7. Debt Securities: Corporate and US Government Loans

What is the Bond Indenture?

It is the legal agreement between the issuer and its bondholders, printed on or attached to the bond certificate.

What is included in the Bond Indenture?

The Maturity Date




The Par Value




The Coupon Rate and Payment Dates




Any Collateral Securing the Bond




Any Callable or Convertible features.




Trustee

Maturity Date

The date bondholders get paid back for the loans they made. They receive par value plus any earned interest.

Par Value

The face value or denomination of the bond. Usually $1,000.

How are Bond Prices quoted? Give an example.

Bond prices are quoted as a percentage of par value.

Coupon Rate

The amount of annual interest received by investors.

How is the Coupon Rate expressed? Give an example.

The coupon rate is expressed as a percentage of par value which is paid semiannually unless stated otherwise.

What are three Bond Issues with specific Maturity Schedules?

Term Bonds




Series Bonds




Serial Bonds

What are Term Bonds?

Bonds that are issued at the same time with the same maturity date.

Why do corporations issue Term Bonds?

In order to lock in a set coupon rate over a long period of time.

What is a Sinking Fund?

Money set aside over time by a corporation in order to retire its debt. It lowers the likelihood of default.

What are Series Bonds?

Bonds that are issued in successive years with the same maturity date in which interest is only paid on bonds already issued.

What are Serial Bonds?

A type of bond where a portion of outstanding bonds mature at regular intervals.

What companies typically issue Series Bonds?

Construction companies building developments in several phases.

What companies typically issue Serial Bonds?

Corporations and Municipalities to fund projects that provide regular income streams.

What is a Balloon Issue?

A Serial Bond that has more bonds maturing on the final maturity date.

What are Secured Bonds?

Bonds backed by collateral. The issuer promises to sell a specific asset to pay outstanding debt in case of default.

What are the different types of Secured Bonds?

Mortgage Bonds




Equipment Trusts




Collateral Trusts




Guaranteed Bonds

Mortgage Bonds

Bonds that are backed by property that the owner issues.

What is the difference between a closed-end mortgage bond and an open-end mortgage bond?

The issuer may borrow more money with the same collateral using an open end mortgage bond, which you can't do in a closed-end mortgage bond.

Equipment Trusts

Bonds issued by transportation companies secured by equipment they own.

Collateral Trusts

Bonds backed by financial assets owned by the issuer.

Guaranteed Bonds

Bonds backed by a firm other than the original issuer, usually a parent company.

What are Unsecured Bonds?

Bonds that aren't backed by any assets.

What are the types of Unsecured Bonds?

Debentures




Income Bonds

Debentures

Bonds that are backed by the issuer's good word and written agreement stating that the issuer will pay the interest payments when due, and par value at maturity.

Income Bonds

Bonds in which the issuer promises to pay the par value at maturity and interest payments when earnings are high enough. The riskiest bond of all.

Who typically issues Income Bonds at a discount?

Companies in the process of reorganization.

Between Secured and Unsecured Bonds which usually has the higher coupon rate?

Unsecured Bonds have higher coupon rate to account for the additional risk.

Between Secured and Unsecured Bonds which has the higher price?

Secured Bonds have higher prices due to how safe they are.

As Rates Go Down Prices Go ________

Up

As Prices Go Down Rates Go ________

Up

The prices and yields of bonds share an ________




relationship.

Inverse

Nominal Yield

The coupon rate on the face of the bonds.

Current Yield

The current annual rate of return of a bond based on changes in the bonds price.

What is the equation for Current Yield?

CY = Annual Interest / Market Price

What are the different concepts of measurement for bonds?

Yield to Maturity




Yield to Call




Yield to Worst




Total Return




Basis Points

Yield To Maturity

The yield an investor can expect if holding the bond until maturity.

What is the equation for Yield to Maturity?

