Ch. 7 Debt Securities Flashcards
Corporate and US Govt Loans
Most ______ are safer than stocks
Bonds
What are Bondholders considered?
Bondholders are considered creditors. They lend $$$ to an institution for a fixed period of time and receive interest for doing so.
Why are bonds attractive to issuers?
Allows the issuer to borrow $$$ on its terms (w/ its chosen maturity date, scheduled interest payments, interest rate, etc.)
The issuer cannot set it’s own terms by borrowing from a lending institution.
What is a Bond Maturity Date?
The date issuers pay bondholder back for the loan they .
Par Value
Stated at issuance
What is Par Value (Bonds)
The face value or principal of the bond
The Par Value for corporate bonds is $1,000 unless otherwise stated
Regardless of what the investor paid at purchase, they will receive the par value plus any interest due at the maturity date
How are Bond Prices Quoted?
Bond prices are quoted as a percentage of par value, often w/o the % sign.
A bond trading at 100 is trading at 100% of par or $1,000.
A bond trading a 86 is trading at 86% of par or $860
How are Corporate Bonds typically quoted?
Corporate bonds are typically quoted in increments of 1/8%
So, a corporate bond quoted at 99 3/8 would be trading at $993.75
How are Government Bonds typically quoted?
Government Bonds are typically quoted in increments of 1/32%
What is the Coupon Rate
Coupon Rates is the interest an investor would receive for providing loans to the issuer
Tells the investor how much annual interest they will receive
Bonds w/ a set coupon rate are considered what kind of security?
Fixed Income Security
How is the coupon rate expressed?
As a percentage of Par Value
How often to Bonds pay interest?
Semi-Annually
What is a Bond Indenture
Deed of trust
Resolution
The legal agreement between the issuer and its bondholders
Contains
1. Maturity Date
2. Par Value
3. Coupon Rate (Nominal Yield) and interest payment dates
4. Any collateral securing the bond
5. Any call or conversion features
6. Includes a Trustee
What is a Trustee (re: a bond indenture)
Charged w/ making sure the issuer does the right thing for the bondholders.
An organization that administers a bond issue for an institution
Ensures that the bond issuer meets all the terms and conditions associated w/ the borrowing
What is Collateral?
assets that the issuer owns
What are secured Bonds?
Bonds backed by collateral adn involve a pledge from the issuer that a specific asset will be sold to pay off the outstanding debt in the event of default
Lower yield than unsecured bonds due to lower risk
Four types of secured bonds
- Mortgage Bonds
- Equipment Trusts
- Collateral Trusts
- Guaranteed Bonds
What are mortgage bonds?
Secured Bond backed by property that the issuer owns
May be OPEN END or CLOSE END
What is an open end mortgage Bond?
a secured bond backed by property that the issuer owns where the issuer MAY BORROW MORE MONEY using the same property as collateral
What is a CLOSED END MORTGAGE BOND?
A secured bond backed by property that the issuer owns where the issuer MAY NOT BORROW MORE MONEY using the same property as collateral.
What is an Equipment Trust?
Secured bond mainly issued by transportation companies. Backed by equipment owned
Trustee holds the title
What is a Collateral Trust?
Secured Debt.
A collateral trust is a bond backed by financial assets of other issuers that the issuer owns.
Trustee holds the assets and sells them to pay off the bonds in the event of default.
What is a Guaranteed Bond?
Secured debt. Backed by a firm other than the original issuer (parent company). If the issuer defaults, the parent company pays of the interest and / or principal
What is an Unsecured Bond?
Bonds not backed by assets, but only backed by the god faith and credit of the issuer
What is a Debenture?
Unsecured Debt
Bonds backed only by the issuer’s good word and written agreement stating that the issuer will pay the investor interest when due and par value at maturity
What is an Income Adjusted Bond?
Unsecured Debt
Super risky
Isssuer promises to pay par value back at maturity and will make interest payments ONLY IF earnings are high enough
Companies reorganizing issue these at deep discounts
Zero Coupon Bond
Can be secured or unsecured
Issued at a deep discount and mature at par value
Require a low investment
b/c issued at a discount, the bonds must be accreted
Good for planning for future events such as college
B/c of deep discount, current prices of discount bonds fluctuate quite a bit when interest rates change
What is a EuroDollar Bond?
