Ch 4 (Corporate and US Gov Debt) & Vocabulary

Question 1

Indenture

Answer 1

The bond contract defining all important features of the bond (interest rate, maturity, callable/puttable, etc)

Question 2

Trust Indenture

Answer 2

All corporate (non-exempt) issues of $50MM or more must have a Trust Indenture under the Trust Indenture Act of 1939

Question 3

Types of Secured (Corporate) Bonds

Answer 3

Mortgage Bonds, Equipment Trust Certificate, Collateral Trust Certificate

Question 4

Secured Bonds

Answer 4

Bonds that are backed by a tangible asset - if the issuer cannot make interest and/or principal payments, the underlying asset would be liquidated

Question 5

Mortgage Bonds

Answer 5

• Most common form of secured corporate debt
  *Backed by a lien on real estate/property

Question 6

Commercial Paper (money market securities)

Answer 6

• Very short maturities (14-90 days, 30 most common)
• May be sold at a discount maturing at par
• Sold in unit of $100,000 up to $1,000,000
  Purchasers are institutions with excess cash to invest
• Limited trading as investors hold them to maturity

Question 7

Debenture

Answer 7

Intermediate and long=term corporate debt backed solely by full faith and credit

Question 8

Guaranteed Bonds

Answer 8

Typically issued by a subsidiary, with the corporate parent guaranteeing the interest and principal due
* These bonds take on the credit rating of the guarantor

Question 9

Income/Adjustment Bonds

Answer 9

• Issued when corporation enters bankruptcy - done to replace existing bonds
• Only obligates issuer to pay if it has sufficient earning
• Trade Flat
• Not suitable for income seeking investors

Question 10

Trade Flat

Answer 10

Without accrued interest
* Income Bonds
* Zero-Coupon Bonds

Question 11

Arbitrage

Answer 11

• When a trader buys the lower priced security and at the same time sells the higher priced security to lock in profit
• Note the stock as to trade ABOVE PARITY for there to be an arbitrage opportunity

Question 12

Conversion Ratio

Answer 12

= (Par Value of Bond) divided by (Conversion Price)

Question 13

Parity Price of Bond

Answer 13

= (Conversion Ratio) times (Stock’s Market Price)

Question 14

Parity Price of Stock

Answer 14

= (Bond Market Value) divided by (Conversion Ratio)

Question 15

US Government Debt

Answer 15

• Treasury Bills (short term)
• Treasury Notes (intermediate)
• Treasury Bonds (long-term)
• Savings bonds are non-negotiable (cannot be traded)
• US Government debt, including GNMA’s (Ginnie Mae Bonds) which are explicitly backed by the US Government, are considered (credit) risk-free
• 100 minimum Par
• Trades settle T+1

Question 16

Government Sponsored Agencies

Answer 16

• Implicitly backed by the US Government, so considered risk-free
  *Sallie Mae,

Question 17

Treasury Bills

Answer 17

• Issued within 4/8/13/26/52 week maturities
• Issued at a discount from par and mature at par (i.e. no interest)
• Quoted on a discount yield basis

Question 18

Treasury Notes

Answer 18

• Maturities range from 2 to 10 years
• Pay interest semi-annually
• Quoted in 32nds

Question 19

Interest Accrual

Answer 19

• Corporate accrues interest on a 30 day per month basis (total of 360 per year)
• Government accrues interest on an actual basis (total of 365 per year)

Question 20

Treasury Bonds

Answer 20

• Matures in 10 to 30 years
• Pay interest semi-annually
• Quoted in 32nds

Question 21

STRIPS

Answer 21

• Interest & Principal separated
• Each interest payment and the principal is sold separately at a discount to par
• Longer maturity = higher discount
• For investors who wish to avoid reinvestment risk (because they are zero-coupon bonds)

Question 22

TIPS

Answer 22

• Have a fixed interest rate over the life of the security
• Every 6 months the principal is adjusted by an amount equal to the change in the consumer price index (CPI)
  -> receives a fixed interest rate semi-annually times the adjusted principal amount as an interest payment
• These bonds are not subject to purchasing power risk
  -> if deflation decreases principal amount, bondholder still receives par at maturity
• Lower interest rate because of the inflation protection

Question 23

Agency Securities

Answer 23

• Federal Farm Credit System
  -> Offers farmers low-rate financing
  -> Issues discount notes, intermediate-term bonds, and long-term bonds
• Mortgage-Backed Securities (MBS) issued by:
  -> Federal Home Loan Banks (FHLB)
  -> Federal National Mortgage Association - Fannie Mae (FNMA)
  -> Government National Mortgage Association - Ginnie Mae (GNMA)
  -> Federal Home Loan Mortgage Corporation - Freddie Mac (FMCC)

Question 24

Mortgage-Backed Pass Through Certificates

Answer 24

• Issued by Fannie Mae, Freddie Mac, and Ginnie Mae, then passes through to investors the monthly mortgage payments made by homeowners
• 25k is the minimum denomination
• Investors are subject to prepayment risk
• Offer monthly payments
• Subject to pre-payment risk if interest rates fall

Question 25

Student Loan Marketing Association

Answer 25

* Sallie Mae * Purchases insured student loans from lending institutions paying interest semi-annually backed by these loans

Question 26

Trading of Government/Agency Debt

Answer 26

* Trading takes place over the counter (OTC), not on an exchange floor * Open Market operations through Repos and Revers Repos

Question 27

Repurchase Agreement (Repo)

Answer 27

* Fed BUYS Treasuries * Used to inject cash in money supply, loosening credit * Interest rates go down as there is more money available to be borrowed * (They will probably sell them back the next day)

Question 28

Reverse Purchase Agreement (Reverse Repo)

Answer 28

* Fed SELLS Treasuries * Used to take money out of the money supply, tightening credit * Interest rates go up as there is less money available to be borrowed * (They will probably buy them back the next day)

Question 29

US Government Agency Debt Tax Status

Answer 29

* Interest received from US Government Bonds is subject to federal income tax, but exempt from state and local taxes * Interest received from investments in mortgage-backed pass-throughs is fully taxable

Question 30

Ginnie Mae

Answer 30

* Government agency, does not issue securities (unlike Freddie Mac and Fannie Mae who are Government Sponsored Enterprises GSE's) * Guarantees the timely payment and interest of certain MBS's