Unit 4 Debt Securities

Interest Rate Risk

Risk that as interest rates rise (more expensive to lend, but getting more for lending) bond prices will fall. More time to maturity... more risk

An issuer is most likely to call

A high interest bond with no call premium

Amortization

Adjusting downward each year if purchase at a premium.

Collateralized Debt Obligation

Pool of non-mortgage backed securities can be backed by pools of loans, leases, credit or a company's receivables.

Your customer calls you with a question. They tell you that they received a phone call from the bond desk telling them that they bought 20 bonds at 100. They want to know how much they paid for the bonds before any commission or other charges. You tell them

20,000

Amount of Insurance from FDIC for CD's

250,000

Banker's Acceptance

270 Day Maximum security, they fascilitate foreign trade

Accrued Interest

the interest that is paid by the buyer of a bond to the seller when a bond is traded between coupon payment dates.

Unsecured Corporate Debt (debentures)

- Debenture is any unsecured long-term bond - More risky (backed by good faith no collateral. - Subordinated debenture ( junior to debenture) -Guaranteed bonds (only backed by a parent company) -Income bonds (adjustment)- companies coming out of bankruptcy, interest payments are made only if there is sufficient revenue to pay the interest

Risks of Bonds

- Safer than equities - Fixed Payments - default -interest rate risk - purchasing power (if you have 3% paper but inflation its not worth It) -call -reinvestment (if you have to reinvest at lower rates)

Current Yield

-Annual Interest rate/market price (note if the interest is given semi annually you will have to annualize It) -Price that the bond is worth right now -Doesnt take into account gains or losses at maturity - Discount Bond: CY > NY (price lowered) - Premium Bond: CY < NY (price jacked up)

Treasury Bills

-One year or less maturity (4 weeks, 13 weeks, 26 weeks, 52 weeks) auctioned weekly. -only bill issued without state Interest Rate - Highly liquid and example (90 day 13 week tbill as risk-free investment) -Issued at discount (sell at par) -No semi Annual Interest -Quotes annualized % discounted from par.(bid price will be higher than ask) (will be on test) -Primary dealers interact with Federal Reserve

Collateralized Mortgage Obligations (CMOS)

-pool of mortgage backed securities -Monthly check -Pooled intro tranches -PACs (tranche) have reduced reinvestment and extension risk. More predicatable maturity dates and lower yields. -TACs (tranche) have elevated risk, least predicatble maturity dates and higher yields. -Buyer signs a suitability statement.

Your customer is in the 30% federal tax bracket. They consider purchasing a 7% corporate bond. Their after-tax yield would be

4.9% (100-30)*0.7

Your customer, Eleanor, purchased an InDebt Inc., 5% debenture at a price of 94. It matures in 12 years. What is the yield to maturity?

5.73 You do not have to calculate YTM for this problem. You could if you really wanted to, but it is not necessary for the question. You do need to recall the bond inverse relationship chart. The bond is trading at a discount so the YTM must be higher than the coupon of 5%; that eliminates two responses. Note that YTM is higher than current yield, and that you do need to calculate CY. The bonds annual interest divided by the price (50/940) is 5.32% (the CY). Only one response is higher than 5.32%.

Banker's Acceptance

A letter of credit (LOC) is a commitment, usually made by a commercial bank, to honor demands for payment of a debt upon compliance with conditions and/or the occurrence of certain events specified under the terms of the letter of credit. Those in the import/export business use these LOCs in the form of bankers' acceptances.

Which of the following is a money market security? (A 30-year T-bond issued by the Treasury 29 years ago, A short-term T-bond mutual fund, A newly issued T-note, A TAN maturing in 14 months)

A money market security is a high quality and highly liquid security with one year, or less, left to maturity. Both the T-note and the Tax Anticipation Note are more than a year form maturity. The mutual fund has no maturity.

