Series 65 - Fundamentals of Debt Securities

After Tax Yield Formula

The after-tax yield is calculated by multiplying the taxable yield of the investment by 100% minus the tax bracket. In this case 12% x (100% - 28%) = 12% x 72% = 8.64%

General Obligation Bond's credit risk:

A general obligation bond is backed by the taxing authority and full faith and credit of a municipality and, on average, is considered to have less credit risk than an unsecured corporate bond.

Treasury Bonds yield

After municipal bonds come Treasury bonds because of safety of principal

Bankers' acceptances (BAs)

Bankers' acceptances (BAs) are time drafts issued by a bank. These securities are backed by a letter of credit and not protected under FDIC. BAs are used to facilitate the import/export business.

Demand Deposits:

Brokered CDs are also covered up to FDIC limits even though they trade in the open market.

An investor who is looking for a relatively high level of potential growth but is also looking to generate income would most likely invest in...

Convertible bond prices are influenced by the underlying common stock into which the bonds may be converted. Therefore, if the stock increases in value, so will the bond; however, if the stock declines in value, the bond will still pay interest on a semiannual basis

Corporate issuers are more likely to call bonds when...

Corporate issuers are more likely to call bonds when interest rates are declining. This means that bond prices would be rising and are likely trading at a premium. If interest rates were rising, it would make little sense for the corporation to refund the debt at higher rates than it is currently paying

An investor who maintains a large portfolio of debt securities anticipates a small change in interest rates. The investor would like to measure the effect that this change would have on the value of her portfolio. What tool will provide her with this information?

Duration would be the best tool, as it is designed to compare the effect of small changes in interest rates on the value of securities with different coupons, maturities, and credit quality.

Compared to Treasury securities, agency securities are

Less Liquid & Higher Yielding: agency issues are not as liquid as Treasury securities, since the issues are usually smaller in size and are not traded as much. Lower liquidity and a slightly greater credit risk for those agencies not directly backed by the U.S. government means that agencies have slightly higher yields than Treasuries

Equivalent taxable yield Formula

Municipal Bond Yield / (100% - Investor's Tax Bracket) = Equivalent Taxable Yield

Municipal bond yield

Municipal securities will have the lowest nominal yield because the interest is federally-tax free.

TIPS (Treasury Inflation-Protected Securities):

TIPS are interest-bearing (fixed-coupon) but the principal is adjusted semiannually to reflect inflation. Therefore, in an inflationary environment, both his income and principal will rise.

Coupon of a bond:

The higher the coupon of a bond, the greater the amount of payout to the bondholder; therefore, the faster he will recover his original invested amount.

Corporate Bond Yield

The bonds with the highest nominal yield are corporate bonds.

Characteristics common to mortgage-backed securities include

They involve the pooling of mortgages • They trade in the over-the-counter market • They are collateralized by mortgage loans on real properties

Treasury STRIPS:

Treasury STRIPS are zero-coupon bonds (long-term). Interest is automatically reinvested and compounded at the same yield and reinvestment risk is avoided.

Rank the following investments from least to most risky: • Common stocks • Preferred stocks • U.S. government securities • Limited partnerships

US Governement Securities Preferred Stocks Common Stocks Limited Partnerships

A convertible bond is convertible at $25. The bond is currently selling in the market at $960. What should the stock be selling at to be at parity with the bond?

• $24 • The bond is convertible at $25. This means the conversion ratio is 40 to 1. ($1,000 par value divided by the conversion price of $25 equals the conversion ratio of 40 to 1.) To find parity for the stock, divide the market value of the bond by the conversion ratio (market value of the bond [$960] divided by the conversion ratio of 40 equals $24 parity price for the stock)

Brady Bond:

• A Brady bond was a debt instrument issued by foreign governments in the 1990's and its principal was collateralized by zero-coupon Treasury securities. • The principal of a Brady bond is backed by U.S. Treasury bonds that are deposited with the Federal Reserve. • are not guaranteed in any way by the Treasury Department or the Federal Reserve or any other agency of the United States government

Barbell Strategy (4)

• A barbell strategy consists of buying short-term and long-term bonds, but not intermediate-term bonds. • The purchase of long-term bonds allows an investor to capture higher long-term interest rates. • The short-term bond provides the opportunity to invest elsewhere if the bond market takes a downturn. • There is no guarantee that any money made on the short end of the strategy will offset losses that could occur on the long end of the barbell.