Debt securities isued by foreign companies and government OR US companies with foreign locations
Issued outside of the US but may trade in the US AFTER 40 DAYS of issuance.
Interest and principal are in US dollars (dollar-denominated)
Do NOT have to register w/ SEC
Subject to currency risk
May be ideal for customers looking to protect themselves from a decline in the value of the US dollar
What is a Sovereign Bond?
Debt security issued by Foreign National Governments
Interest and principal payments are in the foreign currency
Subject to Currency Risk
May be ideal for customers looking to protect themselves from a decline in the value of the US dollar
What are some things bond prices are affected by?
supply & demand
corporate rating change
interest rate changes
purchased at discount or premium
If interest rates increase, outstanding bond prices…
Decrease
If interest rates decrease, outstanding bond prices…
Increase
If you have a 4% coupon bond and interest rates decrease, you would be able to sell your bond at a…
Premium
When interest rates fall, bond prices go up. your 4% bond is more attractive to investors who can get the same bond for 2% or 3%. They will pay more than par value, so you can sell your bond at a premium
What is the nominal yield?
The nominal yield is the coupon rate.
How do you calculate the coupon rate on a bond?
Coupon X par value
So, on a 7% bond…
7% X $1,000 = $70 / year
What is the Current Yield (CY) on a bond?
The annual rate of return on a security
CY changes when the market price changes
How do you calculate Current Yield of a bond?
Current Yield
annual interest CY = ------------------------
market price
What is Yield to Maturity (YTM) of a bond?
The yield an investor can expect if holding the bond until maturity.
Takes into account…
1. market price
2. par value
3. coupon rate
4. amount of time until maturity
What is Yield to Call (YTC) of a bond?
The amount an investor receives if the bond is called prior to maturity
What is Yield to Worst (YTW) of a bond?
The worst number of the YTM and YTC for all call dates
What is Discount Yield?
The yield on securities that are issued at a discount and don’t make interest payments.
These include
- T- Bills
- T- Strips
- Zero-Coupon Bonds
What three debt securities don’t make interest payments?
T-bills
T-STRIPS
Zero-Coupon Bonds
What government debt security is issued on a discount yield basis?
T-Bills
What is Accrued Interest?
Due when bonds are purchased between coupon dates and is the portion of the interest still due to the seller.
(Bonds pay interest semiannually)
Accrued interest on corporate and Municipal bonds is calculated based on…?
30 day month and 360 day year
Accrued interest on US Govt bonds is calculated based on…?
Actual days per month and Actual days per year
Accrued interest is calculated from…to, but…
the previous coupon date up to but not including the settlement date
To calculate Accrued Interest for corporate and municipal debt securities…
- ID the Settlement date (T+1) mm/yy
- ID the Previous Coupon Date mm/yy
- Subtract the mm/yy s
- Multiply the number of months by 30
- Add the result to the number of days of interest accrued
What is the Dated Date of a bond
The first date the bonds start acruing interest
What does it mean if a bond has a Long Coupon?
It means that the dated date of the bonds does not line up exactly six months from the first coupon date.
It is a Long coupon if the first coupon date is MORE than six months from the dated date.
What does it mean if a bond has a Short Coupon?
It means that the dated date of the bonds does not line up exactly six months from the first coupon date.
It is a Long Coupon if the first coupon date is LESS than six months from the dated date.
For newly issued bonds which haven’t made an interest payment yet, accrued interest is calculated from the…
Dated Date (NOT the previous coupon date because there isn’t one.)
The institutions that rate bonds are most interested in what?
likelihood of default
The higher the credit rating, the ____ the bond and the ____ the yield.
The higher the credit rating, the SAFER the bond and the LOWER the yield.
The lower the credit rating, the ____ the bond and the ____ the yield.
The lower the credit rating, the RISKIER the bond and the HIGHER the credit yield.
What are the two companies who rate bonds?
Standard & Poor’s and Moody’s
What is the first rating considered “junk” bonds for S&Ps and Moody’s?
