introduction section 4000 - the fed · accounting treatment ... maturity, unsecured promissory note...

IntroductionSection 4000.1

This section contains product profiles of finan-cial instruments that examiners may encounterduring the course of their review of capital-markets and trading activities. Knowledge ofspecific financial instruments is essential forexaminers’ successful review of these activities.These product profiles are intended as a generalreference for examiners; they are not intended tobe independently comprehensive but are struc-tured to give a basic overview of the instruments.

Each product profile contains a generaldescription of the product, its basic character-istics and features, a depiction of the market-place, market transparency, and the product’suses. The profiles also discuss pricing conven-tions, hedging issues, risks, accounting, risk-based capital treatments, and legal limitations.Finally, each profile contains references formore information.

Trading and Capital-Markets Activities Manual February 1998

Federal FundsSection 4005.1

GENERAL DESCRIPTION

Federal funds (fed funds) are reserves held in abank’s Federal Reserve Bank account. If a bankholds more fed funds than is required to coverits Regulation D reserve requirement, thoseexcess reserves may be lent to another financialinstitution with an account at a Federal ReserveBank. To the borrowing institution, these fundsare fed funds purchased. To the lending institu-tion, they arefed funds sold.

CHARACTERISTICS ANDFEATURES

Fed funds purchases are not government-insuredand are not subject to Regulation D reserverequirements or insurance assessments. Theycan be borrowed only by those depository insti-tutions that are required by the Monetary Con-trol Act of 1980 to hold reserves with FederalReserve Banks: commercial banks, savingsbanks, savings and loan associations, and creditunions. These transactions generally occur with-out a formal, written contract, which is a uniquefeature of fed funds.

Most fed funds transactions are conducted onan overnight-only basis because of the unpre-dictability of the amount of excess funds a bankmay have from day to day.Term fed fundsgenerally mature between two days to one year.Continuing contractsare overnight fed fundsloans that are automatically renewed unlessterminated by either the lender or the borrower—this type of arrangement is typically employedby correspondents who purchase overnight fedfunds from respondent banks. Unless notified tothe contrary by the respondent, the correspon-dent will continually roll the interbank depositinto fed funds, creating a longer-term instrumentof open maturity. The interest payments oncontinuing contract fed funds loans are com-puted from a formula based on each day’saverage fed funds rate.

Fed funds transactions are usually unsecured.Nevertheless, an upstream correspondent bankthat is selling funds may require collateraliza-tion if the credit quality of the purchaser is notstrong.

All fed funds transactions involve only Fed-eral Reserve Bank accounts. Two methods are

commonly used to transfer funds betweendepository institutions:

• The selling institution authorizes its districtFederal Reserve Bank to debit its reserveaccount and credit the reserve account of thebuying institution. Fedwire, the FederalReserve’s electronic funds and securities trans-fer network, is used to complete the transferwith immediate settlement. On the maturitydate, the buying institution uses Fedwire toreturn the funds purchased plus interest.

• A respondent bank tells its correspondent thatit intends to sell funds. In response, thecorrespondent bank purchases funds from therespondent by reclassifying the respondent’sdemand deposits asfederal funds purchased.The respondent does not have access to itsdeposited money as long as it is classified asfederal funds on the books of the correspon-dents. Upon maturity of the loan, the respon-dent’s demand deposit account is credited forthe total value of the loan plus interest.

USES

Banks lend fed funds to other banks which needto meet Regulation D reserve requirements orneed additional funding sources. Since reserveaccounts do not earn interest, banks prefer tosell fed funds rather than keep higher thannecessary reserve account balances. Communitybanks generally hold overnight fed funds sold asa source of primary liquidity.

DESCRIPTION OFMARKETPLACE

Transactions may be done directly betweenbanks, often in a correspondent relationship, orthrough brokers. They may be initiated by eitherthe buyer or the seller. Many regional banksstand ready to buy all excess funds availablefrom their community bank correspondents orsell needed funds up to a predetermined limit.Consequently, there is a large amount of demandin the fed funds market, with selling bankseasily able to dispose of all excess funds.Correspondent banks may also broker funds asagent as long as their role is fully disclosed. Fed

Trading and Capital-Markets Activities Manual February 1998Page 1

funds, including the term fed funds, are nonne-gotiable products and, therefore, there is nosecondary market.

Market Participants

Participants in the federal funds market includecommercial banks, thrift institutions, agenciesand branches of banks in the United States,federal agencies, and government securities deal-ers. The participants on the buy side and sellside are the same.

Market Transparency

Price transparency is high. Interbank brokersdisseminate quotes on market news services.Prices of fed funds are active and visible.

PRICING

Fed fund yields are quoted on an add-on basis.All fed funds yields are quoted on an actual/360-day basis. The fed funds rate is a key rate for themoney market because all other short-term ratesrelate to it. Bid/offer spreads may vary amonginstitutions, although the differences are usuallyslight. The fed effective rate on overnight fedfunds, the weighted average of all fed fundstransactions done in the broker’s market, ispublished inThe Wall Street Journal. ThompsonBankwatch rates the general credit quality ofbanks, which is used by banks when determin-ing credit risk for fed funds sold.

Rates on term fed funds are quoted in thebroker’s market or over the counter. In addition,money market brokers publish indicative quoteson the Telerate screen.

HEDGING

Due to the generally short-term nature of fedfunds, hedging does not usually occur, althoughfed funds futures contracts may be used ashedging vehicles.

RISKS

Interest-Rate Risk

For nonterm fed funds, interest-rate risk is

minimal due to the short maturity. For term fedfunds, interest-rate risk may be greater, depend-ing on the length of the term.

Credit Risk

Fed funds sold expose the lender to credit risk.Upstream correspondent banks may require col-lateral to compensate for their risks. All banksshould evaluate the credit quality of any bank towhom they sell fed funds and set a maximumline for each potential counterparty.

Liquidity Risk

The overnight market is highly liquid. As thereis no secondary market for term fed funds rates,their liquidity is directly related to their maturity.

Banks may purchase fed funds up to themaximum of the line established by sellingfinancial institutions. Those lines are generallynot disclosed to purchasing banks. Active usersmay need to test the availability of funds peri-odically to ensure that sufficient lines are avail-able when needed.

ACCOUNTING TREATMENT

Fed funds sold should be recorded at cost. Termfed funds sold should be reported as a loan onthe call report.

RISK-BASED CAPITALWEIGHTING

A 20 percent risk weight is appropriate for fedfunds. For specific risk weights for qualifiedtrading accounts, see section 2110.1, ‘‘CapitalAdequacy.’’

LEGAL LIMITATIONS FOR BANKINVESTMENT

A bank may sell overnight fed funds to anycounterparty without limit. Sales of fed fundswith maturities of one day or less or undercontinuing contract have been specifically

4005.1 Federal Funds

February 1998 Trading and Capital-Markets Activities ManualPage 2

excluded from lending limit restrictions by12 CFR 32. Term fed funds are subject to the 15percent lending limit with any one counterpartyand may be combined with all other creditextensions to that counterparty. Sales of fedfunds to affiliates are subject to 12 USC 371c,‘‘Loans to Affiliates.’’

REFERENCES

Federal Reserve Bank of New York.Fedpoints#15.New York, June 1991.

Federal Reserve Bank of Richmond.Instru-ments of the Money Market.Richmond,Virginia. 1993.

Stigum, Marcia.The Money Market.3rd ed.Homewood, Illinois: Business One Irwin,1990.

Woelfel, Charles J.Encyclopedia of Banking &Finance.10th ed. Chicago: Probus PublishingCompany, 1994.

Federal Funds 4005.1


Commercial PaperSection 4010.1

GENERAL DESCRIPTION

Commercial paper (CP) is a short-term, fixed-maturity, unsecured promissory note issued inthe open markets as an obligation of the issuingentity. CP is usually issued with maturities ofless than 270 days, with the most commonhaving maturities of 30 to 50 days or less. CP issold either directly by the issuer or through asecurities broker. For entities with a sufficientcredit rating, CP is generally backed by banklines of credit or letters of credit. However,some entities with lesser-quality credit will issueCP without credit enhancements. These issuesare typically through private placements and aregenerally not rated. Foreign corporations mayalso issue CP. Banks are active in the CP marketas issuers, investors, dealers, and lenders onlines of credit used to back CP issuance.


CP is issued in maturities that range anywherefrom a few days to 270 days (the Securities andExchange Commission (SEC) does not gener-ally require registration of securities due in lessthan 270 days), depending on the funding needsof the issuer. Most CP matures in less than 30days. Issuers prefer to issue CP with a maturityof less than 90 days so that banks can use the CPas collateral at the Federal Reserve discountwindow. Most issuers need ongoing financingand roll the CP over at maturity, using the newproceeds to pay off the maturing CP. The mini-mum round-lot transaction is $100,000. Some

issuers will sell CP in denominations of $25,000.CP is quoted on a 360-day discount basis. Asmall amount of CP is issued in interest-bearingform; the rate paid on this paper is the quoteddiscount rate converted to the equivalent simpleinterest rate. CP is typically issued in bearerform, but it may also be issued in registeredform.

CP Credit Ratings

Credit ratings are crucial to the CP marketbecause most investors restrict their CP invest-ments to high-quality CP or will only buy ratedCP. The CP ratings are assessments of theissuer’s likelihood of timely payment. Table 1summarizes CP ratings from the major ratingagencies.

Superior-rated issues are considered to have ahigh likelihood of repayment, satisfactory-ratedissues are considered to have satisfactory likeli-hood, and so on. Before they will assign a rating,the credit agencies require issuers to prove thatthey have adequate short-term liquidity. Someissuers raise their credit ratings by obtainingcredit support to guarantee payment, such as aletter of credit (credit-supported commercialpaper), or by collateralizing the issue withhigh-quality assets (asset-backed commercialpaper).

USES

Investors

CP is generally purchased as a short-term,liquid, interest-bearing security. The short

Table 1—Commercial Paper Ratings

Moody’s S&P Duff & Phelps Fitch

Superior P-1 A-1+/A-1 Duff 1, Duff 1,Duff 1+

F-1

Satisfactory P-2, P-3 A-2 Duff 2 F-2Adequate P-3 A-3 Duff 2 F-2Speculative NP B, C Duff 4 F-3Defaulted NP D Duff 5 F-5

Trading and Capital-Markets Activities Manual April 2003Page 1

maturity structure, low credit risk, and largenumber of issuers make CP an attractive short-term investment alternative for short-term port-folio managers and for the liquid portion oflonger-term portfolios. CP is particularly attrac-tive when interest rates are volatile, as manyinvestors are unwilling to buy long-term, fixed-rate debt in a volatile interest-rate environment.

Investors wishing to take a position in short-term rates denominated in a foreign currencywithout taking the risks of investing in anunfamiliar counterparty or facing country riskoften invest in an instrument such as GoldmanSachs’s Universal Commercial Paper (UCP) orMerrill Lynch’s Multicurrency CommercialPaper (MCCP). With UCP or MCCP, the dealercreates synthetic foreign currency–denominatedpaper by having a U.S. issuer issue CP in aforeign currency. The dealer then executes acurrency swap with the issuer, which eliminatesforeign-exchange risk for the issuer. The inves-tor is therefore left with a short-term piece ofpaper denominated in a foreign currency andthat is issued by a U.S. counterparty, thuseliminating country risk.

Banks and Bank Holding Companies

Bank holding companies (BHCs) are activeissuers of CP. The money raised is often used tofund nonbank activities in areas such as leasingand credit cards and to fund offshore branches.

BHCs use commercial paper in sweep pro-grams. On a BHC level, the sweep programs aremaintained with customers at the bank level, andthe funds are upstreamed to the parent as part ofthe BHC’s funding strategy. Sweep programsuse an agreement with the bank’s deposit cus-tomers (typically corporate accounts) that per-mits them to reinvest amounts in their depositaccounts above a designated level in overnightobligations of the parent bank holding company,another affiliate of the bank, or a third party.These obligations include instruments such ascommercial paper, program notes, and master-note agreements.


Investors

The short-term nature of commercial paper,

together with its low credit risk and largenumber of issuers, makes it an attractive short-term investment for many investors. Investmentcompanies, especially money funds, are thelargest investors in the CP market. Other signifi-cant investors include the trust departments ofbanks, insurance companies, corporate liquidityportfolios, and state and local government bod-ies. If CP carries a rating of A-2, P-2, or better,thrifts may buy CP and count it as part of theirliquidity reserves.

Issuers

Issuers of CP include industrial companies, suchas manufacturers, public utilities, and retailers,and financial institutions, such as banks andleasing companies. Financial issuers account forapproximately 75 percent of CP outstanding,with industrial issuance making up the remain-der. Approximately 75 percent of the CP out-standing carries the highest credit rating ofA-1/P-1 or better, while only approximately5 percent of CP outstanding carries a creditrating of A-3/P-3 or below. In the U.S. marketfor CP, domestic issuers account for approxi-mately 80 percent of issuance, with foreignissuers making up the remainder.

Several large finance companies and bankholding companies place their paper directlywith the investor without using a dealer.Approximately 40 percent of all CP outstandingis placed directly with the investor.

Primary Market

The primary market consists of CP sold directlyby issuers (direct paper) or sold through a dealeracting as principal (dealer paper). Dealer paperaccounts for most of the market. As principals,dealers buy and immediately sell the CP (with asmall markup called the dealer spread). Some-times the dealers hold CP as inventory for ashort time as a service to issuers in need ofimmediate funds. Dealers are mostly large invest-ment banks and commercial banks with subsid-iaries that underwrite and deal in securities.

Although dealers do not normally inventorypositions in CP, at times they will agree toposition any paper that the issuer posted but didnot sell on a particular day. The amount unsoldis usually small, and the positions assumed are

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April 2003 Trading and Capital-Markets Activities ManualPage 2

usually on an overnight basis only. If the marketmoves, most issuers give dealers the discretionto sell CP within established bands set by theissuer.

Issuers of CP have their own dedicated salesforce to market their paper. Direct issuers alsopost their rates on services such as Telerate andReuters and often post rates with bank moneydesks. Sometimes a company sells direct paperunder a master-note agreement, under which theinvestor can buy and sell CP daily, up to aspecific amount, for a specific interest rate that isset daily. The return on the master-note CP isslightly higher than that on an overnight repo.

Secondary Market

The CP market is larger than the market forother money market instruments, but secondarytrading is only moderately active. Most inves-tors have purchased CP tailored to their short-term investment needs and hold it to maturity. Ifan investor chooses to sell CP, he can usuallysell it back to the original seller (dealer orissuer). Although CP is not traded on an orga-nized exchange, price quotes for most of thesignificant issues can be obtained from securitybrokers. Average yields on newly issued CP arepublished in the Wall Street Journal.

PRICING

Each issue is priced based on the strength of thecredit rating of the issuer. CP is a discountinstrument, which means that it is sold at a priceless than its maturity value (though occasion-ally, CP is issued as interest-bearing paper). Thedifference between the maturity value and theprice paid is the interest earned by the investor.When calculating commercial paper, a year isassumed to have 360 days.

The yield on CP tracks that of other moneymarket instruments. CP yields are higher thanthose offered on comparable T-bills—the highercredit risk is due to less liquidity and the stateand local income tax exemption of T-bills. Therate on CP is also slightly higher than thatoffered on comparable certificates of deposit(CDs) due to the poorer liquidity of CP relativeto CDs.

HEDGING

As mentioned above, dealers do not usuallyinventory positions in CP. When they do, thesepositions tend to be small and are usually heldonly overnight. Because of the short-term natureof CP, dealers often do not hedge these openpositions. When these positions are hedged,dealers generally use instruments such as T-billfutures or Eurodollar futures to hedge theirresidual exposure. However, use of these prod-ucts may subject the dealer to basis risk to theextent that the underlying instrument and thehedge instrument do not move in tandem.

RISKS

Credit Risk

Given that CP is an unsecured obligation of theissuer, the purchaser assumes the risk that theissuer will not be able to pay the debt atmaturity. This credit risk is generally mitigatedby the financial strength of most issuers and bysome form of credit enhancement (unused banklines of credit, letters of credit, corporate guar-antees, or asset collateralization). Historically,the default rate on CP has been extremely low.

Liquidity Risk

As most investors hold CP until maturity, trad-ing in the secondary market is relatively thin. Asa result, only the highest-rated issues may bereadily marketable in the secondary market.Privately placed CP is subject to further legallymandated restrictions on resale, which presentsadditional impediments to marketability.

Interest-Rate Risk

Like all fixed-income instruments, CP is subjectto interest-rate risk. However, this risk is usuallyminimal given CP’s short-term nature.

Foreign-Exchange Risk

CP denominated in foreign currency may exposethe purchaser to foreign-exchange risk.

Commercial Paper 4010.1



The accounting treatment for investments incommercial paper is determined by the Finan-cial Accounting Standards Board’s Statement ofFinancial Accounting Standards No. 140 (FAS140), ‘‘Accounting for Transfers and Servicingof Financial Assets and Extinguishments ofLiabilities.’’ Accounting treatment for deriva-tives used as investments or for hedging pur-poses is determined by Statement of FinancialAccounting Standards No. 133 (FAS 133),‘‘Accounting for Derivatives and HedgingActivities,’’ as amended by Statement of Finan-cial Accounting Standards Nos. 137 and 138(FAS 137 and FAS 138). (See section 2120.1,‘‘Accounting,’’ for further discussion.)


CP is generally weighted at 100 percent unless itis backed by a bank letter of credit, in whichcase the asset weight would be 20 percent.Tax-exempt CP may carry weights of 20 percentor 50 percent, depending on the issuer (that is,depending on whether the obligation is a generalobligation or a revenue obligation). For specificrisk weights for qualified trading accounts, seesection 2110.1, ‘‘Capital Adequacy.’’


CP is considered a loan to the issuer and istherefore subject to the applicable lending limitof the purchasing institution. One exceptionwould be general obligation tax-exempt CP,which can be held without limitation. Holdingsof CP issued by an affiliate are subject to thelimitations of section 23A of the Federal ReserveAct regarding loans to affiliates.

REFERENCES

Fabozzi, Frank J., and T. Dessa, eds. The Hand-book of Fixed Income Securities. 4th ed.Chicago: Irwin Professional Publishing, 1995.

Hahn, Thomas K. ‘‘Commercial Paper.’’ Eco-nomic Quarterly 29(1993): 45–67.

Stigum, Marcia. After the Trade. Burr Ridge,Ill.: Dow Jones-Irwin, 1988.

Stigum, Marcia. The Money Market. 3rd ed.Burr Ridge, Ill.: Irwin Professional Publish-ing, 1990.

4010.1 Commercial Paper


Repurchase AgreementsSection 4015.1

GENERAL DESCRIPTION

A repurchase agreement (repo) involves the saleof a security to a counterparty with an agree-ment to repurchase it at a fixed price on anestablished future date. At initiation of thetransaction, the buyer pays the principal amountto the seller, and the security is transferred to thepossession of the buyer. At expiration of therepo, the principal amount is returned to theinitial buyer (or lender) and possession of thesecurity reverts to the initial seller (or borrower).Importantly, the security serves as collateralagainst the obligation of the borrower and doesnot actually become the property of the lender.Given the short tenor of a typical repo and theneed to make proper custody arrangements forthe securities involved, operational issues areimportant to proper management of repo activi-ties. At times, in addition to being a counter-party in some transactions, a bank may serve asthird-party custodian of securities collateral inother transactions as a service to the buyer andthe seller.

In a repurchase agreement, a bank borrowsfunds when it ‘‘sells’’ the security and commitsto ‘‘repurchase’’ it in the future. In a reverserepurchase agreement, the bank lends fundswhen it ‘‘buys’’ the security and commits to‘‘resell’’ it in the future. A reverse repo issometimes termed a resale agreement or a secu-rity purchased under agreement to resell (SPAR).The terms ‘‘repo’’ and ‘‘reverse repo’’ thusdescribe the same transaction, but from theperspective of each counterparty.

A closely related instrument is a dollar roll,which is identical to a repurchase agreementexcept that the ‘‘repurchase’’ leg of the trans-action may involve a similar security rather thanthe specific security initially ‘‘sold.’’ In a dollarroll, the transaction contract explicitly allowsfor substitution of the collateral. The borrowerof funds in this transaction thus runs the risk thatat the closing of the transaction he or she willown a security that is generally comparable butinferior in some material way to the originalsecurity.


Most repos are conducted with U.S. Treasury or

agency securities as collateral. Repos of mort-gage pass-through securities and collateralizedmortgage obligations (CMOs) issued or guaran-teed by U.S. government agencies are less com-mon but occur frequently. Repos of other secu-rities or loans are not common, in part becausethe Federal Reserve System generally considersrepos with other assets to be deposits of theselling institution and subject to Regulation Dreserve requirements.

Repos can be conducted on an overnightbasis, for a longer fixed term, or on an open-account basis. Overnight repos, or one-day trans-actions, represent approximately 80 percent ofall repo transactions. Anything longer (called a‘‘term repo’’) usually extends for less than30 days. Repo agreements ‘‘to maturity’’ arethose that mature on the same day as theunderlying securities. ‘‘Open’’ repo agreementshave no specific maturity, so either party has theright to close the transaction at any time.

USES

In general, repos are attractive to a variety ofmarket participants as (1) a low-cost source ofshort-term funding for borrowers and (2) anasset with high credit quality regardless of thecounterparty for suppliers of funds. Participationin this market requires proper operational andadministrative arrangements as well as an inven-tory of eligible collateral.

Dealers

Repos can be used to finance long positions indealers’ portfolios by short-term borrowing. Therepo market is a highly liquid and efficientmarket for funding dealers’ bond inventory at ashort-term rate of interest. Dealers may also userepos to speculate on future levels of interestrates. The difference between the coupon rate onthe dealer’s bond and the repo rate paid by thedealer is called ‘‘carry,’’ and it can be a source ofdealer profit. Sometimes the borrowing rate willbe below the bond’s coupon rate (positive carry),and sometimes the borrowing rate will be abovethe bond’s coupon rate (negative carry).

Dealers may use reverse repos to cover shortpositions or failed transactions. The advantage


of the reverse repo is that a dealer may borrowa security it has sold short with either positive ornegative carry. A problem arises, however, whendemand exceeds supply for a specific bond issue(collateral), and it goes on ‘‘special.’’ Thismeans that those who own the security can earna premium by lending it to those needing todeliver on short positions. These ‘‘lenders’’ arecompensated by paying a below-market borrow-ing rate on the cash side of the transaction (therepo rate is lower on ‘‘specials’’ because theowner of the special security is the borrower ofcash funds and is seeking the lowest lending ratepossible).

Bank Nondealer Activity

Like dealers, a bank can use repos to fund longpositions and profit from the carry. The marketalso gives a bank the means to use its securitiesportfolio to obtain additional liquidity—that is,funding—without liquidating its investments orrecognizing a gain or loss on the transaction. Formoney market participants with excess funds toinvest in the short term, reverse repos provide acollateralized lending vehicle offering a betteryield than comparable time deposit instruments.

Commercial Depositors

Repos have proved to be popular temporaryinvestment vehicles for individuals, firms, andgovernments with unpredictable cash flows.Repos (like other money market instruments)can also be used as a destination investment forcommercial depositors with sweep accounts,that is, transaction accounts in which excessbalances are ‘‘swept’’ into higher-yielding non-bank instruments overnight. Again, as collateralfor the corporation’s investment, the counter-party or bank will ‘‘sell’’ Treasury bills to thecustomer (that is, collateralize the loan).


On any given day, the volume of repo transac-tions amounts to an estimated $1 trillion. Impor-tant lenders of funds in the market include largecorporations (for example, General Motors) andmutual funds. Borrowers generally include large

money-center or regional banks with a need forfunding.

Repos are not traded on organized exchanges.There is no secondary market, and quoted mar-ket values are not available. The Public Securi-ties Association has produced a standard masterrepo agreement and supplements that are usedthroughout the industry. Although the trans-actions themselves are not rated, the entitiesundertaking repos (such as larger banks anddealers) may be rated by Moody’s, Standard &Poor’s, or other rating agencies.

PRICING

Repo rates may vary somewhat with the type ofcollateral and the term of the transaction. Over-night repos with U.S. government collateral,however, generally take place at rates slightlybelow the federal funds rate. Interest may bepaid explicitly, so that the ‘‘sale’’ price and‘‘repurchase’’ price of the security are the same,or it may be embedded in a difference betweenthe sale price and repurchase price.

The seller of a security under a repo agree-ment continues to receive all interest and prin-cipal payments on the security while the pur-chaser receives a fixed rate of interest on ashort-term investment. In this respect, interestrates on overnight repo agreements usually arelower than the federal funds rate by as much as25 basis points. The additional security providedby the loan collateral employed with reposlessens their risk relative to federal funds.

Interest is calculated on an actual/360 day-count add-on basis. When executed under acontinuing contract (known as a demand oropen-basis overnight repo), repo contracts usu-ally contain a clause to adjust the interest rate ona day-to-day basis.

HEDGING

Since repo rates move closely with those ofother short-term instruments, the hedge vehiclesavailable for these other instruments offer anattractive hedge for positions in repos. If theportfolio of repos is not maintained as a matchedbook by the institution, the dealer or bank couldbe subject to a level of residual market risk.

4015.1 Repurchase Agreements


RISKS

Market Risk

Repos and reverse repos, if used to fund longeror more sensitive positions, expose the institu-tion to changes in the future levels of interestrates.

Credit Risk

The buyer is exposed to the risk that the sellerwill default on his or her obligation to repur-chase the security when agreed. Of course, thebuyer has access to the security as collateral and,in the event of default, the security could be soldto satisfy the debt. However, this could occuronly through legal procedures and bankruptcy.Despite the conventional terminology, this typeof transaction is a collateralized advance and nottruly considered a sale and repurchase. If thevalue of the security has declined since thefunds were disbursed, a loss may be incurred.Overcollateralization and margin arrangementsare used to reduce this risk.

Operational Risk

If the buyer is to rely on its ability to sell asecurity in the open market upon the seller’sdefault, it must exercise effective control overthe securities collateralizing the transactions.The Government Securities Act was passed in1986 to address abuses that had resulted incustomer losses when the security was held bythe seller. Its requirements include (1) writtenrepurchase agreements must be in place, (2) therisks of the transactions must be disclosed tothe customer, (3) specific repurchase securitiesmust be allocated to and segregated for thecustomer, and (4) confirmations must be madeand provided to the customer by the end of theday on which a transaction is initiated and onany day on which a substitution of securitiesoccurs. Participants in repo transactions nowwill often require securities to be delivered orheld by a third-party custodian. (See sec-tion 2020.1 of theCommercial Bank Examina-tion Manual.)


The accounting treatment for repurchase agree-ments is determined by the Financial Account-ing Standards Board’s Statement of FinancialAccounting Standards No. 140 (FAS 140),‘‘Accounting for Transfers and Servicing ofFinancial Assets and Extinguishments of Liabili-ties.’’ Accounting treatment for derivatives usedas investments or for hedging purposes is deter-mined by Statement of Financial AccountingStandards No. 133 (FAS 133), ‘‘Accounting forDerivatives and Hedging Activities,’’ as amendedby Statement of Financial Accounting StandardsNos. 137 and 138 (FAS 137 and FAS 138). (Seesection 2120.1, ‘‘Accounting,’’ for furtherdiscussion.)


In general, assets collateralized by the currentmarket value of securities issued or guaranteedby the U.S. government, its agencies, orgovernment-sponsored agencies are given a20 percent risk weight. If appropriate proceduresto perfect a lien in the collateral are not taken,the asset should be assigned a 100 percent riskweight. For specific risk weights for qualifiedtrading accounts, see section 2110.1, ‘‘CapitalAdequacy.’’


Repos on securities that are eligible for bankinvestment under 12 USC 24 (seventh) and 12CFR 1 and that meet guidelines set forth by theFederal Reserve System may be held withoutlimit. Repos that do not meet these guidelinesshould be treated as unsecured loans to thecounterparty subject to 12 USC 84 and shouldbe combined with other credit extensions to thatcounterparty. Repos with affiliates are subject to12 USC 371c.

REFERENCES

Board of Governors of the Federal ReserveSystem. Commercial Bank ExaminationManual. Section 2030.1, ‘‘Bank DealerActivities.’’

Repurchase Agreements 4015.1


Board of Governors of the Federal ReserveSystem. Bank Holding Company SupervisionManual. Section 2150.0, ‘‘ RepurchaseTransactions.’’

Clarke, David. ‘‘ U.S. Repo: A Model Market.’’International Securities Lending. September1993.

Cook, Timothy Q., and Robert LaRoche, eds.Instruments of the Money Market. 7th ed.Richmond, Va.: Federal Reserve Bank ofRichmond, 1993.

‘‘ How Banks Reap the Benefits of Repo.’’International Securities Lending. Second quar-ter 1994.

Mishkin, Frederic S. The Economics of Money,Banking, and Financial Markets. 4th ed. NewYork: Harper Collins College Publishers, 1995.

Stigum, Marcia. The Money Market. 3rd ed.Burr Ridge, Illinois: Irwin Professional Pub-lishing, 1990.

Stigum, Marcia. The Repo and Reverse Markets.Homewood, Illinois: Dow Jones-Irwin, 1989.

4015.1 Repurchase Agreements


U.S. Treasury Bills, Notes, and BondsSection 4020.1

GENERAL DESCRIPTION

U.S. Treasury bills, notes, and bonds (collec-tively known as ‘‘Treasuries’’) are issued by theTreasury Department and represent directobligations of the U.S. government. Treasurieshave very little credit risk and are backed by thefull faith and credit of the U.S. government.Treasuries are issued in various maturities of upto 10 years.


Treasury Bills

Treasury bills, or T-bills, are negotiable, non-interest-bearing securities with original maturi-ties of three months, six months, and one year.T-bills are offered by the Treasury in minimumdenominations of $10,000, with multiples of$5,000 thereafter, and are offered only in book-entry form. T-bills are issued at a discount fromface value and are redeemed at par value. Thedifference between the discounted purchase priceand the face value of the T-bill is the interestincome that the purchaser receives. The yield ona T-bill is a function of this interest income andthe maturity of the T-bill. The returns are treatedas ordinary income for federal tax purposes andare exempt from state and local taxes.

Treasury Notes and Bonds

Treasury notes are currently issued in maturitiesof 2, 3, 5, and 10 years on a regular schedule.Treasury notes are not callable. Notes and bondspay interest semiannually, when coupon ratesare set at the time of issuance based on marketinterest rates and demand for the issue. Notesand bonds are issued monthly or quarterly,depending on the maturity of the issue. Notesand bonds settle regular-way, which is one dayafter the trade date (T+1). Interest is calculatedusing an actual/365-day-count convention.

USES

Banks use Treasuries for investment, hedging,and speculative purposes. The lack of credit risk

and deep liquidity encourages the use of Trea-suries as investment vehicles, and they are oftenheld in a bank’s investment portfolio as a sourceof liquidity. Since it is the deepest and mostefficient financial market available, many fixed-income and derivative instruments are pricedrelative to Treasuries. Speculators often useTreasuries to take positions on changes in thelevel and term structure of interest rates.


Issuing Practices

T-bills are issued at regular intervals on a yield-auction basis. The three-month and six-monthT-bills are auctioned every Monday. The one-year T-bills are auctioned in the third week ofevery month. The amount of T-bills to beauctioned is released on the preceding Tuesday,with settlement occurring on the Thursday fol-lowing the auction. The auction of T-bills isdone on a competitive-bid basis (the lowest-yield bids are chosen because they will cost theTreasury less money). Noncompetitive bids mayalso be placed on purchases of up to $1 million.The price paid by these bids (if allocated aportion of the issue) is an average of the priceresulting from the competitive bids.

Two-year and 5-year notes are issued once amonth. The notes are generally announced nearthe middle of each month and auctioned oneweek later. They are usually issued on the lastday of each month. Auctions for 3-year and10-year notes are usually announced on the firstWednesday of February, May, August, andNovember. The notes are generally auctionedduring the second week of those months andissued on the 15th day of the month.

Primary Market

Treasury notes and bonds are issued throughyield auctions of new issues for cash. Bids areseparated into competitive bids and noncompeti-tive bids. Competitive bids are made by primarygovernment dealers, while noncompetitive bidsare made by individual investors and smallinstitutions. Competitive bidders bid yields to


three decimal places for specific quantities ofthe new issue. Two types of auctions are cur-rently used to sell securities:

• Multiple-price auction. Competitive bids areranked by the yield bid, from lowest to high-est. The lowest price (highest yield) needed toplace the allotted securities auction is deter-mined. Treasuries are then allocated to non-competitive bidders at the average yield forthe accepted competitive bids. After all Trea-suries are allocated to noncompetitive bidders,the remaining securities are allocated to com-petitive bidders, with the bidder bidding thehighest price (lowest yield) being awardedfirst. This procedure continues until the entireallocation of securities remaining to be sold isfilled. Regional dealers who are not primarygovernment dealers often get their allotmentof Treasury notes and bonds through primarydealers, who may submit bids for the accountsof their customers as well as for their ownaccounts. This type of auction is used for3-year and 10-year notes.

• Single-price auction. In this type of auction,each successful competitive bidder and eachnoncompetitive bidder is awarded securities atthe price equivalent to the highest acceptedrate or yield. This type of auction is used for2-year and 5-year notes.

During the one- to two-week period betweenthe time a new Treasury note or bond issue isauctioned and the time the securities sold areactually issued, securities that have been auc-tioned but not yet issued trade actively on awhen-issued basis. They also trade when-issuedduring the announcement to the auction period.

Secondary Market

Secondary trading in Treasuries occurs in theover-the-counter (OTC) market. In the second-ary market, the most recently auctioned Trea-sury issue is considered ‘‘ current,’’ or ‘‘ on-the-run.’’ Issues auctioned before current issues aretypically referred to as ‘‘ off-the-run’’ securities.In general, current issues are much more activelytraded and have much more liquidity than off-the-run securities. This often results in off-the-run securities trading at a higher yield thansimilar-maturity current issues.

Market ParticipantsSell Side

All U.S. government securities are traded OTC,with the primary government securities dealersbeing the largest and most important marketparticipants. A small group of interdealer bro-kers disseminates quotes and broker trades on ablind basis between primary dealers and users ofthe Government Securities Clearing Corpora-tion (GSCC), the private clearinghouse createdin 1986 to settle trades for the market.

Buy Side

A wide range of investors use Treasuries forinvesting, hedging, and speculation. This includescommercial and investment banks, insurancecompanies, pension funds, and mutual fund andretail investors.

Market Transparency

Price transparency is relatively high for Trea-sury securities since several information ven-dors disseminate prices to the investing public.Govpx, an industry-sponsored corporation, dis-seminates price and trading information overinterdealer broker screens. Prices of Treasuriesare active and visible.

