Lesson 3.1: Debt Securities - Comprehensive Notes
Basic Characteristics of Bonds
LO 3.a: Recall the basic characteristics of bonds, bond yields, and bond prices.
Par Value
Most debt securities have a par value of . This is also called the principal or face value.
Par value is the amount paid to the investor as principal at maturity.
Unless otherwise specified, assume a par value of for most debt.
Maturities
Each bond has its own maturity date, which is the date the investor receives the loan principal back.
Common maturities range from 5-30 years, but can be shorter or longer.
Types of maturities:
Term bond: The entire principal of the issue matures at once. Issuers may establish a sinking fund account to accumulate money to retire the bonds at maturity.
Serial bond: Portions of the principal mature at intervals over a period of years until the entire balance has been repaid.
Balloon bond: Combines features of serial and term maturities. Part of the principal is repaid before the final maturity date, but the major portion is paid off at final maturity.
Series Bond
Normally refers to types of savings bonds.
Savings bonds are a type of debt issued by the federal government that may be purchased and redeemed at banks or from the Treasury Department.
Savings bonds do not trade in the secondary market and are exempt from several securities laws.
Though there is a series bond, series is not a type of maturity used with debt securities.
Coupons and Accrued Interest
The coupon rate (also known as nominal or stated yield) is the interest rate the bond issuer has agreed to pay the investor.
Bonds were once issued with physical interest coupons attached.
It is calculated from the bond's par value, usually stated as a percentage of par.
Par value (face value) for a bond is normally per bond.
A bond with a 6% coupon pays in interest per year ( x par value = ).
Interest is generally paid on a semiannual basis.
A 6% coupon bond pays per year, so semiannual payments would be in interest every six months.
Accrued Interest
If a bond trades between coupon payments, accrued interest calculations determine the interest earned to date.
The buyer (new owner) pays the seller (old owner) the amount of interest earned to date at the time of settlement. The new owner gets paid the full coupon from the issuer in the next payment cycle.
Corporate and municipal trades use a 30-day-month/360-day-year calculation for accrued interest.
Treasury bonds and notes transactions employ the actual number of days elapsed when calculating the amount of accrued interest due.
Buyers of zero-coupon bonds do not pay accrued interest because these securities are not interest bearing.
Pricing
Once a bond is trading in the secondary markets, it can trade at a price of par, a premium to par, or a discount to par.
If par equals , a premium bond might trade at , and a discount bond might trade at . Bond pricing is measured in points, with each point equaling 1% of face value, or . For example, a bond trading at 90 is worth , while a bond trading at 103 is worth . Multiply the quoted price by 10 to get the dollar amount.
Market Forces Affecting Bond Prices
Bond prices are impacted by supply and demand.
Bonds have a particular sensitivity to changes in market interest rates.
The interest rate the issuer pays is the cost of borrowing money.
Bond prices rise and fall as interest rates in the market fluctuate.
Generally, bond prices have an inverse relationship to interest rates.
If interest rates go up, bond prices for those trading in the secondary markets will go down. Conversely, if interest rates are falling, bond prices for those trading in the secondary market will be going up.
If interest rates in the marketplace are at 6%, a bond currently paying 8% trading in the secondary market would look attractive, and its price will push upward.
If interest rates in the marketplace are at 6%, a bond currently paying only 4% would look less attractive, and its price will move downward.
The coupon rate is always the same. The coupon is a fixed percentage of par value; a 6% coupon pays of annual interest, no matter what the current market value of the bond is.
Yields
A bond's yield expresses the cash interest payments in relation to the bond's value.
Yield is determined by the issuer's credit quality, prevailing interest rates, time to maturity, and any features the bond may have, such as a call feature.
A bond can be traded at prices other than par, so the price discount or premium from par is taken into consideration when calculating a bond's overall yield.
Types of Yields:
Nominal yield: Nominal, coupon, or stated yield is set at the time of issue. The coupon is a fixed percentage of the bond's par value.
Current yield (CY): Measures a bond's annual coupon payment (interest) relative to its market price.
Yield to maturity (YTM): Reflects the annualized return of the bond if held to maturity. It takes into account the difference between the price paid for a bond and par value received when the bond matures.
