Series 7 Debt: Bond Basics, Corporate Debt, US Gov Debt

Daily Bond Buyer

Only has info on the municipal primary market (new issues).

A corporation will call its debt when

interest rates fall. An issuer will call its debt when interest rates have fallen sufficiently. The issuer must pay call premiums to the bondholders to "call in" the debt. In order for the call to make economic sense, the issuer must be able to issue new bonds at a lower interest rate to cover the cost of the call premiums and the costs associated with calling the old debt and issuing new debt.

A reverse merger

is a way for a PRIVATELY held company to go PUBLIC by purchasing an existing publicly held company

LBO

leverage buy out

TAC

A TAC is variant of a PAC that has a higher degree of extension risk

Reorganization

A restructuring of a financially troubled company in an attempt to remake the company into viable entity

What type of municipal issue would NOT be exempt from taxation of interest by the Federal Gov?

"Non essential use" private purpose municipal issues are subject to Federal Income tax, via Alternative Minimum Tax computation (AMT)

The minimum denomination for a mortgage backed pass through certificate is

$25,000

Regarding bonds with put options

*Exercise of the put is at the option of the bondholder *Once the option is exercisable, the bond's price will not fall below the option price if interest rates rise *The put option represents a floor on the market price of the bond Because the put option removes some the market risk from the bond, this feature is valued by bondholders, who will accept lower yields on bonds having this option.

Regarding tax equivalent yield of a municipal bond

- The yield will vary depending on the tax bracket of the customer - The tax equivalent yield will change as the market price of the bond varies

Mortgage bonds

-Are issued in term maturities -Are commonly issued by utilities -Secured by real property -In theory if the issuer defaulted, the bondholders could sell that real property to repay the outstanding debt balance. Historically, mortgage bond defaults have been very low, because we need to keep our lights on!

Information about the municipal secondary market can be obtained from

-Bloomberg: -Munifacts -EMMA

All of the following should be considered when constructing a diversified municipal bond porfolio

-Geographical location of the issuers -Revenue sources backing each issue -Credit Ratings of Each Issue Denominations of the bonds have NO BEARING on the risks inherent in those bonds

CMO

-Have serial structure, tranches retire sequentially -CMOs are rated AAA, have same credit rating as the underlying pass through securities held in trust -Are more accessible to individual investors than regular pass through certificates - Have a lower level of market risk than regular pass-through certificates -Subject to lower level of prepayment risk than pass through certificates

To construct a diversified portfolio of municipal bonds, the following must be considered

-Maturities of varying lengths should be chosen to lessen interest rate risk -Differing types of bonds (GOs, Revenues, Special Tax) should be chosen to diversify credit risk; -Bonds of different issuers should be chosen to lessen credit risk - Bonds from different geographic regions should be chosen to reduce the risk of regional economic downturns causing a lowering of credit ratings

Which of the following are characteristics of municipal secondary market joint accounts?

-Order Period -Account Agreement -Concession and Take down Municipal secondary market joint accounts are formed by two or more municipal dealers to DISTRIBUTE LARGE BLOCKS OF BONDS IN THE SECONDARY MARKET. One of the participants acts as a manager. Municipal joint accounts are ESTABLISHED UNDER A WRITTEN AGREEMENT (ACCOUNT AGREEMENT) between the account members; the agreement will specify that the manager has the right to ESTABLISH CONCESSIONS AND TAKEDOWNS and can set an ORDER PERIOD

The interest expense on monies used to buy bank qualified municipal bonds is

80% deductible for bank investors

CDO

A structured product that invests in tranches of private label subprime mortgages. Used to create tranches with different risk/ return characteristics- CDO will have higher risk tranches holding lower quality collateral and lower risk tranches holder higher quality collateral.

GNMA "Pass Through" Certificates

Agency pass through securities, quoted 32 nds, $25,000 minimum denomination, trade "and interest", accrued interest on certificates is computed on a 30 day month/360 day year basis

What is interest rate risk/market risk?

