Trading and Capital-Markets Activities Manual
Profiles: German Government Bonds and Notes
The federal government of Germany issues several types of securities: bonds (Bunds), notes (Bobls and Scha系ze) and Treasury discount paper (U-Scha系ze). Government agencies such as the Federal Post Office and the Federal Railway have also issued bonds (Posts and Bahns) and notes (Scha系ze). In addition, with the unification of West and East Germany in October 1990, the German Unity Fund began to issue Unity Fund bonds (Unities) and notes (Scha系ze). The outstanding debt issues of the Post Office, Railway, and Unity Fund have since been folded into the so-called Debt Inheritance Fund, which has led to an explicit debt service of these issues through the federal government. Hence, these issues are guaranteed by the full faith and credit of the federal government. All government-guaranteed securities are available in book-entry form only.
The government also issues U-Scha系ze, zero-coupon Treasury notes with maturities of one to two years which may not be purchased by foreigners, and short-term Treasury bills, with one-half- to one-year maturities, which may be purchased by foreigners. However, the secondary market for these instruments is small and does not attract substantial foreign investment. Therefore, the following discussion will focus on bonds and notes.
CHARACTERISTICS AND FEATURES
Bunds are issued regularly, usually in deutschemarks (DM) 20 billion to DM 30 billion blocks, with maturities ranging from 8 to 30 years. Bunds are issued in a minimum denomination of DM 1,000, and a typical issue carries a maturity of 10 years. Bunds are redeemable in a lump sum at maturity at face value (bullet structure) with interest paid annually. Until 1990, all bonds issued by the federal government and other public authorities were non-callable and bore a fixed coupon. However, since February 1990, some callable floating-rate bonds have been issued.
Special five-year federal notes (Bobls) have been issued by the federal government since 1979, but foreign investment in these securities has been permitted only since 1988. In the past, medium-term notes with four- to six-year maturities (Scha系ze) were issued irregularly by the federal government, the Unity Fund, and the Federal Post Office and Railway. However, in 1995, the Ministry of Finance decided to discontinue the issuance of these securities to create more transparency in the market. All Bobls and existing Scha系ze issues are fixed-coupon securities with bullet maturities.
Stock-exchange settlement takes place two market days after trade date (T+2). International settlement takes place three business days after trade date (T+3). As of January 1, 1994, German federal government notes and bonds no longer trade ex-coupon. They trade on a cum-coupon basis; the purchaser of the bond pays the seller accrued interest from the last coupon date to settlement. Interest is accrued on a 30/360-daycount basis in which each month is assumed to have 30 days and a year is assumed to have 360 days.
German government bonds and notes are used for investment, hedging, and speculative purposes. Foreign investors, including U.S. banks, often purchase German government securities as a means of diversifying their securities portfolios. In particular, the low credit risk and deep liquidity of German government bonds and notes encourages the use of these instruments as non-U.S. investment vehicles. German government securities may also be used to hedge German interest-rate risk or foreign-currency risk related to positions in deutschemarks. Speculators may use German government bonds to take positions on changes in the level and term structure of German interest rates or on changes in the foreign-exchange rates between Germany and the United States. Because it is a deep and efficient market, some German futures contracts and options are priced relative to Bund issues.
DESCRIPTION OF MARKETPLACE
Bunds are issued using a combination of syndication and bidding procedures. Part of the issue is offered at fixed terms to the members of the Federal Bond Consortium, which consists of German banks, foreign banks in Germany, and the Deutsche Bundesbank (German Central Bank). The Bundesbank is the lead bank in the syndicate and determines the allocation of the offerings among the syndicate members. These allocations are changed infrequently. During the syndicate meeting, the coupon rate, maturity, and issue price are determined by the government and syndicate, although the total size of the issue is unknown. Syndicate members receive a fee from the government for selling bonds received through syndicate negotiations.
