Series 65 Unit 2 Types & characteristics of fixed income (debt) securities

indenture

contract between the borrower and lender

the deed of trust stating issuer's obligation to pay back a specific amount of money on a specific date

long term debt

money borrowed for a minimum of five years although more frequently the length of time is ten to thirty years

inverse relationship between interest rates and the price of debt securities

whenever interest rates in the market (the current cost of borrowing money) go up, the price of outstanding debt securities goes down

likewise, if interest rates fall, the price of outstanding debt securities will rise

although the market price of the debt security will fluctuate, the interest payments stay the same

money market instruments

issued at at discount to their face value with the difference paid at maturity representing the interest

investment grade ratings according to S&P & Moody's

AAA, AA, A, BBB

Aaa, Aa, A, Baa

high-yield bonds

lower grade known as junk bonds

because of their lower ratings (BB or Ba or lower) and additional risk of default, high-yield bonds may be subject to substantial price erosion during slow economic times or when a bond issuer's creditworthiness is questioned

may be suitable for sophisticated investors seeking higher returns and possible capital appreciation from speculative fixed-income investments

risk-reward relationship

the more risk an investor takes, the greater must be the reward

the less creditworthy the borrower, the more risk to the lender, so the greater the reward the lender must receive to compensate for that risk

Practice Question

According to Standard & Poor's rating system, the 4 highest grades of bonds (from best to lowest grade) are

A. Aaa; Aa; A; Baa.

B. A; Aa; Aaa; B.

C. B; A; AA; AAA.

D. AAA; AA; A; BBB.

Answer: D. Choice A would be correct if the question referred to Moody's.

how to price corporate and municipal bonds 1/8

90 1/4 = $902.50

101 3/4 = $1,017.50

how to price treasury securities 1/32

90.8 = $902.50

101.25 = $1,017.50

convertible debt securities

convertible debt, most often debentures, is issued by corporations only

because they may be converted or exchanged for the company's common stock, there are no convertible municipal or government bonds

the conversion privilege is exercised at the discretion of the investor.

nominal yield

the interest stated on the face of the bond

sometimes it is referred to as the coupon rate

to compute the annual interest payments in dollars, multiply this nominal yield by the face amount of the bond ($1,000 unless stated otherwise)

current yield

return/investment

annual income/current market price

discount and premium

if you pay more, you get less

if you pay less, you get more

yield to maturity

the yield to maturity on a discount bond will always be higher than that bond's current yield

the yield to maturity on a premium bond will always be lower than that bond's current yield

purchasing a bond at a discount (below par) will always result in getting back par, which means more (a profit) than the original investment

purchasing a bond at a premium (above par) will always result in getting back par, which means less (a loss) than the original investment

yield to call

the rate of return the bond provides from the purchase date to the call date and price

this calculation generates a lower return than does the yield to maturity and should be considered by investors when evaluating a callable bond trading at a premium

if the bond has a yield to call lower than its current yield it is trading at

premium

if the bond has a yield to maturity and current yield that are equal the bond is trading at

par

if the bond has a yield to maturity less than its yield to call the bond is trading at

discount

if a bond has a yield to maturity greater than its coupon the bond is trading at

discount

bond pricing from lowest discount to highest premium

discount, nominal, CY, YTM, YTC

price/yield relationship

interest rates and bond prices move counter to each other

Practice Question

When a bond with a 6% coupon is selling for 90, each of the following statements is correct except

A. the current yield is approximately 6.67%.

B. the bond is selling at a discount.

C. the bondholder will receive two semiannual interest payments of $27 each.

D. the yield to maturity is slightly higher than the current yield.

Answer: C. A bond with a 6% coupon is going to make two semi-annual interest payments of $30 each, regardless of the bond's market price. After all, the loan was $1,000 at 6% interest and that won't change. A price of 90 is 90% of the $1,000 par—clearly a discount. The current yield is the $60 annual interest divided by the $900 price or 6.67%, and that is a bit lower than the yield to maturity because, if we hold the bond to maturity, we're going to get back the full $1,000, which will represent a $100 profit. Please see the chart at the Test Topic Alert above.