Bond

A security issued by a corporation or government entity to raise capital, representing a loan to a borrower in return for payment of interest and principal to the lender. For purpose of exam: bonds will have a face value of $1000

Bonds most likely to be called

An issuer will call the higher coupon bonds before calling the lower coupon bonds. Of the two bonds with coupons of 7.5%, the one with the lower call price will likely be called first.

nominal yield (coupon yield)

Annual interest rate established at issuance % of the par value does not change doesn't reflect investors return

Coupon

Annual interest rate paid on the face amount of a bond. (also called nominal yield) Represents a % of par: Ex 6% of $1000 Usually paid out semi-annually When a coupon rate is the same yearly until maturity... It is a fixed rate.

Your customer asks to buy a bond that carries a very attractive yield. When checking the bond you see that it has a B rating from the major credit rating agencies. When communicating this information to the customer, all of these terms might be used to describe the bond except

Answer: Lower Grade Though a B rating is certainly a lower investment grade rating, that is not a typical term used in the industry. All of the other terms are terms normally associated with these bonds carrying a greater risk of default.

When do call features benefit who

As interest rates decline, issuers benefit from a cal l feature where as investors benefit from call protection in time of IR.

Revenue Bonds

Backed by user fees. Often used to build a facility. Type of Muni

"Basis"

Basis is a common synonym for yield to maturity, especially for municipal bonds. For any bonds trading at a premium, the nominal yield (or coupon) is higher than the basis (YTM). For bonds at a premium, yields from lowest to highest are as follows: yield to call, yield to maturity, current yield, and nominal yield.

Length of Maturity in order of shortest to longest

Bills, notes, bonds

Ownership of Bonds

Bonds are issued in registered form instead of bearer form, meaning the name of the owner of the bond is recorded with the issuer or transfer agent. Book entryform is the most common method of tracking (recorded electronically). Its in a depository.

CD's

CD may be payable to the bearer or registered in the name of the investor. Often Issued by a bank May be payable to the bearer or registeredin the name of the investor

Current yield on premium/ discount bonds

CY will be less than the coupon if premium bond (price the bond is worth right now vs at maturity will be par) CY will be more than the coupon if trading at a discount. If an investor buys a bond with a YTM > Coupon the bond was purchased at a discount and vice versa. If Market Price is lower (discount) the Current Yield will be greater than It would be at par. If the market price is higher (trading at a premium) the Current Yield will be less that It would be at par

Bond Features

Call feature: can be called in (bad for investor) Put feature: very rare but the investor can put them back to the issuer at par. (better for investor if interest rates rise) Convertible: convert into common stock to share in growth of firm (because its a positive feature coupon will be lower)

Yield to Maturity

Contemplates the difference between what you paid vs the par value and looks at how interest compounds. Shows overall return if bond is held until maturity. Assumes coupons are reinvested Excludes taxes and brokerage fees

Calculating current yield

Current yield is defined as the annual income (or coupon rate) from a bond divided by the bond's current market price. Accordingly, $60 / $1,200 = 0.05 × 100 = 5%. The current yield will be lower than the coupon rate when the bond is trading at a premium.

ELN

Despite their name, ELNs are debt instruments, not equity instruments. They have a partial fixed return, as well as a final payment linked to the performance of a single stock or equity index. Some are exchange traded, while others trade OTC. FINRA, who considers ELNs to be nonconventional structured investments, has expressed concerns that investors might not fully understand ELNs or the risks associated with them. Exchange traded. Protect against downside but must consider suitability

AM Best

Entity that rates the credit strength of insurance companies a key to evaluating fixed annuities and other pure insurance products backed by the claims paying ability of the insurance company.

When a French corporation issues a bond denominated in Swiss francs, it is known as

Eurobond is the name given to a long-term debt instrument issued and sold outside the country of the currency in which it is denominated. In this case, the French company is borrowing in Swiss francs instead of the domestic currency (the euro).

Yield

Expresses the cash interest payments in relation to the bond's value.

