MONASH

BUSINESS
SCHOOL

BFC5926
Financial Institutions and Markets

Seminar 5:
Medium/ Long Term Debt
Markets
Reading list Topic 5
 Learning outcomes

• Explain the various features of debt securities and

how they may impact on their value.
• Define and contrast the characteristics of specific
medium to long term debt securities.
• Explain how credit ratings operate and their
changes impact on the Australian debt market.
• Understand the types of securitisation, their
various risks and uses.

2
 Lecture outline
1. Features of debt securities - coupon rate,
reinvestment, other factors, collateral
2. Government bonds
3. Corporate debt securities - bonds and foreign
bonds
4. Securitisation - mortgage / asset backed

3
 Features
of
Debt Securities

4
 Bonds
• Bonds are medium to long term debt instruments.
They typically pay interest based on a coupon rate
which remains constant for the bond's life.
• The coupon rate times the face value divided by two
gives the twice yearly (semi-annual) interest payment
an investor in Australia can expect.
• This series of equal interest payments (an annuity)
plus the repayment of the bond's principal or face
value on maturity determines its market value.

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6
 A bond's market value
• the present value of the annuity stream (interest) plus
the one time repayment on maturity (face value) when
discounted at the appropriate risk adjusted rate should
equal a bond’s market value.
• As a change in discount rates (market interest rates)
impacts present values of payments to be made in the
distant future more (due to this discount rate being
applied for t number of periods), the prices of long
term bonds will fluctuate more than short term bonds
for any given change of interest rates in the market.

7
 Yield to maturity (YTM)
– Yield to maturity = bond coupon rate
 bond trading ‘at par’ i.e. PV (price of bond) = FV

– Yield to maturity > bond coupon rate

bond trading ‘at discount’ i.e. PV (price of bond) < FV

– Yield to maturity < bond coupon rate

=> bond trading ‘at premium’ i.e. PV (price of bond) > FV

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 Other bond features and value
• Default (credit rating*) and reinvestment risk
– Time left to maturity
– Coupon rate
– Security available (most are unsecured)
– Other credit enhancements (insurance)
• Callable or not
• Other features (convertibility or currency)
• Secondary market liquidity (price risk)

9
 Credit ratings
• Credit ratings are an independent assessment of a
debt issue's potential to default – to not pay its
interest or capital when due.
• The ratings business is dominated by Standard &
Poor's, Moody's and Fitch.
• A potential debt issuer would pay one of these CRA’s
for an indicative or informal view and then, if
pleased, request a formal rating. A fee is paid in
each instance to credit rating agency.
• The highest rating, AAA, indicates a very strong
borrower with little default risk. In contrast, a single
C or D rating means the issuer has defaulted.

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Moody’s S&P & Fitch Information Conveyed
Aaa AAA Highest quality
Aa1 AA+

Investment Grade
Aa2 AA High quality
Aa3 AA-
A1 A+
A2 A Strong/good quality
A3 A-
Baa1 BBB+
Baa2 BBB Adequate quality
Baa3 BBB-
Ba1 BB+
Ba2 BB Adequate in short term
Ba3 BB-

Speculative Grade
B1 B+
B2 B High risk
B3 B-
Caa1 CCC+
Caa2 CCC Likely to default
Caa3 CCC-
Ca CC Highly vulnerable to default
C SD In default

11
 Australian bond spreads & rating

Source: Reserve
Bank of
Australia ( Feb
2019), Chart
Pack.

