Ch 4: Debt Securities Flashcards
3 major issuers of debt sec
- US gov (largest issuer of debt securities)
- Corporations - borrow $ to finance their ops
- State gov and those political entities that are subdivision of s ate; state and local politicala entities are munis
debt capital
money loaned to an issuer by investors purchasing that issuer’s bonds
bond
issuer’s indebtedness
indenture
terms of loan are expressed in a doc known as the bond’s indenture
also called “deed of trust”
states the issuer’s
- obligation to pay back x amt of money on x date
- issuer’s obligation to pay investor x rate of interest
- any collateral pledged as security for the loan and all other pertinent details
LT debt capital
LT debt is money borrowed for min 5 yrs, altho usually it’s 20-30 yrs
money market
market for buying and selling ST loanable funds
called “money mkt” bc that’s what’s traded - money! not cash
normally issued at a discount and DO NOT pay intrest. Principle amt of loan is repaid at maturity.
mm instrumetns DO NOT have an indenture
mm instruments maturity date
1 yr or less; most are less than 6 months
Why issue at a discount?
most money market instrumetns have a maturiy of less than 6 months, so the admin coss of paying out interest would be very high. Therefore, the solution is to issue secutiy at a discount with the investor getting back par at matuirty.
Difference between price paid and the maturity value is considered interest.
primary purchasers of money market securities?
institutions (including banks, insurance cos and mm mutual funds)
industry best practices rec the use of delivery vs payment (DVP) on the purchase of these sec
legal doc describing legaal conditions of the bond?
indenture
Trust Indenture Act deals with…
corporate bonds
negoatiability
both bonds and mm securities are readily transferrable.
This enables investors to sell sec before maturity date.
SECONDARY MARKET TRADING IS LESS COMMON THE MONEY MARKET BC OF THE SHORT MATURITIES.
Payment of interest (frequency?)
interest generally paid semiannaully for bonds
Accrued interst
investor who sells a bond BEFORE semiannnual interst payment? buyer pays seller the amt of interst that has accrued since the last interest payment.
Then, on the next payment date, new owner received the full 6 months of interest.
paying agent
usually a trsut dept of a bank
role of the paaying agent is to transmit paymetns of interest and pricniipal to the investors. Bc most mm instruments are issued at a discount, apying agent only repays the principal.
Pricing of bonds are quoted as…
% of par or face value
Trustee
usually a fin institution (ie. trust company)
often serves as the paying agent
trustee reps the investors; makes sure the borrower lives up to the terms of the loan and its responsibilities.
Callable vs Noncallable
call feature permits the issuer to redeem its bonds (pay off principal) BEFORE matuirty if it so desires.
Call feature is most often exercised when int rates are borrwoing by issuign enw bonds at lower rates prevailing in the market nd using those proceeds to call in the old bonds with their higher coupons.
similar to refunding!
cheapest way for issuer to retire its debt?
buy it in the open market
call provision
if buying from the open market doesn’t work, the issuer invokes a call provision.
“in whole call” meaning the issuer calls the entire issue.
In other cases, the issuer might have surplus funds. Rather than paying interest on the debt, it’ll call in a portion of the bonds (partial call). When this is done, the bonds to be called are usually selected randomly.
(partial calls are similar to someone who uses extra money to pay down credit card debt; it’s not enough to completely pay it off, but paying off a portion certainly saves money)
- usually you pay down the accts carrying the highest interest cost. If the issuer has several callable bonds outstanding, i would do the same thing (aka call the issue with the highest coupons first)
Bc of the ST nature, it’s rare to see a callable mm instrument.
Call protection
number of yrs into the issue before the issuer may exercise the call provision.
Best call protection a bond may have is if a bond is noncallable, the issuer cannot call it early and the investor has the best protection against a calal.
***When the issuer calls the bond, the investors…
tender (sell back) their bonds at the call price.
US T bills
4,8,13,26,52 weeks
no security is as safe as this
Commercial Paper
ST unsecured paper issued by corporations for primary gaol of raising working cpaital.
Issuers of CP usually are companies with excellent creid tratings.
Munis sometimes issue CP
CDs
Jumbo CDs - appropraite titl because minimum size is $100K. most common size is $1M, and tehy can be more than that.
CDs are usnecured time deposits (no asset of bank is pledge) but a negotiable CD allows iitial investor to sell CD in open market before maturity date.
CDs are the oNLY mm instrument issued at face value (not a discount) and that pays periodi intersts, usually semiannually.
***Jumbo CDs are insured (up to the FDIC limit of $250K) but they are not…
secured by any bank assets
Brokered CDs
BDs sell these
Brokered CDs generally have a longer holding period than the jumob mm CDs. Thereofre, they’re NOT part of mm.
Strucutre; more complex than regular bank (not jumbo) issued CDs.
IMPORATN DFIFERENCES:
- commission/fees to buy brokered CDs are gerenlaly higher than banks issued ones
- ma or may not be covered by FDIC Insurance
Ulnlike a bank CD where bank will redeem at face fvalue at any time
brokered CDs are usually NOT redeemble before maatuirty.
B offering the CD may buy it back. It woudl liekly be fees and no assurance that the investor will receive maturity value.