S&P = BB and lower
Moody’s = Ba and lower
What are S&P’s Investment Grade Bond Ratings?
Highest:———————— AAA
High:—————————– AA
Upper Medium:—————- A
Low Medium:—————- BBB
What are Moody’s Investment Grade Bond Ratings?
Highest:————————-Aaa
High:——————————-Aa
Upper Medium:—————– A
Lower Medium:————– Baa
What are S&P Junk / Speculative Grade Bond Ratings?
Speculative ——————————-BB
Speculative missed pymnts———–B
Speculative no interest paid———-C
In default————————————-D
What are Moody’s Junk / Speculative Grade Bond Ratings?
Speculative ——————————–Ba
Speculative missed pymnts———–B
Speculative no interest paid———Caa
In default————————————-D
On an S&P rating, what does the + / - represent?
+ is the high end of the category
- is the low end of the category
No mark is in the middle of the category
On a Moody’s rating, what does the numbers 1, 2, or 3 represent?
1 = highest ranking w/in the category
2 = middle of the category
3 = lowest ranking w/ in the category
Bonds can be issued in ____ and ____ forms
Callable and put forms
What is a Callable Bond?
A bond that the issuer has the right to buy back from investors at the price stated on the indenture (deed of trust)
How are callable bonds priced compared to noncallable bonds?
Callable bonds are riskier for the investor
To compensate for the risk, callable bonds are issued w/ a higher coupon rate.
Most callable bonds are issued with ______ and are sometimes issued with _____.
Call protection
And sometimes a Call Premium
What is Call Protection?
The amount of time (usually several years) that an issuer has to wait before being able to call its bonds
What is a Call Premium?
The amount over par the issuer has to pay if they call the bond
What is a Make Whole Call Provision?
Issuer may call the bond, BUT they will also make a lump sum payment that includes payment for the bond AND the present value of any future interest payments missed due to the call.
What is a Step Coupon Bond?
Start at a low coupon rate which increases at predetermined intervals.
Issuer typically has the right to call the bond at Par Value at the time the coupon rate is due to increase
What is a Put Bond?
Allow the investor to redeem the bonds at any time at the price stated on the indenture
Better for investors
Rarely issued
lower coupon rate
When do issuers tend to call bonds?
When rates decrease
The issuer could call existing bonds and reissue the same bonds at a lower interest rate when interest rates decrease
When to investors tend to put (redeem) bonds?
When rates increase
So the investor could take the money tied up in the bond and invest it at a higher interest rate.
If interest rates increase, what happens to bond yields?
Bond yields increase
What is a Convertible Bond?
It is a bond that the investor can convert into shares of common stock.
Investors convert when
What is Parity re: convertible bonds?
When a convertible bond and its underlying stock are trading equally
ie,. When a bond trading for $1,100 is convertible into $1,100 worth of stock
What is the Conversion Ration re: Convertible Bonds?
The number of shares that the bond is convertible into
You always need to calculate the conversion ration to answer conversion questions
What is the Conversion Ratio Equation? re: Convertible Bonds
Conversion Ration (CR)
Par Value Conv Ratio = -------------------------- shares
Conversion Price
Then use this to calculate the parity price
What is the Parity Price Equation re: Convertible Bonds?
Parity Price of the Bond (PP)
PP = MP of Stock X Conversion Ratio
If the stock is trading above parity to the bond, the investor should…
Convert
(For test purposes)
What is Arbitrage (re: Convertible bonds?)
Taking an advantage of a disparty in prices
Investors will convert their bonds when the value of the convertible bond is trading at a price that is lower than the value of the stock it’s convertible into
US Govt Bonds are considered….
…the safest of all securities
What risks are US government securities subject to?
Interest Risk
Reinvestment Risk
Inflation / Purchasing Power Risk
How can US Govt Securities be purchased?
- Directly (Treasury Direct Website)
- Broker Dealers
- Commercial Banks
What are the maturities on T-Bills?
4, 8, 13, 17, 26, and 52 weeks
What are the maturities on FRNs? (Floating Rate Notes)
2 years
What are the maturities on T-Notes?
2, 3, 5, 7 and 10 years
What are the maturities on T-Bonds?
