the

issuer corporation, the purpose of the finding, company

financial statements and projections, management

profiles, expert reports and other material information.

However, a prospectus is costly and time consuming to

prepare so companies often prefer to use placements where they are only required to provide an information

memorandum.


Efb201 lecture 5 public debt markets reading viney chapters 2 and 6 tutorial questions

  • A bond’s price is the present value of its cash flows,

  • the periodic coupon payments and the repayment of

  • principal at the maturity date.

  • The coupon’s present value will be:

  • PVcoupons= C × [(1-(1+i)-n)/i]

  • The present value of the face value will be:

  • PVface value = FV × (1+i)-n

    • where

    • i = current yield for the period

    • n = number of future coupon periods

    • C = periodic fixed coupon payment

    • FV = principal or face value of the bond


Efb201 lecture 5 public debt markets reading viney chapters 2 and 6 tutorial questions

  • If the bond is not purchased on a date a coupon is paid

  • the following adjustment will need to occur:

  • (PVcoupons + PVface value) x (1+i)k

    • wherek = number of days elapsed since the last coupon

    • payment divided by days in the coupon period.

  • When the bond’s market yield is less than the coupon

  • rate the price of the bond will be greater than its face

  • value. This is called a premium bond.

  • When the bond’s market yield is greater than the coupon

  • rate the price of the bond will be less than its face value.

  • This is called a discount bond.


Efb201 lecture 5 public debt markets reading viney chapters 2 and 6 tutorial questions

  • Coupon Bond Example

  • Calculate the price of a corporate bond on 20 May 2011

  • with a face value of $100,000, paying 10%pa half yearly

  • coupons, maturing 31 December 2016 and trading at a

  • yield of 8%pa:

    • C = $100,000 × 0.10/2 = $5,000;

    • I = 0.08/2 = 0.05;

    • n = 12 coupons will be paid between 20th May 2011 and

    • 31st December 2016

    • k=140/181 as 140 days have elapsed since the last

    • coupon date and the coupon period is 181 days


Efb201 lecture 5 public debt markets reading viney chapters 2 and 6 tutorial questions

PVcoupons = $5,000×[(1-(1+0.04)-12)/0.04] = $46,925.37

PVface value = $100,000×(1+0.04)-12 = $62,459.70

So the bonds price discounted to the last coupon

will be: $46,925.37 + $62,459.70 = $109,385.07

So the bonds price now will be

($109,385.07) x (1+0.04)140/181 = $112,754.27


Efb201 lecture 5 public debt markets reading viney chapters 2 and 6 tutorial questions

Zero Coupon Bond Valuation

A zero coupon bond is one which pays no

Coupons, only the Face Value at maturity

Price = Face Value x (1 + i)-n

= Face Value/(1 + i)n

E.g..A 5 year $100 Zero Coupon Bond is

yielding 12% pa.

P= 100/1.125

= $56.74


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