YTM = Annual Interest (+ Annual Accretion) or




(- Annual Amortization) / (market price + par value)/2

Accretion and Amortization

The adjustment of the bond price towards the par over the amount of time until the bond matures.

What is the equation for annual accretion?

par value - market price / years until maturity

What is the equation for annual amortization?

market price - par value / years until maturity

Yield to Call

The amount the investor receives if the Bond is called prior to the maturity date.

Yield to Worst

The lowest yield to call and yield to maturity for every single call date.

Total Return

The full return on a particular investment over a given period of time.

What are the steps to determining Total Return?

1. Determine the initial cost of the investment

2. Calculate the total amount of interest received over the time of the investment

3. Add interest or dividends to the selling price

4. Divide that number by the initial cost and subtract 1

Basis Point

A Basis point is 1/100th of a percent.

How do you determine which bond is best to invest in?

You need to look at credit rating, callable, put, and convertible features, as well as investment objectives.

What are the two main bond credit ratings agencies?

Standard & Poors and Moody's

What are the investment grade bond ratings for S&P?

AAA, AA, A, BBB

What are the investment grade bond ratings for Moody's?

Aaa, Aa, A, Baa

What are the junk bond (High Yield) ratings for S&P?

BB, B, C, D

What are the junk bond ratings for Moody's?

Ba, B, Caa, D

List The S&P bond credit ratings from highest to lowest.

AAA

AA

A

BBB

BB

B

C

D

List the Moody's bond credit ratings from highest to lowest.

Aaa

Aa

A

Baa

Ba

B

Caa

D

What are the Highest Quality Bond Rating for S&P and Moody's?

AAA for S&P, Aaa for Moody's

What are the High Quality Bond Ratings for S&P and Moody's?

AA for S&P, Aa for Moody's

What are the upper medium quality ratings for S&P and Moody's?

A for S&P and Moody's

What are the lower medium quality ratings for S&P and Moody's?

BBB for S&Ps, Baa for Moody's

What are the speculative junk ratings for S&P and Moody's?

BB for S&Ps, Ba for Moody's

What are the credit ratings for Speculative Junk bonds with interest and principal payments missed for S&P and Moody's?

B for both S&P and Moody's

What are the credit ratings for Speculative Junk bonds with no interest being paid for S&P and Moody's?

C for S&P, Caa for Moody's

What are the credit ratings for Bonds in default for S&P and Moody's

D for both S&P and Moody's

What are Callable Bonds?

Callable Bonds are bonds that an issuer has the right to buy back from investors at a price stated on the indenture.

When does the issuer have a right to call the Step Coupon Bond?

The issuer has the right to call a step coupon bond at the time that the rate is due to increase.

What is a Make Whole Call Provision?

A Make Whole Call Provision is a rule for Callable Bonds that requires the issuer calling the bond to make not only payment for the bond, but also the present value of any future interest payments investors will miss.

What is Call Protection?

Call Protection is a trait of callable bonds that prevents the issuer from calling a bond for a specific amount of time, usually years.

What is a Call Premium?

Call Premium is an amount over par value that the issuer has to pay for calling the bonds immediately after the expiration of Call protection.

What is a Step Coupon Bond?

A step coupon bond is a callable bond that starts with a low coupon rate, but increases at a predetermined interval.

What are Put Bonds?

Put Bonds are bonds that allow the investor to redeem the bonds at any time for the price stated on the indenture.

Why do Put Bonds usually have a lower coupon rate?

They have a lower coupon rate because that is the cost of the flexibility provided to investors.

In relation to inflation when should issuers call bonds?

Issuers should call bonds when interest rates decrease in order to offer newer bonds for the lower rate.

In relation to inflation when should bond holders redeem put bonds?

Bond holders should redeem put bonds when interest rates increase in order to purchase newer bonds at a higher rate.

What are Convertible Bonds?

Convertible Bonds are bonds that convert into common stock.

What is Parity concerning convertible bonds?

Parity is when the price of the convertible bond is equal to the price of the underlying assets.