20 or 30 years
What are the maturities on T-STRIPS? (Separate Trading of Registered Interest and Principal of Securities)
6 months to 30 years
What are the maturity on TIPS (Treasury Inflation Protected Securities)
5, 10, and 30 years
What are the Characteristics of a T-Bill
Short Term - 1 year MAX
Issued at discount, mature at par
The difference b/n the purchase price and par is considered interest even though no interest payments are made.
Sold in $100 increments
What are the Characteristics of a FRN (Floating Rate Note)
Mid Term - 2 years
Pay an adjustable rate of interest quarterly
Tied to the rate of the most recent discount rate of the 13 week T-Bill
Sold in $100 increments
What are the Characteristics of a T-Note?
Mid Term - 2 - 10 years
Pay a fixed rate of interest every 6 months
Sold in increments of $100
What are the Characteristics of a T-STRIPS (Separate Trading of Registered Interest and Principal of Securities)
Across Terms - 6 mos - 30 years
Issued at a discount and mature at par
Minimum investment = $100
Sold by financial instituitions and BDs
Investors do not receive interest payments. The principal and all remaining interest payments are stripped and sold as separate securities
Purchase prices vary
What are the Characteristics of TIPS (Treasury Inflation Protected Securities)
5, 10, and 30 year terms
Pays a fixed rate of interest every 6 months tied to the adjusted principal amount and based on a percentage of par (which moves)
Tied to the Consumer Price Index (CPI)
- If inflation is high, the TIPS par value increases
- If deflation occurs, the TIPS par value decreases
The Par Value and Interest payments adjust according to inflation or deflation.
Sold in investment increments of $100
On what basis are T-Bills sold?
T-Bills are sold on a discount-yield basis where the BID is HIGHER than the ASK.
If you see a BID that is higher than the ASK, it is likely a T-Bill quote.
The interest received from US Govt securities is exempt from ???
State and local taxes
When you see a question on the Series 7 exam about the best investment when planning for a specific future event (ie. college) The right answer will most likely be…
Zero Coupon Bonds or T-Strips
Which government agency’s bonds are DIRECTLY backed by the full faith and credit of the US Government?
GNMA
Government National Mortgage Association
Which government agency’s bonds have implied backing of the US Government but are not guaranteed by the Govt?
FNMA (Federal National Mortgage ASsociation or Fannie Mae)
FHLMC (Federal Home Loan Mortgage Corporation or Freddie Mac)
FFCS (Federal Farm Credit System
SLMA (Student Loan Marketing Association)
GNMAs support what?
The Department of Housing and Urban Development (HUD)
Characteristics of a GNMA Debt Security
Taxed on ALL levels (Fed, State, & Local)
Often called Pass Through certificates
- Investors receive MONTHLY PAYMENTS of interest and principal as people pay their mortgages
Issued w/ a face value of $25,000 but can be purchased in denominations as low as $1,000
Subject to prepayment and extension risk
What are the Characteristics of FNMA?
Publicly held and privately owned but still Government Sponsored Entity (GSE)
Responsible for providing capital for certain mortgages.
Purchases conventional mortgages, VA mortgages, FHA mortgages, etc.
What are the Characteristics of FNMA Debt Securities?
Debentures
3 - 25 year Maturities
$10,000 minimum denominations
Longer term bonds are Pass Through Certificates (Principal & Interest are paid MONTHLY)
Also issues Discount Notes & Benchmark Bills (Shorter term debt securities issued at a discount and mature at PAR)
Taxed on all levels (Fed, State & Local)
Do NOT have the direct backing of the US Govt so risk of default is higher and investors receive a higher return.
What are the Characteristics of FHLMC? (Federal Home Loan Mortgage Corporation or Freddie Mac)
Publicly held
Designed to create a secondary market for mortgages
What are the Characteristics of FHLMC Debt Securities?
Creates Mortgage Backed Securities (MBS) (purchases residential mortgages from FIs and packages them into MBSs)
Also issues Pass Through Certificates and the interest is subject to Fed, State & Local taxes.
Do NOT have the direct backing of the US Govt so risk of default is higher and investors receive a higher return.
