Series 7 PE 2B

Advantages of Convertible Bonds

Convertible bonds allow corporations to borrow money at a lower rate (lower coupon) since the convertible feature is attractive to investors.

Investors are willing to accept the lower interest rate in exchange for the opportunity to convert the bonds into common stock.

Convertible bonds provide investors with a greater degree of safety than preferred or common stock, but also offer them the potential for capital appreciation if the underlying stock rises in value.

In addition, the investor has some downside protection because, even if the price of the stock falls, the convertible bond still has inherent value as a bond

Disadvantages of Convertible Bonds

A disadvantage to convertible bonds is that if all of the bonds are converted into stock, then the number of outstanding shares may increase dramatically.

This will cause the stockholders’ equity to be diluted and the earnings per share (EPS) to decrease.

The company will need to divide the earnings over a larger group of shareholders, thereby giving each of them a smaller percentage.

In order to reflect this possibility, a company’s EPS may need to be restated as fully diluted EPS—a figure that assumes all conversions have been made.

Analyzing General Obligation Bonds

When evaluating the risk of default for a general obligation bond, analysts will consider the following factors:

• The overall economic health of the community including changes in property values, its largest employers, average income, and demographic factors

• The tax burden and source of payments

• The budgetary structure and financial condition of the issuer

• The issuer’s existing debt using measures such as debt per capita and overlapping debt

• Whether this is a mixture of new, growing companies along with reliable, established companies

• Fiscal responsibility of the issuer

• Municipality’s debt trend

Direct Debt

All the debt (bonds and notes) that’s been issued by the municipality

Net Direct Debt

The direct debt (all issues) minus any self-supporting debt (such as revenue and notes issues). In general, the net direct debt is only the general obligation debt (bonds supported by taxes)

Overlapping Debt

This is the result of multiple authorities in a given geographic areas having the ability to tax the same residents

Total Bonded Debt

The sum of both the long-term and short-term debt of a municipality, plus its applicable share of overlapping debt

Auction rate securities (ARS)

Long-term investments that have a short-term twist - their interest rates or dividends they pay are reset at frequent intervals through auctions.

Investors who purchase ARSs are typically seeking a cash like investment that pays higher yield than available from money market mutual funds or certificates of deposit

Two types of ARSs: 20-30 year long term bonds or preferred shares with a cash dividend

Both IR and dividends are set for a short period of time (usually 7, 14, 28, or 35 days) and is done through a dutch auction

Issued by entities such as corporations, municipalities, student loan authorities, and museums, while auction rate preferred shares are issued by closed end funds only

Dutch Auction Process

Each bid and order size is ranked from the lowest to the highest minimum bid rate.

The lowest bid rate at which all of the securities may be sold at par establishes the interest/dividend rate, otherwise referred to as the clearing rate.

This is the rate that’s paid on the entire issue for the upcoming period.

Investors who bid a minimum rate above the clearing rate receive no securities; however, those whose minimum bid rates were at or below the clearing rate receive the clearing rate for the next period

VERY SIMILAR TO HOW TREASURY SECURITIES ARE SOLD IN THEIR AUCTIONS

Companion or Support Bonds

Tranches that absorb all prepayments from the PAC and TAC tranches.

Once the scheduled payments have been made to the PAC or TAC tranches, any excess or shortfall is reflected in the companion tranche.

Therefore, support tranches have greater volatility of cash flow and a high variability of average life and generally, holders are compensated for this risk with higher yields.

Credit Risk

Credit risk is a recognition that an issuer may default and may not be able to meet its obligations to pay interest and principal to the bondholders.

Higher credit risk = higher interest rates on bonds

Generally, if a company is perceived as risky, the prices of its bonds will fall; however, if a company is viewed as improving, its bond prices tend to rise

Housing Revenue Bonds

These are issued by state or local housing finance agencies in an effort to help fund single family or multifamily housing and are normally for low or moderate income families

In some cases, the proceeds of the bond offering are lent to the real estate developers that are constructing the property.

In other situations, the money being raised through the offering is used to support the mortgage markets

Investor Profile (Money-Market Securities)

Essentially, money-market instruments may be viewed as a safe haven for investors.

For example, if a customer has liquidated a long-term investment position and is evaluating different investment options, investing in a money-market instrument may be a good idea.

Alternatively, if an investor intends to make a large purchase in the near future (e.g., a home or a business), the funds may be invested in money-market instruments since they normally have very stable prices.

An investor who is interested in capital preservation may seek a money-market equivalent that’s backed by the U.S. government, such as a T-bill.

A high income investor may seek a money-market equivalent that’s tax-free like tax-exempt commercial paper

Moral Obligation Bonds

These bonds are first secured by the revenues of a project; however, if revenues are insufficient to pay debt service requirements, the state (or a state agency) is morally obligated (but not legally required) to provide the needed funds.

