Lesson 10: The Money Market

Stack of money
This is money. I am talking about the money market. You’re welcome.

The term money market is actually a great example of a misnomer. One might think that “money” in the form of currencies (Euros, U. S. dollars, Chinese Yen, etc.) are traded in this market.  This is incorrect. Instead the money market consists of highly liquid, short term debt investments.  The money market is the alternative to the capital markets which consist of longer term bonds and stocks.  An easy way to remember the difference is that if the asset is short term (it matures in one year), you are in the money market.  If the asset is long term (stocks, bonds, etc.) you are in the capital markets.

Financial Market Breakdown Chart
Here is a nifty breakdown to help remember.

Key Points

  • The money market is where short term debt instruments are traded.
  • Some of the key players in the money market include the U.S. Treasury, Federal Reserve, large companies, and individuals.
  • One of the main purposes of the money market is to house surplus funds and meet short term needs of funds.
  • Some of the securities traded in the money market include T-bills, commercial paper, federal funds, negotiable CDs, Eurodollars, and repurchase agreements.
  • The money market (mainly in the trading of T-bills) is where short term interest rates are determined.

What is the Money Market?

Say a company wants to build a new building or make a long term investment in a new product. A bond would be a perfect way for the company to raise a large amount of funds and pay it back over many years.  What if a company needs a smaller amount of cash for a quick payment (say to fill a small gap in the weekly payroll)? As the process for issuing bonds is very costly in terms of both dollar amount and time, it would be ineffective to issue bonds to address this small need of funds.  Thus in this case and others the money market instruments arose to fulfill the need of short term funds.

There are three common characteristics of money market instruments:

  1. Money market instruments mature in less than one year. Unlike bonds or stocks, money market instruments mature in less than one year than issue date whereas bonds mature in 5-10 years and stocks theoretically never mature.
  2. Money market instruments are highly liquid. The instruments in the money markets have high liquidity due to the large amount of participants and the large amount of funds that flow through the market.
  3. Money market instruments have low risk relative to the average risk of stocks and bonds. With their short maturities and high liquidity money market instruments in general possess very low risk when compared to their capital market counterparts.

Key Participants in the Money Market

The major participants in the money market include the U.S. Treasury, the U.S. Federal Reserve, large public companies, institutional investors, and individual investors.

  • U.S. Treasury: Remember those Treasury bonds that we mentioned in the bond market lesson? Well the U.S.
    Treasury Building
    This whimsical, fun looking building is the U.S. Treasury.

    Treasury also issues T-bills. We will discuss T-bill specifics later, but for now just now that the U.S. Treasury is the largest borrower of money market instruments which it uses to fund the federal debt.

  • Federal Reserve: The U.S. Federal Reserve (Fed) is the most influential player in the U.S. money market. It buys and sells vast amounts of T-bills to influence the money supply and short term interest rates in America.
  • Large Public Companies: Large companies participate in the money markets through buying and selling of securities.  One instrument associated with large companies in the money market is commercial paper which will be discussed later.
  • Institutional Investors: Due to their low risk many institutions (insurance companies, pension funds, etc.) will hold large amounts of money market instruments to generate investment returns while maintaining minimum risk.
  • Individual Investors: Primarily through the use of mutual funds (which we discuss in the next lesson) individual investors are able to participate in the buying and selling of the large dollar denomination securities in the money market.

Purpose of the Market

The primary purpose of the money markets is to provide a market that matches large amounts of excess funds from financial institutions to other firms and governments in need of short term funds.  Imagine a firm, let’s say Apple, has over $1 billion in excess cash.  What should Apple do with these funds? Furthermore let’s assume that the market for stocks and bonds has been volatile and therefore unusually risky lately.  One option is to buy money market instruments to generate higher return than the return that cash offers. (It is important to note that the return on cash is zero. Another way of thinking of this is cash in your wallet generates no return for you).  The money market allows Apple to invest in short term liquid securities that do not put Apple at significant risk and provides short term funds to other firms that need it.

