Unit 3 - Debt Securities

Debt securities

issuer owes interest and principal to the owners of the debt (the owner is the investor), trade in the secondary markets

Par value

the amount paid to the investors as principal at maturity, assume $1k for most debt (aka principal or face value)

Maturity date

the date the investor received the loan principal back

Term bonds

structures so that the principal of the whole issue matures at once, since entire principal is repaid at once issuers may establish a sinking fund (cash reserve) to accumulate money to retire the bonds at maturity

Serial bonds

schedule for portions of the principal to mature at intervals over a period of years until the entire balance is repaid, matures in a series of years

Balloon bonds

have a maturity schedule that is hybrid of serial and term maturities, issuer repays part of the bond’s principal before the final maturity date but pays off the majority of the bond at the final maturity

Series bond

refers to types of savings bonds, NOT a type of maturity used with debt securities

Savings bonds

a type of debt issued by the federal government that may be purchased and redeemed at banks or from the Treasury Department (aka series bonds), they 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 (aka stated yield or nominal yield), a fixed percentage of par value

Accrued interest

calculations used to determine the interest earned to date when the bond trades between coupon payments

Bond pricing

measure in points with each point equaling 1% of face value or $10

Yield

a measure of a bond’s interest payments in relation to the bonds value, set by the bond’s rating, general interest rates, time to maturity, and any other features the bond may have

Nominal yield

set at the time of issue (aka coupon or stated yield), a fixed percentage of the bond’s par value

Current yield (CY)

measures a bond’s annual coupon payment (interest) relative to its current market price, =annual coupon payment/market price

Yield to maturity (YTM)

reflects the annualized rate of return of the bond if held to maturity, the bondholder takes into account the difference between the price that was paid for a bond and par value received when a bond matures (sometimes called a bond’s basis)

Yield to call (YTC)

a bond that may be redeemed by the issuer before maturity, the investor receives the principal back sooner than anticipated (before maturity)

Point

is a measurement of the change in a bond's price, which equals 1% of face value or $10 per bond

Basis point

a measurement of yield equal to 1/100 or 1%, a full percentage point is made up of 100 basis points (bps)

Call feature

allows an issuer to redeem a bond before maturing, part of the bond at issue and disclosed to investors before purchase and is generally exercised when interest rates are falling benefiting the issuer

Put feature

allows investors to force the issuer to pay off the bond before it matures, opposite of a call feature, investors generally do this when interest rates are rising benefitting the bondholders with lower coupon rate than similar bonds without this feature

Convertible bonds

issued by corporate issuers allowing investors to convert the bonds into shares of the issuer’s common stock, giving the investor the opportunity to exchange a debt instrument for one that gives them ownership rights benefiting the investor

Parity

when the value of a convertible bond equals the value of the shares an investor would receive if the conversion feature were exercised

Zero-coupon bonds (zeros or ZR)

debt obligations that do not make regular interest payments, are issued at a deep discount to their face value and mature at par

Bond ratings

how safe a bond is to invest in rating the strength of borrowers, three major organizations recognized by the SEC (Fitch, Moody’s, and Standard & Poor)

Investment-grade debt

bonds rated in the top four categories, generally the only quality eligible for purchase by institutions (banks or insurance companies) and by fiduciaries as they have greater liquidity (more easily sold) than lower-grade instruments

• BBB or Baa and higher (anything with an A or a)

High-yield bonds (non-investment grade)

bonds with low credit ratings and a higher risk of default (aka junk bonds), riskier than investment-grade bonds but higher returns - can experience significant price declines if the issuer's financial condition weakens or during economic downturn and are generally considered speculative investments

• BB/Ba or lower (anything with singular B or C/D no As)

Nonrated

bonds that have not received a credit rating, but does not mean they are risky or low quality, investors must do their own research to evaluate the bond's risk

Volatility

a bond’s sensitivity to changes in interest rates

Duration

a way of measuring a bond’ volatility that combines maturity and coupon rate> higher means a more volatile price while lower brings less price volatility, may also be used to measure the overall volatility of a portfolio of bonds

