Financial Institutions Chapter 7

The minimum denomination for Treasury notes and bonds is now $____.

$100

online trading

- Investors can also buy bonds through the Treasury Direct program (www.treasurydirect.gov).

Minimum denomination of municipal bonds is usually $_________.

-$5,000

2 components of yield (bond yields)

-(1) a set of coupon payments -(2) the difference between the par value that the issuer must pay to investors at maturity and the price it received when selling the bonds.

How long are bond maturities?

-10 years or more

Greek Debt Crisis

-2010 -brought on by weak economic conditions and a large gov't budget deficit. -Credit ratings on Greece were reduced several times. -Concern also spread to Spain and Portugal

Auction-rate securities

-A way for borrowers (e.g., municipalities and student loan organizations) to borrow for long-term periods while relying on a series of short-term investments by investors. -Every 7 to 35 days, the securities can be auctioned off to other investors, and the issuer pays interest based on the new reset rate to the winning bidders.

Characteristics of Corporate Bonds: convertibility

-Allows investors to exchange the bond for a stated number of shares of the firm's common stock

Eurobond Market

-An underwriting syndicate of securities firms participates in the Eurobond market by placing the bonds issued. -The issuer of Eurobonds can choose the currency in which the bonds are denominated.

Trading Treasury Bonds

-Bond dealers serve as intermediaries in the secondary market by matching up buyers and sellers of Treasury bonds. -Dealers profit from the spread between the bid and ask prices. -Treasury bonds are registered at the New York Stock Exchange, but the secondary market trading occurs over the counter -online trading and online qoutations

Characteristics of Corporate Bonds: bond collateral

-Bonds can be classified according to whether they are secured by collateral and by the nature of that collateral

global government debt markets

-Bonds issued by foreign gov'ts are attractive to investors because of the government's ability to meet debt obligations

Secondary Market for Corporate Bonds: liquidity in secondary market

-Bonds issued by large, well known firms are liquid. -Bonds issued by smaller, lesser known firms are less liquid.

CDOs: "Tranches"

-CDOs are segmented into slices ("tranche"), and cash flows are prioritized by seniority -each is rated by a credit rating agency -senior tranches may receive a high credit rating, whereas tranches with lower priority receive lower credit ratings -the investment in a tranche is priced to generate an expected return to investors that compensates them for their risk

Institutional Participation in Bond Markets

-Commercial banks, savings institutions, and finance companies commonly issue bonds in order raise capital to support their operations. -Investors — commercial banks, savings institutions, bond mutual funds, insurance companies, and pension funds

Corporate Bond Offerings: Bond ratings as a measure of credit risk

-Corporations hire rating agencies to have their bonds rated. -Higher rated bonds can have a higher price (lower yield) because they are perceived to have a lower credit risk. -Financial Reform Act of 2010

Financial Reform Act of 2010

-Credit rating agencies are subject to oversight by a newly established Office of Credit Ratings, housed within the Securities and Exchange Commission.

exchange-traded notes

-Debt instruments -the issuer promises to pay a return based on the performance of a specific debt index -Typically mature in 10 to 30 years -not secured by assets -not legally defined as mutual funds and therefore are not subject to mutual funds regulations

Variable-Rate Municipal Bonds

-Have a floating interest rate that is based on a benchmark interest rate.

Bond yields: from the investors perspective

-Holding period return is used by bond investors who do not hold the bond until maturity -Yield consists of two components: (1) a set of coupon payments and (2) the difference between the par value that the issuer must pay to investors at maturity and the price it received when selling the bonds.

Risk of Structured Notes

-In the early 1990s, Orange County, California, suffered losses and filed for bankruptcy due to investments in structured notes. -difficulty in assessing the risk of structured notes so some investors rely on credit ratings -credit rates of structured notes have not always served as accurate indicators of risk.

Tax Advantages of Municipal Bonds

-Interest income is normally exempt from federal taxes. -Interest income within a particular state is normally exempt from the income taxes (if any) of that state.

Characteristics of Corporate Bonds: low and zero-coupon bonds

-Issued at a deep discount from par value. -Are purchased mainly for tax-exempt investment accounts.