12
 Sovereign risk
• Australia was one of a dozen countries that
hold a AAA sovereign risk rating (S&P and
Moody’s, only 11 according to Fitch).
– See https://www.austrade.gov.au/News/Economic-analysis/australias-aaa-credit-rating-a

• If this was downgraded, it would increase the

borrowing costs of not only itself, but also all
other Australian based borrowers – particularly
the Australian
– See: http://www.abc.net.au/news/2017-05-31/s&p-ratings-boss-says-australias-in-
trouble/8577312

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 Unsecured debt
• Unsecured debt depends on the issuer's good faith
and credit.
• On liquidation, these debt holders must wait until all
secured creditors are paid. Their debt, however, will
be repaid before ordinary and preference
shareholders receive any funds.
• Subordinate debt holders are even worse placed in
that they must wait till all unsecured creditors are
paid before they can obtain their funds.
• Unsecured corporate debt can be issued with or
without covenants.

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 Covenants
• Unsecured debt holders may still gain some protection by
using covenants to limit what the borrower can do with its
business and financial activities.
– Positive covenants require the borrower to maintain
certain ratios ( i.e. interest covered, working capital, and
gearing) while the debt is still outstanding.
– Negative covenants preclude the issuer taking certain
actions (prohibiting the sale of major fixed assets or
selling parts of the business) without the debt holders
permission.

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 Types of collateral / security
• Secured debt instruments are supported by either a
fixed or a floating charge:
– A fixed charge is over a particular asset which
gives the holder first rights to any proceeds from
the forced sale of this asset.
– A floating charge gives the first rights to the
proceeds of all assets not otherwise pledged
against fixed assets. These free assets are
sometimes known as “circulating assets.”
• Access to the collateral can also be covered by first
and second ranking charges.

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17
 Treasury bonds
• Treasury bonds (Commonwealth government securities –
CGS or GS) are the Australian government's medium to
longer-term means of funding.
• Most have a fixed rate coupon and pay interest on a six
monthly (semi-annual) basis.
• In contrast, Treasury Indexed Bonds have their Face Value
adjusted for consumer price index (CPI) movements;
coupons are paid quarterly
• Since 2013, Treasury bonds have been traded on the ASX,
but most trading is still in the wholesale market.

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 Treasury bonds
Pricing treasury or corporate bonds:
 1 (1 i )n  
P  C  n
  A(1 i ) (1 i )
k
  i  

where :
i  the nominal interest rate per period expressed as a decimal
n  the number of coupon periods
k  the fraction of the elapsed
interest period since the last coupon payment
C  periodic coupon payments
A  the face value of the bond

19
 Treasury bond pricing example(Manual)
An existing Treasury bond has been issued with a face value of
$1000. The bond pays half-yearly coupons of 7% per annum, and
matures on 15 November 2017. Assume that the bond is sold on
15 July 2014. Current yields for similar Treasury bonds are 8%
per annum. Calculate the price of the bond in the secondary
market.
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 1 (1 0.04)7  

P  $35  
  $1000(1 0.04) (1 0.04)184
7
  0.04  
 
 [$210.07  $759.92]1. 013087
 $982.68

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 Treasury bond pricing example(with HP)
• Clear the bond register : C 7 The ”bond clr” message
flashes in the display to indicate the registers have been cleared.

• Set the date format Verify date format is M.DY. If

the D.MY annunciator is displayed press: INPUT

• coupon payment pattern Verify the coupon payment is

semi-annual press : CST

• Store Call(Face) value input the numbers using the

numbered keys and press : FV
• Actual or 360 calendar? Verify the actual calendar is active.
Press: MU

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 Treasury bond pricing example(with HP)
• Store the annual coupon rate : Input semi annual
payments(35) using the numbered keys and press PMT

• Store the yield : Input semi annual yield(4) using the numbered keys.
Press I/YR

• Store the settlement date in month-day-year

(mm.ddyyyy) format : input 7.152014 using the numbered keys
and press PRC

• Store the maturity date. Input 11.152020 using the numbered

keys. Press MAR

• Calculate the price. Press PV

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 Bonds on issue by issuer type

Source: Reserve Bank of

Australia (Feb 2019),
Chart Pack

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 Debentures
• A debenture in Australia was traditionally a
secured form of corporate debt with a medium to
longer-term maturity. This security may be
provided either a fixed or floating charge against
the issuer’ assets.
• There may also be first ranking and second ranking
debentures.
• Debentures typically have a fixed interest coupon
rate, typically set when the security is issued.
• In the USA, debentures are unsecured debt.

