Fixed-Income Securities: Money-Markets & Bonds

by Ben Best


  6. SWAPS


This article deals primarily with debt market instruments denominated in US dollars, including Eurodollars (US Dollar deposits at banks outside of the United States). Because most debt markets are similar, the principle instruments described should be similar in most countries in which they are used.

The debt market is a bigger source of borrowed funds than the banking system. The market for debt is larger than the market for equities (ie, is larger than the stock market). By dollar volume the largest category of the debt market in the United States is in Mortgage-Backed Securities (MBSs), followed by corporate bonds, federal treasury securities, money market instruments, Government Sponsored Enterprises (GSEs) and municipal bonds, in that order. About half the US national debt is in Treasury Department securities, while the other half represents inter-governmental borrowings, notably money borrowed by the Treasury Department from the Social Security trust fund, which is in excess of one trillion dollars.

The debt market is commonly divided into the so-called money market (short-term debt, maturity of one year or less) and the so-called capital market (long-term debt). Both of these terms are misnomers. All productive assets are capital (including equities). The terminology may be rationalized by the convention that capitalized expenses are amortized over periods in excess of one year. "Money market" instruments are debt and although they can be used as a store of value they can only be regarded as a medium of exchange in the sense that they are readily sold at a price which is usually predictable within a short time frame. Moreover, it is hard to base a conceptual distinction between money & non-money based on a one-year maturity dividing line. Yet the M2 & M3 measures of "money supply" include short-term debt. (For more on the meaning of "money" see The Origin and Nature of Money.)

Most debt instruments are not traded through exchanges, but are traded over-the-counter (OTC) in a telephone/electronic network market where dealers or brokers frequently act as direct intermediaries. Money-market instruments usually have such large denominations that they are not accessible to small investors except through mutual funds.

The market for debt can be viewed as a market for money in the sense that sellers of debt (lenders) have a supply of money which is demanded by would-be buyers (borrowers). In this model, interest rates are the "price" of money. An increase in demand to borrow money due to increased economic opportunity increases interest rates (everything else being equal). The market for debt is influenced by term-to-maturity, credit-worthiness of borrowers, security for loan and many other factors. By their control of money supply, government central banks try to manipulate interest rates to stimulate their economies without causing inflation.

In the US, federal funds (loan of reserves from one bank to another) is an important component of the money-market because the fed funds rate is a benchmark for the short-term interest rates (such as prime) and because it is controlled by the Federal Reserve (US government central bank). (For more on the role of fed funds & central banking, see A "Managed Economy" Under the Federal Reserve System.)

Debt instruments can be sharply divided between coupon & discount instruments. A coupon debt instrument is simply one that pays interest. Originally, bonds that paid interest were physical certificates with physical coupons that were periodically clipped and redeemed for interest payments. Physical certificates are now rare, but the term "coupon" has remained to describe "interest-paying". "Bearer bonds" which paid interest to the bearer (presenter) of coupons were made illegal in the United States in 1982 in an effort to reduce money laundering.

Discount debt instruments have a face value (par value, redemption amount) to be paid at maturity, but are sold at a discount. For example, a $100 face value instrument maturing in one year sold at the discount price of $90.91 would be the equivalent of a $90.91, 10% interest-yielding instrument ($90.91 X 1.10 = $100). T-bills, commercial paper & banker's acceptances are discount instruments, whereas bonds, munis, CDs & repos are coupon instruments (details below).

As with all financial instruments in the United States and Canada, fixed income securities are assigned a CUSIP number developed by the American Banker's Association (ABA) Committee on Uniform Security Indentification Procedures (CUSIP), now administered by Standard & Poor's for the ABA. A CUSIP consists of nine characters, the first six of which identify the issuer, the next two identify the issue and the last is a check digit. The first three characters and the last must be numeric, but the other characters can be alphabetic or numeric. A CINS (CUSIP International Number System) now exists for internationally-traded financial instruments.

(For a useful glossary of bond terminology see Bond Basics Glossary)

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US Treasury Bills (T-Bills) are short-term debt used maintain deficits of the US Government. The trading volume of US T-Bills exceeds that of any other money-market instruments. T-Bills are regarded as the benchmark for risk-free loans. 13-week & 26-week T-Bills are auctioned at a discount by the Fed (Federal Reserve) every Monday (or Tuesday, when Monday is a holiday) on behalf of the US Government. The Fed also auctions 28-day T-Bills or special "cash management bills" as needed. Income earned on US T-Bills is exempt from all state & local income taxes, but not from federal taxes.

Commercial paper is a short-term promissory note issued in large denominations (over $100,000, typically in multiples of $1 million) not secured by collateral. Only top corporations have the credit-worthiness to issue commercial paper, which provides them with a fast, low-cost alternative to bank loans and an alternative to expensive SEC registration. SEC regulations allow registration exemption only if commercial paper is used to finance "current transactions" and if the maturity is not greater than 270 days. Average maturity is 30-35 days. Commercial paper is rated by agencies such as Moody's and Standard & Poor's. Money market funds and bank trust departments do most of the buying of commercial paper. Government regulations limit money market fund holdings of commercial paper that is rated less than "higher A/prime". The largest issuer of commercial paper in recent years has been General Electric Capital, a financial subsidiary of General Electric corporation.

Banker's acceptances have been used by merchant banks for centuries to finance international trade. When an importer and exporter (counterparties) are short on cash or are unsure of the credit-worthiness of their counterparty, a bank can sell its own credit-worthiness to a trusted counterparty (the importer, for example) by means of the banker's acceptance. The bank can buy a draft from an importer at a discount and stamp the draft as ACCEPTED. The importer can then pay the exporter with money from the bank and the bank can either keep the acceptance in its portfolio or rediscount it in the secondary market. On or before the maturity date the importer will pay the bank and the bank will pay the holder of the acceptance. If the importer defaults, the bank is still responsible for the acceptance. Alternatively, an exporter may obtain a discounted acceptance from the importer's bank and rediscount the acceptance on the secondary market. Acceptances provide a less expensive alternative to short-term bank loans for firms whose credit-worthiness is not high enough to obtain commercial paper. Banks are able to charge less because there are no reserve requirements for acceptances.

