C2 Debt Securities

Question 1

Debit Securites

Answer 1

Debit securities = BONDS

Many different types of entities (Corporations, Municipalities, Governments) issues bonds to raise Capital (money).

A bond represents a loan to the issuer. Unlike stock, a bond holder does not “Own” any of the company.

Principal = Face Value – Par Value

Bonds generate Income through Interest payments

Bonds trade on open markets, and the values go up and down based on several factors, mostly important is prevailing interest rates in the economy.

A bond with a fixed interest rate become more valuable as interest rates drop since they are paying a higher than current rate. They become less valuable as interst rates drop because the investor can get better interest rates in other places.

Question 2

Corporate Bonds

Answer 2

Corporations issue bonds to raise working capital to expand their business.

Corporate bondholders are not owners of the company, they are creditors

Bond holders do not have voting rights.

Bond holders are paid before preferred and common stockholders in the case of bankruptcy

Interest on corporate bonds is taxable at all levels, Federal, State and Local.

Question 3

Types of Bonds

Answer 3

Bearer Bonds

Registered Bonds

Principal Only Registered

Fully Registered

Book Entry/Journal Entry -

Question 4

Bearer Bonds

Answer 4

Bonds which are issued in coupon or bearer form do not record the owner’s information with the issuer and the bond certificate does not have the legal owner’s name printed on it. As a result, anyone who possesses the bond is entitled to receive the interest payments by clipping the coupons attached to the bond and depositing them in a bank or trust company for payment. If they are stolen or lost you lose the ability to get interest and principal. Bearer bonds are no longer issued within the United States; however, they are still issued outside the US.

Question 5

Registered Bonds

Answer 5

Registered Bonds - Most bonds are now issued in registered form. Bonds that have been issued in registered form have the owner’s name recorded on the books of the issuer and the buyer’s name will appear on the bond certificate.

Different Types of Registration

Principal Only Registered - Bonds with the owner’s name printed on the certificate, but the coupons are in “Bearer Form”. When sold, the names of the new owner are listed on the certificate. (These are no longer issued)

Fully Registered - Bonds with principal and interest ownership info that are maintained by Transfer Agents. When a bond is sold, the Transfer Agent cancels the seller’s certificate and issues a new bond certificate to the buyer. Most Bonds in US issued this way

Question 6

Book Entry/Journal Entry

Answer 6

Bonds that do not have certificates, rather, the Transfer Agent maintains bond ownership info.

Question 7

Bond Certificate

Answer 7

The Bond certificate must have the following information on it:

• Name if Issuer
• Principal Amount
• Issuing date
• Maturity Date
• Interest payments Dates
• Place where interest is payable (Paying agent)
• Type of Bond
• Interest Rate
• Call feature (if any)
• Reference to the Trust indenture

Question 8

Bond Pricing

Answer 8

Bonds trade in secondary market between investors similar to the way stock do. The price depends on:

• Rating (Credit Quality of the issuer)
• Interest Rates
• Term
• Coupon Rate
• Type of Bond
• Issuer
• Supply and Demand
• Other features (Callable, convertible etc)

Question 9

Par Value

Answer 9

Par Value = Face Value = Principal Amount

Always equal to $1000.00

This is the amount that will be paid to the owner of the band at maturity regardless of how much he bought the bond for.

Question 10

Discount

Answer 10

When an investor buys bond for a value less than par value ($1000) he is buying the bond at DISCOUNT

Question 11

Premium

Answer 11

When an investor buys bond for a value more than par value ($1000) he is buying the bond at PREMIUM

Question 12

Corporate Bond Pricing

Answer 12

Quoted as a percentage of Par Value.

IE: 94 = 94 % = .94 X $1000 = $940.00

97 1/4 = 97.25% = .9725 X 1000 = $972.50

Question 13

Bond Yields

Answer 13

Nominal Yield – The “coupon Rate” the rate printed on the bond.

Interest Payment = Rate X 1000.00

Current Yield – Related to the Interest Rate and the current price of the bond. If Bond is trading at a premium the Current rate is less than Coupon Rate. If Bond is trading at a discount the Current rate is greater than the Coupon Rate.

Current Yield = Annual Interest/Current Price.

Yield to Maturity – The total annualized yield the investor will see until the bond matures.

