Chapter 3 Types of Bonds

A convertible bond can be converted into common stock of the bond issuer at a price of $20 per share. The bond is currently selling for $800. What is the conversion ratio? 40:1 50:1 80:1 It can't be determined from the information given

50:1 1000/20

Pass-Through Certificate

A certificate that represents a portion of ownership in a pool of federally insured mortgages

Collateralized mortgage obligations (CMO)

An MBS that takes the principal and interest payments from underlying mortgages and separates them into various classes of bonds that are referred to as tranches.

repurchase agreement

An arrangement where one firm sells some of its financial assets to another firm with a promise to repurchase the securities at a later date.

What trend would cause the prepayment risk of mortgage-backed securities (MBS) to increase? A. Mortgage rates rise rapidly. B. Mortgage rates fall rapidly. C. Home prices increase rapidly. D. Inflation rises rapidly.

B Most mortgages can be refinanced, and homeowners are most likely to refinance when mortgage rates are falling—i.e., lower-rate alternatives are available. This increases the prepayment risk in mortgage pools, the collateral backing MBS. It means MBS investors must reinvest more returned principal in a lower-rate environment.

what can trade in money market

Because Treasury bills have maturities of one year or less, they can trade in the money market. Similarly, T-notes or T-bonds with one year or less to maturity can trade in the money market. However, no equities (e.g., ADRs or preferred stock) trade in the money market.

General Obligation Bonds (GOs)

Bonds issued by a municipality that are secured by the full faith and credit of the issuer - backed by full taxing power of the issuing municipality

Ginnie mae

Government National Mortgage Association; pools mortgages for investors

Certificates of deposit (CDs)

Investments in which an amount of money invested for a specified period of time earns a guaranteed rate of interest.

What is a big advantage of Treasury STRIPS over T-bonds with similar maturity? No reinvestment rate risk Higher quality More current income Enhanced covenants

No reinvestment rate risk Although T-bonds are of very high quality, they do have reinvestment rate risk, which is the risk that the semiannual coupon payments that the investor receives will be reinvested back into the market at a lower rate. Because STRIPS do not have coupons, they have no reinvestment rate risk.

conversion parity

Two securities, one of which can be converted into the other, of equal dollar value. - the point at which neither a profit nor loss is made at conversion

Which of the following types of bonds generally has the lowest bid-ask spreads in secondary market trading? US Treasuries Municipal bonds Corporate coupon bonds Corporate zero-coupon bonds

US Treasuries US Treasuries are by far the most liquid debt issues in the secondary market, with very narrow bid-ask spreads.

Treasury receipts

Zero coupon bond created by brokerages. B/D buy treasury securities and place them in trust at a bank and sell seperate "receipts" against the principal. *Not backed by the U.S. Government - backed by cash flows from Treasury securities

convertible bond

a bond that an investor can trade for shares of the corporation's common stock - yield less interest than nonconvertible bonds - trade more like equities

over the counter market

a network of dealers who buy and sell the stocks of corporations that are not listed on a securities exchange

bond indenture/trust indenture

a series of promises between the issuer and a trustee

Banker's Acceptance

a written order for a bank to pay a third party a stated amount of money on a specific date - maturities typically 180 days or less - finance and facilitate international trade

Industrial development revenue (IDR) bonds

bonds issued for the benefit of a private corporation, are also considered private activity bonds - encourage economic development and job creation

municipal securities

debt of state and local governments - finance projects for the public good - backed by taxes or revenues received by the issuer

subordinated debt

debt that may be repaid in bankruptcy only after senior debt is paid

Eurodollar bonds

dollar-denominated bonds sold outside the United States - issued and trade outside the US and are not registered with the SEC

public purpose municipal bonds

federal income tax exemption - interest received from public purpose bonds is free from federal income tax - capital gains are taxable

interest paid on US Treasury securities is taxable at what level?

federal level, but exempt from state and local income tax

GO bonds typically used to

fund projects and infrastructure improvements that will serve the entire community, including roads, parks, government buildings

Tax-free municipal bonds are most suitable for those in ________ tax brackets

high - these investors will most benefit from the tax-free interest. They are unsuitable for retirement accounts or pension funds that benefit from income-tax sheltering

muni bonds are

highly illiquid because each issuance is unique, with its own credit structure, terms, and conditions

Revenue bonds

investments secured by the revenue generated by a state or municipal project - Because these bonds are not backed by tax revenue, they can be issued outside of the issuer's legislative debt limits. They help ensure that improvements can move forward without burdening the municipality and its constituents with additional direct debt obligations.

