Chapter 7: Debt Securities (Emmanuel God With Us and Favoured by God)

Bond basics:

Par Value: The Face Value repaid to bondholders at maturity

*Assume $1,000 unless otherwise stated

**Bond prices are quoted as a % of par (e.g. 99⅜ = $993.75)

Coupon Rate: The stated annual interest rate, and it is paid as a % of par value

*Assume semiannual payments unless told otherwise

Maturity date: The date the issuer repays the par value plus any remaining interest

Bond indenture

The legal contract between the issuer and bondholder that specifies: maturity, par value, coupon rate, collateral, and any call or convertible features

Trustee

An organization that makes sure that an issuer honors the terms of the indenture

Term Bonds:

The entire issue matures on a single date: It is usually paired with a sinking fund because of the large lump-sum payment due on the maturity date

Sinking fund

Money an issuer sets aside over time to retire debt; bond’s with sinking funds have lower default risk as there is money intentionally set aside for the repayment of the bond

Series bonds

Bonds issued in stages over successive years but share one maturity date; interest is paid only on bonds already issued

• This is commonly used for construction projects

Serial bonds

Bonds that have a portion of the issue mature at regular intervals (e.g. 10% per year)

• This is commonly the structure for municipal bonds

Balloon Issue

A type of serial bond structure where a large portion of the issue matures on the final date

Mortgage bonds

Bonds backed by real property the issuer owns

Open-ended bonds vs Closed-ended bonds

Open-ended: Debt can issued using the same collateral

Closed-ended: Debt cannot be issued using the same collateral

Equipment trust certificates

Bonds backed by equipment such as planes, trucks, rigs

• This type of bond is typical for transportation companies

Collateral trust bonds

Bonds backed by financial assets (stocks/bonds) held by a trustee

Guranteed bonds

Bonds backed by a company other than the issuer (often times its a parent company)

• The ratings of these bonds are based on the guarantor’s credit rating

Debtentures

Unsecured bonds backed only by the issuer’s general credit and the indenture

Income (adjustment) bonds

The riskiest bond type, as interest is paid only if earnings are sufficient

• Typically issued at a deep discount by companies reorganizing from bankruptcy

Types of Yield

Nominal yield: Is the coupon rate

Current Yield (CY): Is the Annual Interest / Current Market Price of Bond

Yield to Maturity (YTM): The total return if held to maturity, factoring in price, par, coupon, and time remaining.

Yield to Worst: The lowest of all possible YTM/YTC outcomes across every call date

Basis point

Equal to 0.01%

Accrued interest

Interest owed to the seller for days held since the last coupon payment; Accrued interest is added to the buyer’s cost

**Accrued interest is calculated on a 30-day month/360-day year for corporate and municipal

**Accrued interest is calculated on actual days in month /365 day year for US government bonds

Bond price and Yield Relationship

Bond prices and yields move inversely

Callable bond

The issuer can redeem the bond early at a stated call price after a set date

*Call Protection: The period which the issuer cannot call a bond

*Call premium The amount above par an issuer msut pay to call a bond once call protection ends

Step (stepped) coupon bond

A callable bond whose coupon rate increases at set intervals

• its usually called when the rate is about to step up

Put bond

Lets the bondholder redeem the bond early at a stated price

• It is generally rare an pays a lower coupon due to the investor flexibility

Convertible bond

Bonds exchangeable for common stock

US Government Treasury Securities:

Treasury Bills (T-bills): Mature have maturities of less than a year and maturity intervals of 4, 8, 13, 17, 26, and 52

Treasury Notes (T-Notes); 2-10 year maturities with semiannual interest

Treasury bonds (T-bonds): 20-30 year maturities

T-STRIPS: Zero-coupon debt securities with 6month-30 year maturity, bought at a discount

TIPS (Treasury Inflation-Protected Securities): 5/10/30 year maturities and interest payments adjust with inflation

Us Agency Securities:

Agency (GSE) bonds: Issued by government sponsored enterprises: backed but not guaranteed by the US government

*GNMA is the exception

GNMA (Ginnie Mae): Supports US Housing and Urban Development (HUD), the mortgages are considered asset-backed

(FNMA) Fannie Mae

A publically held GSE that provides capital for conventional mortgages

FHLMC (freddie Mac)

A GSE that buys residential mortgages and packages them into mortgage backed securities

FCS (Farm credit System)

A privately owned GSE that raises money to fund loans to farmers

SLMA (Sallie Mae)

A GSE that provides secondary market for student loans

Prepayment risk

When interest rates fall and homeowners refinance, mortgage backed bondholders get paid back early, and they’re forced to reinvest then at lower rates

Extension risk

This comes about when Bondholders end up holding mortgage backed securities longer than expected, when interest rates rise or stay flat

Repurchase agreements (repo) *this is a money market instrument

A short term loan where a seller of securities agrees to buy them back at a set price/time

Federal funds

Overnight loans between banks to meet reserve requirements

Money Market Instruments

Commercial paper: Unsecured corporate debt with a maturity of less than 270 days (it is not SEC registered)

Brokered (negotiable/jumbo) CDs: Bank issued CDs sold through broker dealers, that are tradable on the market (jumbo CDs>100k+)

Bankers’s acceptance (BA) A bank guaranteed time draft used to finance imports and exports

T-bills and Repos