Ch 4: Debt Securities

Question 1

3 major issuers of debt sec

Answer 1

1. US gov (largest issuer of debt securities)
2. Corporations - borrow $ to finance their ops
3. State gov and those political entities that are subdivision of s ate; state and local politicala entities are munis

Question 2

debt capital

Answer 2

money loaned to an issuer by investors purchasing that issuer’s bonds

Question 3

bond

Answer 3

issuer’s indebtedness

Question 4

indenture

Answer 4

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

Question 5

LT debt capital

Answer 5

LT debt is money borrowed for min 5 yrs, altho usually it’s 20-30 yrs

Question 6

money market

Answer 6

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

Question 7

mm instruments maturity date

Answer 7

1 yr or less; most are less than 6 months

Question 8

Why issue at a discount?

Answer 8

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.

Question 9

primary purchasers of money market securities?

Answer 9

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

Question 10

legal doc describing legaal conditions of the bond?

Answer 10

indenture

Question 11

Trust Indenture Act deals with…

Answer 11

corporate bonds

Question 12

negoatiability

Answer 12

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.

Question 13

Payment of interest (frequency?)

Answer 13

interest generally paid semiannaully for bonds

Question 14

Accrued interst

Answer 14

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.

Question 15

paying agent

Answer 15

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.

Question 16

Pricing of bonds are quoted as…

Answer 16

% of par or face value

Question 17

Trustee

Answer 17

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.

Question 18

Callable vs Noncallable

Answer 18

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!

Question 19

cheapest way for issuer to retire its debt?

Answer 19

buy it in the open market

Question 20

call provision

Answer 20

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.

Question 21

Call protection

Answer 21

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.

Question 22

***When the issuer calls the bond, the investors…

Answer 22

tender (sell back) their bonds at the call price.

Question 23

US T bills

Answer 23

4,8,13,26,52 weeks

no security is as safe as this

Question 24

Commercial Paper

Answer 24

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

Question 25

CDs

Answer 25

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.

Question 26

***Jumbo CDs are insured (up to the FDIC limit of $250K) but they are not...

Answer 26

secured by any bank assets

Question 27

Brokered CDs

Answer 27

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

Question 28

Ulnlike a bank CD where bank will redeem at face fvalue at any time

Answer 28

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.

Question 29

BAs

Answer 29

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)"

Question 30

Repo

Answer 30

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

Question 31

Reverse Repo

Answer 31

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.

Question 32

sovereign debt

Answer 32

securities issued by national gov Ex: Treasury sec in the US Safety of a sovereign bond depends on the economy of the issuing country.

Question 33

foreign corporate debt securities

Answer 33

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.

Question 34

Eurobond

Answer 34

any LT debt instrument issued and sold outside the country of the currency in which it's denominated

Question 35

***Eurodollar bond

Answer 35

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.

Question 36

primary reason for ussing bonds (iee. Maple bonds, Matilda bonds, etc)...

Answer 36

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.

Question 37

YTC

Answer 37

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.

Question 38

Duration

Answer 38

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

Question 39

***DURATION CHARACTERISTICS***

Answer 39

- 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

Question 40

Most important rating organizations?

Answer 40

S&P and Moody's

Question 41

IG bonds

Answer 41

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

Question 42

HY bonds

Answer 42

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.

Question 43

When raterrs evaluate a bond they look at...

Answer 43

all the factors, includign collateral. A mortgage bond is NOT necessarily safer than any debenture.

Question 44

What does it mean when a bond isn't rated?

Answer 44

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.

Question 45

ratings system for mm instruments follow...

Answer 45

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

Question 46

Types of alternative investing

Answer 46

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.

Question 47

Equity-linked notes (ELNs)

Answer 47

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.

Question 48

risks of ETNs

Answer 48

- 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)

Question 49

Private placement debt

Answer 49

money is loaned on a private basis securities are NOT registered bc of privaate nature, there are no ratings to guide investors.

Question 50

when comapring alternative investments, debt or equity, to traditional ones, the folllowing factors must be considered:

Answer 50

- 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!