Treasury bonds

longest maturity of US government securities - pay interest every 6 months - maturity of 30 years highly liquid

secondary market

market for reselling financial assets

Money market

market in which money is lent for periods of less than a year - money market instruments are considered near-cash assets - relatively liquid and low in risk

Treasury bills

mature in one year or less - do not pay interest prior to maturity - sold at a discount and mature at par - least risky

Match type of CD to description

non negotiable BA CP Repurchase agreement

Private purpose or private activity municipal issues

not qualify for federal or state tax exemption -not providing benefit to the public

conversion ratio

par value/conversion price

alternative minimum tax

personal income tax rate that applies to cases where taxes would otherwise fall below a certain level

Trust Indenture Act of 1939

requires that corporate debt issues of more than $50 million include a written agreement, or trust indenture, between the issuer and an inde- pendent trustee acting on behalf of the bondholders - includes a number of protective covenants, or promises by the issuer, that are designed to protect the interests of the bondholders.

Treasury security's quote shows the

security's interest rate at the time it was sold, its maturity date, bid and asked prices, the price change from previous day, and the yield

Commercial paper

short-term unsecured debt issued by large corporations - issued in a form of promissory notes - typically issued at a discount to their maturity value, with the discount representing interest that will be paid at maturity - maximum maturity of 270 days

prepayment risk

the risk that mortgages underlying a mortgage-backed security/pass-through will be paid off sooner than expected due to a drop in interest rates. Investors reinvest the principal at a lower rate going forward.

municipal notes

these are short term issues that are normally issued to assist in financing a project or to help a municipality manage its cash flow. these are interest-bearing securities that ultimately pay interest at maturity TANs RANs BANs

Negotiable CDs

transferable to other investors - considered securities and can be traded in the secondary market - most have maturities one year or less - minimum face value is 100,000

T notes and T-bonds pay interest _______ a year

twice

Debentures

unsecured corporate debt - pays more interest than secured debt because it is not backed by specific asset

Treasury STRIPS

- allow investors to purchase the individual interest and principal components of certain Treasury notes and bonds as separate securities - issued at discount and mature to face value - do not have reinvestment rate risk, as there are no coupons to reinvest

the spread

- difference between bid and ask - small spread = strong liquidity large spread - less liquidity

Municipal bond interest

- exempt from federal income tax and may also be exempt from state and local tax - tax benefits from municipal bonds refer to the bond's interest income, not any capital gains generated from the sale of the bond

US government securities

- over 20 trillion in outstanding securities as of 2018 - safest, no default risk as they are guaranteed by the full faith and credit of the US government - ability to raise tax revenues and print currency - pay less interest than corporate and municipal securities

Liquidation priority

1. Secured bondholders 2. Unsecured bondholders and general creditors 3. Subordinated debt and convertible bonds 4. Preferred stockholders 5. Common stockholders

Which of the following treasury securities has the greatest interest rate risk? Six-month T-bill 10-year T-note 30-year T-bond 30-year STRIP

30-year STRIP Long-term, zero-coupon bonds (such as STRIPS) are the most volatile in the face of changing interest rates.

T-notes and T-bonds are quoted on the secondary market as a percentage of par in ______ of a point

32nds 1/32 For example, a quote of 95:07 or 95-07 on a T-note indicates that it is trading at a discount: $952.19 (or 95 7/32%) for a $1,000 bond.

Mark owns general obligation (GO) municipal bonds issued by the county in which he lives. He wants to know what collateral stands behind these bonds. The best answer is: A. the full faith and credit of the state government. B. the ability of his county to stick to its budget. C. his own property taxes. D. a collateral bond posted by the county.

C GO bonds are backed by the full faith and credit of the issuer, a county in this case. This means the full taxing power of the county. The largest source of tax revenue for most counties is ad valorem (property) taxes. The county can increase these taxes, if necessary, to fulfill its obligations to bondholders.

