Bonds
IF a corporation liquidates in bankruptcy, the following is the priority of making payments to creditors
Secured creditors such as mortgage bondholder and equipment trust certificate holders receive the proceeds from the sales of the property pledged Unpaid administrative claims, unpaid wages, taxes, and trade creditors (in this order) Debenture bondholders Subordinated debenture bondholders preferred stock holders common stockholders
Remember, a bond has two components
Semi-annual interest payments the final principal repayment at maturity
Equipment Trust Certificates are issued in serial form
Serial bonds obligate the issuer to repay a portion of the principal each year until the bonds are retired.
Discount notes
Short-term obligations of 1 year or less, sold at a discount from minimum $5,000 face amount with $1,000 increments thereafter. Because these are an agency obligation, with no direct U.S. government guaranteed, they yield more than equivalent maturity t-bills
Privatized Government Agency
Subject to federal tax Subject to state tax
U.S. Gov't
Subject to federal tax exempt from state tax
Corporate
Subject to federal tax subject to state tax
Subordinated Debenture
Subordinated debenture holders agree to a lower status in a corporate liquidation. If the company liquidates, subordinated debt holders are paid after all other creditors.
WHEN A CONVERTIBLE SECURITY IS TRADING BELOW PARITY
THE PROFT CAN BE QUICKLY REALIZED THROUGH ARBITRAGE
Treasury TIPS
TIPS = Treasure inflation protection securities have a fixed interest rate over the life of the bond; however, the principal amount is adjusted every 6 months by an amount equal to the change in the Consumer Price Index. The bond pays interest semi-annually, and the interest amount will increase if the principal amount is adjusted upwards due to inflation and will decrease if the principal amount is decreased due to deflation
Yield to maturity
Takes into account both the market price of the bond as well as any capital gains or losses on the bond if held to maturity.
^ these agencies obtain the funds to buy the mortgages by selling bonds to the public
The U.S. government does not directly back these issues with the exception of the Government National Mortgage Association Ginnie Mae's are directly back by the government
Prime Banker's Acceptance
The bank is now obligated to pay on that date BA's are bearer securities and can be held to maturity or can be traded. the maturity is 9months or less and the security trades at a discount to face value
Trust indenture
The bonds are issued under a bond contract called an indenture. The indenture spells out the interest rate, maturity, collateral, call/put provisions, and all other relevant features of the bonds
Nominal yield (stated rate of interest on the bond.
The bonds stated rate of interest is 10% of $1,000 par.
Construction Loan Notes are typically issued for periods of 2-3 years during periods when the interest rates are high
The borrower is hoping that the interest rates will have dropped by the time the take-out loan is issued.
When a convertible security trades above parity
The conversion feature has no value. There is no reason to convert into stock which is valued at less ($40 market) than the effective conversion price ($45)
When a convertible security trades below parity
The conversion feature is valuable. Assume this $1,000 par bond is trading at $1,100. The market price of the stick is $60 while the conversion price is $50. The bond can be converted into 20 shares of stock worth $60 each or $1,200. Since the market price is $1,100, a large profit ($1,200 conversion - $1,100 purchase = $100 profit) can be made by purchasing the bond and converting it into stock
At the time of issuance for convertible bonds
The conversion price is set at a premium to the stocks current market price.
If the trust indenture is open-end
The corporation can sell additional bonds having equal status against the real estate. However, open-end trust indentures typically include an additional bonds test requirements that must be met before new bonds may be sold. This test usually requires that earnings before interest expense for the preceding period or number of periods must exceed both the current interest expense PLUS the project interest expense on the additional bonds to be sold by a stated multiple.
Calls Occur when interest rates drop
The cost to the issuer for doing this is the call premium. The issuer can then sell new bonds to replace the old at a lower interest rate.
A critical player in the money market is the federal reserve
The fed attempts to control the amount of credit available through open market operations which is the buying and selling of money market instruments with bank dealers. When the fed buys money market instruments, it puts cash into the banks, increasing the credit availability. When the fed sells money market instruments - it drains cash from the banks, decreasing credit availability. Only the safest money market instruments are eligible for fed trading. Those that are eligible are the most actively traded and liquid instruments.
To finance this activity, FHLB issues
discount notes callable bonds /non-callable bullet bonds
U.S. government debt is considered to be the highest rated debt
essentially free of credit risk
Federal home loan bank (FHLB)
first mortgage agency created in 1932 during Great Depression to provide funds to savings and loans so they could give homeowners mortgages.
notes are issued for 2 general purposes
for temporary financing of capital improvements to even out cash flows
Municipal issues are broadly categorized into
general obligation bonds, revenue bonds, special types of bonds, and short-term notes.