Par Value

Face value of a bond

Trust Indenture Act of 1939

Federal law requiring all corporate bonds > 50MM to be issued under an INDENTURE agreement approved by the SEC and providing for the appointment of a qualified trustee free of conflict of interest with the issuer. The Act provides that indentures contain protective clauses for bondholders.

The Alta Loma High School District is asking voters to approve a bond to fund the purchase of new computers and software. The bond will mature in 40 years and the interest and principal payments will be funded from real estate taxes. This is an example of a

GO Bonds. If a municipal bond requires a vote it is most likely a GO bond. Generally revenue bonds do not require a vote (note that there is no revenue generating source here). Debentures and equipment trust certificates are issued by corporations, not municipalities

Municipal Bonds (GO'S)

General obligations: backed by full faith of the issuer. Funded by state and local taxes. Voter approval required. (secured)

Short term municipal obligations (anticipation notes)

Generate funds for a municipality that expects funding soon. Tax anticipation notes Revenue Anticipation Tax Revenue Bond Anticipation Variable Rate Demand Obligations: Muni issues 10 year paper and attach a reset feature to reset interest rate every month. These are also putable bonds. look for terms reset and puttable.

FRB and Member Banks

Have fed funds: they have excess reserves that can be lent. Repurchase agreements: FRB to member banks or other banks. (very secured loan using tbill as collateral) Fed can also engage in Repos.

The term high-yield bond would apply to a bond with a Moody's rating of

High-yield bonds are those whose ratings fall below investment grade. Investment grade is the top four. Using Moody's descriptions, ratings run from Aaa to Aa to A to Baa to Ba to B and then below. The first rating below the top four is Ba. That is equivalent to a BB rating from Standard & Poor's (but the question asks specifically about Moody's).

Five years ago your client purchased at par $100,000 of New Brunswick City GO bonds maturing in 20 years from now and callable in six months. Interest rates have gone down over the last five years. Which of these should your client do? Your client should recognize that the bonds have a high probability to be called. Your client should recognize that the bonds are unlikely to be called. Your client should expect the bond is trading at a large discount. Your client should expect the bonds are trading at a small premium.

I & V If rates have declined the bonds are likely trading at a premium and very likely to be called at the first call date in six months. The proximity of the call date means the bonds premium will be small.

Which of these reasons would allow for a municipality to issue revenue bonds easier instead of general obligation bonds? Revenue bonds do not require voter approval. Revenue bonds generally have a higher rating than GO bonds from the same issuer. Revenue bonds are not constrained by a statutory debt limit. Revenue bonds are supported by ad valorem taxes.

I and III Because revenue bonds are designed to be self-supporting from the revenue derived from the project funded by the bonds, voter approval is not required. On the other hand, because GO bonds are backed by taxes, such as ad valorem taxes, voter approval is generally required and there is a debt ceiling or limit imposed on the issuer.

Junk Bond

Once a bond's rating has fallen below the top four grades (AAA, AA, A, and BBB), it is no longer considered investment grade. At that point, BB (or Moody's Ba) or lower, it is considered a high-yield or junk bond.

Tender Offer

In a tender offer, the issuer is offering to buy back all or a portion of the issue at a stated price. The price of the tender is set by the issuer although the issuer may engage an underwriter to help it set the price. This could happen when interest rates have gone up, causing the price of the outstanding bonds to fall. From a practical standpoint, this would mean the corporation paying off debt at a price below face value.

Other countries sovereign debt

In the United Kingdom, they are called gilts. In Germany, they are called Bunds. In France, they are called OATS.

Jumbo CDs

Interest bearing (100K Miniumum.

Prices and Interest Rates of Bonds

Interest rates effect bond prices. -Reflects what an investor could earn if he deploys his money and deploys a new bond. - As rates change, bond prices adjust to their yield (coupon amount/price) -Interest rates rise, bond prices fall - Interest rates falling, higher bond prices if you think interest rates are going up now, then all bonds existing that are still payng interest will go down in price. (less valulable). *Need to think about current bonds trading* - This is part of interest rate risk. -Measured in points, 1 point = 10 dollar

Zero Coupon Bond Duration

Is equal to its maturity.