PRICING

Treasury Bills

Treasury bills are traded on a discount basis.The yield on a discount basis is computed usingthe following formula:

Annualized Yield =[(Face Value / Price) / Face Value]

× (360 / Days Remaining to Maturity)

4020.1 U.S. Treasury Bills, Notes, and Bonds


Treasury Notes and Bonds

Treasury note and bond prices are quoted on apercentage basis in 32nds. For instance, a priceof 98:16 means that the price of the note or bondwill be 98.5 percent of par (that is, 98 16/32).Notes and bonds can be refined to 64ths throughthe use of a plus tick. A 98:16+ bid means thatthe bid is 98 and 161⁄2 32nds (that is, 9816.5/32), which is equivalent to 98.515625 per-cent of par. When the note or bond is traded, thebuyer pays the dollar price plus accrued interestas of the settlement date. Yields are also quotedon an actual/365-day-count convention.

HEDGING

Treasuries are typically hedged in the futures oroptions markets or by taking a contra position inanother Treasury security. Also, if a position innotes or bonds is hedged using an OTC option,the relative illiquidity of the option may dimin-ish the effectiveness of the hedge.

RISKS

Market Risk

The risks of trading Treasury securities ariseprimarily from the interest-rate risk associatedwith holding positions and the type of tradingconducted by the institution. Treasury securitiesare subject to price fluctuations because ofchanges in interest rates. Longer-term issueshave more price volatility than shorter-terminstruments. A large concentration of long-termmaturities may subject a bank’s investmentportfolio to increased interest-rate risk. Forinstance, an institution that does arbitrage trad-ing by buying an issue that is relatively cheap(that is, an off-the-run security) in comparison tohistorical relationships and selling one that isrelatively expensive (that is, a current security)may expose itself to large losses if the spreadbetween the two securities does not follow itshistorical alignments. In addition, dealers maytake positions based on their expectations ofinterest-rate changes, which can be risky giventhe size of positions and the impact that smallchanges in rates have on the value of longer-duration instruments. If this type of trading isoccurring, the institution’s risk-management sys-tem should be sufficiently sophisticated to handle

the magnitude of risk to which the dealer isexposed.

Liquidity Risk

Because of their lower liquidity, off-the-runsecurities generally have a higher yield thancurrent securities. Many institutions attempt toarbitrage these pricing anomalies between cur-rent and off-the-run securities.


The accounting treatment for investments inTreasuries is determined by the FinancialAccounting Standards Board’s Statement ofFinancial Accounting Standards No. 115 (FAS115), ‘‘Accounting for Certain Investments inDebt and Equity Securities,’’ as amended byStatement of Financial Accounting StandardsNo. 140 (FAS 140), ‘‘Accounting for Transfersand Servicing of Financial Assets and Extin-guishments of Liabilities.’’ Accounting treat-ment for derivatives used as investments or forhedging purposes is determined by Statement ofFinancial Accounting Standards No. 133 (FAS133), ‘‘Accounting for Derivatives and HedgingActivities,’’ as amended by Statement of Finan-cial Accounting Standards Nos. 137 and 138(FAS 137 and FAS 138). (See section 2120.1,‘‘Accounting,’’ for further discussion.)


U.S. Treasury bills, notes, and bonds have a zeropercent risk weighting. For specific risk weightsfor qualified trading accounts, see section 2110.1,‘‘Capital Adequacy.’’


U.S. Treasury bills, notes, and bonds are type Isecurities with no legal limitations on a bank’sinvestment.

REFERENCES

Fabozzi, Frank J., and T. Dessa Fabozzi, ed. TheHandbook of Fixed Income Securities. 4th ed.

U.S. Treasury Bills, Notes, and Bonds 4020.1


Chicago: Irwin Professional Publishing, 1995.Stigum, Marcia L. The Money Market. 3d ed.

Homewood, Ill.: Dow Jones-Irwin, 1990.

U.S. Department of the Treasury. Buying Trea-sury Securities. Washington, D.C.: TheBureau of the Public Debt, 1995.

4020.1 U.S. Treasury Bills, Notes, and Bonds


U.S. Treasury STRIPSSection 4025.1

GENERAL DESCRIPTION

STRIPS are zero-coupon securities (zeros) ofthe U.S. Treasury created by physically separat-ing the principal and interest cash flows. Thisprocess of separating cash flows from standardfixed-rate Treasury securities is referred to as‘‘coupon stripping.’’ Similar trademark securi-ties with such acronyms as CATS and TIGRs arecreated by investment banks.


STRIPS is the U.S. Treasury’s acronym for‘‘Separate Trading of Registered Interest andPrincipal Securities,’’ the Treasury programdeveloped in 1985 to facilitate the stripping ofdesignated Treasury securities. All new Trea-sury bonds and notes with maturities of 10 yearsand longer are eligible to be stripped under thisprogram and are direct obligations of the U.S.government. Under the STRIPS program, theholder of any eligible security can request thatthe U.S. Treasury create separate book-entryinstruments for all of the principal and interestcash flows. The principal and interest portions ofthese instruments are assigned separate identifi-cation (CUSIP) numbers and may be owned andtraded separately.

Trademark Products

Trademark products, which predate the STRIPSmarket, are stripped Treasury securities createdby investment banks. In August 1982, MerrillLynch marketed its Treasury Income GrowthReceipts (TIGRs) and Salomon Brothers mar-keted its receipts as Certificates of Accrual onTreasury Securities (CATS). Other investmentbanks followed suit by issuing their own receipts.These products were created by purchasingTreasury securities and depositing them in atrust. The trusts then issued receipts represent-ing ownership interests in the coupon and prin-cipal payments of the underlying Treasurysecurities.

Since the start of the STRIPS program in1985, creation of trademark products such as

TIGRs and CATS has ceased, and STRIPSnow dominate the market. Trademark productsare, however, still traded in the secondarymarket.

USES

STRIPS and other zero-coupon instruments canbe tailored to meet a wide range of portfolioobjectives because of their known cash-flowvalue at specific future dates. Specifically, theyappeal to investors who want to lock in aterminal value without incurring the risk asso-ciated with reinvesting intervening cash flows.They also appeal to investors with definiteopinions on interest rates, as prices of STRIPSare highly sensitive to changes in interest rates.Due to this high sensitivity to interest-ratechanges, disproportionately large long-maturityholdings of Treasury derivatives such as STRIPS,CATS, or TIGRs in relation to the total invest-ment portfolio or total capital of a depositoryinstitution would be considered an imprudentinvestment practice.


The STRIPS program provides that all strippedsecurities be maintained in a book-entry format.For maintenance and transfer purposes, eachmarketable Treasury security has a unique iden-tification (CUSIP) number. Under STRIPS, eachprincipal and interest component is assigned aseparate CUSIP number. All STRIPS are tradedover the counter (OTC), with the primary gov-ernment securities dealers being the largest andmost important market participants. A smallgroup of interdealer brokers disseminates quotesand broker trades on a blind basis betweenmarket participants. Arbitrageurs continuallymonitor the prices of STRIPS and underlyingcoupon-bearing bonds, looking for profitableopportunities to strip or reconstitute. Price trans-parency is relatively high for STRIPS sinceseveral information vendors disseminate pricesto the investment public.

Trading and Capital-Markets Activities Manual September 2001Page 1

Market Participants

A wide range of investors use zeros for invest-ing, hedging, and speculation. This includescommercial and investment banks, insurancecompanies, pension funds, and mutual fund andretail investors.

PRICING

The prices of STRIPS, CATS, and TIGRs arequoted on a discount basis, as a percentage ofpar. Eligible securities can be stripped at anytime. For a book-entry security to be separatedinto its component parts, the par value must bean amount which, based on the stated interestrate, will produce a semiannual interest paymentof $1,000 or a multiple of $1,000. Quotes forSTRIPS are quoted in yields to maturity.

HEDGING

Zeros are typically hedged in the futures oroptions markets, or by taking a contra positionin another Treasury security. The effectivenessof any hedge depends on yield-curve and basisrisk. Also, if a position in zeros is hedged withan OTC option, the relative illiquidity of thederivative Treasury security and the option maydiminish the effectiveness of the hedge.

RISKS

Many factors affect the value of zeros. Theseinclude the current level of interest rates and theshape of their term structure (interest-rate risk),bond maturities (rate sensitivity or duration),and the relative demand for zero-coupon bonds(liquidity).

Interest-Rate Risk

Increases in the level of interest rates increasethe advantages of stripping. This is because theconstant-yield method applied to premium bondsresults in a lower price than linear amortizationdoes. Zeros have higher sensitivity to changes ininterest rates than bonds with the same maturity.Because they are zero-coupon bonds, their

duration equals their maturity. Duration mea-sures the percentage change in price for a givenchange in rates. The higher the duration, thehigher the potential volatility.

Liquidity Risk

The STRIPS market is significantly less liquidthan the U.S. Treasury bond market. Investorsencounter wider bid/ask spreads and are subjectto higher commissions. In addition, liquiditymay fluctuate significantly in times of marketinstability. However, since a dealer can strip orreconstitute bonds in a fairly flexible manner, ifzero-coupon prices diverge too far from theirequilibrium levels, a new supply can be createdor reduced through the stripping and reconstitu-tion process.

Trademark products may have an uncertainmarketability, as some may be eligible to bepurchased only though the sponsoring dealer.CATS, however, are listed on the New YorkStock Exchange, enhancing their liquidity. Themarket for zero-coupon Treasuries is more retail-oriented than the rest of the market. This oftenresults in wider trading spreads, smaller trans-action size, and less liquidity.

Credit Risk

As an obligation of the U.S. Treasury, STRIPSare considered to be free from default (credit)risk. Trademark products such as CATS andTIGRs are collateralized by the underlying U.S.Treasury, but whether they are considered‘‘obligations’’ of the U.S. Treasury is uncertain.Proprietary products should be reviewed indi-vidually to determine the extent of credit risk.


The accounting treatment for investments inU.S. Treasury STRIPS is determined by theFinancial Accounting Standards Board’s State-ment of Financial Accounting Standards No.115 (FAS 115), ‘‘Accounting for Certain Invest-ments in Debt and Equity Securities,’’ asamended by Statement of Financial AccountingStandards No. 140 (FAS 140), ‘‘Accounting forTransfers and Servicing of Financial Assets andExtinguishments of Liabilities.’’ Accounting

4025.1 U.S. Treasury STRIPS

September 2001 Trading and Capital-Markets Activities ManualPage 2

treatment for derivatives used as investments orfor hedging purposes is determined by State-ment of Financial Accounting Standards No.133 (FAS 133), ‘‘Accounting for Derivativesand Hedging Activities,’’ as amended by State-ment of Financial Accounting Standards Nos.137 and 138 (FAS 137 and FAS 138). (Seesection 2120.1, ‘‘Accounting,’’ for further dis-cussion.)


U.S. Treasury STRIPS have a zero percent riskweighting. Trademark products have a 20 per-cent risk weighting. For specific risk weights forqualified trading accounts, see section 2110.1,‘‘Capital Adequacy.’’


U.S. Treasury STRIPS are a type I security withno limitations on a bank’s investment. Trade-mark products are proprietary products, so legallimits vary. Appropriate supervisory personnelshould be consulted on specific issues.

REFERENCES

Fabozzi, Frank J., and T. Dessa Fabozzi, eds.The Handbook of Fixed Income Securities.4th ed. Chicago: Irwin ProfessionalPublishing.

Federal Reserve Regulatory Service, vol. 1,3–1562.

Gregory, Deborah W., and Miles Livingston.‘‘Development of the Market for U.S. Trea-sury STRIPS.’’ Financial Analyst Journal.March/April 1992.

Nagan, Peter S., and Kenneth A. Kaufman.‘‘STRIPS—An Exciting New Market forZero-Coupons.’’ABA Banking Journal.

Stigum, Marcia L.The Money Market. 3rd ed.Burr Ridge, Ill.: Irwin ProfessionalPublishing.

Woelfel, Charles J.Encyclopedia of Bankingand Finance. 10th ed. Cambridge, England:Probus Publishing Company.

U.S. Treasury STRIPS 4025.1


Treasury Inflation-Indexed SecuritiesSection 4030.1

GENERAL DESCRIPTION

Treasury inflation-indexed securities (TIIs) areissued by the Treasury Department and repre-sent direct obligations of the U.S. government.The securities are designed to provide investorswith a hedge against increases in inflation. Theinitial auction of these relatively new securitieswas held in January 1997, when a 10-year notewas issued. Various longer-term maturities areplanned for future auctions, which will be heldquarterly. TIIs have very little credit risk, sincethey are backed by the full faith and credit of theU.S. government. Banks can be designated asprimary dealers of Treasury securities, but theymay sell them in the secondary markets andinvest in TIIs for their own account.


TIIs were created to meet the needs of longer-term investors wanting to insulate their invest-ment principal from erosion due to inflation.The initial par amount of each TII issue isindexed to the nonseasonally adjusted Con-sumer Price Index for All Urban Consumers(CPI-U). The index ratio is determined bydividing the current CPI-U level by the CPI-Ulevel that applied at the time the security wasissued or last re-indexed. If there is a period ofdeflation, the principal value can be reducedbelow par at any time between the date ofissuance and maturity. However, if at maturitythe inflation-adjusted principal amount is belowpar, the Treasury will redeem the security at par.Every six months, interest is paid based on afixed rate determined at the initial auction; thisrate will remain fixed throughout the term of thesecurity. Semiannual interest payments are deter-mined by multiplying the inflation-adjusted prin-cipal amount by one-half the stated rate ofinterest on each payment date. TIIs are eligiblefor stripping into their principal and interestcomponents under the Treasury STRIPSprogram.

Similar to zero-coupon bonds, TIIs are taxdisadvantaged in that investors must pay tax onthe accretion to the principal amount of thesecurity, even though they do not currentlyreceive the increase in principal in cash. Paying

tax on income not received reduces the effectiveyield on the security.

The following example illustrates how TIIswork: suppose an investor purchases a $1,000note at the beginning of the year, in which theinterest rate set at the time of the auction is3 percent. Also suppose that inflation for the firstyear of the note is 3 percent. At the end of thefirst year, the $1,000 principal will be $1,030,reflecting the increase in inflation, although theinvestor will not receive this increase in princi-pal until maturity. The investor will receive,however, the 3 percent interest payment. At theend of the first year, the notes will be paying3 percent interest on the increased principalbalance of $1,030. Principal will be adjustedeach year, based on the increase or decrease ininflation.

USES

At present, the primary strategy behind thepurchase of a TII would be to hedge againsterosion in value due to inflation. However,banks also use TIIs for investment, hedging, andspeculative purposes. As TIIs are tax disadvan-taged, they are most likely to appeal to investorswho are not subject to tax.

An investor in TIIs is taking a view that realinterest rates will fall. Real interest rates aredefined as the nominal rate of interest less therate of inflation. If nominal rates fall, but infla-tion does not (that is, a decline in real interestrates), TIIs will appreciate because their fixedcoupon will now represent a more attractive raterelative to the market. If inflation rises, butnominal rates rise more (that is, an increase inreal interest rates), the security will decrease invalue because it will only partially adjust to thenew rate climate.


Issuing Practices

The auction process will use a single pricingmethod identical to the one used for two-yearand five-year fixed-principal Treasury notes. Inthis type of auction, each successful competitive


bidder and each noncompetitive bidder isawarded securities at the price equivalent to thehighest accepted rate or yield.

Market Participants

Sell Side

Like all U.S. government securities, TIIs aretraded over the counter, with the primary gov-ernment securities dealers being the largest andmost important market participants. A smallgroup of interdealer brokers disseminate quotesand broker trades on a blind basis betweenprimary dealers and users of the GovernmentSecurities Clearing Corporation (GSCC), theprivate clearinghouse created in 1986 to settletrades for the market.

Buy Side

A wide range of investors are expected to useTIIs for investing, hedging, and speculation,including commercial and investment banks,insurance companies, pension funds, mutualfunds, and individual investors. As noted above,TIIs will most likely appeal to investors who arenot subject to tax.

Market Transparency

Price transparency is relatively high for Trea-sury securities since several information ven-dors disseminate prices to the investing public.Govpx, an industry-sponsored corporation, dis-seminates price and trading information viainterdealer broker screens. Prices of TIIs areactive and visible.

RISKS

Interest-Rate Risk

TIIs are subject to price fluctuations because ofchanges in real interest rates. TIIs will decline invalue if real interest rates increase. For instance,if nominal interest rates rise by more than theincrease in inflation, the value of a TII willdecrease because the inflation component willnot fully adjust to the higher level of nominal

rates in the market. As the coupon rate on TIIsis well below market for similar maturity instru-ments, the duration of TIIs will be higher,increasing the price sensitivity of the instrumentfor a given change in real interest rates. Also,the CPI-U index used in calculating the princi-pal accretion on TIIs is lagged three months,which will hurt the investor when inflation isrising (and help the investor when inflation isfalling).

Longer-term issues will have more price vola-tility than shorter-term instruments. A largeconcentration of long-term maturities may sub-ject a bank’s investment portfolio to unwar-ranted interest-rate risk.

Liquidity Risk

The Treasury securities market is the largest andmost liquid in the world. While an active sec-ondary market for TIIs is expected, that marketinitially may not be as active or liquid as thesecondary market for Treasury fixed-principalsecurities. In addition, as a new product, TIIsmay not be as widely traded or well understoodas Treasury fixed-principal securities. Lesserliquidity and fewer market participants mayresult in larger spreads between bid and askedprices for TIIs relative to the bid/ask spreads forfixed-principal securities of the same maturity.Larger bid/ask spreads normally result in highertransaction costs and/or lower overall returns.The liquidity of the TII market is expected toimprove over time as additional amounts areissued and more entities enter the market.


The accounting treatment for investments inTreasury inflation-indexed securities is deter-mined by the Financial Accounting StandardsBoard’s Statement of Financial Accounting Stan-dards No. 115 (FAS 115), ‘‘Accounting forCertain Investments in Debt and Equity Securi-ties,’’ as amended by Statement of FinancialAccounting Standards No. 140 (FAS 140),‘‘Accounting for Transfers and Servicing ofFinancial Assets and Extinguishments of Liabili-ties.’’ Accounting treatment for derivatives usedas investments or for hedging purposes is deter-mined by Statement of Financial AccountingStandards No. 133 (FAS 133), ‘‘Accounting for

4030.1 Treasury Inflation-Indexed Securities


Derivatives and Hedging Activities,’’ as amendedby Statement of Financial Accounting StandardsNos. 137 and 138 (FAS 137 and FAS 138). (Seesection 2120.1, ‘‘Accounting,’’ for furtherdiscussion.)


TIIs have a zero percent risk weighting. Forspecific risk weights for qualified tradingaccounts, see section 2110.1, ‘‘CapitalAdequacy.’’


TIIs are a type I security so there are no legallimits on a bank’s investment in them.

REFERENCES

U.S. Department of the Treasury.Buying Trea-sury Inflation-Indexed Securities. Washing-ton, D.C.: The Bureau of the Public Debt,1997.

Treasury Inflation-Indexed Securities 4030.1


U.S. Government Agency SecuritiesSection 4035.1

GENERAL DESCRIPTION

Agency securities are debt obligations issued byfederal agencies or federally sponsored agen-cies. Federal agencies are direct arms of the U.S.government; federally sponsored agencies areprivately owned and publicly chartered organi-zations which were created by acts of Congressto support a specific public purpose (also referredto as government-sponsored entities or GSEs).

Federal agencies are arms of the federalgovernment and generally do not issue securitiesdirectly in the marketplace. These agenciesinclude the Government National MortgageAssociation (GNMA or Ginnie Mae), Export-Import Bank, Farmers Home Administration(FmHA), General Services Administration(GSA), Maritime Administration, Small Busi-ness Administration (SBA), Tennessee ValleyAuthority, Commodity Credit Corporation,Rural Electrification Administration, Rural Tele-phone Bank, and Washington Metropolitan AreaTransit Authority. All federally related institu-tions are exempt from registration with theSecurities and Exchange Commission (SEC).Except for securities of the Private Export Fund-ing Corporation and the Tennessee ValleyAuthority, the securities are backed by the fullfaith and credit of the U.S. government.

Government-sponsored entities include agen-cies in the following areas:

• housing (such as the Federal Home LoanMortgage Corporation and Federal NationalMortgage Association)

• farm credit (such as the Federal Farm CreditBank System and Farm Credit System Finan-cial Assistance Corporation)

• student loans (such as the Student Loan Mar-keting Association)

• small business (the Small BusinessAdministration)

• export funding (the Export-Import Bank)

GSEs issue both discount and coupon notes andbonds. Discount notes are short-term obliga-tions, with maturities ranging from overnight to360 days. Coupon notes and bonds are sold withmaturities greater than two years. The securitiesare not backed by the full faith and credit of theU.S. government. Consequently, investors pur-chasing GSEs are exposed to some potential

credit risk. The yield spread between thesesecurities and Treasury securities of comparablematurity reflects differences in perceived creditrisk and liquidity.

GSEs issue direct debt obligations and guar-antee various types of asset-backed securities.This section discusses only securities that rep-resent direct obligations of federal and federallysponsored agencies. For a discussion of securi-ties issued or guaranteed by some of theseagencies, see ‘‘Residential-Mortgage-BackedSecurities,’’ section 4110.1. Also, many GSEsare active in issuing structured notes. The role ofthe agency and particular risks involved in thesesecurities are discussed in section 4040.1,‘‘Structured Notes.’’


Federal-agency securities such as those issuedby the Government National Mortgage Associa-tion are backed by the full faith and credit of theU.S. government. However, government-sponsored agency securities are not guaranteedby the U.S. government, although market par-ticipants widely believe that the governmentwould provide financial support to an agency ifthe need arose. This view has gained somecredence as a result of the federal government’soperations to bolster the Farm Credit System inthe mid-1980s. U.S. agency securities are alsoexempt from SEC registration.

USES

Agency securities are deemed suitable invest-ments for banks. They are frequently purchasedby banks and held in their investment portfolios.


In the primary market, government agencies andGSEs sell their securities to a select group ofcommercial banks, section 20 subsidiaries ofcommercial banks, and investment banks knownas ‘‘selling groups.’’ Members of a selling groupadvise the agencies on issuing debt, placing the


debt with end-users, and making markets inthese securities.

Prices for the securities traded in the second-ary market can be obtained from the ‘‘Moneyand Investing’’ section of The Wall Street Jour-nal or the financial section of local newspapers.Other media, such as Internet financial sites andBloomberg, provide over-the-counter quotes aswell.

Federal Agencies

Federal agencies do not issue securities directlyin the marketplace. Since 1973, most haveraised funds through the Federal Financing Bank,although many of these institutions have out-standing obligations from previous debt issues.Federal agencies include the following: theExport-Import Bank of the United States, Com-modity Credit Corporation, Farmers HomeAdministration, General Services Administra-tion, Government National Mortgage Associa-tion, Maritime Administration, Private ExportFunding Corporation, Rural ElectrificationAdministration, Rural Telephone Bank, SmallBusiness Administration, Tennessee ValleyAuthority, and Washington Metropolitan AreaTransit Authority (neither the Tennessee ValleyAuthority nor the Private Export Funding Cor-poration is backed by the full faith and credit ofthe U.S. government).

Federally Sponsored Agencies

Following is a summary of the main federallysponsored agencies and the types of obligationsthat they typically issue to the public. TheFederal Farm Credit Bank System issues dis-count notes; short-term bonds with maturitiesof three, six, and nine months; and long-termbonds with maturities of between one and10 years. The Federal Farm Credit Bank alsoissues medium-term notes which have maturi-ties of between one and 30 years. The FederalFarm Credit System Financial Assistance Cor-poration issues 15-year notes, guaranteed by thefederal government, which were issued to sup-port the Farm Credit System in the mid-1980s.

The Federal Home Loan Bank System issuesdiscount notes that mature in one year or lessand noncallable bonds with maturities rangingfrom one to 10 years. These debts are consoli-

dated obligations of the 12 regional FederalHome Loan Banks whose mandate is to providefunds to savings and other home-financing mem-ber organizations.

The Federal National Mortgage Association(Fannie Mae) issues short-term discount notesand long-term bonds with maturities of up to30 years. Fannie Mae has also issued indexedsinking-fund debentures which are callable andcontain features of both mortgage-backed secu-rities and callable corporate bonds. The FederalHome Loan Mortgage Corporation (FreddieMac) issues discount notes and a limited numberof bonds. The Student Loan Marketing Associa-tion (Sallie Mae) issues unsecured debt obliga-tions in the form of discount notes to providefunds to support higher education.

PRICING

Agency notes and bonds are quoted in terms of32nds (a percentage of par plus 32nds of apoint). Thus, an investor will be willing to pay101.5 percent of par for an agency security thatis quoted at 101:16. Short-term discount notesare issued on a discount basis similar to the waythat U.S. Treasury bills are priced.

Agency securities trade at yields offering apositive spread over Treasury security yieldsbecause of slightly greater credit risk (due tothe lack of an explicit government guaranteefor most obligations) and somewhat lowerliquidity.

HEDGING

The price risk of most agency securities ishedged in the cash market for Treasury securi-ties or by using Treasury futures or options. Aswith all hedges, yield curve and basis risk mustbe monitored closely. In addition, dealers whoare actively conducting arbitrage trades andother strategies should have the capability tomonitor their positions effectively.

RISKS

As with any security, much of the risk is afunction of the type of trading strategy con-ducted by an institution.

4035.1 U.S. Government Agency Securities


Interest-Rate Risk

Agency securities are subject to price fluctua-tions caused by changes in interest rates. Aswith other types of securities, the longer theterm of the security, the greater the fluctuationand level of interest-rate risk. Moreover, someagency securities are subject to greater interest-rate risk than others. Agencies that issue struc-tured notes that are direct obligations, such asstep-up notes from a Federal Home Loan Bank,may have greater risk than other agencysecurities.

Credit Risk

The credit risk of agency securities is slightlyhigher than that of Treasury securities becauseagency securities are not explicitly guaranteedby the U.S. government. However, their creditrisk is still low due to the implied governmentguarantee.

Liquidity Risk

Agency securities as a whole are not as liquid asU.S. Treasury securities, but liquidity varieswidely within the agency market, depending onthe issuer and the specific debt obligation. Ingeneral, agency securities have large tradingvolumes on the secondary market that help tokeep the liquidity risk low. However, variousdebt provisions and structured notes of differentagency securities contribute to differing levelsof liquidity risk within the agency market.


The Financial Accounting Standards Board’sStatement of Financial Accounting StandardsNo. 115 (FAS 115), ‘‘Accounting for CertainInvestments in Debt and Equity Securities,’’ asamended by Statement of Financial AccountingStandards No. 140 (FAS 140), ‘‘Accounting forTransfers and Servicing of Financial Assets andExtinguishments of Liabilities,’’ determines theaccounting treatment for investments in govern-ment agency securities. Accounting treatmentfor derivatives used as investments or for hedg-ing purposes is determined by Statement of

Financial Accounting Standards No. 133 (FAS133), ‘‘Accounting for Derivatives and HedgingActivities,’’ as amended by Statement of Finan-cial Accounting Standards Nos. 137 and 138(FAS 137 and FAS 138). (See section 2120.1,‘‘Accounting,’’ for further discussion.)


Federal-agency securities have a zero percentrisk asset capital weight, as they are direct andunconditionally guaranteed obligations of fed-eral agencies. Obligations of federally spon-sored agencies (not explicitly guaranteed) havea 20 percent risk asset capital weight. Forspecific risk weights for qualified tradingaccounts, see section 2110.1, ‘‘CapitalAdequacy.’’


General obligations of U.S. government agen-cies are type I securities, and are exempt fromthe limitations of 12 USC 24 (section 5136 ofthe U.S. Revised Statutes). Banks may purchasethese securities for their own accounts withoutlimitation, other than the exercise of prudentbanking judgment. (One exception is an obliga-tion of the Tennessee Valley Authority (TVA),which is a type II security. Investments in theTVA are limited to 10 percent of a bank’s capitalstock and unimpaired surplus.)

REFERENCES

Board of Governors of the Federal ReserveSystem. Commercial Bank ExaminationManual.

Fabozzi, Frank J., ed. The Handbook of FixedIncome Securities. 4th ed. Burr Ridge, Ill.:Irwin, 1991.

First Boston Corporation, The. Handbook ofU.S. Government and Federal Agency Securi-ties. 34th ed. Chicago: Probus PublishingCompany, 1990.

Stigum, Marcia L. The Money Market. 3d ed.Homewood, Ill.: Dow Jones-Irwin, 1990.

U.S. Government Agency Securities 4035.1


Structured NotesSection 4040.1

GENERAL DESCRIPTION

Structured notes are hybrid securities, possess-ing characteristics of straight debt instrumentsand derivative instruments. Rather than paying astraight fixed or floating coupon, the interestpayments of these instruments are tailored to amyriad of possible indexes or rates. The FederalHome Loan Bank (FHLB), one of the largestissuers of such products in the United States, hasmore than 175 indexes or index combinationsagainst which cash flows are calculated. Inaddition to the interest payments, the redemp-tion value and final maturity of the securities canalso be affected by the derivatives embedded instructured notes. Most structured notes containembedded options, generally sold by the inves-tor to the issuer. These options are primarily inthe form of caps, floors, or call features. Theidentification, pricing, and analysis of theseoptions give structured notes their complexity.

Structured notes are primarily issued bygovernment-sponsored enterprises (GSEs),suchas the Federal Home Loan Bank (FHLB), Fed-eral National Mortgage Association (FNMA),Student Loan Marketing Association (SLMA),and Federal Home Loan Mortgage Corporation(FHLMC). Although the credit risk of thesesecurities is minimal, other risks such as interest-rate risk, market (price) risk, and liquidity riskcan be material.


There are many different types of structurednotes; typically, a structure is created specifi-cally to meet one investor’s needs. Thus, anexhaustive description of all the types of struc-tures in which an institution may invest isimpossible. However, certain structures are fairlycommon and are briefly described below.

In many cases, very complex probability andpricing models are required to accurately evalu-ate and price structured notes. As mentionedearlier, most structures have embedded options,implicitly sold by the investor to the note’sissuer. The proper valuation of these optionsposes unique challenges to investors consideringstructured notes. Many popular structures include

embedded, path-dependent options for whichpricing involves complex models and systems.

Inverse Floating-Rate Notes

An inverse floating-rate note (FRN) has a cou-pon that fluctuates inversely with changes in thereference rate. The coupon is structured as abase rate minus the reference rate, for example,a three-year note with a semiannual coupon thatpays 13 percent minus six-month LIBOR, andan interest-rate floor of 0 percent, which ensuresthat rates can never be negative. The return onan inverse FRN increases in a decreasing-rateenvironment, and decreases in an increasing-rate environment. An investor in an inverseFRN is taking a view that rates will decrease. Aninverse FRN has the risk characteristics of aleveraged fixed-rate instrument: inverse FRNswill outperform nonleveraged fixed-rate instru-ments when rates decrease and underperformwhen rates increase. If rates increase signifi-cantly, the investor may receive no couponpayments on the note.

The leverage inherent in an inverse FRNvaries with each structure. The leverage amountof a particular structure will be equal to theunderlying index plus one (that is, 13 percentminus 6-month LIBOR has a leverage factor of2; 20 percent− (2 × 6-month LIBOR) has aleverage factor of 3). The degree of leverageincorporated in an FRN will increase the vola-tility and, hence, the interest-rate and price riskof the note.

Step-Ups/Multi-Steps

Step-up notes or bonds are generally callable bythe issuer; pay an initial yield higher than acomparable fixed-rate, fixed-maturity security;and have coupons which rise or ‘‘step up’’ atpredetermined points in time if the issue is notcalled. If the coupon has more than one adjust-ment period, it is referred to as a multi-step.Step-up notes have final maturities ranging fromone year to as long as 20 years. Typicallock-outperiods (periods for which the note cannot becalled) range from three months to five years.

Trading and Capital-Markets Activities Manual March 1999Page 1

An example of a step-up note is a five-yearnote which has an initial coupon of 6 percent;the coupon increases 50 basis points every sixmonths. The note is callable by the issuer on anysix-month interest-payment date.

Step-up notes contain embedded call options‘‘sold’’ to the issuer by the investor. Any time anissue is callable,the purchaser of the securityhas sold a call option to the issuer.In the aboveexample, the investor has sold a series of calloptions, called aBermuda option,to the issuer.The note is callable onany interest-paymentdate after a specified lock-out period. Unlikecallable issues which pay aflat rate until matu-rity or call, the step-up feature of these securitiesincreases the value of the call options to theissuer and likewise increases the prospect ofearly redemption. Multi-steps can also be thoughtof as one-way floaters since the coupon canadjust higher, but never lower. As such, they canbe viewed as securities in which the investor hasbought a series of periodic floors and has sold aseries of periodic caps in return for above-market initial yield.

As the investor has sold a series of calloptions to the issuer, a step-up note will outper-form a straight bond issue when rates are rela-tively stable and underperform in a volatile rateenvironment. In a decreasing-rate environment,the note is likely to be called and the investorwill be forced to invest the proceeds of theredemption in a low-interest-rate environment.Conversely, in a rising-rate environment, aninvestor will be in a below-market instrumentwhen rates are high. Step-up notes with verylong maturities (beyond 10 years) may havegreater liquidity and price risk than other secu-rities because of their long tenor.

Index-Amortizing Notes

An index-amortizing note (IAN) is a form ofstructured note for which the outstanding prin-cipal or note amortizes according to a predeter-mined schedule. The predetermined amortiza-tion schedule is linked to the level of a designatedindex (such as LIBOR, CMT, or the prepaymentrate of a specified pass-through pool). Thus, thetiming of future cash flows and, hence, theaverage life and yield to maturity of the notebecome uncertain. The IAN does have a statedmaximum maturity date, however, at which timeall remaining principal balance is retired.

An embedded option feature, called apath-dependent option, is present in this type ofsecurity. The option is termed path-dependentbecause the payoff structure of the option willdepend not only on the future path of theunderlying index but on where that index hasbeen in the past. The investor, in return for anabove-market initial yield, effectively sells thisoption to the issuer. The issuer has the option toalter the principal amortization as the interest-rate environment changes. Caps and floors mayalso be present if the issue has a floating-ratecoupon.

A typical IAN is structured so that as thedesignated index (for example, LIBOR) risesabove a trigger level, the average life extends.Conversely, if the designated index is at orbelow the trigger level, the IAN’s principal willquickly amortize, leading to a shorter averagelife. The outstanding principal balance will varyaccording to the schedule at each redemptiondate. One may equate the amortization of thenote to the retirement (call) of some portion ofthe principal. As the amortization quickens,more and more of the note is ‘‘called.’’

