There are a number of bond categories that are primarily traded by professional or experienced investors and differ from Treasuries, munis, corporates, agencies and mortgage-backed securities. They include money market securities, asset-backed and preferred securities, as well as auction rate and event-linked securities.
Money Market Securities
Money market securities are often considered a good place to invest funds that are needed in a shorter time period—usually one year or less. Money market instruments include bankers' acceptances, certificates of deposit and commercial paper. Bankers' acceptances are typically used to finance international transactions in goods and services, while certificates of deposit (CDs) are large-denomination, negotiable time deposits issued by commercial banks and thrift institutions. Commercial paper takes the form of short-term, unsecured promissory notes issued by both financial and non-financial corporations.
Some combination of these products makes up a money market fund. All money market funds are required to have a dollar-weighted average portfolio maturity that cannot exceed 90 days. While money market securities are highly liquid (you can usually receive your money in a few days, compared to months or years with a CD), the interest you earn on your money tends to be quite low and may not keep pace with inflation.
Asset-Backed Securities
Asset-backed securities are certificates that represent an interest in a pool of assets such as credit card receivables, auto loans and leases, home equity loans, and even the future royalties of a musician (for instance, Bowie bonds). Once you get beyond mortgage-backed securities, which are a type of asset-backed security, investing and trading in the asset-backed market is almost exclusively done by more sophisticated investors; like mortgage-backed securities, there can be significant risks associated with any asset-based security.
Preferred Securities
There are two common types of preferred securities: equity preferred stock and debt preferred stock.
- Equity preferred stock is much like common stock in that it never matures, and it declares dividends rather than awarding regular interest payments.
- Debt preferreds pay interest like traditional bonds, and since they are corporate debt, they stand ahead of equity preferred securities in the payout hierarchy should the company default. However, many preferreds are hybrids—they contain a combination of debt and equity features, and it is not always clear which type of security they are.
Unlike traditional bonds, preferreds generally have a par value of $25 instead of the traditional $1,000. They also tend to pay interest quarterly, rather than the traditional semiannual payment associated with most bonds. Most preferreds are listed just like stocks, with the majority trading on the New York Stock Exchange. Like traditional bonds, preferreds tend to have credit ratings, and upgrades and downgrades often play an important role in the price a preferred can command in the secondary market.
Auction Rate Securities
Auction rate securities (ARS) are often debt instruments (corporate or municipal bonds) with long-term maturities, but their interest rates can be regularly reset through Dutch auctions. For many years, investors purchased ARS seeking cash-like investments that paid a higher yield than money market mutual funds or certificates of deposit. Those expectations changed in early 2008 when credit market turbulence led many ARS auctions to fail. For more information, see FINRA’s Investor Alert, Auction Rate Securities: What Happens When Auctions Fail.
Event-Linked Bonds
Event-linked bonds—also called insurance-linked, or “catastrophe” bonds—are financial instruments that allow investors to speculate on a variety of events, including catastrophes such as hurricanes, earthquakes and pandemics. These products are not offered directly to individual investors. But various funds, including mutual funds and closed-end funds, have purchased or are authorized to purchase them on behalf of individual investors. While not widespread, holdings of event-linked securities in these funds—especially high income funds—are also not unusual. Event-linked securities currently offer higher interest rates than similarly rated corporate bonds. But, if a triggering catastrophic event occurs, holders can lose most or all of their principal and unpaid interest payments.
For more information, see Insurance-Linked Securities.
The Money and Foreign Exchange Markets Are Key Components of the Financial System
Money markets are the financial markets where short-term financial assets are bought and sold. By definition, the financial assets, such as stocks and bonds, that are traded in these markets will mature in one year or less. Over a billion dollars in transactions take place in these markets on a daily basis. Financial institutions, corporations, governments, and the U.S. Treasury are active in the money markets as they adjust their short-term portfolios.