Another way to think about the money market is imagine you as an individual have excess cash. One option you have is to go to a bank and put the money in a savings deposit.  The return on this account will be quite low. Now imagine there is a market where you can invest and get a slightly higher return with a corresponding slightly higher risk profile. You will provide the funds to institutions and businesses who have a short term need for funds and will compensate you with a higher rate for doing so.  This is the purpose of the money market.

Types of Money Market Instruments

  • T-bills: Treasury bills are issued by the U.S. Treasury Department and are used to finance the federal debt. The U.S. Treasury bill is arguably the most liquid and widely traded security in the world. As a result the interest rate offered on T-bills is used as a proxy for the short term risk-free rate.  T-bills do not pay interest and are instead sold at a discount and later matures at par value.  (Similar to the zero-coupon bonds discussed last chapter)
  • Federal Funds: Federal funds are short-term funds transferred between large financial institutions (usually larger commercial banks). Because banks must have minimum reserves relative to the amount of deposits they have, some banks need quick, overnight funds to avoid legal repercussions. As an investor you may hear the “federal funds rate” mentioned. This is the interest rate charged on these overnight bank loans.
  • Commercial Paper: Commercial paper are money market securities that are issued by corporations and mature in less than 270 days.  Commercial paper is offered directly from issuer to buyer and is used to fund the issuing companies’ activities.
  • Negotiable CDs: Negotiable certificates of deposit (CDs) are large, bank issued securities that range in value from $100,000- $10 million. Most individual investors will have little interaction with negotiable CDs, but it is worth noting that a negotiable CD is not the same instrument as the certificate of deposit that an individual can get at a consumer bank.
  • Repurchase agreements: Repurchase agreements (repos) occur when a firm sells Treasury securities and agrees to buy back the securities at a later date. In essence a repo is a short-term loan.  One firm sells the securities for quick funds and promises to rebuy the securities at a later date.  Repos are used by the Federal Reserve in conducting monetary policy.

The Risk Free Interest Rate

As mentioned above the T-bill is one of the most important securities within the financial markets.  The interest rate on the 3 month Treasury bill is commonly used as the “interest-free rate”. The interest free rate represents the return an investor should expect to earn on an investment with no risk. The T-bill is used for this theoretical rate because of its unparalleled liquidity and the ability of the U.S. Federal government to create more money to pay off the T-bill obligations as they come due.

 

Definitions

  1. Money market: The market for short term debt obligations used to facilitate short term borrowing and lending of excess funds.
  2. Interest free rate: The theoretical return an investor should earn on a security with zero risk. The interest rate on the 3-month Treasury bill is commonly used as a proxy for this theoretical rate.

Further Reading

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Lesson 9: The Bond Market

L9.2 Barry Bonds Pic
Still not the type of Bond I will discuss. Image courtesy of milwaukeechiro.com.

The bond market is much larger in dollar amount than the stock market in the United States. This is mainly driven by the ability for governments (including federal, state, and local) to participate in the bond market to raise capital.  This large market also produces Treasury bond interest rates (or yields), which are closely monitored proxies for long term interest rates.  In short the bond market lacks the glamour of the stock market due to its slower moving nature, but it still holds a place of great importance in the U.S. capital markets.

Key Points

  • Bonds have many commonalities with the stock market including primary vs. secondary markets, OTC markets vs. exchanges, and brokers vs. dealers.
  • The two primary issuers of bonds are governments and corporations.
  • Treasury bonds are arguably the most important type of bond traded.
  • Municipal bonds are bonds issued by local, county, and state governments that have favorable taxation characteristics.
  • Corporate bonds have different characteristics than federal bonds.

