Level 1 CFA® Exam:
Fixed-Income Markets & Bond Market Sectors
Fixed-Income Classifications of Markets & Sectors for CFA Candidates
star content check off when doneThis lesson is to serve as a kind of catalogue of different types of fixed-income markets and bond market sectors to be used in your level 1 CFA exam. What we mean to do here is to have a go at various classifications used by investors. We will enumerate different types of fixed-income markets and, at the end of the lesson, we’ll touch on the subject of primary and secondary bond markets.
Even though there is no formally accepted division of global fixed-income markets, different classifications exist. These classifications are built upon certain criteria distinguishable for these markets, such as the type of issuer, the bond’s credit quality, bond maturity, currency denomination of the bond, the type of coupon, as well as the place of issuing and trading bonds.
We should have a look at them one by one.
First of all, we said that we can classify fixed-income markets by the type of issuer. This, generally, leads us to distinguish 3 bond market sectors, which include:
- the government and government-related sector,
- the corporate sector, and
- the structured finance sector.
The government and government-related sector refers to bonds issued by governments, both at the national and local level, but also by many different international organizations, such as the World Bank, or quasi-government entities either owned or sponsored by governments, for example rail services.
The corporate sector relates to bonds that are issued by financial or non-financial companies.
Finally, the structured finance sector, which is also called securitized sector, includes securitized debt instruments.
From among all the entities that we enumerated, governments and financial institutions are the largest issuers of bonds. What is also quite interesting, the importance of the three bond market sectors that we’ve mentioned, differs worldwide among countries.
Another way of classifying bond markets is according to the credit quality of bonds.
(...)
Let’s now try to make a classification of fixed-income securities according to their original maturity. We will distinguish here:
- money market securities, which are securities whose original maturity ranges from overnight to one year; Treasury bills fall into this class of fixed-income securities, and
- capital market securities, which are secu¬rities with an original maturity longer than one year.
With respect to money market securities, it is worth mentioning that this class includes also some fixed-income securities which are issued by the corporate sector and which are characterised by relatively short maturities. Commercial paper serves as a good example here.
This time it’s going to be the classification by currency denomination. Bonds issued in global markets may be denominated in different currencies. The lion’s share of these bonds are denominated in euros and U.S. dollars. Depending on the currency that a bond in denominated in, the bond’s price is subject to the interest rates of the country or region where the currency is used.
The next classification is the classification by the type of coupon. There are a couple of things that we have to mention here.
(...)
We may divide bonds into:
- domestic bonds,
- foreign bonds, and
- Eurobonds.
If some bonds are denominated in the currency of a given country and they are issued and sold in that country, and if their issuer is from that particular country, we are dealing with domestic bonds. If, however, the issuer of the same bonds was domiciled in another country, we would speak of foreign bonds. Because both domestic and foreign bonds are directly related to one particular country, they are governed by the law of this country, also tax-wise. This is why issuers often opt for Eurobonds, which are not subject to jurisdiction of any particular country and, thus, are less restrictive. Eurobonds are bonds traded in the so-called Eurobond market.
As far as the worldwide classification of markets is concerned, we also have to mention:
- developed markets, which refer to countries with established capital markets, and
- emerging markets, or in other words countries with their capital markets in earlier stages of development.
Within emerging bond markets, currency denomination decides about the division into:
- local currency bonds, and
- foreign currency bonds.
The latter include bonds denominated in the euro or the U.S. dollar.
Emerging market bonds draw investors’ interest mainly because of attractively high yields, but also for the sake of risk diversification.
(...)
Primary & Secondary Bond Markets: Definitions
We speak of primary bond markets when bonds are sold directly after their issuance by their issuers with the aim of raising some capital. Secondary bond markets are markets of re-used bonds, so to say, which means that investors trade in bonds already existing in the market among themselves.
Appropriate authorities regulate and control these markets, their structure and their participants’ credentials.
Issuance of brand new bonds is quite a common phenomenon in fixed-income markets. Depending on the type of issuer and bond issued, different procedures are used. Among them, we distinguish:
- public offerings, in which issued bonds are addressed to the general public, and
- private placements, when only selected investors are able to engage in the purchase.
Public offerings may be further divided into:
- underwritten offerings,
- best effort offerings, and
- auctions.
Let’s say a few words about each of these bond issuing mechanisms.