A further tranche is issued to the syndicate by means of an American-style auction. The terms-coupon rate, maturity, and settlement date-are the same as those determined in the syndicate meeting, although the overall size of the issue is not specified. The German Central Bank accepts bids starting with the highest price and accepts lower bids until the supply of securities it wishes to sell is depleted. Non-competitive bids may also be submitted, which are filled at the average accepted price of the auction. The size of the issue is announced after the auction. The difference between the issue size and the amount that has been issued through the underwriting syndicate plus the auction is retained by the Bundesbank for its bond market operations.
Bobls are issued on a standing-issue basis (similar to a tap form in which a fixed amount of securities at a fixed price is issued when market conditions are considered favorable) with stated coupon and price. During the initial selling period, which may last a few months, the price is periodically adjusted by the Ministry of Finance to reflect changes in market conditions. The sales of a given series are terminated when either the issuing volume has been exhausted or the nominal interest rate has moved too far away from the going market rate. The new series is launched within a short period of time. Only domestic private individuals and domestic non-profit institutions are permitted to purchase the issues in the primary market. German banks (which cannot purchase these securities for their own account) receive a commission for selling the bonds to qualified investors. After the selling period is over and an issue is officially listed on the German stock exchange, the securities may be purchased by any investor.
German bonds are listed and traded on all eight German stock exchanges seven days after they are issued. Bobl issues are officially listed on the stock exchanges after the initial selling period of one to three months. In addition to the stock exchange transactions, substantial (OTC) over--the-counter trading occurs. In Germany, the secondary market for both stocks and bonds is primarily an interbank market.
For some issues, prices are fixed once during stock-exchange hours (stock-exchange fixing takes place from 11:00 a.m. to 1:30 p.m. Greenwich mean time +1). However as of October 3, 1988, variable trading was introduced at the German stock exchanges for Bunds, Bobls, Bahns, and Posts issued after January 2, 1987, with a minimum size of DM 2 billion. The Unity Fund issues also participate. After the fixing of the prices on the stock exchanges, the securities are traded on the OTC market (OTC hours are from 8:30 a.m. to 5:30 p.m.). Bunds are typically quoted in the OTC market on the basis of a difference from the fixing price, for example, a price quote of -10 means a price of 10 pfennigs (1/100 of a DM) less than the fixing price.
Seventy to 80 percent of the secondary-market trading of Bunds, Bahns, and Posts takes place in the OTC market. About 75 percent of Bobl trading takes place in the OTC market, as does most Scha系ze trading. However, the stock markets are important because the prices determined there provide standard, publicly available benchmarks.
The underwriting of public authority bonds is done by the Federal Bond Syndicate, which consists of German banks, foreign banks in Germany, and the Deutsche Bundesbank (German Central Bank). German banks are responsible for placing Bobls with qualified investors.
Domestic banks are the largest holders of German bonds, and private German individuals are the second largest investment group due in part to the propensity of German households to save and invest their savings. German insurance companies are also major holders of German bonds, as are German investment funds. Foreign investors, such as U.S. commercial and investment banks, insurance companies, and money managers also hold German government securities.
The market for German government bonds and notes is active and liquid, and price transparency is considered to be relatively high for these securities. Several vendors, including Reuters and Telerate, disseminate price information to the investing public.
Bonds and notes are quoted as a percentage of par to two decimal places. For example, a price of 98.25 means that the price of the bond or note is 98.25 percent of par. Bonds are traded on a price basis, net of accrued interest (clean). Prices generally move in increments of five pfennigs. The bid/offer spread is usually eight pfennigs for liquid issues and 15 pfennigs for less liquid issues. For notes, bid/offer spreads are five to 10 pfennigs for liquid issues.
Interest-rate risk can be hedged using swaps, forwards, futures, or options, or by taking a contra position in another German government security. The effectiveness of a particular hedge is dependent on yield-curve and basis risk. For example, hedging a position in a five-year note with an over-hedged position in a three-year note may expose the dealer to yield-curve risk. Hedging a 30-year bond with a bond future exposes the dealer to basis risk if the historical price relationships between futures and cash markets are not stable. Also, if a position in notes and bonds is hedged using an OTC option, the relative illiquidity of the option may diminish the effectiveness of the hedge. Foreign-exchange risk may be hedged with currency swaps, forwards, futures, and options.