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When a bank or other depository institution has received a large time-deposit it can often issue a Certificate of Deposit (CD) which can be sold in the secondary market as a negotiable instrument. Because most CDs have maturities of one to twelve months they trade on the so-called money market (although some CDs have maturities as long as five years). Banks issue CDs as a means of funding new loans while limiting their exposure to the risk that interest-rates will change unfavorably. Although CDs give a slightly higher rate of return than T-Bills, they are less marketable and lock-in the money like a time-deposit. Eurodollar CDs are dollar-denominated CDs issued by banks abroad, Yankee CDs are CDs issued by US branches of foreign banks and Thrift CDs are CDs issued by savings & loan associations or savings banks.

A repurchase agreement ("repo") is a sale of securities under an agreement to repurchase those securities at a specified date with a payment of interest. A reverse repurchase agreement is a purchase of securities under an agreement to resell. Obviously, any repo will be a reverse repo from the point of view of the other counterparty, but the convention is to classify the agreement from the point of view of the party that initiated the transaction. When the Federal Reserve is one of the parties, however, the agreement is classified from the point of view of the dealer -- a repo occurs when the Fed buys securities from a dealer. A reverse repo involving the Fed is termed a Matched Sale-Purchase agreement (MSP). The repo market is a primary medium through which the Fed conducts open market operations. (For more information on the Fed & open market operations, see A "Managed Economy" Under the Federal Reserve System.)

Nearly all repos are in denominations of not less than $1 million and for maturities not longer than a few days. The Fed has allowed repos to be exempt from reserve requirements, but has restricted repo collateral to T-Bills and other federal government securities. The repo market and the federal funds market have become a united overnight loan market. Because repos are secured and fed funds are not, the fed funds rate is usually higher than the overnight repo rate.

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Formally, debt instruments with maturity in the one-year to ten-year range are called notes and those with maturities over ten years are called bonds. Informally, all debt instruments which have maturities over one-year are called bonds. Although some corporate bonds are traded on the New York Stock Exchange or AMEX, the great preponderance of bond trading occurs "over-the-counter" (OTC, "on the street") -- directly through brokers & dealers. The bond market can be classified into corporate bonds, Treasury bonds, municipal bonds, agency bonds and Eurobonds.

Bonds are typically issued with a standard minimum $1,000 denomination face value (par value, the principal amount paid upon redemption of the bond on the maturity date). Although bond denominations can be $1 million or more, current market prices are quoted relative to 100. Thus, a bond with a face value of $1,000 that is selling for $970 will be quoted as 97.

When coupons are paid, such payments are typically made semi-annually either on the first or the 15th of the month. No coupon (interest) is paid on zero-coupon bonds. Zero coupon bonds created by third parties who separate ("strip") the coupon from the principal and market the two independently are called strips.

Rather than have fixed principal & interest, some bonds have principal & interest indexed to inflation, such as Treasury Inflation-Protected Securities (TIPS).


Corporations can raise capital for long-term projects by borrowing from banks, issuing shares or selling bonds. Issuing shares dilutes control of the company and dividends can only be paid on after-tax income. Banks charge high interest and are reluctant to loan for over five years. A company with a good credit rating can issue long-term bonds at low interest and deduct interest payments as a business expense. The better the credit rating of the the corporation, the lower the interest cost.

Moody's Investor Services (Moody's) Standard & Poor's (S & P), Fitch IBCA and Duff & Phelps are the major US bond rating agencies. The most prominent rating agency is Moody's, closely followed by S & P. The highest rating is AAA , with AA being lower and D being the lowest. (Unlike the other three rating agencies, Moody's uses Aaa, Aa, A, etc., rather than AAA, AA, A, etc.) The ratings can be grouped as follows (make the lower-case adjustments for Moody's):

AAA, AA, A, BBB -- investment grade

BB, B, CCC, CC -- speculative grade

C, DDD, DD, D -- questionable to default grade

Speculative grade bonds are also called high-yield bonds or "junk bonds" because high interest is paid in return for the greater risk of default. The yield spread between 10-year BB-rated bonds and 10-year Treasuries might be four times the spread for 10-year AAA-rated bonds and 10-year Treasuries. Companies can take steps to increase the rating of a bond, such as establishing a sinking fund. With a sinking fund a trust company is appointed as trustee and the bond-issuer pays a specified amount of money on a specified annual date to the trustee to cover the cost of redeeming the bond at maturity. Credit quality can also be increased by bond insurance, wherein an insurance company such as Financial Guarantee Insurance Company (FGIC) will guarantee timely payment of principal & interest on insured bonds.

Interest on a corporate bond will also be determined by how the bond is secured. The best security is a mortgage on land or buildings. Collateral trust bonds are bonds secured by a portfolio of securities held in trust. Equipment trust bonds, secured by capital assets, are not common. Debentures are bonds for which the only security is the creditworthiness of the issuing company. Bonds with less security pay higher interest as the price of greater risk.

Corporate bonds are often callable. If market interest rates fall, the company may decide that it is paying too much above market rates on the bonds it has issued. A call provision allows the company to force redemption of the bond prior to maturity date. To compensate the bond holder, the early redemption price paid when the bond is called will be above the face value. Callable bonds should be priced by yield-to-call rather than yield-to-maturity.

If a bond is retractable or extendible, the bondholder has the option of redeeming the bond at par earlier or later than the normal maturity date. Corporations can also issue convertible bonds, which can be converted into common shares of the corporation at a specified price any time the bondholder chooses to do so. Bonds issued with these privileges can pay less interest than bonds without them.

Insurance companies are the predominant holders of corporate bonds.

Corporate bonds, like stocks, are regulated by the Securities and Exchange Commission (SEC). To issue a new bond a registration statement must be filed with the SEC and subjected to bureaucratic scrutiny & delays. The contract underlying a bond issue which spells out all the features in dense legal language is called the indenture. A prospectus summarizes these features in layperson's terms.