Mortgage Backed Securities (MBS)
have an unusual risk that small investors may not understand, prepayment risk
Intermediate-term securities
have maturities ranging from over 1 to 10 years. These notes are issued in minimum denominations of $100 par value and pay interest semi-annually to registered holders. Treasury notes are quoted as a percentage of par value in 32nds. Non-callable
Issuers desire an UNQUALIFIED LEGAL OPINION
here - the bond counsel says everything is OK - there are no problems. If the bond counsel does find a problem, he "qualifies" the opinion stating that there is a legal uncertainty of which a purchaser should be aware
Price at Premium
if the 5.50% bond where quoted on a 5.00% basis, then the price would be 103.59% par value, or $1,035.90 for every $1,000 par bond (this is from a bond calculator). This bond is selling at a premium. In order to decrease the yield on the bond below the stated coupon rate, the dealer had to raise the price above par.
Federal home loan mortgage corporation (Freddie Mac) debt obligations are
implicitly backed by the federal government and are rated AAA by Moody's and AA by Standard and Poor's
Debenture
intermediate and long-term corporate debt which is backed solely by the full faith and credit of the issuer no collateral backing the issue.
Money market instrument
is a debt obligation that matures in one year or less because of the short maturity it will be turned into money very rapidly
Bond
is a debt security which obligates the issuer to pay interest (usually semi-annually) and to repay the principal amount when the debt matures.
Capital appreciation bond
is a municipal zero coupon bond with a "legal" twist to it. a conventional zero coupon general obligation bond is counted AGAINST an issuers debt limit at par value because the discount is treated as "principal". If a new issue discount bond is legally crafted as a Capital appreciation bond, then the principal counted against the issuers debt limit is the discounted principal amount and the discount earned is considered to be interest income.
Revenue bond
is one backed by a specific source of revenue to which the full faith and credit of the issuer is not pledged. Such bonds do not allow bondholders to compel taxation or legislative appropriation for payment as is true of general obligation bonds. Since only the specified revenues back a revenue bond, this is said to be a self-supporting debt.
Unsecured Corporate debt
is simply backed by the issuers promise to pay. There is not collateral backing the issue Is issued in short-term, intermediate-term, and long-term maturities.
The basic idea behind the taxation of interest income on U.S. government obligations
is that one level of government cannot tax the other's obligations. So interest received from a U.S. government obligation is subject to federal income tax BUT IS EXCLUDED FROM STATE AND LOCAL INCOME TAXED
Spread
is the difference between the price at which a dealer would buy the stock, versus the price at which the dealer would sell the stock. If the dealer is willing to buy the stock at $10 and it willing to sell the same stock at $10.20 the spread is $0.20.
Tax and Revenue Anticipation Notes (TRANs)
issued in anticipation of both future tax collections AND revenue collections. A combination of a TAN and RAN offering
Tax anticipation notes
issued in anticipation of future property (ad valorem) tax receipts; paid off from those receipts. Secured by the general obligation pledge of the issuer
Revenue Anticipation Notes (RANs)
issued in anticipation of future revenue collection and tax collections other than ad valorem taxes. Most RAN's are also backed by the general obligation pledge of the issuer, making them very marketable
Negotiable Certificates of Deposit (CDs)
jumbo CD's with a minimum face amount of $100,000. the issuer promises to pay par value PLUS accrued interest at maturity These CD's are negotiable so they can be traded, if one holds a 3-month CD and wants to cash out after 2 months, once can sell it in the secondary market The price received depends on the interest rate movements
Corporate debt can take the form of
long-term bonds, intermediate-term notes, and short-term notes aka commercial paper
negotiable debt issues take the form of
long-term bonds, intermediate-term notes, and short-term notes aka treasury bills
Treasury bonds
long-term securities issued with maturities of 30 years. These bonds are issued in minimum denominations of $100 and pay interest semi-annually to registered holders.
State issues are backed by a different source of taxing power
most states do not assess property taxes; instead the revenue sources are income and sales taxes
Bearer bonds
not registered in an owners name. They are payable to the bearer have rows of coupons attached to the bond Each semi-annual coupon has a payment date and amount on it. The bearer of the bond clips the coupon at the due date and sends it to the paying agent for cash payment
The municipal market is a state by state market
people in Maine by Maine bonds not New York bonds people in New York buy New York bonds not Maine bonds
Sallie Mae (Student Loan Marketing Association)
purchases insured student loans from qualified lending institutions. is privatized
mortgage bond
real estate such as a factory is pledged as collateral for the bond issue. Te bond holder has a lien on the real estate. Under a lien, the bondholder has the legal right to sell the mortgaged property if the bondholders claims are not satisfied. The real estate that is pledged is worth more than the bonds that are issued. This collateral = cushion
Primary dealers
represent the later participants in the market about 20 firms are primary dealers - JP Morgan, Goldman Sachs, chase bank etc.
discount notes
short-term obligations of 1 year or less sold at a discount minimum $100,000 face amount with $1,000 increments thereafter yield more than equivalent maturity t-bill because these agency obligation have no direct U.S. government guarantee
There are two unusual forms of short term municipal financing
some issuers have sold "tax exempt commercial paper" with very short maturities (under 30 days). to make these marketable, they are sold backed by a bank line of credit. Thus, if the municipal issuer cannot pay, the bank is obligated to pay.
when a bond is secured
specific collateral is pledged to back the bond issue. If the corporation defaults, the bondholders have claim to the collateral. Because of this extra protection, secured bonds can be sold at lower interest rates than unsecured bonds. secured bonds are typically issued with long-term maturities.