Characteristics of Zero-Coupon Bonds (4)

• A zero-coupon bond is purchased at a discount and does not pay periodic interest. • All interest is paid at maturity (the difference between cost and par value). • The discount must be accreted each year and is treated as ordinary income even though it was not actually received. • Since interest is not paid each year, a zero-coupon bond would not satisfy an investor's need for cash flow.

Characteristics of Convertible Bonds:

• All bondholders are creditors of the issuing corporation. If the bond is convertible, then there are some unique considerations. • First, since the conversion feature provides the bondholder with additional flexibility, a convertible bond will have a lower coupon than similar issues. • Secondly, because the bondholder can convert the bond into common stock at her discretion, the prices of the bond and the common stock are linked. • However, if the stock drops to such a low level that the chance of conversion is practically zero, the bond will trade solely on its own merits and the conversion feature will have no impact on the bond's price.

An investor purchased a new issue municipal bond at 101: What is true if the investor held the bond to maturity?

• All premium bonds must be amortized annually, that is, the cost basis is reduced each year until maturity. • If held to maturity, the investor's basis will equal par value. • There will be no capital loss. • Although the amortization of the premium may be deducted against interest income in the cases of corporate and U.S. Treasury instruments, amortization is NOT deductible for municipal bonds.

Industrial development bonds:

• Although they are issued by municipalities, industrial development bonds (IDBs) are unsecured and often issued to finance the creation of certain types of industrial facilities. • IDBs are more subject to credit risk than the other choices since they are backed by the creditworthiness of the corporation that leases the facility that has been created

Characteristics of Corporate Bonds (3)

• An investor's capital is at less risk than if the investor purchased stock in the same company • Secured bonds are backed by specific assets the company owns • These bonds do not offer the same potential for capital appreciation that common stocks do

Treasury bills

• Are initially sold at a discount • Are safe, easily marketable securities • Account for the largest amount of short-term money-market instruments sold

An adviser is comparing two bonds of similar credit quality and duration for a client. The client is seeking a yield of 6.5%. After performing discounted cash flow analysis on each bond, the adviser has determined that Bond A is trading at a discount to its present value, while Bond B is trading at a premium to its present value.

• Bond A is priced attractively and should be purchased. • The investor will earn an annual interest rate greater than 6.5% with Bond A.

Which bonds would have the greatest sensitivity to changes in interest rates?

• Bonds with a long duration • Bonds with a low coupon

Two features that commercial paper and U.S. Treasury bills have in common are:

• Both are issued at a discount from face • Both are considered cash equivalents

A portfolio manager heavily invested in bonds is concerned about an increase in interest rates. In order to make his portfolio less price sensitive to yield changes, the manager should make which two changes in the portfolio?

• Buy bonds with low durations • Buy bonds with large coupons Bonds with low durations and large coupons will be less price sensitive to changing interest rates. Bonds with high durations and small coupons will be more volatile in price as interest rates change.

Callable bonds (4)

• Callable bonds are able to be repurchased by the issuer earlier than anticipated (i.e., they will not reach maturity). • Investors buying callable bonds must be aware of both the yield to maturity and the yield to call. • If the bond is trading at its par value, the two yields will be the same. • However, if the bond is trading at a discount or premium, the two yields will be different.

Characteristics of Certificates of Deposit (3)

• Certificates of Deposit (CDs) carry fixed rates of interest and mature after a specified period. • There is no maximum maturity, though a minimum maturity of seven days exists. • CDs are insured by the FDIC up to $250,000 and holders of CDs are assessed a penalty if redemption is made prior to maturity.