In a period of stable interest rates, the price of the ___________ bond will be more volatile than that of other types of debt

Convertible bond This is because the convertible bond will fluctuate in price with the underlying stock.

Which one of the following is not a feature of a negotiable CD? A. Backed by FDICinsurance B. Minimum face value of $100,000 C. Transferable to other investors D. Pays federally tax-exempt interest

D Negotiable CDs have many of the same characteristics as regular CDs. They are issued by banks and carry FDIC insurance coverage, currently up to $250,000 per depositor. Also, they pay interest that is taxable. Key differences are 1) a larger minimum face value (at least $100,000) and 2) ability to be transferred to other investors through secondary- market sales.

What is the purpose of a bond covenant? A. To pledge collateral for repaying bonds B. To restrict ability to sell bonds prior to maturity C. To protect bond issuers D. To protect bondholders

D The trust indenture, a written agreement between the bond issuer and a trustee, includes various covenants. Each covenant is a promise that protects the interests of bondholders. For example, a covenant can prevent issuers from selling key assets.

debt limit and bond referendum

Debt limit establishes the total amount of GO principal that can be outstanding at any time Requires that any bonded indebtedness (and the taxes imposed to pay off this indebtedness) must be approved by voters

Asset Backed Securities

Represent a claim to a portion of a pool of assets and the return is passed through to investors with different tranches having different levels of risk and return Asset-backed securities permit the securitization of financial assets, not of hard corporate assets. For example, a pool of student loans, auto loans, and equipment leases can all be securitized into an ABS. A piece of equipment itself (a truck, ship, or airplane) cannot be securitized.

Which type of bond has the highest liquidation priority? 1. Secured bond 2. Debenture 3. Subordinated bond 4. Convertible bond

Secured bond Secured bonds have the highest liquidation priority, followed, in order, by unsecured bondholders and general creditors, and then subordinated debt and convertible bonds. All bondholders rank ahead of equity holders (preferred and common) in liquidation priority.

Secured corporate debt

Secured bond is backed by collateral 1. mortgage bonds - secured by real estate 2. Collateral trust bonds - secured by financial asset owned by the corporation such as stocks, bonds, or other securities 3. Equipment trust obligations are debt instruments that are secured by equipment or physical assets such as airplanes

Match description

TIPS Tbills Tbills STRIPS T bonds

extension risk

The risk that when interest rates rise, fewer prepayments will occur because homeowners are reluctant to give up the benefits of a contractual interest rate that now looks low. As a result, the security becomes longer in maturity than anticipated at the time of purchase.

Interest from territory bonds is generally exempt from taxation by federal, state, and local authorities anywhere in the US

Therefore, US-territory bonds are also considered triple-tax- free. US territories include Guam, Samoa, Puerto Rico, and the US Virgin Islands.

In trading any bond, what does the spread indicate? Relative quality Relative yield to maturity (YTM) Trading volume Trading liquidity

Trading liquidity

Treasury Inflation-Protected Securities (TIPS)

Treasury issues in which the principal amount is tied to the Consumer Price Index to protect the buyer against the effects of inflation The coupon rate is constant, but generates a different amount of interest when mul- tiplied by the inflation-adjusted principal, thus protecting the holder against inflation.

Government Sponsored Enterprises

authorized to raise money through issuing debt securities - agency securities not fully backed by the US government but are considered safe from default - yields are higher than those of treasury securities Fannie Mae and Freddie Mac

ad valorem tax

backing GO bonds A tax levied according to value, generally used to refer to real estate tax. Also called the general tax.

unlike quotes on notes and bonds

bid quotes on bills are always higher than the asked because the quoted amount must be subtracted from the face amount to determine the price.

discounted yield basis

bills are quoted at a discount from face value, with the discount expressed as an annual rate based on a 360- day year

mortgage-backed securities

bonds backed by mortgage payments

non-negotiable CDs

cannot be resold and can only be redeemed but the issuing bank

Treasury bonds, because of their longer maturity, would be more affected by a change in _____________ than T-notes or T-bills.

change in interest rates

securitization

converting mortgages into bonds

Corporate bonds vs. notes vs. commercial paper

corporate bonds are issued by commercial and industrial entities to raise money for expansion - long term at least 10 years Notes - medium term commercial paper - no more than 270 days