Chapter 5 - Fundamentals of Debt

FIXED INCOME SECURITIES

What is a bond?

• A loan from an investor to the issuer with a promise from the issuer to pay the debt service

What is leverage financing?

What is a leveraged issuer?

• An issuer raising money through loans against its net worth

• Has more debt than equity issued

What is the par value?

What are we assuming for exam?

• The principal amount of the “loan” that is paid back to the issuer

• $1,000

What is the coupon rate?

What is calculated against?

• Interest rate that is paid to the investor through the life of the bond

• The par value, not the market price

What days to bonds typically pay their interest?

• The 1st and the 15th of the month

What is a long coupon?

What is a short coupon?

• Depending on issuance date, to synchronize payments to the 1st and 15th schedule, sometimes the first payment period can be + / - 6 months

• Long coupon is more than 6 months

• Short coupon is less than 6 months

What is accrued interest?

How is the period calculated?

What is the formula to find amount of interest?

• If a bond is traded in between coupon payments, there will be interest due to the seller for that period from the buyer

• From the last interest payment date up to the settlement date, but not including the settlement date

• Principal X Rate x (days of interest /360)

  • This if for corp and munis

  • Treasuries would be days over 365 with exact day count

What do Munis/Corporates assume for days/months?

What do treasuries assume for days/months?

• 360 days and 30 days a month

• 365 days and actual days in a month

Do bills trade with accrued interest?

• No, they trade flat since there are no coupon payments on these

What is the maturity date?

What is a term bond issue?

What is a serial bond issue?

What is level debt service?

• The date when the principal is returned

• All bonds from an issue mature on the same day

• Bonds in the same issue mature at different times

• When the debt service is structured that roughly the combined annual payments of P&I are constant through the bond’s life

How would a serial issue effect the principal and interest schedules?

• They would reduce faster since bond are being retired faster

What is the dated date?

• The day that interest begins to accrue

WHY BOND PRICES FLUCUATE FROM PAR

Why do the market prices of bonds differ from the par value it is issued at?

• Price will change due to factors like market interest rates and credit rating

What is interest rate risk?

Does this effect longer or shorter maturities more?

• As the market interest rates change, the price of the bond will change with it

• Short term rates move more sharply while long term prices are more effected

What is credit risk?

How could this effect the price of the bond?

*Review rating agency tables

• The risk that the issuer of the bond may default

• If credit risk goes up, investors will demand more yield, so prices will go down

What is reinvestment Risk

• The risk that the investor will not be able to reinvest at the same rate when the bond matures or is called back

What is call risk?

When is this most prevalent?

• The risk that a bond will be called back

• When rates are going down because the issuer will be looking to refinance

BOND PRICING

How are bond prices expressed?

Give an example?

• As a percentage of par value

• 99 = 99% = $990

What fraction are corporates/munis traded in?

What fraction are treasuries traded in?

• 1/8

• 1/32

What would 99 1/8 signify?

What about 99 -04?

• Corporates/muni with a price of $991.25

• Treasury with price of $991.25

PRICES AND YIELDS: AN INVERSE RELATIONSHIP

• What happens to the bond’s price if rates rise?

• What if they fall?

• If rates rise, then prices fall due to less demand for a lower coupon bond

• If rates fall, then prices rise due to more demand for a higher coupon bond

What is nominal yield?

• The quoted coupon rate

What is the current yield?

How is it calculated?

• Measures what a bond investor gets in coupons for the market price they are paying

• CY = Annual Interest / Market Price

What is yield to maturity?

• Accounts for everything that an investor receives from the time of purchase to maturity

What is yield to call?

Is YTC or YTM quoted to the customer?

• The yield to the call date of the bond

• Lower of the two yields

If bond is trading at a discount what is shown?

If a bond is trading at a premium what is shown?

• Discount: YTM

• Premium: YTC

REDEEMING BONDS

What is a call provision?

What is included if a bond is called back?

• A bond that can be bought back by the issuer

• The par value and any accrued interest from the last payment date

What is a call protection period?

• A period in which the bond cannot be called back

What is a call premium?

• Issuers will typically buy their bonds back at a premium to compensate the investor

What is an “in whole” call?

• The entire issue is called back at one time

What is a partial call?

• A lottery is done to call back a portion of the bonds

What is a continuous call?

• A call feature that can be exercised at any point after the 1st call date

What is a catastrophe call?

• Bonds are called back because the underlying collateral is destroyed

Which call types need to be disclosed at issuance?

• If it is in whole or partial, catastrophe is unlikely so does not need to be

What is a refunding?

Why might this be done?

What kind of risk does this pose to investors?

• The process of using new bonds to pay off outstanding bonds

• If rates are going down, companies may look to refinance

• Reinvestment risk

What is prefunding?

What is another name for this?

• It is similar to refunding in the sense that new bonds are issued to pay off old bonds, but this is done earlier so the proceeds are held in escrow and invested into treasuries in the mean time

• Defeasance

How does prefunding effect the bond’s value?

• The price should go up because the bonds are essentially backed by the US government and have lower credit risk

What is '“escrowed to maturity” or “escrowed to call”?

• Money is put into escrow till that date

How does a cross over refunding work?

• New bonds are issued and the proceeds are escrowed to cover the debt debt service of the existing bonds

• Once the old bonds are called or mature, the revenue stream that originally secured them now secures the new bonds

What are sinking funds?

• A fund that is setup where the deposited funds are used specifically to redeem or pay off old bonds

What is a put provision?

How does this provision effect the bond’s yield?

• Opposite of a call provision, it allows the investor to sell the bond back prior to maturity

• Typically lower since it gives the investor optionality

TAX ISSUES ASSOCIATED WITH DEBT SECURITIES

How is corporate interest taxed?

How are treasuries taxed?

How are municipals taxed?

• Taxed at the ordinary income level for federal, state, and local level

• Federal level only

• State only (unless you buy them in your own sate)

How should the buyer and seller of a bond report accrued interest for taxes?

• The seller will need to report the accrued interest as income

• The buyer will need to report the full interest payment minus the accrued interest

How are zero coupon bonds taxed?

What is the process called?

• The cost basis will need to be adjusted on an annual basis so taxes are paid each year

• Accretion

• If you buy a bond at 600 that matures in 20 years, it will be adjust by 20 each year (400/20)

How are bonds that are bought at a premium taxed?

What is this process called?

• The cost basis will need to be adjusted down annually and netted against interest income

• Amortization

• If a bonds is purchased at 1100 and 10 years till maturity, the cost basis needs to be adjusted down by 10 each year