The Similarities between the Bond and Stock Market

Before we delve into what separates the two it would be easier to identity what the bond and stock markets have in common. Both the stock and bond markets have primary and secondary markets. A primary market is where securities are issued for the first time (when offered to the investing public this is called an initial public offering (IPO)) whereas the secondary market is where securities are traded between investors.  In addition bonds can be traded either in over-the-counter (OTC) or organized exchanges with brokers and dealers providing liquidity to these markets.

The Differences between the Bond and Stock Market

Other than the obvious differences between the nature of the securities being traded (there is a lot more knowns with bonds compared to L9.3 Featured Image for Bondsstocks) the largest difference is between the market participants.  While only private corporations participate in the stock market, both corporations and government entities may raise capital in the bond market. The reason governments do not participate in the stock market is that they would be selling ownership claims (imagine a super bank owning a small foreign government…yikes). Governments still have to fund different activities such as infrastructure, defense, and social programs and thus may turn to bond debt to finance these activities.  This is what is referred to when people quote the “$3 trillion deficit” America possesses, its bond debt.

The Importance of Treasury Bonds

The 10-year Treasury bond plays a key role in the U.S. financial markets.  It is one of the main ways the U.S. government funds federal expenditures.  They also have very little risk associated with them as in theory the U.S. government can always print more money to pay these bonds off as they come due.

Because of the low amount of risk these securities possess, little return is offered. In fact in some years the rate of inflation has been higher than the interest rate (or yield) offered on 10-year Treasury Bonds.  It also noted that the interest rate offered on 20-year Treasury Bonds is consistently higher than the interest rate offered on 10-year Treasury Bonds. The reason for this is simple and ubiquitous. The 20-year Treasury Bond has a longer maturity than the 10-year Treasury Bond and thus has more inherent risk and as our risk vs. return principal dictates the higher this possibility of risk the more compensation that must be offered to investors.  The U.S. federal government is of course not the only government that can sell bonds and at any given time you can buy French, Russian, or Argentinian bonds.  Depending on the riskiness of the country issuing, different returns are offered.  Similar to corporate bonds, bonds offered by governments are rated by rating agencies.

L9.1 Inflation vs. 10 Year Treasury Yield
Graph of 10-Yr U.S. Treasury Yield vs. Inflation Over Time

 

Municipal Bonds

Municipal bonds are bonds issued by local, state, or county governmental entities for the purpose of raising capital to fund public projects.  “Munis” have a small amount of default risk as a municipality can in fact default on its bonds. The two common types of municipal bonds are general obligation bonds and revenue bonds.  General obligation bonds are municipal bonds that do not have specific assets pledged as security for the bond and are instead supported by the “full faith and credit” of the issuer.  Bonds like this can also be referred to as unsecured bonds as there is no assets that serve as collateral for the bond.  A revenue bond is backed by the promised revenue of a project. An example of this would be charging fees to use a hospital or public port. These revenue streams provide funds to pay off the interest charges and principal of the outstanding bonds.  Revenues bonds can be referred to as secured bonds as there is an asset base supporting the repayment of the bonds.

One of the most important characteristics from an investor standpoint is that many municipalities place tax reductions or make the interest payments on the bond paid to the investor tax free, provided the investor is a resident of that municipality.  This is solely at the discretion of the issuing municipality, but for some high tax bracket investors muni’s present an opportunity to avoid large tax reductions from their investments.

Corporate Bonds

As a whole corporate bonds function similarly to government based bonds, but they have some differing characteristics. In general, corporate bonds pay a higher return than their government counterparts due to higher perceived risk of default on corporate. In the last lesson I discussed how the rating agencies rate the corporate bonds on the perceived risk of default the list of which I have provided again.  In addition corporate bonds are almost always issued in $1,000 par value, have the standard coupon payment structure, and may have a call provision which enables the issuing company to buy back (or “call”) the bond after a certain time period has elapsed.

