Bills, notes and bonds.
03 . 12 . 18
By Ignatius Wilson
Bills, notes and bonds are all debt. That is, they are debt securities which businesses, treasuries and individual investors can buy, sell or issue. They are important for many reasons but I will cover three central reasons, including how they can obscure the risk of the of the underlying debt, which led to the GFC; how they are a critical way businesses finance day-to-day operations; and because for investors they are an alternative to equities.
In many ways debt securities can be considered the ‘opposite’ of equities which give you a slice of ownership of a publicly listed company. Debt securities offer you an obligation from the issuer to pay you back the money you have lent them, plus interest.
The interest compensates you for a number of risks, including inflation and liquidity risk, the lost opportunity cost of lending the issuer your money plus the risk the issuer defaults on the debt and you lose the money you have lent them.
A debt security is characterised by its face value, coupon rate and maturity date. The face value is the purchase price, the coupon rate decides the size of the of repayments the investor receives over the lifetime of the product, and the maturity date is the date the issuer pays the face value back, plus any interest, to the owner.
That covers the features of a bond a retail or institutional investor might buy. Bills and notes share the same characteristics (coupon, maturity and face value) but are defined by their maturity dates and are used to finance short to medium-term expenditure.
Bills have a maturity of a year or less. This is cheaper for the issuer. It is cheaper because the risks that interest rates compensate for and I mentioned earlier, including default risk and lost opportunity cost, are much lower over shorter terms.
Bills, notes and bonds are also offered by treasuries, so that retail investors can actually lend their money to governments by buying these treasury-issued debt securities.
Notes have a maturity of between two and ten years. They are similar to bills but allow the issuer more time before they have to pay the face value back to the investor.
Unlike bonds and notes, bills actually trade at a discount to their face value. The effect is the same, however, with a gain realised on maturity date through the repayment of face value and interest to the owner. This means bills do not have a coupon paid during the lifetime of the product.
Asset-backed securities are debt products which are tied to other debts, such as retail mortgages. The asset here is the mortgage. As long as the retail borrower makes their repayments on time, the end investor gets their coupon payment.
The antecedent to the GFC was the unusually large number of mortgages owned by people who were at greater risk of default than usual. Lax lending practices allowed this to happen and when these debtors began defaulting, many banks who had large exposures to the asset-backed securities found both their assets losing value and liquidity drying up.
Because of the complex securitisation many banking customers and businesses didn’t understand the underlying asset they had invested in. They were left open to the default risk which had been obscured by strong housing demand.
I hope this has laid out some of the elements of debt securities and the role they played in the GFC. If you want to read more on the GFC or financial instruments, check out our videos on investing and capital markets.