Federal Agency Bonds

-Issued by federal agencies such as the Federal National Mortgage Association (Fannie Mae) and the Federal Home Loan Mortgage Association (Freddie Mac) who use the proceeds to purchase mortgages in the secondary market

Municipal Bonds

-Issued by state and local gov'ts. -General obligation bonds -Revenue bonds -Typically promise semiannual interest payments. -Minimum denomination is usually $5,000. -Most contain a call provision.

savings bonds

-Issued by the Treasury, but they can be purchased from many financial institutions. -Can be purchased with as little as $25. -Interest income on savings bonds is not subject to state and local taxes but is subject to federal taxes.

Bonds

-Long-term debt securities issued by government, agencies or corporations. -The issuer is obligated to pay interest (or coupon) payments periodically (such as annually or semiannually) and the par value (principal) at maturity. -often classified according to the type of issuer: treasury bonds, federal agency bonds, municipal bonds, and corporate bonds. -Most bonds have maturities of between 10 and 30 years. -Can be issued as bearer bonds or registered bonds. -issued in the primary market through a telecommunications network.

Characteristics of Corporate Bonds: variable rate bonds

-Long-term debt securities with a coupon rate that is periodically adjusted

Corporate Bonds

-Long-term debt securities, issued by corporations, that promise the owner coupon payments (interest) on a semiannual basis. -Minimum denomination is $1,000. -Maturity is typically between 10 and 30 years. -Interest paid by the corporation to investors is tax deductible to the corporation. -Interest income earned on corporate bonds represents ordinary income to the bondholders and is therefore subject to federal taxes and to state taxes.

Treasury bonds are registered at the _____________, but the secondary market trading occurs __________.

-New York Stock Exchange -over the counter

Treasury Bond Auctions

-Normally held in the middle of each quarter. -Financial institutions submit bids for their own accounts or for their clients. -Bids are submitted on a competitive or a noncompetitive basis.

Characteristics of Corporate Bonds: call provisions

-Normally requires a price above par value when bonds are called. -The difference between the bond's call price and par value is the call premium. -If market interest rates decline, the firm may sell a new issue of bonds with a lower interest rate and use the proceeds to retire the previous issue by calling the old bonds.

TIPS

-Provide returns tied to the inflation rate. -(Treasury Inflation-Protected Securities). -The principal value is increased by the amount of the U.S. inflation rate. -inflation-indexed treasury bonds

Characteristics of Corporate Bonds

-Sinking fund provision -Protective covenants -Call provisions -bond collateral -low and zero-coupon bonds -variable rate bonds -convertibility

Corporate Bond Offerings: Private Placement

-Small firms that borrow small amounts of funds (such as $30 million) may consider private placements rather than public offerings. -The institutional investors that purchase a private placement include insurance companies, pension funds, and bond mutual funds.

Corporate Bond Offerings: Timing

-Some corporations attempt to time their bond offerings when market interest rates are low, so that their cost of financing with bonds will be low.

structured notes

-The amount of interest and principal to be paid is based on specified market conditions -long-term debt instruments that allow investors to bet indirectly on or against a specific market that they cannot bet on directly because of restrictions

call premium

-The difference between the bond's call price and par value

Trading and Quotations of Municipal Bonds

-Today there are more than 1 million different municipal bonds outstanding and more than 50,000 different issuers. -Many have inactive secondary markets. -Electronic trading of municipal bonds has become very popular.

online qoutations

-Treasury bond prices are accessible online at www.investinginbonds.com.

Corporate Bond Offerings: Public Offering

-Underwriters try to place newly issued bonds with institutional investors.

Characteristics of Corporate Bonds: sinking fund provision

-a requirement that the firm retire a certain amount of the bond issue each year

Dealers profit from the spread between the ______ and __________.

-bid -ask prices

__________ serve as intermediaries in the ____________ market by matching up buyers and sellers of Treasury bonds.

-bond dealers -secondary market

Secondary Market for Corporate Bonds: dealer role in secondary market

-broker bonds between buyers and sellers

CDOs

-collateralized debt obligations -Investors receive the interest or principal payments generated by the debt securities -Some contain other types of debt such as credit card loans, car loans, and commercial or residential mortgages -Corporate bonds are sometimes packaged by commercial banks into collateralized debt obligations -segmented into slices ("tranches"), and cash flows are prioritized by seniority.