Corporate Bonds

Issued by commerical and industrial entities to raise money for expansion. Usually longer term with maturities of ten years. Commercial Paper is no more than 270 Days

Eurodollars are paid in

It is always the final part of the word that describes the currency of a eurobond. A Eurodollar bond pays in U.S. dollars, while a Euroyen bond would pay in Japanese yen.

Credit Quality of ETN

Linked to the issuer structuring the note not the performance its tied to.

Treasury Bonds

Long term (30 year maturity) Secondary Market for T-Bonds is very liquid. Come out at or around par and receive semi annual interest payments. Will be quoted as a % of par using fractions of 32 93:16 means 93 and a half (93 + 16/32) x 100

Features that make bonds sensitive to interest rates

Low coupon, long maturity.

Bond Quotations

Market Price = the price of the bond paid by investors in secondary trading. The Market Price is usually a % of the par value.

Notes vs Bonds

Maturity for notes (2-10 years) Bonds can be longer.

Treasury Notes

Medium Duration (2-10 Semi Annual Interest (6 months) Most Important is the 10 year t-note.. all treasuries are backed by the US gov with power to tax the people.

Government National Mortgage Association (GNMA)

Monthly Payment of principal and interest Fully Taxable Backed by US treasury

Three major bond rating companies

Moodies (upper case and lower case) Fitch S & P (Upper case) investment grade: Baa or BBB Junk Bonds (high-yield bonds)- For the S & P (BB+ to D) For Moody's: Ba1 to C

Volatility scale of Bonds

More time to maturity (more volatile) less time to maturity (less volatile) Lower coupon (more volatile) subject more to i(r) change higher coupon (less volatile)

Lando Entertainment, Inc., issues a bond collateralized by a trust holding the company's Las Vegas headquarters. This type of bond is called a

Mortgage Bond: A secured bond backed by real estate is called a mortgage bond. Collateral trust bonds hold other securities in trust as collateral. A guaranteed bond is an unsecured bond backed by a third party. A headquarters debenture is a fictional thing.

Secured Corporate debt securities

Mortgage Bonds: Backed by real estate and physical assets of issuer: Equipment Trust Certificates: Railroads and other transportation companies finance the aquisition of capital equipment, entitled in trust. Collateral Trust bonds: Backed by stocks and bonds in other companies (puts securities in trust)

Federal Home Loan Mortgage Association (Freddie Mac)

Only difference is that when they buys up a pool of mortgages, freddie mac buys from thrift banks (savings and loans)

Federal National Mortgage Association

Semi annual interest payments. Backed by their own issuing authority. Have an indirect obligation to Federal Government (GNMA pays a lil bit lower because risk is a little lower)

Yield to Call

Similar to yield to maturity but assumes the bond is called on the earliest called date. -Includes premium if applicable. For premium bonds: YTC < YTM because the investor loses the premium paid for the bond more quickly Will be highest yield for discount bond but lowest yield for discount

Farm Credit Association

Tax exempt at state and local level Bank by issuing FCA Bank

Taxation of Treasuries

Taxable at federal level but not at the state and local level. Safest investment for the US investor.

Types of Bond Maturities

Term: All bonds issued at same time and returned at same time. Serial: All issues at same time, but mature in a staggered fashion (this way company avoids having to pay off at one time) Balloon: Type of serial that goes out at one time, but they mature (big chunk gets due in the middle)

Accrued Interest

The earned but unreceived interest. Although bonds pay coupons semi annually, interest is being accrued every day so you get your payout at the end of 6 months. Accrued Interest is added to the purchase price of the bond. It is paid from buyer to seller so that the seller receives their share of the upcoming coupon. Zeros or default bonds do not have accrued interest. 365 Days for T-notes and T-Bonds 360 Days for Corporate, Muni, Agency Bonds

An investor sells 10 5% bonds at a profit and buys another 10 bonds with a 5¼% coupon rate. The investor's yearly return will increase by

The first bonds are 5% and pay $50 per year per bond. The new bonds are 5¼% and pay $52.50 per year per bond, for a difference of $2.50 per bond.