As interest rates go up, bond prices fall

Treasury Receipt

Broker created zero coupon bond, bought at a discount from face, matures at par, no reinvestment risk much like a STRIP

Treasury Receipts

Are "zero coupon" Treasury bonds or Treasury notes that pay interest earned at maturity

STRIPS

Are zero-coupon Treasury obligations, have the highest purchasing power risk if they are not held till maturity. If there's inflation, market interest rates are forced upwards, and zero-coupon bonds such as STRIPS fall dramatically in price.

CMO repayment scheme

As payments are received from the underlying mortgages, interest is paid pro-rata to all tranches; but principal repayments are paid sequentially to the first, then the second, then third etc. Thus, earlier tranches are retired first.

Convertible Bond

At the time of issuance, the conversion price is set at a premium to the stock's current market price When the stock price is at a premium to the conversion price, the bond price movements are usually caused by those of the stock When the stock price is at a discount to the conversion price, bond price movements are usually caused by interest rate changes

Dealer offerings of corporate bonds can be found on

Bloomberg and Reuters

Municipal bonds are unsuitable for retirement accounts?

Because they give a lower yield than government or corporate which are taxable bonds. Retirement accounts are tax deferred envelopes so you naturally would want to get a corp or gov bonds instead.

Municipal bonds trading flat

Bonds trading without accrued interest Interest payments are not currently being made

Characteristics that are common to both Treasury STRIPS and Treasury Bills

Both have a minimum denomination of $100, both pay interest at maturity, both are guaranteed by the government

Freddie Mac

Buys conventional mortgages from financial institutions Is an issuer of mortgage backed pass-through certificates Is a corporation that is publicly traded Restricted to purchasing conventional mortgages that are NOT VA or FHA insured

Trades for corporate and municipal bonds settle in...

CLEARING HOUSE FUNDS trades settle through NSCSS- National Securities Clearing Corporation

Which Treasury security is NOT sold on regular auction schedule?

CMBs, (Cash Management Bills); sold at auction by Treasury to meet unexpected cash shortfalls, not part of regular auction cycle

Municipal term bonds

Called dollar bonds, they are quoted on a dollar price basis. Quoted percentage of par in 1/8th, similar to corporate bonds Don't pay down principal over time, they pay interest only. They pay principal back at maturity

GNMA

Certificates pay holders on a monthly basis, each payment consists of a combo of interest and principal

CDO

Collaterized Debt Obligations

The Federal Reserve would permit which of the following to be "primary" US Government securities dealers?

Commercial and foreign banks, domestic BD's, foreign BD's

Standard and Poor's Bond Guide includes information on

Corporate Bonds, gives capsule summaries of every outstanding corporate issue, including recent price, rating, and yield

Compare corporate bonds, government, and muni bonds bring yields to the after tax result

Corporate- subtract Fed and State tax from yield Gov- subtract Fed tax from yield Muni- if the person lives in that state than that is the yield, if not then subtract State tax from yield

Rating agencies like Moody's Investors Services and Standard and Poor's rate _____ issues for credit risk- that's risk of default

Debt, the 2 largest credit rating agencies are Moody's and Standard and Poor's

Which bonds trade "flat"

Default bonds, adjustment (income) bonds, zero coupon bonds

CMO investors are subject to all of the following risks except

Default risk, CMOs have almost no default risk- they are rated the highest investment grade "AAA"

Types of municipal bonds trading flat

Defaulted bonds and zero-coupon bonds

A collateralized mortgage obligation is best defined as

Derivative product

Accrued interest for short-term municipal notes

Differs from that for municipal bonds. Interest on short-term notes accrues on a actual day month/ actual year basis. Usual arrangement for any "money market" (under 1 year maturity) instrument.

Which of the following agencies is fully taxable?

Fannie Mae, Ginnie Mae, Freddie Mac

Yield quotes for CMOs are based on

Expected life of the tranche

US Government and agency bonds settle in...

FEDERAL FUNDS trades settle through GSCC- Government Securities Clearing Corporation

All of the following agencies may issue securities except 1) TVA 2) FRB 3) FHLMC 4) FHLB

FRB The Federal Reserve Bank doesn't issue bonds. It's a national central bank.