BAs
import-export biz
essentailly a postdated check/line of creidt
180 days, neve more than 270 days. The bank accepts repsonsiblity to maek apyment upon maturity.
Acceptance/bank liabiltiy makes the instrument a very marketable instrument.
Always issued at a discount from face value.
BA typically pays for g/s in a foreign country. You might see this called a “bill of exchange” or “letter of credit (LOC)”
Repo
Repo is the sale of sec with an agreemtn to repurhcase them at a higher price on an agreed upon future date. Difference between sale price and repurhcase price reps the interest earned by the investor (meaning thesea rea lways purhcaseed at a discount).
Repors trade as mm instrumetns.
The sec that’s exchanged stands a s colalteral for the loan advanced to the seller. Most common colalteral behind repo is a Treasury security
Reverse Repo
purcahser, not the seller, initiated the deal.
Purcahse of sec with an attendant agreement to resell them at a higher price on an agreed upon ftureudate; the difference between the pruchase price and the resale price reps the intererst earned by t he investor.
sovereign debt
securities issued by national gov
Ex: Treasury sec in the US
Safety of a sovereign bond depends on the economy of the issuing country.
foreign corporate debt securities
foreign corporations issue debt sec;
it’s unusual to find foreign sovereign and corporate debt issues in the same portfolio of individual investors.
Individuals wishing foreign exposure typically do so through mutual funds and/or ETFs.
Eurobond
any LT debt instrument issued and sold outside the country of the currency in which it’s denominated
***Eurodollar bond
US dollar-denominated Eurobond is a bond issued by a non-American co/gov, sold outside the US and the issuer’s country, but principal and interest are stated and paid in US dollars
***Tip: the name of the instrument tells you how principal and interest is paid.
primary reason for ussing bonds (iee. Maple bonds, Matilda bonds, etc)…
free from the requirement to register with the SEC, resulting in lower issuance costs. Bc the liquidity is not as great with US deomstic issues and bc the political and country risks tends ot be higher, yields are generally higher.
YTC
call feature may be redeemed before maturity at the issuere’s option. The call price may be at par/premium.
YTC is the rate of return the bond provides from the pruchase date to the call date and price.
Duration
measures the sensitivity of a debt seuciryt when itnerst rates change in the marketplace; basically measurement of the time it takes for the CF (interest payments) to repay the invested principal.
- general rule: higher the coupon rate, the shorter the duration
- longer the duration, greater the market price movement
- long duration debt seucirites have greater interest rate risk than those with a short duration
DURATION CHARACTERISTICS
- lower the coupon rate, longer a bond’s duration; higher the coupon, shorter the duration
- longer a bond’s maturity, longer the bond’s duration
- for coupon bonds, duration is always less than the bond’s maturity
- duration for a zero coupon bond is always equal to its maturity
Most important rating organizations?
S&P and Moody’s
IG bonds
rated in the top 4 categories (BBB or Baa or higher)
only qulaity eliglble for purchase by the institutions (ie. banks or insurance companies) and by fiduciaries and therefore have greater liquidity than lower-graade instruments
HY bonds
junk bonds
lower ratings (BB or Ba or lower) with additional risk of default
HY bonds may be subject to substantial price erosion during slow economic times or when a bond issuer’s creditworthiness is questioned.
When raterrs evaluate a bond they look at…
all the factors, includign collateral.
A mortgage bond is NOT necessarily safer than any debenture.
What does it mean when a bond isn’t rated?
Rating organizations rate those issues that either PAY to be rated or have ENOUGH BONDS outstanding to generate constant investor interst. No rating does NOT indicate its qulaity. Many issues are too small to justify the expense of a bond rating.
ratings system for mm instruments follow…
same concept as bonds, except for ST debt issues; Moody’s IG ST note rating are:
MIG1 (best quality) to MIG 4 (adequate quality).
SG = Speculative
S&P rates notes as SP-1, SP-2, SP-3.
Fitch rates notes as F-1, F-2, and F-3
Types of alternative investing
ETNs, leveraged ETFs, and new, highly sophisticated financial derivatves.
Often built “from the ground up” - another way of saying they could be created to meet the needs of a specific investor.
Equity-linked notes (ELNs)
debt instruments where final paym at maturity is based on the return of a SINGLE STOCK, BASKET OF STOCKS, or EQUITY INDEX.
In the case where the note is based ont ehr eteurn of an index, the security would be knwon as an index-linked note.
ELNs, exchange-traded or not, are considered alternative products with unique risks, and therefore, not sutiable for most investors.
risks of ETNs
- credit risk (ELNs/ETNs are unsecured debt obligations)
- market risk
- liquidty risk (altho exchange-traded, a trading mkt may not develop)
- call, early redemption, and accleeration risk (ETNs may be called at the issuer’s discretion); and
- conflicts of interest (the issuer may engaged in trading activites that are at odds with note hodlers (ie. shorting)
Private placement debt
money is loaned on a private basis
securities are NOT registered
bc of privaate nature, there are no ratings to guide investors.
when comapring alternative investments, debt or equity, to traditional ones, the folllowing factors must be considered:
- lack of regulation
- low tranparency
- low liquidity
- high fees
- lack of historical data
the investors are institutions/higly sophisticed individuals who are willing to take risk for higher potential rewards. This is why we lend money!