If the bond is purchased at a discount, the investor makes money at maturity (the discount amount increases the return).
If the bond is purchased at a premium, the investor loses money at maturity (the premium amount decreases the return).
If you see a bond that is trading on a “basis of” and the question then provides you a yield, that yield is the YTM.
Yields are measured in basis points.
A basis point is a measurement of yield equal to 1/100 of 1%. A full percentage point is made up of 100 basis points (bps).
A point is a measurement of the change in a bond's price, which equals 1% of face value, or per bond.
YTM is sometimes called a bond's basis. For example, a bond trading at a 5.83 basis means the bond has a YTM of 5.83%.
If a bond is purchased for (a discount) and is held to maturity, at maturity the investor will receive (par). The amount of the discount () increases the investor's total return.
If a bond is purchased for (a premium) and is held to maturity, at maturity the investor will receive (par), and the amount of the premium paid () reduces the investor's total return.
Yield to call (YTC)
Some bonds are issued with a call feature. A bond with a call feature may be redeemed before maturity at the issuer's option.
When a callable bond is called in by the issuer, the investor receives the principal back sooner than anticipated (before maturity).
YTC calculations reflect the early redemption date and consequent acceleration of the discount gain if the bond was originally purchased at a discount, or the accelerated premium loss if the bond was originally purchased at a premium.
Bond Features
Bonds can be issued with different features attached.
Call Feature
As previously described, a call feature allows an issuer to call in a bond before maturity.
If a bond has a call feature, that feature is part of the bond at issue and is disclosed to investors before purchase.
Issuers will generally exercise the call when interest rates are falling.
From the issuer's perspective, the issuer may call in the 6% bond and simply issue a new bond paying the lower current interest rate.
If called, the (former) bondholder now has the dilemma of finding a similar rate of return in a lower interest rate environment.
To compensate for this dilemma, bonds with a call feature will need to have a slightly higher coupon rate than a similar bond that does not have a call feature.
Put Feature
A put feature for a bond is the opposite of a call feature.
Instead of the issuer calling in a bond before it matures, with a put feature, the investor can put the bond back to the issuer before it matures.
Investors will generally do this when interest rates are rising.
From the investor's perspective, the investor may put the 6% bond back to the issuer, take the principal returned, and invest it in a new bond paying the current interest rate of 8%.
A put feature is very attractive to a bond investor, so these bonds will have a lower coupon rate than similar bonds that do not have this feature.
Convertible Feature
Much like convertible preferred stock, convertible bonds are issued by corporate issuers, allowing the investor to convert the bond into shares of common stock.
Giving the investor the opportunity to exchange a debt instrument for one that gives the investor ownership rights (shares of common stock) is generally considered a benefit for the investor.
If the related stock rises in value, convertible bonds may often track the value of the underlying shares that the bondholder would be entitled to upon conversion.
Investors may engage in arbitrage transactions, which involve the simultaneous buying and selling of the bond and underlying stock in an attempt to capture price differentials between the related securities.
When the value of a convertible bond equals the value of the shares an investor would receive if the conversion feature were exercised, the bond is said to be at parity.
When bonds are issued with features that benefit the issuer, such as a call feature, the issuer generally will need to pay a slightly higher coupon rate to make the bond attractive to new investors.
Conversely, when bonds are issued with features that benefit the bondholder, such as put or conversion features, the issuer will usually pay a slightly lower coupon rate of interest because the feature will compensate for the lower return.
Zero-Coupon Bonds
Bonds are normally issued as interest-paying securities.
Zero-coupon bonds (zeroes, sometimes abbreviated ZR) are an issuer's debt obligations that do not make regular interest payments.
Instead, zeroes are issued, or sold, at a deep discount to their face value and mature at par.
The difference between the discounted purchase price and the full face value at maturity is the return, or accreted interest, the investor receives.
Lonsdale Corporation issues a zero-coupon bond at a price of 50 ( a bond) maturing in 20 years. The bond makes no interest payments. At maturity, it pays face value (par ) to investors: principal and interest. This would calculate to a YTM rate of 3.53%.