Government agency
subject to federal tax exempt from state tax
Registered to principal only bond
the $1,000 face amount of the bond is now registered in the owners name but still has bearer coupons attached
The types of revenues that back these bonds include revenues from
the operation of a project, user feeds, rents, grants, excise and other non-ad valorem taxes
In order for the conversion feature to benefit the bondholder
the stocks price must rise in the market above the conversion price
CD's subject to market risk
these CD's are not redeemable prior to maturity, but they may be resold in the secondary market
FHLB also issues bullet bonds.
these are non-callable bonds. identified in dealer offering listing with a bullet next to the listing, indicating a non-callable bond
bankers acceptance
this instrument is used to finance imports and exports before a foreign exporter will ship goods to the US he wants assurance that the funds are ready for payment when the goods arrive. The exporter will demand a draft (for $100,000 for example) on a bank payable at a future date
federal funds
this is the shortest term money market instrument available only to member institutions of the federal reserve system federal funds are reserves held on deposit by member banks A bank with excess reserves can lend them to a bank that is deficient at the federal funds rate. These loans are overnight and the interest rate is quite volatile - changing as the demand for reserves changes
special assessment bonds
to fund an improvement which does not benefit the general public but rather a small portion of the community, a municipality will float a bond issue backed by a special assessment of increased taxes designed to pay for the improvement
The biggest player in the repo market is the FEDERAL RESERVE
to inject cash into the money supply it will enter into repurchase agreements with dealers (the large banks) where the fed buys the "paper" from the dealer backed by eligible securities. the bank then gets cash which can be lent out
Over-The-Counter Trading
trading of government and agency securities takes place solely in the over-the-counter market. There is not trading on any exchange floor The participants in the market include large commercial banks, foreign banks, U.S. government securities dealers, full service brokerage firms and the federal reserve itself
Long-term CD's
while most conventional CD's have lives of 1 year or less, banks have increased their offerings of CD's that have a longer maturity than 1 year.
Variable rate demand notes
The issuer resets the interest rate daily or weekly based on a given index. At the reset point, the note holder has the option of redeeming the note at par or holding it for the next period (1 day or 1 week) at the new interest rate. This was the first attempt by issuers to sell-long term bonds (because there is not stated maturity date) at short-term interest rates.
Typically, money market obligations are traded in large units
$1,000,000 - $5,000,000 minimum between institutions they are issued at a discount to par value, maturing at par, wit the gain being interest income. Some instruments are issued at par and mature with accrued interest
Prepayment risk
The length of the certificate depends on the underlying mortgages in the pool. In reality, the actual life of the certificate is shorter because mortgage prepayments occur when homes are sold or mortgages refinanced. These prepayments are passed through to the certificate holder. Because of prepayment risk, the real maturity is unknown.
Long Term CD's are often called Brokered CD's and differ in key respects from conventional CD's issued by banks.
The most common way that they are issued is that the brokerage firm buys a large (say $10,000,000) CD from a bank and then chops it up into units, say $10,000 to be sold to its customers.
Commercial paper is sold in book entry form.
The purchasers are not small investors because of the large denominations. They are large institutions with excess cash to invest and money market mutual funds.
Revenue bond financing accounts for 45% of municipal issues while general obligation bonds account for another 45%.
The rest of the municipal market is composed of special types of bonds
Credit risk aka default risk
The risk that the issuer cannot make interest and principal payments on an issue.
A bond can be visualized as having 2 components - these are:
The stream of interest payments over the life of the bond. The financial principal repayment
If a municipality has a tax rate of 6 mills, a property with an assessed valuation of $100,000 would pay taxes of
0.006 X $100,000 = $600
To find the approximate price of a long-term municipal series bond quoted on a yield basis.
30 year 4% general obligation bond on a 5.00 basis. 4% coupon / 5% basis = 80% of $1,000 par = $800 30 Year 6% general obligation bond on a 5.00 basis 6% coupon / 5% basis =120% of $1,000 par = $1200
Current yield
= Annual interest in dollars / bonds market price.
Parity price of the stock
= bond market value / conversion ratio = $900 / 20 = $45 The market price of the stock must be $45 (its currency $40) for the stock to be at parity. Therefore, the stock is selling below its parity value.