An investor who is looking for a relatively high level of potential growth but is also looking to generate income would most likely invest in:

• Convertible bonds • Convertible bond prices are influenced by the underlying common stock into which the bonds may be converted. Therefore, if the stock increases in value, so will the bond; however, if the stock declines in value, the bond will still pay interest on a semiannual basis

Discounted Cash Flow evaluates:

• DCF evaluates the present value of each coupon payment and the repayment of a bond's principal at a present value, based on a rate of return. • This makes it possible to evaluate a bond's value against current rates of return.

Your client purchased a U.S. government bond that yielded 5%, but has a nominal yield of 4%. Later he sells the bond at a price that yields 3%. This means that when your client originally purchased the bond, it was trading at a:

• Discount but at the time of sale it was trading at a premium. • Since the bond has a nominal yield of 4% and was trading with a current yield of 5%, it was originally purchased at a discount. When sold, it still had a coupon of 4% but has a current yield of 3%; therefore, it may be inferred that interest rates have declined since the bond is trading at a premium.

Discounted Cash Flow when comparing two different bonds:

• Discounted cash flow (DCF) analysis evaluates the present value of all coupon payments and the repayment of a bond's principal at a present value, based on a rate of return. • This makes it possible to evaluate a bond's value against the investor's desired rate of return. • The sum of each of the discounted cash flows, plus the present value of the bond's principal, determine the total value of the bond. • By comparing this value to the current price of the bond, the adviser will be able to determine if the bond is an attractive investment for a client. • If a bond is trading at a discount to its present value, the investor will earn more than the interest rate that has been used to calculate the present value. Conversely, a bond that is trading at a premium to its total present value will be worth less than the price of the bond. (The investor would be overpaying for the bond.)

Bond's Duration:

• Duration is the measure of a bond's pricing sensitivity to small changes in interest rates measured in years. The longer the bond's duration, the greater its pricing sensitivity • Bonds with low coupons will be more sensitive to interest-rate changes than bonds with high coupons because a change in rates in the market will be a greater percentage change for a low-coupon bond than a high-coupon bond.

Important things investors should know about General Obligation Bonds (3)

• Every municipal bond, whether a general obligation (GO) or revenue issue, is subject to market fluctuations. • The call feature on any bond is important, since it determines if the investor will be required to redeem the bond prior to its original maturity. • Legislative action can affect the tax-levying capability of a municipality and would therefore be a factor for a GO bond

In comparing two bonds, each with a 20-year maturity, if one has a low coupon, while the other has a high coupon, you would expect the

• High coupon bond to have a lower duration • Low coupon bond to have greater pricing volatility

Municipal Bond's exempt from what?

• Interest earned on municipal obligations (state or local) is typically exempt from federal tax.

Money Market Security:

• Money-market securities are defined as debt instruments with less than one year until maturity. • It does not meet the definition of a money-market instrument. • Negotiable CDs that mature in less than one year are money-market securities. Examples: U.S. Treasury bill, 30 year municipal bond with 3 months until maturity and Tax anticipation notes

Municipal Bond Yield Formula

• Municipal Bond Yield / (100% - Investor's Tax Bracket) = Equivalent Taxable Yield

Municipal Bond's interest maybe subject to what?

• Municipal bond interest may be subject to state and local tax, depending on the laws of the individual state. In most states, taxpayers do not pay state and local tax on bonds issued by government entities in that state.

Municipal Bonds Exemptions (3)

• Municipal bonds are issued by state and local governments that need to raise money. • Municipal bonds are exempt from the filing and registration requirements of the Securities Act of 1933, although the antifraud provisions of the Act do apply. • Interest received from municipal issues is exempt from federal taxation but may be subject to state and/or local taxation. • Municipal bonds issued by a territory or possession of the U.S., like Puerto Rico, Guam, the U.S. Virgin Islands, or American Samoa, are exempt from federal, state, and local taxation--they are triple-tax-exempt.