FFCFC

Federal Farm Credit Funding Corporation

FHLB

Federal Home Loan Bank

FHLMC

Federal Home Loan Mortgage Corporation

Freddie Mac

Federal Home Loan Mortgage Corporation

FNMA

Federal National Mortgage Association

Fannie Mae

Federal National Mortgage Association

Reinvestment risk

For bondholders, is the risk that interest rates drop after issuance of the bonds; and that as interest payments are received over the life of the issue, they cannot be reinvested at the same rate. This risk is the greatest for high coupon bonds; and the lowest for low or zero coupon bonds.

Customer must pay accrued interest

From dated date, up to but not including settlement date

GNMA

Government National Mortgage Association

Ginnie Mae

Government National Mortgage Association

Wide swings in market interest rates would affect which of the following for holders of CMOs? I Prepayment Rate II Interest Rate III Market Value IV Credit Rating

I and III If market interest rates drop substantially, homeowners will refinance their mortgages and pay off their old loans earlier than expected. Thus, the prepayment rate for CMO holders will increase. Furthermore, as interest rates drop, the value of the fixed income stream received from those mortgages increases, so the market value of the security will increase. Market interest rate movements have no effect on the stated interest rate paid by the security; and would not affect the credit rating of the issue.

Call Effect on Bond Prices as Interest Rates Move

If interest rates rise, callable and non-callable bond prices will fall in the same manner. If interest rates fall, callable bond prices will rise slower than non-callable bonds, since it's likely that they will be called

Put Effect on Bond Prices as Interest Rates Move

If interest rates rise, puttable bond prices will fall slower than non-puttable bond prices, since the holder of a bond with a put option can always put the bond back to the issuer at par. If interest rates fall, puttable and non-puttable bond prices will rise in the same manner.

Regarding the effect of changing interest rates on the expected maturity of CMO tranches

If interest rates rise, the expected maturity length will lengthen If interest rates fall, the expected maturity length will shorten

CMOs principal repayments are made in varying dollar amounts every month

If interest rates start dropping, homeowners refinance and prepay their mortgages, and these prepayments are passed through to pay off the tranches. On the other had, if market interest rates rise, homeowners stay in the homes longer than expected and the rate of expected principal repayment slows, extending the maturity of the tranches

US Gov T-STRIPS are quoted

In 32nds, as well as other long term Treasury and Agency Securities REMEMBER T-Bills are quoted on a DISCOUNT YIELD BASIS because they are a short term money market instrument

What is another name for purchasing power risk

Inflation risk

IO tranche

Interest only tranche Early years more of the payments are interest, larger payments in the early years; Later years less of the payments are interest, smaller payments in the later years. Price movements mirror move directly with the movements of interest rates. The price movements of IOs are counterintuitive! Unlike regular bonds, when interest rates rise, price rises!!!

The trust indenture of a bond has the following information

Interest rate, maturity, collateral backing the issue, call provisions

Fannie Mae

It's a PUBLICLY TRADED COMPANY Debt securities are negotiable Interest payments are subject to state and local tax

Which of the following are issued with a fixed coupon rate? I Treasury Bills II Treasury Notes III Treasury Bonds IV Treasury STRIPS

Just Treasury Notes and Bonds REMEMBER Treasury Notes and Bonds are issued at par with a stated interest rate. Treasury Bills and STRIPS are zero coupon original issue discount obligations that don't have a stated interest rate.

Floating rate tranches

Least susceptible to interest rate risk. When interest rates rise, the interest rate on the tranche rises as well. When interest rates drop, the interest rate paid on the tranche goes down as well. A floating rate CMO tranche has a interest rate that varies, tied to the movements of the recognized interest rate index like LIBOR. There is usually a cap on how high the rate can go and a floor on how low the rate can drop. Because the interest rate moves with the market, the price stays close to par- as is the case with any variable rate security.