Parity price of the bond
= conversion ratio * Stock's market price = 20 * $40 = $800 In order for the bond to be of equal value to the stock, it must trade for $800. The current market price is $900. therefore, the bond is trading above its parity price
Conversion Ratio
= par value of bond / conversion price = $1,000 / $50 = 20:1 The bond is convertible into 20 shares of stock
Series bonds
A bond issue where the bonds have the same maturity but different dates of issuance. Rarely issued used to finance long-term construction projects where all of the money is not needed at once. Ex: Instead of floating a $10,000,000 bond issue today to build a new plant, a corporation could float a series bond issue, selling $5,000,000 of bonds this year, $3,000,000 next year, and $2,000,000 the following year for a total issue of $10,000,000. By phasing in the bonds, the total interest cost to the issuer is reduced.
Discount bond
A bond sells at a discount when the par value is in excess of the bond's purchase price $1,000 par corporate bond quoted at 90 is selling at a discount of 10 points ($100 from par)
Premium Bond
A bond that sells at a premium when the bond's purchase price is in excess of par value a $1,000 par corporate bond quoted at 110 is selling at a premium of 10 points ($100 over par)
Put definition
A put give the investor the right to tender the bond (he/she can "put" the bond) to the issuer after a specific date for a price set ins the bond contract
Transfer agent / paying agent
The transfer agent keeps the record of the owners of the debt outstanding, and when the debt is traded, "transfers" the ownership record to the new owner. The same financial institution usually acts as paying agent for the issuer as well. The paying agent makes the actual interest payments to the owners of record and handles debt redemptions.
Moody's and Standard & Poor's
The two main agencies
A general obligation bond is backed by the full faith, credit, and taxing power of the issuer.
The type of taxes which back general obligation bonds depends on the issuing entity.
Local governments have the ability to collect property taxes known as
Ad valorem taxes
Mill rate
Ad valorem taxes back local general obligation bond issues. These taxes are based on "Millage" One mill = 1/10th of 1 percent or 0.001
Trust indenture act of 1939
All corporate issues of $50,000,000 or more must have a Trust Indenture as specified by the Trust Indenture Act of 1939.
Trading in the municipal bond market is very limited
All trades take place over-the-counter. The cause of this is the fact that in addition to the federal tax exemption that municipal interest enjoys, if a bond is purchased by the resident of a state, most states will also exempt the issue from state and local tax.
Yield to maturity formula
Annual income + annual capital gain (Discount bond) or - annual capital loss (premium bond) / (Purchase price + redemption price/2
Long-term zero coupon issues bonds (deep discount long-term maturities)
Are the most volatile bonds. have no interest payments the entire value is in the final principal repayment at maturity
Municipalities like level debt service bond issues because it allows them to budget the same annual dollar amount to pay debt service requirements.
As long as they pay the level debt service amount yearly, the bond issue will be completely retired at maturity.
Price at Par
Assuming that it is now 2021, a bond maturing in 2030 has nine years to maturity. The coupon rate on the bond is 5.5%. This is the rate of interest that is printed on the $1,000 par bond certificate. If the bond is being offered at a price quoted to a 5.50% yield or basis, the price will be 100% of par. Since the amount of interest received per $1,000 par bond does not change (the holder receives 5.50% of $1,000 = $55 of annual interest). If market interest rates move up after the bond has been issued, the price of the bond must fall below par, so that the bond gives a complete yield to the current market.
Redemption
At maturity, ABC corporation must repay the $1,000 principal amount to the bondholder. The bond is redeemed by the issuer at par.
Most long-term issues are serial maturities with the maturities spread over a sequence of years
These bonds are issued at par and pay interest semi annually
To induce bondholders to accept income bonds
They are often given a greater principal amount than they had before.
Basis points
Basis quotes are in "yields" a quote of 5.50% is a bond price to yield 5.50%. If the quote were 5.60, the bond is priced to yield 5.60%. The difference between the 5.50 and 5.60 is a change of 10 basis points. One basis point equals 0.01% on a bond. Ten basis points equals 0.1% One hundred basis points equals one full point or 1%
The very first bonds issues were
Bearer bonds
Unsecured Corporate debt discount instrument
Because of the short-term nature, commercial paper is sold at a discount and matures at face value. Commercial paper is sold in large units - $100,000 = minimum denomination and is often sold in multiples of $1,000,000
In the event of a default, general obligation bondholders have the right to compel a tax levy or legislative appropriation to make payment on the debt.
Because of this, general obligation bonds are generally considered the safest type of municipal credit.
Zero-coupon bonds
Bonds can also be issued with a stated par value (usually $1,000 minimum) but without a stated rate of interest. No semi-annual interest payments are made on these "zero-coupon" bonds. Instead the bonds are purchased at a discount from par and are redeemed at maturity at par value.
Industrial development bond
Bonds issued by a state, city, or local agency to build an industrial facility that is leased to a private company. the lease payments of the company are the revenues sources. IDB's are also guaranteed by the private user, take on its credit rating, and are considered the users liability
The federal reserve maintains its own trading account and buys/sells large quantities of government securities in the market to manage interest ratee
This activity is called open market operations
Assume that a corporate bond dealer is offering a 10-year, 10% bond at a price of 90.