Participation in the bond market: Finance Companies

-commonly issue bonds as source of long-term funds

Bond yields: from the issuer's perspective

-commonly measured by the yield to maturity

Corporate Bond Offerings: junk bonds

-corporate bonds perceived as very high risk -Primary investors — mutual funds, life insurance companies, and pension funds -Offer a high yield compared to Treasury yields

Secondary Market for Corporate Bonds

-dealer role in secondary market -liquidity in secondary market -electronic bond networks -types of orders through brokers: market order and limit order -trading online

Credit Crisis and Fannie Mae and Freddie Mac

-experienced financial problems because they had purchased risky subprime mortgages that had a high frequency of defaults -federal gov't rescued Fannie Mae and Freddie Mac so that they could resume issuing bonds and continue to channel funds into the mortgage market

Participation in the bond market: brokerage firms

-facilitate bond trading by matching up buyers and sellers of bonds in the secondary market

most types of ________ are major investors in bonds

-financial institutions

-Bonds issued by smaller, lesser known firms are __more / less___ liquid.

-less

How long are note maturities?

-less than 10 years

-Bonds issued by large, well known firms are ___.

-liquid

Secondary Market for Corporate Bonds: types of orders through brokers

-market order -limit order

Secondary Market for Corporate Bonds: electronic bond networks

-match institutional investors that wish to sell some bond holdings or purchase additional bonds in the over-the-counter bond market at a lower transaction cost

Secondary Market for Corporate Bonds: trading online

-more orders to buy and sell corporate bonds are being placed online -some online bond brokerage services now charge a commission instead of posting a bid and ask spread

Participation in the bond market: investment banking firms

-place newly issued bonds for governments and corporations -may place the bonds and assume the risk of market price uncertainty or place the bonds on a best-efforts basis in which they do not guarantee a price for the issuer

Participation in the bond market: insurance companies

-purchase bonds for their asset portfolio

Participation in the bond market: pension funds

-purchase bonds for their asset portfolio

Participation in the bond market: commercial bank and savings and loan associations (S&Ls)

-purchase bonds for their asset portfolio -sometimes place municipal bonds for municipalities -sometimes issue bonds as a source of secondary capital

Commercial banks, savings institutions, and finance companies commonly issue bonds in order to do what?

-raise capital to support their operations.

Characteristics of Corporate Bonds: protective covenants

-restrictions placed on the issuing firm that are designed to protect bondholders from being exposed to increasing risk during the investment period

Competitive bids

-specify a price and a dollar amount of securities to be purchased.

Noncompetitive bids

-specify only a dollar amount of securities to be purchased.

STRIPS

-stripped treasury bonds -(Separate Trading of Registered Interest and Principal of Securities). -not issued by the Treasury but instead are created and sold by various financial institutions -The cash flows of bonds are commonly transformed (stripped) by securities firms to create principal only and interest only bonds.

Corporate Bond Offerings: Credit risk of corporate bonds

-subject to the risk of default -yield paid contains a risk premium

bond yields: yield to maturity

-the annualized discount rate that equates the future coupon and principal payments to the initial proceeds received from the bond offering

types of orders through brokers: market order

-the transaction will occur at the prevailing market price

types of orders through brokers: limit order

-the transaction will occur only if the price reaches the specified limit

Corporate Bond Offerings

-timing -public offerings -private placement -credit risk of corporate bonds -bond ratings as a measure of credit risk -junk bonds

bonds are issued to ____.

-to finance government expenditures, housing, and corporate expenditures

bonds can be classified in 4 categories (according to the type of issuer)

-treasury bonds -federal agency bonds -municipal bonds -corporate bonds

The U.S. Treasury commonly issues ___________ and ___________ to finance federal government expenditures.

-treasury bonds -treasury notes

Participation in the bond market: mutual funds

-use of funds received from the sale of shares to purchase bonds -some bond mutual funds specialize in particular types of bonds, while others invest in all types

true or false: Bonds yield vary among countries

True

Revenue bonds are supported by what?

revenues of the project (tollway, toll bridge, state college dormitory, etc.) for which the bonds were issued.

General obligation bonds are supported by what?

the municipal government's ability to tax