SIE Unit 3 - Debt Securities

Par value for most debt securities is...

$1000

Par value for most preferred stock is...

$100

Par value for a debt security is the amount paid...

to the investor as principal at maturity.

Maturity Date

the date on which a bond's principal is repaid to the investor and interest payments cease

Common maturities are in the range of (years)

5-30 years

Term Bond

type of bond where the entire principal is repaid to bondholders on a single, specific maturity date rather than being paid off in installments over time

Sinking Fund

money set aside by corporations to repay bonds at maturity

Serial Bond

bond with a maturity schedule where portions of the principal mature in intervals over a period of years until it's fully repaid

Balloon Bonds

bond with a hybrid maturity schedule. Issuer pays off part of the principal in intervals but then pays off the majority of the principal at the final maturity date

Savings Bonds

type of debt issued by the federal government that may be purchased and redeemed at banks or from the treasury department

What's special about Savings Bonds in terms of how they are traded and regulated?

Savings bonds do not trade in the secondary market and are exempt from several securities laws

Coupon Rate

the interest rate the bond issuer has agreed to pay the investor

Other terms for coupon rate (2)

1. Stated Yield

2. Nominal Yield

Since interest rate is usually a % of par value ($1000), a bond with a 6% coupon rate is paying how much interest per year?

$60

What happens if the bond is traded between coupon payments?

Interest has accrued -- the seller has already earned some interest, even though the next payment hasn't happened yet. So, the buyer pays the seller that earned interest at the sale, and on the next payment date, the issuer sends the full interest payment to the current owner of the bond. Both investors end up with the amount of interest that accrued while they held the bond.

Buyers of Zero-Coupon bonds do not pay accrued interest because...

these securities do not pay interest

Interest in generally paid on a ____ ______ basis

Semi Annual

If interest is paid semiannually, what would each payment be for a 6% coupon bond?

$30 every 6 months

Once a bond is trading in secondary markets, it can trade at (3)

1. Price of par

2. Premium to par

3. Discount to par

Premium Bond

one selling at a higher price than its face value (ex. $1200)

Discount Bond

a bond selling at lower than its face value (ex. $800)

Bond pricing is measured in ______

Points

Each point equals __% of face value, which is typically $__ if par is $1000

1%, $10

So, a bond trading at 90 is worth....

$900

A bond trading at 103 is worth...

$1030

Bonds have a particular sensitivity to changes in....

Market Interest Rates

The interest rate the issuer pays is essentially the cost of _________ _____ and the reward for _______ _____

Borrowing Money, Lending Money

Bond Prices have an _______ relationship with interest rates

Inverse (when interest rates go up, bond prices go down)

Explaining the inverse relationship:

if you own an old bond paying 3% and interest rates have risen to where new bonds are being issued paying 5%, nobody wants to pay full price for your dumb 3% bond. The bond price will go down

Yield

the return an investor gets from a bond relative to the amount they paid for it

Profit

Yield is set by (4)

1. Bond rating

2. General interest rates

3. Time to maturity

4. Special features

Bond Rating

an evaluation of a bond's relative safety according to an issuer's ability to repay principal and make interest payments.

Ratings range from...

AAA or Aaa (the highest) to C or D (company in default)

Nominal Yield

the fixed, stated annual interest rate of a bond. Calculated as a percentage of par

Another word for coupon rate

Current Yield (CY)

Measures a bonds annual interest/coupon payment relative it its CURRENT value (rather than its par value)

Current Yield Formula =

Annual Coupon Payment / Market Price

Yield to Maturity (YTM)

The total estimated annual return on a bond if its held until its maturity date

Yield to Maturity Formula

Difference between the Price paid for the bond and the par value received when the bond matures

If the bond is purchased at a discount....

the investor makes money at maturity

If the bond is purchased at a premium....

the investor loses money at maturity

If a bond is trading at a 5.83 basis, that means...

the YTM is 5.83%

Call feature

bond may be redeemed by the issuer before maturity. Investor receives the principal back sooner than anticipated

Yield to call (YTC)

the estimated annualized return an investor will receive if they buy a bond at its current market price and the issuer calls it before its official maturity date

Yields are measured in _____ points

basis

Basis points are equal to...

1/100 of 1% of a yield

.01

Example: a bond whose yield has increased from 7.0% to 7.5% is said to increase by ___ basis points

50

Rank the value of Coupon, CY, YTM, and YTC for:

a bond trading at a discount

Coupon < CY < YTM < YTC

Rank the value of Coupon, CY, YTM, and YTC for:

a bond trading at par

Coupon = CY = YTM = YC

Rank the value of Coupon, CY, YTM, and YTC for:

a bond trading at a premium

Coupon > CY > YTM > YTC

Note: there are questions on the exam that make it seem like you need to calculate YTM or YTC, but if you understand the chart that corresponds with the above ^ you will not need to

.

