Unit 3

What are debt securities?

Loans

The issuer lends money to?

The issuer and promises to pay interest & repay principal at maturity

What are the types of debt securities?

Bonds

Notes

Bills

Certificates

Money Market Instruments

Who are the main issuers of debt?

Corporate = Corporate Bonds

U.S. Gov. = Treasury Securities

Municipal Gov. = Municipal Bonds

What are the key characteristics of bonds?

Par value

Maturity

Coupon Rate

Accrued Interest

What is a par value (face value)?

Amount repaid at maturity

Usually $1,000 per bond

What is Maturity?

Date investors get principal back

What are the types of maturities?

Term Bond = Entire issue matures at once

Serial Bond = Portions mature over time

Balloon Bond = Combination of serial + term

What are Term Bonds?

Principal Repaid: At one time

Uses a sinking fund to cash reserve and repay bonds

What are Serial Bonds?

Principal Repaid: In installments over years

What are Balloon Bonds?

Some paid earlier

Large final payment at maturity

What is a coupon rate (Nominal yield or Stated Yield)?

Interest rate paid by issuer

What’s the coupon formula?

Coupon Rate x Par Value = Coupon Payment

Interest is usually paid…

Semiannually

What is accrued interest?

If bonds trades between interest payments: Buyer pays seller accrued interest.

Who has no accrued interest?

Zero-coupon bonds because no periodic interest payments

What are bond pricing?

At par

At premium

At discount

What is a par bond?

Price: $1,000

Quoted as: 100

What is premium bond?

Trades: Above Par

EX: 120 = $1,200

What is Discount bond?

Trades: Below par

EX: 80 = $800

What’s the point system?

1% of par value usually $10 per bond

What’s the formula for Bond Price?

Quoted Price x 10 = Bond Price

If interest rate rise?

Bond prices fall

If interest rates fall?

Bond prices rise

What is bond yield?

Return earned from bond interest

What are the types of yield?

Nominal Yield = Coupon rate

Current Yield (CY) = Coupon/market price

Yield to Maturity (YTM) = Total return if held to maturity

Yield to Call (YTC) = Return if called early

What happens when you have a discount bond & YTM?

Buy for less than par

At maturity receive full par

(gain increase)

What happens when you have a premium bond & YTM?

Buy for more than par

At maturity only receive par

(loss reduces return)

What is Yield to Call (YTC)

If issuer calls bond early

Allows issuers to redeem bond before maturity

Benefits Issuer

Why would issuer call bonds?

Usually when interest rates fall issuers can refinance cheaper.

What is a put feature?

Allows investors to force early repayment

Benefits: investors

Why use put feature?

Usually when interest rates rise investors reinvests at higher rates.

What is convertible feature?

Allows bondholder to convert bond into stock

Benefits: Investor

What is parity?

Bond value = value of shares received upon conversion

What’s the coupon rule?

Issuer benefits (call) = higher coupon

Investor benefits (put/convertible) = lower coupon

What are zero-coupon bond?

Pay NO periodic interest

Sold at a deep discount

Mature at par

Interest earned

Zeroes are?

More volatile since there are no coupon payments

What is phantom income?

No interest is received yearly but taxes are still owed annually called: Annual Accretion of Discount or

What are bond ratings?

Measures credit quality/default risk

Major rating agencies

Moody’s

Standard & Poor’s (S&P)

Fitch

What’s a good investment grade?

BBB/Baa or higher

What are junk bonds?

BB/Ba or lower

called: high-yield bonds

Speculative bonds

Risk/Reward rule

Higher rating:

Safer

Lower yield

Lower rating:

Riskier

Higher yield

What are non-rated bonds?

Does NOT automatically mean risky

could simply be:

Too small to rate

What’s Bond Volatility?

Sensitivity to interest rate changes

Longer maturity =

More volatile

More volatile than 5-year bond

Lower coupon =

more volatile

more volatile than 6% bond

What does duration measure?

Bond Volatility

Higher duration = more volatility

Benefits of Bonds?

Income:

Predictable income

Interest payments are a legal obligation

Safety:

Bondholders have higher claim than stockholders

In bankruptcy Bondholders paid first

What are the risks of Bonds?

Default Risk:

Issuers may fail to pay interest (credit risk) & repay principal (financial risk)

Interest Rate Risk: Bond prices fall

Purchasing Power Risk (Inflation Risk)

Buying power of fixed payments

Treasury Securities have

Virtually no default risk

Preferred stock also has

Inflation risk because payments are fixed

What is municipal bonds (munis)?

Are debt securities issued by:

States

Cities

Counties

U.S. territories

Local authorities/special districts

What’s the purpose of Munis?

Finance public projects like:

Roads

Hospitals

Airports

Sewer System

Schools

Civic centers

What are the key features of Municipal Bonds?

Safety: 2nd safest after U.S. gov. securities

Safety depends on:

Issuer’s financial strength

Taxing power

Taxes:

Interest: exempt from federal income tax

exempt from: state tax & local tax (has to be issuing state)

Capital gains: ALWAYS taxable

What are the trading rules?

Settlement = T-1

30-day month

360-day year

What are the two main types of Municipal Bonds?

General Obligation (GO) Bonds

Revenue Bonds

What is a General Obligation Bond? (Full faith & credit bonds)

Municipal bonds backed by the issuer’s taxing power.

What are the key features of GO Bonds?