Foreign exchange markets facilitate the trade of one foreign currency for another. Most exchanges are made in bank deposits and involve U.S. dollars. Over a trillion dollars in foreign exchange trades take place every day; foreign exchange dealers handle most transactions. Businesses, financial institutions, governments, investors, and individuals use the foreign exchange markets to adjust their currency holdings.
Domestic Money Markets
Money markets provide an important mechanism in an economy for transferring short-term funds from lenders to borrowers.1 For corporations, governments, and financial institutions with temporary excess funds, these markets provide an efficient means to lend to other corporations, governments, and individuals who have a temporary need for funds. Money markets, therefore, represent the short-term spectrum of the financial markets, where securities that mature in a year or less are traded.
Key money market characteristics:2
- "Generally characterized by a high degree of safety of principal."
- Most markets are informal "telephone" markets with low transaction costs.
- Assets are typically issued in large denominations, often $1 million or more.
- Most money market instruments are liquid, which means that they can be quickly converted into cash assets without a sizeable loss.
Each day billions of dollars are traded in the money markets. Several important money market instruments are listed below:3
- U.S. Treasury bills
- Short-term Federal agency securities
- Commercial paper
- Federal funds
- Net Eurodollar borrowings by domestic banks from their own foreign branches
- Large-denomination certificates of deposit ($100,000 or more)
Money Market Interest Rates
Forces influencing interest rates in the money markets are varied and may reflect supply and demand conditions in different money market instruments. There are also broader forces that affect interest rates in all money and capital markets. Rose notes that Treasury bills, with no default risk and an active secondary market, usually yield the lowest rate in the money market and that other instruments appear to move with Treasury bill rates. Goodfriend and Whelpley, however, point out that the current and expected interest rates on federal funds are "… the basic rates to which all other money market rates are anchored." That relationship reflects the use of the federal funds rate by the Federal Reserve in implementing monetary policy.4
Foreign Exchange Markets Play an Important Role
The foreign exchange markets play a critical role in facilitating cross-border trade, investment, and financial transactions. These markets allow firms making transactions in foreign currencies to convert the currencies or deposits they have into the currencies or deposits they want. Most transactions are handled by foreign exchange dealers; on a typical day they handle over a trillion dollars in foreign currency exchanges involving U.S. dollars alone. The importance of foreign exchange markets has grown with increased global economic activity, trade, and investment, and with technology that makes real-time exchange of information and trading possible.
Factors Driving Exchange Rate Movements
A number of factors may influence foreign exchange rates, including the following cited by Rose (1994):
- Balance-of-payments position. A country experiencing a trade deficit usually faces downward pressure on its foreign exchange rate.
- Speculation over future currency values. Speculators buy or sell currencies when they see profitable opportunities.
- Domestic economic and political conditions. Deteriorating economic conditions and inflation typically have an adverse affect on foreign exchange rates.
- Central bank intervention. Central banks may buy or sell currencies to influence the value of their currency.
Endnotes
1. See Cook (1993), editor, Instruments of the Money Market, Federal Reserve Bank of Richmond, page 1.
2. Cook, page 1
3. Other money market instruments include bankers' acceptances, and securities repurchase agreements. In addition, futures, options, and swaps markets usually involve money market instruments.
4. See Cook (1993), Chapter 2, page 7, Goodfriend, Marvin, and William Whelpley, "Federal Funds."
References
Cook, Timothy Q., and Robert K. LaRoche, editors. (1993) Instruments of the Money Market, Federal Reserve Bank of Richmond, Richmond, Virginia.
Federal Reserve Bank of New York. All About…the Foreign Exchange Market in the United States, July 23, 2001.
//www.ny.frb.org/pihome/
Rose, Peter S. Money and Capital Markets, Irwin, Burr Ridge, Illinois, Fifth Edition, 1994.
See other Dr. Econ Answers:
What makes Treasury bill rates rise and fall? What effect does the economy have on T-bill rates? December 2000.
/education/activities/drecon/2000/0012.html
Why does a trade deficit weaken the currency? October 1999.
/education/activities/drecon/1999/9910.html