IANs generally appeal to investors who wantan investment with a CMO-like risk-return pro-file, but with reduced uncertainty as to theaverage life. As the amortization schedule of anIAN depends only on the level of the underlyingindex, an IAN eliminates the noneconomic pre-payment factors of a CMO. However, like aCMO, an IAN will outperform a straight bondissue in a stable rate environment and underper-form it in a volatile rate environment. In adecreasing-rate environment, the IAN is likelyto be called, and the investor will be forced toinvest the proceeds of the redemption in a lowinterest-rate environment. Conversely, in a rising-rate environment, the maturity of the IAN willextend, and an investor will be in a below-market instrument when rates are high.

De-Leveraged and Leveraged Floaters

De-leveraged and leveraged floating-rate notesgive investors the opportunity to receive anabove-market initial yield and tie subsequentcoupon adjustments to a specific point on theyield curve. A leveraged note’s coupon willadjust by a multiple of a change in the relevantinterest rate, for example, 1.25 × LIBOR + 100basis points. Conversely, a de-leveraged securi-

4040.1 Structured Notes

March 1999 Trading and Capital-Markets Activities ManualPage 2

ty’s coupon adjusts by a fraction of the changein rates, for example, .60 × 10-year CMT + 100basis points.

De-leveraged floaters are combinations offixed- and floating-rate instruments. For exam-ple, a $10 million de-leveraged floater with acoupon of 60 percent of the 10-year CMT + 100basis points is equivalent to the investor holdinga $6 million note with a coupon equal to a10-year CMT/LIBOR basis swap and a $4 mil-lion fixed-rate instrument. If rates rise, an inves-tor in a de-leveraged floater participates in therise, but only by a fraction. The leverage factor(for example, 60 percent) causes the couponsto lag the actual market. Thus, de-leveragedfloaters will outperform straight bond issuancesin a declining or stable interest-rate environment.

Conversely, a leveraged floater such as theexample above should be purchased by inves-tors with an expectation of rising rates in whichthey would receive better than one one-to-oneparticipation. The degree of leverage amplifiesthe risks as well as the rewards of this type ofsecurity. The greater the leverage, the greater theinterest-rate and price risk of the security.

Other alternatives in this category includefloaters which do not permit the coupon todecrease, so-called one-way de-leveraged float-ers which can effectively lock in higher couponsin an environment where the index rises thenfalls.

Ratchet Notes

Ratchet notes typically pay a floating-rate cou-pon that can never go down. The notes generallyhave periodic caps that limit the amount of theincreases (ratchets) or that set a predeterminedincrease for each quarter. These periodic capsare akin to those found in adjustable-rate mort-gage products.

An investor in a ratchet note has purchasedfrom the issuer a series of periodic floors andhas sold a series of periodic caps. As such, aratchet note will outperform a straight floating-rate note in a stable or declining interest-rateenvironment, and it will underperform in arapidly rising interest-rate environment. In arapidly rising interest-rate environment, a ratchetnote will perform similarly to a fixed-rate instru-ment with a low coupon which gradually stepsup. The price volatility of the instrument will

therefore depend on the frequency of resets, theamount of coupon increase at each reset, andthe final maturity of the note. Longer maturitynotes, which have limited reset dates and limitedcoupon increases, will be more volatile inrising- rate environments and will thereforehave a greater degree of interest-rate and pricerisk.

Dual-Index Notes

A dual-index note (sometimes called a yieldcurve anticipation note (YCAN)) is a securitywhose coupon is tied to the spread between twomarket indexes. An example is a three-yearsecurity which pays a semiannual coupon equalto (prime + 250 basis points− 6-month LIBOR).Typical indexes used to structure payoffs tothese notes are the prime rate, LIBOR, COFI,and CMT yields of different maturities. Yield-curve notes allow the investor to lock in a veryspecific view about forward rates. Such a play,while constructable in the cash market, is oftendifficult and costly to an investor. A purchaser ofthis type of security is typically making anassumption about thefuture shapeof the yieldcurve. These notes can be structured to rewardthe investors in either steepening or flatteningyield-curve environments. However, these notescan also be tied to indexes other than interestrates, such as foreign-exchange rates, stockindexes, or commodity prices.

An example of a note which would appeal toinvestors with expectations of a flattening yieldcurve (in a currently steep yield-curve environ-ment) would be one with a coupon that floats at

[the 5-year CMT− the 10-year CMT+ a designated spread].

Based on this formula, the coupon will increaseif the yield curve flattens between the 5-year andthe 10-year maturities. Alternatively, a yield-curve-steepening play would be an issue thatfloats at—

[the 10-year CMT− the 5-year CMT+ a designated spread].

In this case, coupons would increase as thespread between the long- and medium-termindexes widens.

Structured Notes 4040.1


A dual-index note is equivalent to being along basis swap (in the example above, theinvestor receives prime and pays LIBOR) and tobeing long a fixed-rate instrument. As such, thenote has the risk-return elements of both a basisswap and a comparable fixed-rate instrument.The note will underperform comparable fixed-rate instruments in an environment when thebasis relationship (between prime and LIBOR inthe above example) narrows. These instrumentsare subject to incremental price risk in a rising-rate environment in which the basis spread isnarrowing.

Principal-Linked Notes

An example of a principal-linked note is aone-year security which pays a fixed semi-annual coupon of 8 percent, and the principalreceived at maturity is determined by the fol-lowing formula using market yields two daysbefore maturity:

P = 100 + 5 ( ((2-year swap rate− 3-monthLIBOR) − 1.40) )

The resulting principal-redemption amount undervarying rate scenarios would be as follows intable 1.

Table 1—Examples of Possible Principal-Redemption Schemes

Par

Rate

RedemptionPercentage

2-Year SwapRate− 3-Month

LIBOR Rate− 1.40 5*(Rate− 140)

100 180 .4 2.00 102100 160 .2 1.00 101100 140 .00 0.00 100100 120 −0.20 −1.00 99100 100 −0.40 −2.00 98

Under a principal-linked structured note, thematurity and the fixed coupon payments areunchanged from the terms established at issu-ance. The issuer’s redemption obligation atmaturity, however, isnot the face value of thenote. Redemption amounts are established by aformula whose components reflect historical orprevailing market levels. Principal-linked noteshave been issued when the principal redemptionis a function of underlying currency, commod-ity, equity, and interest-rate indexes. As thereturn of principal at maturity in many types ofprincipal-linked notes is not ensured, these struc-tures are subject to a great degree of price risk.

Range Notes

Range notes (also called accrual notes)accrueinterest daily at a set coupon which is tied to anindex. Most range notes have two coupon lev-els; the higher accrual rate is for the period that

the index remainswithin a designated range, thelower rate is used during periods that the indexfalls outside the range.This lower level may bezero.Range notes have been issued which ref-erence underlying indexes linked to interestrates, currencies, commodities, and equities.Most range notes reference the index daily suchthat interest may accrue at 7 percent on one dayand at 2 percent on the following day, if theunderlying index crosses in and out of the range.However, they can also reference the indexmonthly, quarterly, or only once over the note’slife. If the note only references quarterly, thenthe index’s relationship to the range mattersonly on the quarterly reset date. With the pur-chase of one of these notes, the investor has solda series of digital (or binary) options:1 a call

1. A digital option has a fixed, predetermined payoff if theunderlying instrument or index is at or beyond the strike atexpiration. The value of the payoff is not affected by themagnitude of the difference between the underlying and thestrike price.



struck at the high end of the range and a putstruck at the low end of the range. This meansthat the accrual rate is strictly defined, and themagnitude of movement outside the range isinconsequential. The narrower the range, thegreater the coupon enhancement over a likeinstrument. In some cases, the range varies eachyear that the security is outstanding.

However, range notes also exist which requirethat the investor sell two barrier options:2 adown-and-out put struck at the low level of therange and an up-and-out call struck at the highlevel of the range. For these range notes, theindex must remain within the target band for theentire accrual period, and sometimes for theentire life of the instrument. If it crosses eitherbarrier on even one day, the investor’s couponwill drop to zero for the whole period.3 Thistype of range note is quite rare, but investorsshould pay careful attention to the paymentprovisions attached to movements outside therange.

As the investor has sold leveraged call andput options to the issuer of these securities, arange note will outperform other floating-rateinstruments in stable environments when theindex remains within the specified range, and itwill underperform in volatile environments inwhich the underlying index is outside of thespecified range. Given the degree of leverageinherent in these types of structures, the securi-ties can be very volatile and often exhibit asignificant degree of price risk.

USES

Structured notes are used for a variety of pur-poses by investors, issuers, and underwriters ortraders. Banks are often involved in all three ofthese capacities.

Uses by Investors

Structured notes are investment vehicles thatallow investors to alter the risk profile of their

portfolios and/or to express a viewpoint aboutthe course of interest rates or other financialvariables. The basic appeal of structured noteslies in their attendantcustomizedrisk param-eters. Attributes that typically arenot available(or not easily available) to an investor areassembled in a prepackaged format. Addition-ally, investors find the notes attractive for otherdistinct reasons. In a sustained period of lowinterest rates (such as the United States experi-enced for the five years leading up to February1994), receiving an ‘‘acceptable’’ return on aninvestment became increasingly difficult. Struc-tured notes, whose cash flows and market valuesare linked to one or more benchmarks, offeredthe potential for greater returns than prevailingmarket rates. The desire for higher yield ledinvestors to make a risk-return tradeoff whichreflected their market view.

The fact that most structured notes are issuedby government-sponsored enterprises (GSEs)means that credit risk—the risk that the issuerwill default—is minimal. GSEs are not, how-ever, backed by the full faith and credit of theU.S. government, though most have explicitlines of credit from the Treasury. As a result,investors were attracted by the potential returnsof structured notes and by their high creditquality (implied government guarantee). Asnoted above, however, the credit risk of thesenotes may be minimal, but their price risk maybe significant.

Uses by Issuers

Issuers often issue structured notes to achieveall-in funding rates, which are more advanta-geous than what is achievable through a straightdebt issue. To induce issuers to issue complexand often very specialized debt instruments,investors often will sacrifice some return, whichlowers the issuer’s all-in cost of funding. Gen-erally, only highly rated (single-A or better)banks, corporations, agencies, and finance com-panies will be able to issue in the structured-notemarket. A detailed discussion of issuing prac-tices is included in the ‘‘Description of Market-place’’ subsection below.

Uses by Underwriters or Traders

Investment banks and the section 20 subsidiariesof banks often act to underwrite structured-note

2. Path-dependent options with both their payoff patternand their survival to the nominal expiration date are dependentnot only on the final price of the underlying but on whether theunderlying sells at or through a barrier (instrike, outstrike)price during the life of the option.

3. McNeil, Rod. ‘‘The Revival of the Structured NoteMarket.’’ International Bond Investor.Summer 1994, pp.34–37.



issuances. They are often actively involved inmaking a market in secondary structured notes.A detailed discussion of these activities isincluded in the ‘‘Description of Marketplace’’subsection below.


Background

In its heyday, the structured-note market was aby-product of a unique period in financial his-tory. In 1992 and 1993, Wall Street firms engi-neered debt that allowed borrowers to attainhighly attractive below-market funding and thatrewarded investors (in large part)as long asinterest rates remained low.The incredible andat times implausible array of structure typescame into being in response to the investmentcommunity’s desire for higher returns during asustained period of low interest rates. Issuersand investment dealer firms were more thanwilling to address this need, introducing inves-tors to more attractive (and by definition riskier)securities whose cash flows were linked to, forexample, the performance of the yen; the yen’srelationship to the lira; and a host of otherindexes, currencies, or benchmarks.4 Investors’quest for enhanced yield caused them to adopt,in many cases, very tenuous risk-reward mea-sures with respect to potential investmentchoices.

Structured notes received heightened atten-tion from both regulators and investors in thespring and summer of 1994. Many of thesestructured securities, created to satisfy a per-ceived need at the time, deteriorated in value asa result of the rate increases of 1994. In manycases, the leverage inherent in the securityworked against the investor, obliterating onceattractive coupon payments. Market values ofmany of these instruments fell below par as theircoupons became vastly inferior to comparablematurity investments and as maturities wereextended beyond investors’ original expectations.

Primary Market

Structured notes are primarily issued by GSEssuch as the FHLB, FNMA, SLMA, and FHLMC,which carry an implicit government guaranteeand are rated triple-A. Many large corporations,banks, and finance companies, generally ratedsingle-A or better, also issue structured notes.

Most structured-note issuances originate withinvestors on areverse inquiry basis,through themedium-term note (MTN)market. The processoriginates when an investor has a demand for asecurity with specific risk characteristics. Througha reverse inquiry, an investor will use MTNagents such as the underwriting desk of aninvestment bank or section 20 subsidiary of abank to communicate its desires to the issuer. Ifthe issuer agrees to the inquiry, the issuer willissue the security which is sold through theMTN agent to the investor.

Although structured notes in the MTN marketoften originate with the investor, investmentbanks and section 20 subsidiaries of banks alsoput together such transactions. Most investmentbanks and section 20 subsidiaries have derivative-product specialists who design structured notesto take advantage of specific market opportuni-ties. When an opportunity is identified, theinvestment bank or section 20 subsidiary willinform investors and propose that they buy thestructured note. If an investor tentatively agreesto purchase the security, the MTN agents in theinvestment bank or section 20 subsidiary willcontact an issuer with the proposed transaction.If the structure meets the funding needs of theissuer, the structured note will be issued to theinvestors.

Secondary Market

Structured notes are traded in the secondarymarket through market makers such as invest-ment banks or section 20 subsidiaries of banksor through brokers. Market makers will buy orsell structured notes, at a predetermined bid andoffer. Market makers will usually trade GSEstructured notes through their secondary agencytrader and trade corporate-issued structured notesthrough their corporate bond trader. Some mar-ket makers trade secondary structured notesthrough their structured-note desk, a specializedgroup who will buy and trade all types ofstructured notes.

4. As more exotic structured-note issues came into being(and especially in light of the Orange County debacle), muchof the bad press centered on the (quasi-government) agencieswho issued the paper. As discussed later, the impetus for thevast majority of deals in fact emanated from Wall Street.



Investors in secondary structured notes maybuy the notes at a discount or premium toissuance and receive the performance character-istics of the note as shown in the prospectus.Investors may also purchase structured notes onanasset-swap basis,which strips the optionalityout of a note and leaves the investor with asynthetically created ‘‘plain vanilla’ return suchas LIBOR. Asset-swap pricing is discussed inthe ‘‘Pricing’’ subsection below.

Secondary structured notes are also used tocreate special-purpose vehicles such as MerrillLynch’s STEERS program. In these types ofprograms, secondary structured notes are placedin a special-purpose vehicle, the receipts ofwhich are then sold to investors. A series ofswap transactions is then entered into between aswap counterparty and the special-purpose vehi-cle, which strips the optionality out of thestructures. The investor therefore receives a trustreceipt which pays a plain vanilla return such asLIBOR.

Structured notes often possess greater liquid-ity risk than many other types of securities. Themost important factor affecting the liquidity ofthe note in the secondary market is the size ofthe secondary note being traded. Generally, thelarger the size of the note, the more liquid thenote will be in the secondary market. Mostinvestors will not buy a structured note oflimited size unless they receive a significantpremium to cover the administrative costs ofbooking the note. Similarly, most market makerswill not inventory small pieces of paper unlessthey charge a significant liquidity premium.

Another factor which may affect the liquidityof a structured note in the secondary market isthe one-way ‘‘bullishness’’ or ‘‘bearishness’’ ofa note. For example, in a rising-rate environ-ment, leveraged bullish instruments such asinverse floaters may not be in demand byinvestors and may therefore have less liquidityin the secondary market. As many structurednotes are sold on an asset-swap basis, thecharacteristics of the structured note can be‘‘engineered’’ out of the note, leaving the inves-tor with a plain vanilla return. The asset-swapmarket, therefore, helps to increase the liquidityof these types of notes.

PRICING

The two primary methods by which structurednotes are priced in the secondary market are

(1) on an asset-swap basis or (2) on a straight-pricing basis.

Asset-Swap Pricing

Structured notes are typically constructed byembedding some form of optionality in thecoupon, principal, or maturity component of adebt issue. Once these embedded derivatives arequantified, a swap or series of swaps can beundertaken to strip out those options and effec-tively create a synthetic instrument with eitherfixed or variable cash-flow streams. This pro-cess is known as asset-swap pricing.5

Asset-swap pricing initially involves decom-posing and valuing the components of the note,including contingent cash flows. It conveyswhere those components can be cashed out inthe market, often referred to as thebreak-upvalueof the note. After the note is decomposed,an alternate cash-flow stream is created throughthe asset-swap market.

When structured notes are priced on an asset-swap basis, the issue is analyzed based on itssalvage value.6 The salvage value on mostagency structured issues varies based on thecurrent market and the size, type, and maturityof the note.

Liquidity in the structured-notes market existsbecause every note has a salvage value. Ifdemand for the note as a whole is weak, its cashflows can be reconstructed via the asset-swapmarket to create a synthetic security. In manycases, the re-engineered security has broaderinvestor appeal, thereby generating neededliquidity for the holder of the original issue.

Straight Pricing

Contrasted with an asset-swapped issue, a notetrading on a straight-pricing basis is purchasedand sold as is.7 Traders who price structurednotes on this basis compare the note with similartypes of instruments trading in the market andderive a price accordingly.

5. See the Federal Reserve product summaryAsset Swaps—Creating Synthetic Instrumentsby Joseph Cilia for a detailedtreatment on the topic.

6. Goodman, Laurie. ‘‘Anatomy of the Secondary Struc-tured Note Market.’’Derivatives Quarterly,Fall 1995.

7. Peng, Scott Y., and Ravi E. Dattatreya.The StructuredNote Market.Chicago: Probus, 1995.



HEDGING

Structured notes are, from a cash-flow perspec-tive, a combination of traditional debt instru-ments and derivative contracts. As a result, thevalue (or performance) of a structured note canbe replicated by combining components consist-ing of appropriate zero-coupon debt plus appro-priate futures or options positions that reflect theoptionality embedded in the issue. Similar to thedecomposition process employed in an asset-wap transaction, the fair value of this replicatedportfolio should be equivalent to the fair valueof the structured note.

Theoretically, one should be indifferent aboutinvesting in a structured note or in its equiva-lently constructed portfolio as long as the priceof the note equals the present value of itsreplication components.8 Price discrepancyshould govern the selection process betweenthese alternatives.

A hedge of a structured-note position involvesengaging in the opposite of the replication tradesnoted above. To be fully protected in a hedge,the sum of the present values of each componentof the hedge should be less than or equal to themarket value of the note. If, for some reason, thenote was pricedhigher than the cost of theworst-case replication components, the hedgingfirm stands to lock in a positive spread if thatworst-case scenario fails to materialize.9

A structured-note position itself can serve tohedge unique risks faced by the investor. Forexample, a company which is long (owns)Japanese yen (¥) is exposed to the risk of yendepreciation. The FHLB issued a one-year struc-tured range note which accrued interest daily at7 percent if the ¥/U.S.$ is greater than 108.50 orat 0 percent if the ¥/U.S.$ is less than 108.50. Ifthe yen depreciates, the note accrues interest atan above-market rate. Meanwhile, the compa-ny’s yen holdings will decline in value. Thisnote could serve as a perfectly tailored hedge forthe company’s business-risk profile. In fact, thedesign of many of the most complicated struc-tured notes is driven not by the innovations ofnote issuers and underwriters, but rather byinvestors seeking to hedge their own unique riskprofiles.

RISKS

Market Risk

The embedded options and other leverage fac-tors inherent in structured notes result in a greatdeal of uncertainty about future cash flows.Thus, price volatility is generally high in thesetypes of securities. An institution should have—or should have ready access to—a model whichis able to quantify the risks. The model shouldbe able to forecast the change in market price atvarious points in time (for example, one yearlater or the first call date) for a given shift ininterest rates. For the many variants of theseproducts which are tied to the shape of the yieldcurve, the ability to model price effects fromnonparallel interest-rate shifts is also crucial. Inmost cases (except for some principal-linkednotes), full principal will be returned at maturity.However, between issuance and redemption,changes in fundamental factors can give rise tosignificant reductions in the ‘‘market’’ price.

As with other types of instruments in whichan investor has sold an option, structured noteswill underperform similar straight debt issu-ances in a volatile rate environment. For notessuch as callable step-ups and IANs, the investormay be exposed to reinvestment risk (investingthe proceeds of the note in a low-interest-rateenvironment) when rates decrease and to exten-sion risk (not being able to invest in a high-interest-rate environment) when rates increase.

Liquidity Risk

Due to the complex nature of structured notes,the number of firms that are able and willing tocompetitively price and bid for these securitiesis quite small; however, an active secondarymarket has developed over the past few years.When the structure is complex, however, bid-ders may be few. Consequently, an institutionhoping to liquidate a structured-note holdingbefore maturity may find that their only option isto sell at a significant loss. In certain cases, theissue’s original underwriter is the only sourcefor a bid (and even that is not always guaranteed).

Some factors influencing the liquidity of thenote include the type, size, and maturity of thenote. In general, the more complex the structureor the more a note exhibits one-way bullishnessor bearishness, the less liquidity a note willhave. Although the asset-swap market allows

8. Kawaller, Ira G. ‘‘Understanding Structured Notes.’’Derivatives Quarterly,Spring 1995.

9. Ibid., p. 32.



the derivative components to be engineered outof these complex structures, liquidity may beimpaired because many institutions have invest-ment guidelines that prohibit the purchase ofcertain types of complex notes. Thus, the size ofthe potential market is diminished, and liquiditydecreases. Also, notes with a smaller size (gen-erally under $10 million) and a longer maturity(generally greater than five years) will tend to beless liquid.

Volatility Risk

For each of these structures with embeddedoptions, assumptions about the volatility ofinterest-rate moves are also inherent. For any ofthese options that are purchased by investors(for example, interest-rate floors), the risk thatexpectations for market-rate volatility willdecrease over time exists. If that happens, mar-ket valuation of these securities will alsodecrease, and the investor will have ‘‘pur-chased’’ an overvalued option for which he orshe will not be compensated if the instrument issold before maturity. For options that are sold byinvestors (for example, interest-rate caps), therisk that volatility increases after the note ispurchased exists. If that occurs, the marketvaluation of the structured note will decrease,and the investor will have ‘‘sold’’ an underval-ued option for which he or she will have to paya higher price if the instrument is sold beforematurity.


The Financial Accounting Standards Board’sStatement of Financial Accounting StandardsNo. 115 (FAS 115), ‘‘Accounting for CertainInvestments in Debt and Equity Securities,’’ asamended by Statement of Financial AccountingStandards No. 140 (FAS 140), ‘‘Accounting forTransfers and Servicing of Financial Assets andExtinguishments of Liabilities,’’ determines theaccounting treatment for investments in struc-tured notes. Accounting treatment for deriva-tives used as investments or for hedging pur-poses is determined by Statement of FinancialAccounting Standards No. 133 (FAS 133),‘‘Accounting for Derivatives and HedgingActivities,’’ as amended by Statement of Finan-cial Accounting Standards Nos. 137 and 138

(FAS 137 and FAS 138). (See section 2120.1,‘‘Accounting,’’ for further discussion.)


Structured notes issued by GSEs should begiven a 20 percent risk weighting. Structurednotes issued by investment-grade corporationsshould be given a 100 percent risk weighting.For specific risk weights for qualified tradingaccounts, see section 2110.1, ‘‘CapitalAdequacy.’’


The limitations of 12 CFR 1 apply to structurednotes. Structured notes issued by GSEs are typeI securities, and there is no limitation on theamount which a bank can purchase or sell.Structured notes issued by investment-grade-rated corporations are type III securities. Abank’s purchases and sales of type III securitiesare limited to 10 percent of its capital andsurplus.

REFERENCES

Audley, David, Richard Chin, and ShrikantRamamurthy. ‘‘Derivative Medium-TermNotes’’ and ‘‘Callable Multiple Step-UpBonds.’’ Prudential Securities Financial Strat-egies Group, October 1993 and May 1994,respectively.

‘‘BankAmerica Exec Explains What Happenedwith Its $68M Fund Bailout.’’ AmericanBanker, October 17, 1994.

Cilia, Joseph. Product Summary— Asset Swaps—Creating Synthetic Instruments. FederalReserve Bank of Chicago, August 1996.

Cilia, Joseph, and Karen McCann. ProductSummary—Structured Notes. Federal ReserveBank of Chicago, November 1994.

Crabbe, Leland E., and Joseph D. Argilagos.‘‘Anatomy of the Structured Note Market.’’Journal of Applied Corporate Finance, Fall1994.

Goodman, Laurie, and Linda Lowell. ‘‘Struc-tured Note Alternatives to Fixed Rate and



Floating Rate CMOs.’’ Derivatives Quarterly,Spring 1995.

Kawaller, Ira G. ‘‘Understanding StructuredNotes.’’ Derivatives Quarterly, Spring 1995.

McNeil, Rod. ‘‘The Revival of the Structured

Note Market.’’ International Bond Investor.Summer 1994, pp. 34–37.

Peng, Scott Y., and Ravi E. Dattatreya. TheStructured Note Market. Chicago: Probus,1995.



Corporate Notes and BondsSection 4045.1

GENERAL DESCRIPTION

Corporate bonds are debt obligations issued bycorporations. Corporate bonds may be eithersecured or unsecured. Collateral used for secureddebt includes but is not limited to real property,machinery, equipment, accounts receivable,stocks, bonds, or notes. If the debt is unsecured,the bonds are known as debentures. Bondhold-ers, as creditors, have a prior legal claim overcommon and preferred stockholders as to bothincome and assets of the corporation for theprincipal and interest due them and may have aprior claim over other creditors if liens ormortgages are involved.

Corporate bonds contain elements of bothinterest-rate risk and credit risk. Corporate bondsusually yield more than government or agencybonds due to the presence of credit risk. Corpo-rate bonds are issued asregistered bondsand areusually sold inbook-entry form. Interest may befixed, floating, or the bonds may be zero cou-pons. Interest on corporate bonds is typicallypaid semiannually and is fully taxable to thebondholder.


Security for Bonds

Various types of security may be pledged tooffer security beyond that of the general stand-ing of the issuer. Secured bonds, such as first-mortgage bonds, collateral trust bonds, andequipment trust certificates, yield a lower rate ofinterest than comparable unsecured bondsbecause of the greater security they provide tothe bondholder.

First-Mortgage Bonds

First-mortgage bonds normally grant the bond-holder a first-mortgage lien on the property ofthe issuer. Often first-mortgage bonds are issuedin series with bonds of each series securedequally by the same first mortgage.

Collateral Trust Bonds

Collateral trust bonds are secured by pledges ofstocks, notes, bonds, or other collateral. Gener-ally, the market or appraised value of the collat-eral must be maintained at some percentage ofthe amount of the bonds outstanding, and aprovision for withdrawal of some collateral isoften included, provided other acceptable collat-eral is provided. Collateral trust bonds may beissued in series.

Equipment Trust Certificates

Equipment trust certificates are usually issuedby railroads or airlines. The issuer, such as arailroad company or airline, buys a piece ofequipment from a manufacturer, who transfersthe title to the equipment to a trustee. The trusteethen leases the equipment to the issuer and at thesame time sells equipment trust certificates(ETCs) to investors. The manufacturer is paidoff through the sale of the certificates, andinterest and principal are paid to the bondhold-ers through the proceeds of lease payments fromthe issuer to the trustee. At the end of somespecified period of time, the certificates are paidoff, the trustee sells the equipment to the issuerfor a nominal price, and the lease is terminated.As the issuer does not own the equipment,foreclosing a lien in event of default is facili-tated. These bonds are often issued in serialform.

Debenture Bonds

Debenture bonds are not secured by a specificpledge of designated property. Debenture bond-holders have the claim of general creditors on allassets of the issuer not pledged specifically tosecure other debt. They also have a claim onpledged assets to the extent that these assetshave value greater than necessary to satisfysecured creditors. Debentures often contain avariety of provisions designed to afford somedegree of protection to bondholders, includinglimitation on the amount of additional debtissuance, minimum maintenance requirementson net working capital, and limits on the pay-ment of cash dividends by the issuer. If an issuer


has no secured debt, it is customary to provide anegative pledge clause—a provision that deben-tures will be secured equally with any securedbonds that may be issued in the future.

Subordinated and Convertible Debentures

Subordinated debenture bonds stand behindsecured debt, debenture bonds, and often somegeneral creditors in their claim on assets andearnings. Because these bonds are weaker intheir claim on assets, they yield a higher rate ofinterest than comparable secured bonds. Often,subordinated debenture bonds offer conversionprivileges to convert bonds into shares of anissuer’s own common stock or the commonstock of a corporation other than an issuer—referred to asexchangeable bonds.

Guaranteed Bonds

Guaranteed bonds are guaranteed by a corpora-tion other than the issuer. The safety of aguaranteed bond depends on the financial capa-bility of the guarantor, as well as the financialcapability of the issuer. The terms of the guar-antee may call for the guarantor to guarantee thepayment of interest and/or repayment of princi-pal. A guaranteed bond may have more than onecorporate guarantor, who may be responsible fornot only its pro rata share but also the entireamount guaranteed by other guarantors.

Maturity

Corporate bonds are issued in a broad maturityspectrum, ranging from less than one year toperpetual issues. Issues maturing within oneyear are usually viewed as the equivalent of cashitems. Debt maturing between one and five yearsis generally thought of as short-term.Intermediate-term debt is usually considered tomature between 5 and 12 years, whereas long-term debt matures in more than 12 years.

Interest-Payment Characteristics

Fixed-Rate Bonds

Most fixed-rate corporate bonds pay interest

semiannually and at maturity. Interest pay-ments once a year are the norm for bonds soldoverseas. Interest on corporate bonds is basedon a 360-day year, made up of twelve 30-daymonths.

Zero-Coupon Bonds

Zero-coupon bonds are bonds without couponsor a stated interest rate. These securities areissued at discounts to par; the difference betweenthe face amount and the offering price whenfirst issued is called theoriginal-issue discount(OID). The rate of return depends on the amountof the discount and the period over which itaccretes. In bankruptcy, a zero-coupon bondcreditor can claim the original offering priceplus accrued and unpaid interest to the date ofbankruptcy filing, but not the principal amountof $1,000.

Floating-Rate Notes

The coupon rates for floating-rate notes arebased on various benchmarks ranging fromshort-term rates, such as prime and 30-daycommercial paper, to one-year and longerconstant maturity Treasury rates(CMTs). Cou-pons are usually quoted as spread above orbelow the base rate (that is, three-month LIBOR+ 15 bp). The interest rate paid on floating-ratenotes adjusts based on changes in the base rate.For example, a note linked to three-month U.S.LIBOR would adjust every three months, basedon the then-prevailing yield on three-month U.S.LIBOR. Floating-rate notes are often subject toa maximum (cap) or minimum (floor) rate ofinterest.

Features

A significant portion of corporate notes andbonds has various features. These include callprovisions, in which the issuer has the right toredeem the bond before maturity; put options, inwhich the holder has the right to redeem thebond before maturity; sinking funds, used toretire the bonds at maturity; and convertibilityfeatures that allow the holder to exchange debtfor equity in the issuing company.

4045.1 Corporate Notes and Bonds


Callable Bonds

Callable bonds are bonds in which the investorhas sold a call option to the issuer. This increasesthe coupon rate paid by the issuer but exposesthe investor to prepayment risk. If market inter-est rates fall below the coupon rate of the bondon the call date, the issuer will call the bond andthe investor will be forced to invest the proceedsin a low-interest-rate environment. As a rule,corporate bonds are callable at a premium abovepar, which declines gradually as the bondapproaches maturity.

Put Bonds

Put bonds are bonds in which the investor haspurchased a put option from the issuer. The costof this put option decreases the coupon rate paidby the issuer, but decreases the risk to aninvestor in a rising interest-rate environment. Ifmarket rates are above the coupon rate of thebond at the put date, the investor can ‘‘put’’the bond back to the issuer and reinvest theproceeds of the bond in a high-interest-rateenvironment.

Sinking-Fund Provisions

Bonds with sinking-fund provisions require theissuer to retire a specified portion on a bondissue each year. This type of provision reducesthe default risk on the bond because of theorderly retirement of the issue before maturity.The investor assumes the risk, however, thatthe bonds may be called at a special sinking-fund call price at a time when interest rates arelower than rates prevailing at the time the bondwas issued. In that case, the bonds will beselling above par but may be retired by theissuer at the special call price that may be equalto par value.

Convertible Bonds

Convertible securities are fixed income securi-ties that permit the holder the right to acquire, atthe investor’s option, the common stock of theissuing corporation under terms set forth in thebond indenture. New convertible issues typi-cally have a maturity of 25 to 30 years and carrya coupon rate below that of a nonconvertible

bond of comparable quality. An investor in aconvertible security receives the upside poten-tial of the common stock of the issuer, combinedwith the safety of principal in terms of a priorclaim to assets over equity security holders. Theinvestor, however, pays for this conversion privi-lege by accepting a significantly lower yield-to-maturity than that offered on comparable non-convertible bonds. Also, if anticipated corporategrowth is not realized, the investor sacrificescurrent yield and risks having the price of thebond fall below the price paid to acquire it.Commercial banks may purchase eligible con-vertible issues if the yield obtained is reasonablysimilar to nonconvertible issues of similar qual-ity and maturity, and the issues are not selling ata significant conversion premium.

USES

Corporate bonds can be used for hedging, invest-ment, or speculative purposes. In some instances,the presence of credit risk and lack of liquidityin various issues may discourage their use.Speculators can use corporate bonds to takepositions on the level and term structure of bothinterest rates and corporate spreads over govern-ment securities.

Banks often purchase corporate bonds fortheir investment portfolios. In return for increasedcredit risk, corporate bonds provide an enhancedspread relative to Treasury securities. Banksmay purchase investment-grade corporate secu-rities subject to a 10 percent limitation of itscapital and surplus for one obligor. Banks areprohibited from underwriting or dealing in thesesecurities. A bank’s section 20 subsidiary may,however, be able to underwrite and deal incorporate bonds.

Banks often act as corporate trustees forbond issues. A corporate trustee is responsiblefor authenticating the bonds issued and ensuringthat the issuer complies with all of the covenantsspecified in the indenture. Corporate trusteesare subject to the Trust Indenture Act, whichspecifies that adequate requirements for theperformance of the trustee’s duties on behalfof the bondholders be developed. Furthermore,the trustee’s interest as a trustee mustnot conflict with other interest it may have,and the trustee must provide reports tobondholders.