Backed by Taxes

Sate uses:

Income taxes

Sales taxes

License fees

Cities/Counties use:

Property taxes (ad valorem taxes)

License fees

Other municipal income

What is the purpose of GO Bonds?

Used for:

Schools

Roads

Parks

Infrastructure

Capital improvements

These project usually do NOT generate revenue

What are some GO Bond facts?

Voter approval

Debt limit

What are Revenue Bonds? (self-supporting debt)

Municipal bonds repaid from revenues generated by the project itself.

Projects funded by Revenue Bonds?

Utilities:

Water

Sewer

Electric system

Transportation:

Airports

Toll roads

Bridges

Tunnels

Other Projects:

Hospitals

Stadiums

Dormitories

Public Housing

Revenue Bond Facts

NOT backed by taxes

NOT subject to debt limits

Does NOT require voter approval

Who issues revenue bonds?

Transit authorities

Bridge authorities

Tunnel authorities

What are territorial bonds?

U.S. Territory Bonds

Puerto Rico Guam U.S. Virgin Islands

Tax Advantage:

Interest is tax-free at:

Federal level

State level

Local level

Tax-Equivalent Yield (TEY)

Compares tax-free muni yields to taxable bond yields

What’s the formula for Tax-equivalent yield (TEY)?

Municipal Yield / (1-Tax Rate)

What’s the After-Tax Yield of Taxable Bond Formula?

Corporate Yield / (1-Tax Rate)

Is Municipal Yield ALWAYS lower than Taxable corporate yield?

YES

What is short-term municipal debt note?

Is used until expected funds arrive

Typical maturities:

Less than 12 months

Sometimes up to 3 years

Types of Municipal Notes

TANs: Anticipate tax receipts

RANS: Anticipate project revenues

TRANs: Combination of TAN + RAN

BANs: Temp. financing before bond issue

GANs: Anticipate gov. grants

CLNs: Construction financing

Variable-Rate Demand Notes: Floating-rate notes with put feature

What are TANs (Tax Anticipation Notes)?

Borrow now

Repay when taxes collected

What are RANs (Revenues Anticipation Notes)?

Borrow against future project revenues

What are BANs (Bond Anticipation Notes)?

Temporary financing until long-term bonds issued

What are Variable-Rate Demand Notes?

Floating interest rate

Usually include put option

Investor may return note to issuer periodically

What are Money Market Securities?

Short-term debt securities used for temporary financing and investing.

What are 3 characteristics of Money Market Instruments?

Short-term: 1 year or less remaining to maturity

High Quality: Generally very safe

High Liquid: Easy to buy/sell

Who uses Money Market Instruments?

Corporations

Banks

Broker-dealers

Municipalities

Federal Government

What are the benefits of Money Market Instruments for investors?

Pros:

Safety

Liquidity

Short-term cash needs

Cons:

Long-term growth

High income

Common Money Market Instruments

Jumbo CDs (Negotiable CDs)

Bankers’ Acceptances (BAs)

Commercial Paper

Treasury Bills

Municipal Notes

Repurchase Agreements (Repos)

Federal Funds Loans

What are Jumbo CDs (Negotiable CDs)?

Issued by banks

Minimum size: $100,000+

Fixed interest rate

Tradable: 2nd market

Non-negotiable CDs

Illiquid

NOT MONEY MARKET INSTRUMENTS

What are Bankers’ Acceptances (BAs)? (Bill of exchange or Letter of credit)

Short-term bank-guaranteed drafts used in international trade.

Maturity: 1-180 days typically

Maximum 270 days

Issued at discount

What is a commercial paper? (Promissory notes)

Short-term unsecured corporate debt.

Maturity: 1-270

Under 90 days

Used for: Accounts receivable & Seasonal Financing

What is a Treasury Bill?

Are money market securities

Sold at discount

Mature at par

What is a repurchase agreements (repos)

Temporary sale of securities with agreement to repurchase later at higher price.

Purpose: Raise short-term cash

Reverse Repo

Dealer buys securities and sell back later at higher price

What is a federal fund loa?

Overnight loans between banks to meet reserve requirements.

Pros and Cons on Market Money Instruments

Pros:

Safe

Liquid

Stable

Cons:

Low returns

Reinvestment Risk

Income Fluctuates

What is an Asset-Backed Securities (ABS)?

Securities backed by pools of loans or debt instruments

EX:

Mortgages

Auto Loans

Credit Card Debt

Leases

What is Securitization?

Pooling loans together and selling interests to investors.

Pros:

Diversifies risk

Make illiquid debt tradable

Who creates ABS?

Investment banks NOT gov-issued or guaranteed

What is a collateralized Mortgage Obligation (CMOs)?

Pool mortgages

Include: FNMA Mortgages & FHLMC Mortgages

What are tranches? (slices)

CMOs are divided into:

Maturity classes

Risk levels

CMO Cash flow

Principal repayments go:

1. Highest tranche 1st

2. Next tranche

3. then next

What’s a prepayment risk?

Mortgage refinancing changes:

Principal repayment timing

Interest cash flow

What is a Collateralized Debt Obligations (CDOs)?

Complex ABS backed by many types of debt

Includes:

Bonds

Auto Loans

Credit Card Debt

Receivables

Derivatives

What are the characteristics of CDOs

Structures into tranches

Different:

Risks

Returns

Maturities

HIGHER RISK = HIGHER YIELD