First come underwritten offerings, also known as firm commitment offerings. When talking about this category of public offerings, we have to mention things such as investment bank, offering price, underwriter, or syndicated offering. When an issuer decides to issue bonds via an underwritten offering, it seeks an investment bank, which serves as an underwriter.
What does it mean that the investment bank is an underwriter? It means that it takes on the responsibility for the issuance of bonds and guarantees its sale at the offering price previously agreed upon with the issuer. For larger bond issuances, syndicated offerings are rather common, which is when a group of investment banks becomes the underwriter. One of the banks is always the leader, which we describe by the name: ‘lead underwriter', and invites other banks to join the syndicate.
Underwritten offerings are generally used for corporate bonds, some local government bonds (such as U.S. municipal bonds), and some securitized instruments (for example mortgage-backed securities).
Let’s see how the process of issuing bonds under an underwritten offering looks like. Typically, we identify the following steps:
(...)
The next type of public offering that we mentioned was the best effort offering. The difference that you need to know is that here the investment bank does not act as the guarantor of the whole process but serves only as a broker. What it means is that it helps to sell the bonds for a commission. The investment bank does not, however, bear any responsibility if it’s unable to sell any of the issued bonds.
The next type of public offering is an auction. It is based on bidding. There are two kinds of bids: competitive and non-competitive bids. Competitive bidding is when bidders themselves determine the interest rate, but if at the auction it proves too high, they will not receive any offers to buy bonds – in other words, they will be excluded from the auction. In non-competitive bidding, bidders accept the rate set at the auction and they always receive their bonds.
We also need to distinguish between single-price auctions and multiple-price auctions. The former is when all bidders pay the same price and get the same coupon rate for the same bond issue. It is very common in the US. Multiple-price auctions are conducted for example in Germany or Canada and they involve various prices and various coupon rates for the same bond issue.
Every bond issuance has its offering prospectus. Shelf registration is a mechanism that allows big companies that have proved themselves to be successful issuers to issue new bonds under the same prospectus. Thus, there’s no need to prepare a new document, and the old terms apply to multiple bond issues even for years.
We are dealing with private placement when only selected investors are able to engage in the purchase. Typically, these are large institutional investor that do not need all of their investments to be liquid. This is quite important because there is no secondary market for bonds issued via private placements. Such bonds are issued only for selected investors through unregistered offerings and are delivered by issuers directly to these investors.
Sometimes investment banks participate in private placements, but such offerings are never underwritten. Since bonds issued via private placements are limited to certain investors only, these investors have the right to influence the bond issue in order to tailor it to their needs.
Bond secondary markets are markets for already existing bonds. For this reason, it is also called the 'aftermarket'. The participants of bond secondary markets are usually large institutional investors and central banks.
Secondary markets make use of two ways of trading in securities, namely organized exchange and over-the-counter markets (aka. OTC markets). When a transaction is held through organized exchange it has to follow the rules established by the exchange and be conducted in the exchange, whereas if bonds are traded in the OTC market, electronic trading platforms are used. Generally, in secondary markets, bonds can be traded either directly among investors or with the aid of brokers or dealers.
(...)
Level 1 CFA Exam Takeaways: Fixed-Income Markets & Bond Market Sectors
star content check off when done- We can classify fixed-income markets by the type of issuer, credit quality, maturity, currency denomination, types of coupon, and by geography.
- We speak of primary bond markets when bonds are sold directly after their issuance by their issuers with the aim of raising some capital. Secondary bond markets are markets of re-used bonds, which means that investors trade in bonds already existing in the market among themselves.
- Public offering is when issued bonds are addressed to the general public, and private placement is when only selected investors are able to engage in the purchase.
- If an investment bank is an underwriter, it means that it takes on the responsibility for the issuance of bonds and guarantees its sale at the offering price previously agreed upon with the issuer.
- In case of the best effort offering, an investment bank does not act as the guarantor of the whole process but serves only as a broker.
- An auction is based on bidding. There are two kinds of bids: competitive and non-competitive bids.
- Shelf registration is a mechanism that allows big companies that have proved themselves to be successful issuers to issue new bonds under the same prospectus.
- Secondary markets make use of two ways of trading in securities: organized exchanges and over-the-counter markets (aka. OTC markets).
- The bid-offer spread (aka. bid-ask spread), shows prices at which dealers are willing to buy and sell bonds. This spread serves well as an indicator of liquidity.