Default risk

primary risk when owning any debt security is that the issuer will fail to pay interests or principal when due, also called financial or credit risk, worst outcome of owning a bond

Purchasing power risk (inflation risk)

risk of any security that produces a fixed payment, like bonds and preferred stock, as the fixed payment stays the same while prices are rising the amount of good the payment will buy decreased

Secured debt

debt that has collateral, meaning an asset of the corporation is pledged to secure the loan (mortgage bonds, equipment trust certificates, and collateral trust bonds)

Mortgage bonds

bonds that are backed by real estate that is owned by the corporation

Equipment trust certificate

bonds that are secured by equipment the corporation uses in its operations, titles to the assets (not actual equipment) backing the security are held in a trust

Collateral trust bonds

bonds that are backed by a portfolio of securities held in trust to secure the loan

Unsecured debt (sr. debt)

debt securities not backed by collateral only backed by the promise of a corporation, dependent on the financial strength of the issuer (“full faith and credit”)

Debentures

bonds are the most senior (highest priority) of the unsecured debt obligations, and you may see the term "senior debt" (another term for an unsecured bond)

Guaranteed bonds (aka adjustment)

the responsibility of the issuer but are further backed by a third party should the issuer default, most common third-party is a parent company of the issuer

Subordinated debt

debt obligations are below debentures in order of seniority, often carrying a higher coupon rate because of the additional risk (subordinated debenture or junior debt)

Liquidation (or bankruptcy)

when a corporation cannot pay its creditors and vendors, a court may oversee the sale of its all its assets so creditors can be paid in order of priority

Order of liquidation

law of a long-established order for creditors in how they are paid during a liquidation (secured debtholders>unsecured debt and general creditors>subordinate debtholders>preferred stockholders>common stockholders)

Secured debtholders

first to be paid in liquidation, they are paid from the proceeds of the sale of the assets that secured the debt and if the assets are insufficient to pay what is owed, any additional amount is paid at the general creditor level

Unsecured debt (debentures) and general creditors

second to be paid in liquidation, those the company owes money to as part of its operations (typically vendors and other suppliers) where wages and taxes are often paid out

Subordinated debtholders

third to be paid in liquidation, the increased risk for these investors is why these bonds will have a higher coupon rate

Common stockholders

last to be paid in liquidation, the actual owners of the company are the last in line and the downside of being the investors that make the most when the company is successful > it is extremely rare for them to get anything at liquidation

Administrative claim holders or administrative claimants

parties (attorneys, the courts, property appraisers, auctioneers, and liquidators) are brought in to assist with the liquidations that demand assurance that they will be paid for their service, their claim will be honored and paid before any other unsecured debt but after secured creditors

Treasury securities

quantity and type of government securities that are determined by the U.S Treasury Department that are issued to meet federal budget needs, marketplace determines the interest rate these securities pay and are among the highest in quality in safety of principal

Government securities (bonds)

issued by the U.S Treasury in book entry form, meaning no physical securities, with a T+1 settlement cycle and accrued interest is calculated based on actual calendar days elapsed

Treasury bills (T-Bills)

short-term debt obligation of the federal government, do not pay a periodic interest as all interest is paid at maturity

• Issued by the U.S. Treasury, weekly with maturities of 4, 6, 8, 13, and 26 weeks, monthly with a maturity of 52 weeks

• Issued at a discount and mature at par

• Interest payment is the difference between the discount and par value

Treasury Notes (T-Notes)

an intermediate-term direct debt of the federal government, issued at par and pay periodic interest

• Issued by the Treasury, with maturities from as short as two years to a maximum of 10 years

• Pay interest every six months (semi-annually)

• At maturity, the investor receives the final semi-annual interest payment and the par value

Treasury Bonds (T-Bonds)

a long-term direct debt of the federal government, issued at par and pay periodic interest

• Issued by the Treasury with maturities greater than 10 years and up to 30 years

• Pay interest every six months (semi-annually)

• At maturity, the investor receives the final semi-annual interest payment and the par value

