SIE Ch. 2
The city of Leadville, with a population of 90,000, wishes to issue a new general obligation bond. Currently, Leadville has $140 million in outstanding GO bonds, $300 million in revenue bonds, and $20 million in cash and reserves. In addition, its citizens owe $50 million for debt service to Crawford County. What is Leadville's overall debt per capita?
$1,889. Leadville's general obligation debt ($140 million in GO bonds) minus its cash and cash equivalents ($20 million) gives a $120 million net direct debt. Because revenue bonds are self-supporting and are not a direct obligation of the taxpaying public, the city's $300 million in these bonds is not included in the measurement. The sum of Leadville's net direct debt and the overlapping debt owed the county ($50 million) is $170 million. To get the debt per capita, you divide $170 million by 90,000 residents, which equals $1,889 per resident.
What denominations are municipal bonds usually issued in, and are they generally considered less safe or safer than corporate bonds?
$5,000 denominations. Considered safer than corporate bonds
What is 'Breaking the buck'?
. Money market funds seek stability and aim to maintain a $1 per share price, but it is possible for them to fall below $1, causing investors to lose money. If this happens, it is called "breaking the buck."
In government securities, a price of 103-08 refers to a price of of what of par value?
103 8/32 of par, or 103
Unlike corporate bonds, which are quoted in eights of a percent, government securities are in units of ?
32nds
In government securities, a price quote of 98-11 refers to a price of what of par value?
98 11/32 % of par value or 98.34375% of par
What is a prospectus?
A detailed disclosure document required by most issuers of securities
What is an official statement regarding Municipal bonds?
A document that contains information about the bonds and the financial condition of the issuer, as well as a legal opinion verifying the municipality's authority to issue the bonds
What is net overall debt per capita?
A measure of the total tax burden on a municipality's residents
What is a pass-through security?
A pool of fixed-income securities backed by a package of assets
What is Tax-exempt commercial paper?
A short-term promissory note issued by states and municipalities, usually backed by a line of credit with a bank. Maturities range between 1 and 270 days, and notes are issued at a discount to par. Issuers typically pay the principal on maturing commercial paper by issuing new commercial paper. Tax-exempt commercial paper can reissue as many units of paper as necessary to provide a specified amount of funding for a specific period, but a lot of times elected officials and sometimes voters must give their approval
What are ad valorem property taxes?
A type of tax based on the value of the asset being taxed, such as real estate
What are some of the things that Revenue Bonds finance?
Airports, mass transit systems, roads and bridges, libraries, and hospitals
What is purchasing power risk?
Also referred to as inflation risk, it is the change that the cash flows from an investment won't be worth as much in the future because of changes in purchasing power due to inflation
For a corporate bond with a par value of $1,000, how much is 60 basis points? I. 0.6% II. $6 III. $60 IV. 6% A. I and II B. I and III C. II and III D. II and IV
Answer: A. Basis points refer to one-hundredths of a percent on a yield quote. So 60 basis points would be equivalent to 0.6%. On a $1,000 par bond, 0.06% would be equivalent to $6 (0.6% x $1,000)
Which of the following bonds could have a coupon payment that comes in the mail? I. Fully registered bonds II. Partially registered bonds III. Book-entry bonds IV. Bearer bonds A. I and II B. I and III C. II and IV D. III and IV
Answer: B. A bondholder of a bearer bond or a partially registered bond will have to present the coupons to the issuer to receive payment because the coupons are not registered in the bondholder's name. Owners of fully registered and book-entry bonds could have their coupon payments sent to them through the mail because the issuer has the bondholder's name and address on file
Which of the following is not true of pre-refunded bonds? A. They are typically AAA rated. B. They are not defeased. C. They no longer count as debt on the issuer's balance sheet. D. The funds that will be used to refund the bonds are held in escrow
Answer: B. When a company issues a set of new bonds and puts the proceeds in an escrow fund to pay off a set of older bonds, it is called pre-refunding or advance refunding. The pre-refunded bonds are typically AAA rated. The funds that will be used in advance refunding must be kept in an escrow account. The pre-refunded bonds will no longer count as debt on the issuer's balance sheet, and when this occurs, the bonds are considered defeased
XYZ has issued a 5% convertible bond with a conversion price of $25. Its current share price is $45. At what price would the bond be trading at parity? A. $1,000 B. $1,125 C. $1,800 D. $1,050
Answer: C. In order for a bond to be trading at parity, it needs to be trading at the conversion value. To calculate this value, first find the conversion ratio by dividing the conversion price into $1,000 ($1,000 / $25 = 40 shares per bond). Then take the ratio times the share price, which is equal to $1,800 ($45 x 40). Parity is the price of the bond that is equal to the bond's value if converted to common stock
XYZ Corporation has issued four different types of bonds. They are all callable bonds. Which bond will XYZ be most likely to call? A. 5% bond callable at 102 B. 5% bond callable at par C. 8% bond callable at 102 D. 8% bond callable at par
Answer: D. A corporation would be most likely to call the issue of bonds with the highest interest payments. It would also prefer to call the issue without a call premium
What was the most commonly used variable rate bond until recently?