Prior to issuing the bonds as moral obligation bonds, the legislative approval of the state government must be obtained

Out Firm and Recall

Out firm is a quotation that a dealer is committed to honor, usually for a set period. The firm providing the quote may also establish a specific recall period.

All or none (AON) order

Type of order which indicates that the prospective purchaser must buy all of the securities being offered if it wants to buy

Fill or Kill order

indicates that the prospective purchaser must act immediately and purchase the securities at the offering price or the quotation will be withdrawn.

Planned Amortization Class (PAC)

This form of CMO is designed for more risk-averse investors and provides a predetermined schedule of principal repayments, but it’s based on mortgage prepayment speeds remaining within a certain range.

This greater predictability of maturity is accomplished by establishing a sinking-fund type of schedule.

The PAC tranche has top priority and receives principal payments up to a specified amount and any excess heads to the companion tranche.

Prerefunding (Advance Refunding)

If an issuer intends to lock in a lower rate prior to a scheduled call date, it may choose to prerefund its outstanding issue

The new issue being sold is called the refunding issue

The proceeds of this new issue are usually invested in government securities and are deposited in a bank. An escrow agreement is signed and the bank ensures that the securities on deposit, along with their earnings, will be available to pay the interest and principal on the outstanding issue.

At this point, the original issue is considered to be prerefunded

Private Label CMOs

Some private institutions, such as subsidiaries of investment banks, financial institutions, and home builders also issue mortgage-backed securities.

When issuing these securities, the institutions often issue non-agency mortgage pass-through securities with the underlying collateral typically including different or specialized types of mortgage loans or mortgage loan pools that don’t qualify as agency securities.

They are the sole obligation of the issuer and is not guaranteed by a GSE or U.S. Government

Revenue Anticipation Notes (RANs)

These are issued to finance current municipal operations in that the anticipated revenues are typically federal or state subsidies. Usually GO securities

Revenue Bonds

e issued for either projects or enterprise financings in which the issuer pledges to repay the bondholders using the revenues generated by the financed project.

Requires a feasibility study

Serial versus Term Issues

A serial bond issue (one with maturities that are staggered) provides greater flexibility when meeting debt requirements than a term issue (one with a single maturity date).

This flexibility is due to the fact that serial maturities may be organized to coincide with expected tax revenues

Future financing also plays a part in general obligation bond analysis. Rather borrow early than waiting till later cause prices may increase

Special Assessment Bonds

These bonds are payable only from an assessment on those who directly benefit from the facilities.

Examples include bonds issued to develop/improve water and sewer systems, sidewalks, and streets

Special Tax Bonds

These bonds are backed by special taxes (e.g., excise taxes on tobacco, liquor, gasoline, hotel/motel stay) for a specific project or purpose, but not by ad valorem taxes.

For example, highway bonds that are payable from an excise tax on gasoline are considered special tax bonds.

Targeted Amortization Class (TAC)

Form of CMO that was also developed to provide investors with greater protection from prepayment risk than a plain vanilla bond. However, TACs generally provide protection only from contraction risk (a shorter maturity schedule), not extension risk (a longer maturity schedule). The degree of protection that’s offered by a specific TAC tranche will depend on the existence of PAC and TAC tranches that have higher priorities

The Effect of Stock Splits and Stock Dividends

Both the conversion price and conversion ratio are established at the time the bonds are issued and will not change unless there’s a change in the underlying stock which comes in the form of stock splits and stock dividends. BOTH WILL NEED TO BE ADJUSTED WHEN THIS OCCURS

Parity

If a convertible bond’s conversion value (the market value of the stock received at conversion) is equal to its market price, then the bond is considered to be trading at parity.

Most bonds trade at a premium to parity, which means that the market price of the bond is higher than the aggregate market value of the stock the investor will receive if he converted

Parity price of a Bond formula = number of shares X price per share

Parity price of a stock formula = Market value of bond/Conversion Ratio

Treasury Bills (T-Bills)

short-term securities that mature in one year or less.

Currently, an investor may purchase T-bills with maturities of one month (4 weeks), three months (13 weeks), six months (26 weeks), and one year (52 weeks).

T-bills are only issued in book-entry form and are sold in minimum denominations of $100, with subsequent multiples of $100.

Z-Tranches (Z-bonds)

tranches that are deferred-interest bonds that have the longest average life of any tranche.

During the initial phase of a Z-tranche’s life, the bond provides no cash flow. Instead, similar to a zero-coupon bond, interest will compound.

Only after all of the other tranches have been retired will interest and principal payments be made to the Z-tranche.

Because they’re last to be paid, they have the most price volatility