Treasury receipts

a type of bond created by broker-dealers from U.S. T-notes and T-bonds in which the BDs buy treasury securities, place them in a trust at a bank, and sell separate receipts against the principal and coupon payments (not backed by the full faith and credit of the U.S. government)

Stripping

the separating of the coupon interest payments from the principal creating new securities and providing investors with several maturities to choose from, yielding more profit for the BD than is offered by selling the original Treasury securities outright

Treasury STRIPS (separate trading of registered interest and principal of securities)

the Treasury Department’s own version of receipts, designates certain issues as suitable for stripping into interest and principal components that are backed by the full faith and credit of the U.S. government

Treasury inflation-protected securities (TIPS)

a special type of Treasury security issued with maturities of 5, 10, or 30 years with a fixed coupon rate paying interest every six months, principal value of bond is adjusted every six months based on inflation rate

Agency securities

debt securities issued by U.S. government agencies or government-sponsored entities (GSEs) that have been authorized by Congress to raise money for specific public purposes (housing, agriculture, or education), generally offering higher yields than Treasury securities because they may carry slightly more risk

Agency

sometimes used to refer to entities that are not technically government agencies but have ties to the governments

Farm credit system (FCS)

national network of lending institutions that provide agricultural financing and credit, overseen by the FCA (a government agency)

Government National Mortgage Association (GNMA or Ginnie Mae)

Government-owned corporation supporting the Department of Housing and Urban Development

• Certificates are the only agency securities backed by the full faith and credit of the federal government with a stated 30-year life

• When sold, maturities are based on an average life expectancy of the mortgages in the portfolio

• When mortgages are paid off early, investors will receive back all outstanding principal of that loan at par

• Certificates pay a monthly payment that is part principal, part interest (pass-through security

Federal Home Loan Mortgage Corporation (FHLMC or Freddie Mac)

a public corporation created to promote the development of a nationwide secondary market in mortgages

• Buys residential mortgages from financial institutions

• Packages mortgages into mortgage-backed securities for sale to investors

• Certificates pay a monthly payment that is part principal, part interest (pass-through security). FHLMC also issues bonds that pay semi-annual interest

• Securities it issues are backed by FHLMC's general credit, not by the U.S. Treasury

Federal National Mortgage Association (FNMA or Fannie Mae)

a publicly held corporation that provides mortgage capital by purchasing conventional and insured mortgages from agencies such as the Federal Housing Administration (FHA) and the Veterans Administration (VA)

• Certificates pay a monthly payment that is part principal and part interest (pass-through security), also issues bonds that pay semi-annual interest

• Securities it issues are backed by general credit, not by the U.S. treasury

Municipal bonds (munis)

securities issued by state or local government, U.S. territories, or other local authorities and special districts; investors who buy them are lending money to the issuers to raise funds for public works and construction projects (i.e. roads, hospitals, civic centers, airports, sewer systems, etc.), Settle T+1 and pay accrued interest based on a 30-day month/360-day year

General obligation (GO) bonds

municipal bonds issued to generate capital for infrastructure or property improvements that benefit the community (called capital improvements), projects do no produce revenues so principal and interest must be paid form taxes

Debt limit

amount of debt that a municipal government may incur as set by state or local law, makes a bond safer for investors

Revenue bonds

used to finance a municipal facility that generates sufficient income to pay the bond, considered to be self-supporting debt because principal and interest payments are made from revenues generated by the project or facility for which the debt was issued and are not subject to statutory debt limits and do not require voter approval.