treasury bills

direct, short-term debt obligations of the U.S. government

treasury bills are the only treasury security that pay no interest

they are known, with maturities of 4 weeks, 13 weeks, and 26 weeks, are issued, and, once each four weeks, bills with a 52-week maturity are issued

they are always issued at a discount from their par value

used in market analysis as the stereotypical risk-free investment

U.S. treasury notes

direct debt obligations of the U.S. treasury

they pay semiannual interest as a percentage of the stated par value

they have intermediate maturities (2, 3, 5, 7, and 10 years)

they are noncallable and mature at par value

U.S. treasury bonds

direct debt obligations of the U.S. treasury

they pay semiannual interest as a percentage of the stated par value

they have long-term maturities generally 10-30 years

they are noncallable and mature at par value

Practice Question

When Treasury bills are issued, they are quoted at

A. a premium over par.

B. 100% of the par value.

C. par value with interest coupons attached.

D. a discount from principal with no coupons attached.

Answer: D. Treasury bills are always issued at a discount; they pay no interest. The investor profits by receiving back par value and makes the difference between the discounted purchase price and the par received at maturity. All government bonds are now book entry (electronic record); there has not been a Treasury note or bond issued since July 1986 with interest coupons attached.

treasury inflation-protected securities

helps protect investors against purchasing power risk

these notes are issued with a fixed interest rate, but the principal amount is adjusted semiannually by an amount equal to the change in the consumer price index, the standard measurement of inflation

they are issued with maturities of 5, 10, and 30 years

Practice Question

A customer wishes to buy a security providing periodic interest payments, safety of principal, and protection from purchasing power risk. The customer should purchase

A. TIPS.

B. TIGRS.

C. CMOs.

D. STRIPS.

Answer: A. TIPS offer inflation protection and safety of principal because they are backed by the U.S. government.

government national mortgage association securities

guaranteed by the full faith and credit of the U.S. government

wholly owned government corporation backed by the federal government

pays interest on a monthly basis, not semiannually

federal national mortgage association

purchases and sells real estate mortgages

issues bonds backed by these mortgages

issued at par and pay semiannual interest

interest is taxable at state, local, and federal

benefits of mortgage-backed securities

compared with other debt securities with similar ratings, they pay a higher rate of return

risks of mortgage-backed securities

difficult to understand

refinancing when rates drop

default risk

reinvestment risk

liquidity risk

Tennessee valley authority

nation's largest public power provider and a corporation of the U.S. government

not backed by the U.S. government

backed by generated revenue from projects

Practice Question

All of the following debt instruments pay interest semiannually except

A. Ginnie Mae pass-through certificates.

B. U.S. Treasury notes.

C. U.S. Treasury bonds.

D. TIPS.

Answer: A. A unique feature of Ginnie Maes is that they pay interest on a monthly basis, not semiannually. In addition to the interest, investors receive their share of that portion of the mortgage payments that represented principal repayment.

types of secured debt securities

backed by various kinds of assets of the issuing corporation

mortgage bonds

equipment trust certificates

collateral trust bonds

types of unsecured debt securities

backed only by the reputation, credit record, and financial stability of the corporation

debenture

guaranteed bond

subordinated

Practice Question

A debenture is issued based on

A. the general credit of the corporation.

B. a pledge of real estate.

C. a pledge of equipment.

D. the ability to levy taxes.

Answer: A. There are no pledged assets behind a debenture, merely the credit standing of the corporation. It is a corporate IOU.

when examining the capital structure of a corporation, it is important to know the liquidation priority:

secured creditors

unsecured creditors

subordinated debt holders

preferred stockholders

common stockholders

general obligation bonds

backed by a pledge of the issuer's full faith and credit for prompt payment of principal and interest

they are generally very safe

revenue bonds

payable from the earnings of a revenue-producing enterprise, such as a water, sewer, electric or gas system, toll bridge, airport, college dormitory, or any other income-producing facility

The yield, generally, is higher for this type of bond than for a general obligation bond (taxes are more secure than revenues)

tax equivalent yield

the interest on corporate bonds is taxed as ordinary income on both state and federal tax returns

the interest on treasury debt is only taxable on the federal level

municipal bonds interest is free of federal income tax, and if the investor resides in the issuer's state, it is generally free of state income tax as well

coupon rate/(100% - investor's tax bracket)

Practice Question

If an investor in the 27% federal income tax bracket invests in municipal general obligation bonds selling at par with a coupon of 4.5%, what is the tax equivalent yield?

