A treasury bond is a government security that has a maturity that ranges from 10 years to 30 years. It is thus a security that is traded in the capital market.
Like the treasury note it is issued at a discount. It also pays a coupon every six months according to a coupon rate. This security is mostly held by institutions that have long term liabilities like pension funds, long term insurers, etc.
The capital market is a market where securities that that has a long-term maturity are traded. These include treasury notes, treasury bonds, normal and preferential stocks. Generally securities with a maturity of greater than 1 years are traded in it. As you can see all securities that are not traded in the money market are traded in the capital market. The name capital market also indicate that companies and government raise capital in this market.
The capital market is divided into two different markets. Firstly the stock market also known as the equity market where normal and preferential stocks are traded. Secondly the bond market also known as the debt market where notes and bonds are traded.
Hence we can see that when companies and government need short term financing they raise funds in the money market whereas if they want to raise fund over the long term they would do so in the capital market.
Government securities are debt instruments that are issued by central banks with the aim of raising funds to finance government deficits. They can also be issued as a result of monetary policy where they are used to drain liquid. Although government usually prefer to use longer maturity to finance deficits while central banks usually like short-term maturity securities in monetary policy.
Types of government securities
There are four main types of securities that government issues
4. Treasury inflation protected securities (Tips)
These securities given the fact that they are issued by the government they are considered to be quite safe. However you should be aware that not all government securities are safe. Investors should remember examples such as Argentina defaulting on its bonds or Dubai trying to dodge out of its obligations by asserting that legally the bonds are not issued by the government but by a separate entity control by the government.
These government securities are also highly liquid. In fact government securities are the most traded of all securities. This is because by law banks, insurers and other financial institutions are required to hold a certain percentage of safe assets on their balance sheets. Hence a lot of these institutions hold government securities to reduce risk in their portfolio.
The increased liquidity comes from the fact that these institutions needs to have access to their funds at short notice. However when they do not need their money they need to invest it in a safe asset that they can sell easily. Hence this add to the increased liquidity of the government securities.
These securities can be obtained from two ways. Either over the counter at central banks and with financial institutions or though a system of auction at which financial institutions bid for them. we have already seen this system in the post on treasury bills.
A repo is a repurchase transaction and it is a security that is part of the money market.
So what is a repurchase transaction? A repurchase transaction is similar to a transaction that takes place in a pawn shop. The owner of a property goes to a pawn shop and exchange it for cash but he promises to come back later to buy the property at a higher price.
Now the same goes for a repo.
1. An institution that needs cash over a short period of time goes to lender with government securities such as government bonds, treasury bills or any other financial instruments that have a high rating as collateral.
2. The lender will lend money to the borrower in exchange for the collateral. The borrower also agrees to buy back the security at a higher price at a particular time. The difference between the two price is the profit of the lender. The time of repurchase can be from one day to a few months.If the repo transaction is greater than a month it is called a term repo. Less than a month it will be a simple repo.
3. At the agreed time the borrower buy back the collateral at the agreed higher price.
4. In case of default of the borrower the lender keep the collateral.
You can also have what is called a reverse repo. This is the opposite of a repo. In a reverse repo the the institution will buy a security and later agree to sell the security to the seller at a higher price.
Technically the two terms are used in different circumstances but put simply if the transactions is viewed from the borrower’s perspective where the borrower will repurchase the security later it is a repo but from the lender’s perspective the lender is forced to sell the security to the borrower then it is a reverse repo.
A typical case is when banks obtain funds from the central bank. the bank is considered to be doing a repo while the central bank is considered to be doing a reverse repo.
However it is mostly large institutions that deal in repos.
There are two ways in which securities are issued. They are either issued and interest is earned on the principal, hence the term interest-based securities, or they can be issued at a discount or at a premium, hence the term discount based securities.
In this post I am going to talk about those securities that are interest-based.
When you talk about such securities the investor, you, will invest a certain amount of money called the principal. This is the amount that you would invest at the beginning of the contract and at maturity you will receive this same amount.