Yield to Call - The total annualized yield the investor will see until the bond could be called.

Question 14

Yield to Maturity Equation

Answer 14

This equation can also be used for Yield to Call. Substitute the number of years to callable for the number of years to Maturity.

Question 15

Yield to Maturity/Call Relationships

Answer 15

For a Discount Bond:

the Yield to Maturity is high because in addition to the interest payments you will get more principal back then you paid (IE..Paid 900 getting 1000)

the Yield to Call will be the highest. Same reason as above, but less time until you get the extra principal.

For a Premium Bond:

the Yield to Maturity is low because in addition to the interest payments you will get less principal back then you paid (IE..Paid 1100 getting 1000)

The yield to Call will be the highest. Same reason as above, but less time until you lose the extra principal.

Question 16

Yield Spreads

Answer 16

Different types of bonds have different yields. The difference between the yields is called the yield spread. Usually the spread is measure between Treasury Bonds and Corporate Bonds. As the economy changes, the size of the Yield Spread changes.

During uncertain times the spread is largest because investors are afraid corporations will default, and they want higher rates to compensate for that.

In good economic times the yield spread is smallest since there is less of a chance the corporations will default.

Increasing spread is a predictor of uncertain economic times ahead.

Decreasing spread is a predictor of good economic times ahead.

Question 17

Real Interest Rate

Answer 17

Investors make take into account the effect inflation on the interest they receive on fixed income securities. The real interest rate is what the investor will receive after inflation is taken into account. For example, if the investor is getting 8% and inflation is averaging 2% the Real Interest rate is 6% (8% -2% = 6% )

Question 18

Bond Maturities

Answer 18

When a bond matures, the principal payment and the last semiannual interest payment are due. There are different maturity schedules.

Term Maturity – This is the most common type of corporate bond issue. With Term Maturity the entire principal amount becomes due a specified date.

Serial Maturity – A serial bond issue is one that has a portion of the issue maturing over a series of years. The portion of bonds maturing in the later years will have a higher yield because the investors will have their money at risk longer.

Balloon Maturity – Like a Serial Maturity, Bonds mature over a period of years, but with a Balloon the majority of them mature on the last date.

Series Issue – The bonds are ISSUED over several years. This gives the company flexibility to borrow money only as they need it.

Question 19

Types of Corporate Bonds - Secured

Answer 19

Secured Bond - Backed by a specific pledge of assets. The assets are known as collateral. The assets are held by a trustee. In the event of a forfeiture/default, the trustee will attempt to sell the assets to pay the bond holders.

• Mortgage Bonds - Backed by real estate as collateral. In the event of a forfeiture/default, the bond owners take ownership of the property.
• Equipment Trust Certificates - Backed by large equipment (Airplanes, Railroads ships) that the company needs to run its business. They issue Equipment Trust Certificates to raise money to buy this equipment, and the bond is backed by the equipment. In the event of a forfeiture/default, the trustee will attempt to sell the assets to pay the bond holders.
• Collateral Trust Certificates – backed by a pledge of securities the issuer has purchased for investments, or of a wholly owned subsidiary.

Question 20

Types of Corporate Bonds - Unsecured

Answer 20

Unsecured Bonds are called Debentures. They have no specific asset pledged as collateral for the loan. They are only backed by the good faith and credit of the issuer. In the case of default, bond owners are treated like a general creditor.

• Subordinated Debentures – A subordinated debenture is an unsecured loan that has a junior claim on the issuer relative to the straight debenture. If the issuer defaults, holders of “normal;” debentures and other general creditors will be paid first. Interest rates are higher on subordinated debentures due to the higher risk.
• Income/Adjustment Bonds – Very risky – Corporations in sever financial difficulty issue income or adjustment bonds. The bond is unsecured and the investor is only paid interest if the corporation has enough income to do so. Because of the high risk, they have very high interest rates, and are sold at a heavy discount to Par. These bonds are very risky and should never be recommended to someone who is looking to preserve capital.

Question 21

Zero Coupon Bonds

Answer 21

A Zero Coupon bond is a bond that pays no semi-annual interest. It is sold at a deep discount from Par value, and appreciates up to Par value at maturity. The appreciation represents the investor’s interest for purchasing the bond. Zero Coupon bonds are issued to finance operations.

