Debt: Money Market
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Money market instruments are
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defined as unsecured debts with 1 year or less to maturity.
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Commercial paper is
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a short term, unsecured/unfunded corporate debt, with a maximum maturity of 270 days.
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Commercial paper is an original issue discount obligation, quoted
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yield basis
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Commercial paper is mainly purchased by
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institutional investors, such as money market funds.
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Commercial paper is typically sold in
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large blocks
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maximum maturity for commercial paper is
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270 days (9 months).
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The most commonly available maturity is
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30 days
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Commercial paper is an exempt security under
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the Securities Act of 1933, and is sold without a prospectus, as long as its maturity does not exceed 270 days.
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A longer maturity than 270 days would require
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registration with the SEC - an expensive and time consuming process.
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A Banker's Acceptance is a
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draft on a bank, payable at a future date (typically 30-90 days in the future).
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\"post dated\" checks that
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are used to finance imports and exports.
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BAs trade at a
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discount to face; and mature at face; with the difference being the interest earned
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BAs are quoted
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on a yield basis.
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Prime Banker's Acceptance is
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one that is eligible for trading with the Federal Reserve.
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Prime BAs are issued
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by banks that are primary U.S. Government dealers.
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Negotiable Certificates of Deposit are
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$100,000 minimum face amount certificates that are issued by banks, and are very often issued in minimums of at least $1,000,000.
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Negotiable Certificates of Deposit are issued
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at a discount, these are issued at face and accrue interest above the face amount.
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Negotiable CDs are not FDIC insured for any amount
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that exceeds the $250,000 insurance limit.
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Banks issue both
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short term and long term negotiable CDs.
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Long term negotiable CDs have maturities
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over 1 year.Because of the long maturity, these are technically not a money market instrument.
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Long term negotiable CDs:
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accrue interest and pay semi-annually; are subject to reinvestment risk because of their longer maturity and semi-annual payment of interest; are subject to market risk because of their longer maturity; can be variable rate (a step-up or step-down CD); can be callable.
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Brokered CDs are
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long-term CDs issued by banks that are sold through brokerage firms.
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long term CDs, often with maturities of up to
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5 years.
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Because of the long maturity, if market rates rise after issuance,
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the market value of the security can drop below par.
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interest rate can be resettable, adjusting to market conditions every
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6 months.
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Initial interest rates can be set artificially high to attract investors
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he first adjustment date, the interest rate \"steps-down\" to the current market rate.
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no penalty for early withdrawal of funds, except
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for loss of interest to be earned for that 6 month period.
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if the CD is redeemed prior to maturity
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the customer will receive that market value at that moment in time - not par value.
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Long term CDs can be callable, so that if interest rates drop after issuance,
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the issuer can call in the CD, returning the investor's principal. The investor then must reinvest at lower current market rates.
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secondary market for these is quite
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limited - most are held to maturity or redemption.
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A \"step-down\" CD is
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starts with a high introductory \"teaser\" interest rate that is higher than the market rate at that moment. Then the rate \"steps down\" to the market rate of interest at a specified date or at specified intervals.
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CD steps down to a lower rate, this rate is usually a bit
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lower than the market rate at that time, so that, on average, the investor will still earn the market rate over the life of the CD.
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lower than the market rate at that time, so that, on average, the investor will still earn the market rate over the life of the CD.
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banks that are sold through brokerage firms.
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Bank deposits qualify for
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FDIC (Federal Deposit Insurance Corporation) insurance coverage, up to $250,000 per customer.
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brokered CD \"deposit\" to qualify for coverage
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CD must be titled in the customer's name
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. It cannot be held in
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\"street\" name in the name of the brokerage firm.
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In determining coverage per customer,
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all deposits that the customer already had at the issuing bank, plus the CD held at the issuing bank,are aggregated
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Structured products
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are securities based on, or derived from, a basket of securities, an index, or other securities, commodities or currencies.
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There are many types of structured products, but generally
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they consist of a \"bond\" portion, which pays interest based on the performance of a well-known index such as the S & P 500 Index or NASDAQ 100 Index. However, there is most often a cap on the maximum annual return.
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structured products have a derivative component (an embedded option) that
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allows the holder to sell the security back to the issuer (at par) at maturity, protecting principal
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Structured products are created by
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many different brokerage firms and each firm's version is somewhat different. They can be exchange listed, though trading is typically pretty thin
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Market Index Linked Certificates of Deposit tie their investment return to an equity index, usually
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the Standard and Poor's 500 Index.
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it appears that this is a hybrid product that gives the advantages of a bank certificate of deposit
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(FDIC insurance up to $250,000; no risk of loss of principal) long with a \"stock market\" rate of return
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FINRA has seen increased sales of market index linked certificates of deposit and worries
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that investors are not being informed of the differences between traditional CDs and these hybrid products.
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Market Risk
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Redemption of a traditional CD prior to maturity might involve a loss of interest; but there is no loss of principal.
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can be penalties imposed for redeeming a market index linked CD prior to maturity (most have a minimum 3 year maturity) that result
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in a loss of principal (e.g., a 3-5% principal penalty for early withdrawal has been fairly common). Thus, market index linked CDs can have market risk if there is an early redemption.
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Liquidity Risk
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because these cannot be redeemed on demand.; Most market index linked CDs only allow redemption on pre-set quarterly dates. During the rest of the year, these cannot be redeemed.
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Return may have a Limit
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market index linked CDs place a cap on the amount that can be earned. For example, in a year when the S & P Index rises by 10%, there might be a cap limiting earnings on the product to, say, 6%.