This bond is being offered at a discount, therefore the true yield of the bond is being offered at a discount, therefore the true yield of the bond is higher than the stated yield.
Local government issues (towns and cities) are usually backed by UNLIMITED ad valorem taxes
This means that the issuer promises to raise taxes without any limit in order to payoff the bondholders
Because treasury strips are long-term zero-coupon (deep discount) obligations, price swings are very volatile as interest rates move.
This security is HIGHLY SUSCEPTIBLE to interest rate risk.
U.S. government bonds and the market participants are exempt from regulation under the securities act of 1933 and the securities exchange act of 1934
Thus, the SEC does not oversee U.S. government bond trading
Build America Bonds
To help with an economic recovery municipalities could issue build America bond. Which are taxable bond issues however, these bonds get a 35% interest rate credit from the federal government
Reverse repos - tightens credit
To tighten the money supply, the fed enters into reverse repurchase agreements, selling the paper to government dealers. The dealers are temporarily drained of cash, tightening the money supply. This is also called a matched sale
Treasury debt - AAA rated
Top rated bond by Moody's They are considered to have no credit risk
Cash - same day
Cash settlement for U.S. Government and Agency Trades is the same business day before 2:30pm
Convertible debentures
Convertible bonds are corporate debentures which can be converted, at the option of the owner, into the common stock of the issuer. At the time of issuance, a conversion price is set per share The bond can then be converted, based on its par value, into a fixed number of common shares.
Trades settle in fed funds
Trades of U.S. Government and Agency securities clear through the federal reserve wire system. These trades settle in "fed funds" - good funds immediately payable at a federal reserve branch member institution
Corporate bonds % of par in 1/8ths
Corporate bonds are quoted as a percentage of par value with minimum changes of 1/8th point ABC corporation debentures are quoted at 101 3/8 The dollar price of a $1,000 par bond is 101.375% of $1,000 par = $1,013.75
Mortgage bonds are the most common form of
Corporate debt represents the principal financing source for public utilities. These issues generally get high credit ratings due to the quality of the collateral backing the issue AND can be sold at a lower interest rate than unsecured debt
Regular way settlement - next day for treasuries
Trades of U.S. Government treasury bills, notes, and bonds settle regular way 1 business day after trade date
Regular way settlement - depends for agencies
Trades of agency securities that pay interest semi-annually generally settle "regular way" 1 business day after trade date.
Callable bonds/non-callable bullet bonds
Traditional callable bonds issued with up to a 30 year maturity pay interest semi-annually. These are fixed rate bonds issued in $10,000 minimum face counts
Bonds
Traditional callable bonds issued with up to a 30 year maturity that pay interest semi-annually. These can be fixed-rate bonds issued in $5,000 minimum face amount with $1,000 increments thereafter, or floating rate bonds issued in $100,000 minimum face amounts, with $1,000 increments thereafter
Designated bonds
Traditional non-callable bonds that pay interest semi-annually issued in 2-10year maturities. These are issued in $5,000 minimum face amount with $1,000 increments thereafter.
Variations of treasury bonds
Treasury strip Treasury Tips
Government Bonds % of par in 1/32nds
U.S. Government bonds are quoted as a percentage of par value, wit minimum changes of 1/32nd point A U.S. treasury bond is quoted at 99.24. The dollar price of a $1,000 par bond is 99 and 24/32% of par = 99 and 0.75% = 99.75% of $1,000 par = $997.50
Cash management bill (CMB)
Very short-term securities with typical maturities that can range anywhere from 5 days to 6 months. these are sold at auction on an "as needed" basis when the treasury is running low on cash. Thus, they are used by the treasury to smooth out its cash flow needs. Sold in minimum amounts of $100 and pay a slightly higher interest rate than equivalent maturity T-bills sold on a regular auction schedule
Commercial papaer
Very-short-term corporate financing needs are met by issuing commercial paper. Maturities range from 14-90 day with 30 days being the most common maturity. the maturity will never exceed 270 days as the issue would then have to be registered with the SEC which is expensive and time consuming.
Call definition
When a bond is callable, the issuer has the right to redeem (To call in) the bond at a predetermined price at a date prior to maturity. However, the issuer is not obligated to do so.
Repurchase agreement
Dealers government securities carry a large inventory at any given time. In order to improve liquidity aka get cash, a dealer will sell some of those securities to another dealer with an agreement to buy them back at a later date at a price to give a fixed yield.