Bonds that are most susceptible to interest rate risk are:

Longer maturity issues and Low Coupon issues

2 components of return on a TIPS

Lower coupon rate Principal adjustment equal to that year's inflation rate

A bond rated BBB by Standard and Poor's. The bond is:

Lowest Quality Investment Grade AAA Highest Quality Investment Grade AA and A High Quality Investment Grade BBB Lowest Quality Investment Grade

Who insures municipal bonds?

MBIA Corp- Municipal Bond Insurance Corp AMBAC- American Municipal Bond Assurance Corp. FGIC- Financial Guaranty Insurance Corp. FSA-Financial Security Assurance Corp.

EMMA

MSRB's retail oriented website for municipal investors. It's includes "RTRS"- Real Time Reporting System, which reports municipal bond trades occurring in the secondary market.

Are GO bonds municipal bonds or US government?

MUNICIPAL

P1 P2 P3 NP

Moody's short term corporate debt

MIG1 MIG 2 MIG3 SG

Moody's short term municipal debt

Municipal bonds are suitable for?

Only suitable for those who are in high tax brackets because municipals are federally income tax exempt Insurance companies buy municipal issues Banks buy municipals as part of their investment portfolio (if they purchase a "bank qualified" municipal issue this gives the bank a large tax advantage)

GNMA

Owned by the US Government Guaranteed by the US Government

Zero coupon bonds

PAY INTEREST AT MATURITY, are bought at a DISCOUNT and MATURE AT PAR.

PSA

Prepayment Speed Assumption, used to "guesstimate" the expected life of a mortgage backed pass-through certificate.

PO tranche

Principal Only tranche When interest rates rise, the price of the tranche falls; when interest rates fall, the price of the tranches rises

Principal repayments made later than expected are applied to the PAC class prior to being applied to the Companion

Principal repayments made earlier than that required to retire the PAC at its maturity are applied to the Companion class

What is the primary risk associated with holding long term US Gov obligations?

Purchasing power risk

RTRS

Real Time Reporting System

Funded debt

Refers to corporate debt that is considered part of a company's permanent long term funding.

Network B Tape

Reports trades of AMEX (now renamed NYSE American) and regional listed equity issues

Network C Tape

Reports trades of NASDAQ listed equity issues.

Network A Tape

Reports trades of NYSE listed equity issues

TRACE

Reports trades of corporate, government, and agency bonds. Any OTC dealers trading these bonds must report each trade to TRACE, "asapractical" but no later than 15 min after execution.

RTRS

Reports trades of municipal bonds.

Market risk

Risk of price volatility due to movements in market interest rates

Who doesn't insure municipal bonds?

SIPC, FDIC, MSRB

Series EE bonds

Savings bonds

Priority of claim to corporate assets in a liquidation is

Secured bondholders, unpaid wages and taxes, trade creditors, unsecured bondholders (debenture bondholders, subordinated bondholders), preferred stockholders, common stockholders

Equipment trust certificates

Secured, backed by EQUIPMENT that has been pledged as collateral. Equipment trust certificates are issued by common carries like airlines, railroads, and trucking companies.

CMO's have what type of structure

Serial

Secondary Market Joint Account

Similar to new issue syndicates, in that they are a group of firms who pool their capital to buy a large block of bonds at a good price from INSTITUTIONS that are in the SECONDARY MARKET. The dealers reoffer these bonds in Bloomberg for a profit. In Bloomberg, only a single quote is permitted for the account.. Multiple quotes are prohibited, since there really is only 1 market in the bonds- that being the joint account.

A1 A2 A3

Standard and Poor's short term corporate debt

Trades of US Gov bonds settle

T+1, next business day in payment by Federal Funds

Which investment does not have purchasing power risk?

TIPS (Treasury Inflation Protection Securities)

Reports of corporate bond trades are made through

TRACE

Municipal bonds quoted on a yield basis, the following information is needed to compute total price of the trade

TRADE DATE, MATURITY DATE- to compute time till maturity COUPON RATE AND BASIS- to compute the dollar price, using the time to maturity SETTLEMENT DATE- to compute accrued interest

Commercial Paper Typical Buyers

Tend to be institutions and money market funds (ie insurance companies, trust companies, open-end investment companies) buyers purchases in minimum lot sizes of $100,000

Municipal term bonds

Term issues that are quoted on a dollar basis. Usually part of large combined serial and term bond offerings made by municipal issuers. These bonds trade in the secondary market.