All bills, notes and bonds issued by the US Treasury Department ("Treasuries") are done so through the agency of the Federal Reserve System (the Fed). The Fed acts as both investment banker and regulatory agency for Treasury Department issues insofar as T-bills, T-notes and T-bonds are not regulated by the SEC. The Fed sells government securities thorough its Primary Dealers. Firms become Primary Dealers by anointment from the Federal Reserve Bank of New York. There are over 20 Primary Dealers, which includes such names as Morgan Stanley, USB Warburg and Goldman Sachs. Primary Dealers receive a connection to the Fed's electronic funds transfer service known as the Fed Wire. The TreasuryDirect program now allows investors to buy Treasuries directly from the Treasury Department.

T-notes & T-bonds are issued in denominations of $1,000, $5,000, $10,000, $100,000 and $1 million. Only 2-year, 5-year and 10-year T-notes were issued since 2001 when the issuance of 30-year bonds was stopped, but 30-year bonds are to resume sale in 2006. T-notes (maturities 10-years or less) are non-callable, but some long-term T-bonds have been callable at 100 five years before nominal maturity. Although income from Treasuries are taxed by the federal government, such income is exempt from state & local taxes. No bond, however, is exempt from capital gain if it is sold at a higher price than the purchase price (as might happen if the market rate of interest falls).

Treasury bonds, notes and bills are all sold in a Dutch auction (single-price auction) in which the bid yield that clears the market is the yield paid to all competitive and non-competitive bidders alike. Competitive bidders who bid yields higher than the clearing yield get no securities.

US Treasuries are backed by the taxing power of the United States government, the world's most powerful political organization in a country with one of the strongest economies. Treasuries therefore pay the lowest interest rates, a so-called "default-free rate". Treasuries are also the most liquid of securities: the market for them is huge and they are readily traded. Corporate bonds are far less liquid -- with much higher spreads between bid-price & ask-price. Foreign investors own the largest share (40%) of Treasuries, followed by the Federal Reserve, which owns about 15%.

TIPS (Treasury Inflation Protected Securities) are bonds whose principal is related to the rate of inflation. At maturity principal paid will include an income proportional to the rise in the Consumer Price Index for all Urban Consumers (CPI-U). If, for example, the CPI-U increased 2.5% during the first year following issuance of a $1,000 TIPS bond having a coupon rate of 3%, the face value of the bond would increase to $1,025 and the interest paid would be 3% X $1,025. TIPS are issued as 5-year, 10-year and 20-year bonds, each denomination auctioned about twice per year. The actual inflation protection provided by TIPS is questionable. The bond market factors-in anticipated inflation in determining bond prices anyway. TIPS should only benefit if inflation is much greater than bond traders anticipate. The Consumer Price Index is a political entity created by the Bureau of Labor Statistics, and thus is vulnerable to manipulation. Moreover, the TIPS market is a tiny percentage of the normal Treasury bond market, which means that trading TIPS is disadvantaged by the lower liquidity -- bid-ask spreads could be costly or buyers/sellers hard to find. (For more information on TIPS see FAQs about T-Bills, Notes, Bonds and TIPS.)

Savings bonds are "bearer bonds", ie, non-negotiable property of the buyer which can only be bought & sold from an agent acting on behalf of the government. Savings bonds cannot be used as collateral for loans. Because savings bonds are registered in the name of the purchaser they can be replaced if they are lost, stolen or destroyed.


Municipal debt securities ("munis") are bonds or money-market instruments issued by states, counties, cities and other local governments in the United States — over 50,000 government agencies. Over 70% of munis are owned by individual investors rather than by institutions. People who buy munis usually do so with the intention of holding them until maturity. Daily trading volume on munis is very low (less than 3% of the volume of Treasuries).

State governments have less taxing power than the federal government and have smaller markets for their securities, so must pay higher interest. But default on munis is very rare. Even during the 1930s Depression, fewer than 2% of municipal issues defaulted — and most of those eventually repaid. Defaults on high-yield munis jumped from 2% to 3% in 2002 — nearly ten times the historic 0.3% default rate. About half of newly issued munis are insured against default by municipal bond insurance companies, which would cover the cost upon default. Bond insurance raises bond rating and lowers bond yield below that of uninsured munis — but not below the yield of uninsured AAA-rated munis.

Although default on investment-grade munis are rare (New York City in 1975 being one of the most notable), there is always a risk from investment downgrade. Falling stock prices drove many investors into the so-called "safe-haven" of munis in 2002 — perhaps forgetting that recession was driving most governments into deficit. Standard & Poor's downgraded the debt of New Jersey, Wisconsin and Colorado in 2002.

Most debt securities issued by state & local governments are done on a coupon basis, but some are issued in discount form. Historically, income from municipal bonds have been exempt from federal taxes, state taxes and local taxes. The tax exemptions make wealthy individuals & corporations the largest investors in munis because these parties have the largest marginal tax rates. The federal tax-exemption has tempted state & local governments to issue tax-exempt securities and use the proceeds to purchase higher-yielding taxable securities to profit from the spread. Congress has attempted to combat this practice.

In 1986 Congress passed legislation that restricted exemption from federal income tax only to municipal bonds designated "public purpose bonds". Bonds designated "private purpose" — such as those issued for sports stadiums — are fully taxable at the federal level, but may still be exempt from state & local tax. "Nongovernmental purpose" bonds used for non-municipal purposes such as housing construction are federally taxed through the Alternative Minimum Tax (AMT).


A number of agencies have been created by the US government which issue securities backed by the government, including the Export-Import Bank and farm credit agencies. The largest Government-Sponsored Enterprises (GSEs) issuing bonds, however, are the mortgage credit agencies:

Federal National Mortgage Association (FNMA) — "Fannie Mae"

Federal Home Loan Mortgage Corporation (FHLMC) — "Freddie Mac"

Government National Mortgage Association (GNMA) — "Ginnie Mae"

These agencies issue debenture-like bonds as well as mortgage-backed bonds. The mortgage-backed bonds pay the bondholder not only monthly interest, but monthly partial repayment of principal. The principal repayment portion is nontaxable, but the interest portion is taxable as income by all levels of government. The government agencies bear all of the default risk on the mortgages. Ginnie Mae is actually a government agency rather than a government-sponsored agency. The Federal government is fully responsible for the debt of Ginnie Mae, but is nominally not responsible for the debt of Fannie Mae and Freddie Mac, which have been "privatized". But the Federal government is seen to be closely tied to these GSEs and has a hard time dissociating itself from responsibility — giving GSE debt an implicit backing of the Treasury Department.