Eurodollars
Deposits denominated in dollars held in a bank branch outside the US these are large dollar deposits typically made by corporations with a fixed term from 1 day to 5 years. foreign banks trade these deposits similar to the domestic trading of fed funds. domestic banks with a reserve deficiency can borrow euros as a substitute for fed funds. The difference is that fed funds are loaned overnight euros can be loaned for longer periods The interest rate charged on eurodollar loans between major international banks is LIBOR - London interbank offered rate - is the average offered rate for eurodollar loans of 5 major banks centered in London
retail bonds
Designed for retail investors, these are similar to the bonds offering listed above but are available in minimum $1,000 denominations and they have a unique estate planning feature. These bonds have a survivors option which allows the bonds to be redeemed at par PLUS accused interest upon death
To provide funding to farmers, such as short-term loans for planting/harvesting, intermediate-term loans to buy equipment and long-term loans to buy land and buildings. The federal farm credit banks funding corporation issues the following securities
Discount notes Designated bonds Bonds Retail Bonds these agency obligations are offered but a selling group of dealers, mainly large commercial banks and brokerage firms. typically yield 0.25% more than equivalent maturity treasuries because they don't have a direct U.S. government guarantee
Bonds are issued with a stated par value (usually $1,000 minimum) and a stated rate of interest on the debt
EX: A $1,000 par value bond is issued wit a stated rate of interest of 8% by ABC corporation in 2021. The maturity on the debt is 2041. ABC must pay $80 of interest annually to the bondholder for each of the 20 years the bond is outstanding
Balloon Maturity
Each maturity has a different interest rate on the bond. this is natural because the longer the maturity, the higher the interest rate that investors demand.
Equipment Trust Certificate
Equipment owned by the corporation is pledged as collateral. This is the typical form of financing for common carriers such as airlines, trucking companies, and railroads. are rated highly because if the issuer defaults, the equipment can easily be sold to repay the bondholders. non-callable
Municipal
Exempt from federal tax subject to state tax HOWEVER, if the bond is purchased by a state resident, then they are exempt from state tax.
Income bonds aka adjustment bonds
When a corporation goes bankrupt, the issuer defaults on the outstanding debt. The company then tries to reorganize and emerge from bankruptcy. part of the reorganization is getting the existing bondholders to give up any claims under the old bonds and accept a new type of bond. This new bond is an INCOME BOND that only obligates the issuer to pay if it has sufficient earnings.
Fed looseing
When the fed wishes to loosen credit, it will buy treasury securities from the primary dealers, which places cash into the dealers. This lowers market interest rates since banks have more cash to lend
Fed tightening
When the fed wishes to tighten credit, it will sell treasury securities to the primary dealers which removes cash from the dealers. this raises market interest rates since banks have less cash to lend
Fannie, Freddie, Ginnie / issuers of mortgage backed securities
Fannie, Freddie, and Ginnie are primarily issuers of mortgage backed pass through certificates. They also issue other types of debt, but the vast majority of their debt issuance is in the form of Mortgage Backed Securities
Federal Farm Credit System
Farmers can obtain low rate financing through the federal farm credit system.
The U.S. government promotes some ownership through
Federal home loan banks (FHLB) Federal national mortgage association (Fannie Mae) Government national mortgage association (Ginnie Mae) Federal home loan mortgage corporation (Freddie Mac)
Treasury Tips
For investors that wished to avoid purchasing power risk
Treasury Strips
For investors that wished to avoid reinvestment risk Treasury bonds that have been stripped of their coupons. These are essentially zero-coupon treasury obligations
Long-term corporate debt is referred to as
Funded debt
Because revenue bonds are backed by a single source of funds, they have
GREATER CREDIT RISK THAN GENERAL OBLIGATION BONDS AND TRADE AT HIGHER YIELD
Fully registered bonds
Gets rid of bearer coupons This bonds is a bond that is "registered to principal and interest". fully registered bonds have the bondholder registered with the transfer agent as the owner of record and a physical certificate is issued to the bondholder. The paying agent send the semi-annual interest payments directly to the registered owner and at maturity, sends the final $1,000 principal repayment to the registered owner.
Government national mortgage association (Ginnie Mae)
Ginnie does NOT buy conventional mortgages It only buys FHA, VA, and Farmers Home Administration insured mortgages from banks and places them in mortgage pools which are then securitized and sold to investors
All new municipal bonds are issued in book-entry form.
HOWEVER, older bonds that have not matured still trade and come in fully registered form or bearer form.
TIPS example cntd
With the addition of TIPS, the treasury is giving the investor a choice - you can buy a 2.5% conventional 30 year treasury bond that is subject to interest rate risk Or you can buy a 2% TIPS where each year your return will be the 2% real interest rate PLUS an additional return equal to that year's inflation rate So if inflation rises by 1% in 2021, the TIPS return for that year will be the 2% real rate + the 1% inflation rate = 3% total return Thus as inflation rises, the return rises, and the TIPS price will not fall.
Another factor that limits municipal trading is that most issues are "serial" maturities.
Within a bond offering are multiple maturities, with each maturity having a relatively small principal amount. The small amount of each maturity available limits trading
Maximum maturity on commercial paper is 270 days to be exempt from the provisions of the securities act
If commercial paper is issued with a maturity longer than 270 days, it must register with the SEC, making it very costly for issuers to sell such securities.