What does a quote of 5.00 mean?

That the bill is priced at 5% discount from par For example 1 year, $1000 par T-bill, offered on a 2% basis would be priced at $1,000 minus a 2% discount ($20)=$980 If the T-bill is held to maturity, $1,000 is paid back and customer earns $20 discount.

If market interest rates fall, what happens to the homeowners?

The homeowners will repay their mortgages faster because they will refinance and use the proceeds to pay off their old high rate mortgages that collateralize this mortgage-backed security.

Why do zero coupons not have reinvestment risk?

They don't make semi-annual interest payments that must be reinvested to maintain the overall rate of return on the investment portfolio, they avoid "reinvestment risk".

What type of risk do CMOs have

They have market risk, prepayment and extension risk, and a bit more marketability risk than underlying pass through certificates

Which bonds are most likely to be called?

Those with high interest rates and low call premiums.

Bonds least likely to be called?

Those with low interest rates and high call premiums

Bank qualified municipal issue

To be bank qualified, the issue must be a public purpose issue. The purchasing bank can deduct 80% of the interest expense it incurs on deposits used to fund the purchase of the bonds, while the interest income from the municipal issue is not taxable to the bank

TRACE

Trade Reporting and Compliance Engine

Trading of government and agency bonds

Trading is performed by primary and secondary dealers Trading is performed by the Federal Reserve The trading market is active

Which security has the lowest level of credit risk?

Treasury Bond because it's backed by the US Gov

The physical securities which are the underlying collateral for Treasury Receipts are

Treasury Notes and Bonds, Treasury Receipts were created by broker dealers who have bought Tnotes and Tbonds and stripped them of coupons

Which of the following trade "flat"?

Treasury bills, STRIPS, Receipts Treasury bills are short term original issue discount obligations, with the discount earned being the "interest". Obligations doesn't make period interest payments, so they trade "flat"

If interest rates are rising rapidly, US gov debt prices would be least volatile?

Treasury bills. The shorter the maturity, the lower the price volatility of negotiable debt instruments. Treasury STRIPS are zero-coupon T-bond issue with a long maturity, and would be the most volatile

Price volatility of a CMO issue would most closely parallel that of an equivalent maturity

Treasury bond NOT mortgage backed pass-through certificates

Trades that settle in Fed Funds

US Gov and agency bonds trades settle in Fed Funds. These include US Gov bonds, US agency bonds, GNMA Pass through certificates SETTLE NEXT DAY Municipal and corporate bond trades settle in clearing house funds General Obligation bonds are MUNICIPAL bonds

Which bonds don't have interest rate risk?

Variable rate bonds, their rate resets to the market rate so the price stays at par Bond with put or tender options don't have interest rate risk-because the holder has the right to put the bond back to the issuer at par, the price will not fall in the market below the put price.

Tender offer

When a corporation is making a limited offer to buy its own securities or the securities of another company at the price that is above the current market price.

When a recession is expected, yields on I corporate bonds will increase II US Government bonds will increase III corporate bonds will decrease IV US Gov bonds will decrease

When a recession is expected, investors sell corporate bonds (increasing yield, less expensive) and buy gov bonds (decreasing yield, more expensive) The spread between corporate and gov bond yields widen.

When does an investor assume exchange rate risk

When an investment is made outside the US and the investment is denominated in foreign currency. This is the risk that the foreign currency weakens against the US dollar. (same as US dollar strengthening)

What happens to mortgage backed pass through certiicates?