Corporate Notes and Bonds 4045.1



The size of the total corporate bond market was$2.2 trillion dollars at the end of 1993. Nonfi-nancial corporate business comprised approxi-mately 56 percent of total issuance in 1993.

Market Participants

Buy Side

The largest holder of corporate debt in theUnited States is the insurance industry, account-ing for more than 33 percent of ownership at theend of 1993. Private pension funds are thesecond-largest holders with 13.7 percent ofownership. Commercial banks account forapproximately 4.5 percent of ownership of out-standing corporate bonds.

Sell Side

Corporate bonds are underwritten in the primarymarket by investment banks and section 20subsidiaries of banks. In the secondary market,corporate bonds are traded in the listed andunlisted markets. Listed markets include theNew York Stock Exchange and the AmericanStock Exchange. These markets primarily ser-vice retail investors who trade in small lots. Theover-the-counter market is the primary marketfor professional investors. In the secondarymarket, investment banks and section 20 sub-sidiaries of banks may act as either a broker ordealer. Brokers execute orders for the accountsof customers; they are agents and get a commis-sion for their services. Dealers buy and sell fortheir own accounts, thus taking the risk ofreselling at a loss.

Sources of Information

For a primary offering, the primary source ofinformation is contained in aprospectusfiled bythe issuer with the Securities and ExchangeCommission. For seasoned issues, major con-tractual provisions are provided in Moody’smanuals or Standard & Poor’s corporationrecords.

Bond ratings are published by several orga-nizations that analyze bonds and express theirconclusions by a ratings system. The four majornationally recognized statistical rating organiza-tions (NRSROs) in the United States are Duff &Phelps Credit Rating Co. (D&P); Fitch InvestorService, Inc. (Fitch); Moody’s Investor Service,Inc. (Moody’s); and Standard & Poor’s Corpo-ration (S&P).

PRICING

The major factors influencing the value of acorporate bond are—

• its coupon rate relative to prevailing marketinterest rates (typical of all bonds, bond priceswill decline when market interest rates riseabove the coupon rate, and prices will risewhen interest rates decline below the couponrate) and

• the issuer’s credit standing (a change in anissuer’s financial condition or ability to financethe debt can cause a change in the riskpremium and price of the security).

Other factors that influence corporate bondprices are the existence of call options, putfeatures, sinking funds, convertibility features,and guarantees or insurance. These factors cansignificantly alter the risk/return profile of abond issue. (These factors and their effect onpricing are discussed in the ‘‘Characteristics andFeatures’’ subsection above.)

The majority of corporate bonds are traded onthe over-the-counter market and are priced as aspread over U.S. Treasuries. Most often thebenchmark U.S. Treasury is the on-the-run (cur-rent coupon) issue. However, pricing ‘‘abnor-malities’’ can occur where the benchmark U.S.Treasury is different from the on-the-run security.

HEDGING

Interest-rate risk for corporate debt can be hedgedeither with cash, exchange-traded, or over-the-counter instruments. Typically, long corporatebond or note positions are hedged by selling aU.S. Treasury issue of similar maturity or byshorting an exchange-traded futures contract.The effectiveness of the hedge depends, in part,on basis risk and the degree to which the hedge



has neutralized interest-rate risk. Hedging strat-egies may incorporate assumptions about thecorrelation between the credit spread and gov-ernment rates. The effectiveness of these strat-egies may be affected if these assumptions proveinaccurate. Hedges can be constructed withsecurities from the identical issuer but withvarying maturities. Alternatively, hedges can beconstructed with issuers within an industrygroup. The relative illiquidity of various corpo-rate instruments may diminish hedgingeffectiveness.

RISKS

Interest-Rate Risk

For fixed-income bonds, prices fluctuate withchanges in interest rates. The degree of interest-rate sensitivity depends on the maturity andcoupon of the bond. Floating-rate issues lessenthe bank’s interest-rate risk to the extent that therate adjustments are responsive to market ratemovements. For this reason, these issues gener-ally have lower yields to compensate for theirbenefit to the holder.

Prepayment or Reinvestment Risk

Call provisions will also affect a bank’s interest-rate exposure. If the issuer has the right toredeem the bond before maturity, the action hasthe potential to adversely alter the investor’sexposure. The issue is most likely to be calledwhen market rates have moved in the issuer’sfavor, leaving the investor with funds to investin a lower-interest-rate environment.

Credit Risk

Credit risk is a function of the financial condi-tion of the issuer or the degree of supportprovided by a credit enhancement. The bondrating may be a quick indicator of credit quality.However, changes in bond ratings may lagbehind changes in financial condition. Banksholding corporate bonds should perform a peri-odic financial analysis to determine the creditquality of the issuer.

Some bonds will include a credit enhance-ment in the form of insurance or a guarantee by

another corporation. The safety of the bond maydepend on the financial condition of the guaran-tor, since the guarantor will make principal andinterest payments if the obligor cannot. Creditenhancements often are used to improve thecredit rating of a bond issue, thereby reducingthe rate of interest that the issuer must pay.

Zero-coupon bonds may pose greater credit-risk problems. When a zero-coupon bond hasbeen sold at a deep discount, the issuer musthave the funds to make a large payment atmaturity. This potentially large balloon repay-ment may significantly increase the credit risk ofthe issue.

Liquidity Risk

Major issues are actively traded in large amounts,and liquidity concerns may be small. Tradingfor many issues, however, may be inactive andsignificant liquidity problems may affect pric-ing. The trading volume of a security determinesthe size of the bid/ask spread of a bond. Thisprovides an indication of the bond’s marketabil-ity and, hence, its liquidity. A narrow spread ofbetween one-quarter to one-half of 1 percentmay indicate a liquid market, while a spread of2 percent or 3 percent may indicate poor liquid-ity for a bond. Even for major issues, news ofcredit problems may cause temporary liquidityproblems.

Event Risk

Event risk can be large for corporate bonds. Thisis the risk of an unpredictable event that imme-diately affects the ability of an issuer to servicethe obligations of a bond. Examples of eventrisk include leveraged buyouts, corporate restruc-turings, or court rulings that affect the creditrating of a company. To mitigate event risk,some indentures include a maintenance of networth clause, which requires the issuer to main-tain its net worth above a stipulated level. If therequirement is not met, the issuer must begin toretire its debt at par.


The Financial Accounting Standards Board’sStatement of Financial Accounting Standards

Corporate Notes and Bonds 4045.1


No. 115 (FAS 115), ‘‘Accounting for CertainInvestments in Debt and Equity Securities,’’ asamended by Statement of Financial AccountingStandards No. 140 (FAS 140), ‘‘Accounting forTransfers and Servicing of Financial Assets andExtinguishments of Liabilities,’’ determines theaccounting treatment for investments in corpo-rate notes and bonds. Accounting treatment forderivatives used as investments or for hedgingpurposes is determined by Statement of Finan-cial Accounting Standards No. 133 (FAS 133),‘‘Accounting for Derivatives and HedgingActivities,’’ as amended by Statement of Finan-cial Accounting Standards Nos. 137 and 138(FAS 137 and FAS 138). (See section 2120.1,‘‘Accounting,’’ for further discussion.)


Corporate notes and bonds should be weightedat 100 percent. For specific risk weights forqualified trading accounts, see section 2110.1,‘‘Capital Adequacy.’’


Corporate notes and bonds are type III securi-ties. A bank may purchase or sell for its ownaccount corporate debt subject to the limitationthat the corporate debt of a single obligor maynot exceed 10 percent of the bank’s capital andsurplus. To be eligible for purchase, a corporatesecurity must be investment grade (that is, ratedBBB or higher) and must be marketable. Banksmay not deal in or underwrite corporate bonds.

REFERENCES

Fabozzi, Frank, and T. Dessa, eds. The Hand-book of Fixed Income Securities. Chicago:Irwin Professional Publishing, 1995.

Fabozzi, Frank, and Richard Wilson. CorporateBonds. Frank J. Fabozzi Associates, 1996.

‘‘How Do Corporate Spread Curves Move OverTime?’’ Salomon Brothers, July 1995.



Municipal SecuritiesSection 4050.1

GENERAL DESCRIPTION

Municipal securities are interest-bearing obliga-tions issued by local governments or theirpolitical subdivisions (such as cities, towns,villages, counties, or special districts) or by stategovernments, agencies, or political subdivi-sions. These governmental entities can borrowat favorable rates because the interest incomefrom most municipal securities generally receivesadvantageous treatment under federal incometax rules. There are important restrictions onthese tax advantages, however, and banks aresubject to different tax treatment than otherinvestors.

The two principal classifications of municipalsecurities are general obligation bonds andrevenue bonds.General obligation bondsaresecured by the full faith and credit of an issuerwith taxing power. General obligation bondsissued by local governments are generallysecured by a pledge of the issuer’s specifictaxing power, while general obligation bondsissued by states are generally based on appro-priations made by the state’s legislature. In theevent of default, the holders of general obliga-tion bonds have the right to compel a tax levy orlegislative appropriation to satisfy the issuer’sobligation on the defaulted bonds.

Revenue bondsare payable from a specificsource of revenue, so that the full faith andcredit of an issuer with taxing power is notpledged. Revenue bonds are payable only fromspecifically identified sources of revenue. Pledgedrevenues may be derived from operation of thefinanced project, grants, and excise or othertaxes.Industrial development bondsare a com-mon example of revenue bonds. These bonds aremunicipal debt obligations issued by a state orlocal government (or a development agency) tofinance private projects that generate tax rev-enues. The debt service on these bonds isdependent on the lease income generated by theproject or facility. In certain instances, industrialdevelopment bonds may be categorized as loans(see the instructions to the call report).

In addition to municipal and industrial devel-opment bonds, state and local governmentalentities issue short-term obligations in the formof notes. These debt obligations are generallyissued to bridge the gap between when expensesare paid and tax revenues are collected. The

types of notes issued includetax anticipationnotes (TANs), revenue anticipation notes (RANs),tax and revenue anticipation notes (TRANs),grant anticipation notes (GANs),and bondanticipation notes (BANs).


Municipal bonds are typically issued in denomi-nations of $5,000, known as the par value orface value amount of the bond. Municipal bondsare generally issued in serial maturities. Atypical offering is made up of different maturi-ties which allow the issuer to spread out debtservice and stay within financial requirements.In recent years, however, term bonds havebecome increasingly popular. Term bonds arebonds comprising a large part or all of a par-ticular issue which comes due in a single matu-rity. The issuer usually agrees to make periodicpayments into a sinking fund for mandatoryredemption of term bonds before maturity or forpayment at maturity. Most municipal bonds areissued with call provisions which give the issuerflexibility in controlling its borrowing coststhrough the early retirement of debt.

A prime feature of municipal securities hadbeen the exemption of their interest from federalincome taxation. However, two significantrestrictions have been imposed on the tax bene-fits of owning municipal securities. First, begin-ning in 1986, all taxpayers became subject to thealternative minimum tax (AMT), which wasintended to provide an upper limit on the degreeto which individuals and corporations can pro-tect their income from taxation. Interest incomefrom private-activity securities issued since thenis potentially subject to the AMT. Second,investors became unable to deduct interestexpense incurred in funding tax-advantagedsecurities, a measure that was intended to removethe benefit of borrowing funds from others toinvest in municipal securities. In this regard,special federal tax rules apply to bank holdingsof municipal securities, including the manner inwhich the amount of nondeductible interestexpense is calculated. Exceptions to these vari-ous limitations apply only to tax-exempt obliga-tions issued after August 1986 that are issued bysmall entities and are not private-activity bonds.


The state and local income taxation treatmentof municipal securities varies greatly from stateto state. Many states and local governmentsexempt interest income only on those bonds andnotes issued by government entities locatedwithin their own boundaries.

USES

Municipal securities have traditionally been heldprimarily for investment purposes by investorswho would benefit from income that is advan-taged under federal income tax statutes andregulations. This group includes institutionalinvestors such as insurance companies, mutualfunds, commercial banks, and retail investors.The value of the tax advantage and, therefore,the attractiveness of the security increase whenthe income earned is also advantaged under stateand local tax laws. Wealthy individuals andcorporations face the highest marginal tax ratesand, therefore, stand to receive the highesttax-equivalent yields on these securities. Privateindividuals are the largest holders of municipalsecurities, accounting for three-fourths of thesesecurities outstanding.


Issuing Practices

State and local government entities can markettheir new bond issues by offering them publiclyor placing them privately with a small group ofinvestors. When a public offering is selected, theissue is usually underwritten by investmentbankers and municipal bond departments ofbanks. The underwriter may acquire the securi-ties either by negotiation with the issuer or byaward on the basis of competitive bidding. Theunderwriter is responsible for the distribution ofthe issue and accepts the risk that investorsmight fail to purchase the issues at the expectedprices. For most sizable issues, underwriters jointogether in a syndicate to spread the risk of thesale and gain wider access to potential investors.

Standards and practices for the municipalsecurities activities of banks and other marketparticipants are set by the Municipal SecuritiesRulemaking Board (MSRB), a congressionallychartered self-regulatory body that is overseen

by the SEC. Examination and enforcement ofMSRB standards is delegated to the NASD forsecurities firms and to the appropriate federalbanking agency (Federal Reserve, OCC, orFDIC) for banking organizations.

Secondary Market

Municipal securities are not listed on or tradedin exchanges; however, there are strong andactive secondary markets for municipal securi-ties that are supported by municipal bond deal-ers. These traders buy and sell to other dealersand investors and for their own inventories. Thebond broker’s broker also serves a significantrole in the market for municipal bonds. Thesebrokers are a small number of interdealer bro-kers who act as agents for registered dealers anddealer banks. In addition to using these brokers,many dealers advertise municipal offerings forthe retail market through theBlue List. TheBlueList is published by Standard & Poor’s Corpo-ration and lists securities and yields or prices ofbonds and notes being offered by dealers.

Market Participants

Market participants in the municipal securitiesindustry include underwriters, broker-dealers,brokers’ brokers, the rating agencies, bondinsurers, and investors. Financial advisors, whoadvise state and local governments for bothcompetitive and negotiated offerings, and bondcounsel, who provide opinions on the legality ofspecific obligations, are also important partici-pants in the industry. The underwriting businessprimarily consists of a small number of largebroker-dealers, typically with retail branch sys-tems, and a large number of regional under-writers and broker-dealers with ties to localgovernments and who specialize in placing debtin their individual regions.

Market Transparency

Price transparency in the municipal securitiesindustry varies depending on the type of securityand the issuer. Prices for public issues are morereadily available than prices for private place-ments. Two publications quote prices formunicipal securities:The Bond Buyerand theBlue List.

4050.1 Municipal Securities


PRICING

Municipal securities are priced either on a yieldor dollar basis depending on the issue. Securitiesthat are priced on a dollar basis are quoted as apercentage of the par value. A bond that istraded and quoted as a percentage of its parvalue is called a ‘‘dollar bond.’’ Municipalsecurities, however, are generally traded andquoted in terms of yields because there are somany issues of different maturities. A bondquoted at 6.751-6.50 percent means that adealer is willing to purchase the bond to yield6.75 percent and will sell it to yield 6.50 percent.

To compare the yield of a municipal securitywith that of a taxable bond, the yield of thematurity must be adjusted to account for anumber of factors that may be unique to theindividual investor. For example, a fully taxableequivalent (FTE) yield would consider the rel-evant federal, state, and local marginal tax ratesof the investor; specific characteristics of thesecurity; the applicability of the alternative mini-mum tax (AMT); the ability to deduct interestexpense associated with funding the acquisition;and other elements of the institution’s tax status.(These factors are discussed more fully in the‘‘Characteristics and Features’’ subsection.)

HEDGING

Generally, the special features and uniquepotential tax advantages of municipal securitiesmake it difficult to construct an ideal hedge. Themunicipal bond futures contract from the Chi-cago Board of Trade (and corresponding options)is frequently used to hedge positions in munici-pal bonds. These contracts are cash settled to thevalue of the Bond Buyer Index, an index ofactively traded municipal bonds, whose compo-sition changes frequently. The market for theseexchange contracts is not very liquid, however,and the possibility of basis risk may be large.

Municipal securities also can be hedged usingmore liquid Treasury securities, futures, andoptions. Treasury securities can be used tomitigate exposure to yield-curve risk; however,the significant basis risk present in the municipal/Treasury securities price relationship wouldremain unhedged. Some dealers use over-the-counter municipal swaps to hedge interest-raterisk. This would reduce basis risk to the rela-tionship between the security being hedged and

the municipal index employed in the swaptransaction. Municipal swaps are relatively newand are not widespread in the industry. As aresult, their use as hedging vehicles is limited.

RISKS

Credit Risk

Municipal securities activities involve differingdegrees of credit risk depending on the financialcapacity of the issuer or economic obligor.Noteworthy cases in which municipal securitieshave been unable to perform as agreed rangefrom New York City in the 1970s and WPPSS (aWashington state power utility) in the 1980s tomore recent examples. For revenue bonds, theability to perform depends primarily on thesuccess of the project or venture funded by thebond. Trends in real estate values, fiscal man-agement, and the size of the tax base beardirectly on the issuer’s ability to service generalobligation bonds.

An important starting point in performing acredit review of a potential issuer is to obtain alegal opinion that the issuing entity has the legalauthority to undertake the obligation. The entitymust also have the capacity to repay as well asthe willingness to perform, both influenced notonly by financial factors but by political factors.Since some issuers depend on legislatures orvoters to approve bond issues or new funding,credit analysis can become problematic; issuerscould default on their bond obligations despitehaving the funds to service debt. These politicalissues may reach beyond the direct jurisdictionof the issuing entity, including decisions madeby state legislatures or Congress. Therefore, tofully evaluate market risk, market participantsmust monitor how political and legislative fac-tors may affect a security’s default risk.

The lack of standardized financial statementsand the large number of different issuers (asmany as 50,000 entities issue municipal bonds)also make credit analysis of municipal securitiesmore difficult. This heightens the importance ofthe role of the rating agencies and bond insurersin comparison to other markets. Larger issuersof municipal securities are rated by nationallyrecognized rating agencies. Other issuers achievean investment-grade rating through the use ofcredit enhancements such as insurance from amunicipal bond insurance company or a letter ofcredit issued by a financial institution. Credit

Municipal Securities 4050.1


enhancements are often used to improve thecredit rating of a security, thereby lowering theinterest that the issuer must pay.

Liquidity Risk

One of the problems in the municipal marketis the lack of ready marketability for manymunicipal issues. Many municipal bonds arerelatively small issues, and most general obliga-tion issues are sold on a serial basis, which ineffect breaks the issues up into smaller com-ponents. Furthermore, a large percentage ofmunicipal securities are purchased by retailinvestors and small institutions that tend to holdsecurities to maturity. Overall, smaller issuesand those with thin secondary markets oftenexperience liquidity difficulties and are thereforesubject to higher risk.

Interest-Rate Risk and Market Risk

Like other fixed-income securities, fixed-incomemunicipal securities are subject to price fluctua-tions based on changes in interest rates. Thedegree of fluctuation depends on the maturityand coupon of the security. Variable-rate issuesare typically tied to a money market rate, sotheir interest-rate risk will be significantly less.Nonetheless, since bond prices and interest ratesare inextricably linked, all municipal securitiesinvolve some degree of interest-rate risk.

Holders of municipal securities are alsoaffected by changes in marginal tax rates. Forinstance, a reduction in marginal tax rates wouldlower the tax-equivalent yield on the security,causing the security to depreciate in price.

Prepayment or Reinvestment Risk

Call provisions will affect a bank’s interest-rateexposure. If the issuer has the right to redeemthe bond before maturity, the risk of an adverseeffect on the bank’s exposure is greater. Thesecurity is most likely to be called when rateshave moved in the issuer’s favor, leaving theinvestor with funds to invest in a lower-interest-rate environment.


The accounting treatment for investments inmunicipal securities is determined by the Finan-cial Accounting Standards Board’s Statement ofFinancial Accounting Standards No. 115 (FAS115), ‘‘Accounting for Certain Investments inDebt and Equity Securities,’’ as amended byStatement of Financial Accounting StandardsNo. 140 (FAS 140), ‘‘Accounting for Transfersand Servicing of Financial Assets and Extin-guishments of Liabilities.’’ Accounting treat-ment for derivatives used as investments or forhedging purposes is determined by Statement ofFinancial Accounting Standards No. 133 (FAS133), ‘‘Accounting for Derivatives and HedgingActivities,’’ as amended by Statement of Finan-cial Accounting Standards Nos. 137 and 138(FAS 137 and FAS 138). (See section 2120.1,‘‘Accounting,’’ for further discussion.)


General obligations, BANs, and TANs have a20 percent risk weight. Municipal revenue bondsand RANs have a 50 percent risk weight.Industrial development bonds are rated at100 percent. For specific risk weights for quali-fied trading accounts, see section 2110.1, ‘‘ Capi-tal Adequacy.’’


The limitations of 12 USC 24 (section 5136 ofthe Revised Statutes) apply to municipal secu-rities. Municipal securities that are generalobligations are type I securities and may bepurchased by banks in unlimited amounts.Municipal revenue securities, however, are eithertype II or type III securities. The purchase oftype II and type III securities is limited to10 percent of equity capital and reserves foreach obligor. That limitation is reduced to 5percent of equity capital and reserves for allobligors in the aggregate when the judgment ofthe obligor’s ability to perform is based predomi-nantly on reliable estimates versus adequateevidence.

4050.1 Municipal Securities


REFERENCES

Fabozzi, Frank J., Sylvan G. Feldstein, IrvingM. Pollack, and Frank G. Zarb, ed. TheMunicipal Bond Handbook. Homewood, Ill.:Dow Jones-Irwin, 1983.

Feldstein, Sylvan G., Frank J. Fabozzi, andT. Dessa Fabozzi. ‘‘ Chapter 8: Municipal

Bonds.’’ The Handbook of Fixed IncomeSecurities. 4th ed. Chicago: Irwin Profes-sional Publishing, 1995.

Municipal Securities Rulemaking Board. Glos-sary of Municipal Securities Terms. 1st ed.Washington, D.C.: 1985.

Public Securities Association. Fundamentals ofMunicipal Bonds. 4th ed. New York: 1990.

Municipal Securities 4050.1


Eurodollar Certificates of DepositSection 4055.1

GENERAL DESCRIPTION

A Eurodollar certificate of deposit (EurodollarCD) is a negotiable dollar-denominated timedeposit issued by a U.S. bank located outside theUnited States or by a foreign bank locatedabroad. Dollars deposited in international bank-ing facilities (IBFs) in the United States are alsoconsidered Eurodollars.


Eurodollar CDs are not FDIC-insured. Euro-dollar deposits are generally free from domestic(U.S.) regulation and reserve requirements, andthese deposits are not subject to other feesimposed by the FDIC. Most Eurodollar CDs areissued in denominations over $1 million.Although their maturities must be at least sevendays and most CDs are issued for three to sixmonths, there is no upward limit on the term.Issuing banks cannot purchase their own CDs.

USES

The primary reason for issuing in the Eurodollarmarket (besides the basic reason to issue aCD—to provide a source of funds) is the lowercost of funds available as a result of the elimi-nation of regulatory costs and reserve require-ments. Buyers, on the other hand, can takeadvantage of the slightly higher yields whilemaintaining reasonable liquidity. Eurodollar CDissuers subsequently take the funds receivedfrom the issuance and redeposit them with otherforeign banks, invest them, retain them toimprove reserves or overall liquidity, or lendthem to companies, individuals, or governmentsoutside the United States.


The Eurodollar CD market is centered in Lon-don. Activity also takes place in offshorebranches, including those in Nassau and theCayman Islands. Issuers include the overseas

branches of money-center U.S. banks, largeBritish banks, and branches of major Canadianand Japanese banks. Only the largest banks withstrong international reputations usually sell Euro-dollar CDs. Since the advent of the medium-term note market, the Eurodollar CD market hasbeen on a decline and is now a relatively illiquidmarket.

Eurodollar CDs are sold by the issuing bankat face value either directly to investors ordepositors or through CD dealers and brokers.Settlement is on a two-day basis and occurs atthe New York correspondents of the issuers’ andinvestors’ banks.

PRICING

Eurodollar CDs are priced off the London Inter-bank Offered Rate (LIBOR). Their yields aregenerally slightly higher than yields for domes-tic CDs to compensate the investor for theslightly higher risk.

Eurodollar CDs are quoted and sold on aninterest-bearing basis on an actual/360-day basis.The bid/offer quotes are in 16ths (for example,12 7/16). The quotes directly translate to rateson the given Eurodollar CD. Thus, bid/offerrates of 12 7/16 and 12 3/16 would roughlytranslate to a bid interest rate of 12.4375 percentand an offer rate of 12.1875 percent, respec-tively, giving the dealer a spread of .25 percent.

HEDGING

Eurodollar futures may be used to hedge Euro-dollar time deposits. Eurodollar futures are oneof the most actively traded futures contracts inthe world.

RISKS

The risks associated with purchasing EurodollarCDs include credit risk, sovereign risk, andliquidity risk. To reduce credit risk, a detailedanalysis should be performed on all EurodollarCD issuers in which the investor has invested.Although the instruments themselves are notrated, most issuers are rated by either Thompson


Bankwatch (for domestic banks) or IBCA, Ltd.(for foreign banks).

The secondary market for Eurodollar CDs isless developed than the domestic CD market.The current perception of the issuer’s name, aswell as the size and maturity of the issue, mayaffect marketability.


The Financial Accounting Standards Board’sStatement of Financial Accounting StandardsNo. 115 (FAS 115), ‘‘Accounting for CertainInvestments in Debt and Equity Securities,’’ asamended by Statment of Financial AccountingStandards No. 140 (FAS 140), ‘‘Accounting forTransfers and Servicing of Financial Assets andExtinguishments of Liabilities,’’ determines theaccounting treatment for investments in Euro-dollar CDs. Accounting treatment for deriva-tives used as investments or for hedging pur-poses is determined by Statement of FinancialAccounting Standards No. 133 (FAS 133),‘‘Accounting for Derivatives and HedgingActivities,’’ as amended by Statement of Finan-cial Accounting Standards Nos. 137 and 138(FAS 137 and FAS 138). (See section 2120.1,‘‘Accounting,’’ for further discussion.)


In general, a 20 percent risk weighting is appro-priate for depository institutions based in OECD

countries. For specific risk weights for qualifiedtrading accounts, see section 2110.1, ‘‘CapitalAdequacy.’’


Owning Eurodollar CDs is authorized under the‘‘incidental powers’’ provisions of 12 USC 24(seventh). Banks may legally hold theseinstruments without limit.

REFERENCES

Cook, Timothy Q., and Robert LaRoche, eds.Instruments of the Money Market. 7th ed.Richmond, Va.: Federal Reserve Bank ofRichmond, 1993.

Munn, Glenn G. et al. Encyclopedia of Bank-ing Finance. 9th ed. Rolling Meadows, Ill.:Bankers Publishing Company, 1991.

Oppenheim, Peter K. ‘‘The Eurodollar Mar-ket.’’ International Banking. 6th ed. Washing-ton, D.C.: American Bankers Association,1991.

Stigum, Marcia. The Money Market. 3rd ed.Homewood, Ill.: Business One Irwin, 1990.

4055.1 Eurodollar Certificates of Deposit


Asset-Backed Securities and Asset-Backed Commercial PaperSection 4105.1

GENERAL DESCRIPTION

Asset-backed securities (ABS) are debt instru-ments that represent an interest in a pool ofassets. Technically, mortgage-backed securities(MBS) can be viewed as a subset of ABS, butthe term ‘‘ABS’’ is generally used to refer tosecurities in which underlying collateral consistsof assets other than residential first mortgagessuch as credit card and home equity loans,leases, or commercial mortgage loans. Issuersare primarily banks and finance companies,captive finance subsidiaries of nonfinancial cor-porations (for example, GMAC), or specializedoriginators such as credit card lenders (forexample, Discover). Credit risk is an importantissue in asset-backed securities because of thesignificant credit risks inherent in the underlyingcollateral and because issuers are primarily pri-vate entities. Accordingly, asset-backed securi-ties generally include one or more creditenhancements, which are designed to raise theoverall credit quality of the security above thatof the underlying loans.

Another important type of asset-backed secu-rity is commercial paper issued by special-purpose entities. Asset-backed commercial paperis usually backed by trade receivables, thoughsuch conduits may also fund commercial andindustrial loans. Banks are typically more activeas issuers of these instruments than as investorsin them.


An asset-backed security is created by the saleof assets or collateral to a conduit, whichbecomes the legal issuer of the ABS. Thesecuritization conduit or issuer is generally abankruptcy-remote vehicle such as a grantortrust or, in the case of an asset-backed commer-cial paper program, a special-purpose entity(SPE). The sponsor or originator of the collat-eral usually establishes the issuer. Interests inthe trust, which embody the right to certain cashflows arising from the underlying assets, arethen sold in the form of securities to investorsthrough an investment bank or other securitiesunderwriter. Each ABS has a servicer (often theoriginator of the collateral) that is responsible

for collecting the cash flows generated by thesecuritized assets—principal, interest, and feesnet of losses and any servicing costs as well asother expenses—and for passing them along tothe investors in accord with the terms of thesecurities. The servicer processes the paymentsand administers the borrower accounts in thepool.

The structure of an asset-backed security andthe terms of the investors’ interest in the collat-eral can vary widely depending on the type ofcollateral, the desires of investors, and the use ofcredit enhancements. Often ABS are structuredto reallocate the risks entailed in the underlyingcollateral (particularly credit risk) into securitytranches that match the desires of investors. Forexample, senior subordinated security structuresgive holders of senior tranches greater creditrisk protection (albeit at lower yields) thanholders of subordinated tranches. Under thisstructure, at least two classes of asset-backedsecurities are issued, with the senior class hav-ing a priority claim on the cash flows from theunderlying pool of assets. The subordinatedclass must absorb credit losses on the collateralbefore losses can be charged to the seniorportion. Because the senior class has this prior-ity claim, cash flows from the underlying pool ofassets must first satisfy the requirements of thesenior class. Only after these requirements havebeen met will the cash flows be directed toservice the subordinated class.

ABS also use various forms of credit enhance-ments to transform the risk-return profile ofunderlying collateral, including third-party creditenhancements, recourse provisions, overcollat-eralization, and various covenants. Third-partycredit enhancements include standby letters ofcredit, collateral or pool insurance, or suretybonds from third parties. Recourse provisionsare guarantees that require the originator tocover any losses up to a contractually agreed-upon amount. One type of recourse provision,usually seen in securities backed by credit cardreceivables, is the ‘‘spread account.’’ Thisaccount is actually an escrow account whosefunds are derived from a portion of the spreadbetween the interest earned on the assets in theunderlying pool of collateral and the lowerinterest paid on securities issued by the trust.The amounts that accumulate in this escrowaccount are used to cover credit losses in the


underlying asset pool, up to several multiples ofhistorical losses on the particular asset collater-alizing the securities.

Overcollateralization is another form of creditenhancement that covers a predetermined amountof potential credit losses. It occurs when thevalue of the underlying assets exceeds the facevalue of the securities. A similar form of creditenhancement is the cash-collateral account,which is established when a third party depositscash into a pledged account. The use of cash-collateral accounts, which are considered byenhancers to be loans, grew as the number ofhighly rated banks and other credit enhancersdeclined in the early 1990s. Cash-collateralaccounts provide credit protection to investorsof a securitization by eliminating ‘‘event risk,’’or the risk that the credit enhancer will have itscredit rating downgraded or that it will not beable to fulfill its financial obligation to absorblosses.

An investment banking firm or other organi-zation generally serves as an underwriter forABS. In addition, for asset-backed issues thatare publicly offered, a credit-rating agency willanalyze the policies and operations of the origi-nator and servicer, as well as the structure,underlying pool of assets, expected cash flows,and other attributes of the securities. Beforeassigning a rating to the issue, the rating agencywill also assess the extent of loss protectionprovided to investors by the credit enhance-ments associated with the issue.

Although the basic elements of all asset-backed securities are similar, individual transac-tions can differ markedly in both structure andexecution. Important determinants of the riskassociated with issuing or holding the securitiesinclude the process by which principal andinterest payments are allocated and down-streamed to investors, how credit losses affectthe trust and the return to investors, whethercollateral represents a fixed set of specific assetsor accounts, whether the underlying loans arerevolving or closed-end, under what terms(including maturity of the asset-backed instru-ment) any remaining balance in the accountsmay revert to the issuing company, and theextent to which the issuing company (the actualsource of the collateral assets) is obligated toprovide support to the trust/conduit or to theinvestors. Further issues may arise based ondiscretionary behavior of the issuer within theterms of the securitization agreement, such asvoluntary buybacks from, or contributions to,

the underlying pool of loans when credit lossesrise.

A bank or other issuer may play more thanone role in the securitization process. An issuercan simultaneously serve as originator of loans,servicer, administrator of the trust, underwriter,provider of liquidity, and credit enhancer. Issu-ers typically receive a fee for each element ofthe transaction.

Institutions acquiring ABS should recognizethat the multiplicity of roles that may be playedby a single firm—within a single securitizationor across a number of them—means that creditand operational risk can accumulate into signifi-cant concentrations with respect to one or asmall number of firms.

TYPES OF SECURITIZED ASSETS

There are many different varieties of asset-backed securities, often customized to the termsand characteristics of the underlying collateral.The most common types are securities collater-alized by revolving credit-card receivables, butinstruments backed by home equity loans, othersecond mortgages, and automobile-financereceivables are also common.

Installment Loans

Securities backed by closed-end installment loansare typically the least complex form of asset-backed instruments. Collateral for these ABStypically includes leases, automobile loans, andstudent loans. The loans that form the pool ofcollateral for the asset-backed security may havevarying contractual maturities and may or maynot represent a heterogeneous pool of borrow-ers. Unlike a mortgage pass-through instrument,the trustee does not need to take physical pos-session of any account documents to perfectsecurity interest in the receivables under theUniform Commercial Code. The repaymentstream on installment loans is fairly predictable,since it is primarily determined by a contractualamortization schedule. Early repayment on theseinstruments can occur for a number of reasons,with most tied to the disposition of the under-lying collateral (for example, in the case of anABS backed by an automobile loan, the sale ofthe vehicle). Interest is typically passed throughto bondholders at a fixed rate that is slightly

4105.1 Asset-Backed Securities and Asset-Backed Commercial Paper


below the weighted average coupon of the loanpool, allowing for servicing and other expensesas well as credit losses.