Auction Rate Securities (ARS). With an auction rate security, interest rates are reset by Dutch auction, usually ever 7, 28, or 35 days. They trade at par and are callable at par on any interest payment date at the option of the issuer. With a Dutch auction, existing bondholders willing to sell and potential investors enter a competitive bidding process through sealed bids. Each bid specifies the number of shares (in $25,000) denominations) that the bidder is willing to purchase or sell at the lowest interest rate it will accept. The lowest bid rate at which all the shares can be sold at par establishes the interest rate (Clearing rate) for the next period. Investors who bid at or below the clearing rate purchase their bid at that rate
Which of the following is the most likely to be a spread of Treasury bills with a par value of $1,000? A. 3.25% - 3.35% B. 3.35% - 3.25% C. 97.5 - 98.0 D. 98.0 - 97.5
B. T-bills are quoted in yields rather than on a dollar or bond point basis. Because the yield represents the discount that the investor receives of the bill's par value, an investor will want a larger yield and, thus, a larger discount to the par value. For this reason, when a T-bill spread is quoted, the bid will be higher than the ask. The dealer wants to buy T-bills at a higher discount (lower price) and sell at a lower discount (higher price) and profit from the difference.
Trades for U.S. Treasury securities settle: A. The next day B. The next business day C. The day after the next business day D. The third day after the next day
B. Trades for U.S. Treasury securities, such as T-bills, notes, and bonds, settle on the next business day, also known as T + 1, or trade day plus one business day. Corporate and municipal bonds settle like stocks: two business days after the trade date, or T + 2.
All of the following are characteristics of a Treasury bill except: A. They are sold at a discount to the par value. B. They pay low periodic interest payments. C. They are considered the safest of Treasury securities. D. They have a maximum 52-week maturity.
B. Treasury bills are issued at a discount to the $100 face value of the bill. They make no periodic interest payments. Because of their short lives, they are considered the safest of the Treasury securities.
Why are municipal notes called anticipation notes?
Because they are issued in anticipation of an expected source of income. Anticipation notes allow a project to get underway before funding has been received
What are municipal bonds?
Bonds issued by states, cities, and counties to raise money for their day-to-day operations. They are also issued by school districts, highway departments, and other public authorities to finance specific projects, such as public education, highway construction, football stadiums, and mass transit systems
What are Asset-Backed Securities (ABS)?
Bonds that are backed by the cash flows of other kinds of debt
What are General Obligation (GO) Bonds?
Bonds that are issued to fund the general operating expenses of the municipal government or to provide funds for capital improvement projects, such as roads, parks, courthouses, and schools. They are backed by the full faith and credit of the issuer, which means that the issuer must use its full taxing and borrowing authority to ensure the timely payment of principal and interest
What are Revenue Bonds?
Bonds that finance projects in which principal and interest payments to the bondholder are paid from the revenue generated by those projects
What are floating rate securities?
Bonds whose interest rates are adjusted by a predetermined index. Interest rates are reset periodically at some fixed spread above the selected index
Most corporate bonds pay interest every: A. Month B. Three months C. Six months D. Year
C. Most interest-paying bonds pay interest every six months, also known as semiannually.
How much would you pay for a $1,000 10-year Treasury bond priced at 95-08 (excluding accrued interest)? A. $95.08 B. $950.80 C. $952.50 D. $1,000.00
C. Treasury bonds are typically priced in $10 units and in fractions of 32nds. The 95 would equate to $950, and the 0.08 is 8/32 of $10, which works out to $2.50 ($950 + $2.50 = $952.50)
A dealer posts a spread on Treasury notes of 103.08 - 103.16. For a $1,000 par note, what is the value of the spread? A. $0.80 B. $8 C. $2.50 D. $1.25
C. Treasury notes are quoted in 32nds, and the question stated a par value of $1,000. First, 103.08 means 103 8/32, or a price of $1,030 + 8/32 of $10 = $1,032.50. Second, 103.16 means 103 16/32, or a price of $1,030 + 16/32 of $10 = $1,035.00. The difference between these two prices is the spread of $2.50.