The price of a zero-coupon bond reflects the general interest rate climate for similar maturities, going up and down in an inverse relationship with interest rates.
Because the coupon rate is zero, these bonds tend to be more volatile than other bonds with similar maturities.
Zero-coupon bonds are issued by corporations, municipalities, and the U.S. Treasury and may be created by broker-dealers (BDs) from other types of securities.
Zero-coupon bonds issued by the U.S. Treasury are called STRIPS.
A more common form of zeroes is built by BDs from a basket of Treasury bonds; these are called Treasury receipts. These Treasury receipts are issued by a BD and not the Treasury.
Treasury receipts are made up of a basket of Treasury bonds.
Unlike STRIPS, a Treasury receipt is not backed by the full faith and credit of the Treasury.
Though a zero's interest payment is paid at maturity, owners of zeroes will pay taxes on the interest annually.
The total interest payment is divided by the years remaining to maturity, and a 1099 interest form will be sent to the owners.
If the interest payment is and 10 years remain to maturity, then the 1099 will reflect every year. This is called "annual accretion of the discount" or "phantom income."
LO 3.b Identify benefits and risks associated with bond investing.
Bond Investing Analysis
There are benefits and risks with bond investing.
To understand the benefits and risks of bond investing, we need to understand bond ratings and volatility.
Bond Ratings
The purchase of a debt security is only as safe as the strength of the borrower.
That strength can be enhanced if the loan has collateral.
Most investors consult the rating services, which rate the strengths of borrowers.
There are several different rating organizations.
Major Credit Rating Agencies:
Fitch Ratings, Inc.
Moody's Investors Service, Inc.
Standard and Poor's Rating Service (S&P)
A.M. Best Co., Inc., is historically associated with rating insurance companies' ability to pay claims and their debt issues.
The most important rating organizations for the exam are Standard & Poor's and Moody's.
Both organizations have highly qualified personnel who analyze all the details of the debt issue and arrive at a letter rating indicating their opinion of the debt's quality (safety).
Fitch ratings follow the same pattern as Standard & Poor's.
Standard & Poor's Rating System
AAA: Highest rating. Capacity to repay principal and interest judged high.
AA: Very strong. Only slightly less secure than the highest rating.
A: Judged to be slightly more susceptible to adverse economic conditions.
BBB: Adequate capacity to repay principal and interest. Slightly speculative.
Moody's Rating System
Aaa: Highest rating. Capacity to repay principal and interest judged high.
Aa: Very strong. Only slightly less secure than the highest rating.
A: Judged to be slightly more susceptible to adverse economic conditions.
Baa: Adequate capacity to repay principal and interest. Slightly speculative.
Speculative (Noninvestment-Grade) Bonds
Standard & Poor's
BB: Speculative. Significant chance that issuer could miss an interest payment.
B: Issuer has missed one or more interest or principal payments.
C: No interest is being paid on bond at this time.
D: Issuer is in default. Payment of interest or principal is in arrears.
Moody's
Ba: Speculative. Significant chance that issuer could miss an interest payment.
B: Issuer has missed one or more interest or principal payments.
Caa: No interest is being paid on bond at this time.
D: Issuer is in default. Payment of interest or principal is in arrears.
Investment-Grade Debt
Bonds rated in the top four categories (BBB or Baa and higher) are called investment grade.
Investment-grade bonds are generally the only quality eligible for purchase by institutions (e.g., banks or insurance companies) and by fiduciaries and, therefore, have greater liquidity than lower-grade instruments.
Risk/reward concept
All other things being equal, the higher the rating, the lower the yield.
These ratings are being like your personal credit score. The greater your credit score, the lower the interest rate charged for the loan will be.
High-Yield Bonds
High-yield bonds are lower-grade bonds, once known in the industry 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.
Their volatility is usually substantially higher than investment-grade bonds, but they may be suitable for sophisticated investors seeking higher returns and possible capital appreciation from speculative fixed-income investments.
Risk/reward
The less creditworthy the borrower, the more risk to the lender.
That requires a greater reward to the lender to compensate for that risk. That is why lower-rated bonds carry higher interest rates.
When the credit rating agency evaluates a bond, they look at all the factors, including collateral.