Revolving Credit

Unlike closed-end installment loans, revolving-credit receivables involve greater uncertaintyabout future cash flows. Therefore, ABS struc-tures using this type of collateral must be morecomplex to afford investors more comfort inpredicting their repayment. Accounts includedin the securitization pool may have balances thatgrow or decline over the life of the ABS.Accordingly, at maturity of the ABS, any remain-ing balances revert to the originator. During theterm of the ABS, the originator may be requiredto sell additional accounts to the pool to main-tain a minimum dollar amount of collateral ifaccountholders pay down their balances inadvance of predetermined rates.

Credit card securitizations are the most preva-lent form of revolving-credit ABS, althoughhome equity lines of credit are a growing sourceof ABS collateral. Credit card ABS are typicallystructured to incorporate two phases in the lifecycle of the collateral: an initial phase duringwhich the principal amount of the securitiesremains constant, and an amortization phaseduring which investors are paid off. A specificperiod of time is assigned to each phase. Typi-cally, a specific pool of accounts is identified inthe securitization documents, and these specifi-cations may include not only the initial pool ofloans but a portfolio from which new accountsmay be contributed.

The dominant vehicle for issuing securitiesbacked by credit cards is a master-trust structurewith a ‘‘spread account,’’ which is funded up toa predetermined amount through ‘‘excessyield’’—that is, interest and fee income lesscredit losses, servicing, and other fees. Withcredit card receivables, the income from thepool of loans—even after credit losses—is gen-erally much higher than the return paid toinvestors. After the spread account accumulatesto its predetermined level, the excess yieldreverts to the issuer. Under GAAP, issuers arerequired to recognize on their balance sheet anexcess-yield asset that is based on the fair valueof the expected future excess yield; in principle,this value would be based on the net presentvalue of the expected earnings stream from the

transaction. Issuers are further required to revaluethe asset periodically to take account of changesin fair value that may occur due to interest rates,actual credit losses, and other factors relevant tothe future stream of excess yield. The account-ing and capital implications of these transactionsare discussed further below.

Asset-Backed Commercial Paper

A number of larger banks use ‘‘special-purposeentities’’ (SPEs) to acquire trade receivables andcommercial loans from high-quality (ofteninvestment-grade) obligors and to fund thoseloans by issuing (asset-backed) commercial paperthat is to be repaid from the cash flow of thereceivables. Capital is contributed to the SPE bythe originating bank; together with the highquality of the underlying borrowers, this capitalis sufficient to allow the SPE to receive a highcredit rating. The net result is that the SPE’s costof funding can be at or below that of theoriginating bank itself. The SPE is ‘‘owned’’ byindividuals who are not formally affiliated withthe bank, although the degree of separation istypically minimal.

These types of securitization programs enablebanks to arrange short-term financing supportfor their customers without having to extendcredit directly. This structure provides borrow-ers with an alternative source of funding andallows banks to earn fee income for managingthe programs. As the asset-backed commercialpaper structure has developed, it has been usedto finance a variety of underlying loans—insome cases, loans purchased from other firmsrather than originated by the bank itself—and asa remote-origination vehicle from which loanscan be made directly. Like other securitizationtechniques, this structure allows banks to meettheir customers’ credit needs while incurringlower capital requirements and a smaller bal-ance sheet than if it made the loans directly.

USES

Issuers obtain a number of advantages fromsecuritizing assets, including improving theircapital ratios and return on assets, monetizinggains in loan value, generating fee income byproviding services to the securitization conduit,closing a potential source of interest-rate risk,

Asset-Backed Securities and Asset-Backed Commercial Paper 4105.1


and increasing institutional liquidity by provid-ing access to a new source of funds. Investorsare attracted by the high credit quality of ABS,as well as their attractive returns.


The primary buyers for ABS have been insur-ance companies and pension funds looking forattractive returns with superior credit quality.New issues often sell out very quickly. Bankstypically are not active buyers of these securi-ties. The secondary market is active, but newissues currently trade at a premium to moreseasoned products.

Market transparency can be less than perfect,especially when banks and other issuers retainmost of the economic risk despite the securiti-zation transaction. This is particularly true whenexcess yield is a significant part of the transac-tion and when recourse (explicit or implicit) is amaterial consideration. The early-amortizationfeatures of some ABS also may not be fullyunderstood by potential buyers.

PRICING

ABS carry coupons that can be fixed (generallyyielding between 50 and 300 basis points overthe Treasury curve) or floating (for example, 15basis points over one-month LIBOR). Pricing istypically designed to mirror the coupon charac-teristics of the loans being securitized. Thespread will vary depending on the credit qualityof the underlying collateral, the degree andnature of credit enhancement, and the degree ofvariability in the cash flows emanating from thesecuritized loans.

HEDGING

Given the high degree of predictability in theircash flows, the hedging of installment loans andrevolving-credit ABS holdings is relativelystraightforward and can be accomplished eitherthrough cash-flow matching or duration hedg-ing. Most market risk arises from the perceivedcredit quality of the collateral and from thenature and degree of credit enhancement, a risk

that may be difficult to hedge. One source ofpotential unpredictability, however, is the riskthat acceleration or wind-down provisions wouldbe triggered by poor credit quality in the assetpool—essentially, a complex credit-quality optionthat pays off bondholders early if credit lossesexceed some threshold level.

For issuers, variability in excess yield (interms of carrying value) or in the spread account(in terms of income) can represent a materialinterest-rate risk, particularly if the bonds payinterest on a variable-rate basis while the under-lying loans are fixed-rate instruments. While therisk can be significant, the hedging solutions arenot complex (that is, dollar-for-dollar in notionalterms). Potential hedging strategies include theuse of futures or forwards, forward rate agree-ments (FRAs), swaps, or more complex optionsor swaptions. In the case of home equity loans orother revolving credits for which the pool earn-ings rate is linked to prime while the ABSinterest rate is not, prime LIBOR swaps orsimilar instruments could be used to mitigatebasis risk. The presence of interest-rate risk mayhave credit-quality ramifications for the securi-ties, as tighter excess yield and spread accountswould reduce the ability of the structure toabsorb credit losses.

An asset-backed commercial paper (ABCP)program can lead to maturity mismatches for theissuer, depending on the pricing characteristicsof the commercial loan assets. Similarly, thepresence of embedded options—such as prepay-ment options, caps, or floors—can expose theABCP entity to options risk. These risks can behedged through the use of options, swaptions, orother derivative instruments. As with homeequity ABS, prime-based commercial loanscould lead to basis-risk exposure, which can behedged using basis swaps.

RISKS

Credit Risk

Credit risk arises from (1) losses caused bydefaults of borrowers in the underlying collat-eral and (2) the issuer’s or servicer’s failure toperform. These two elements can blur together,as in the case of a servicer who does not provideadequate credit-review scrutiny to the servicedportfolio, leading to a higher incidence



of defaults. ABS are rated by major ratingagencies.

Market Risk

Market risk arises from the cash-flow character-istics of the security, which for most ABS tendto be predictable. Rate-motivated prepaymentsare a relatively minor phenomenon because ofthe small principal amounts on each loan and therelatively short maturity. The greatest variabilityin cash flows comes from credit performance,including the presence of wind-down oracceleration features designed to protect theinvestor if credit losses in the portfolio rise wellabove expected levels.

Interest-Rate Risk

Interest-rate risk arises for the issuer from therelationship between the pricing terms on theunderlying loans and the terms of the rate paidto bondholders, as well as from the need to markto market the excess servicing or spread-accountproceeds carried on the balance sheet. For theholder of the security, interest-rate risk dependson the expected life or repricing of the ABS,with relatively minor risk arising from embed-ded options. The notable exception is valuationof the wind-down option.

Liquidity Risk

Liquidity risk can arise from increased per-ceived credit risk. Liquidity can also become amajor concern for asset-backed commercialpaper programs if concerns about credit quality,for example, lead investors to avoid the com-mercial paper issued by the SPE. For thesecases, the securitization transaction may includea ‘‘liquidity facility,’’ which requires the facilityprovider to advance funds to the SPE if liquidityproblems arise. To the extent that the bankoriginating the loans is also the provider of theliquidity facility and that the bank is likely toexperience similar market concerns if the loansit originates deteriorate, the ultimate practicalvalue of the liquidity facility to the transactionmay be questionable.

Operations Risk

Operations risk arises from the potential misrep-resentation of loan quality or terms by theoriginating institution, the misrepresentation ofthe nature and current value of the assets by theservicer, and inadequate controls over disburse-ments and receipts by the servicer.


The Financial Accounting Standards Board’sStatement of Financial Accounting StandardsNo. 115 (FAS 115), ‘‘Accounting for CertainInvestments in Debt and Equity Securities,’’ asamended by Statement of Financial AccountingStandards No. 140 (FAS 140), ‘‘Accounting forTransfers and Servicing of Financial Assets andExtinguishments of Liabilities,’’ determines theaccounting treatment for investments in govern-ment agency securities. Accounting treatmentfor derivatives used as investments or for hedg-ing purposes is determined by Statement ofFinancial Accounting Standards No. 133 (FAS133), ‘‘Accounting for Derivatives and HedgingActivities,’’ as amended by Statement of Finan-cial Accounting Standards Nos. 137 and 138(FAS 137 and FAS 138). (See section 2120.1,‘‘Accounting,’’ for further discussion.)


For the holder of ABS, a 100 percent riskweighting is assigned for corporate issuesand a 20 percent rating for state or municipalissues. Under risk-based capital regulations, atransfer of assets is a ‘‘true sale’’ as long as thebanking organization (1) retains no risk ofloss and (2) has no obligation to any partyfor the payment of principal or interest on theassets transferred. Unless these conditions aremet, the banking organization is deemed to havesold the assets with recourse; thus, capitalgenerally must be held against the entire risk-weighted amount of the assets sold unless (1) thetransaction is subject to the low-level capitalrule or (2) the loans securitized are small-business loans and receive preferential treat-ments. For assets sold in which an interest-onlyreceivable is recognized under FAS 140, orin which the spread account is recognized onthe balance sheet and provides credit enhance-



ment to the assets sold, those assets are deemedto have been sold with recourse. In the case ofasset-backed commercial paper, capital gener-ally must be held against the entire risk-weighted amount of any guarantee, other creditenhancement, or liquidity facility provided bythe bank to the SPE.


Asset-backed securities can be either type IVor type V securities. Type IV securities wereadded as bank-eligible securities in 1996 prima-rily in response to provisions of the RiegleCommunity Development and RegulatoryImprovement Act of 1994 (RCDRIA), whichremoved quantitative limits on a bank’s abilityto buy commercial mortgage and small-businessloan securities. In summary, type IV securitiesinclude the following asset-backed securitiesthat are fully secured by interests in a pool (orpools) of loans made to numerous obligors:

• investment-grade residential mortgage–relatedsecurities offered or sold pursuant to section4(5) of the Securities Act of 1933 (15 USC77d(5))

• residential mortgage–related securities, asdescribed in section 3(a)(41) of the SecuritiesExchange Act of 1934 (15 USC 78c(a)(41)),that are rated in one of the two highestinvestment-grade rating categories

• investment-grade commercial mortgage secu-rities offered or sold pursuant to section 4(5)of the Securities Act of 1933 (15 USC 77d(5))

• commercial mortgage securities, as describedin section 3(a)(41) of the Securities ExchangeAct of 1934 (15 USC 78c(a)(41)), that arerated in one of the two highest investment-grade rating categories

• investment-grade, small-business loan securi-ties as described in section 3(a)(53)(A) of theSecurities Exchange Act of 1934 (15 USC78c(a)(53)(A))

For all type IV commercial and residentialmortgage securities and for type IV small-business loan securities rated in the top tworating categories, there is no limitation on theamount a bank can purchase or sell for its ownaccount. Type IV investment-grade small-business loan securities that are not rated in thetop two rating categories are subject to a limit of

25 percent of a bank’s capital and surplus forany one issuer. In addition to being able topurchase and sell type IV securities, subject tothe above limitations, a bank may deal in thosetype IV securities that are fully secured by typeI securities.

Type V securities consist of all ABS that arenot type IV securities. Specifically, they aredefined as marketable, investment grade–ratedsecurities that are not type IV and are ‘‘fullysecured by interests in a pool of loans tonumerous obligors and in which a national bankcould invest directly.’’ They include securitiesbacked by auto loans, credit card loans, homeequity loans, and other assets. Also included areresidential and commercial mortgage securitiesas described in section 3(a)(41) of the SecuritiesExchange Act of 1934 (15 USC 78c(a)(41)) thatare not rated in one of the two highestinvestment-grade rating categories, but are stillinvestment grade. A bank may purchase or selltype V securities for its own account providedthe aggregate par value of type V securitiesissued by any one issuer held by the bank doesnot exceed 25 percent of the bank’s capital andsurplus.

REFERENCES

SR-97-21, ‘‘Risk Management and CapitalAdequacy of Exposures Arising fromSecondary-Market Credit Activities.’’ July1997.

SR-96-30, ‘‘Risk-Based Capital Treatment ofAsset Sales with Recourse.’’ November 1996.

SR-92-11, ‘‘Asset-Backed Commercial PaperPrograms.’’ April 1992.

Dierdorff, Mary D., and Annika Sandback.‘‘ABCP Market Overview: 1996 Was AnotherRecord-Breaking Year.’’ Moody’s StructuredFinance Special Report. 1st Quarter 1997.

Kavanaugh, Barbara, Thomas R. Boemio, andGerald A. Edwards, Jr. ‘‘Asset-Backed Com-mercial Paper Programs.’’ Federal ReserveBulletin. February 1992, pp. 107–116.

Moody’s Structured Finance Special Report.‘‘More of the Same. . .or Worse? TheDilemma of Prefunding Accounts in Automo-bile Loan Securitizations." August 4, 1995.

Rosenberg, Kenneth J., J. Douglas Murray, andKathleen Culley. ‘‘Asset-Backed CP’s NewLook.’’ Fitch Research Structured FinanceSpecial Report. August 15, 1994.

Silver, Andrew A., and Jay H. Eisbruck. ‘‘Credit



Card Master Trusts: The Risks of AccountAdditions.’’ Moody’s Structured Finance Spe-cial Report. December 1994.

Silver, Andrew A., and Jay H. Eisbruck. ‘‘CreditCard Master Trusts: Assessing the Risks ofCash Flow Allocations.’’ Moody’s StructuredFinance Special Report. May 26, 1995.

Stancher, Mark, and Brian Clarkson. ‘‘Credit

Card Securitizations: Catching Up with Wind-Downs.’’ Moody’s Structured Finance Spe-cial Report. November 1994.

van Eck, Tracy Hudson. ‘‘Asset-Backed Securi-ties.’’ In The Handbook of Fixed IncomeSecurities. Fabozzi, F., and T.D. Fabozzi.Chicago: Irwin Professional Publishers, 1995.



Residential Mortgage–Backed SecuritiesSection 4110.1

GENERAL DESCRIPTION

A mortgage loan is a loan which is secured bythe collateral of a specified real estate property.The real estate pledged with a mortgage can bedivided into two categories: residential and non-residential. Residential properties include houses,condominiums, cooperatives, and apartments.Residential real estate can be further subdividedinto single-family (one- to four-family) andmultifamily (apartment buildings in which morethan four families reside). Nonresidential prop-erty includes commercial and farm properties.Common types of mortgages which have beensecuritized include traditional fixed-rate level-payment mortgages, graduated-payment mort-gages, adjustable-rate mortgages (ARMs), andballoon mortgages.

Mortgage-backed securities (MBS) are prod-ucts that use pools of mortgages as collateral forthe issuance of securities. Although these secu-rities have been collateralized using many typesof mortgages, most are collateralized by one- tofour-family residential properties. MBS can bebroadly classified into four basic categories:

1. mortgage-backed bonds2. pass-through securities3. collateralized mortgage obligations and real

estate mortgage investment conduits4. stripped mortgage-backed securities

Mortgage-Backed Bonds

Mortgage-backed bonds are corporate bondswhich are general obligations of the issuer.These bonds are credit enhanced through thepledging of specific mortgages as collateral.Mortgage-backed bonds involve no sale or con-veyance of ownership of the mortgages acting ascollateral.

Pass-Through Securities

A mortgage-backed pass-through security pro-vides its owner with a pro rata share in under-lying mortgages. The mortgages are typicallyplaced in a trust, and certificates of ownershipare sold to investors. Issuers of pass-throughinstruments primarily act as a conduit for the

investors by collecting and proportionallydistributing monthly cash flows generated byhomeowners making payments on their homemortgage loans. The pass-through certificaterepresents a sale of assets to the investor, thusremoving the assets from the balance sheet ofthe issuer.

Collateralized Mortgage Obligationsand Real Estate Mortgage InvestmentConduits

Collateralized mortgage obligations (CMOs)and real estate mortgage investment conduit(REMICs) securities represent ownership inter-ests in specified cash flows arising from under-lying pools of mortgages or mortgage securities.CMOs and REMICs involve the creation, by theissuer, of a single-purpose entity designed tohold mortgage collateral and funnel payments ofprincipal and interest from borrowers to inves-tors. Unlike pass-through securities, however,which entail a pro rata share of ownership of allunderlying mortgage cash flows, CMOs andREMICs convey ownership only of cash flowsassigned to specific classes based on establishedprincipal distribution rules.

Stripped Mortgage-Backed Securities

Stripped mortgage-backed securities (SMBS)entail the ownership of either the principal orinterest cash flows arising from specified mort-gages or mortgage pass-through securities.Rights to the principal are labeled POs (princi-pal only), and rights to the interest cash flowsare labeled IOs (interest only).


Products Offered under AgencyPrograms

The Government National Mortgage Associa-tion (GNMA or Ginnie Mae), Federal HomeLoan Mortgage Corporation (FHLMC or FreddieMac), and the Federal National Mortgage Asso-ciation (FNMA or Fannie Mae) are the three


main government-related institutions whichsecuritize like groups of mortgages for sale toinvestors. Major mortgage-purchasing programssponsored by these three agencies are listedbelow.

Abbreviation Description

GNMA30-YR 30-year single-family programs15-YR 15-year single-family programsGPMs Graduated-payment programsPROJ Loans Project-loan programsARMs Single-family adjustable-rate

programs

FNMA30-YR SF 30-year single-family programs30-YR MF 30-year multifamily programs30-YR FHA/

VA FHA/VA 30-year single- andmultifamily programs

15-YR 15-year single-family programsSF ARMs Single-family adjustable-rate

programsMF ARMs Multifamily adjustable-rate

programsBalloons Balloon-payment seven-year

programsTwo-step Five- and seven-year two-step

programs

FHLMC30-YR 30-year single-family programs15-YR 15-year single-family programsTPMs Tiered-payment single-family

programsARMs Single-family adjustable-rate

programsMF Multifamily programs5- & 7-year

balloons Balloon-payment, five- toseven-year programs

While the majority of outstanding mortgageloans are structured as 30-year fixed-rate loans,in recent years the size of the 15-year, fixed-ratesector has grown. Declining interest rates and asteep yield curve have led many borrowers torefinance or prepay existing 30-year, higher-coupon loans and replace them with a shortermaturity. This experience also has demonstratedthe prepayment risk inherent in all mortgages.

Public Securities AssociationPrepayment Rates

Mortgagors have the option to prepay the prin-cipal balance of their mortgages at any time. Thevalue of the prepayment option to investors andmortgagors depends on the level of interest ratesand the volatility of mortgage prepayments.Prepayment rates depend on many variables,and their response to these variables can beunpredictable. The single biggest influence onprepayment rates is the level of long-term mort-gage rates; mortgage prepayments generallyincrease as long-term rates decrease. Whilefuture long-term rates are not known, highervolatility in long-term interest rates means lowerrates are more likely, making the prepaymentoption more valuable to the mortgagor. Thishigher value of the prepayment option is reflectedin lower mortgage security prices, as mortgageinvestors require higher yields to compensatefor increased prepayment risk.

The importance of principal prepayment tothe valuation of mortgage securities has resultedin several standardized forms of communicatingthe rate of prepayments of a mortgage security.One standard form is that developed by thePublic Securities Association (PSA). The PSAstandard is more accurately viewed as a bench-mark or reference for communicating prepay-ment patterns. It may be helpful to think of thePSA measurement as a kind of speedometer,used only as a unit for measuring the speed ofprepayments.

For a pool of mortgage loans, the PSA stan-dard assumes that the mortgage prepayment rateincreases at a linear rate over the first 30 monthsfollowing origination, then levels off at a con-stant rate for the remaining life of the pool.Under the PSA convention, prepayments areassumed to occur at a 0.2 percent annual rate inthe first month, 0.4 percent annual rate in thesecond month, escalating to a 6.0 percent annualrate by month 30. The PSA’s annualized pre-payment rate then remains at 6.0 percent overthe remaining life of the mortgage pool (seechart 1). Using this convention, mortgage pre-payment rates are often communicated in mul-tiples of the PSA standard of 100 percent. Forexample, 200 percent PSA equals two times thePSA standard, whereas 50 percent PSA equalsone-half of the PSA standard.

4110.1 Residential Mortgage–Backed Securities


Mortgage Pass-Through Securities

Mortgage pass-through securities are createdwhen mortgages are pooled together and sold asundivided interests to investors. Usually, themortgages in the pool have the same loan typeand similar maturities and loan interest rates.The originator (for instance, a bank) may con-tinue to service the mortgage and will ‘‘passthrough’’ the principal and interest, less a ser-vicing fee, to an agency or private issuer ofmortgage-backed securities. Mortgages are thenpackaged by the agency or private issuer andsold to investors. The principal and interest,less guaranty and other fees are then ‘‘passedthrough’’ to the investor, who receives a pro ratashare of the resulting cash flows.

Every agency pass-through pool is unique,distinguished by features such as size, prepay-ment characteristics, and geographic concentra-tion or dispersion. Most agency pass-throughsecurities, however, trade on a generic or to-be-announced (TBA) basis. In a TBA trade, theseller and buyer agree to the type of security,coupon, face value, price, and settlement date atthe time of the trade, but do not specify theactual pools to be traded. Two days beforesettlement, the seller identifies the specific poolsto be delivered to satisfy the commitment.Trading in agency pass-throughs may take placeon any business day, but TBA securities usuallysettle on one specific date each month. ThePublic Securities Association releases a monthlyschedule that divides all agency pass-throughsinto six groups, each settling on a different day.Agency pass-throughs generally clear throughelectronic book-entry systems.

Nonagency pass-throughs are composed ofspecific pools and do not trade on a TBA basis.New issues settle on the date provided in theprospectus. In the secondary market, thesesecurities trade on an issue-specific basis andgenerally settle on a corporate basis (threebusiness days after the trade).

Collateralized Mortgage Obligations

Since 1983, mortgage pass-through securitiesand mortgages have been securitized as collat-eralized mortgage obligations (CMOs).1 Whilepass-through securities share prepayment riskon a pro rata basis among all bondholders,CMOs redistribute prepayment risk among dif-ferent classes or tranches. The CMO securitiza-tion process recasts prepayment risk into classesor tranches. These tranches have risk profilesranging from extremely low to significantly highrisk. Some tranches can be relatively immune toprepayment risk, while others bear a dispropor-tionate share of the risk associated with theunderlying collateral.

CMO issuance has grown dramaticallythroughout the 1980s and currently dominatesthe market for FNMA and FHLMC pass-throughs or agency collateral. Given the dra-matic growth of the CMO market and its com-plex risks, this subsection discusses the structuresand risks associated with CMOs.

In 1984, the Treasury ruled that multiple-class pass-throughs required active manage-ment; this resulted in the pass-through entities’being considered corporations for tax purposesrather than trusts. Consequently, the issuer wasno longer considered a grantor trust, and theincome was taxed twice: once at the issuer leveland again at the investor level. This rulingultimately had complex and unintended ramifi-cations for the CMO market.

The issue was ultimately addressed in the TaxReform Act of 1986 through the creation of realestate mortgage investment conduits (REMICs).These instruments are essentially tax-free vehi-cles for issuing multiple-class mortgage-backedsecurities. REMIC is a tax designation; a REMICmay be originated as a trust, partnership, orother entity.

1. Today almost all CMOs are structured as real estatemortgage investment conduits (REMICs) to qualify for desir-able tax treatment.

Chart 1—PSA Model

Conditional Prepayment Rate (%)14

12

10

8

6

4

2

00 30 60 90 120 150 180 210 240 270 300 330 360

Mortgage Age (Months)

200% PSA

100% PSA

50% PSA

Residential Mortgage–Backed Securities 4110.1


The Tax Reform Act of 1986 allowed for afive-year transition during which mortgage-backed securities could be issued pursuantto existing Treasury regulations. However, as ofJanuary 1, 1992, REMICs became the solemeans of issuing multiple-class mortgage-backed securities exempt from double taxation.As a practical matter, the vast majority of CMOscarry the REMIC designation. Indeed, manymarket participants use the terms ‘‘CMO’’ and‘‘REMIC’’ interchangeably.

CMOs do not trade on a TBA basis. New-issue CMOs settle on the date provided in theprospectus and trade on a corporate basis (threebusiness days after the trade) in the secondarymarket. Common CMO structures includesequential pay, PACs, TACs, and floaters andinverse floaters as described below.

Sequential pay structure. The initial form ofCMO structure was designed to provide moreprecisely targeted maturities than the pass-through securities. Now considered a relativelysimple design for CMOs, the sequential paystructure dominated CMO issuance from 1983(when the first CMO was created) until the late1980s. In the typical sequential pay deal of the1980s (see chart 2), mortgage cash flows were

divided into four tranches, labeled A, B, C, andZ. Tranche A might receive the first 25 percentof principal payments and have an averagematurity, or average life, of one to three years.2

Tranche B, with an average life of between threeand seven years, would receive the next 25 per-cent of principal. Tranche C, receiving thefollowing 25 percent of principal, would have anaverage life of 5 to 10 years. The Z tranche,receiving the final 25 percent, would be an‘‘accrual’’ bond with an average life of 15 to20 years.3

The sequential pay structure was the first stepin creating a mortgage yield curve, allowingmortgage investors to target short, intermediate,or long maturities. Nevertheless, sequential paystructure maturities remained highly sensitive toprepayment risks, as prepayments of the under-lying collateral change the cash flows for eachtranche, affecting the longer-dated tranches most,especially the Z tranche. If interest rates declinedand prepayment speeds doubled (from 100 per-cent PSA to 200 percent PSA as shown on chart2), the average life of the A tranche wouldchange from 35 months to 25 months, but theaverage life of the Z bond would shift from280 months to 180 months. Hence, the change inthe value of the Z bond would be similarlygreater than the price change of the A tranche.

Planned amortization class (PAC) structure.The PAC structure, which now dominates CMOissuance, creates tranches, called planned amor-tization classes, with cash flows that are pro-tected from prepayment changes within certainlimits. However, creating this ‘‘safer’’ set oftranches necessarily means that there must beother tranches, called ‘‘support’’ bonds, that areby definition more volatile than the underlyingpass-throughs. While the PAC tranches are rela-tively easy to sell, finding investors for higher-yielding, less predictable support bonds hasbeen crucial for the success of the expandingCMO market.

Chart 3 illustrates how PACs are created. Inthe example, the estimated prepayment ratefor the mortgages is 145 percent of the PSAstandard, and the desired PAC is structured to

2. Average life, or weighted average life (WAL), is definedas the weighted average number of years that each principaldollar of the mortgage security remains outstanding.

3. Unlike the Z tranche, the A, B, and C tranches receiveregular interest payments in the early years before the princi-pal is paid off.

Chart 2—Four-Tranche SequentialPay CMO

Monthly Payment, Thousands of Dollars

200 Percent PSA1.5

1.0

.5

0

Tranche A

Tranche B

Tranche C

Tranche Z

100 Percent PSA1.5

1.0

.5

0

0 60 120 180 240 300 360

Month



be protected if prepayments slow to 80 percentPSA or rise to 250 percent PSA. The PACstherefore have some protection against both‘‘extension risk’’ (slower than expected prepay-ments) and ‘‘call risk’’ (faster than expectedprepayments). In order to create this 80 to 250percent ‘‘PAC range,’’ principal payments arecalculated for 80 percent PSA and 250 percentPSA.

The area underneath both curves indicatesthat amount of estimated principal that can beused to create the desired PAC tranche ortranches. That is, as long as the prepaymentrates are greater than 80 percent PSA or lessthan 250 percent PSA, the four PACs willreceive their scheduled cash flows (representedby the shaded areas).

This PAC analysis assumes a constant prepay-ment rate of between 80 and 250 percent of thePSA standard over the life of the underlyingmortgages. Since PSA speeds can change everymonth, this assumption of a constant PSA speedfor months 1 to 360 is never realized. If prepay-ment speeds are volatile, even within the PACrange, the PAC range itself may narrow overtime. This phenomenon, termed ‘‘effective PACband,’’ affects longer-dated PACs more thanshort-maturity PACs. Thus, PAC prepayment

protection can break down from extremely high,extremely low, or extremely volatile prepay-ment rates.

A PAC bond classified as PAC 1 in a CMOstructure has the highest cash-flow priority andthe best protection from both extension andprepayment risk. In the past, deals have alsoincluded super PACs, another high-protection,lower-risk-type tranche distinguished byextremely wide bands. The mechanisms thatprotect a PAC tranche within a deal may dimin-ish, and its status may shift more toward thesupport end of the spectrum. The extent of asupport-type role that a PAC might play dependsin part on its original cash-flow priority statusand the principal balances of the other supporttranches embedded within the deal. Indeed, asprepayments accelerated in 1993, supporttranches were asked to bear the brunt, and manydisappeared. A PAC III, for example, became apure support tranche, foregoing any PAC-likecharacteristics in that case.

A variation on the PAC theme has emerged inthe scheduled tranche (SCH). Like a PAC, anSCH has a predetermined cash-flow collar, but itis too narrow even to be called a PAC III. AnSCH tranche is also prioritized within a dealusing the above format, but understand that itsinitial priority status is usually below even thatof a PAC III. These narrower band PAC-typebonds were designed to perform well in low-volatility environments and were popular in late1992 and early 1993. At that time, many inves-tors failed to realize what would happen to thetranche when prepayments violated the band.

In chart 3, the four grey shaded areas repre-sent the PAC structure, which has been dividedinto four tranches to provide investors with aninstrument more akin to the bullet maturity ofTreasury and corporate bonds.4 The two supporttranches are structured to absorb the full amountof prepayment risk to the extent the prepaymentrate for the PAC tranches is within the specifiedrange of 80 to 250 percent PSA. The secondpanel of chart 3 shows principal cash flows atthe original estimated speed of 145 percent PSA,which are divided between the PAC and supportbonds throughout the life of the underlyingmortgages.

4. Treasury and corporate bonds usually return principal toinvestors at stated maturity; the PAC structure narrows thetime interval over which principal is returned to the investors.

Chart 3—Principal Payments

Monthly Payment, in Thousands of Dollars

145 Percent PSA2.0

1.5

1.0

.5

0

Tranche A

Support Tranche

Tranche B

Tranche C

Tranche D

Multi-PAC Redemption Schedulewith a Range of 80%–250% PSA

2.0

1.5

1.0

.5

00 60 120 180 240 300 360

Month



Chart 4 shows how both PACs and the sup-port tranches react to different prepaymentspeeds. The average lives of the support bondsin this example could fluctuate from 11⁄2 to25 years depending on prepayment speeds. Sim-ply put, support-bond returns are diminishedwhether prepayment rates increase or decrease(a lose-lose proposition). To compensate holdersof support bonds for this characteristic (some-times referred to as ‘‘negative convexity’’),support bonds carry substantially higher yields

than PAC bonds.5 Conversely, PAC bond inves-tors are willing to give up yield in order toreduce their exposure to prepayment risk ornegative convexity. Nevertheless, PAC bondholders are exposed to prepayment risk outsidethe protected range and correspondingly receiveyields above those available on comparableTreasury securities. In extreme cases, even PACtranches are subject to prepayment risk. Forexample, at 500 percent PSA (see the third panelof chart 4), the PAC range is broken. Thesupport bonds fail to fully protect even the firstPAC tranche; principal repayment acceleratessharply at the end of the scheduled maturity ofPAC A.

Targeted amortization tranche structure. A tar-geted amortization tranche (TAC) typically offersprotection from prepayment risk but not exten-sion risk. Similar to the cash-flow schedule ofa PAC that is built around a collar, a TAC’sschedule is built around a single pricing speed,and the average life of the tranche is ‘‘targeted’’to that speed. Any excess principal paid typi-cally has little effect on the TAC; its targetedspeed acts as a line of defense. Investors inTACs, however, pay the price for this defensewith their lack of protection when rates increase,subjecting the tranche to potential extensionrisk.

Floaters and inverse floaters. CMOs and REMICscan include several floating-rate classes. Floating-rate tranches have coupon rates that float withmovements in an underlying index. The mostwidely used indexes for floating-rate tranchesare the London Interbank Offered Rate (LIBOR)and the Eleventh District Cost of Funds Index(COFI). While LIBOR correlates closely withinterest-rate movements in the domestic federalfunds market, COFI has a built-in lag featureand is slower to respond to changes in interestrates. Thus, the holders of COFI-indexed float-ers generally experience a delay in the effects ofchanging interest-rate movements.

5. Price/yield curves for most fixed-income securities havea slightly convex shape, hence the securities are said topossess convexity. An important and desirable attribute of theconvex shape of the price/yield curve for Treasury securitiesis that prices rise at a faster rate than they decline. Mortgageprice/yield curves tend to be concave, especially in the rangeof premium prices, and are said to possess negative convexity.Securities with negative convexity rise in price at a slower ratethan they fall in price.

Chart 4—Principal Payments

Monthly Payment, Thousands of Dollars

80 Percent PSA2.0

1.5

1.0

.5

0

PAC A

PAC B

PAC C

PAC D

SupportTranche

250 Percent PSA2.0

1.5

1.0

.5

0

500 Percent PSA2.0

1.5

1.0

.5

00 60 120 180 240 300 360

Month



Since most floating-rate tranches are backedby fixed-rate mortgages or pass-through securi-ties, floating-rate tranches must be issued incombination with some kind of ‘‘support.’’ Thedesigned support mechanism on floaters is aninterest-rate cap, generally coupled with a sup-port bond or inverse floater. If interest rates rise,where does the extra money come from to payhigher rates on the floating CMO tranches? Thesolution is in the form of an inverse floating-ratetranche. The coupon rate on the inverse tranchemoves opposite of the accompanying floatertranche, thus allowing the floater to pay highinterest rates. The floater and the inverse tranches‘‘share’’ interest payments from a pool of fixed-rate mortgage securities. If rates rise, the couponon the floater moves up; the floater takes moreof the shared interest, leaving less for theinverse, whose coupon rate must fall. If ratesfall, the rate on the floater falls, and more moneyis available to pay the inverse floater investorand the corresponding rate on the inverse rises.