Yield to Maturity

The most widely spread quoted return of a bond. Accounting for interest payments, and difference between their purchase price and the amount of principal received at maturity.

Refunding

The process by which a bond issuer refinances, selling cheaper bonds to replace callable outstanding bonds in an environment in which interest rates are declining.

Which of these statements regarding Treasury bills is correct?

They have the highest interest rate risk of all Treasury securities. Treasury bills are always issued at a discount, without a stated interest rate. Receiving par value back at maturity represents the interest income to the investor. Because of their short-term maturities, they have the lowest interest rate risk for Treasury securities, not the highest. T-Bills are issued in initial maturities of 4, 13, 26, and 52 weeks.

Which of these is not backed by the full faith and credit of the U.S. government? (Tbonds, Strips, TBills, treasury receipts)

Treasury Bills Treasury bills, bonds, and notes are backed in full by the U.S. government. Treasury STRIPS are also backed in full by the U.S. government but Treasury receipts are not because they are issued by broker-dealers. Therefore the government's backing can only be as good as the credit rating of the broker-dealer that issued them.

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 Adjusts semi annually.

Parity Price

Value where the price of the convertable bond is the same as the converted stock. We expect convertable bonds to trade at parity. Parity Price = Market Value of Bond/Conversion Ratio

Annual Accretion

When an in investor buys a bond at a discount or premium, the IRS requires the investor to adjust the cost basis towards Accretion is the cost of the bond that must be adjusted upwards towards par each year so that at maturity the investor's cost basis is equal to par Annual Accretion= discount of par/#years to maturity

Zero Coupon Bonds

Zero coupon bonds are issued at a deep discount, and the amount received at par is purchase price + interest accrued over the years. Ex: Zero issued at 50 ($500) maturing in 20 Years. At Maturity It pays par ($1000) = $500 Principal, $500 Interest = Interest rate of 3.6% Price of a zero reflects interest rate culture and thus more volatile than other bonds. Owners of Zeros pay taxes on the interest annually (phantom income) Treasury Receipts: Issued by Bank (BD) and can provide collateral. (buys at $400, at maturity receives $1000 ($600 received at end) Strips: issued by the US treasury, backed by the full faith and credit of the united states government. Zeros may be issues by corporations or municipalities. Suitable for investment with stated need on a date (aka college savings)

Treasury Receipts

Zero coupon bonds that are structured by BDS and backed by cash flow from treausury securities. Secured by intesest and principal from Treasury securities.

A 6% corporate bond trading on a 7% basis is trading

at a discount

A zero-coupon bond interest pays

at maturity and is taxed annually.

When interest rates are flat, which type of bond sees higher price volatility

convertible bonds, price is driven by underlying equity

Money Market Securities

debt instruments or securities with maturities of one year or less Highly liquid and high quality debt. ex: government T-Bill Commercial Paper: 270 Days (promise to pay back debt)

capital appreciation bond (CAB)

has a similar structure to a zero-coupon bond. CABs do not pay periodic interest and are NOT suitable for investors who seek income.

Client has 6 months to invest for a mortgage downpayment what do you suggest

higher-yielding 6 month CD over a MM as both are liquid but one pays more.

What happens to bond etf when interest is falling

if one of the underlying bonds in the fund is called they will typically reinvest the proceeds in a new bond (but typically with lower interest rates)

An investor might expect to receive the greatest gain on an investment in a corporate bond by purchasing

long-term bonds when interest rates are high. If an investor purchases bonds when market interest rates are high, a drop in interest rates will lead to a corresponding increase in bond value. Long-term debt instruments will fluctuate to a greater degree than those with short-term interest rates. Thus, long-term debt offers the greater chance of gain.

A put feature causes a bond to have a coupon that is

lower because it benefits investor