The German government bond market is the third largest bond market in the world, and is considered the most liquid government bond market after the U.S. government bond market. Bunds are the most liquid and actively traded bond issues in Germany. Unities issued by the German Unity Fund are generally as liquid as Bunds, but Bahn and Post issues of government agencies are fairly limited compared with the federal government's bonds. Therefore, these agency securities tend to be less liquid and generally trade at a higher yield than Bunds.
The on-the-run (most recent) Bund issue is the most liquid of its category and serves as the benchmark. The most liquid area of the Bund yield curve is in the eight- to-10-year maturity range, as most Bund issues carry a 10-year maturity. Similar to Bunds, on-the-run Bobls are the most liquid type of note. Off-the-run prices are not as transparent as current coupon securities, which makes these issues less liquid and trading more uncertain. Of course, larger issues of bonds and notes are generally more liquid than smaller ones.
At the stock exchange, the German Central Bank makes a market in Bunds, Bobls, Unities, and Post issues. The German Central Bank is responsible for maintaining an orderly secondary market in these securities and regularly intervenes to support or regulate their prices. This tends to increase the liquidity in the market for these issues. However, the Bundesbank is not responsible for stabilizing Scha系ze prices. For this reason, these securities tend to be much less liquid than Bunds or Bobls; their issue sizes are also normally much smaller. The Railway Bank makes a market in Bahn issues, which enhances the liquidity of these issues.
German bonds and notes are subject to price fluctuations due to changes in German interest rates. The variation in the term structure of interest rates accounts for the greatest amount of local market risk related to foreign bonds. Longer-term issues have more price volatility due to interest-rate fluctuations than do shorter-term instruments. Therefore, a large concentration of long-term maturities may subject a bank's investment portfolio to unwarranted interest-rate risk.
Currency fluctuations can account for up to two-thirds of the return and risk of an un-hedged international fixed-income portfolio. There are two types of currency risk related to foreign bonds: (1) the coupons and face value are paid in the foreign currency, which means that any change in the exchange rate affects the bond's value to the U.S. investor, and (2) the bond's yield may be affected by currency movements.
A number of factors exert a direct influence on foreign-exchange rates, including the balance of payments and prospective changes in that balance; inflation and interest-rate differentials between Germany and the United States; the social and political environment in Germany, particularly with regard to the impact on foreign investment; and central bank intervention in the currency markets. Historically, German exchange rates have been very stable.
A change in the political environment, withholding tax laws, or market regulation can have an adverse impact on the value and liquidity of an investment in foreign bonds. Investors should be familiar with the local laws and regulations governing foreign bond issuance, trading, transactions, and authorized counterparties.
The accounting treatment for investments in foreign debt is determined by the Financial Accounting Standards Board's Statement of Financial Accounting Standards (SFAS) No. 115, ''Accounting for Certain Investments in Debt and Equity Securities,'' as amended by SFAS 125, ''Accounting for Transfers and Servicing of Financial Assets and Extinguishments of Liabilities.'' SFAS 125 has been replaced by SFAS 140, which has the same title. Accounting treatment for derivatives used as investments or for hedging purposes is determined by SFAS 133, ''Accounting for Derivatives and Hedging Activities.'' (See section 2120.1, ''Accounting,'' for further discussion.)
RISK-BASED CAPITAL WEIGHTING
German government bonds and notes are assigned to the 0 percent risk-weight category.
LEGAL LIMITATIONS FOR BANK INVESTMENT
German government bonds and notes are type III securities. As such, a bank's investment in them is limited to 10 percent of its equity capital and reserves.
Fabozzi, Frank J., and Franco Modigliani.
Capital Markets: Institutions and Instruments. Englewood Cliffs, N.J.:
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