Then the return every year on this amount that is invested is called the interest. The interest earned will be calculated using the interest rate on the investment. The higher the interest rate the higher the interest earned.
Hence generally this principal is invested for a length of time ranging from 7 days to five years. The interest rate of the investment also depend on the length of time for which the principal is invested. Generally the longer the time the higher the interest rate. This is because your money is locked in the investment for a longer length of time. You will thus have to be compensated for the decrease liquidity and the greater risk taken.
Now there are two ways in which interest will be accrued on the principal. It will be either a simple interest whereby the interest will be calculated every year on the principal alone. Hence you will obtain the same interest every year.
You can read a post on simple interest here.
The other type of interest is the compound interest whereby the interest earned every year is calculated on the principal and the interest earned in previous years. You can read a post on compound interest here.
As we have seen in an earlier post, the Banker’s Acceptance is one of the instruments traded in the money market.
It is simply an instruments that are used by companies to obtain funds. It is generally cheaper than loans or overdraft.
Let us take the examples below to understand how it works.
A company needs money to buy goods for the Christmas season and want to obtain funds from the bank and will pay back the money after Christmas. This company generally needs to pay cash especially if it is buying goods abroad where companies do not want to take the risk to give goods on credit.
The company will approach his bank and will enter into an agreement according to the sequence below.
1. The company approach the bank to enquire about the discount rate on BAs.
2. The BA will have a face value that the company will have to pay after a specific period of time. Likewise any investor that have bought the BA on the secondary market and who will present the BA to the bank at maturity will receive the face value as indicated on the BA.
The BA will also contain the commission that the bank will take from the company. Hence the bank will pay the company the face value minus the commission. If the face value is $ 1 million and the commission of the bank is $ 20000 then the company will receive only $ 980 000.
3. If the bank accepts this agreement it will endorse it. Hence the name of Banker’s Acceptance. If the bank has accepted the agreement it would have to pay the face value of the BA to the holder of the BA at maturity.
4. The bank will then sell the BA on the secondary market where it will be traded until it reaches maturity.
5. At maturity the company will pay back the face value of the BA to the bank. However even if this does not happen, the bank will have to pay the holder the face value.
However I would still discourage small investors from investing directly in the money market. It is much better to invest in a money market mutual fund.
The commercial paper is a form of debt securities that is issued by companies. As we have seen in this post on bonds government and corporations issue bonds that have maturities of greater than one year on the capital market. With regards to maturities shorter than one year the government will issue treasury bills whereas corporations will issue commercial papers. The commercial paper will thus be, like the treasury bill, a money market instrument.
Hence the commercial paper will be issued at a discount by companies and at maturity the holder of the commercial paper will be paid the face value of the commercial paper. The discount rate will depend on the credit rating of the company and present market conditions. Since it is only companies with good credit rating that can issue commercial papers, the discount rate will slightly higher than government for treasury bills.
Companies are constantly in need of funds to settle current liabilities and to buy inventories. This is because there is always a mismatch between income and spending, The companies will thus raise the short term fund needed in the money market because use of banks for such short-term financing is costlier and time consuming.
Just like the treasury bills, commercial papers are quite safe. This is because the short-term maturities at which they are issued means that investors can determine whether the firm has a risk of default on the commercial paper. This is because investors would have known from previous financial statements whether the companies is sound and what is the possibility of it going bankrupt. However as you may know banks with their exposure to risky derivatives or bank runs may go bankrupt even if they were sound a few months or weeks before.However given the slight possibility of going bankrupt the return will be slightly higher than on treasury bills.
You might thus think that commercial papers will be good to invest in. However these commercial papers are issued at high denominations. As a result the retail investors like you cannot invest directly in them. Thus the only way to get exposure to them is through money market mutual funds.But like I have said in a previous post it would be better if you invest in stocks, government and corporate bonds and other higher yielding instruments.
Happy investing.