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 Unsecured notes
• These securities rely solely on their issuer's good
faith and credit.
• Their only protection offered is usually through a
negative pledge arrangement and a debt covenant.
• The former involves the issuer promising not to
take certain actions while the latter involves
promising to fulfil certain conditions.
• Most corporate debt issues in Australia are
unsecured.

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 Retail losses in corporate debt
• All were unlisted and unrated property related
finance businesses:
– Westpoint (2005) with some 4,000 investors losing
$300 million in unsecured promissory notes.
– Fincorp “First Ranking Notes” with advertisements
suggesting these loans were secure (30 cents in a $
return; Unsecured Notes – Nil return)
– Australian Capital Reserve (2007), 7,000 investors
in TV $300 m “deposit notes” (60 cents in a $)
• ASIC guidelines now require issuers and trustees to
be licensed and all debentures to have credit ratings.
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 Retail corporate bonds
• In 2001, ASIC introduced new rules on retail debt issues
made by qualified listed companies.
• The debt must be listed, follow the normal trustee rules,
be denominated in Australian dollars, have a fixed
maturity of no more than 10 years, pay periodic interest
(fixed or floating rate), not be sub-ordinate or convertible,
sold at the same price to all investors, and for at least
$100 million.
• The listed firm must have its shares quoted for at least
three months, not suspended for more than 5 days, and
have an unqualified auditor's report.

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 Foreign bond issues
A foreign bond issue is long-term debt raising by a
foreign borrower made in a domestic debt market
(AUD bonds issued in Australia by a US borrower):
– Foreign issues in USA - yankee bonds
– Foreign issues in UK - bulldog bonds
– Foreign issues in Japan - samurai bonds
– Foreign issues in China – panda bonds
– Foreign issues in Hong Kong – dim sum bonds
– Foreign issues in Australia – kangaroo bonds

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Foreign bond issues

Source: Reserve Bank

of Australia (Feb
2019), Chart
Pack

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 Panda bonds
• Panda bonds, renminbi-denominated bonds
sold by foreign entities to investors in China,
offer lower interest rates than dim sum bonds,
which are sold offshore.
• The panda bonds commenced in 2005 with
issues from the International Finance
Corporation and the Asian Development Bank.
In August 2015, Poland became the first
European country to offer panda bonds.

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Panda bonds

Source: Reserve Bank

of Australia (Feb
2019), Chart
Pack

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33
 Securitisation
• Securitisation is the creation and sale of new
tradeable financial assets based on other, typically
illiquid assets, like existing loans.
• By shifting the risks and cash flow streams, structured
finance makes these otherwise illiquid assets
marketable.
• The mortgage originator (bank) creates a portfolio of
residential mortgage loans. It then creates a separate
vehicle (SPV), usually a trust, to purchase them. The
SPV then raises the cash to pay for these assets (loans)
through the issue of its own debt securities.

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USA bank before securitisation
100 100

Loans and Capital and

other assets Liabilities

35
Bank then creates a separate pool of $20 worth of loan
100 100
Loans and
other assets Capital and
Liabilities

80

Home loans

20

36
The bank then creates a SPV and sells it the $20 loan
pool

Home loans
Loans and Special
other assets 20 purpose
vehicle
Cash
80
20

37
The SPV raises $20 cash by selling own debt

Cash
$

Special
$
purpose
Investors
vehicle
(SPV) $

$
$20
Debt
securities $

38
USA bank after securitisation
100 100
Loans and
other assets Capital and
Liabilities

80

Cash

20

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 Impact of the simple US example
• The bank now has $20 of cash that it can use to make new
loans.
• This $20 was much cheaper than $20 worth of deposits due to
the costs involved and the credit ratings.
• It reduced its risky asset holdings and so also reduced its risk
weight capital adequacy ratio requirement – so less Tier One
capital is now needed.
• The bank removed the risk associated with these loans to debt
securities issued by SPV (loan default risk now with investors).
• As the bank was appointed to manage the SPV’s loan portfolio,
it has created a stream of future fee income.