Such agreements do have purchasing power risk even though the agreement covers a time period of 1 day. The underlying collateral consists of longer maturity government securities.
If during the day 1 period of the agreement interest rates rise, then on the next day, the collateral is returned to the seller at the pre-agreed price. However this collateral may be substantially devalued due to the rise in interest rates
The customer must be informed that the ownership title of the CD determines whether FDIC insurance covers the instrument.
If the CD is titled in the customers name - then FDIC insurance covers the instrument. If the title is held in the name of the broker-dealer solely, the instrument is NOT FDIC insured to the customer
Level debt service
If the issue is structured so that the combined annual payments of interest and principal equal the same total amount each year
Close-end
If the trust indenture is closed-end, new bonds can be issued against the real estate ONLY if they have lower status in a liquidation (junior status) to the existing bonds.
Premium Bond Yield Order from lowest to highest
Yield to Maturity (basis) Current Yield Nominal Yield
In order to induce customers to buy subordinated debentures
a "Conversion" feature is offered which allows the bondholder to convert the bond into a fixed number of common shares
Convertible bond EX
a $1,000 par bond is issued, convertible into stock at $50 per share. As of the date of issuance, the market price of the stock is $40. The bond is convertible into 20 shares ($1,000/$50 conversion price = 20 shares per bond). In order for the shareholder to benefit, the market price must rise above $50.
Term bonds
a bond issue where every bond has the same interest rate and maturity ex: corporate bond issues and U.S. government bond issues
Serial Bonds
a bond issue with differing maturities is a serial bond issue. Because of the nature of interest rates, differing maturities require different interest rates. Thus, both the maturities and stated interest rates differ for the bonds in the issue. Ex: municipal bonds and corporate equipment trust certificiates
Parity bonds
a municipal parity bond is one that has an equal claim on tax collections or revenues as other obligations of that issuer.
in an arbitrafge
a trader buys the lower price security and simultaneously sells the equivalent higher priced security
the market for agency securities is dominated by the primary dealers
agency securities are issued by assembling a selling group of firms who market the agency issues they act as fiscal agents for the agency
secondary dealers
all other firms trading U.S. government securities are termed secondary dealers most smaller banks and brokerage firms are secondary dealers these firms buy and sell treasuries in the market through the primary dealers
Special tax bonds
an issue secured by a tax other than an ad valorem tax, usually excise taxes such as cigarette, liquor and gasoline taxes
Lease rental bond
an issue used to finance office construction where the user is a state or city agency. The rents paid by the user are the revenue source
Double barreled bond
an issued backed by a revenue source other than ad valorem taxes but also backed by the faith, credit and taxing power of a municipal issuer This type of bond is treated as a general obligation bond since the ultimate source of payment is taxing power
Municipal bonds
are debt issues of state and local governments, territories, and political subdivisions. A principal feature of municipal bonds is the tax status of the interest income. Generally it is exempt from federal income tax but subject to state and local tax.
Interest income for municipal obligations
Interest income from municipal obligations is exempt from federal income tax but IS SUBJECT TO STATE AND LOCAL INCOME TAX
Standard and Poor's (S&P)
Investment Grade AAA AA A BBB Speculative Grade (Junk) BB B CCC CC C
Moody's
Investment Grade Aaa Aa A Baa Speculative grade (Junk) Ba B Caa Ca C
Construction loan notes
are issued to start the building of multifamily housing projects; the note is paid off by the placement of a final long-term bond issue. the final long-term bond issue is known as the "take-out" loan since it replaces the CLN issue
Grant Anticipation Notes (GANs)
Issued in expectation of receiving grant monies from the federal government usually for mass transit, energy conservation, and pollution control programs.
Bond Anticipation Notes (BANs)
Issued to start capital projects; the note is paid off by the placement of the final long-term bond issue. BAN's are used because the ultimate final cost of the project is unknown during the construction period. Most BAN's are secured by the general obligation pledge of the issuer.
Federal home loan mortgage corporation (Freddie Mac)
Its purpose is to buy conventional mortgages from baks and places them into mortgage pools which are then securitized and sold to investors and do not carry government insurance or a government guarantee This contrasts with Ginnie Mae who only buys government guaranteed or insured mortgages AND Fannie Mae that can buy both government guaranteed and conventional mortgages.
in some cases, local issuers will sell bonds backed by
LIMITED taxing power this means that there is a limit placed on the rate that the issuer uses to assess taxes. if the issuer is not collecting enough taxes to pay the bondholders and is at the maximum MILLAGE RATE. then the bondholder is at risk
Short-term securities
are issued with 1,2,3,6, and 12 month maturities. Treasury bills are issued at a discount from par ($100 minimum) and mature at par. The discount earned is considered to be the interest income. They are quoted on a discount yield basis.
treasury bills
are the largest money market instruments offered with 1,3,6, and 12 month maturities
Certificate of Participation (COP)
as municipalities reached their debt limits with general obligation bond issuance, they found it hard to get voter approval to increase the limits so that more bonds could be issued. To get around this the certificate of participation was invented by creative municipal bond attorneys This allows state entities to issue a tax exempt security that pledges the revenue from a project
Moral obligation bond
assume an issuer is at or above its statutory debt limit and cannot legally issue more debt backed by taxing power. Also assume that the issuer needs more financing, mainly to have the funds to "roll over" existing debt or it will default. THE SOLUTION: issue a bond backed by the promise to pay, but not the legal obligation to pay.
