Primary and secondary market trading

There are basically three ways you can access the fixed income markets; by buying fixed income products when they are first offered by the issuers known as new issues, by buying and selling fixed income products in the secondary markets using the network of dealers and more recently buying through the ASX.

Buying new issues

With new issues, product originators like the investment banks, approach potential borrowers when they see a window of opportunity to borrow directly from the market. For example, interest rates may be low or because the equity markets are too expensive. Once in agreement over the terms of the proposed offer, a prospectus is prepared clearly outlining the terms and conditions of the borrowing program. These terms and conditions will match the demand in the market and investors requirements to ensure that the offer is fully taken up. The prospectus is distributed through the relevant institutions like RIMSec who then bring the offer to the attention of interested investors. Intermediaries like RIMSec play an important role in disseminating this important information and providing smaller investors with access to attractive new issues.

Secondary market trading

Until recently, the secondary markets were really the only way that investors could get access to the fixed income markets. There is an active secondary market in Australia that has been traditionally the domain of professional investors, fund managers and financial institutions. Once the fixed income products have been issued, they are then if required, sold to other investors in the market. This buying and selling of fixed income instruments and securities after they have already been issued is called the secondary markets.

Issuers usually cater to the requirements of wholesale markets (i.e. the institutional investors) to keep the cost of their borrowing down This yield is affected by the issuers standing in the markets therefore the issuers put a lot of effort into catering to the demands of the wholesale investors. This has made it difficult however, for normal investors to get access to traditional fixed income products leading to the establishment of companies like RIMsec who give other investors access to these markets by buying from the wholesalers and selling to investors.

Buying through the ASX

While RIMsec is not a member or participating broker of the ASX, we have arrangements with ASX participating brokers who will execute the required transactions on our behalf for our clients. We are able to transact on all ASX listed fixed income securities

Using a licensed dealer

Unlike the stock market, where the trading of shares has been centralised on the trading board, trading in fixed income products occurs through a network of intermediaries including the borrowers (who are also called "issuers" because they issue the securities to investors), licensed dealers and investors who communicate and trade with each other. This is why, as a retail investor, it is important to have a licensed dealer, like RIMsec, accessing the right opportunities in the market for you.

One of the most fascinating aspects of markets is their ability to centralise the process of exchange. It is a lot simpler and cheaper for buyers and sellers to communicate and trade with each other via centralised networks of screens and telephones then it is for each of them to try to locate each other independently. The other important aspect of this centralised trading mechanism is that pricing (i.e. the interest rate) is transparent to the borrowers and lenders.

Time value of money

Before investing in fixed income securities, you should have a basic understanding of the concept of the "time value of money". This concept underlies the pricing of fixed income products. Generally speaking, people buy investments because of the expectation that they will earn income from it and be repaid the principal on maturity. The price of the investment should reflect the value of these future cash flows. But you can't simply add these cash flows up because you have to take into account the "time value of money".

Think about it this way. Would you choose to be paid $100 today or $100 in a year's time? Obviously, you would choose $100 today because you know you could place it on deposit in a bank at 5.0% and in a year's time it would be worth $105, which is $5 more than the offer of $100 in a years time. So in technical terms at a yield or interest rate of 5%, the future value of $105 is equal to a present value of $100. This concept is known as the time value of money and has important consequences for fixed income investing. First, $100 today should be worth more than $100 at some future date because you can invest the $100 today at some interest rate or yield. Second, the higher the yield or interest rate, the greater the difference between the present value and the future value, for example $100 invested at 20% today would have a future value of $120 in a years time.

To calculate the price that should be paid today for a fixed income product that produces a series of future income stream requires the investor to discount the future cash flows and the principal repayment at the nominated yield to a present value using various discount rates. The use of bond calculators, price lists and computer software has simplified this pricing process considerably for both market professionals and investors alike. Refer to the "Pricing formulas for fixed income products" section for more information on pricing.

Pricing of fixed income products

As with all investments, it is important to have some idea about how fixed income products are valued and priced. With both money market instruments and bonds there are specific pricing formulas that are used to calculate the price, yield and accrued interest of the instrument or security. Generally speaking, if you know the yield you want, the price of the security can be calculated. Alternatively, a yield for a given price can also be calculated. Market conventions have also been adopted to make the calculations of prices and yields easier. In reality, most market participants use financial calculators to calculate prices and yields because this is simpler. There is a special section in this website providing investors with the financial formulas, market conventions and calculators for fixed income products.

Yield curves

Yield curves are graphical illustrations of the latest market yields according to their term to maturity. A normal or positive shaped curve means that longer term investments have higher interest rates while a negative or downward sloping curve means that there are higher rates for shorter term maturities. Often the yield curve is used as a benchmark against which other securities can be priced. A positive yield curve reflects expectations of rising interest rates in the future and a negative yield curve reflects expectations of falling interest rates in the future.

Executing and settling trades

When atransaction has been executed for a client, the transaction must then be settled i.e. if a security has been purchased it must be paid for and the certificate evidencing ownership of the instrument or security sent to the investor. If a security has been sold, then the certificate must be sent to the dealer for onward transmission to the new owner and the proceeds from the sale paid to the seller. Settlement can occur on the same day as the trade or it can occur after the trade, for example settlement of Commonwealth Government bonds occurs within three days of the trade date i.e. T+3. Pricing occurs up to the settlement date to incorporate accrued interest.

Settlement arrangements differ between securities. Some settlement procedures are performed electronically whilst others are manual systems requiring the processing of transfer and acceptance forms. Your RIMsec authorised representative will inform you of the settlement procedures relevant to your trade.