A. 3.29%

B. 5.72%

C. 6.16%

D. 16.67%

Answer: C. The formula for computing tax equivalent yield is nominal (coupon) yield divided by (1 − federal income tax rate): 0.045 ÷ (1 − 0.27) = 0.045 ÷ 0.73 = 6.16%.

advantages of investing in foreign bonds include

potentially higher returns

diversification

hedging against a drop in the value of the U.S. dollar

risks of investing in foreign bonds include

currency risk

potentially higher risk of default

generally less liquidity

generally higher trading costs

eurobond

any long-term debt instrument issued and sold outside the country of the currency in which it is denominated

must be issued outside of the U.S.

eurodollar bonds pay in U.S. dollars

eurobonds pay in foreign currency

advantages of eurodollar bonds to investors are:

they bear no currency risk to U.S. investors

risk is clear

may offer higher yields than domestic bonds from the same issuer

disadvantages of eurodollar bonds are:

may be a lack of transparency

political and country risks

less liquidity than domestic issues

currency risk if denominated in a currency other than one's home country

Brady bonds

exchange defaulted commercial bank loans issued in less-developed countries

encouraged emerging market countries to undertake economic reforms

no Brady bond carries a U.S. government guarantee

Practice Question

Which of the following statements is not true?

A. A country wishing to restructure its debt using Brady bonds would do so to save on debt servicing costs.

B. One of the benefits of holding convertible debentures is the option to convert into the corporation's common stock.

C. U.S. Treasury securities are backed by the full faith and credit of the United States of America.

D. A resident of France purchasing Eurodollar bonds does not incur currency risk.

Answer: D. As the name implies, Eurodollar bonds are denominated in U.S. dollars. That means that someone in France will have the risk that the euro, the home currency in France, will rise against the dollar and, as a result, interest payments will be worth less as will the ultimate payback at maturity. Only U.S. residents have no currency risk with Eurodollar bonds. One of the benefits of Brady bonds is the ability of the sovereign government to borrow at a lower cost because of the collateral behind the bond. At least for exam purposes, there are no securities with a stronger guarantee of timely payment of interest and principal than those issued by the U.S. Treasury. Convertible debentures are convertible into the issuer's common stock, which is a benefit if the stock rises in price.

zero-coupon bonds

they are always issued at a discount

there is no reinvestment risk because there are no interest payments to worry about reinvesting

they are more volatile than other bonds of similar quality

particularly useful when there is a target goal, such as a college education or a qualified retirement plan

unless it is a large quantity, the child generally incurs little, if any, tax liability, and the earnings in the retirement plan are tax deferred

callable bonds

the call feature permits the issuer to redeem its bonds (pay off the principal) before maturity if it so desires

the call feature is most often exercised when interest rates (borrowing costs) have declined

in this case, the issuer could take advantage of the lower cost of borrowing by issuing new bonds at the lower rate prevailing in the market and using those proceeds to call in the old bonds with their higher coupons

call protection

the number of years into the issue before the issuer may exercise the call provision

the best call protection a bond may have is if a bond is noncallable

Practice Question

A bond issue that may be retired in advance of maturity at the option of the issuer is said to have

A. a callable feature.

B. an optional reserve.

C. a conversion feature.

D. a cumulative feature.

Answer: A. A bond that is callable has a provision that the issuer, at its option, may redeem that bond at a specified price known as the call or redemption price. As we will see below, the conversion feature may be exercised by the investor, not the issuer.

convertible debt

although the term convertible bonds is often used, in reality most are debentures rather than secured debt

advantages of convertible debt

downside protection

upside potential

disadvantages to investors

antidilutive protection

money market

the market for buying and selling short-term loanable funds in the form of securities and loans

money is what is traded not cash

negotiable certificates of deposit

referred to as jumbo CDs

unsecured time deposits (no asset of the bank is pledged as collateral), and the money is being loaned to the bank for a specified period of time

must have a face value of $100,000 or more, with $1 million or more being most common

commercial paper

short-term unsecured paper issued by corporations (especially finance companies) primarily to raise working capital—in other words, for current rather than long-term needs

generally issued at a discount—instead of receiving interest, the investor receives the face amount at maturity

Practice Question

A company realizes money from the sale of surplus equipment. It would like to invest this money but will need it in 4-6 months and must take that into consideration when selecting an investment. You would recommend

A. preferred stock.

B. Treasury bills.

C. AAA rated bonds with long-term maturities.

D. common stock.

Answer: B. For this client, the appropriate investment is a money market instrument, and nothing is safer than a T-bill.