What are negotiable CDs? And why are they also called Jumbo CDs?
CDs that can be sold to someone else in a secondary market. These CDs offer higher yields but are not FDIC insured. Instead, they may be guaranteed by the issuing financial institution. They are also called jumbo CDs because they are often denominated in millions of dollars
What are Alternative minimum tax bonds?
Certain private activity bonds continue to be exempt from taxation, however, such as those that finance airports and docks, hazardous waste disposal, water and sewer, schools and charities, green or sustainable building projects, and some residential housing projects. However, many of these "qualified" private activity bonds are not exempt for purposes of the alternative minimum tax
What are Certificates of deposit (CDs)?
Certificates of deposit allow bank, savings and loan, and credit union customers to receive higher interest on their deposits than a savings or checking account. To obtain the higher returns, customers must be willing to tie their money up for a fixed period, typically one month to five years. The longer the term, the higher the interest rate.
What is Securitization?
Creating securities out of different types of cash flows
An investor purchases a $1,000 TIPS note with an interest rate of 2%, and at the end of the first year the CPI has risen to 3%. Which of the following is true?
D. At the end of the first year, the CPI has risen to 3%. This means that the Treasury will increase the $1,000 principal by 3% to $1,030. To find the amount of the second interest payment, multiply the principal by half of the interest rate (because interest is paid semiannually) ($1,030 x 1% = $10.30).
What is overlapping debt?
Debt issued by municipalities that have overlapping geographic boundaries
Are STRIPS issued at a discount or premium?
Discount
What are two important GSEs that are privately owned, publicly traded companies that purchase mortgages on the secondary market and pool them to create mortgage-backed securities?
Fannie Mae and Freddie Mac
What are the 3 agency securities?
Fannie Mae, Freddie Mac, and Ginnie Mae
What are Variable-rate demand obligations (VRDOs)
Floating-rate obligations that have a nominal long-term maturity, but whose interest rates are automatically reset on a daily, weekly, or monthly basis. They also contain a put option, which gives investors the right to put the security back to the issuer, at a price equal to the bond's face value plus accrued interest. The put option may be exercised after a notification period that normally corresponds to the length of time between interest rate adjustments.
Are GOBs or Revenue Bonds backed by taxes?
GOBs are but revenue bonds are not
Which of the 3 agency securities is backed by the Federal government? Not just implied guarantee?
Ginnie Mae
What are Tax and Revenue Anticipation Notes (TRANs)?
If a government needs an influx of cash to pay expenses for various projects funded by both GO and revenue bonds, it may issue TRANs. They are backed by future tax and revenue receipts
Why are municipal bonds good for investors in high tax brackets?
Income is exempt at the federal level, and municipal bonds often provide an easy, low-risk way to diversify a portfolio
What taxes usually pay for state GO bonds
Income, sales, and excise taxes collected at the state level
What is TIPS and how does it work?
Inflation-adjusted securities issued by the U.S. Treasury and the principal is adjusted according to the Consumer Price Index (CPI)
What are seven major characteristics of municipal bonds?
Interest income not taxed at the federal level • Exempt from registration • Come with an official statement instead of a prospectus • Good for investors in higher tax brackets • Typically lower yields than corporate bonds, but higher than Treasuries • Typically less risky than corporate bonds • Good for portfolio diversification
What is Commercial paper?
Issued by large corporations, banks, and financial firms with high credit ratings to cover short-term needs, such as payroll and inventory, and to finance general operations. Commercial paper is unsecured and issued at a discount, and typically matures in less than 90 days, although it can have a term as long as 270 days. It is generally issued in lots of $100,000. Even though it is unsecured, commercial paper is generally considered safe enough to be purchased by money market funds because it is short-term and issued only by banks and large corporations with high credit ratings
What is Ginnie Mae?
It is a public government agency. It does not buy or sell mortgages or issue mortgage backed securities. Ginnie Mae securities are often issued by private companies, such as banks. Ginnie Mae guarantees the timely payment of interest and principal of certain MBS, and it has the full faith and credit of the U.S. Federal government to do so
What is Debt service coverage ratio?
It is one important measure of the success of a revenue bond. This is the ratio of a project's net operating income to its annual principal and interest payments. It tells the investor whether a project's operating income will cover its outstanding debt payments
What are protective covenants?