A typical purchase price would be $300 for a $1000 Par value 20 year bond. The annual appreciation is taxable even though the investor doesn’t see the money. This is known as phantom Income.

US Savings bond are an example of a zero coupon bond.

Question 22

Guaranteed Bonds

Answer 22

Guaranteed Bonds is a bond whose interest and principal are guaranteed by a third party, such as a parent company.

Question 23

Convertible Bonds

Answer 23

A convertible bond is a corporate bond that can be converted or exchanged for common stock of the corporation at a predetermined price known as the subscription price.

Convertible bonds have good features for the issuers and owners, and usually have lower interest rates because of these features.

For the investor, if the common stock goes up over the subscription price they have an option to buy it below market, while they are a bond owner, they are a more superior security than the stock holders, a and therefore have less risk.

Question 24

Converting Bonds Into Common Stock

Answer 24

In order for the conversion to make economic sense, the holder must be able to determine the Parity Price of the conversion. The Parity Price is the price where the value to investor is equal to what the investor already owns with his bond. The price of the stock should be higher than the parity price for the investor to convert.

Two Step process

1. Find out how many shares the holder will get –> Par Value / Subscription Price
2. Finds the Parity Price -> Markey Value of Bond / # of shares you will receive.

Question 25

Advantages and Disadvantages of issuing Convertible Bonds

Answer 25

Add later

Question 26

Reverse Convertibel Securites

Answer 26

The issuer (the company) not the owner has the right to convert the bond to common stock.

Question 27

The Trust Indenture Act of 1939

Answer 27

The Trust Indenture Act of 1939 requires that corporate bond issues in excess of $5,000,000 that have a term greater than 1 year issue a Trust Indenture. The Trust Indenture is a contract between the issuer and the trustee. The trustee acts as an overseer to make sure the issuer does everything they are supposed to.. Only corporate issuers need this, federal and municipal issuers are exempt.

Question 28

Bond Indenture - Closed vs Open

Answer 28

Open –

permits the corporation to issue **more bonds of the same class later**
subsequent issues are secured by **same collateral** backing the initial issue

Closed –

• *-does not permit the corporation to issue more bonds of the same class in the future**
• subsequent issues have subordinate claim on collateral

Question 29

Bond Ratings

Answer 29

Bonds are rated by external companies (Moody’s, Standard and Poor’s) to determine a company’s financial condition. The better the rating, the less risky the bond is, and the company can issue the bond with a lower interest rate.

Good Bonds rated with “A”s and considered investment grade. Bonds with “B”’s are considered speculative or Junk Bonds and have higher yields to compensate for the extra risk.

Question 30

Retiring Corporate Bonds

Answer 30

Retiring a bond means, paying back the investor back his principal and closing out the bond’s debt. Bonds can be retied several ways.

Redemption – Normal method. At Maturity, the investor’s principal is retuned along with last semi-annual interest payment.

Refunding – raising money, through a new bond offering, to call a bond -issuer sells new bond issue to generate funds to retire existing issue.

Prefunding – Similar to refunding, but raising the money in advance of the bond being callable. The money is placed in the bank, and covers (cancels) the old bond on the company books because the debt is covered with cash/securities. This is called Defeasance.

Exercise Call feature by the company – The company can call the bonds early and pay the investors their principal. This feature benefits bond issuers.

Exercise Put feature by the investor – On some Bonds the owner has a put feature which allows the bond owner to sell (put) the bonds back to the company. This feature benefits bond owners.

A Tender Offering – A company puts out an offer to bond holders to buy the bonds. The company will usually offer a premium price to make it attractive.

Open Market Purchases – The company can buy the bonds on the open market.

Question 31

Collateralized Mortgage Obligation

More complex CMOs are not suitable for all investors and investors should sign a suitability statement before investing. The secondary market for complex CMOs may also be very illiquid.

When recommending a CMO it is important that CMOs never be compared to binds and CDs. They have risk and performance very different than CDs and Bonds.

(CMO)

Answer 31

A mortgage backed security issued by private finance companies as well as FHLMC, FNMA (called agency issues). They are like pass-through certificates. They are “pools” of mortgages packaged together. They are grouped into “Tranches” based on different maturity and risk profiles. Because they are based on mortgages on real estate they are considered generally safe, and often given AAA rating.