Effectively, the interest-payment characteris-tics of the underlying home mortgages have notchanged; another tranche is created where risk isshifted. This shifting of risk from the floaterdoubles up the interest-rate risk in the inversefloater, with enhanced yield and price ramifica-tions as rates fluctuate. If rates fall, the inversefloater receives the benefit of a higher-rate-bearing security in a low-rate environment.Conversely, if rates rise, that same investor paysthe price of holding a lower-rate security in ahigh-rate environment. As with other tranchetypes, prepayments determine the floating cashflows and the weighted average life of theinstrument (WAL).

With respect to floaters, the two most impor-tant risks are the risk that the coupon rate willadjust to its maximum level (cap risk) and therisk that the index will not correlate tightly withthe underlying mortgage product. Additionally,floaters that have ‘‘capped out’’ and that haveWALs that extend as prepayments slow mayexperience considerable price depreciation.

Stripped Mortgage-Backed Securities:Interest-Only and Principal-Only

Interest-only (IO) and principal-only (PO) secu-rities are another modification of the mortgagepass-through product. This market is referred toas the stripped mortgage-backed securities(SMBS) market. Both IOs and POs are more

sensitive to prepayment rates than the under-lying pass-throughs.6 Despite the increasedexposure to prepayment risk, these instrumentshave proved popular with several groups ofinvestors. For example, mortgage servicers maypurchase POs to offset the loss of servicingincome from rising prepayments. IOs are oftenused as a hedging vehicle by fixed-incomeportfolio managers because the value of IOsrises when prepayments slow—usually in risinginterest-rate environments when most fixed-income security prices decline.

Two techniques have been used to create IOsand POs. The first, which dominates outstand-ings in IOs and POs, strips pass-throughs intotheir interest and principal components, whichare then sold as separate securities. As ofOctober 1993, approximately $65 billion of thesupply of outstanding pass-throughs had beenstripped into IOs and POs.7 The second tech-nique, which has become increasingly popularover the past few years, simply slices off aninterest or principal portion of any CMO trancheto be sold independently. In practice, IO slices,called ‘‘IOettes,’’8 far outnumber PO slices.

Since IOs and IOettes produce cash flows inproportion to the mortgage principal outstand-ing, IO investors are hurt by fast prepaymentsand aided by slower prepayments. The value ofPOs rises when prepayments quicken and fallswhen prepayments slow because of the increasesin principal cash flows coupled with the deepdiscount price of the PO.

IOs and IOettes are relatively high-yieldingtranches that are generally subject to consider-able prepayment volatility. For example, fallinginterest rates and rising prepayment speeds inlate 1991 caused some IOs (such as thosebacked by FNMA 10 percent collateral) to fallup to 40 percent in value between July andDecember. IOs also declined sharply on severaloccasions in 1992 and 1993 as mortgage ratesmoved to 20- and 25-year lows, resulting in veryhigh levels of prepayment. CMO dealers useIOettes to reduce coupons on numerous tranches,allowing these tranches to be sold at a discount

6. This counterintuitive result arises because IO and POprices are negatively correlated.

7. Of this amount, FNMA has issued $26 billion, FHLMC$2.3 billion, and private issuers $6.5 billion.

8. Securities and Exchange Commission regulations forbidpure IO slices within CMOs. IO slices therefore includenominal amounts of principal and are termed ‘‘IOettes.’’ As apractical matter, IOettes have the price performance charac-teristics of IOs.



(as preferred by investors). In effect, much ofthe call risk is transferred from these tranches tothe IOette.

The fact that IO prices generally moveinversely to most fixed-income securities makesthem theoretically attractive hedging vehicles ina portfolio context. Nevertheless, IOs representone of the riskiest fixed-income assets availableand may be used in a highly leveraged way tospeculate about either future interest rates orprepayment rates. Given that their value rises(falls) when interest rates increase (decrease),many financial institutions, including banks,thrifts, and insurance companies, have pur-chased IOs and IOettes as hedges for theirfixed-income portfolios, but such hedges mightprove problematic as they expose the hedger toconsiderable basis risk.

USES

Both pass-through securities and CMOs arepurchased by a broad array of institutionalcustomers, including banks, thrifts, insurancecompanies, pension funds, mortgage ‘‘bou-tiques,’’9 and retail investors. CMO underwriterscustomize the majority of CMO tranches forspecific end-users, and customization is espe-cially common for low-risk tranches. Since thiscustomization results from investors’ desire toeither hedge an existing exposure or to assume aspecific risk, many end-users perceive less needfor hedging. For the most part, end-users gen-erally adopt a buy-and-hold strategy, perhaps inpart because the customization makes resalemore difficult.

Uses by Banks

Within the mortgage securities market, banksare predominately investors or end-users ratherthan underwriters or market makers. Further-more, banks tend to invest in short to inter-mediate maturities. Indeed, banks aggressivelypurchase short-dated CMO tranches, such asplanned amortization classes, floating-ratetranches, and adjustable-rate mortgage securities.

To the extent that banks do operate as marketmakers, the risks are more diverse and challeng-ing. The key areas of focus for market makersare risk-management practices associated withtrading, hedging, and funding their inventories.The operations and analytic support staff requiredfor a bank’s underwriting operation are muchgreater than those needed for its more traditionalrole of investor.

Regulatory restrictions limit banks’ owner-ship of high-risk tranches. These tranches are socomplex that the most common approaches andtechniques for hedging interest-rate risks couldbe ineffective. High-risk tranches are so elabo-rately structured and highly volatile that it isunlikely that a reliable hedge offset exists.Hedging these instruments is largely subjective,and assessing hedge effectiveness becomesextremely difficult. Examiners must carefullyassess whether owning such high-risk tranchesreduces a bank’s overall interest-rate risk.


Primary Market

The original lender is called the mortgage orig-inator. Mortgage originators include commercialbanks, thrifts, and mortgage bankers. Origina-tors generate income in several ways. First, theytypically charge an origination fee, which isexpressed in terms of basis points of the loanamount. The second source of revenue is theprofit that might be generated from selling amortgage in the secondary market, and the profitis called secondary-marketing profit. The mort-gage originator may also hold the mortgage inits investment portfolio.

Secondary Market

The process of creating mortgage securitiesstarts with mortgage originators which offerconsumers many different types of mortgageloans. Mortgages that meet certain well-definedcriteria are sold by mortgage originators toconduits, which link originators and investors.These conduits will pool like groups of mort-gages and either securitize the mortgages andsell them to an investor or retain the mortgagesas investments in their own portfolios. Both

9. Mortgage boutiques are highly specialized investmentfirms which typically invest in residuals and other high-risktranches.



government-related and private institutions actin this capacity. Ginnie Mae; Freddie Mac, andFannie Mae are the three main government-related conduit institutions; all of them purchaseconformingmortgages which meet the under-writing standards established by the agencies forbeing in a pool of mortgages underlying asecurity that they guarantee.

Ginne Mae is a government agency, and thesecurities it guarantees carry the full faith andcredit of the U.S. government. Fannie Mae andFreddie Mac are government-sponsored agen-cies; securities issued by these institutions areguaranteed by the agencies themselves and aregenerally assigned an AAA credit rating partlydue to the implicit government guarantee.

Mortgage-backed securities have also beenissued by private entities such as commercialbanks, thrifts, homebuilders, and private con-duits. These issues are often referred to asprivate label securities. These securities are notguaranteed by a government agency or GSE.Instead, their credit is usually enhanced by poolinsurance, letters of credit, guarantees, or over-collateralization. These securities usually receivea rating of AA or better.

Private issuers of pass-throughs and CMOsprovide a secondary market for conventionalloans which do not qualify for Freddie Mac andFannie Mae programs. There are several reasonswhy conventional loans may not qualify, but themajor reason is that the principal balance exceedsthe maximum allowed by the government (theseare called ‘‘jumbo’’ loans in the market).

Servicers of mortgages include banks, thrifts,and mortgage bankers. If a mortgage is sold to aconduit, it can be sold in total, or servicingrights may be maintained. The major source ofincome related to servicing is derived from theservicing fee. This fee is a fixed percentage ofthe outstanding mortgage balance. Consequently,if the mortgage is prepaid, the servicing fee willno longer accrue to the servicer. Other sourcesof revenue include interest on escrow, floatearned on the monthly payment, and late fees.Also, servicers who are lenders often use theirportfolios of borrowers as potential sources tocross-sell other bank products.

PRICING

Mortgage valuations are highly subjectivebecause of the unpredictable nature of mortgage

prepayment rates. Despite the application ofhighly sophisticated interest-rate simulationtechniques, results from diverse proprietaryprepayment models and assumptions about futureinterest-rate volatility still drive valuations. Thesubjective nature of mortgage valuations makesmarking to market difficult due to the dynamicnature of prepayment rates, especially as onemoves farther out along the price-risk con-tinuum toward high-risk tranches. Historicalprice information for various CMO tranchetypes is not widely available and, moreover,might have limited value given the generallydifferent methodologies used in deriving mort-gage valuation.

Decomposition of MBS

A popular approach to analyzing and valuing acallable bond involves breaking it down into itscomponent parts—a long position in a noncall-able bond and a short position in a call optionwritten to the issuer by the investor. An MBSinvestor owns a callable bond, but decomposingit is not as easy as breaking down more tradi-tional callables. The MBS investor has written aseries of put and call options to each homeowneror mortgagor. The analytical challenge facing anexaminer is to determine the value and riskprofile of these options and their contribution tothe overall risk profile of the portfolio. Com-pounding the problem is the fact that mortgagorsdo not exercise these prepayment options at thesame time when presented with identical situa-tions. Most prepayment options are exercised atthe least opportune time from the standpoint ofthe MBS investor. In a falling-rate environment,a homeowner will have a greater propensity torefinance (or exercise the option) as prevailingmortgage rates fall below the homeowner’soriginal note (as the option moves deeper intothe money). Under this scenario, the MBSinvestor receives a cash windfall (principal pay-ment) which must be reinvested in a lower-rateenvironment. Conversely, in a high- or rising-rate environment, when the prevailing mortgagerate is higher than the mortgagor’s original termrate, the homeowner is less apt to exercise theoption to refinance. Of course, the MBS investorwould like nothing more than to receive his orher principal and be able to reinvest that princi-pal at the prevailing higher rates. Under thisscenario, the MBS investor holds an instrument



with a stated coupon that is below prevailingmarket rates and relatively unattractive to poten-tial buyers.

Market prices of mortgages reflect an expectedrate of prepayments. If prepayments are fasterthan the expected rate, the mortgage security isexposed to call risk. If prepayments are slowerthan expected, the mortgage securities areexposed to extension risk (similar to havingwritten a put option). Thus, in practice, mort-gage security ownership is comparable to own-ing a portfolio of cash bonds and writing acombination of put and call options on thatportfolio of bonds. Call risk is manifested in ashortening of the bond’s effective maturity orduration, and extension risk manifests itself inthe lengthening of the bond’s effective maturityor duration.

Option-Adjusted Spread Analysis

For a further discussion of option-adjusted spread(OAS) analysis or optionality in general, seesection 4330.1, ‘‘Options.’’

HEDGING

Hedging mortgage-backed securities ultimatelycomes down to an assessment of one’s expecta-tion of forward rates (an implied forward curve).A forward-rate expectation can be thought of asa no-arbitrage perspective on the market, serv-ing as a pricing mechanism for fixed-incomesecurities and derivatives, including MBS.Investors who wish to hedge their forward-rateexpectations can employ strategies which involvepurchasing the underlying security and the useof swaps, options, futures, caps, or combinationsthereof to hedge duration and convexity risk.10

With respect to intra-portfolio techniques,one can employ IOs and POs as hedge vehicles.Although exercise of the prepayment optiongenerally takes value away from the IO classand adds value to the PO class, IOs and POsderived from the same pool of underlying mort-gagesdo not have a correlation coefficient of

negative one.11 If that were the case, the value ofa pass-through security wouldalwaysbe hedgedwith respect to interest rates. However, IOs andPOs do represent extremities in MBS theoryand, properly applied, can be used as effectiverisk-reduction tools. Because the value of theprepayment option and the duration of an IO andPO are not constant, hedges must be continuallymanaged and adjusted.

In general, a decline in prepayment speedsarises largely from rising mortgage rates, withfixed-rate mortgage securities losing value. Atthe same time, IO securities are rising in yieldand price. Thus, within the context of an overallportfolio, the inclusion of IOs serves to increaseyields and reduce losses in a rising-rate environ-ment. More specifically, IOs can be used tohedge the interest-rate risk of Treasury stripsecurities. As rates increase, an IO’s valueincreases. The duration of zero-coupon stripsequals their maturity, while IOs have a negativeduration.12 Combining IOs with strips creates aportfolio with a lower duration than a position instrips alone.13

POs are a means to synthetically add discount(and positive convexity) to a portfolio, allowingit to more fully participate in bull markets. Forexample, a bank funding MBS with certificatesof deposit (CDs) is exposed to prepayment risk.If rates fall faster than expected, mortgageholders (in general) will exercise their prepay-ment option while depositors will hold theirhigher-than-market CDs as long as possible.The bank could purchase POs as a hedge againstits exposure to prepayment and interest-raterisk. As a hedging vehicle, POs offer preferablealternatives to traditional futures or options; theperformance of a PO is directly tied to actualprepayments, thus the hedge should experiencepotentially less basis risk than other cross-market hedging instruments.

RISKS

Prepayment Risk

All investors in the mortgage sector share acommon concern: the mortgage prepayment

10. Davidson, Andrew S., and Michael D. Herskovitz.Mortgage Backed Securities—Investment Analysis andAdvanced Valuation Techniques. Chicago: Probus Publishing,1994.

11. Zissu, Anne, and Charles Austin Stone. ‘‘The Risks ofMBS and Their Derivatives.’’Journal of Applied CorporateFinance, Fall 1994.

12. Ibid., p. 102.13. Ibid., p. 104.



option. This option is the homeowner’s right toprepay a mortgage any time, at par. The prepay-ment option makes mortgage securities differentfrom other fixed-income securities, as the timingof mortgage principal repayments is uncertain.The cash-flow uncertainty that derives fromprepayment risk means that the maturity andduration of a mortgage security are uncertain.For investors, the prepayment option creates anexposure similar to that of having written a calloption. That is, if mortgage rates move lower,causing mortgage bond prices to move higher,the mortgagor has the right to call the mortgageaway from the investor at par.

While lower mortgage interest rates are thedominant economic incentive for prepayment,idiosyncratic, noneconomic factors to prepay amortgage further complicate the forecasting ofprepayment rates. These factors are sometimessummarized as the ‘‘five D’s’’: death, divorce,destruction, default, and departure (relocation).Prepayments arising from these causes may leadto a mortgage’s being called away from theinvestor at par when it is worth more or less thanpar (that is, trading at a premium or discount).

Funding and Reinvestment Risk

The uncertainty of the maturities of underlyingmortgages also presents both funding and rein-vestment risks for investors. The uncertainty ofa mortgage security’s duration makes it difficultto obtain liabilities for matched funding of theseassets. This asset/liability gap presents itselfwhether the mortgage asset’s life shortens orlengthens, and it may vary dramatically.

Reinvestment risk is normally associated withduration shortening or call risk. Investors receiveprincipal earlier than anticipated, usually as aresult of declines in mortgage interest rates; thefunds can then be reinvested only at the newlower rates. Reinvestment risk is also the oppor-tunity cost associated with lengthening dura-tions. Mortgage asset durations typically extendas rates rise. This results in lower investorreturns as they are unable to reinvest at the nowhigher rates.

Credit Risk

While prepayments expose pass-throughs andCMOs to considerable price risk, most MBS

pass-throughs have little credit risk.14 Approxi-mately 90 percent of all outstanding pass-through securities have been guaranteed byGinnie Mae, Fannie Mae, and Freddie Mac.15

This credit guarantee gives ‘‘agency’’ pass-through securities and CMOs a decisive advan-tage over nonagency pass-throughs and CMOs,which comprise less than 10 percent of themarket.

In general, nonagency pass-through securitiesand CMOs use mortgages that are ineligible foragency guarantees. Issuers can also obtain creditenhancements, such as senior subordinated struc-tures, insurance, corporate guarantees, or lettersof credit from insurance companies or banks.The rating of the nonagency issue then partiallydepends upon the rating of the insurer and itscredit enhancement.

Settlement and Operational Risk

The most noteworthy risk issues associated withthe trading of pass-through securities is theforward settlement and operational risk associ-ated with the allocation of pass-through trades.Most pass-through trading occurs on a forwardbasis of two to three months, often referred to as‘‘TBA’’ or ‘‘to be announced’’ trading.16 Duringthis interval, participants are exposed to coun-terparty credit risk.

Operating risk grows out of the pass-throughseller’s allocation option that occurs at settle-ment. Sellers in the TBA market are allowed a2.0 percent delivery option variance when meet-ing their forward commitments. That is, between98 and 102 percent of the committed par amountmay be delivered. This variance is provided toease the operational burden of recombiningvarious pool sizes into round trading lots.17 Thisdelivery convention requires significant opera-tional expertise and, if mismanaged, can be a

14. Credit risk in a pass-through stems from the possibilitythat the homeowner will default on the mortgageand that theforeclosure proceeds from the resale of the property will fallshort of the balance of the mortgage.

15. For a full explanation of the minor differences betweenthese agencies, see chapter 5 in Fabozzi,The Handbook ofMortgage-Backed Securities, 1995.

16. In the forward mortgage pass-through trading, or TBAtrading, the seller announces the exact pool mix to bedelivered the second business day before settlement day.

17. ‘‘Good delivery’’ guidelines are promulgated by thePublic Securities Association in itsUniform Practicespublication.



source of significant risk in the form of failedsettlements and unforeseen carrying costs.

Price Volatility in High-Risk CMOs

When the cash flow from pass-through securi-ties is allocated among CMO tranches, prepay-ment risk is concentrated within a few volatileclasses, most notably residuals, inverse floaters,IOs and POs, Z bonds, and long-term supportbonds. These tranches are subject to sharp pricefluctuations in response to changes in short- andlong-term interest rates, interest-rate volatility,prepayment rates, and other macroeconomicconditions. Some of these tranches—especiallyresiduals and inverse floaters—are frequentlyplaced with a targeted set of investors willing toaccept the extra risk. These classes are alsoamong the most illiquid bonds traded in theCMO market.

These high-risk tranches, whether held bydealers or investors, have the potential to incursizable losses (and sometimes gains) within ashort period of time.18 Compounding this pricerisk is the difficulty of finding effective hedgingstrategies for these instruments. Using differentCMOs to hedge each other can present prob-lems. Although pass-through securities fromdifferent pools tend to move in the same direc-tion based on the same event, the magnitude ofthese moves can vary considerably, especially ifthe underlying mortgage pools have differentaverage coupons.19

Risks in ‘‘Safe’’ Tranches

Investors may also be underestimating risks insome ‘‘safe’’ tranches, such as long-maturityPACs, PAC 2s, and 3s, and floaters, becausethese tranches can experience abrupt changes intheir average lives once their prepayment ranges

are exceeded. Even floating-rate tranches facerisks, especially when short-term rates rise sig-nificantly and floaters reach their interest-ratecaps. At the same time, long rates may rise andprepayments slow, causing the floaters’ maturi-ties to extend significantly since the floater isusually based on a support bond. Under suchcircumstances, floater investors could face sig-nificant losses.

In addition to possible loss of market value,these safe tranches may lose significant liquidityunder extreme interest-rate movements. Thesetranches are currently among the most liquidCMOs. Investors who rely on this liquiditywhen interest-rate volatility is low may find itdifficult to sell these instruments to raise cash intimes of financial stress. Nevertheless, investorsin these tranches face lower prepayment riskthan investors in either mortgage pass-throughsor the underlying mortgages themselves.

Cap Risk

The caps in many floating-rate CMOs and ARMsare an embedded option. The value of floating-rate CMOs or ARMs is equal to the value of anuncapped floating-rate security less the value ofthe cap. As the coupon rate of the securityapproaches the cap rate, the value of the optionincreases and the value of the security falls. Therate of change is non-linear and increases as thecoupon approaches the cap. As the coupon rateequals or exceeds the cap rate, the security willexhibit characteristics similar to those of afixed-rate security, and price volatility willincrease. All else being equal, securities withcoupon rates close to their cap rates will tend toexhibit greater price volatility than securitieswith coupon rates farther away from their caprates. Also, the tighter the ‘‘band’’ of caps andfloors on the periodic caps embedded in ARMs,the greater the price sensitivity of the securitywill be. The value of embedded caps alsoincreases with an increase in volatility. Thus, allelse being equal, higher levels of interest-ratevolatility will reduce the value of the floating-rate CMO or ARM.

FFIEC Regulations ConcerningUnsuitable Investments

The Federal Financial Institutions ExaminationCouncil (FFIEC) issued a revised policy state-

18. Examples of single-firm losses include a $300 millionto $400 million loss by one firm on POs in the spring of 1987;more recently, several firms have lost between $50 million and$200 million on IO positions in 1992 and 1993.

19. For a discussion of the idiosyncratic prepaymentbehavior of pass-throughs, see Sean Becketti and Charles S.Morris, The Prepayment Experience of FNMA Mortgage-Backed Securities. New York University Salomon Center,1990, pp. 24–41.



ment concerning securities activities for mem-ber banks. These rules became effective Febru-ary 10, 1992, for member banks and bankholding companies under the Board’s jurisdic-tion. A bank’s CMO investments are deemedunsuitable if—

• the present weighted average life (WAL) isgreater than ten years,

• the WAL extends more than four years orshortens more than six years for a parallelinterest-rate shift of up and down 300 basispoints, or

• the price changes by more than 17 percentfrom the asking price for a parallel interest-rate shift of up and down 300 basis points.

An affirmation of any of these three parametersmeans that the bond in question (1) may beconsidered high risk and (2) may not be asuitable investment for banks or bank holdingcompanies. An institution holding high-risksecurities must demonstrate that these securitiesreduce overall interest-rate risk for the bank.

Floating-rate CMOs with coupons tied toindexes other than LIBOR (sometimes called‘‘mismatched floaters’’) are generally exemptfrom the average-life and average-life-sensitivitytests. Given the degree of price sensitivity asso-ciated with these securities, however, institu-tions that purchase non-LIBOR-indexed floatersmust maintain documentation showing that theyunderstand and are able to monitor the risks ofthese instruments. The documentation shouldinclude a prepurchase analysis and at least anannual analysis of the price sensitivity of thesecurity under both parallel and nonparallelshifts of the yield curve. See theCommercialBank Examination Manual for more informa-tion on the FFIEC testing parameters detailedabove.


The accounting treatment for investments inmortgage-backed securities is determined by theFinancial Accounting Standards Board’s State-ment of Financial Accounting Standards No.115 (FAS 115), ‘‘Accounting for Certain Invest-ments in Debt and Equity Securities,’’ asamended by Statement of Financial AccountingStandards No. 140 (FAS 140), ‘‘Accounting forTransfers and Servicing of Financial Assets and

Extinguishments of Liabilities.’’ Accountingtreatment for derivatives used as investments orfor hedging purposes is determined by State-ment of Financial Accounting Standards No.133 (FAS 133), ‘‘Accounting for Derivativesand Hedging Activities,’’ as amended by State-ment of Financial Accounting Standards Nos.137 and 138 (FAS 137 and FAS 138). (Seesection 2120.1, ‘‘Accounting,’’ for furtherdiscussion.)


Pass-through securities are assigned the follow-ing weights:

GNMA (Ginnie Mae) zero percentFNMA (Fannie Mae) 20 percentFHLMC (Freddie Mac) 20 percentPrivate label 50 percent–

100 percent

Collaterialized mortgage obligations are assignedthe following weights:

Backed by Ginnie Mae,Fannie Mae, orFreddie Macsecurities 20 percent–100 percent

Backed by whole loansor private-labelpass-throughs 50 percent–100 percent

Stripped MBS are assigned a 100 percent riskweighting.


Pass-Through Securities

Ginnie Mae, Fannie Mae, and Freddie Macpass-through securities are type I securities.Banks can deal in, underwrite, purchase, and sellthese securities for their own accounts withoutlimitation.

CMOs and Stripped MBS

CMOs and stripped MBS securitized by small



business–related securities and certain residential-and commercial-related securities rated Aaa andAa are type IV securities. As such, a bank maypurchase and sell these securities for its ownaccount without limitation. CMOs and strippedMBS securitized by small business–relatedsecurities rated A or Baa are also type IVsecurities and are subject to an investmentlimitation of 25 percent of a bank’s capital andsurplus. Banks may deal in type IV securitiesthat are fully secured by type I transactionswithout limitations.

CMOs and stripped MBS securitized by cer-tain residential- and commercial-mortgage-related securities rated A or Baa are type Vsecurities. For type V securities, the aggregatepar value of a bank’s purchase and sales of thesecurities of any one obligor may not exceed25 percent of its capital and surplus.

REFERENCES

Bartlett, William W. Mortgage-Backed Securi-ties. Burr Ridge, Ill.: Irwin Publishing, 1994.

Becketti, Sean, and Charles S. Morris. ThePrepayment Experience of FNMA Mortgage-

Backed Securities. New York: New YorkUniversity Salomon Center, 1990.

Cilia, Joseph. Advanced CMO Analytics forBank Examiners—Practical ApplicationsUsing Bloomberg. Product Summary. Chicago:Federal Reserve Bank of Chicago, May 1995.

Davidson, Andrew S., and Michael D.Herskovitz. Mortgage-Backed Securities—Investment Analysis and Advanced ValuationTechniques. Chicago: Probus Publishing,1994.

Fabozzi, Frank J., ed. The Handbook of Mortgage-Backed Securities. Chicago: Probus Publish-ing, 1995.

Fabozzi, Frank J. Valuation of Fixed-IncomeSecurities. Summit, N.J.: Frank J. FabozziAssociates, 1994.

Klinkhammer, Gunner, Ph.D. ‘‘ Monte CarloAnalytics Provides Dynamic Risk Assess-ment for CMOs.’’ Capital ManagementSciences, Inc. October 1995.

Kopprasch, Robert W. ‘‘ Option Adjusted SpreadAnalysis: Going Down the Wrong Path?’’Financial Analysts Journal. May/June 1994.

Zissu, Anne, and Charles Austin Stone. ‘‘ TheRisks of MBS and Their Derivatives.’’ Jour-nal of Applied Corporate Finance. Fall 1994.



Australian Commonwealth Government BondsSection 4205.1

GENERAL DESCRIPTION

The Australian Treasury issues AustralianCommonwealth Government Bonds (CGBs) tofinance the government’s budget deficit and torefinance maturing debt. Since 1982, bonds havebeen issued in registered form only, althoughsome outstanding issues may be in bearer form.The principal and interest on CGBs are guaran-teed by the Commonwealth Government ofAustralia.


CGBs, with maturities ranging from one to20 years, are issued every six to eight weeks inan average tender size totaling A$800 million.Most CGBs are noncallable, fixed-coupon secu-rities with bullet maturities. The AustralianTreasury has issued some indexed-linked bondswith either interest payments or capital linked tothe Australian consumer price index. However,there are few of these issues and they tend to bevery illiquid. CGBs can be issued with currentmarket coupons, but in many cases the Austra-lian Treasury will reopen existing issues.

Interest for government bonds is paid semi-annually on the 15th day of the month, and it iscalculated on an actual/365 day-count basis.Coupon payments that fall on weekends orpublic holidays are paid on the next businessday. Semiannual coupon payments are preciselyhalf the coupon rate. Bonds that have more thansix months left to maturity settle three businessdays after the trade date (T+3). Bonds with lessthan six months left to maturity may settle onthe same day, provided they are dealt beforenoon; otherwise, they settle the next day.

USES

Australian banks are the largest single group ofinvestors in outstanding CGB issues. They usethese securities to meet regulatory capitalrequirements. The Australian pension industryholds CGBs mainly as investment vehicles. Inaddition, CGBs are viewed as attractive invest-ment vehicles by many foreign investors

because (1) they offer high yields relative tothose available on other sovereign debt instru-ments and (2) the Australian bond market isregarded as stable. Although the bond markethas a substantial foreign participation, due toits attractive yield and a much shorter periodof time required for the bonds to mature, themajority of CGB investors are domestic. U.S.banks purchase CGBs to diversify their port-folios, speculate on currency and Australianinterest rates, and to hedge Australian-denominated currency positions and positionsalong the Australian yield curve.


Issuing Practices

CGBs are issued periodically on an as-neededbasis, typically every six to eight weeks. Gen-erally, issuance is through a competitive tenderwhereby subscribers are invited to submit bidsas they would in an auction. Issue size isannounced one day before the tender day. Bids,which are sent to the Reserve Bank of Australiathrough the Reserve Bank Information TransferSystem (RBITS), are submitted to the ReserveBank of Australia on a semiannual, yield-to-maturity basis. Specific information on the issueis announced later on the tender day, such as theamounts tendered and issued, the average andrange of accepted bids, and the percentage ofbids allotted at the highest yield.

Secondary Market

While CGBs are listed on the Australian StockExchange, nearly all trading takes place over thecounter (OTC), by screen or direct trading. Theprimary participants in the secondary market areauthorized dealers and share brokers. OTC trans-actions must be in amounts of A$250,000 ormore. Stock-exchange transactions are essen-tially limited to retail transactions under A$1 mil-lion. Usually, authorized dealers trade bondswhich are within five years of maturing.


Market Participants

Sell Side

Authorized dealers are the primary participantsin the sell side of the CGB market.

Buy Side

Australian banks and other financial institutionsare the largest single group of investors inCGBs. These entities usually hold large quan-tities of shorter-term government bonds forregulatory purposes, as these securities may beincluded in the prime asset ratios of banks. Inaddition, a variety of other domestic investorsparticipate in the CGB market.

The Australian bond market has been knownto attract substantial foreign participation overthe years, primarily because it is regarded as astable market which offers relatively high yields.In general, foreign market participants are insti-tutional investors, such as securities firms, lifeinsurance companies, banks, and fund managers.

Market Transparency

Prices tend to be active and liquid. Price trans-parency is enhanced by the dissemination ofprices by several information vendors includingReuters and Telerate.

PRICING

CGBs are quoted in terms of yield and roundedto three decimal places to determine gross pricefor settlement purposes. While tick size isequivalent to one basis point, yields are oftenquoted to the half basis point.

HEDGING

Interest-rate risk may be hedged by taking anoffsetting position in other government bonds orby using interest-rate forward, futures, options,or swap contracts. Foreign-exchange risk maybe hedged by using foreign-currency derivativesand swaps.

RISKS

Liquidity Risk

The CGB market is considered fairly active andliquid. Trading volume among the benchmarkbonds is about equal, although the three-yearand 10-year benchmark issues tend to have themost turnover.

Interest-Rate Risk

CGBs are subject to price fluctuation resultingfrom interest-rate volatility. Generally, longer-term bonds have more price volatility thanshorter-term instruments. If an institution has alarge concentration of long-term maturities, itmay be subject to unwarranted interest-rate risk.


Currency fluctuations may affect the bond’syield as well as the value of coupons andprincipal paid in U.S. dollars. A number offactors may influence a country’s foreign-exchange rate, including its balance of paymentsand prospective changes in that balance; infla-tion and interest-rate differentials between thatcountry and the United States; the social andpolitical environment, particularly with regardto the impact on foreign investment; and centralbank intervention in the currency markets.

Political Risk

A change in the political environment, withhold-ing tax laws, or market regulation can have anadverse impact on the value and liquidity of aninvestment in foreign bonds. Investors should befamiliar with the local laws and regulationsgoverning foreign bond issuance, trading, trans-actions, and authorized counterparties.


The accounting treatment for investments inforeign debt is determined by the FinancialAccounting Standards Board’s Statement ofFinancial Accounting Standards No. 115 (FAS115), ‘‘Accounting for Certain Investments in

4205.1 Australian Commonwealth Government Bonds


Debt and Equity Securities,’’ as amended byStatement of Financial Accounting StandardsNo. 140 (FAS 140), ‘‘Accounting for Transfersand Servicing of Financial Assets and Extin-guishments of Liabilities.’’ Accounting treat-ment for derivatives used as investments or forhedging purposes is determined by Statement ofFinancial Accounting Standards No. 133 (FAS133), ‘‘Accounting for Derivatives and HedgingActivities,’’ as amended by Statement of Finan-cial Accounting Standards Nos. 137 and 138(FAS 137 and FAS 138). (See section 2120.1,‘‘Accounting,’’ for further discussion.)


Australian CGBs are assigned to the zero per-cent risk-weight category.


Australian CGBs are a type III security. As such,a bank’s investment is limited to 10 percent ofits equity capital and reserves.

REFERENCES

de Caires, Bryan, ed. The Guide to InternationalCapital Markets 1990. London: EuromoneyPublications PLC, 1990.

Crossan, Ruth, and Mark Johnson, ed. TheGuide to International Capital Markets 1991.London: Euromoney Publications PLC, 1991.

J.P. Morgan Securities. Government Bond Out-lines. 9th ed. April 1996.

Australian Commonwealth Government Bonds 4205.1


Canadian Government BondsSection 4210.1

GENERAL DESCRIPTION

The federal government of Canada issues bonds,known as ‘‘Canadas,’’ to finance its public debt.The Canadian government bond market is struc-turally similar to the U.S. bond market, particu-larly with regard to the types of securitiesissued. Canadas come in a wide variety ofmaturities ranging from two to thirty years.Recently, the longer-maturity bonds haveincreased in popularity.


Canadas are issued at a price close to par valueand are denominated in C$1,000, C$25,000,C$100,000, and C$1 million allotments. Cana-das are available in bearer form with couponsattached or in registered form. All new Canadianbonds are issued with bullet maturities andgenerally are not callable. All Canadas havefixed coupons. Principal and coupon paymentsfor these bonds are linked to the Canadianconsumer price index.

Interest on Canadas is paid semiannually andis accrued from the previous coupon date(exclusive) to the settlement date (inclusive) upto a maximum value of 181.5 days. As a result,the value date is always the same as the settle-ment date. New issues may offer short firstcoupons but not long first coupons. Interest onshort first coupons is accrued from the dateddate to the first coupon date. Any ‘‘reopened’’bonds include the accrued interest in the issueprice to ensure that the new tranches carry thesame coupons as the existing bond and that theytrade indistinguishably. Canadas with remainingmaturities of less than three years settle twomarket days after the trade date (T+2), whileCanadas with maturities over three yearssettle three market days after the trade date(T+3).

USES

Canadas are held for investment, hedging, andspeculative purposes by both domestic and for-eign investors. U.S. banks purchase Canadas to

diversify their portfolios, speculate on currencyand Canadian interest rates, and hedge Canadian-denominated currency positions and positionsalong the Canadian yield curve.


