Chapter 2- Debt Securities 15-25 questions Flashcards
Most common issuers of debt securities
Corporations, Municipalities and Us government
Senior security
Bondholders are considered senior because they are settled before common stock
Funded debt
Corporate bond with 5+ years till maturity
Treasury bill or note or bond
Bills are less than a year while notes are 2 to 10 year maturities.
Bonds are 10 or more years
Interest on a bond
Called the coupon rate
The interest rate is calculated from the par value or face value
Usually 1000 per bond
Interest on a bond accrues daily
Final bond semiannual interest is paid when bond matures with original amount
How to read a bond sale:
5M ABC J&J 15 8s of ‘21
5 1,000 dollar bonds
ABC is the issuer
January 15 and July 15
8% annually
Principal repaid in 2021
Three basic types of bond maturity
Term- Principal of the whole issue repaid on a maturity date. Issuers will establish a sinking fund to retire bonds.
Serial- Principal to mature at intervals over a period of years.
Balloon- pays part of issue off before maturity and makes lump sum payment at term
Basic bond info
Name of issuer Interest rate and payment date Maturity date Call features Principal amount CUSIP Dated date (interest starts to accrue) Reference to bond indenture
Bearer bond (coupon)
Used to be sold normally
Would clip coupons and collect interest for the bond from the company
No longer issued, no name was on bond
Were not registered so the holder could do what they pleased with them
Deliver to paying agent to receive interest
Fully registered
Records the principal and interest the bond has
Transfer agent Issues a new one upon sale to another customer
Receive a physical certificate of the bond
Issued in 1000 denominations or multiples of 5000 up to 100,000
Book entry bonds
Do not receive certificates rather the trade confirmation acts as the certificate
Primary issues determining price of a bond
- Issuers financial stability
2. Overall trends in interest rates
Pricing bonds
Bonds are usually priced in 1/8ths increments
So a bid of 98 1/8 means a bond is worth 98.125
1 basis point is either .01% or .0001 of a dollar
80 Bp is .8% or $8 on a 1000 face value bond
Standard and Poors Ratings
Moody’s ratings
SP- give either a + for the top half of a category or - for bottom half
Ratings listed top to bottom:
AAA, AA, A, BBB, (non invest grade) BB, B, C, D
Moody’s- Adds numerical qualifiers to indicate where a bond is within a category such as 1, 2, 3
A1 and Baa1 to indicate high quality within two categories
Moody’s also provides ratings on short term munis designated MIG 1-4 and SG (speculative)
Aaa, Aa, A, Baa (below is speculative), Ba (could miss), B (missed 1 or more payments), Caa (no interest being paid), D (Default)
No rating does not reflect poorly, as most issues are too small to justify the expense
Mood Swings is a creative way to remember as Moody’s uses both upper case and lower case letters
Basis for bond ratings
Amount and comp of debt Stability of cash flow Ability to meet payment schedule Asset protection Management capability
Bank grade bonds
Rating of BBB or Baa and up
Ranking of safety in bonds
US gov Securities and series EE OR HH bonds
Gov agency though US gov does not officially back
Municipal issues (general obligation bonds protected by taxation while revenue bonds are backed by facility revenues)
Corporate debt usually ranked (Secured bonds, debentures, subordinated debentures, income bonds)
Debt service
Shcedule of interest and principal payments due on bond issue
Sinking fund
Facilitates the retirement of bonds
Can be used to call bonds, redeem bonds at maturity or buy back bonds
Makes bonds more marketable if low rated
Usually required by the trust indenture
Call feature
Redemption before maturity date either wholly or partial
Issuer notifies bondholders that it will call bonds at particular price
Partial calls are selected by lottery
Call premium
The difference between the call price and the par for the bond
If callable at 102, call premium is two points or $20 per bond
A point is $10
Term bonds vs serial bonds
Tender
Term bonds are called by random drawing
Serial bonds are usually called in inverse order of their maturities because longer maturities tend to have higher interest rates. This lowers the overall interest rate
If no call option is available, the bond is usually tendered
Call risk
Generally, a bond is only called when interest rates decrease
Usually a newly issued bond has a 5-10 year window of call protection
Refunding
Pre refunding
Practice of raising money to call a bond or selling new bonds to close old ones
Common when maturity is approaching
Pre refunding is doing the raising before the call is ready to lock in a lower interest rate
AAA rated, escrowed in government securities
Form of defeasance, or termination, of an issuers obligation. DO NOT COUNT AS ISSUERS DEBT.