Limitations agreed to by the issuer of revenue bonds to provide protection for the bondholder from a deterioration of value and default. They are included as part of the official statement. Stronger protective covenants reduce the risks of revenue bonds
What are Variable rate securities?
Long-term bonds with interest rates that are reset on a short-term basis
What is STRIPS (Separate Trading of Registered Interest and Principal of Securities)
Long-term zero coupon bonds consisting of U.S. Treasury Securities
What are Treasury bonds Maturity length, purchase size, interest paid, and how are they quoted?
Maturity: 10 to 30 years Purchase Size: $100 up to $5 million Interest Paid: Semiannually Quotes: Bond points in 32nds
What are Treasury notes Maturity length, purchase size, interest paid, and how are they quoted?
Maturity: 2 to 10 years Purchase Size: $100 up to $5 million Interest Paid: Semiannually Quotes: Bond points in 32nds
What are treasury bills Maturity length, purchase size, interest paid, and how are they quoted?
Maturity: One year or less Purchase size: $100 up to $5 million Interest Paid: None; price is discount to par Quotes: Yield
An investor who purchases a $1,000 mortgage-backed security will receive payments how often?
Monthly
How does the MBS market work?
Mortgage-backed securities allow lending banks to sell off the debt they hold. Once the new mortgage-backed securities are sold on the secondary market to investors, the banks that granted the original mortgages are able to remove them from their balance sheets, decreasing their debt. These lending banks are then able to issue new mortgages at lower interest rates
CMOs typically pay investors interest and principal how often? And what is the lockout period?
On a monthly basis. The lockout period is the time before a CMO investor will begin receiving principal payments
Treasury Notes and bonds are quoted in the secondary market on a price basis where one point equals ____ what percent of par?
One percent
What are Public authorities?
Organizations formed to promote the public interest by financing, building, and operating public facilities
What are Government Sponsored Enterprises (GSEs)?
Privately owned, corporate entities that are chartered by the federal government to direct funds into areas of national importance where borrowing is in high demand but lending may be scarce
What kind of fund does income from concesssions, tolls, and other user fees go into?
Revenue Fund
What are principal transactions?
Securities that are sold out of a dealer's own inventory
What are Municipal Notes?
Short-term debt obligations, whose term may last from months to three years; though, most often, their duration does not exceed a year. Treasury bills, they obligate the issuer to pay a specified principal by a certain date, and also like T-bills, municipal notes sell at a discount to par in lieu of paying interest. They are zero coupon securities, in other words. The primary purpose of municipal notes is to meet an agency's cash flow needs in anticipation of the taxes, fees, or other sources of revenue that fund its ongoing commitments
What are tax anticipation notes (TANs)
Tax anticipation notes are issued to finance a project's current operations in anticipation of future tax receipts. Tans have first claim on any tax collections before they are otherwise disbursed
What are private activity bonds?
Taxable municipal bonds were created to fund private activities that would no longer qualify for exemption from federal taxes. These are known as private activity bonds. Besides supporting nonpublic functions, private activity bonds may also be issued to refund debt or bolster underfunded pension funds. While the interest on private activity bonds is typically taxable at the federal level, it is often tax-free at the local level and often the state level. Because most private activity bonds are taxable at the federal level, they offer higher interest rates than other tax-exempt municipal bonds
What is Net direct debt?
The short- and long- term general obligation debt minus cash and cash equivalents
What is Net overall Debt?
The sum of direct debt and overlapping debt?
What are double-barreled bonds?
These are bonds having characteristics of both a revenue and general obligation bond. Double-barreled bonds are backed by two sources of revenue. The primary source is the revenue from the project being financed. However, tax dollars may be summoned if project revenue is insufficient. Ultimately, this bond is guaranteed by the full faith and credit of the issuing entity
What are Revenue Anticipation Notes (RANs)
These are issued to finance the current operations of a project backed by a revenue bond, in anticipation of fees from the completed project to repay the notes
What are Bond Anticipation Notes (BANs)?
These notes enable work to start on a capital project before the municipality completes its issuance of a long-term bond. Rather than issue bonds before the project is finished and final costs are known and certain, a municipality may sell notes that will be retired by proceeds from the new bond issue
What are Collateralized mortgage obligations? (CMOs)
They are another type of asset-backed security. Cmos are pass-through securities that are issued by a GSE or a private sector financing corporation and are often backed by Fannie Mae, Freddie Mac, and Ginnie Mae. They are often rated AAA
Are Money Market securities Liquid/safe?
