C2 Debt Securities Flashcards

Question

Advantages and Disadvantages of issuing Convertible Bonds

Answer 1

The i**ssuer (the company)** not the owner **has the right to convert the bond** to common stock.

Answer 2

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.**

Answer 3

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

Answer 4

Bonds are rated by external companies (**Moody’s, Standard and Poor’s) t**o 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.

Answer 5

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.

Answer 6

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.

Answer 7

**_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).**

Answer 8

**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.

Answer 9

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 u**nderwriting 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.**

Answer 10

**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 i**ssued 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.**

Answer 11

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.