Fannie Mae & Freddie Mac owned or insured 40% of US mortgages in 2002 — an amount of money equivalent to two-thirds of America's publicly-traded government debt. The GSEs themselves are exempt from state & local taxes, receive billions of dollars worth of federal subsidies, and are exempt from control by the Securities and Exchange Commission (SEC) — giving a tremendous advantage over private mortgage companies in addition to lowering the GSE borrowing costs. Holders of GSE debt, however, must pay state taxes on interest (in contrast to interest on Treasuries).

The market for GSE securities has grown rapidly, quadrupling in the 1990s. When US debt was being retired there was talk of Freddie Mae debt replacing Treasuries as the benchmark security.

Some economists have questioned the wisdom of the government underwriting of borrowing which has encouraged so many long-tailed, highly leveraged mortgages by agencies which themselves are highly leveraged and have so few disclosure requirements. Many have wondered why homeowner borrowing should be subsidized & encouraged more than borrowing by businesses or credit-card holders. The danger that GSEs could precipitate a global financial crisis has created political pressure for SEC control and for removal of backing by the Treasury Department.


Mortgage-Backed Securities (MBS) are pooled mortgages (on houses) that have been issued as securities. The MBS market is the largest debt market in the world, and the second most actively-traded (after US Treasuries). Most MBSs are issued by the government agencies Fannie Mae, Freddie Mac and Ginnie Mae, in that order of dollar volume.

MBSs are classified as pass-through securities or Collateralized Mortgage Obligations (CMOs). A pass-through security represents a pro-rata ownership of the principal and interest of a pool of mortgage loans. The government agency or private company that has securitized the pool of mortgages deducts a service fee, however. A CMO divides holders of the MBS into classes based on priority to receive prepayments.

Pre-payment risk is a major risk faced by MBS holders. If interest rates drop, home owners want to refinance at lower rates. The MBS holder is thus forced to re-invest the repaid money in the lower interest-rate environment. In this sense, MBSs face the same risk as callable bonds.


Eurobonds are bonds that are sold outside of the country in whose currency they are denominated. American corporations and governments issue such bonds in US dollars, but sometimes pay interest in another currency. Most Eurobonds are unrated, but are issued by well-known companies who often provide security through sinking funds. Eurobonds are not regulated by the SEC or by any other government agency and can be issued at low cost.

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For historical reasons bank deposits denominated in a currency having a different nationality from the bank are given the prefix Euro (which can be confused with the newer European currency). By this terminology bank deposits of Yen outside Japan are Euroyen, bank deposits of US Dollars outside the US are Eurodollars and bank deposits of Euros outside of Europe are Euroeuros.

American dollars have been an international medium of exchange for decades. In countries with high inflation such as Peru & Bolivia, more local commercial transactions are conducted in dollars than in the native currency. The US dollar has dominated international trade for most of the 20th century. In the 1960s many London banks began to offer banking services in US dollars which were subject to neither British nor American banking laws. The emergence of similar banking services elsewhere in Europe led to the development of what came to be called the Eurodollar market.

Most Eurodollars are held in fixed-rate time-deposits for periods of less than 180 days. Because Eurodollar accounts do not require deposit insurance and are not subject to high regulatory costs of American banks, Eurodollar bankers are able to operate on narrower spreads — paying higher interest to depositors and loaning money for less interest charge to borrowers. Eurodollars soon came to dominate international lending — including lending for trade. Helpless to regulate Eurodollars, American authorities eliminated reserve requirements on non-personal time deposits & CDs in the United States in 1990. Although this reduced Eurodollar market volume somewhat, the Eurodollar market remains the largest deposit market in the world.

While most short-term interest rates are subject to manipulation by national central banks, the inter-bank lending of Eurodollars by international banks seeking to manage their cash is perhaps the closest thing to an unregulated, free-market interest rate in the world. For this reason the London InterBank Offer Rate (LIBOR) has become the most internationally recognized and utilized benchmark interest rate. LIBOR is the rate at which a bank offers funds for lending to other banks. The Federal Reserve clearly still controls the supply of dollars, so there is a close correlation between the overnight LIBOR and the fed funds rate.

There are now active "Euro" markets in all the major currencies including the European Union currency which is also called, confusingly, the "Euro". Quotations of LIBOR always specify both the time to maturity and the currency — 3-month Yen LIBOR, for example. Eurocurrency banks are no longer restricted to Europe — there are such banks in Canada, Japan, Panama, Hong Kong and elsewhere. The offshore banking industry was initially fostered by the establishment of Eurodollar banks in countries with minimal taxes, such as the Cayman Islands.

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A swap occurs when an investor exchanges one security to obtain another security. Sometimes swaps involve outright purchase and sale of bonds to save on taxes. An investor who has made capital gains on other investments may own a bond currently worth less than the purchase price. By selling the bond and simultaneously buying an equivalent one, the investor effectively is able to continue owning the bond while realizing a capital loss that can offset capital gain. But the vast majority of swaps involve foreign exchange or interest payment.

Futures & options markets provide means by which firms can hedge (protect-against) currency exchange-rate risk and interest-rate risk by selling that risk to speculators. But the expenses of the heavily regulated exchanges, the lack of specificity of the standardized contracts to maturity & cash-flow requirements of companies and even the lack of privacy in the exchanges has led to the emergence of the swap market — which is almost entirely unregulated by governments.

Because neither party to a swap can be called a buyer or seller, both are referred to as counterparties. If a dealer is involved, the dealer is also a counterparty. In a currency swap, company A might exchange US$10 million for 1.3 billion Yen from company B for a period of 5 years to fund development of a factory in Japan. The company holding the dollars would pay interest in dollars and the company holding the Yen would pay interest in Yen. A broker who brought the counterparties together would charge a commission ("finder's fee") because finding counterparties with matching needs can be difficult.

Most swaps, however, are interest-rate swaps rather than currency swaps. For example, counterparty A may want to hedge-away the risk of changing interest rates. Counterparty B agrees to swap a stream of fixed interest-rate payments from counterparty A in exchange for a stream of floating interest-rate payments for 5 years. The fixed rate of interest will be high enough to compensate counterparty B for the risk of paying a floating rate. Because LIBOR is an international benchmark for market interest, the floating rate might be adjusted every 3-months to the Eurodollar 3-month LIBOR rate for the 5-year period of the swap plus a spread.