40
 Australian securitisation
• The above example reflects the practiced overseas but Australia
is rather different.
• Australian securitisation regulation developed prior to the
accounting profession developing a standard.
• So whereas the bank originated debt in the USA might be
securitised via a “clean sale” to a third party and managed by
some one different. Australian borrowers would seldom know
that their mortgage was securitised. This is because loans
typically remain on the bank’s books for accounting purposes,
but not for regulatory capital calculations.

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 Securitisation plus for banks
• Help avoid RWCAR* on balance sheet lending
• Potentially lower cost of funds (higher rating)
• Diversifies funding sources and maturities
• Reduces the need for deposit raising
• Can remove fixed rate debt from the portfolio and
hence reduce duration gap problems
• The resulting cash improves liquidity
• Reduce default exposure (to certain geographic areas
/ asset types)
• May reduce prepayment risk (early repayment)
• Enforces greater transparency
* Risk weighted capital adequacy ratio

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 ADIs are not the only ABS issuers

Source: Reserve Bank of

Australia (2017), Financial
Stability Review, April.

Note that non-ADI issues

were very active prior to
the GFC and have only
started to return in
importance. These lend
typically to more risky
borrowers.

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 Types of securitised products
• Residential mortgage backed securities
(RMBS)
• Commercial mortgage backed securities
(CMBS)
• Asset backed securities (ABS)
• Collateralised loan obligations (CLOs)
• Collateralised debt obligations (CDOs)
Each are discussed separately in subsequent slides

44
 Securitisation issues in Australia

Source: Australian Securitisation Forum (2017), Market Snapshot, 31 July

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 RMBS products
• On the asset side, residential mortgages were for owner
occupied housing, but investment properties are now
important. Some issues will now include higher risk but
higher return low-doc and jumbo loans in their portfolio.
• On the liability side, the SPV issues debt securities with
some maturity and risk choice to investors. These
tranches are usually structured so that the senior
security has an AAA rating.
• The subordinate nature of the junior issues mean that
they suffer any credit loss first.

46
A tranche liability structure

47
 Australian Capital Territory – Metropolitan 2.33%

Westpac Australian Capital Territory - Other

New South Wales – Sydney Metropolitan
0.00%
28.15%

Securitisation New South Wales – Other

Northern Territory – Darwin Metropolitan
7.67%
0.68%

Trust (WST) Northern Territory – Other

Queensland – Brisbane Metropolitan
0.30%
9.41%

RMBS Queensland – Other

South Australia – Adelaide Metropolitan
9.23%
3.60%

collateral pool Tasmania – Hobart Metropolitan

Tasmania – Other
0.39%
0.67%
Victoria – Metropolitan 21.33%
Victoria – Other 3.05%
Western Australia – Perth Metropolitan 3.85%
Western Australia – Other 1.23%
Other 2.27%
Source: Westpac Banking Corporation, WST Trust
Series 2011-2 Information Sheet, 2011 Total 100.00%

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 WST RMBS collateral pool data
Number of Housing Loans 5,904