A bond with collateral is generally considered safer than one without.
Nonrated
Not all bonds are rated.
The rating organizations rate those issues that either pay to be rated or have enough bonds outstanding to generate constant investor interest.
The fact that a bond is not rated does not indicate its quality.
Many issues are too small to justify the expense of a bond rating.
In those cases, investors have to do their own homework.
Volatility
Bond prices move in an inverse direction to interest rates.
A bond's sensitivity to these movements is called volatility.
The more a bond moves in response to a change in interest rates, the more volatile it is said to be; the less it moves, the less volatility it has.
As a rule, the more time left to maturity, the more volatile a bond's price will be given a change in interest rates. With little exception, a bond with 10 years to go until it matures will be more volatile than a bond with 5 years to maturity.
Secondarily, the lower a bond's coupon rate, the more volatile it is. A 3% bond with five years remaining will be more volatile than a 6% bond with the same five years left.
A way of measuring a bond's volatility that combines maturity and coupon rate is called duration.
A higher duration means a more volatile price; lower duration brings less price volatility.
Duration may also be used to measure the overall volatility of a portfolio of bonds.
Benefits of Owning Debt Securities
Income
Bonds are considered the best way to produce current income for an investor.
The nature of debt securities is that the issuer must make interest payments or go into default.
These investments produce a steady and predictable income, unlike dividends from stocks, which are never guaranteed and are not an obligation of the issuer.
Safety
If a corporation fails, bonds are higher in priority than equity securities.
The bondholder's senior position combined with the obligation to make interest payments make these investments generally safer and much less volatile in price than stocks.
More conservative investors often prefer the relative stability of bonds.
Risks of Owning Debt Securities
Default
The primary risk when owning any debt security is that the issuer will fail to pay interest or principal when due.
This is called default risk, financial risk, or credit risk.
For most debt securities, we depend on credit rating agencies to rate the financial strength of an issuer.
A default is the worst outcome of owning a bond.
For test purposes, the default risk in debt backed by the U.S. Treasury is effectively zero. Treasury-backed securities are the safest investment for U.S. investors.
Interest Rate Risk
All debt securities will fluctuate in response to changes in prevailing interest rates.
Purchasing Power Risk (Inflation)
Any security that produces a fixed payment is subject to purchasing power risk or inflation risk.
Inflation is a rise in the price of goods over time.
As the fixed payment stays the same while prices are rising, the amount of goods the payment will buy decreases.
Over a long period of time, this loss of purchasing power may become significant.
Example
Customer owns one share of Lando Entertainment preferred, which she purchased in 1985. In that year, the annual dividend would pay for two tickets to a movie and two sodas.
Just one ticket to the movies today is around . So much for the date.
Preferred stock, though not a debt, does produce a fixed payment and is subject to purchasing power risk.
Types of corporate bonds and the order of liquidation.
Corporate Bonds
Corporate debt securities, like any other loan, may be either secured or unsecured.
Secured debt securities are backed by various kinds of assets owned by the issuer, whereas unsecured debt securities are backed only by the reputation, credit record, and financial stability of the issuer.
The latter is commonly referred to as being “backed by the corporation's full faith and credit."
Corporate securities settle T+2 and pay accrued interest based on a 30-day month/360-day year.
Secured Debt
Mortgage Bonds
A corporation will borrow money backed by real estate and physical assets of the corporation.
The value of the real assets pledged by the corporation will be in excess of the amount borrowed under that bond issue.
If the corporation develops financial problems and is unable to pay the interest on the bonds, those real assets pledged as collateral are generally sold to pay off the mortgage bondholders.
Having the real assets as collateral for the loan puts the purchaser of a mortgage bond in a position of safety.
Equipment Trust Certificates
Corporations, particularly railroads and other transportation companies, finance the acquisition of capital equipment used in the course of their business by issuing secured debt.
Railroads issue equipment trust certificates to purchase their rolling stock (train cars) and locomotives.
Title to the newly acquired equipment is held in trust, usually by a bank acting as a trustee, until the certificates have been paid in full.
When the railroad has finished paying off the loan, it receives clear title to its equipment from the trustee.