Note that in an interest-rate swap there is no exchange of principal, only an exchange of interest payments. Note also that the counterparty paying the fixed interest-rate has assumed greater risk than the counterparty paying the floating rate, and can thus charge a premium (higher rate) to compensate for the assumption of that risk. Of course, the fixed-rate payer gets an additional benefit if market rates fall.

SWAP with 2 counterparties
[SWAP with 2 counterparties]

As a practical example, Party A (a savings and loan association) may have assumed a fixed-rate five-year mortgage of $1 million at 12%. If the savings and loan association pays its depositors an interest rate equal to LIBOR+1%, it would lose money if LIBOR should rise to 11% or higher. Under the terms of the swap, the savings and loan sends the 12% it receives from the mortgage payments to Party B and receives LIBOR+3%. In this way Party A has locked-in a 2% return as the difference between what it receives from Party B and what it pays to depositors.

As another example, Party B might be a company wanting to reduce the company-specific risk of interest payments on its commercial paper. Rather than issue more commercial paper, Party B issues a long-term bond at a fixed rate of interest and enters a swap whereby it receives fixed-rate payments to service the cost of the bond and pays a floating rate to Party A in return. If Party B had simply issued more commercial paper it would be vulnerable both to the risk that market rates would rise and to the risk that interest rates of its own commercial paper would rise above the market rate. By issuing the bond and entering the swap, Party B has eliminated its company-specific interest rate risk.

Swaps are also advantageous between companies with different credit ratings. A company with higher rating (such as AAA) pays lower interest on (and/or has better access to) short-term credit than a company with a lower credit rating (such as BBB). In a swap, the BBB company would pay a fixed-rate to the AAA company while receiving a floating rate, which BBB company would use to cover payments on its short-term borrowings. In this way BBB company can fund long-term projects while having protection against rising interest rates. AAA-company receives a good fixed rate and can finance the floating-rate payment through its short-term borrowings.

SWAP with 3 counterparties, including dealer
[SWAP with 3 counterparties, including dealer]

The swap market has grown enormously since its inception in the late 1970s. By the end of 1999 there was nearly US$2 trillion in currency swap principal and US$52 trillion in interest-rate swap principal. By 2002 the swap market was approaching half-a-trillion US$ valuation per day, with the value of Euro (European Union currency) swaps approaching twice the value of dollar swaps. The swap market is facilitated primarily by dealers, rather than brokers. Dealers are typically large international commercial & investment banks with the financial means to act as a counterparty intermediate between fixed-rate payers and floating-rate payers. Dealers are market-makers who buy & sell swaps as intermediaries, whereas brokers act as agents and charge commission without risking capital. The dealer profits from a spread between the fixed rate paid by the fixed-rate payer and the fixed-rate passed-on to the fixed-rate receiver. The value-added by the dealer not only comes from matching counterparties, but in assuming risk for the credit-worthiness of the counterparties. Moreover, large dealers can maintain a large enough portfolio of swaps that money-management can compensate for lack of exact matches between individual counterparties.

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Mathematical details of bond cash-flow can become extremely complicated, but it is possible to describe some of the main concepts & terminology underlying these calculations in somewhat simple terms. To assist this process, many complexities are sometimes ignored, such as the use of a 360-day year in calculating accrued interest on corporate and municipal bonds sold between coupon dates (an approximation not used when calculating accrued interest on US Treasury notes & bonds). Sometime the fact that bond interest is paid semi-annually is ignored as a calculation simplification.

People can buy & sell future money in exchange for money currently held. The price of future money is the interest rate. A bond that is sold for a face value (par value, principal amount) of $1,000 and is redeemable in three years for the $1,000 plus $80 interest per year formally has an interest rate of $80/$1,000 = 0.08 = 8%. The $80 interest can be called the coupon or coupon rate, a terminology arising from the time when bonds were usually certificates with the interest payments collected by cutting and redeeming coupons from the certificate. The coupon interest rate is also called the nominal yield. If you buy a $1,000 face value bond for $1,000 with a 3-year maturity and an 8% nominal yield, and if you hold the bond to maturity collecting $80 each year, the nominal yield will be the actual yield that you earned.

But what if you buy a $1,000 face value, $80 coupon bond maturing in one year for a price of $800 rather than $1,000? In one year you would receive $1,080. Having bought the bond at a discount, the current yield (yearly coupon payment as percent of purchase price) is $80/$800 = 10% rather than the $80/$1,000 = 8% nominal yield (yearly coupon payment as percent of face value). The issuer of the bond may have created it when prevailing interest rates were 8%, but when he/she went to sell the bond on the market, was forced to sell it at the discount price of $800 because prevailing interest rates had increased to 10%. In general, any bond sold before the maturity date is likely to be sold at a discount (lower price) or premium (higher price) because current interest rates and anticipated future interest rates will probably be different from the interest rates and interest-rate forecasts which were prevailing when the bond was issued. Note that current yield ignores the fact that selling price may be different from face value, and is therefore not a true yield.

What if you buy a 3-year-maturity zero-coupon bond (no annual interest payments) having a face value of $1,000 yielding 8% interest? The $1,000 is discounted 3 times, for each of the three years: $794 = $1,000/(1.08)3. $794 is the present value (PV) of $1,000 received in 3 years, discounted at 8% interest. Viewed another way, three years worth of compounded 8% interest on $794 pays $1,000 at maturity: $1,000 = $794 X 1.08 X 1.08 X 1.08 = $794 X (1.08)3. $1,000 is the future value in 3 years of $794 in the present if invested at 8% interest.