Authorities

quasi-governmental entities often tasked with building roads, tunnels, bridges, and other infrastructure

Tax equivalent yield

calculation required to determine a municipal bond investment’s tax benefit

= tax free yield/ (100%-investor’s tax rate/tax bracket)

Short-term municipal debt (muni notes)

short-term securities that generate funds for a municipality that expects other revenues soon having less than 12-month maturities, maturities may range from 3 months to 3 years, and are repaid when the municipality receives the anticipated funds (TANs, RANs, TRANs, BANs, GANs, CLNs, variable-rate demand notes)

Tax anticipation notes (TANs)

finance current operations in anticipation of future tax receipts, helping municipalities to even out cash flow between tax collection periods (muni note)

Revenue anticipation notes (RANs)

offered periodically to finance current operations in anticipation of future revenues from revenue-producing projects or facilities (muni note)

Tax and revenue anticipation notes (TRANs)

a combination of the characteristics of both TANs and RAN, paid off from future tax receipts and revenues (muni note)

Bond anticipation notes (BANs)

sold as interim financing that will eventually be converted to long-term funding through a sale of bonds (muni note)

Tax-exempt commercial paper

often used in place of BANs and TANs for up to 270 days; maturities are most often 30, 60, or 90 days

Grant anticipation notes (GANs)

issued with the expectation of receiving grant money, usually from the federal government (muni note)

Construction loan notes (CLNs)

issued to provide interim financing for the construction of housing projects (muni note)

Variable-rate demand notes

have a fluctuating interest rate and are usually issued with a put option, meaning the investor could periodically (e.g., weekly, monthly) return the security to the issuer for its stated value (muni note)

Capital markets

provide longer-term financing often through the sale and trading of stocks and bonds

Money markets

provide very short-term funds to corporations, banks, BDs, government municipalities, and the U.S. government, debt securities with one year or less left to maturity

Jumbo Certificate of Deposit (CD)

banks issued and guaranteed with fixed interest rates, having a minimum face values of $100,000 (a face values of $1 million or more are common) and often maturing in one year or less

Negotiable CDs

some jumbo CDs that can be traded in the secondary market, considered money market instruments

Retail CDs

typical CD a customer would buy from a bank, difficult to transfer (not liquid), are often for specific amounts, and any minimum investment is set by the bank selling the CD

Bankers' Acceptances (BAs)

often used by corporations in the import-export business, a short-term time draft (debt instrument with a short time to maturity) with a specified payment date drawn on a bank; essentially a postdated check or line of credit with a payment date normally between 1 and 180 days and never more than 270 days

Commercial Paper (Promissory Notes)

short-term, unsecured debt sold by corporations to raise cash to finance accounts receivable (to allow customers to purchase on credit and pay later) and seasonal swings in business, maturities range from 1 to 270 days though most mature within 90 days, mostly issued by companies with excellent credit ratings

Municipal Notes

short term municipal debt issued by state and local governments to meet temporary funding needs before permanent financing or expected revenues are received, generally mature in one year or less

Repurchase Agreements (Repos)

a financial institution, like a bank or a BD, raises cash by temporarily selling some of the assets it holds, with an agreement to buy back the assets at a specific future date, the maturity date, and at a slightly higher price, investor makes a profit on the difference between what they paid at the asset sale and what they receive at repurchase

Reverse repurchase agreements (reverse repos)

a dealer agrees to buy securities from an investor and sell them back later at a higher price

Federal Funds Loans

overnight loans between Federal Reserve member banks, banks with excess reserves lend those reserves to banks that need money to meet their Federal Reserve reserve requirements.

Asset backed securities

value and income payments are derived from a specific pool of underlying assets, can include different types of loans

Collateralized mortgage obligations (CMOs)

pool a large number of mortgages often containing mortgage-backed securities like FNMA and FHLMC certificates, structured into maturity classes called tranches

• Pay monthly principal and interest payments

• Repays principal to only one tranche at a time, highest tranche to lowest

• Changes in interest rates affect the rate of mortgage prepayments (refinancing), which affects the flow of interest payment and principal repayment to the CMO investor

Collateralized Debt Obligations (CDOs)

complex asset-backed securities that do not specialize in any single type of debt, represents different types of debt and credit risk

• Portfolios consist of nonmortgage loans, bonds, auto loans, leases, credit card debt, a company’s receivables

• The higher the risk, the more it pays

• Like CMOs in that illiquid debt can be made liquid through securitization

Tranches (or slices)

maturity classes, the different types of debt and risk categories, each one having a different maturity and risk associated with it