What are the characteristics of the FFCS? (Federal Farm Credit System)
Government Sponsored Entity but privately owned.
Consists of lending institutions which provide financing and credit to farmers
Overseen by the FCA (Farm Credit Admin)
What are the characteristics of FFCS debt securities?
Sells securities through member banks to investors and in turn loans the funds raised to farmers
Issues DISCOUNT NOTES & BONDS
Maturities from 1 DAY to 30 YEARS
Interest received is EXEMPT from State and Local Taxes
Must pay Fed Taxes on interest received
What are the Characteristics of SLMA (Student Loan Marketing Association or Sallie Mae)?
Provides a secondary market for student loans
No longer a GSE! (Government Sponsored Entity)
Private Company and issues stock
What are the Characteristics of SLMA debt securities?
Purchases student loans and repackages them as short- and medium- term debt securities.
Interest earned is subject to Federal Tax.
Interest earned MAY BE exempt from state and local taxes, depending on the state.
Certain mortgage backed securities have an AVERAGE LIFE, which is…
Shorter than the initial loan term due to investors selling or refinancing.
Subject to prepayment risk, reinvestment risk, and extension risk
What are Collateralized Mortgage Obligations (CMOs)
Debt securities backed by pools of mortgages
Do NOT have a set maturity date
Prepayment risk associated w/ CMOs
The risk that a tranche (slice/portion) of the loan will be called sooner than expected due to decreasing interest rates;
more people refinance when interest rates are low
Average life associated w/ CMOs
The average amount of time until a mortgage is refinanced or paid off;
for example, a 30-year mortgage may have an average life of 17 years
Extension Risk associated w/ CMOs
The risk that a tranche will be called later than expected due to a less-than-normal amount of refinancing;
extension occurs when interest rates are high
Plain Vanilla Offering Tranche (re: CMO)
Tranches paid in a specific sequence.
All tranches receive interest payments
Only the tranche w/ the shortest maturity receives principal payments until it is retired.
After the shortest is paid off, the next shortest tranche receive principal payments until it is retired.
and so on
Planned Ammortizaton Class (PAC) Tranches (CMO related)
Most common b/c most certain prepayment date
Low yield b/c safe
can mitigate the prepayment and & extension risk it does have with a companion tranche
Targeted Amortization Class (TAC) Tranches (CMO related)
Second Safest CMO
Somewhat less-certain principal payments
More subject to prepayment & extension risk
Low yields but higher than PAC tranches
Companion Tranches (Support Bonds) (CMO related)
Included in every CMO that has PAC or TAC tranches
Absorb prepayment risk associated w/ CMOs
Average life varies greatly depending on interest rate flux
More risky, so higher yields
Z Tranches (Accrual Bonds) (CMO related)
Last tranche in a series of PAC or Companion tranches due to longest maturity
Do NOT receive interest or principal until all of the other tranches in the series have been retired
Wide fluctuations in market value
Similar to zero-coupon bonds
Principal Only (PO) Tranches (CMO Related)
Purchased at a deeply discounted price
Investors receive face value through regularly schduled mortgage payments and prepayments
Market Value increases IF
- Interest Rates DROP AND
- Prepayments INCREASE
Interest Only (IO) Tranches (CMO related)
All CMOs w/ principal-only tranches also have interest-only tranches.
IOs are sold at a deep discount below their expected value based on the principal amount used to calculate the amount of interest due
The market value of an IO increases IF
- Interest Rates INCREASE AND
- Prepayments DECREASE
Floating Rate Tranches (CMO related)
Appear when interestrates are tied to an interest rate index (ie. LIBOR)
Investors can use Floating Rate tranches to HEDGE interest rate risk on other investments
What are the four basic points of CMO Tranches?
The Plain Vanilla Offering is the most basic
PAC tranches are the safest
TAC tranches are the second safest
Companion tranches support PAC and TAC tranches
Z-tranches have the longest maturity
Retail communications re: CMOs MUST include…
- Must include the words “Collateralized Mortgage Obligation
2 .Must NOT compare CMOs to other investment vehicles
- Must disclose that the GSE backing the CMO are only responsible for face value and not any premium paid
- Must disclose that the CMO YIELD & AVERAGE LIFE WILL FLUX based on interest rates and repayment and refinance rates.