In a rising interest-rate environment, the current interest rate (the spot rate) will be less than the expected prevailing interest rate one or two years in the future (the forward rate). For example, assume that investors could receive coupon (C) payments of $80 for each of the next three years and $1,000 at the end of the third year. If the spot rate is 7% (r1), the one-year forward rate is 8% (r2) and the forward rate expected in two years is 9% (r3), the term structure of the cash flows would result in a price (PV) of $977.31 (ie, bond price equals present value) :

                C               C               C                 P            
PV  =   -------   +   -------   +   -------   +   -------   
            (1+r1)        (1+r2)2        (1+r3)3        (1+r3)3     

             $80            $80             $80          $1,000         
      =   -------   +   -------   +   -------   +   -------    =   $74.77  +  $68.59  +  $61.77  +  $722.18 =  $977.31
           (1.07)        (1.08)2        (1.09)3       (1.09)3

Someone faced with buying a bond for a certain price which pays a principal (P) at maturity plus yearly coupons (C) might ask: what single interest rate could be attributed to the bond selling for $977.31 with $80 paid annually and a $1,000 redemption paid at maturity in 3 years?

              $80            $80             $80           $1,000
PV  =   -------  +    -------  +    -------  +    --------   =   $977.31
             (1+y)         (1+y)2         (1+y)3          (1+y)3

The interest rate y is called yield-to-maturity (YTM, also called internal rate of return). There is no simple algebraic formula to solve for yield-to-maturity in the above formula — solution must be either by trial-and-error or by an iterative program. In this case y can be shown to be 0.0889 (8.89%). Note that this YTM is distinct from the nominal yield of 8% and distinct from the current yield of $80/$977.31 = 0.819 (8.19%). Note also that the only way the $80 coupons can be discounted if bond price is equal to present value is if the $80 coupons are reinvested at interest rate y upon each payment and held until the maturity date.

Unlike nominal yield, the current yield and yield-to-maturity includes capital gain or loss. Current yield accounts for the effect of capital gain/loss on coupon interest. Yield-to-maturity reflects capital gain/loss on both coupon & principal. Nominal & current yield only give the return on a bond in a given year prior to maturity, whereas yield-to-maturity gives the full annualized return one receives by buying a bond, holding that bond, reinvesting the coupons at the same rate of interest and redeeming that bond at maturity. In the bond market yield typically means yield-to-maturity. For a callable bond, yield-to-call is used rather than yield-to-maturity.

For a present value (selling price) equal to the $1,000 face-value the value of y will be 0.08 (8%), ie, nominal yield, current yield and yield-to-maturity are all the same. This will be true whenever selling price equals face value (no capital gain or loss).

Yield-to-maturity does not determine bond price, the reverse is true. Yield-to-maturity is a conceptual tool — it is the most common means of comparing the relative values of bonds. Bond prices are determined by a series of different expected forward rates, not a single yield for all future time periods. Bond prices also are determined by supply & demand — and subjective values. Yield-to-maturity can be used to, for example, illustrate the effects of interest rate changes on bond price. A decrease in bond price is associated with an increased yield-to-maturity and the converse is also true. The following table illustrates the effects of a one and two percent increase/decrease from 8% yield-to-maturity (YTM) on bond price for 3-year, 10-year and 30-year bonds having face value of $1,000 and coupon of $80:

$80 Coupon, $1,000 face value
YTM3-year PV10-year PV30-year PV
6% $1,053$1,147$1,275
7% $1,026$1,070$1,124
8% $1,000$1,000$1,000
9% $975$936$897
10% $950$877$811

If you own an $80 coupon, $1,000 face value 3-year bond and YTMs rise 2%, the price (PV) will increase $53 whereas the price will decrease $50 for a 2% drop in rates. For a 30-year bond, prices will increase $275 or decline $189 for a 2% rise or drop, respectively. Thus, longer maturities are expected to show greater sensitivity/volatility for interest-rate changes than shorter maturities, everything else being equal.

A standard approximation of the sensitivity of bond price to a change in interest rates is called duration. In the example shown in the table, a 1% change in the YTM of a 3-year note from 8% to either 7% or 9% is about $25 or a 2.5% change. Thus, the duration of the 3 year bond is 2.5. For the 30-year bond a 1% change in YTM results in a change of about 12.4%, a 12.4 duration. An exact determination of sensitivity of bond price to interest rate change requires the use of calculus to determine second derivative to give convexity. In most cases the correction provided by convexity is very small and duration is an adequate measure of bond price volatility in response to interest rate changes.

Bonds with a higher coupon rate have a lower duration and bonds with a low coupon rate have a higher duration. When the coupon rate is zero (a zero-coupon bond), the duration is equal to the term-to-maturity. Speculators who want to trade in interest-rate-sensitive bonds prefer high duration, whereas investors who are averse to interest rate change risk (and who are not certain of holding bonds until the maturity date) prefer bonds with low duration. Duration does not, however, capture the volatility associated with credit rating or possible credit rating changes. Bonds with low credit rating are more volatile.

Yield Curve
[Yield Curve]

Investors normally will demand a higher interest rate for a given amount of money invested for a longer period of time to compensate for greater risk & deprivation, even without an expected interest-rate increase. For example, yield-to-maturity might be 7% for a 1-year debt instrument and 8% for a 2-year debt instrument. A plot of yield-to-maturities against time-to-maturities (normally 3-months to 30 years) is called a yield curve. Yield curves are usually drawn for US Treasuries because these are the most standardized debt instruments and because they are regarded as giving risk-free returns. Daily updates of the Treasuries yield curve can be found on the Bloomberg website, among others.


Inverted Yield Curve
[Inverted Yield Curve]

A yield curve will normally be upward-sloping because of the higher interest rates demanded for longer maturities, with a sharper slope for short-term maturities and a more flattened slope for longer-term. (The difference between 30 years & eternity is relatively negligible in the minds of investors.) If interest rates are expected to increase in the future the yield curve will slope upwards more strongly. Conversely, if there are strong expectations that interest rates will decline in the future, the yield curve may actually slope downward, and be called "inverted". Inverted yield curves were seen for US bond markets in 1989 and the year 2000.

(For more details on the mathematics of bond calculations, see Investopedia Advanced Bond Tutorial.)

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As in any freely-traded market for any good, bond market prices are a function of supply & demand. This simple fact can lead to confusion in the case of bonds, however, because of the inverse relationship between bond prices & bond yields. In times of crisis investors will seek the security of bonds, driving prices up and yields down. When governments increase bond sales to finance increased deficit spending the price of bonds fall, causing yields to increase. In times of economic growth when stock prices are soaring, yields on bonds must be high in order to compete for available capital — causing bond prices to fall. If the dollar is appreciating relative to other currencies, foreigners will buy more US bonds, causing yields to fall. High levels of inflation and expected future inflation cause interest rates (and bond yields) to rise, thereby lowering the price of bonds. Anticipated increases or decreases in the fed funds rate by the US Federal Reserve lead to decreases or increases in bond prices, respectively.