benefits of investing in money market securities

highly liquid

very safe

the best place to store money that will be needed soon

risks of investing in money market securities

rate of return is not suitable for long term investors

fluctuating income

bank accounts

demand deposit account is the legal term for a checking account and the favorite repository for funds that will be needed in the very near term

certificates of deposit (time deposit)

nonnegotiable, can't be sold, can only be redeemed at the bank

benefits of certificates of deposit

the answer for capital preservation with no risk

no interest rate risk

liquid but not as liquid as a demand deposit account

risks of certificates of deposit

inflation risk

yields tend to be low so should not be major portion of long term investment

Practice Question

One would expect to have checkbook access to a

A. CMO.

B. DDA.

C. GNMA.

D. LIBOR.

Answer: B. DDA stands for demand deposit account, most often a checking account at a bank.

Which of the following would you not expect to see issued at a discount?

A. Zero-coupon bond

B. Treasury bill

C. Commercial paper

D. Bank jumbo CD

D. Bank jumbo CD

The GHIJ Corporation has a 3% convertible debenture outstanding with a conversion price of $40. The bond's current market price is 126. The most probable reason for this is

A. the current market price of the GHIJ common stock is approximately $50 per share.

B. interest rates have risen since the debenture was issued.

C. the current market price of the GHIJ common stock is approximately $35 per share.

D. GHIJ's earnings have risen since the debenture was issued.

A. the current market price of the GHIJ common stock is approximately $50 per share.

Which of the following projects is most likely to be financed by a general obligation rather than a revenue bond?

A. Expansion of an airport

B. Public library

C. Public golf course

D. Municipal hospital

B. Public library

MNO is planning to raise capital through an offering of 30-year bonds. Which call price would be most beneficial to MNO?

A. 102

B. 104

C. 110

D. 106

A. 102

The owner of a convertible debt issue

A. is a creditor of the issuer.

B. has the choice of receiving the bond's interest or dividends on the underlying stock, whichever is higher.

C. is generally in a senior position to other bondholders.

D. generally expects a higher current return than with a nonconvertible bond of the same quality and maturity.

A. is a creditor of the issuer.

To secure the debt that a subsidiary is offering, a railroad holding company transfers to a trustee the common stock of another subsidiary. The offering is one of

A. secured income notes.

B. collateral trust certificates.

C. guarantee trust bonds.

D. equipment trust certificates.

B. collateral trust certificates.

A TIPS bond is issued in the principal amount of $1,000, paying 3.5%. Over the security's 5-year term, the annual inflation rate is 6%. What is the principal value of the bond at the end of 4 years?

A. $1,344

B. $1,300

C. $1,267

D. $1,240

C. $1,267

Which of the following statements regarding U.S. government agency securities is true?

A. They generally offer higher yields than direct U.S. obligations.

B. Interest received on agency securities is exempt from federal income tax.

C. They generally trade on the major stock exchanges.

D. They are direct obligations of the U.S. government.

A. They generally offer higher yields than direct U.S. obligations.

Which of the following is not a money market instrument?

A. Newly issued treasury notes

B. Banker's acceptances

C. Commercial paper

D. Treasury bills

A. Newly issued treasury notes

Which of the following debt instruments generally presents the least amount of default risk?

A. High-yield corporate bonds

B. Municipal revenue bonds

C. Convertible senior debentures

D. Municipal general obligation bonds

D. Municipal general obligation bonds

In general, among the advantages to investing in Brady bonds over those issued by countries classified as emerging economies is

A. higher yields.

B. greater risk.

C. shorter maturities.

D. increased liquidity.

D. increased liquidity

The current yield on a bond with a coupon rate of 7.5% currently selling at 105½ is approximately

A. 7.50%.

B. 8.00%.

C. 7.11%.

D. 6.50%.

C. 7.11%

Which of the following statements regarding convertible bonds is not true?

A. Coupon rates are usually higher than nonconvertible bond rates of the same issuer.

B. If there is no advantage to converting the bonds into common stock, they would sell at a price based on their market value without the convertible feature.

C. The conversion rate is set at issuance and does not change.

D. Convertible bondholders are creditors of the corporation.

A. Coupon rates are usually higher than nonconvertible bond rates of the same issuer.

The DERP Corporation has an outstanding convertible bond issue with a conversion price of $125 per share. If the current market price of the bond is 80, the parity price of the stock is

A. $125.00 per share.

B. $100.00 per share.

C. $156.25 per share.

D. $64.00 per share.

B. $100.00 per share