Title LM05 Fixed-Income Markets for Government Issuers IFT Notes.pdf ✅

LM05 Fixed-Income Markets for Government Issuers 2025 Level I Notes © IFT. All rights reserved 1 LM05 Fixed-Income Markets for Government Issuers 1. Introduction ........................................................................................................................................................... 2 2. Sovereign Debt ...................................................................................................................................................... 2 3. Sovereign Debt Issuance and Trading ......................................................................................................... 5 4. Non-Sovereign, Quasi-Government, and Supranational Agency Debt ............................................ 5 Summary ...................................................................................................................................................................... 7 Required disclaimer: IFT is a CFA Institute Prep Provider. Only CFA Institute Prep Providers are permitted to make use of CFA Institute copyrighted materials which are the building blocks of the exam. We are also required to create / use updated materials every year and this is validated by CFA Institute. Our products and services substantially cover the relevant curriculum and exam and this is validated by CFA Institute. In our advertising, any statement about the numbers of questions in our products and services relates to unique, original, proprietary questions. CFA Institute Prep Providers are forbidden from including CFA Institute official mock exam questions or any questions other than the end of reading questions within their products and services. CFA Institute does not endorse, promote, review or warrant the accuracy or quality of the product and services offered by IFT. CFA Institute®, CFA® and “Chartered Financial Analyst®” are trademarks owned by CFA Institute. © Copyright CFA Institute Version 1.0
LM05 Fixed-Income Markets for Government Issuers 2025 Level I Notes © IFT. All rights reserved 2 1. Introduction This learning module covers:  Fixed income securities issued by sovereign and non-sovereign governments, quasi- government entities, and supranational agencies  Differences between the issuance of government versus corporate fixed-income instruments 2. Sovereign Debt Sovereign debt is issued by national governments primarily for fiscal reasons. Taxes are the primary source of revenue for a government. If tax revenue is insufficient, then a government raises money by issuing sovereign debt. Sovereign debt is not backed by collateral. The primary source of repayment is tax collections. Additional sources include tariffs, usage fees, and cash flows from government owned enterprises. Exhibit 1 from the curriculum presents a government’s economic balance sheet.
LM05 Fixed-Income Markets for Government Issuers 2025 Level I Notes © IFT. All rights reserved 3 While corporate financial statements are accrual based, financial accounting for governments is often cash based. Items such as depreciation of fixed public goods (e.g., national highways), or accrual of unfunded liabilities (e.g., government pension obligations) are typically excluded from the balance sheet. However, expected future claims and obligations are included because they are of greater relevance for public issuers as compared to corporates. Developed market versus emerging market sovereign issuers: An important distinction among sovereign debt is the difference between developed market (DM) and emerging market (EM) sovereign issuers.  DMs are characterized by a strong, stable, well-diversified domestic economy. They typically have a stable and transparent fiscal policy. For these reasons, the debt issued by DM sovereign issuers is often referred to as default-risk free.  EMs are usually characterized by higher growth but less stable and less well- diversified economies that may be subject to greater fluctuations over the economic cycle. Rating agencies distinguish between a DM sovereign bond issued in local currency and one in foreign currency. Local currency bonds generally have a higher credit rating than foreign currency bonds, because if needed the national government can print local currency to repay the bond, however it cannot print the foreign currency. Investors based in developed markets who purchase external debt of emerging and frontier market sovereign issuers face indirect exposure to currency fluctuations, because their returns depend on an issuer’s ability to generate foreign currency revenue to meet foreign currency interest and principal payments through international capital, goods, and services flows. Government debt management policies: Government debt management policies determine the composition of sovereign debt, i.e. short-term versus long-term, as well as other features. Sovereign debt issues include the following:  Short-term securities (often known as Treasury bills) with maturities ranging from 1 to 12 months. They are usually issued as zero-coupon instruments and are sold at a discount to par.  Medium- and long-term securities (often known as Treasury notes and Treasury bonds). They are often issued as fixed-rate domestic currency instruments. But sovereigns may also issue floating rate, inflation linked, and foreign currency instruments.  Sometimes sovereign governments do not directly issue securities but instead provide a guarantee that effectively makes the securities a type of sovereign debt. For example,
LM05 Fixed-Income Markets for Government Issuers 2025 Level I Notes © IFT. All rights reserved 4 Mortgage-backed securities in US. Ricardian equivalence: According to the Ricardian equivalence, a government’s choice of debt maturity is irrelevant in determining the present value of future tax cash flows. Taxpayers expect government debt to be offset by higher future taxes, implying that a sovereign government should be indifferent between collecting taxes today or raising debt of any maturity based on the following assumptions:  Taxpayers smooth consumption over time, saving expected future taxes today for future payment.  Taxpayers form rational expectations that today’s tax cuts will result in future tax increases.  Capital markets are perfect with no transaction costs, and taxpayers can freely borrow and lend.  Taxpayers are altruistic on an intergenerational basis; that is, they pass on tax savings to descendants. Based on this theory governments should fund themselves with the shortest maturity to minimize borrowing costs (long term bonds have higher interest rates due to term premiums). However, this strategy will introduce significant rollover risk. Also, the assumptions rarely hold perfectly. Therefore, in practice, governments seek to minimize interest rate and rollover risks by distributing debt across maturities, while issuing debt in regular, predictable intervals. Benefits of longer-term sovereign government securities: As mentioned above, long-term sovereign debt has higher borrowing costs, however, it provides the following benefits:  Establishment of a risk-free benchmark for all debt of specific maturities: Sovereign bond yields are often used as a benchmark to calculate a corporate issuer’s credit risk premium. Therefore, government debt policies frequently require the regular issuance of benchmark securities with varying maturities in order to improve capital market efficiency and transparency for private issuers.  Use in managing and hedging market interest rate risk: These instruments and related derivatives are often used by financial intermediaries and asset managers to manage interest rate risk separately from credit risk.  Preferred use as collateral in repo and derivative transactions: These instruments are the most common form of collateral for both repo and derivative transactions due to their high degree of liquidity and safety.  Government bond use in monetary policy and foreign exchange reserves: Central banks