The bond market can seem like a ghoulish place where prices rally on international crisis & bad economic news — and fall in times of peace & prosperity. Although bond yields must compete with rising stock prices for capital during economic booms, recession is not entirely good for bond prices. In times of recession bond defaults increase and many corporate bonds see their ratings cut by the rating agencies — causing bond prices to fall and yields to increase. The number of investment-grade companies reduced to junk status was roughly 50% greater in 2001 than in 1989, the previous record year. Bond ratings in general had been falling since the late 1990s as companies such as IBM increasingly borrowed money to buy their own shares — thereby increasing the earnings per share (increasing price/earnings ratio). With debt cheaper than equity it made sense to increase leverage (borrowings) at the cost of credit rating — until the recession made credit more expensive. Cyclical industries such as automaking need to be more wary of debt than utilities, whose income is less affected by general economic conditions.


Foreign net purchases of U.S. securities, in billions
[Foreign net purchases of U.S. securities, in billions ]

Most of the US current account deficit (balance-of-trade, about 5% of GDP in 2002) was financed by foreigners buying investment-grade corporate & agency bonds. In mid-2002 foreigners owned 40% of Treasuries, 24% of corporate bonds and 13% of American equities. The decline of corporate credit ratings not only increases corporate bond yields, but increases the spread between corporate yields and those of Treasuries. Normally spreads between corporate bonds and Treasuries widen in times of prosperity due to high demand for credit, but in the late 1990s spreads had also increased due to the fact that the US government had been running fiscal surpluses and issuing fewer bonds.

With the profit recession of 2001 and the decline of credit ratings, companies which had been financing long-term projects by rolling-over commercial paper found their lower ratings forced them into issuing long-term bonds — steepening the yield curve. There was a huge increase in the issuance of convertible bonds by large-capitalized companies in 2001 as a cheaper financing alternative to commercial paper and standard long-term bonds. But 2001/2002 also saw considerable cutting of costs and of all forms of debt by corporations, a phenomenon commonly seen in recessions.

In times of political, economic & military crisis, not only do bond prices rally while stock prices sink, but Treasuries sell better than corporate municipal bonds and short-term Treasuries sell better than long-term. The "flight to quality" or "safe-haven buying" drives international capital into short-term US Treasury securities — as in the aftermath of the "911", 2001 World Trade Center attack. Short-term yields fall the most, causing the yield curve to steepen.

A steep yield curve would be expected at the bottom of a recession. Interest rates are low during times of recession because there is little demand for credit and central banks are cutting interest rates to stimulate the economy. But if economic growth and a bull market for stocks lie ahead, forward rates will be increasingly high, reflecting the high demand for credit when prosperity is creating many profitable investment opportunities. A steep yield curve encourages lending by banks, which can lend at higher rates than they can borrow — regarded as a boost for economic growth. Expecting that higher interest rates lie ahead, bond investors prefer to stick with short-term notes whereas borrowers try to extend their maturities to benefit from low rates while they can — further steepening the yield curve. But rising government budget deficits can also steepen the yield curve, as the large supply of long-term government debt on the market drives long-term bond prices lower & long-term bond yields higher. Anticipated future inflation will also steepen the yield curve because forward interest rates reflect nominal interest rate (real interest rate plus rate of inflation).

In times of prosperity the yield curve flattens as bond investors are less fearful about owning long-term maturities and as long-term bonds compete with rising stock prices in capital markets. Corporations issue more long-term bonds to finance long-term projects anticipated to yield long-term profits — driving long-term yields down.

In the extreme, the yield curve will invert when short-term debt pays higher interest rates than long-term debt. In recent decades an inverted yield curve has been a signal of coming recession. The Treasury yield curve inverted before the 1973 recession, inverted in 1989 before the 1990 recession and inverted again in the year 2000 before the 2001 recession.

The destructive effects of money supply by government central banks is reflected in the confounding of the effects of economic growth and inflation in bond markets. The Federal Reserve controls the short end of the yield. Normally the 2-year T-note trades with a yield about 20 basis points (ie, 0.2%) above the Fed Funds rate. Occasions in which the 2-year note trades below or well above the Fed Funds rate are usually short-lived anticipations of an impending Fed rate cut or hike, respectively. The Federal Reserve decreases the Fed Funds rate (thereby increasing the money supply) in order to stimulate the economy and increases the Fed Funds rate to fight the inflation which it has caused (thereby weakening the economy further). (For details on how central banks cause business cycles through interest-rate manipulation see my article An Austrian Theory of Business Cycles.)

Inverted Yield Curve
[Inverted Yield Curve]

High interest rates are normally associated with high economic growth (high real return) and/orr high inflation (high nominal return). So a yield curve based on the fact that long-term debt must pay higher interest to compensate for greater risk and longer separation from money will be steepened by expectations of future interest rates associated with inflation (Fed rate hikes) and/or economic growth. High anticipated risk of default or credit downgrades steepens the curve, as does a weakening US Dollar and rising government debt. Conversely, inverted yield curves have served as effective predictors of coming recession. Many investors regard the yield curve as the best predictor of future economic conditions — a better predictor than the stock market.

In January, 2000 the 30-year bond yield fell below that of the 10-year bond. The effect was dismissed as an artifact of the buying-back of long-term debt by the US government. But the Fed raised the fed funds rate 100 basis points (1%) in the next four months such that the entire Treasury yield curve was inverted by the summer. The swaps yield curve — not directly controlled by the Fed — did not invert, but it did flatten considerably. Only at the end of 2000 did the yield curve begin to slope positively again.

An inverted yield curve does more than fight inflation — it destroys investment and economic growth. At the peak of the interest-rate cycle — when yield curves have often inverted — capital is expensive for both long-term & short-term, but investors have no incentive to provide capital for long-term investments. Banks have no incentive to make long-term loans. The Dow Jones Industrial Average peaked in January, 2000, the same month the yield curve began to invert and the NASDAQ (financed more by equity than by debt) peaked two months later. A peak in the stock market is only recognized in retrospect, but a yield curve inversion is seen immediately.