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Tax Issues
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the return is linked to an equity index, returns are taxed as \"interest\" - maximum rate of 35% (or 39.6% for very high earners) as opposed to the maximum tax rate on dividends and long-term capital gains of 15% (or 20% for very high earners).
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Credit Risk
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if the issuing bank goes \"bust,\" there is nothing backing these securities other than \"faith and credit\" of the issuing bank
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if the CD is titled in the customer's name, it does get
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FDIC insurance.
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customers are attracted to CDs for
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their safety and known rate of return. there is some market risk and a potentially higher rate of return (subject to limits)
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\"reasonable basis\" suitability determination has been completed, then the member firm can offer the structured product only
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to its customers that are suitable for that investment. This is \"customer specific\" suitability.
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ETN is
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Exchange Traded Note. It is a type of structured product offered by banks that gives a return tied to a benchmark index.
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debt of the bank
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is backed by the faith and credit of the issuing bank.
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if the bank's credit rating is lowered,
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the value of the ETN will fall as well - so it has credit risk.
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ETNs are listed on
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an exchange and trade, so they have minimal liquidity risk.
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ETN returns can be based on \"exotic\" indexes
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such as a Brazil or India index, so they can give investors access to the returns of foreign markets.
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ETNs make
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no interest or dividend payments
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Their value grows as they are held based on the growth of the benchmark index, with any gain at sale or redemption currently taxed at capital gains rates. Thus,
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they are tax-advantaged as compared to conventional debt instruments.
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Exchange Traded Note (ETN) is a
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debt of the issuing bank, and is backed by the faith and credit of the issuing bank. Thus, if the bank's credit rating is lowered, the value of the ETN will fall as well - so it has credit risk.
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ETNs are listed on an
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exchange and trade, so they have minimal marketability risk.
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ETNs, as with all securities that trade, are
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subject to market risk (the risk of a general decline in prices).
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ETNs avoid liquidity risk
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because they are exchange traded
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ETNs avoid reinvestment risk
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there are no actual interest payments made - the \"interest\" earned is credited to the ETN holder and \"grows\" the value of the investment automatically, with the gain in value taxed at lower capital gains rates.
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Reverse convertible notes were
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created for customers looking for enhanced yield in a low interest rate environment. Of course, any enhanced yield comes with higher risk.
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, if, at maturity, the reference stock falls below
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\"knock-in\" price, then the holder will receive the shares of stock.
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structured note typically has a
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1-year maturity
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The holder gets a higher interest rate, but
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takes the risk of losing on the underlying equity security if the market price of the stock drops below the \"knock-in\" price as of the note's maturity date.
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Auction Rate Securities are long-term debt issues
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where the interest rate is reset weekly (or monthly) via Dutch auction (an auction where the bids are accepted from low interest rate on up and the last interest rate bid that will \"clear\" the auction is given to all bidders). ARSs are available from both corporate and municipal issuers.
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This gives the issuer the advantage of
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paying a short-term market interest rate on a long-term security.
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these securities do not have an
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put option, so they cannot be \"put\" back to the issuer at the auction reset date.
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, a holder of an ARS needs to find a buyer at the auction if it wishes to sell.
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A lack of bidders at the auction means that holders cannot sell these securities - which is exactly what happened when the market \"froze\" in early 2008
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Broker-dealers that acted as agents for corporations and municipalities that issued ARSs would typically bid at the weekly auctions, but they pulled out
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credit conditions worsened and the market imploded.
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Simply put, a failed auction will result
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if there are more sellers than buyers. Thus, if there are offers (sellers) of the securities without corresponding buyers (bidders), then the auction will fail.
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auction is conducted as a \"Dutch Auction,\"
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where bids are accepted in minimum $25,000 increments to buy the amount of securities offered.
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bids are accepted from
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lowest interest rate on up to highest interest rate, and bids are accepted until the total amount offered is sold. The highest interest rate that is accepted to complete the sale of the issue is called the \"Clearing Rate\" and the entire offering gets this interest rate for the next week
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auction agent sets
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the \"Clearing Rate,
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\"Clearing Rate,\"
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which is the interest or dividend rate necessary to \"clear\" the sale of all securities offered by sellers.
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If bids received are at interest rates that
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are at or below the maximum or clearing rate, the auction is conducted and the bids are filled.; There is usually a maximum interest rate set in any auction
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If bids are received at interest rates that are above the maximum (which implies that market conditions are very unsettled) then
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the bids are not filled and the auction has \"failed.\"
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Sellers must hold their positions and will receive the maximum interest rate for that week,
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after which another auction will be attempted.
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Repurchase Agreement
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an overnight agreement where a government securities dealer sells part of its inventory overnight (to get cash) to another dealer; the other dealer earns interest on a 1 day loan.
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the next day, the repurchase agreement is
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closed-out with the return of the securities at a slightly higher price (the difference is the interest earned)
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Repurchase agreements allows government dealers
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with excess cash to earn extra interest income; and allows dealers with cash deficits to obtain the cash at a low financing rate.
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rate of interest charged is the
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\"Repo\" rate, which tracks, but is somewhat lower than, the Fed Funds rate.
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Repurchase agreements have no
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credit risk, and virtually no liquidity risk.
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Repurchase agreements do have
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market risk, since the value of the underlying securities used as collateral can move in response to interest rate movements.
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Federal Reserve can enter
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repurchase agreements with the primary dealers as a means of controlling credit availability in the economy.