Parity bond example
assume that a municipality has a debt limit of $500 million. Also assume that the municipality has already issued $300 million of general obligation bonds. If the municipality issues another $100 million of General obligation bonds within its debt limit, these bonds have the same claim on tax Collections as the prior issue. THUS, both issues are on parity with each other / are called parity bonds
As market interest rates move up, the percentage downward price movement of bonds, ranked from greatest percentage movement to lowest, is:
Large discount bond (lowest coupon) Small discount bond Par bond Small premium bond Large premium bond (highest coupon)
As market interest rates move
Long maturity bond prices move more rapidly than do short maturity issues Short maturity bond prices move less rapidly than do long maturity issues Low coupon (discount) bond prices move more rapidly than do high coupon (premium) bond price High coupon (premium) bond prices move less rapidly than do low coupon (discount) bond prices
All new issues of bonds coming out in the United States are now book entry only
bearer bonds etc were very expensive to print
Longer term obligations are called capital market instruments
because they are a source of long term capital for the issuer
all municipal issues have a legal opinion printed on the face of the bond.
before a bond can be issued, the municipality retains a bond counsel. the bond counsel examines the issue to make sure that it is legally binding on the issuer, is valid, and that the interest is exempt from federal tax under current law.
Guaranteed bond / guaranteed debentures
bonds are typically issued by a subsidiary company; with the corporate parent company guaranteeing payment of interest and principal as due.
Short-term notes aka treasury bills, intermediate term-nots, and long-term bonds are typically issued in
book entry form
Federal national mortgage association (Fannie Mae)
buys government guaranteed and insured mortgages as well as conventional mortgages from banks. it derives its income from the spread between the rate at which it borrows funds from the public and the rate it earns on purchased mortgages. It earns fees as well
debt is also issued by agencies of the U.S. government
Most agency debt is not backed directly by the governments promise to pay. Instead, there is an implicit promise on the part of the government to pay if the debt defaults.
Because local issues are backed by property taxes, and property owners are very unhappy when mill rates are raised.
Most municipals have imposed a debt limit on the dollar amount of general obligation bonds that can be outstanding at any one time. This is either a statutory or constitutional limit which is expressed as a % of assessed valuation. If a municipality is at a limit, it cannot issue additional general obligation bonds. The only way to change the limit is through majority approval in a public referendum
Municipal serial bonds
Municipal bond issues are generally serial bonds. In a serial bond offering, each maturity has a different interest rate. This means that each maturity has a different value, and therefore has a different market price. Serial bonds are quoted on a yield basis aka a basis quote Ex: a municipal dealer quotes the 2030 5.50% bond of Los Angeles on a 5.50 basis. Meaning, he or she is offering the bond to the purchaser at a price to yield 5.50%. Since the coupon is 5.50%, this bond will be priced at par.
Short term municipal notes
Municipalities issue short term notes usually with less than 12-month maturities although it is not uncommon for notes to be issued with maturities as short as 3 months and as long as 3 years
Arranging the yields from discount bonds from lowest to highest
Nominal Yield Current Yield Yield to Maturity (basis)
Lets compute the nominal yield, current yield, and yield to maturity for a premium bond. Assume a 10-year, 10% corporate bond quoted at 110.
Nominal yield = 10% Current yield = $100 / $1100 = 9.09% YTM = $100 - $10 /($1,100 + $1,000) / 2 = $90/$1,050 = 8.57%
TIPS example
Over the past 20 years, the inflation rate in the U.S. has dropped and nominal rates have fallen at a similar rate. However, the real interest rate on 30 year treasury bonds has not changed at all - stayed between 2-3%. Nominal interest rates for treasury bonds have 2 components - the real interest rate of 2% PLUS that years inflation rate. So as inflation rates drop, nominal rates do as well, and real rates stay the same. On the other hand, if inflation increases, so will nominal rates. This HURTS holders of conventional long-term treasury bonds.
Corporate bonds trade settles "regular way"
Regular way trade settles 2 business days after trade date
The two largest types of municipal offering by far are
Revenue bonds and General obligation bonds
Series EE bonds
Savings bonds issued by the U.S. government with a minimum purchase amount of $25 or more. the bonds have no stated maturity - the holder can redeem at any time do not trade - issued by the treasury to the public via the treasury direct website