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Treasuries have high liquidity — are easily-traded by individual investors. Only a few corporate bonds are traded on exchanges, however, and it is difficult for individuals to know prices or spreads. The Internet has improved this situation, but corporate bonds still trade thinly and individual investors still pay for large spreads between bid price and ask price. For bonds below investment grade, even brokers can have a hard time determining prices or executing trades in desired volumes. And doing research on corporate bonds can be a challenge. For these reasons, most individual investors buy corporate bonds through mutual funds.

Buying bonds from primary dealers who have access to more bonds is a way of reducing costs associated with large bid-ask spreads. Seeking actively-traded bonds is another way of reducing spreads. Spreads on corporate bonds are typically twice that of Treasuries. Bid-ask spreads on 2-year T-notes are typically lower than those on longer Treasuries. Actively traded corporates will have narrower spreads than corporates that trade rarely. Trading at times when trading volume is high is a way to reduce spreads (early in the day is better than late in the day, although trading can be heavy near a close). Holding bonds to maturity gives protection against both liquidity risk (spread risk) and interest-rate risk.

Investors often forget that yield-to-maturity calculations are based on the assumption that coupon payments are reinvested at the same rate of return. If interest rates fall this will clearly not be the case. To protect against interest-rate risk an investor could buy zero coupon bonds (bonds with no coupon) and hold those bonds until maturity, which will only leave the problem of how to reinvest at the maturity date. A series of bonds with evenly-spaced maturity dates provides some protection against this risk.

Corporate bonds and MBSs tend to widen their yield spread against Treasuries when interest rates are rising and tend to narrow the spread when interest rates are falling, in anticipation of worse & better economic outlook, respectively. Rising interest rates are seen as weakening the economy and falling rates are seen as strengthening. Increasing bond issues by corporations are often a sign that low interest rates and good future economic prospects are incentives to borrow.

High-yield bonds can be profitable, but shopping for them with an understanding of how to avoid default can be difficult for many investors. A bond fund from a company like PIMCO (Pacific Investment Management COmpany) ensures that the bond selection process is done by professional managers.

TIPS (Treasury Inflation-Protected Securities) are widely seen as a protection against inflation, but there are many drawbacks associated with this strategy: (1) TIPS are not protected against less-than-expected inflation, which can result in a low return (2) TIPS are not very liquid due to the small size of the market, which can mean a bad price if they must be sold (3) TIPS are not sold in maturities less than 5 years, which could mean a forced sale at the worst time (4) people who tend to bid for TIPS during a Treasury auction are very risk-averse types of people who might pay such a high price to avoid risk that the return is lower than an accurately predicted inflation. (5) the semi-annual adjustment made to the TIPS price is based on inflation data which is 6 months old, and therefore might not adequately compensate for inflation. (6) if the Federal Reserve and the US government is truly more committed-to and effective-at combating inflation now than in the past, other interest-rate and investment risks (and opportunity costs) might be more important to consider.

Counter to these objections: (1) market liquidity is not a concern if the TIPS are held to maturity (2) although less liquid than other Treasuries, TIPS are more liquid than most bonds and the payoff could compensate for bid-ask spread selling cost (3) over the long term the semi-annual adjustment delay seems less important — and can be advantageous in a falling CPI-U environment.

The 2-year US Treasury T-note tracks the Fed Funds rate fairly closely, and the Fed Funds rate tracks all forms of interest rate risk, including that due to inflation. But the 2-year note held for 2 years is not as limber as the Fed Funds rate, and investors may not be able to forecast two year's worth of interest-rate risk accurately.

An alternative strategy for inflation (and interest rate) protection is to invest in floaters (floating rate notes or bonds) which are adjusted on the basis of a prime rate, LIBOR or another benchmark interest rate.

The 1999 stock market rally helped make that year one of the worst for bonds in history — a 13.4% loss. In 1990 bond funds held more assets than equity funds, but by 1999 although bond fund assets had tripled, equity funds had four times more assets than bond funds. Exchange Traded Funds (ETFs) in bonds are still in the early stages, but unlike stock ETFs, bond ETFs cannot be structured to prevent yearly capital gains due to the high proportion of returns generated from interest income. Zero-coupon bonds offer no relief from capital gains because even though they pay no interest they are taxed as if they do.

For investors who are intent on timing the market, the expression "sell in May then go away" reflects the fact that most stock market gains occur in the October to May period, with more losses occurring June to September period is a good time to be invested in bonds. Also, buying very long-term Treasuries, munis or corporates when the yield curve is inverted — or when interest rates have peaked — is always a good strategy. The bonds will pay the highest interest for the longest time if held to maturity or can be sold at a good profit when interest rates have bottomed.

Interest-rate bottoms are a good time to buy callable bonds, because they pay better interest and will not be called as interest rates rise. But bond investors would do best to avoid buying anything but short-term bonds when at the bottom of the credit cycle because rising interest rates lower bond prices. The "bottom" is the best time to buy stocks & high-yield ("junk") bonds — unless things get worse! The trick, of course, is to be able to recognize the tops & bottoms!

Bond market prices often move opposite to stock market prices — when the stock market rallies the bond market falls. But bad news about a corporation hurts both its stock & bond prices. Bond prices of corporations in interest-rate sensitive sections of the economy (housing, automobiles & capital spending, especially) respond more strongly to interest-rate changes than do bond prices of utilities or companies producing consumer staples, including health-care products.

Rapid job growth is often seen as leading to higher inflation and therefore higher bond yields. Transportation and hotel industries can be quite sensitive to economic and political news. Mortgage-backed securities and callable bonds are bad investments in an environment of falling interest rates.

The bond market — and especially the Treasury market — is much more sensitive to general economic news than the stock market. A good source for information about bond market conditions and how the bond markets are reacting to economics news is the BondTalk website. Prices on recently-traded corporate & municipal bonds as well as links to bond dealers can be found on the website of The Bond Market Association.

(For a broader understanding of investing & trading strategies, see my article Investing & Trading in Equities: Art & Science.)

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