Zero Coupon Bonds

A zero coupon bond is a type of bond that does not pay the investor interest payments but instead sells at a deep discount and is redeemed at maturity for a higher value.  In zero coupon bonds the investor forgoes the coupon payments in return for buying the bond at a discount and receiving a higher principal amount when the bond matures. For example you could buy a bond for $500 that in five years matures for $1,000 that offers no coupon payments. Many federal and municipal bonds function as zero coupon bonds.

Definitions

  1. Municipal bonds: Bonds issued by local, state, or county governmental entities for the purpose of raising capital to fund public projects.
  2. General obligation bonds: Unsecured municipal bonds that are backed by the “full faith and credit” of the issuing municipality.
  3. Revenue bonds: Municipal bonds that are secured by the revenue stream that will result from the completion and operation of the project the bond is funding.
  4. Call provision: A provision on bonds that enables the issuer to buy back bonds for a fixed payment that results in ceased interest payments to the investor who owns the bonds.
  5. Zero coupon bonds: Bonds that do not offer interest payments but are instead issued far below par and mature at par. The difference between the issuance price and the maturity is the yield the investor receives.

Further Reading

Lesson 8: Let’s Talk Bonds

 

Bond actors
This is not the type of “bond” I will be discussing. Image courtesy of moviepilot.com

The bond market. You may think you haven’t heard about it.  You are probably wrong. In addition to occasionally hearing about “rallies” in the bond market most Americans has heard of the $3 trillion deficit the U.S. government currently faces.  What makes up this deficit? Treasury bonds. These bonds and other securities the U.S. Treasury issues help fund the activities of the U.S. Government and have an integral role in the bond market. The bond market is comprised of many different types of bonds which can greatly vary in features. Let’s explore some basic functionality.

Key Points

  • A bond is a debt security that obligates the borrower to pay a specified amount to the investor on a given date and usually includes coupon payments.
  • A bond offers investors returns through appreciation and interest (coupon) payments.
  • A bond has many distinguishing features including par value, maturity, coupon rate, issuer, credit rating.
  • There is an inverse relationship between bond yield and bond price.

Continue reading Lesson 8: Let’s Talk Bonds

Lesson 7: Stock Market Indices

Stock Chart Going Up
Lines Going Up = Good in Finance

In the last lesson I mentioned how my father would always mention to me how “the market was up”.  Knowing now that there thousands of companies traded in the equity markets you may wonder what my father meant by “the market”. Was it that on that day he saw more green, upward arrows on MSNBC than red, downward arrows? Was it that on that particular day his stocks were doing well and he wasn’t paying attention to the other stocks? He was most likely looking at stock market indices such as the DJIA, S&P 500, or Russell 2000. These indices (or indexes) are commonly used to describe the health of the overall stock market and as a result are closely monitored day in and day out.

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Lesson 6: The Stock Market

Now that we have some working knowledge about what a stock is and how it functions let’s discuss how it is traded. The stock market is one of the most often discussed things in everyday financial life. To this day in discussions with my aging father he sometimes makes the comment “Did you see what the market did today?”  The U.S. stock market is half of the size of the U.S. bond market. So why does the stock market get all of the glory, media attention, and yelling pundits? It gets this following because it is the place where people can go from rags to riches (or vice versa) very quickly, or to be blunt it’s exciting. You will see that much of the stock market is very jargon heavy so at any point remember that the definitions of the terms can be found at the post in case you need a quick refresher. So what are the mechanics of this wondrous machine?

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Lesson 5: Let’s Talk Stocks

You’ve heard a lot about it. You may have flipped past MSNBC and saw the green and red arrows and the acronyms and wondered “What does it mean?” and “Why do people care so much?” Before we go into what those arrows mean and why the talking heads on those networks continue to blab on let’s strip away all the opinion and discuss the facts concerning stocks. (You’ll notice I am not going to discuss much of the mechanics of how stocks are traded that is the subject of the next lesson).

Continue reading Lesson 5: Let’s Talk Stocks