Housing
Number ofLoan Pool
Housing Size (A$)
Loans 5,904 2,158,371,430
Housing Loan Pool Size (A$) 2,158,371,430
Average Housing Loan Balance (A$) 242,405
Average Housing Loan Balance (A$) 242,405
Maximum Housing Loan Balance (A$) 1,480,000
Maximum Housing Loan Balance (A$) 1,480,000
Total Valuation of the Properties 3,795,499,130
Total Valuation of the Properties 3,795,499,130
Weighted Average Current Loan-to-Value Ratio
Weighted Average Current Loan-to-Value Ratio 61.89%
61.89%
Weighted Average
Weighted Average Seasoning
Seasoning (months)
(months) 37 37
Weighted Average
Weighted AverageRemaining Term to
Remaining Maturity
Term (months) (months)
to Maturity 315 315
Maximum Current Remaining Term to Maturity (Months) 359
Maximum Current Remaining Term to Maturity (Months) 359
Percentage of Interest Only* 5.28%
Percentage of Interest Only* 5.28%
Percentage of Principal and Interest Only* 24.72%
Percentage of Principal and Interest Only* 24.72%

Source: Westpac Banking Corporation, WST Trust Series 2011-2 Information Sheet, 2011
 RMBS loan to value ratios

Source: Australian Securitisation Forum (2017), Market Snapshot, 31 July

Note – lower loan to valuation ratios (LVRs) and longer seasoning periods both mean less risky debt.
Seasoning refers to the number of repayments made on the loan in terms of months.

50
 Commercial MB securities
• Commercial mortgage backed securities (CMBS)
involve loans related to non-residential real estate.
They have apparently proved popular in the UK, but
have not been so popular in Australia.
• One measure to enhance their standing is to use
“Small balance CMBS.” These are backed by a large
portfolio of much smaller loans averaging around A$
8 to 10 million each. The lower size affords more
diversification than larger commercial mortgages.

51
 Asset backed securities
• While asset backed securities (ABS) sometimes refer to
all securitisation products, it normally refers to only
non-mortgage related assets.
• Virtually the rights to any cash flow can be financial
engineered to back a securitisation issue.
• The importance of non-mortgage related asset backing
will increase as the local market develops.
• Credit card and charge card receivables as well as
equipment leases are asset backed examples.

52
 Collateralised loan obligations
• CLOs allow banks, via securitisation, to remove
credit risk from their balance sheet.
• Unlike other securitised products, they relate to
ordinary business loans rather than mortgages.
• They were initially attractive to international
institutional investors seeking to diversity their debt
portfolios.
• They have not been so popular as yet in Australia.

53
 Collateralised debt obligations
• A CDO is financial engineered asset back security that
became infamous during the GFC. Rather than a
portfolio of all same assets, like residential first
mortgages, a CDO uses a mixed (heterogeneous)
portfolio of debt types, sizes and credit ratings.
• Three to seven year bonds account for 55% of CDO
underlying portfolios and 25% loans.
• Subordinate tranches are used to enhance the credit
standing of the senior or “super” senior tranche.

54
 CDO and credit ratings
• These subordinate tranches mean that a CDO could
have both a AAA and BB credit rating at the same time.
It is function of each tranche’s seniority.
• Recent CDO problems reflect their relatively poorer
secondary market liquidity than credit risk.
• The press more reflects hedge funds Basis Capital that
borrowed heavily and then invested in CDOs. When
the CDO declined in line with higher interest rates, the
resulting leverage resulted in huge losses and partly
contributed to the GFC.

55
 Credit default swaps
• A credit default swap is a derivative contract that provides
synthetic insurance against an issuer defaulting on their debt.
The writer (seller) agrees to pay the buyer a specific amount
(the loss) should the security in question default.
• Unfortunately, there is yet no central exchange or clearing
house to net exposures or to record the exposures of
counterparties. No capital is required to provide this
"insurance." So it is more risk transfer than insurance.
• With CDS, default depends on whether the International Swaps
and Derivatives Association (ISDA) rules there is one. The
haircuts (losses) in Greek government loans, for example, was
not considered default!

56
 Review of learning outcomes

• Explain the various different features of debt

securities and how they may impact on their value.
• Define and contrast the different characteristics of
specific medium to long term debt securities.
• Explain how credit ratings operate and their
changes impact on the Australian debt market.
• Understand the different types of securitisation,
their various risks and uses

57
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