Mini Chapter Five
Money Market and Cash Bonds
Vanilla Cash Products
Let’s begin with the most basic building block of the fixed income cash market that would become the foundation of derivative instruments ahead.
- Money Market Instruments – Are single cash flow simple interest-bearing products, typically up to a 12-month tenor. They could be issued at par or discount, can be negotiable or non-negotiable though economically there isn’t any difference between the two.
- Negotiable instruments are those that do not need the issuer’s/originator’s permission to trade onward. The most basic form it can take is a bearer cheque i.e. if one issues a bearer cheque to person A they are free to pass it onward for the receiver to encash it. Other real market examples are a treasury bill, a certificate of deposit, a commercial paper et al.
- Examples of non-negotiable instruments i.e. those that cannot be transacted onward without both parties’ consent are bank deposits, inter-bank call/notice money, repo borrowing/lending, trade receivables, bill discounting et al.
- A simple formula for understanding the return on a money market instrument:
Where:
FV: Future Value,
PV: Present Value,
r: simple rate of interest,
t: TenorÂ
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- Coupon Bearing Instruments – these are non-zero interest/coupon bearing financial products with multiple cash flows during the tenor of the product. Examples are sovereign and corporate bonds, medium term notes, or any other interest bearing security. One could also think of Bank Loans, External Commercial Borrowings in the same vein just that these are non-negotiable in nature. Yield on these instruments is understood as the internal rate of return (discussed earlier) or the yield to maturity.
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- We have discussed fixed cash flows above, but coupon bearing instruments could also have floating coupons tied to a benchmark index decided at the time of issuance reset at regular intervals for eg. mortgage rates linked to prime lending rate plus a spread, inflation linked notes/bonds, floating rate bonds linked to SOFR.
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- Another popular variation are the zero coupon bonds i.e. for the present value formula above the coupon is set at zero with IRR calculated as the compounded rate for the tenor of the bond. While this is a single cash flow instrument the return on it is referenced as its IRR (as it’s typically longer than 1y and a compounded rate) that’s different from a money market instrument return (also zero coupon in nature but simple interest up to 12 month tenor).
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- As an example a 5y Zero coupon bond with a maturity value of 100 @ an IRR of 4% has a PV as denoted below:
- A coupon bearing bond can be considered as a package of cash flows occurring at different tenors. Each of the component cash flow is effectively a zero coupon bond out to their respective tenor and can be traded / valued independently. In certain markets one could essentially separate the tenor-specific cash flows (coupon or principal) in a coupon bearing bond and trade each of them as independent securities (aka zero coupon bonds) called coupon and principal STRIPS (Separately Traded Registered Interest and Principal Securities). STRIPS typically trade as deep discount bonds, where the independent STRIPS are sold to a diverse investor base who would likely pay a higher price for it than where it trades as part of a package of cash flows.
- One could also in theory reconstitute individual components of the STRIPS and trade them back as a single bond package. In theory, the ability to strip and reconstitute allows for a better price discovery of the different tenor cash flows in a bond.Â
- Trivia
Long term liability holders (Insurance/ pension funds) prefer zero coupon long dated bonds (still better long dated STRIPS) to lock in the IRR and mitigate the reinvestment risk effectively maximising the duration of their portfolio.