Issuing Practices

Canadas are issued by two methods: allotmentand auction. In the allotment system, the amount,coupon, and issue price for each of the maturitytranches is announced after consultation withthe primary distributors. The Bank of Canadapays a commission to all primary distributorswho are responsible for placing the issue.

The auction system is very similar to the U.S.system. On the Thursday before the regularWednesday auction, the Bank of Canadaannounces details, including the size, maturity,and delivery date for the upcoming auction, andactive open market trading begins on a yieldbasis. The coupon for new issues is not knownuntil auction results are released, and it is setat the nearest1⁄4 percent increment below theauction average. The Bank of Canada acceptsboth competitive and noncompetitive bids fromprimary distributors. However, it will only acceptone noncompetitive bid, which may have amaximum value of C$2 million.

On the auction date, bids are submitted to theBank of Canada, and primary distributors receivebonds of up to 20 percent of the total amountissued based on the competitiveness of theirbids. The delivery date and dated date areusually ten days to two weeks after the auction.Issues typically range from C$100 million toC$8.8 billion, and any issue may be reopened bythe Department of Finance on the basis ofmarket conditions.

Secondary Market

Canadas are not listed on any stock exchangesbut trade in over-the-counter (OTC) markets24 hours a day. Settlement occurs through abook-entry system between market participantsand the Canadian Depository for Securities


(CDS). Therefore, Canadas may trade when-issued without an exchange of cash.


Primary distributors include investment dealersand Canadian chartered banks.

Buy Side

A wide range of investors use Canadas forinvesting, hedging, and speculation, includingdomestic banks, trust and insurance companies,and pension funds. The largest Canadian holdersof Canadas are trust pension funds, insurancecompanies, chartered banks, and the Bank ofCanada.

Foreign investors are also active participantsin the Canadian government bond market. Ingeneral, foreign market participants are institu-tional investors such as banks, securities firms,life insurance companies, and fund managers.

Market Transparency

Price transparency is relatively high for Cana-das; several information vendors disseminateprices to the investing public. Trading of Cana-das, both domestically and internationally, isactive and prices are visible.

PRICING

Bonds trade on a clean-price basis (net ofaccrued interest) and are quoted in terms of apercentage of par value, with the fraction of apercent expressed in decimals. Canadas typi-cally trade with a 1⁄8- to 1⁄4-point spread betweenbid and offer prices. Canadas do not tradeex-dividend. If a settlement date occurs in thetwo weeks preceding a coupon payment date,the seller retains the upcoming coupon but mustcompensate the buyer by postdating a checkpayable to the buyer for the amount of thecoupon payment.

HEDGING

Interest-rate risk on Canadas may be hedged

using interest-rate swaps, forwards, futures (suchas futures on 10-year and 5-year Canadas, whichare traded on the Montreal Stock Exchange(MSE)), and options (such as options on allCanadas issues, which are traded on the MSE).Hedging may also be effected by taking a contraposition in another Canadian government bond.Foreign-exchange risk may be hedged throughthe use of currency forwards, futures, swaps,and options. The effectiveness of a particularhedge depends on the yield curve and basis risk.For example, hedging a position in a 10-yearCanadas future with an overhedged position in a5-year bond may expose the dealer to yield-curve risk. Hedging a 30-year bond with aCanadas future exposes the dealer to basis risk ifthe historical price relationships between futuresand cash markets are not stable. Also, if aposition in notes or bonds is hedged using anOTC option, the relative illiquidity of the optionmay diminish the effectiveness of the hedge.

RISKS

Liquidity Risk

The Canadian bond market is considered to beone of the most liquid bond markets in theworld, and Canadas are traded actively in bothdomestic and international capital markets. Mostinvestment dealers in Canadas will make mar-kets on all outstanding issues. The most liquidissues are the short-term issues of less than10 years, but several 15-year and 30-year Cana-das are actively traded and very liquid. Allgovernment bond issues are reasonably liquidwhen their outstanding size, net of stripping, isover C$1 billion. ‘‘ Orphaned’’ issues, smallissues that are not reopened, are the only Cana-das that are very illiquid because they are notactively traded.

Interest-Rate Risk

Canadas are subject to price fluctuations causedby changes in interest rates. Longer-term issuestend to have more price volatility than shorter-term issues; therefore, a large concentration oflonger-term maturities in a bank’s portfolio maysubject the bank to a high degree of interest-raterisk.

4210.1 Canadian Government Bonds



Because of the low volatility of the Canadiandollar exchange rate, there has been a low levelof foreign-exchange risk associated with Cana-dian bonds. To the extent that this risk exists, itcan be easily reduced by using foreign-currencyderivatives instruments as described above.

Political Risk



The accounting treatment for investments inforeign debt is determined by the FinancialAccounting Standards Board’s Statement ofFinancial Accounting Standards No. 115 (FAS115), ‘‘Accounting for Certain Investments inDebt and Equity Securities,’’ as amended byStatement of Financial Accounting StandardsNo. 140 (FAS 140), ‘‘Accounting for Transfersand Servicing of Financial Assets and Extin-guishments of Liabilities.’’ Accounting treat-ment for derivatives used as investments or forhedging purposes is determined by Statement ofFinancial Accounting Standards No. 133 (FAS

133), ‘‘Accounting for Derivatives and HedgingActivities,’’ as amended by Statement of Finan-cial Accounting Standards Nos. 137 and 138(FAS 137 and FAS 138). (See section 2120.1,‘‘Accounting,’’ for further discussion.)


Canadas are assigned to the zero percent risk-weight category.


Canadas are type III securities. As such, abank’s investment in them is limited to 10 per-cent of its equity capital and reserves.

REFERENCES

Crossan, Ruth, and Mark Johnson, ed. ‘‘ Cana-dian Dollar.’’ The Guide to International Capi-tal Markets 1991. London: Euromoney Pub-lications PLC, 1991, pp. 37–49.

Fabozzi, Frank J. Bond Markets, Analysis, andStrategies. 3d ed. Upper Saddle River, N.J.:Prentice-Hall, 1996.

Fabozzi, Frank J., and T. Dessa Fabozzi, ed. TheHandbook of Fixed Income Securities. 4th ed.New York: Irwin, 1995.

J.P. Morgan Securities. Government Bond Out-lines. 9th ed., April 1996.

Canadian Government Bonds 4210.1


French Government Bonds and NotesSection 4215.1

GENERAL DESCRIPTION

The French Treasury is an active issuer of threetypes of government debt securities, which coverall maturities.Obligation Assimilable du Tresor(OATs), issued since 1985, are the French gov-ernment’s long-term debt instruments of up tothirty years. Bons du Tresor a Taux Fixe etInterest Annuel (BTANs) are medium-term,fixed-rate notes of up to five years. The FrenchTreasury also issues discount Treasury bills,Bons du Tresor a Taux Fixe et Interest Pre-comptes (BTFs), that have maturities of up toone year. In addition, an active market forstripped OATs has developed. Stripping involvesseparating a bond’s interest and principal pay-ments into several zero-coupon bonds.


The French Treasury issues OATs that havematurities of up to thirty years. Most OATs carrya fixed interest rate and have bullet maturities.However, some OATs are issued with floatingrates that are referenced to various short-term orlong-term indexes. OATs generally pay interestannually. OATs are settled three days after thetrade date (T+3), both domestically and interna-tionally. Domestically, OATs are cleared throughthe SICOVAM Relit system (a French securitiessettlement system), while OATs that settle inter-nationally are cleared through Euroclear or Cedel(international clearing organizations).

BTANs are fixed-rate, bullet-maturity notesthat have maturities of up to five years. Intereston BTANs is paid annually on the 12th of themonth. Domestic settlement for BTANs andBTFs usually occurs one day after the trade date(T+1) through the Bank of France’s Saturnesystem. Internationally, BTANs and BTFs settlethree days after the trade date. Like OATS,BTANs and BTFs may also be cleared throughEuroclear or Cedel. Interest on all governmentbonds and notes is calculated using a 30/360-day-count convention in which each month isassumed to have thirty days.

Since May 1991, French government securi-ties primary dealers,Specialistes en Valuers duTresor (SVTs), have been allowed to strip mostlong-term OATs. Primary dealers may strip

OATs and subsequently reconstitute them. Allstripped coupons carry a uniform face value toensure the fungibility of receipts that have thesame maturities but that are derived from OATsof different maturities.

USES

French government securities are used for invest-ment, hedging, and speculative purposes. Theyare considered attractive for investment pur-poses by foreign and domestic investors becauseof the market’s liquidity, lack of credit risk, andwide range of maturities and structures (forexample, fixed versus floating rates). Foreigninvestors often choose to invest internationallyto enhance the diversification of their invest-ment portfolios or derive higher returns. StrippedOATs can be used as tools for hedging or asset-liability management purposes, for example, toimmunize a portfolio in terms of interest-raterisk. Speculators also use OATs, BTANs, andstripped OATs to take positions on the directionof interest-rate changes and yield-curve shifts.Finally, there is an active market for futures andoptions on French government securities tradedon theMarche a Terme International de France(Matif), the Paris financial futures exchange.


Issuing Practices

The French Treasury issues OATs, BTANs, andBTFs through Dutch auction. The Treasuryusually issues tranches of securities that are partof a single borrowing line. The auction scheduleis generally announced several months inadvance. Securities are supplied at the price oreffective rate tendered by the bidder rather thanthe marginal price or rate. The highest bids arefilled first, followed by lower bids. Althoughbidding is open to any institution that has anaccount with the SICOVAM, Saturne, or Bankof France, SVTs account for 90 percent of thesecurities bought in the primary market. SVTsalso quote two-way prices on a when-issuedbasis several business days before an auction.


Secondary Market

There is an active secondary market for mostissues of French government securities. OATs,BTANs, and BTFs are listed on the Paris StockExchange. In 2000, HTS France, an electronictrading system for the secondary market inFrench government bonds, was launched.Liquidity is ensured by the SVTs, who serve asmarket makers. The repo market allows inves-tors to finance short-term positions.


Since 1987, SVTs have managed the market forFrench government securities. The SVTs workclosely with the French Treasury in determiningissuance policy, market conditions, and prices.SVTs are required to quote prices for clients andother primary dealers in tradable securities andare responsible for the maintenance of liquidprimary and secondary markets. In exchange,the French Treasury permits SVTs to strip andreconstitute OATs and participate in noncom-petitive bidding.

Buy Side

French government securities are used for invest-ment, hedging, and speculative purposes by awide range of institutional investors, both inter-national and domestic. These investors includeinsurance companies, pension funds, mutualfunds, and commercial and investment banks.

Market Transparency

The market for French government bonds isactive, and market transparency is relativelyhigh for most issues. The French Treasuryregularly publishes the debt-issuance scheduleand other information on the management of itsdebt. Auction results, trading information, andprices for most issues are available on inter-dealer broker screens such as Reuters, Telerate,and Bloomberg.

PRICING

OATs are quoted as a percentage of par to two

decimal places. For example, the price quote of106.85 refers to an OAT that is trading at106.85 percent of its par value. Strips are quotedon the basis of their yield. BTANs and BTFs arequoted on an annual-yield basis to two decimalplaces.

HEDGING

The interest-rate risk of French governmentsecurities can be hedged in the futures or optionsmarket at the Matif or by taking a contraposition in another French government security.Swaps and options can also be used to hedgeinterest-rate risk. The effectiveness of a particu-lar hedge is dependent on yield-curve and basisrisk. For example, hedging a position in afive-year note with an overhedged position in athree-year note may expose the dealer to yield-curve risk. Hedging a thirty-year bond with aTreasury bond future exposes the dealer to basisrisk if historical price relationships betweenfutures and cash markets are not stable. Also, ifa position in notes or bonds is hedged using anOTC option, the relative illiquidity of the optionmay diminish the effectiveness of the hedge.

Non–euro zone investors are also exposed toforeign-exchange risk. Foreign-exchange riskcan be hedged using currency forwards, futures,swaps, or options. An international investor canuse a series of forward foreign-exchange con-tracts that correspond to each of the couponpayments and the final principal payment tohedge this risk. Swaps, futures contracts, orcurrency options, traded either on the Matif orOTC, can also be used to hedge currency risk.

RISKS

Liquidity Risk

French bonds are among the most liquid inEurope. Because the French Treasury issuesOATs and BTANs as tranches of existing bonds,most bond issues have sizable reserves andliquidity. SVTs make a market in French gov-ernment bonds, a practice that enhances liquid-ity of the market. The most recently issuedten-year OAT generally serves as the benchmarkand is thus the most liquid of these issues. Forthe medium-term market, the most recent issuesof two- and five-year BTANs serve as the

4215.1 French Government Bonds and Notes


benchmark. Next to the U.S. Treasury stripmarket, French strips are the most liquid in theworld. As stated above, the face value of allstripped OATs is uniform, ensuring the fungibil-ity of coupons of different maturities. Becauseprimary dealers may reconstitute strips at anytime, their liquidity is comparable to the refer-ence OAT.

Interest-Rate Risk

From the perspective of an international inves-tor, the market risk of French government bondsconsists primarily of interest-rate risk andforeign-exchange risk. The interest-rate risk of aFrench government bond depends on its dura-tion and the volatility of French interest rates.Bonds with longer durations are more pricesensitive to changes in interest rates than bondswith shorter durations. Because they are zero-coupon instruments, French strips have longerdurations than OATs of comparable maturity,and they are more volatile.


From the perspective of an international inves-tor, the total return from investing in Frenchgovernment securities is partly dependent on theexchange rate between the U.S. dollar and theeuro.

Political Risk

A change in the political environment, withhold-ing tax laws, or market regulation can have anadverse impact on the value and liquidity of aninvestment in foreign bonds. Investors should befamiliar with the local laws and regulations

governing foreign bond issuance, trading, trans-actions, and authorized counterparties.


The accounting treatment for investments inforeign debt is determined by the FinancialAccounting Standards Board’s Statement ofFinancial Acounting Standards No. 115 (FAS115), ‘‘Accounting for Certain Investments inDebt and Equity Securities,’’ as amended byStatement of Financial Accounting StandardsNo. 140 (FAS 140), ‘‘Accounting for Transfersand Servicing of Financial Assets and Extin-guishments of Liabilities.’’ Accounting treat-ment for derivatives used as investments or forhedging purposes is determined by Statement ofFinancial Accounting Standards No. 133 (FAS133), ‘‘Accounting for Derivatives and HedgingActivities,’’ as amended by Statement of Finan-cial Accounting Standards Nos. 137 and 138(FAS 137 and FAS 138). (See section 2120.1,‘‘Accounting,’’ for further discussion.)


French government bonds and notes are assignedto the zero percent risk-weight category.


French government bonds and notes are type IIIsecurities. A bank’s investment in them is lim-ited to 10 percent of its equity capital andreserves.

French Government Bonds and Notes 4215.1


German Government Bonds and NotesSection 4220.1

GENERAL DESCRIPTION

The federal government of Germany issuesseveral types of securities: bonds (Bunds), notes(Bobls and Schatze), and Treasury discountpaper (U-Schatze). Government agencies suchas the Federal Post Office and the FederalRailway have also issued bonds (Posts andBahns) and notes (Schatze). In addition, after theunification of West and East Germany in Octo-ber 1990, the German Unity Fund began to issueUnity Fund bonds (Unities) and notes (Schatze).The outstanding debt issues of the post office,railway, and Unity Fund have since been foldedinto the so-called Debt Inheritance Fund, whichhas led to an explicit debt service of these issuesthrough the federal government. Hence, theseissues are guaranteed by the full faith and creditof the federal government. All government-guaranteed securities are available in book-entryform only.

The government also issues U-Schatze, zero-coupon Treasury notes that have maturities ofone to two years and that may not be purchasedby foreigners, and short-term Treasury bills thathave half-a-year to one-year maturities and thatmay be purchased by foreigners. However, thesecondary market for these instruments is smalland does not attract substantial foreign invest-ment. Therefore, the following discussion willfocus on bonds and notes.


Bunds are issued regularly, usually in deutschemarks (DM) 20 billion to DM 30 billion blocks,and have maturities ranging from eight to thirtyyears. Bunds are typically issued with a maturityof ten or thirty years. Bunds are redeemable in alump sum at maturity at their face value (bulletstructure) with interest paid annually. Until 1990,all bonds issued by the federal government andother public authorities were noncallable andbore a fixed coupon. However, since February1990, some callable floating-rate bonds havebeen issued.

Special five-year federal notes (Bobls) havebeen issued by the federal government since1979, but foreign investment in these securitieshas been permitted only since 1988. Federal

Treasury notes (Schatze) are one-off issues thathave a two-year maturity. Only credit institu-tions that are members of the Bund IssuesAuction Group may bid directly in auctions.

On the short end of the maturity range areFederal Treasury financing paper that has matu-rities of twelve to twenty-four months andTreasury discount paper (Bubills) that hasmaturities of six months. Tap issues of FederalTreasury financing paper are sold in the openmarket unlike most sales of German governmentbonds, which occur through auctions.

Stock-exchange settlement takes place twomarket days after trade date (T+2). Internationalsettlement takes place three business days aftertrade date (T+3). As of January 1, 1994, Germanfederal government notes and bonds no longertrade ex-coupon. They trade on a cum-couponbasis; the purchaser of the bond pays the selleraccrued interest from the last coupon date tosettlement. Interest is accrued on an actual/365-day-count basis, except for Federal Trea-sury financing paper, for which a 30/360-day-count basis is used.

USES

German government bonds and notes are usedfor investment, hedging, and speculative pur-poses. Foreign investors, including U.S. banks,often purchase German government securities asa means of diversifying their securities port-folios. German government securities may alsobe used to hedge German interest-rate risk.Speculators may use German government bondsto take positions on changes in the level andterm structure of German interest rates or onchanges in the foreign-exchange rates betweenthe euro zone and the United States. Because theGerman government bond market is deep andefficient, some German futures contracts andoptions are priced relative to Bund issues.


Issuing Practices

Bunds are issued using a combination of syndi-cation and bidding procedures. Part of the


issue is offered at fixed terms to the members ofthe Federal Bond Consortium, which consists ofGerman banks, foreign banks in Germany, andthe Deutsche Bundesbank (German CentralBank). The Bundesbank is the lead bank in thesyndicate and determines the allocation of theofferings among the syndicate members. Theseallocations are changed infrequently. Duringthe syndicate meeting, the coupon rate, matur-ity, and issue price are determined by the gov-ernment and syndicate, although the total sizeof the issue is unknown. Syndicate membersreceive a fee from the government forselling bonds received through syndicatenegotiations.

A further tranche is issued to the syndicateby means of an American-style auction. Theterms—coupon rate, maturity, and settlementdate—are the same as those determined in thesyndicate meeting, although the overall size ofthe issue is not specified. The Deutsche Bundes-bank accepts bids starting with the highest priceand accepts lower bids until the supply ofsecurities it wishes to sell is depleted. Noncom-petitive bids may also be submitted, which arefilled at the average accepted price of the auc-tion. The size of the issue is announced after theauction. The difference between the issue sizeand the amount that has been issued through theunderwriting syndicate plus the auction isretained by the Bundesbank for its bond marketoperations.

Five-year federal notes, Bobls, are issued on astanding-issue basis (similar to a tap form inwhich a fixed amount of securities at a fixedprice is issued when market conditions areconsidered favorable) with stated coupon andprice. During the initial selling period, whichmay last a few months, the price is periodicallyadjusted by the Ministry of Finance to reflectchanges in market conditions. The sales of agiven series are terminated when either theissuing volume has been exhausted or the nomi-nal interest rate has moved too far away fromthe going market rate. The new series is launchedwithin a short period of time. Only domesticprivate individuals and domestic nonprofit insti-tutions are permitted to purchase the issues inthe primary market. German banks (which can-not purchase these securities for their ownaccount) receive a commission for selling thebonds to qualified investors. After the sellingperiod is over and an issue is officially listed onthe German stock exchange, the securities maybe purchased by any investor.

Secondary Market

German bonds are listed and traded on all eightGerman stock exchanges seven days after theyare issued. Bobl issues are officially listed on thestock exchanges after the initial selling period ofone to three months. In addition to the stock-exchange transactions, substantial over-the-counter (OTC) trading occurs. In Germany, thesecondary market for both stocks and bonds isprimarily an interbank market.

For some issues, prices are fixed once duringstock-exchange hours (stock-exchange fixingtakes place from 11:00 a.m. to 1:30 p.m. Green-wich mean time +1). However as of October 3,1988, variable trading was introduced at theGerman stock exchanges for larger issuances ofBunds, Bobls, Bahns, and Posts issued afterJanuary 2, 1987. The Unity Fund issues alsoparticipate. After the fixing of the prices on thestock exchanges, the securities are traded on theOTC market (OTC hours are from 8:30 a.m. to5:30 p.m.).

Seventy percent to 80 percent of the secondary-market trading of Bunds, Bahns, and Posts takesplace in the OTC market. About 75 percent ofBobl trading takes place in the OTC market, asdoes most Schatze trading. However, the stockmarkets are important because the prices deter-mined there provide standard, publicly availablebenchmarks.

Market Participants

Sell Side

The underwriting of public authority bonds isdone by the Federal Bond Syndicate, whichconsists of German banks, foreign banks inGermany, and the Deutsche Bundesbank. Ger-man banks are responsible for placing Boblswith qualified investors.

Buy Side

Domestic banks, private German individuals,German insurance companies, and Germaninvestment funds are major holders of Germanbonds. Foreign investors, such as U.S. commer-cial and investment banks, insurance companies,and money managers, also hold German gov-ernment securities.

4220.1 German Government Bonds and Notes


Market Transparency

The market for German government bonds andnotes is active and liquid, and price transparencyis considered to be relatively high for thesesecurities. Several vendors, including Reutersand Telerate, disseminate price information tothe investing public.

PRICING

Bonds and notes are quoted as a percentage ofpar to two decimal places. For example, a priceof 98.25 means that the price of the bond or noteis 98.25 percent of par. Bonds are traded on aprice basis, net of accrued interest (clean).

HEDGING

Interest-rate risk can be hedged using swaps,forwards, futures, or options or by taking acontra position in another German governmentsecurity. The effectiveness of a particular hedgeis dependent on yield-curve and basis risk. Forexample, hedging a position in a five-year notewith an overhedged position in a three-year notemay expose the dealer to yield-curve risk. Hedg-ing a thirty-year bond with a bond future exposesthe dealer to basis risk if the historical pricerelationships between futures and cash marketsare not stable. Also, if a position in notes andbonds is hedged using an OTC option, therelative illiquidity of the option may diminishthe effectiveness of the hedge.

RISKS

Liquidity Risk

Bunds are the most liquid and actively tradedbond issues in Germany. Unities issued by theGerman Unity Fund are generally as liquid asBunds, but Bahn and Post issues of governmentagencies are fairly limited compared with thefederal government’s bonds. Therefore, theseagency securities tend to be less liquid andgenerally trade at a higher yield than Bunds.

The on-the-run (most recent) Bund issue isthe most liquid of its category and serves as thebenchmark. The most liquid area of the Bundyield curve is in the eight- to ten-year maturityrange, as most Bund issues carry a ten-year

maturity. Similar to Bunds, on-the-run Bobls arethe most liquid type of note. Off-the-run pricesare not as transparent as current coupon securi-ties, which makes these issues less liquid andtrading more uncertain. Of course, larger issuesof bonds and notes are generally more liquidthan smaller ones.

At the stock exchange, the German CentralBank makes a market in Bunds, Bobls, Unities,and Post issues. The Deutsche Bundesbank isresponsible for maintaining an orderly second-ary market in these securities and regularlyintervenes to support or regulate their prices.This tends to increase the liquidity in the marketfor these issues. However, the Bundesbank isnot responsible for stabilizing Schatze prices.For this reason, these securities tend to be muchless liquid than Bunds or Bobls; their issue sizesare also normally much smaller. The RailwayBank makes a market in Bahn issues, whichenhances the liquidity of these issues.

Interest-Rate Risk

German bonds and notes are subject to pricefluctuations caused by changes in German inter-est rates. The variation in the term structure ofinterest rates accounts for the greatest amount oflocal market risk related to foreign bonds.Longer-term issues have more price volatilitybecause of interest-rate fluctuations than doshorter-term instruments. Therefore, a large con-centration of long-term maturities may subject abank’s investment portfolio to unwarrantedinterest-rate risk.

Political Risk



The accounting treatment for investments inforeign debt is determined by the FinancialAccounting Standards Board’s Statement ofFinancial Accounting Standards No. 115 (FAS

German Government Bonds and Notes 4220.1


115), ‘‘Accounting for Certain Investments inDebt and Equity Securities,’’ as amended byStatement of Finanical Accounting StandardsNo. 140 (FAS 140), ‘‘Accounting for Transfersand Servicing of Financial Assets and Extin-guishments of Liabilities.’’ Accounting treat-ment for derivatives used as investments or forhedging purposes is determined by Statement ofFinancial Accounting Standards No. 133 (FAS133), ‘‘Accounting for Derivatives and HedgingActivities,’’ as amended by Statement of Finan-cial Accounting Standards Nos. 137 and 138(FAS 137 and FAS 138). (See section 2120.1,‘‘Accounting,’’ for further discussion.)


German government bonds and notes areassigned to the zero percent risk-weight category.


German government bonds and notes are type IIIsecurities. As such, a bank’s investment in themis limited to 10 percent of its equity capital andreserves.

4220.1 German Government Bonds and Notes


Irish Government BondsSection 4225.1

GENERAL DESCRIPTION

Irish government bonds (IGBs) are issued bythe National Treasury Management Agency(NTMA), which is responsible for the manage-ment of Ireland’s national debt.1 Bonds areissued to fund the government’s borrowingrequirements and to fund maturing bond issues.


Bond issuance is confined to a limited numberof designated fixed-rate benchmark bonds in keymaturities of four, ten, and thirteen years. Theamounts in issue in the benchmark bonds rangefrom euro 4.4 billion to euro 7.5 billion. Issuesare transferable in any amount and are listed andtraded on the Irish stock exchange. Coupons arepaid annually or semiannually, depending on thetype of bond. Interest is accrued from thecoupon payment date to the settlement date.Interest is computed using the actual/365-day-count convention for semiannual coupon bondsand the 30/365-day-count convention for annualcoupon bonds. Settlement takes place three daysafter the trade date (T+3). The interest on annualcoupon bonds that have an accrued ex-dividenddate is negative if the settlement date fallsbetween the ex-dividend date (exclusive) andthe coupon date (inclusive). The benchmarkbonds carry no ex-dividend period. IGBs areavailable in registered form and are clearedthrough Euroclear, an international clearingorganization.

USES

Irish government bonds and notes are used forinvestment, hedging, and speculative purposes,by both domestic and foreign investors andtraders. U.S. banks purchase Irish governmentbonds to diversify their portfolios, speculate onIrish interest rates, and hedge euro zone cur-rency positions and positions along the Irishyield curve.


Issuing Practices

About 80 percent of issuance is by the tapsystem, and the rest of the bonds are issued byregular auctions. Taps are sales of a fixedamount of securities at a fixed price whenmarket conditions are considered favorable. Thetype of bond and size of the tap issue arecommunicated to the market, but the price isonly communicated to the primary dealers whobid by telephone. The auction system has both acompetitive and noncompetitive element. Thecompetitive auction is open to all investors whomay bid directly or through a primary dealer orstockbroker. Following the auction, noncompeti-tive bids are filled at the average auction price.Only primary dealers may submit noncompeti-tive bids.

Secondary Market

IGBs are listed on the Dublin, Cork, and Londonstock exchanges. They are also traded in theover-the-counter (OTC) market.

Market Participants

Sell Side

Seven primary dealers quote firm bid and offerprices in each of a specified list of four bonds. Inreturn for their market-making services, theNTMA provides these dealers with exclusiveaccess to the supply of bonds issued in tap form.The designated brokers are ABN AMRO, AIBCapital Markets, Credit Agricole Indosuez, Davy,Deutsche Bank, NCB, and Schroder SalomonSmith Barney.

Buy Side

The principal holders of IGBs are domestic andforeign institutional investors, such as banks,securities firms, insurance companies, pensionfunds, and money managers.1. For more information, see www.ntma.ie/govtbonds.


Market Transparency

Price transparency for Irish government securi-ties is relatively high as a result of the structureof the primary dealer system, which enhancesliquidity. Several information vendors dissemi-nate prices to the investing public.

PRICING

Bonds are quoted as a percent of par to twodecimal places. The price paid by the buyer doesnot include accrued interest. The bid/offer spreadfor maturities up to ten years ranges from euro.05 to euro .07. For longer-term maturities, thebid/offer spread is euro .15.

HEDGING

Interest-rate risk may be hedged by takingcontra positions in government securities or byusing swaps or futures. Foreign-exchange riskcan be hedged using currency swaps, futures, orforward rate agreements.

RISKS

Liquidity Risk

Active portfolio management, the wide range ofcoupons and maturities available, and the devel-opment of a trading rather than a purely invest-ment outlook among Irish investors haveincreased the liquidity of the Irish governmentbond market. The large issues tend to be veryliquid throughout the yield curve; the four bondsfor which the primary dealers are obliged tomake markets are particularly liquid.

Interest-Rate Risk

IGBs are exposed to interest-rate risk as a resultof the inverse relationship between bond pricesand interest rates. Longer-term issues have moreprice volatility than short-term instruments.

Political Risk



The accounting treatment for investments inforeign debt is determined by the FinancialAccounting Standards Board’s Statement ofFinancial Accounting Standards No. 115 (FAS115), ‘‘Accounting for Certain Investments inDebt and Equity Securities,’’ as amended byStatement of Financial Accounting StandardsNo. 140 (FAS 140), ‘‘Accounting for Transfersand Servicing of Financial Assets and Extin-guishments of Liabilities.’’ Accounting treat-ment for derivatives used as investments or forhedging purposes is determined by Statement ofFinanical Accounting Standards No. 133 (FAS133), ‘‘Accounting for Derivatives and HedgingActivities,’’ as amended by Statement of Finan-cial Accounting Standards Nos. 137 and 138(FAS 137 and FAS 138). (See section 2120.1,‘‘Accounting,’’ for further discussion.)


Irish government bonds are assigned to the zeropercent risk-weight category.


Irish government bonds are type III securi-ties. As such, a bank’s investment in them islimited to 10 percent of its equity capital andreserves.

4225.1 Irish Government Bonds


Italian Government Bonds and NotesSection 4230.1

GENERAL DESCRIPTION

The Italian Treasury issues bonds, notes, andbills, which are guaranteed by the Italiangovernment. These securities are issued withmaturities ranging from three months to thirtyyears in a wide variety of structures. Thesestructures include Treasury bonds, Treasuryfloating-rate notes, Treasury notes with a putoption, and short-term Treasury bills. Govern-ment securities are issued in book-entry formbut may be converted to bearer form followingtheir issuance.


Treasury bonds, or Buoni del Tesero Poliennali(BTPs), are fixed-coupon medium- to long-termgovernment bonds with semiannual dividendpayments. These bonds have played an impor-tant role in financing the Treasury, especiallyafter the establishment of the telematic marketfor government bonds, which provides theliquidity necessary for these instruments. Thesebonds are issued with five-, ten-, and thirty-yearmaturities. Interest on the bonds is paid throughdeferred semiannual coupons.

Treasury floating-rate notes, or Certificati diCredito del Tesoro (CCTs), are floating-ratenotes indexed to T-bill rates. CCTs are generallyissued with seven-year maturities, although five-and ten-year notes have also become popular.Interest on these bonds is paid through deferredsemiannual or annual dividend coupons, withrates indexed to Italian Treasury Bill (BOT)yields. The coupon is calculated by adding aspread of 30 basis points to the six-month T-billrecorded in the last auction.

Domestic and international settlement of Ital-ian government bonds takes place three businessdates after the trade date (T+3). The onlyexception is BOTs, which settle two businessdates after the trade date (T+2). Italian govern-ment bonds with a coupon can be settled throughEuroclear or Cedel (international clearing orga-nizations). Settlement through Euroclear andCedel takes five days. Interest is calculatedusing a 30/360-day count in which each monthis assumed to have 30 days.

USES

Italian government securities are used for invest-ment, hedging, and speculative purposes. Inves-tors may buy Italian bonds as a way to diversifytheir investment portfolios, but the bonds mayalso be used to hedge positions that are sensitiveto movements in interest rates. Speculators, onthe other hand, may use long-term bonds to takepositions on changes in the level and termstructure of interest rates.


Issuing Practices

Italian government bonds are issued through amarginal auction, in which there is no baseprice. Each allotment is made at the marginalaccepted bid, which represents the stop-outprice. No bids are considered below the stop-outprice. Partial allotments may be given at thestop-out price if the amount bid at that priceexceeds the amount not covered by the higher-priced bids. Each participant is limited to threebids. The exclusion price, or the price belowwhich no bids will be accepted, is calculated bylisting the bids in decreasing order and proceed-ing as follows:

• If the amount of competitive bids is greaterthan or equal to the amount offered—— take the amount of bids (in a decreasing

price order) needed to cover half theoffered amount,

— calculate the weighted average of the aboveset of bids, and

— subtract 200 basis points from the weightedaverage to obtain the exclusion price.

• If the amount of competitive bids is less thanthe amount offered—— take half of the bids in a decreasing price

order,— calculate the weighted average of the above

set of bids, and— subtract 200 basis points from the weighted

average to obtain the exclusion price.

Once the exclusion yield is calculated, bidsare accepted in decreasing order of price. Bids


are accepted to the point that covers the amountto be offered up to the stop-out price. Noncom-petitive bids may also be accepted and awardedat the average of accepted competitive bids plusa Treasury spread.

The Treasury makes an announcement ofauction dates annually and also makes a quar-terly announcement of the types of bonds andminimum issue sizes to be offered in the fol-lowing three months. The auctions are held atthe beginning and middle of the month. Gener-ally, three- and five-year bills are sold on thesame day, ten- and thirty-year bonds are soldtogether, and CCTs are sold on the third day ofthe auctions.

The Bank of Italy may reopen issues, that is,sell new tranches of existing bonds, until thelevel outstanding reaches a certain volume.After that threshold volume is reached, a newbond must be issued. If an issue is reopened, theBank of Italy issues new tranches of securitieswith the same maturities, coupons, and repay-ment characteristics as existing debt. The abilityto reopen issues improves liquidity and avoidsthe potential poor pricing of securities that oftenoccurs when a market is flooded with one verylarge issue.

Secondary Market

Italian government bonds can be traded on anyof the following: the Milan Stock Exchange, thetelematic government bond spot market (Mer-cato Telematico dei Titoli di Stato or MTS), andthe over-the-counter (OTC) market. Bonds maybe traded on the Milan Stock Exchange if theyare transformed into bearer bonds (at least sixmonths after being issued). The stock exchangeis the reference market for the small saver; onlysmall dealings are transacted there. At the end ofthe day, the exchange publishes an official list ofthe prices and volumes of trading. The MTS isthe reference market for professional dealers.