They have unique risks associated with them. One of the most significant is the risk of homers owners refinance earlier than expected when interest rates drop.

CMOs pay Interest and Principal monthly. However they only pay Principal to one tranche (the most current) at a time. The last tranche to get paid off is the Z Tranche, which is the most volatile of tranches.

FHLMC = Federal Home Loan Mortgage Corporation = Freddie Mac

FNMA = Federal National Mortgage Association = Fannie Mae

Important Agent Notes

More complex CMOs are not suitable for all investors and investors should sign a suitability statement before investing. The secondary market for complex CMOs may also be very illiquid.

When recommending a CMO it is important that CMOs never be compared to binds and CDs. They have risk and performance very different than CDs and Bonds.

Question 32

Types of CMOs

Answer 32

Principal Only (PO) – Receive principal only, therefore sold at a discount to PAR. The price of a principal only CMO is sensitive to a change in interest rates. As interest rates drop, the price of the principal only CMO will rise because homeowners will refinance their mortgages, and the owners of the principal only CMO will get their money back faster. A rise in interest rates will have the opposite effect

Interest Only (IO) – Receive interest only, they are also sold at a discount. Interest only CMOs will increase in value as interest rates rise and drop as they fall (Opposite of principal only). As interest rates rise, people don’t refinance and the owner of the interest only CMO receives more payments.

Planned Amortization Class (PAC) - Planned Amortization Class (PAC) are paid off first and offer the investor the most protection against prepayment (Refinance) risk. If prepayments come in to quickly (prepayment risk) or principal payments are made too slowly (extension risk), money from other mortgages (Support class) will be used to cover the owners of the PACS.

Targeted Amortization Class (TAC) – Similar to PACS, except they only protect the owners from prepayments come in to quickly (prepayment risk) and NOT principal payments are made too slowly (extension risk).

Question 33

Private-Label CMOs

Answer 33

Private-Label CMOs – Issued by investment banks, and the payment of interest and principal are the responsibility of the investment bank, therefore not guaranteed by a government agency. The credit ratings of private CMOS are based on the credit worthiness of the issuing investment bank. If the private label CMO used agency issues as collateral for the CMO, those agency issues still carry he guarantee of the issuing agency.

Question 34

Exchange Traded Notes (ETNs)

Answer 34

An exchange-traded note (ETN) is a senior, unsecured, unsubordinated debt security issued by an underwriting bank. Similar to other debt securities, ETNs have a maturity date and are backed only by the credit of the issuer.

ETNs are designed to provide investors access to the returns of various market benchmarks. The returns of ETNs are usually linked to the performance of a market benchmark or strategy, less investor fees. When an investor buys an ETN, the underwriting bank promises to pay the amount reflected in the index, minus fees upon maturity. Thus ETN has an additional risk compared to an ETF; if the credit of the underwriting bank becomes suspect, the investment might lose value, the same way a senior debt would.

Often linked to the performance of a market benchmark, ETNs are not equities, equity-based securities, index funds or futures. Although ETNs are usually traded on an exchange and can be sold short, ETNs don’t actually own any underlying assets of the indices or benchmarks they are designed to track.

Question 35

Euro and Yankee Bonds

Answer 35

Eurobond – A bond issued in domestic currency of the issuer, but sold outside the issuer’s country. Eurobonds have significant currency risk. Trade with accrued interest which is paid annually

Eurodollar Bond – A bond issued by a foreign issuer, but denominated in US dollars. Sold to people outside the US and the issuers country.

Yankee Bond – Similar to Eurodollar Bond, but sold to US investors. For US Investors, a Yankee bond does not have currency risk.

Question 36

Variable Rate Securities

Answer 36

Two main types

• Variable Rate Demand Obligations (VRDO) – Interest rates are set by the dealer daily, weekly or monthly at a rate which would make the security trade at par value. Investors may elect to “put” the bond back to the dealers to a third party on the rate reset date
• Auction Rate Securities – Long term securities that are traded as short term securities. Interest rate paid is reset at regularly scheduled auctions every 7, 28 or 35 days. Investors who own them will get the interest rate of the auction, until the next auction changes it. If he auctions fails due to noninterest, investors who were looking to sell may not have immediate access to their money.

Question 37

Tranches

Answer 37