When interest rates rise, mortgage back pass through certificates fall in price- at a faster rate than for a regular bond. This is true because when the certificate was purchased, assume that the average life of the underlying 15 year poll was 12 years. Thus, the certificate was priced as 12 year maturity. If interest rates rise, than the average maturity will lengthen, due to a lower prepayment rate than expected. If the maturity lengthens, then for a given rise in interest rates, the price will fall faster. When interest rates fall, mortgage backed pass through certificates rise in price- at a slower rate than a regular bond. This is true because when the certificate was purchased, assume that the average life of the underlying 15 year pool was 12 yers. The certificate was priced as a 12 year maturity. If interest rates fall, then the average maturity will shorten due to higher prepayment rate than expected. If the maturity shortens, then for a given fall in interst rates, the price will rise slower.

Dated date

When interest starts to accrue

Leverage buy out

Where an undervalued PUBLICLY held company is "bought out" and taken PRIVATE. The funds to do this are raised by selling bonds, so this is the "leverage" used to complete the buy out.

Which CMO tranche receives no payments until maturity?

Z-Tranche, it gets no payments until all prior tranches are retired. Then its paid off at par. It is the most susceptible to interest rate risk.

Is the interest income from corporate zero coupon bonds taxed annually?

YES, the holder earns the discount on the bond over its life. This "earning" of the discount is taxed annually as interest income to the bondholder even though no physical payment is made.

Are corporate bonds traded on the NYSE and Over the Counter:

Yes, though a very small amount of corporate bonds are traded on the NYSE (in a separate trade matching computer) most of the trading volume takes place over the counter between corporate bond dealers such as Goldman Sachs and other firms

A government securities dealer quotes a 3 month Treasury Bill at 6.00 Bid- 5.90 Ask. Customer wishes to buy 1 Treasury Bill will pay

a dollar price quoted on a 5.90 basis. Treasury Bills are quoted on a yield basis. From the basis quote, the dollar price is computed. A customer who wishes to buy will pay the "Ask" of 5.90. This means that the dollar price will be computed by deducting a discount of 5.90 percent from the par value of $100. This is the discount earned over the life of the instrument.

Series EE bonds

are issued at face value and pay interest at redemption

Series EE bonds

are non-negotiable and pay interest at redemption

If the principal amount of a TIP is adjusted upwards due to inflation, the adjustment amount is taxed

as interest income received

Series EE bonds

don't trade, issued by the treasury and redeemed with the treasury

Nominal yield curve

economic expansion

The nominal interest rate on a TIPS is (more or less) than the rate on an equivalent maturity Treasury Bond

less

Derivative product

one whose value is "derived" via a "formula" from an underlying investment.

Exchange rate risk is a factor to consider when investing in debt issues

outside the US, that are denominated in a foreign currency.

Pass through certificate is best described as a

security which gives the holder an undivided interest in a pool of mortgages

Adjustment (income) bonds

semi-annual payment of interest and repayment of principal t maturity is not assured

Municipal bonds for which basis quotes are given are

serial bonds quoted on a yield to maturity basis

Interest earned on corporate bonds is

subject to Federal tax, state and local tax

If the principal amount of TIP is adjusted downwards due to deflation

the adjustment is tax deductible in that year against ordinary interest income

In periods of deflation for TIPS

the amount of each interest payment will decline in periods of deflation, the interest rate is unchanged in periods of deflation, the principal amount received at maturity is unchanged at par

Yield curve analysis is useful for an investor in debt securities because

the curve shows market expectations for interest rates investors can compare rates of return relative to changing maturities the yield of a specific security can be compared to the market expectation for similar securities the curve can show relative demand for differing maturities by comparing the change in yield tot he change in maturity

Sallie Mae debentures are backed by

the full faith and credit of the Student Loan Marketing Association

Liquidity risk

the risk that effecting a securities transaction will result in larger than normal transaction costs. Liquidity risk increase for securities that are thinly traded, meaning that they are difficult to trade (compare marketability risk)

Reinvestment risk

the risk that the dividends, interest, and principal received from securities can only be invested at a lower rate of return than earned from the previous investments. In other words, as the investment is being held, interest rates are going down, and reinvested monies are not earning as high a rate of return as the original investment.

Quotes for corporate bonds found on Bloomberg are

wholesale corporate bond prices for broker/dealers. Quote providers such as Bloomberg and Reuters give dealer to dealer prices (the "wholesale" market) for corporate bonds daily