They are generally highly liquid, meaning they can be easily bought and sold and they are also considered very safe and are often referred to as cash equivalents
What certain privileges do GSEs have that private corporations don't?
They don't have to pay state or local taxes and are exempt from SEC oversight. They have access to a stnading line of credit in excess of $2 billion, and their securities are issued and paid through the facilities of the Federal Reserve bank
How do monthly payments from a CMO work?
They will be a combination of varying amounts of both interest and principal, therefore, the CMO invesstor's principal is returned over the life of the security, rather than repaid in a single lump sum at maturity as with other types of debt securities. Interest payments become smaller because they are based on a lower amouont of outstanding principal
What are feasibility studies?
To determine whether or not there is sufficient demand for the project that the issuer has proposed. These studies also help to determine if expected revenue will be sufficient to repay the debt that the municipal entity is issuing
The CMO's pool of investments is sclied up into what?
Tranches. The bonds in the various tranches offer different rates of interest, repayment schedules, and levels of priority for principal repayment. Investors can choose the bond rating, maturity, and risk level that are most suitable for them. Like MBS investors, CMO investors are at the mercy of interest rate changes to determine the flow of interest payments and principal repayments
What time of Treasury Security has the shortest maturity? And how long? Treasury notes, Treasury Bills, or Treasury Bonds
Treasury Bills; One year or less
STRIPS are sometimes called ______ because the underlying securities consist of U.S. Treasury notes and bonds
Treasury Receipts
What are some examples of common money market securities?
U.S Treasury Bills, commercial paper, and banker's acceptances. CDs are not considered securities, but are still considered part of the money market
What is an agency transaction?
When a broker acts as an intermediary between a buyer and a seller. The broker will often take a commission on the transaction from a markup or markdown
What is an example of "Phantom Income"?
When the IRS taxes interest payments as if they were paid every year on zero coupon bonds, even though interest payments are not received until maturity
What is extension risk for MBS owners?
When they get their money back slower than expected (Which may happen when interest rates rise)
What is prepayment risk for MBS owners?
When they get their money back sooner than expected (which may happen when interest rates fall)
How is TIPS calculated
With a fixed interest rate that is calculated twice a year by multiplying half the interest rate(Because is is paid semiannually) by the principal
What is a mortgage-backed security? (MBS)
a bond backed by the mortgage payments of a pool of mortgages
What is a reverse repurchase agreement?
a contract to buy an asset now and sell it at a lower price in the future. Repurchase agreements are often used by institutions such as banks to protect themselves from interest rate risk. The contracts allow them to lock into a set interest rate for borrowed funds
What is a Banker's acceptance?
a short-term credit instrument issued by a business for the purchase or sale of goods, usually in an international market. Bankers' acceptances are usually issued at a discount to face value, like a Treasury bill, and they can be traded on the secondary market. Banker's acceptances facilitate international trade by minimizing credit risk
What are Special assessment bonds?
are backed by ad valorem taxes assessed only on those who directly benefit from the facilities. Bonds for the repair of sidewalks and streets may be backed by a rise in property taxes via a special assessment on those property owners in the neighborhoods that will benefit from the project
What are Money market Securities?
debt securities that mature in 397 days or less. You may see one year on your exam because 397 days is right around one year
Tranches of CMOs with the lowest exposure to prepayments offer lower/higher yields?
lower
Why does the Government have enterprises and agencies that facilitate the MBS market?
mortgage-backed securities increase the ability of the average person to purchase a home, and home ownership is thought to be good for the nation.
What are Money market funds?
mutual funds that invest in highly rated, short-term money market debt securities, such as commercial paper, Treasury bills, and CDs
What is the formula to find debt service coverage ratio?
net operating income/annual principal and income payments
What are brokered long-term CDs?
offer higher returns but come with liquidity risk. If the investor would like to sell this type of CD before maturity, the customer will usually pay a penalty, which can cut into the principal
What is a Repurchase Agreement?
or repo, is a short-term contract to sell an asset, such as a Treasury bond, and simultaneously buy it back in the future at an agreed-upon price (typically a higher price). There is usually no secondary market for repurchase agreements
What are Special tax bonds?
revenue bonds payable from the proceeds of a special tax that is unrelated to the project being financed. For example, a highway bond may be financed by an increased property tax on likely users, or a school bond may be financed by an increase in liquor or cigarette taxes