If the railroad does not make the payments, the lender repossesses the collateral and sells it for their benefit.
If you don't make the payment, the car gets repossessed.
The obligation to pay the investor is secured by the equipment.
Collateral Trust Bonds
Sometimes, a corporation wants to borrow money and has neither real estate (to back a mortgage bond) nor equipment (to back an equipment trust) to use as collateral.
Instead, it deposits securities it owns into a trust to serve as collateral for the lenders.
The securities the corporation deposits as collateral for a trust bond can be securities issued by the corporation itself, or they can be stocks and/or bonds of other issuers.
Regardless of the issuer, all deposited collateral securities must be marketable (readily liquidated if necessary).
Collateral trust certificates are secured by the securities deposited—and obviously, the better the quality of the securities, the better the quality of the certificate.
Unsecured Debt
Debentures
A debenture is a debt obligation of the corporation backed only by its word and general creditworthiness.
Debentures are written promises of the corporation to pay the principal at its due date and interest on a regular basis.
Debentures are not secured by any pledge of property.
They are issued on the general good faith and credit of the company, unsecured.
Although debentures are unsecured, there are issuers whose credit standing is so good that their debentures might be considered safer than secured bonds of less creditworthy companies.
Guaranteed Bonds
Guaranteed bonds are backed by a company other than the issuing corporation, such as a parent company.
The value of the guarantee is only as good as the strength of the company making that guarantee.
The primary responsibility for the debt belongs to the issuer, but if the issuer defaults, the guarantee kicks in and the guaranteeing company must make the interest or principal payments.
Because there is no asset held as security, these are unsecured debts.
Never be fooled by the apparent strength of the word guaranteed as it relates to guaranteed bonds issued by a corporation. These are still unsecured debt securities with no collateral beyond the financial strength of the corporation.
Income Bonds
Income bonds, also known as adjustment bonds, are used when a company is reorganizing and coming out of bankruptcy.
Income bonds pay interest only if the corporation has enough income to meet interest on debt obligations and if the board of directors (BOD) declares that the interest payment be made.
Income bonds are a true oxymoron: they do not provide income. If an investor is seeking income, an income bond is not a suitable recommendation.
Subordinated Debt
Sometimes, the term subordinated is used to describe a class of debt securities.
This means "belonging to a lower or inferior class or rank; secondary."
It is usually used in describing a type of debenture.
A subordinated debenture has a claim that is behind (junior to) that of any other creditor.
However, no matter how subordinated the debenture, it is still senior to any stockholder.
Subordinated debt is the lowest level of unsecured debt. The other types of unsecured debt described (including income and guaranteed bonds) are senior to subordinated debt in order of priority.
Order of Liquidation
When things go seriously bad, a corporation may be unable to make payments to its creditors and vendors.
When that happens, the only route out of the mess may be for the company to declare bankruptcy.
The courts then step in and begin the process of liquidating the company (so this process is sometimes called liquidation instead of bankruptcy).
All assets are sold off, and those who are owed money line up to be paid.
The law has a long-established order for creditors; it is called the order of liquidation:
Secured debt holders are first. They are paid from the proceeds of the sale of the assets that secured the debt. 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 are second. General creditors are those the company owes money to as part of its operations (typically vendors and other suppliers). Wages and taxes are often paid out at this level.
Subordinated debt holders are third in line. The increased risk for these investors is why these bonds will have a higher coupon rate.
Preferred stockholders come in next. Preferred stock is an equity holding and will come after all creditors have been paid but will be before common shareholders.
Common stockholders are last. The actual owners of the company are the last in line. This is the downside of being the investors that make the most when the company is successful. In a bankruptcy, it is extremely rare for the common stockholders to get anything at liquidation.
The courts may shift some creditors up or down for different reasons. It is not uncommon for wages or taxes to be moved up in priority if it appears that there will be insufficient assets to pay them otherwise.
Administrative claim holders or administrative claimants
These parties (attorneys, the courts, property appraisers, auctioneers, and liquidators) are brought in to assist with the liquidation.
They will demand assurance that they will be paid for their services.
Their claim will be honored and paid before any other unsecured debt but after secured creditors.