SIE Chapter 4: Corporate and US Government Debt

Bearer Bonds

Historically issued in physical form with coupons attached

These are no longer issued

Fully Registered Bonds

bonds with interest and principal payments are tracked/registered for purposes of taxation. Physical certificate with the owner's name, and interest payable automatically by the paying agent. No physical coupons.

Book Entry

These securities have no physical certificates issued. Instead, the bondholder's name, address, and purchase amount are registered with the transfer agent

Registrar

keeps record of the owners of the debt outstanding

Transfer Agent

Transfers the ownership record to a new owner if the debt is ever traded.

Indenture

the written agreement between the corporation and the lender detailing the terms of the debt issue

Protective Provisions / Covenants

Indentures may include these to maintain specific protections for the bondholders

Examples:

- insurance coverage

- audit by independent accountant

- ratios of assets to liabilities

Trustee

Appointed to monitor compliance with the provisions of the indenture

What $$ minimum of corporate issues must have a trust indenture as specified by the Trust Indenture Act of 1939?

$50 million or more

Do government or municipal bonds have indentures?

No - they are exempt

Regular way settlement for corporate bond trades

T+1

Cash settlements

Occur the same day as the trade date if the trade is done before 2:30 pm ET.

Secured Bonds

Bonds that have specific assets of the issuer pledged as collateral.

Interest rates are typically lower than unsecured

Typically have longer maturities

Mortgage Bonds

Bonds that are secured by real property.

Can you claim the same real estate on multiple mortgage bonds?

Yes if the trust indenture is open end; they will typically include an additional bonds test requirement that must be met before new bonds may be sold

New mortgage bonds can be issued against the real estate only if they are junior to the existing bonds if the trust indenture is close ended

Equipment Trust Certificates

bonds secured with factory and equipment as collateral

What form are equipment trust certificates issued in?

Serial form

They are required to repay a portion of the principal each year until the bonds are retired. The life of the issue coincides with, or is less than, the equipment's life

Why are equipment trust certificates highly rated?

If the issuer defaults, the equipment can be easily sold to repay the bondholders

they are generally non-callable

Collateral trust certificates

Issued with a portfolio of marketable securities as collateral

Typically, a parent company uses the securities of a subsidiary as collateral

Commercial Paper

short-term unsecured debt issued by large corporations

What is the maturity range for commercial paper?

14 to 90 days

30 days is most common

If over 270 days, you have to register it with the SEC

Does commercial paper pay interest payments?

It is sold at a discount and matures at face value

What is the minimum amount for commercial paper?

$100,000 minimum

Who purchases commercial paper?

large institutions with excess cash (e.g. money market mutual funds)

Does commercial paper trade a lot?

No, there is limited trading

Debentures

intermediate and long-term unsecured corporate debt

often issued by stronger companies that have solid financials

Subordinated Debentures

Have a junior status in corporate liquidations

May include a conversion feature that allows the bondholder to convert the bond into a fixed number of common shares

Guaranteed Bonds

Another form of debenture that takes on the credit rating of the parent

Typically issued by a subsidiary company with the corporate parent company guaranteeing payment of interest and principal as due

Income Bonds

Issued as part of a corporate reorganisation

Obligates the issuer to pay if it has sufficient earnings in the future

NOT suitable for investors seeking income because payments are not guaranteed

What price do income bonds trade at?

They trade flat

If there is a missed payment, it is not considered a default, but unpaid interest accrues

What price do zero-coupon bonds trade at?

They trade flat since these issues pay no periodic interest

Accrued Interest

Interest that has been earned but not yet received

This is paid by the buyer to the seller of a bond

Convertible Bonds

Corporate debentures that can be converted, at the option of the owner, into the common stock of an issuer based on its par value

A conversion price is set per share at the time of issuance

What is the conversion price set to for a convertible bond?

At a premium to the stock's current market price at the time of issuance

What is the benefit of convertible bonds to corporations?

They are issued with a lower coupon than non-convertible bonds

Conversion Ratio

Par Value of Bond / Conversion Price

Parity

market price of the convertible bond = the value of the stock it could be converted to

Parity Price of Bond

conversion ratio x stock's market price

Parity Price of Stock

bond market value/conversion ratio

When would you convert your convertible bond?

When the bond trades below parity

Arbitrage

When a trader buys the lower priced security and simultaneously sells the equivalent higher priced security to lock in a profit

When a convertible security is trading above par, what is pulling up the price?

The rising market price of the common stock

When a convertible security is trading below par, what is dragging down the price?

interest rate changes (going up)

Is conversion a taxable event?

No - only taxable when the common stock is sold

1. Priority in Liquidation

Secured creditors

2. Priority in Liquidation

Unpaid administrative claims, unpaid wages, taxes, trade creditors

3. Priority in Liquidation

Unsecured creditors (e.g. debenture bondholders)

4. Priority in Liquidation

Subordinated creditors including subordinated debenture bondholders

5. Priority in Liquidation

Preferred stockholders

6. Priority in Liquidation

Common stockholders paid anything remaining - they have residual claim in any assets

Does the SEC oversee issuance of US government bonds or their trading?