Before selling a CMO to any investor (except institutional investors), members MUST…
- Offer the investor educational materials about CMOs which includes…
-Characteristics and risks of investing in CMOs
-Structure of the CMO
-Different tranches & their risks
-The relationship b/n Mortgage securities & Mortgage loans
-Questions an investor should ask before investing in CMOs
-A Glossary of Terms
What are the characteristics and risks of investing in CMOs?
Credit quality
Prepayment rates
Average lives
How interest rates affect prepayment rates
Tax considerations
Liquidity
Minimum investments
Transaction costs
Any retail communications mailed out re: CMOs (and other securities) must include
Firm’s name
Memberships
Address
Phone
Reps Name
If promoting a specific CMO, any communications must include the following:
Coupon rate
specific tranche (# & class)
Anticipated yield
Anticipated average life
Final maturity date
Underlying collateral
disclosure “The yield and average life shown above consider prepayment assumptions that may or may not be met. Changes…”
Radio and TV ads for CMOs must include the following statements:
The following is an ad for CMOs. Contact your representative for information on CMOs and how they react to different market conditions
The yield and average life reflect prepayment assumptions that may or may not be met. Changes in payments may significantly affect yield and average life.
What is a Collateralized Debt Obligation (CDO)?
Backed by a pol of bonds, loans or other debt instruments, broken down into tranches representing differing amounts of risk and/or maturities.
In the event of a shortfall of cash, holders of Senior CDOs are paid first.
Interest received is taxable at Fed, State & Local levels
For sophisticated investors
What are Money Market instruments?
aka Cash Equivalents
Relatively safe
short term loans (mature in 1 year or less)
can be issued by corporations, banks the US Govt and municipalities
Issued at a discount and mature at Par.
What are Federal Funds?
Money Market instrument for banks
usually overnight Loans between banks to help meet reserve requirements
What are Reserve Requirements?
Percentage of deposits that member banks must hold each night
Banks unable to meet these may borrow from other banks at the Fed Funds Rate
What is Corporate Commercial Paper?
A Money Market Instrument
Unsecured corporate debt
issued at a discount, matures at par
issued w/ an initial maturity of 270 days or less
Exempt from SSEC registration
What are Brokered (Negotiable) Certificates of Deposit (CDs)?
A Money Market Instrument
AKA Jumbo CDs
Low risk investments
originate from a bank and outsourced to BDs to sell to investors
Negotiable (can be traded in the market)
Min investment of $100,000
What is a Banker’s Acceptance?
A Money Market Instrument
Time Draft (short term credit investment)
Created by a company whose payment is guaranteed by a bank
Used for importing and exporting goods.
What is a T-Bill? (re: Money Market)
A money market instrument
US Govt Issued
Issued at a discount and matures at PAR
Maturities of 4, 8, 13, 17, 26 or 52 weeks
Sold and quoted on a Discount-yield basis (YTM)
Safest security of all securities
What are a list of Money Market Instruments?
Fed Funds
Corporate Commercial Paper
Brokered (Negotiable Certificates of Deposit)
Banker’s Acceptances
T-Bills
What are Structured Products?
Packaged products based on derivatives
require a minimum investment
Fixed term
Combine a note (short term debt security) and a derivative product
Investors receive interest payments and, at maturity, receive face value of the note plus a premium if the derivative portion performs well
Considered complex products and require investors to tie $$ up for a number of years. Not suitable for most investors.
ETNs
Equity Linked Notes
What are Exchange Traded Notes?
Unsecured debt securities issued by a bank of FI that trade on an exchange
Returns are linked to a market index or commodities or currency
Don’t receive dividends or coupon payments
Do receive income at a specified maturity date
May be purchased on Margin or sold short
At maturity, investor receives a principal amount less any fees based on the performance of the index the note is tracking
ETNs value may drop due to a drop in the credit rating of the ETN issuer even if the index has not decreased.
DO NOT represent a pool of ownership. They simply track the performance of a specified market index.
What is an Equity Linked Note?
Bonds where the interest payments are variable depending on the return of the underlying equity securities.
NOT traded on an exchange