Characteristics of U.S. Government Agency Bonds (4)

• Not a direct obligation of the U.S. Government • Are taxable at the federal level • May be issued in book-entry form • Are generally a low-risk investment

Federal National Mortgage Association bonds: Fannie Mae (FNMA) bonds

• Not guaranteed by the US Government • FNMA is a publicly owned corporation that purchases government-backed mortgages (and conventional mortgages) from lenders and resells them in packaged form to the public.

Equipment trust certificates & Mortgage Bonds:

• On the other hand, equipment trust certificates and mortgage bonds are types of secured corporate bonds. • Since these bonds are backed by physical assets owned by a corporation, they have less credit risk.

Your client purchased a U.S. government bond with a YTM of 4%, and a coupon of 5%. Later he sells the bond at a price producing a YTM of 6%. This indicates that when your client originally purchased the bond it was trading at a:

• Premium but at the time of sale it was trading at a discount • Since the bond has a nominal yield of 5% and was purchased at a YTM of 4%, it was originally purchased at a premium. When sold, the bond still had a coupon of 5% but a YTM of 6%; therefore, the bond was trading at a discount.

An investor has been consistently investing in Treasury bills over a long period. The investor will have... (4)

• Stable principal & Unstable Interest • An investor in Treasury bills over a long period will have safety of principal because Treasury bills are backed by the U.S. government. • The interest income will not be stable because short-term interest rates, such as T-bill rates, are more volatile than longer-term interest rates. • Since the investor will frequently be reinvesting funds from maturing T-bills, there will be a good chance that the rates on new T-bills will be different. Therefore, an investor will have stable principal and unstable interest

Yield to maturity of a bond:

• The internal rate of return is used in its calculation • The calculation uses the nominal yield, the price, par value, and time left until maturity • • A central consideration is the time value of money

How are Short-term bonds affected by rising interest rates?

• The prices of short-term bonds tend to decline less when interest rates rise than bonds with longer maturities. • Zero-coupon bonds also tend to be particularly vulnerable to increases in interest rates.

Treasury Inflation Protected Security (TIPS) Annual inflation adjusted return:

• The principal of a Treasury Inflation Protected Security (TIPS) is adjusted upward or downward based on an inflation index. • Since the coupon payment is also adjusted at the same rate as the principal, the inflation adjusted return will always be the same as the coupon rate.

Characteristics common to mortgage-backed securities include (4)

• They involve the pooling of mortgages • They trade in the over-the-counter market • They are collateralized by mortgage loans on real properties • Many mortgage-backed securities issued in the marketplace involve collateral comprised of nontraditional mortgages, such as adjustable-rate mortgages and tiered-payment mortgages, as well as mortgages with nontraditional maturities (i.e., maturities other than 15 or 30 years).

A corporate bond has a 12% nominal yield. To be equivalent, an investor in the 28% tax bracket would need a municipal bond with a yield of:

• To determine the net yield of a taxable bond, multiply the yield times the complement of the tax bracket. • The net yield would be 8.6% (12% yield multiplied by 72%, which is the complement of the tax bracket).

An investor's goal is to buy a security that establishes a fixed return, for a long period of time, with no reinvestment risk. Which of the following BEST suits the investor's needs? a. Treasury bills b. Common stock c. AAA corporate bonds d. Treasury STRIPS

• Treasury STRIPS • The typical yield to maturity calculation assumes that each interest payment is reinvested at the same yield. There would be no guarantee that the investor could reinvest at the same yield (reinvestment risk). Treasury STRIPS are zero-coupon bonds (long-term). Interest is automatically reinvested and compounded at the same yield and reinvestment risk is avoided.

Guaranteed by the U.S. government:

• Treasury notes • Treasury Bills • Government National Mortgage Association Certificates

What advantage do Zero-coupon bonds have compared to regular bonds? (4)

• Zero-coupon bonds are issued at a deep discount and mature at par value, thus requiring a smaller capital outlay. • They do not pay interest semiannually, so they have no reinvestment risk. • Since a portion of the discount is taxed each year as interest income, there is no tax liability at maturity. • Bonds, in general, do not keep pace with inflation.