When is a convertible bond trading below parity?

A convertible bond is trading below parity when the price of the convertible is trading below the value of the underlying.

What is the Conversion Ratio?

Conversion Ratio = Par Value / Conversion Price

What are the different types of treasury securities?

Treasury Bills




Treasury Notes




Treasury Bonds




T- Strips




Treasury Inflation Protected Securities

What are Treasury Bills (T-Bills) ?

Treasury Bills are short term US debt securities that are issued at discount and mature at par. It has a minimum purchase price of $100.

What are the maturities for T-Bills?

4 Weeks

8 Weeks

13 Weeks

26 Weeks

52 Weeks

What are Treasury Notes (T-Notes) ?

Treasury Notes are intermediate term US debt securities that pay interest every 6 months. It has a minimum purchase price of $100.

What are the maturities for T-Notes?

2 years

3 years

5 years

7 years

10 years

What are Treasury Bonds (T-Bonds) ?

Treasury Bonds are long-term US debt securities that pay interest every 6 months. It has a minimum purchase price of $100.

What are T-Strips?

T Strips are zero coupon securities that are issued at discount and mature at par. Their purchase price varies.

What are the maturities for T-Strips?

T-Strips maturities vary from 6 months to 30 years.

What are Treasury Inflation Protected Securities (TIPS) ?

Treasury Inflation Protected Securities are securities whose par value and coupon payments adjusts according to inflation and deflation. They pay interest every 6 months and have a minimum purchase of $100.

What are the maturities for TIPS?

The maturities for TIPS are 5, 10, and 30 years.

What are Agency Bonds?

Agency bonds are bonds issued by US Government Sponsored Entities (GSEs)

Name all of the GSEs?

Government National Mortgage Service (Ginnie Mae)




Federal National Mortgage Association (Fannie Mae)




Federal Home Loan Mortgage Corp (Freddie Mac)




Farm Credit System (FCS)




Student Loan Marketing Association (Sallie Mae)

What is the single GSE whose bonds are fully guaranteed by the faith and the credit of US gov't?

Government National Mortgage Service




(Ginnie Mae)

What does the Government National Mortgage Service (Ginnie Mae) do?

Ginnie Mae is the only agency whose securities are fully backed by the government. It supports the US Department of Housing and Urban Development.

What does the Federal National Mortgage Service (Fannie Mae) do?

Fannie Mae is publicly held corporation that provides capital for certain mortgages. It can purchase

What does the Federal Home Loan Mortgage Corporation (Freddie Mac) do?

Freddie Mac is a publicly held corporation that creates a secondary market for Mortgages. They purchase residential mortgages and packages them into Mortgage Backed Securities.

What does the Farm Credit System (FCS) do?

The FCS consists of lending institutions that provide financing and credit to farmers. They sell securities and loan the funds raised to farmers.

What does the Student Loan Marketing Association (Sallie Mae) do?

Sallie Mae provides a secondary market for student loans. It purchases and packages student loans into short and medium term debt securities.

What is the reinvestment risk with Mortgage Backed Securities?

Some mortgage backed securities are susceptible to reinvestment risk because many homeowners refinance when interest rates fall. In that case, holders of MBSs get paid back sooner and are reinvesting at a lower interest rates.

What is the extension risk with Mortgage Backed Securities?

If interest rates increase homeowners won’t refinance as often and holders will be susceptible to extension risk, holding onto their investments for a longer period than expected.

What are Money Market Instruments?

Money Market Instruments are relatively safe short term loans that can be issued by corporations, banks, the federal government, and municipalities.

Name the basic Money Market Instruments.

Repurchase Agreements(Repos)

Federal Funds

Corporate Commercial Paper

Brokered CDs

Eurodollars

Banker's Acceptances

T-Bills

What is a Repurchase Agreement (Repos)?

Repos are agreements where the seller of securities agrees to repurchase them at a previously determined price and time.