MARKET PARTICIPANTS

Sell Side

Only banks authorized by the government ofItaly may act as primary dealers of Italiangovernment bonds. Branches of foreign banksand nonfinancial institutions can also act as

dealers, provided they are residents of the Euro-pean Union and subject to comparable financialregulations.

Buy Side

A wide range of investors use Italian govern-ment bonds for investing, hedging, and specu-lation. These investors include domestic banks,nonfinancial corporate and quasi-corporate pub-lic and private enterprises, insurance companies,and private investors. Foreign investors, includ-ing U.S. commercial banks, securities firms,insurance companies, and money managers, arealso active in the Italian government bondmarket.

Market Transparency

The Italian government bond market is an activeone. Price transparency is relatively high forItalian government securities because severalinformation vendors, including Reuters, dissemi-nate prices to the investing public.

PRICING

Prices and yields of Italian government securi-ties are stated as a percentage of par to twodecimal places. For instance, a price of 97.50means that the price of the bond is 97.50 percentof par. The price spread is generally narrow dueto the efficiency of the market.

Bonds trade on a clean-price basis, quoted netof accrued interest. Italian government bonds donot trade ex dividend. Interest on Italian bonds isaccrued from the previous coupon date to thesettlement date (inclusive). In this regard, Italianbonds pay an extra day of interest comparedwith other bond markets.

HEDGING

Italian government bonds can be hedged forinterest-rate risk in the Italian futures market(Mercato Italiano Futures or MIF) as well as theLondon International Financial Futures Exchange(LIFFE). The MIF and LIFFE offer futures onten-year Italian government securities, and theMIF offers futures on five-year Italian govern-

4230.1 Italian Government Bonds and Notes


ment securities. The LIFFE also offers OTCoptions on individual bonds as well as optionson futures contracts. OTC forwards and swapscan also be used to hedge interest-rate risk.

The effectiveness of a hedge depends on theyield-curve and basis risk. For example, hedginga position in a five-year note with an overhedgedposition in a two-year note may expose thedealer to yield-curve risk. Hedging a thirty-yearbond with an Italian bond future exposes thedealer to basis risk if the historical price rela-tionships between futures and cash markets arenot stable. Additionally, if a position in notes orbonds is hedged using an OTC option, therelative illiquidity of the option may diminishthe effectiveness of the hedge.

RISKS

Liquidity Risk

The Italian bond market is one of the most liquidmarkets in the world. Liquidity is maintained by40 market makers, which include 16 specialists,top-tier market makers (Morgan Guaranty,Milan), and 24 other market makers who areobligated to quote two-way prices. Ten marketmakers have privileged access to the Bank ofItaly on the afternoon of an auction to buy extrabonds at the auction price. The purchases aresubject to a limit set by the Bank. For instance,if a particular issue were oversubscribed andprices were likely to shoot up, the selectedmarket makers would be able to buy more of thesame bond and maintain or increase marketliquidity.

Before selling a new bond, the Bank of Italymay reopen issues until they reach a certainvolume. Liquidity is also maintained by limitingthe number of government entities that issuedebt. In the case of Italy, only the centralgovernment may issue debt securities.

Interest-Rate Risk

Italian government bonds are subject to pricefluctuations due to changes in interest rates.Longer-term issues have more price volatilitythan shorter-term instruments. Therefore, a largeconcentration of longer-term maturities in an

investment portfolio may increase interest-raterisk.

Political Risk



The accounting treatment for investments inforeign debt is determined by the FinancialAccounting Standards Board’s Statement ofFinancial Accounting Standards No. 115 (FAS115), ‘‘Accounting for Certain Investments inDebt and Equity Securities,’’ as amended byStatement of Financial Accounting StandardsNo. 140 (FAS 140), ‘‘Accounting for Transfersand Servicing of Financial Assets and Extin-guishments of Liabilities.’’ Accounting treat-ment for derivatives used as investments or forhedging purposes is determined by Statement ofFinancial Accounting Standards No. 133 (FAS133), ‘‘Accounting for Derivatives and HedgingActivities,’’ as amended by Statement of Finan-cial Accounting Standards Nos. 137 and 138(FAS 137 and FAS 138). (See section 2120.1,‘‘Accounting,’’ for further discussion.)


Italian government bonds and notes are assignedto the zero percent risk-weight category.


Italian government notes and bonds are type IIIsecurities. As such, a bank’s investment in themis limited to 10 percent of its equity capital andreserves.

Italian Government Bonds and Notes 4230.1


Japanese Government Bonds and NotesSection 4235.1

GENERAL DESCRIPTION

Japanese government bonds (JGBs) are issuedby the Japanese national government. The Min-istry of Finance (MOF) authorizes the issuanceof coupon and non-coupon-bearing JGBs in avariety of maturities: super-long-term (twentyand thirty years), long-term (ten years), andmedium-term (two through six years). The MOFalso issues short-term Treasury bills, which areissued at a discount with maturities of threemonths, six months, or one year.


JGB revenue bond issues are categorized asconstruction bonds, deficit-financing bonds, orrefunding bonds, although there is no differencein these bonds from an investment perspective.Super-long-term coupon-bearing bonds are issuedquarterly (with a twenty-year maturity) or semi-annually (with a thirty-year maturity) in units ofyen 50,000 and have a fixed semiannual coupon.Long-term coupon-bearing bonds are issuedmonthly in units of yen 50,000 and have a fixedsemiannual coupon. Medium-term coupon-bearing bonds are issued monthly (with a two-year maturity) or bimonthly (with four- andsix-year maturities) in units of yen 50,000 andhave a semiannual coupon.

USES

Domestic and foreign investors use JGBs forinvestment, hedging, and speculative purposes.U.S. investors, including commercial banks, maypurchase JGBs to speculate on interest rates orforeign-exchange rates, diversify portfolios,profit from spreads between U.S. and Japaneseinterest rates, and hedge various positions.


Issuing Practices

Super-long-term coupon-bearing bonds are

issued through a syndicate underwriting system,in which 90 percent of the issue is distributed tosyndicate members through a competitive priceauction. The remaining 10 percent is executed atthe average price paid in the competitive priceauction. For long-term coupon-bearing bonds,60 percent of the issue is distributed by syndi-cate members through an auction; the remaining40 percent is distributed by syndicate memberson the basis of a preset share at a price set at theaverage of the price paid in the auction. Formedium-term coupon-bearing bonds, 90 percentof the issue is distributed to syndicate membersthrough a competitive price auction, and theremaining 10 percent is executed at the averageprice paid in the competitive price auction.

Secondary Market

Most JGBs are listed on the Japanese stockexchanges, although the majority of JGB tradingoccurs in the over-the-counter (OTC) market.While the OTC market is characterized by verylarge trading volume, stock-exchange trading isimportant because it enhances transparency inpricing—the Tokyo Stock Exchange closingprices serve as a public pricing source for JGBs.Long-term government bonds account for thelargest share of secondary-market trading ofgovernment securities, partly because they havehigher credit ratings and greater marketabilitythan shorter-maturity JGBs. In the secondarymarket, the broker and investor negotiate the‘‘invoice price,’’ which includes commissionsfor the agent.

The secondary market for JGBs has someunusual features. The first relates to the bench-mark or bellwether bond issue. In the U.S.Treasury market, the on-the-run issue (the mostrecently auctioned issue for a given maturity) isthe benchmark issue for each maturity. How-ever, the Japanese benchmark issue is deter-mined through an informal process that occursover a few weeks. The characteristics of bench-mark issues are (1) a coupon that is near theprevailing rate, (2) a large outstanding amount(approximately yen 1.5 trillion or more), (3) awide distribution or placement after the bench-mark’s issue, and (4) a remaining maturity thatis very close to ten years.


Another unusual feature of the JGB market isthe so-called reverse coupon effect. In mostbond markets, high-coupon bonds trade at ahigher yield than low-coupon bonds of the sameduration. This ‘‘coupon effect,’’ which varieswith the duration of the bond as well as overtime, is often attributed to such institutionalfactors as different taxation of capital gains andordinary income. In Japan, however, there is astrong preference for high-coupon bonds. As aresult, high-coupon bonds trade at lower yieldsthan low-coupon bonds for the same duration(the ‘‘reverse coupon effect’’). This effect occursin spite of the Japanese tax code that requiresincome tax to be paid on coupon income butgenerally not on capital gains on Japanese gov-ernment bonds. Banks prefer coupon interestbecause banks’ current income ratios are closelymonitored by Japanese bank regulators.

Market Participants

Sell Side

JGBs are issued through a syndicate consistingof domestic banks, life insurance companies,other domestic financial institutions, and someforeign securities firms.

Buy Side

A wide range of domestic and foreign investorsuse JGBs for investing, hedging, and specula-tion. Japanese financial institutions, particularlycity banks, long-term credit banks, regionalbanks, and insurance companies, tend to be thelargest investors in yen-denominated bonds,although corporate and individual investors arevery active investors in the medium-term gov-ernment bond market. Foreign investors, such asU.S. commercial banks, securities firms, insur-ance companies, and money managers, are alsoactive in the Japanese government bond market.

MARKET TRANSPARENCY

Price transparency is relatively high for JGBs.JGBs are actively traded and pricing informa-tion is available from a variety of price infor-mation services, including Reuters and Telerate.

PRICING

JGB prices are quoted in yield, specifically onthe basis of simple yield, in basis points. Marketprice is calculated from simple yield. The fol-lowing formulas are used to calculate price andyield:

Ys = [C + (100 − P / T] / P orP = [(C * T) + 100] / [1 + (T * Ys)],

whereYs = simple yieldC = coupon stated in decimal formP = priceT = time to maturity = number of days to

maturity/365

Discount Bonds

Discount bonds are quoted on a simple-yieldbasis, which is different from the simple yieldused on coupon bonds. Simple yield is used fordiscount bonds with a maturity of less than oneyear, but the formula is adjusted to reflect thefact that discount bonds do not pay interest.Annually compounded yield is used for discountbonds with a maturity greater than one year.

The yield on a discount bond with less thanone year remaining to maturity is the value of Ysthat solves—

P = 100 / (1 + T + Ys).

The yield on a discount bond with more thanone year remaining to maturity is the value ofYm that solves—

P = 100 / (1 + Ym)T,

where T is the number of days to maturity(excluding leap days) divided by 365.

HEDGING

Because of the multiple risks associated withpositions in foreign government bonds, inves-tors may need to hedge one position in severalmarkets using various instruments. Interest-raterisk related to JGBs is typically hedged bytaking contra positions in other governmentbonds or by investing in interest-rate forwards,

4235.1 Japanese Government Bonds and Notes


futures, options, or swaps. Similarly, foreign-exchange risk can be reduced by using currencyforwards, futures, options, or swaps.

RISKS

Liquidity Risk

The market for longer-term JGBs tends to bemore liquid than that for the shorter-term issues,although liquidity has improved for the shorter-term issues in the past few years. The bench-mark ten-year JGB still accounts for the major-ity of trading volume in the secondary marketand therefore enjoys the best liquidity. JGBsissued more recently also tend to be more liquidthan older issues. The market for medium-termbonds is less liquid because such bonds aretypically purchased by individuals and invest-ment trust funds, which tend to be buy-and-holdinvestors. The existence of a large and activeJGB futures market enhances the liquidity ofthese issues.

Interest-Rate Risk

Like all bonds, the price of JGBs will change inthe opposite direction from a change in interestrates. If an investor has to sell a bond before thematurity date, an increase in interest rates willmean the realization of a capital loss (selling thebond below the purchase price). This risk is byfar the major risk faced by an investor in thebond market. Interest-rate risk tends to be greaterfor longer-term issues than for shorter-termissues. Therefore, a large concentration of long-term maturities may subject a bank’s investmentportfolio to unwarranted interest-rate risk.


A non-dollar-denominated bond (a bond whosepayments are made in a foreign currency) hasunknown U.S. dollar cash flows. The dollar-equivalent cash flows depend on the exchangerate at the time the payments are received. Forexample, a U.S. bank that purchases a ten-yearJGB receives interest payments in Japanese yen.If the yen depreciates relative to the U.S. dollar,fewer dollars will be received than would havebeen received if there had been no depreciation.Alternatively, if the yen appreciates relative to

the U.S. dollar, the investor will benefit byreceiving more dollars than otherwise. Over thelast few years, volatility in the U.S.-Japaneseexchange rate has been particularly high, pri-marily because of the Japanese banking crisis.

Political Risk





Japanese government bonds and yields areassigned to the zero percent risk-weight cate-gory.


Japanese government bonds and notes are typeIII securities. As such, a bank’s investment inthem is limited to 10 percent of its equity capitaland reserves.

Japanese Government Bonds and Notes 4235.1


Spanish Government BondsSection 4240.1

GENERAL DESCRIPTION

The Spanish Treasury issues medium- and long-term bonds, Bonos del Estado (Bonos) andObligaciones del Estado (Obligaciones), whichare guaranteed by the Spanish government.Since 1987, these bonds have been issued inbook-entry form only.


Bonos are issued with maturities of three or fiveyears, while Obligaciones are issued with matu-rities of ten or fifteen years. Bonos and Obliga-ciones are noncallable, have bullet maturities,and can be issued with either annual or semian-nual coupons. All Spanish government bondsbear a fixed coupon. Domestic settlement takesplace the market date after the trade date (T+1),while international settlement takes place sevencalendar days following the trade date (T+7).Settlement is done on a delivery-against-paymentbasis for all transactions between interbankmarket participants. Bonos and Obligaciones arealso eligible for settlement through Euroclearand Cedel (international clearing organizations).Interest is calculated using an actual/365-daycount.

USES

Historically, Bonos and Obligaciones have beenused as medium- and long-term investments.However, in the early 1990s, the trading volumeof these bonds doubled as banks and corpora-tions began to use Bonos and Obligaciones forcash-management purposes. These securities canalso be used for hedging and speculativepurposes.


Issuing Practices

Currently, all Bonos and Obligaciones are issuedthrough monthly competitive auctions. The Span-

ish Treasury publishes the auction calendar atthe beginning of the year. On the first Tuesdayof the month, the three- and ten-year bonds areissued. The five- and fifteen-year bonds areissued on the following Wednesday. Each issueis sold in at least three competitive tenders. Bidsare submitted before 10:30 a.m. on the auctiondate. Auction results are announced at 11:30a.m. on the same day on Reuters. Paymentsgenerally occur on the 15th of the same month.

At the beginning of each issue, the Treasuryfixes the coupon to be paid for at least the nextthree auctions. After all bids are made, theTreasury fixes the total issue amount and allo-cates bids from the highest price to a cut-offprice. The total issue amount is not disclosed.The lowest bid submitted is referred to as themarginal price of the issue. Bids between theaverage and the marginal price are filled at theprice the bidders submitted. Bids above theaverage are filled at the average price bid.

If the Treasury announces a target issuancelevel and the volume awarded during the initialbidding stage is equal to or higher than 70 per-cent of the target level—but does not reach thetarget issuance level—the Treasury has the right,but not the obligation, to hold a second auctionexclusively with the primary dealers. In thiscase, every primary dealer must submit bids foran amount at least equal to—

(target issuance level − volume awarded) /number of primary dealers.

If the target issuance level is met with the firstbidding stage or if the Treasury does notannounce a target issuance level, primary deal-ers may submit up to three additional bids.These bids cannot have yields higher than theaverage yield during the first bidding stage. Inthis scenario, the Treasury must accept bidsequal to at least 10 percent of the volumeawarded during the first bidding stage if it hadaccepted more than 50 percent of the bids. If ithad accepted less than 50 percent of the bids, theTreasury must accept bids equal to at least20 percent of the volume awarded during thefirst bidding stage.

Interest begins to accrue from a date nomi-nated by the Treasury. Historically, the date hasbeen set so that the first coupon period will beexactly one year. Thus, tranches issued before


the nominated date have an irregular periodduring which they trade at a discount withoutaccrued interest.

Secondary Market

About 40 percent of all bond transactions areexecuted through a system of interdealer brokers(blind brokers) instituted by the Bank of Spain.In the secondary market, only entities desig-nated as ‘‘primary dealers’’ can deal directlywith the Bank of Spain. For example, if acustomer wants to buy a bond that a dealer doesnot have in inventory, a primary dealer can go tothe Bank of Spain to obtain the bond. Nonpri-mary dealers would have to obtain the bondsthrough interdealer trading. Interdealer tradingis executed through information screens. Amountsand prices are quoted but counterparties are notdisclosed.

Market Participants

Sell Side

The dealers of government securities are classi-fied as either primary dealers or nonprimarydealers. The Bank of Spain designates primarydealers with whom they will conduct business.Other dealers obtain government securitiesthrough interdealer trading.

Buy Side

The primary holders of Bonos and Obligacionesare private and savings banks. The Bank ofSpain, corporations, and foreign investors,including U.S. commercial banks, securitiesfirms, insurance companies, and money manag-ers, also hold outstanding bonds.

MARKET TRANSPARENCY

Several information vendors disseminate priceinformation on Spanish government bonds.Reuters and Telerate provide pricing informa-tion for Bonos and Obligaciones. A Telerateservice called 38494 provides the latest auctioninformation. Reuters carries bond prices, dealerprices, the latest auction results, and SpanishTreasury pages.

PRICING

Bonos and Obligaciones are quoted in eighthson a percentage-of-par basis. Bid/offer spreadsare typically five to ten basis points for activelytraded issues and about twenty basis points forilliquid issues. Bonos and Obligaciones do nottrade ex dividend, but they do trade before theTreasury nominates a date to begin couponaccruals. The period before the nomination dateis referred to as the irregular period. Becausethere is no accrued interest until a couponpayment date is nominated by the Treasury,issues outstanding before the nomination arepriced at a discount and adjustments to yieldmust be made accordingly. The following price/yield relationship holds during the irregularperiod:

PV0 = PV1 / (1 + y)(n / 365),

wherePV1 = standard price/yield on the nominated

date

y = annual internal rate of return

n = the number of days until the end of theirregular period

HEDGING

Foreign-currency and interest-rate risk may behedged by using derivative instruments such asforwards, futures, swaps, or options. Interest-rate risk may also be hedged by taking anoffsetting position in another Spanish fixed-income security.

RISKS

Liquidity Risk

Liquidity risk is increased when market volumesof a security are low. In the case of Bonos andObligaciones, market volumes have been vola-tile as investor objectives and strategies havechanged, such as when banks and corporationsbegan to use Bonos and Obligaciones as cash-management instruments rather than as medium-term investments. These bonds may experiencevarying levels of liquidity. Liquidity may alsobe a function of how close to maturity a bondissue is. In other words, more recently issued

4240.1 Spanish Government Bonds


bonds tend to be more liquid than bonds thathave been traded in the market for a longerperiod of time.

Interest-Rate Risk

Interest-rate risk is derived from price fluctua-tions caused by changes in interest rates. Longer-term issues have more price volatility thanshorter-term issues. A large concentration oflong-term maturities may subject a bank’s invest-ment portfolio to greater interest-rate risk.

Political Risk



The accounting treatment for investments inforeign debt is determined by the FinancialAccounting Standards Board’s Statement of

Financial Accounting Standards No. 115 (FAS115), ‘‘Accounting for Certain Investments inDebt and Equity Securities," as amended byStatement of Financial Accounting StandardsNo. 140 (FAS 140), ‘‘Accounting for Transfersand Servicing of Financial Assets and Extin-guishments of Liabilities.’’ Accounting treat-ment for derivatives used as investments or forhedging purposes is determined by Statement ofFinancial Accounting Standards No. 133 (FAS133), ‘‘Accounting for Derivatives and HedgingActivities,’’ as amended by Statement of Finan-cial Accounting Standards Nos. 137 and 138(FAS 137 and FAS 138). (See section 2120.1,‘‘Accounting,’’ for further discussion.)


Spanish government bonds are assigned to thezero percent risk-weight category.


Spanish government bonds are type III securi-ties. As such, a bank’s investment in them islimited to 10 percent of its equity capital andreserves.

Spanish Government Bonds 4240.1


Swiss Government Notes and BondsSection 4245.1

GENERAL DESCRIPTION

Swiss government notes (SGNs) and bonds(SGBs), also known as confederation notes andbonds, are fully guaranteed debt obligations ofthe Swiss government. The Swiss governmentdebt market has historically been relatively smallas a result of the country’s low level of debt andits balanced-budget policy. The Swiss govern-ment does not engage in open market operationsbecause of the high degree of liquidity in thebanking system. However, budget deficits inrecent years have resulted in an increase in thevolume of activity. Bonds and notes are issuedthrough the Swiss National Bank in bearer formonly.


Bonds have average maturity ranges of seven totwenty years and are issued in denominationsof Swiss franc (SFr) 1,000, SFr 5,000, andSFr 100,000. Notes have average maturities ofthree to seven years and are issued in denomi-nations of SFr 50,000 and SFr 100,000. Bothbonds and notes are fixed-coupon securitiesredeemable at par (bullets). Interest is paidannually and there are no odd first coupons.Most issues are callable, but many recent issuesdo not have a call feature. Settlement is based onEuroclear (an international clearing organiza-tion) conventions, three days after the trade date(T+3). Interest is calculated using the 30E+/360-day-count convention. If a starting date is the31st, it is changed to the 30th, and an end datethat falls on the 31st is changed to the 1st.

USES

Swiss government bonds and notes are used forinvestment, hedging, and speculative purposes.Foreign investors, including U.S. banks, oftenpurchase Swiss government securities as a meansof diversifying their securities portfolios. Thelow credit risk and liquidity of Swiss govern-ment bonds encourage their use. Swiss govern-ment securities may also be used to hedge aninvestor’s exposure to Swiss interest rates or

currency risk that is related to its positions inSwiss francs. Speculators may use Swiss gov-ernment bonds to take positions on changes inthe level and term structure of Swiss interestrates or on changes in the foreign-exchangerates between Switzerland and the United States.


Issuing Practices

The Swiss Treasury issues debt through a Dutchauction, and allocations are made to the highestbidders in descending order until the supply ofsecurities the Treasury wishes to sell is depleted.The lowest accepted tender price is consideredthe clearing price. The debt-issuance calendar isannounced at the beginning of each year. Cur-rently, issuance takes place on the fourth Thurs-day of every second month.

Secondary Market

SGBs are listed on the Swiss stock exchanges inZurich, Geneva, and Basel, as well as on theover-the-counter (OTC) market. SGNs are tradedOTC only.

Market Participants

Sell Side

The main dealers of SGBs are the Union Bankof Switzerland, Credit Suisse, and the SwissBank Corporation. The Swiss National Bankdoes not allow non-Swiss banks to underwrite ormanage issues.

Buy Side

Many investors, foreign and domestic, areattracted to the Swiss bond market becauseof the strength of the Swiss economy, thecountry’s low inflation rates, and the stabilityof its political environment and currency, all ofwhich contribute to a stable and low-risk


government bond market. Investors includebanks, securities firms, insurance companies,and money managers.

Market Transparency

The market of SGBs and SGNs is fairly active.Price transparency is relatively high for Swissgovernment securities since several informationvendors, including Reuters and Telerate, dissemi-nate prices to the investing public.

PRICING

Notes and bonds are quoted as a percentage ofpar to two decimals. For example, a quote of98.16 would mean a price that is 98.16 percentof par value. The price quoted does not includeaccrued interest. Notes and bonds do not tradeex dividend.

HEDGING

Interest-rate risk may be hedged by takingcontra positions in other government securitiesor by using interest-rate swaps, forwards,options, or futures. Foreign-exchange risk canbe hedged by using currency swaps, forwards,futures, or options.

RISKS

Liquidity Risk

The market for SGBs is more liquid than themarket for SGNs due to a lower number of SGNissues. Bonds typically trade in a liquid marketfor the first few months after they are issued.However, after a few months on the secondarymarket, liquidity tends to decrease as a result ofthe fact that issue size is relatively small. Inaddition, liquidity is hampered by buy-and-holdinvestment practices and by federal and cantonaltaxes levied on secondary transactions.

Interest-Rate Risk

SGBs and SGNs are subject to interest-rate riskas a result of the inverse relationship betweenbond prices and interest rates. Longer-term issues

have more price volatility than short-term instru-ments. However, the Swiss capital market ischaracterized by relatively low and stable inter-est rates.


Currency fluctuations may affect the bond’syield as well as the value of coupons andprincipal paid in U.S. dollars. The Swiss franc isone of the strongest currencies in the world as aresult of the strength of the Swiss economy andthe excess liquidity in the banking system.Volatility of Swiss foreign-exchange rates hashistorically been low.

Political Risk

A change in the political environment, withhold-ing tax laws, or market regulations can have anadverse impact on the value and liquidity of aninvestment in foreign bonds. Investors shouldbe familiar with the local laws and regulationsgoverning foreign bond issuance, trading, trans-actions, and authorized counterparties.




Swiss government notes and bonds are assignedto the zero percent risk-weight category.

4245.1 Swiss Government Notes and Bonds



Swiss government notes and bonds are type IIIsecurities. As such, a bank’s investment in themis limited to 10 percent of its equity capital andreserves.

REFERENCES

Crossan, Ruth, and Mark Johnson, ed. The

Guide to International Capital Markets 1991.London: Euromoney Publications PLC, 1991.

Fabozzi, Frank J., and Franco Modigliani. Capi-tal Markets: Institutions and Instruments.Englewood Cliffs, N.J,: Prentice-Hall, 1992.

J.P. Morgan Securities. Government Bond Out-lines. 9th ed.

Kemp, L.J. A Guide to World Money andCapital Markets. New York: McGraw Hill,1981.

Swiss Government Notes and Bonds 4245.1


United Kingdom Government BondsSection 4250.1

GENERAL DESCRIPTION

United Kingdom government bonds, known as‘‘gilts’’ or ‘‘gilt-edged stocks,’’ are sterling-denominated bonds issued by the Bank ofEngland (BOE) on behalf of the Treasury.Effective April 1, 1998, the Debt ManagementOffice assumed responsibility for gilt-marketoversight. The bonds are unconditionally guar-anteed by the U.K. government and, therefore,are considered to have very low credit risk.Shorts are those gilts having zero to five yearsremaining to maturity; mediums, five to fifteenyears; and longs, over fifteen years. The securi-ties are generally held in registered form in thedomestic settlement system. The securities canalso be held through Euroclear and Cedel(international clearing organizations).


Gilts come in a variety of structures. Conven-tional gilts, or ‘‘straights,’’ are noncallable bulletissues that pay interest semiannually. Thesebonds comprise around 80 percent of the out-standing gilt-edged securities. The governmentalso issues callable gilts, so-called double-datedgilts, which may be called at the government’sdiscretion anytime after the designated call date.In addition to these bonds, a number of noncon-ventional gilt issues are considered to be ofminor importance because of their insignificantissue sizes and lack of liquidity. Such noncon-ventional issues include convertible gilts (inwhich short-dated bonds may be converted tolonger-dated bonds), index-linked gilts, andirredeemable gilts (consols). Most gilt issuespay a fixed coupon. Floating-rate gilts, firstissued in March 1994, have coupon paymentslinked to the London Interbank Bid Rate(LIBID). Unlike fixed-rate gilts, interest onfloating-rate gilts is paid quarterly to investors.

Settlement in the gilt market is usually doneon the market date following the trade date(T+1), although two-day and seven-day settle-ments are also fairly common. Deals are nor-mally cleared through the Bank of England’sCentral Gilt Office (CGO). The CGO is linkedto Euroclear and Cedel. Interest is calculatedusing an actual/actual day count.

USES

Gilts are used for investment, hedging, andspeculative purposes by domestic and foreignentities. Foreign investors may buy gilts as ameans of diversifying their investment port-folios; however, gilts may also be used to hedgepositions that are sensitive to movements inU.K. interest rates or foreign-exchange rates.Speculators, on the other hand, may use long-term bonds to take positions on changes in thelevel and term structure of interest rates.


Issuing Practices

Gilt-edged market makers (GEMMs) quoteprices on a when-issued basis. Deals cannot besettled until the business day after the auctionwhen trading in the newly issued bonds offi-cially begins. The existence of a shadow market,however, ensures that the market can trade to alevel in which new bonds will be easily absorbed,thus limiting the chances of a surplus inventoryof bonds. (See ‘‘Sell Side’’ below.)

During the auction process, bids are acceptedon a competitive and noncompetitive basis.Competitive bids are for a minimum of £500,000and can be made at any price. Bids are acceptedgoing from the highest price to the lowest priceuntil the bank exhausts the amount of securitiesit wants to sell. If the issue size is not largeenough to satisfy demand at the lowest acceptedprice, bidders get a proportion of their requests.In such a bid, the BOE cannot give more than25 percent of the amount offered to any onebidder. Noncompetitive bids vary between£1,000 and £500,000 per bidder. Bonds areallocated to noncompetitive bidders at a priceequal to that of the weighted average of bidsfilled in the competitive auction.

The BOE also sells a fixed amount of securi-ties at a fixed price (tap form). This form ofissuance allows the BOE to respond to marketdemand and add liquidity to the market. Morespecifically, tap issues are normally done fromthe supply of bonds that have not been sold at anauction. Typically, bonds are held back with theintent to sell them when demand has improved


or when there is an increased need for funds. Ina tap issuance, stock is issued to GEMMs inthe form of ‘‘ tranchettes,’’ typically up to£500 million.

Payment for gilts may be made in full orin part. In a partly paid auction, competitivebidders are required to deposit a portion of theamount bid, and the rest is due after issue asspecified in the prospectus. In a partly paidauction, the first coupon payment and themarket price reflect the partly paid status ofthe gilt. After the installments are cleared asspecified in the prospectus, the partly paiddistinction disappears.

Secondary Market

U.K. gilts are traded on the London StockExchange, International Stock Exchange, andLondon International Financial Futures Exchange(LIFFE). Gilts can be traded 24 hours a day.Generally, gilts are traded on the InternationalStock Exchange between 9 a.m. and 5 p.m. andon the LIFFE between 8:30 a.m. and 4:15 p.m.and between 4:30 p.m. and 6:00 p.m. Thetypical transaction size in the secondary marketvaries between £5 to £100 million.

Market Participants

Sell Side

The primary dealers of U.K. government bondsare the GEMMs. GEMMs quote the exact size,amount, and terms of the issuance beginningeight days before an auction, thereby creating a‘‘ shadow market.’’ At this time, they quoteprices on a when-issued basis.

Buy Side

A wide range of investors use U.K. governmentbonds for investing, hedging, and speculation.These investors include banks, nonfinancial cor-porate and quasi-corporate public and privateenterprises, pension funds, charities, the pensiondivisions of life insurance companies, and pri-vate investors. The largest holders of gilts aredomestic entities, but foreign investors, includ-ing U.S. banks, are also active participants in themarket.

Market Transparency

The gilt market is active and price transparencyis relatively high for these securities. Severalinformation vendors, including Reuters, dissemi-nate prices to the investing public.

PRICING

Prices are quoted in decimals, rounded to twodecimal places.

HEDGING

U.K. gilts may be hedged for foreign-exchangerisk using foreign-exchange options, forwards,and futures. Gilts can be hedged for interest-raterisk by taking a contra position in another gilt orby using derivative instruments such as for-wards, swaps, futures, or options. Currently, theLIFFE gilt futures contract is the most heavilytraded hedging instrument. The effectiveness ofa particular hedge depends on the yield curveand basis risk. For example, hedging a positionin a six-year note with an overhedged position ina two-year bill may expose the dealer to yield-curve risk. Hedging a thirty-year bond with abond future exposes the dealer to basis risk if thehistorical price relationships between futuresand cash markets are not stable.

RISKS

Liquidity Risk

Gilts trade in an active and liquid market.Liquidity in the market is ensured by the BOE,which is responsible for maintaining the liquid-ity and efficiency of the market and, in turn,supervises the primary dealers of gilts. GEMMs,who act as primary dealers, are required to quotetwo-way prices at all times. An increase inforeign investment activity in the gilt market hasled to a substantial increase in competition andenhanced liquidity.

Liquidity is also enhanced through the BOE’sability to reopen auctions and tap issues. Theability to reopen issues improves liquidity andavoids the unfavorable pricing that may occurwhen the market is flooded with one very largeissue. A tap issue allows the BOE to relieve a

4250.1 United Kingdom Government Bonds


market shortage for a particular bond. An activerepo market allows market makers (GEMMs) tofund their short positions, and it improves turn-over in the cash market and attracts internationalplayers who are familiar with the instrument,which further improves liquidity.


Currency movements have the potential to affectthe returns of fixed-income investments whoseinterest and principal are paid in foreign curren-cies. The devaluation of a foreign currencyrelative to the U.S. dollar would not only affecta bond’s yield, but would also affect bondpayoffs in U.S. dollar terms. Some factors thatmay affect the U.K. foreign-exchange rateinclude—

• wider exchange-rate mechanism bands, whichincrease the risk of holding high-yieldingcurrencies;

• central bank intervention in the currencymarkets;

• speculation about the European economic andmonetary union and its potential membership,which puts European currencies under pres-sure vis-a-vis the deutsche mark; and

• endemic inflation in the United Kingdom.

Political Risk

A change in the political environment, withhold-ing tax laws, or market regulation can have anadverse impact on the value and liquidity of aninvestment in foreign bonds. Investors should befamiliar with the local laws and regulations

governing foreign bond issuance, trading, trans-actions, and authorized counterparties.


The Financial Accounting Standards Board’sStatement of Financial Accounting StandardsNo. 115 (FAS 115), ‘‘Accounting for CertainInvestments in Debt and Equity Securities,’’ asamended by Statement of Financial AccountingStandards No. 140 (FAS 140), ‘‘Accounting forTransfers and Servicing of Financial Assets andExtinguishments of Liabilities,’’ determines theaccounting treatment for investments in foreigndebt. Accounting treatment for derivatives usedas investments or for hedging purposes is deter-mined by Statement of Financial AccountingStandards No. 133 (FAS 133), ‘‘Accounting forDerivatives and Hedging Activities,’’ as amendedby Statement of Financial Accounting StandardsNos. 137 and 138 (FAS 137 and FAS 138). (Seesection 2120.1, ‘‘Accounting,’’ for furtherdiscussion.)


United Kingdom government bonds are assignedto the zero percent risk-weight category.


United Kingdom government bonds are type IIIsecurities. As such, a bank’s investment in themis limited to 10 percent of its equity capital andreserves.

United Kingdom Government Bonds 4250.1


introduction section 4000 - the fed · accounting treatment ... maturity, unsecured promissory note...

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