Common Bond Features (4)

1. Call

2. Put

3. Convertible

4. Zero-Coupon

again, a Call feature...

allows an issuer to redeem a bond before maturity

When do issuers generally exercise a call

when interest rates are falling

how do the issuers compensate for a call feature?

bonds with a call feature must have a slightly higher coupon rate than a similar bond that does not have a call feature

some issuers set their callable bonds at __________ of par

Premium

Put Feature

allows the investor to force the issuer to pay off the bond before it matures

How does a put feature impact the coupon rate?

It's very attractive so it lowers the coupon

Convertible Feature

issued by corporate issuers, allow the investor to convert the bond into shares of the issuer's common stock

Parity

when the value of a convertible bond equals the value of the common stock

Zero-Coupon bonds

do not make regular interest payments. Only pay par at maturity

Zero coupon bonds trade at a....

Discount

the market for zero coupon bonds is extremely...

Volatile

Explain how an investor is taxed on a zero coupon bond

Annually, even though it hasn't matured

Example: At maturity, a zero pays face value (par $1,000) to investors in 10 years: $500 principal and $500 interest. How much tax will the investor pay on the interest annually?

$50

Phantom Income

taxable income that has not yet been received but is taxed as if it were

If a 6% corporate bond is trading on a 7% basis, that means it's trading at a....

Discount.

If it's YTM is 7% but the coupon is only 6%, that means interest rates have risen higher than 6% and you can buy this bond for a discount, which gives it that extra 1% of YTM

Volatility

a bonds sensitivity to changes in interest rates

Collateral

certain assets set aside and pledged to a lender for the duration of a loan.

If the borrower fails to meet obligations to pay principal or interest....

the lender has claim to collateral assets

Standard & Poor, Moody's, and Fitch are...

the three major organizations that rate bonds

What are Standard & Poor's 4 highest ratings categories?

AAA

AA

A

BBB

What are Moody's 4 highest ratings categories?

AAA

AA

A

BAA

Followed by...

BA

B

CAA CA

C

Investment Grade

bonds rated in the top four categories

Investment grade bonds are the only bonds eligible to be purchased by financial institutions because they are easier to sell. This means they have greater ________ than lower grade bonds

Liquidity

Explain the risk/reward when it comes to bond ratings and investing

the higher the rating, the lower the yield. The higher someone's credit score, the lower the rate they get. There's potential for higher yield when taking a risk on a lower rating

High Yield Bonds

a bond with a less-than-investment grade rating

High yield bonds are also known as....

Junk bonds

Are all non-rated bonds junk?

Not necessarily. Not all companies pay to get their bonds rated

The more time left to maturity, the more ______ a bond's price will be

Volatile

What's the relationship between coupon rate and volatility?

the lower the coupon rate, the more volatile. A 3% coupon rate with 5 years remaining could easily see much higher interest rates over that time

Duration

a measure of a bonds volatility that combines maturity and coupon rate

Higher duration =

more price volatility

Which of the following debt securities will experience the highest price volatility?

A 3% bond maturing in 5 years

B 3% bond maturing in 10 years

C Zero coupon bond maturing in 10 years

D Zero coupon bond maturing in 5 years

C

Benefits of debt investments (2)

Income

Safety

Bonds are the best way for an investor to produce....

current income

Because?

the nature of debt securities is they either pay interest or go into default

If a corporation fails, bondholders are at a....

higher priority at dissolution than anybody else

Default Risk

the risk that the issuer will fail to pay interest/principal when due

The default risk for a US T-bill is....

effectively 0

Purchasing Power Risk

Inflation risk that comes with a fixed payment

Secured Debt

backed by collateral, meaning that an asset of the corporation is pledged to secure the loan

(3) types of secured bonds:

Mortgage Bonds

Equipment Trust Certificate

Collateral Trust Bonds

Mortgage Bonds

backed by real estate that owned by a corporation

Equipment Trust Certificate

bonds secured by equipment the corporation uses in its operations

Collateral Trust Bonds

bonds backed by a portfolio of securities held in trust to secure the loan. This portfolio can't be touched except for the purpose of paying back debt

A term often used with unsecured debt is....

"Full Faith and Credit"

(4) types of unsecured debt:

Debentures

Guaranteed bonds

Income bonds

Subordinated debt

Debentures

Unsecured bonds with the highest priority of all unsecured debt obligations

Guaranteed Bonds

bonds that are backed by a third party should the issuer default

Income Bonds

only make interest payments when the company has enough income