No - they are exempt from regulation under the Securities Act of 1933 and the Securities Exchange Act of 1934

Savings Bonds (EE Bonds)

Non-negotiable and cannot be traded

Bought from the government and can only be redeemed with the government

Who keeps record of ownership of government bonds?

the Treasury keeps the book of owners

What level of risk is debt issued by the government and its agencies?

risk free (AAA)

Treasury Bonds

long-term securities issued with maturities of 30 years

What is the minimum denomination of treasury bonds?

$100

What are the characteristics of treasury bonds? (Interest payment schedule and callable/non-callable)

Semi-annual interest payments and non-callable

STRIPS (Separate Trading of Registered Interest and Principal Securities)

Introduced for investors who wish to avoid reinvestment risk

Treasury bonds that have been stripped of their interest payments, making them zero-coupon Treasury obligations

What is another name for STRIPS?

Treasury receipts

Are the price of STRIPS volatile?

Yes - as they are deep discount obligations, price swings are very volatile as interest rates move

Highly susceptible to interest rate risk but investors usually don't worry about this because they are held to maturity

TIPS (Treasury Inflation-Protected Securities)

Introduced for investors who want to avoid purchasing power risk

Have a fixed interest rate over the life of the bond and the principal amount is adjusted every six months by an amount equal to the change in CPI

How often do TIPS pay interest?

Semi-annually

Interest payment will increase if the principal amount is adjusted upwards due to inflation and vice versa

If there is deflation by maturity of the TIPS what will the bondholder recieve?

They will still receive par.

If inflation - will receive above par.

Treasury Notes (T-Notes)

Intermediate-term securities issued with maturities ranging from 2-10 years.

Quoted as a % of par value in 32nds and are non-callable

Treasury Bills (T-Bills)

Short-term securities issued with 1,2,3,6, and 12 month maturities

How are T-Bills issued?

Issued at a discount from par ($100 minimum) and mature at par

Quoted on a discount yield basis

Series EE Bonds

Savings products issued by the US government with a minimum purchase amount of $25

They DON'T trade but are redeemable with the Treasury

Are Series EE Bonds securities?

No - they are not securities

Are government sponsored entities (GSEs) directly backed by the full faith and credit of the US Treasury?

No - and as a result, agency securities offer somewhat higher yields than corresponding treasury securities

The Federal Farm Credit System

- offers farmers low-rate financing through the Federal Farm Credit System

- the federal farm credit banks funding corporation issues discount notes, intermediate-term bonds and long-term bonds

Mortgage-backed Securities (MBS) are issued by what agencies?

- FHLB

- Fannie Mae

- Ginnie Mae

- FHLMC, Freddie Mac

FHLB

Federal Home Loan Bank

- 12 U.S. sponsored banks offering low-cost funding to banks for home mortgage loan and other purposes.

Fannie Mae

Federal National Mortgage Association

- The nation's largest, and privately owned, investor in residential mortgages.

Ginnie Mae

Government National Mortgage Association

pools mortgages for investors

FHLMC, Freddie Mac

Federal Home Loan Mortgage Corporation

- a privately owned secondary money market player. It is federally regulated.

Which agency does the US government back?

Ginnie Mae

Who are the primary issuers of MBS?

- Ginnie Mae

- Fannie Mae

- Freddie Mac

What are the primary differences between MBS and bonds?

- $25k minimum

- Monthly mortgage payments are passed through to certificate holders

- prepayment risk

When does prepayment risk increase for MBS?

When interest rates fall since homeowners are more likely to refinance in a low-interest rate environment

Sallie Mae

Student Loan Marketing Association

Purchases insured student loans from qualified lending institutions. They sell normal debentures paying interest semi-annually backed by these loans.

They DON'T deal in mortgage debt

Does Ginnie Mae issue MBS and CMOs?

No but they do guarantee MBS and CMOs

Where does trading of US government securities take place?

OTC

Primary dealers

government securities dealers, operating out of private firms or commercial banks, with whom the Fed's open market desk trades

Secondary dealers

All other firms trading U.S. Government securities are termed "secondary" dealers. These firms buy and sell Treasuries in the market through the primary dealers and can also bid in the weekly auction. Most smaller banks and brokerage firms are "secondary" dealers.

Open Market Operations

the purchase and sale of U.S. government bonds by the Fed

How does the Fed loosen credit?

Buys treasury securities

Market interest rates would lower as there would be more cash to lend

Dovish stance

How does the Fed tighten credit?

Sells treasury securities

Removes cash from the banking system and market interest rates go up

Hawkish stance

How are most agency securities quoted?

By dealers on a yield spread basis against equivalent maturing securities

What yield spread do Ginnie Mae (GNMA) bonds typically trade at?

25-50 bps over treasuries

Fed funds

immediately payable at a Federal Reserve Branch member institution

What taxes do you have to pay on US government obligations?

Federal income tax but NOT state or local income taxes

What taxes do you have to pay on municipal obligations?

Exempt from federal income tax but may be subject to state and local income tax

Most states that have income taxes exempt their own issues from taxation if they are purchased by a resident of that state

What is the tax status of MBSs?

Same for corporate bonds - the interest is fully taxable at both the federal and state level