Putable bonds
The investor has the right to sell the bond to the issuer at full face.
Must take a lower interest rate to get feature
Municipal bonds sometimes do this
Nominal yield vs current yield
Coupon yield set at issuance
Current yield is coupon payment / market price
Price and yield are inverse
Yield to maturity formula
Reflects the annualized return of the bond if held to maturity. Difference between price paid for bond and par value are taken into effect
Minus if premium, plus if discount
Annual Interest -/+ (premium or discount / years to maturity)
Divided by
Average price of the bond (price paid + original / 2)
Example
Bought at 800, coupon of 8%, 5yrs left
80 - (200 / 5) divided by 900 = 4.4% return due to purchasing at premium
Trading at a basis is referring to the yield to maturity
Yield to call
Reflects the early redemption date
The sooner a bond is called, the sooner a premium is lost
YTC is always lower than yield, current yield and YTM if bought for a premium and sold at par
Ranking Yields highest to lowest for a:
Discount
Premium
Discount: YTC, YTM, CY, Nominal Yiled (coupon)
Premium: Nominal Yield, Current Yield, Yield to Maturity and Yield to Call
This is due to the time span at which they would be called and how the different yields are calculated
Yield Curve
The difference between short term and long term bonds with the same quality
Normal Yield Curve
Yields typically differs by about 3% or 300 basis points in the total Curve.
If rates are expected to dip, long term bond yields drop lower in anticipation while short term remain the same. Creates an inverted yield curve.
If rates are expected to increase, the opposite will occur
Yield curve predicting recessions and expansions
If the gap between corporate bonds and gov bonds increases, a RECESSION! might be coming due to investors seeking safety
If it’s narrowing, then an economic expansion may be forming as investors are willing to take risk
Relationship between bonds and rates
If interest rates rise, bond prices will decrease to meet market demand
If given two discount bonds, the deeper discounted bond will appreciate most with interest rates decreasing
Mortgage bonds
Have the highest priority claim on assets pledged as collateral.
Tend to have multiple issues so the first issued would have highest claim
Open end indentures
Allows a company to issue more bonds on the same asset at a later date
Collateral trust bonds
Bonds secured by securities held by a corporation of another.
The corporation issuing the bonds must then hold the securities for the bonds
Can be backed by subsidiaries stock or obligations of corp clients as well
Equipment Trust Certificates
Used to finance capital equip
Has a serial retirement schedule that is set at the same rate as the depreciation of the asset
Debentures
Backed by general credit of the corporation
Owners of the bonds are considered general creditors
Above subordinated debentures and preferred stock in chain
Subordinated debentures
Last of all debt obligations in liquidation (still above preferred stock)
Often have conversion features
Liquidation claim order
Unpaid wages IRS Secured debt Unsecured liabilities (includes debentures) Subordinated debt Preferred stock Common shareholders
Income bonds (adjustment bonds)
Bonds issued by a company that is coming out of bankruptcy
Will only pay interest if corporation has income to meet interest payments
Do not accumulate for future payments
Not suitable for investors seeking income
Zero-Coupon Bonds
Issued at a deep discount without a regular interest payment
Return is the difference between the sale price and maturity
Substantially more volatile, fluctuate wildly with market rate changes
Taxed on the accretion of the bond even though they do not pay interest
IRS requires accretion of the discount on an annual basis, cost basis also goes up with each year
What security has no reinvestment risk?
Zero coupon bond, because it locks in a return
Trust indenture act of 1939
If a corporate bond is over $50 million, it must be issued under a trust indenture
Trust indenture is a legal contract between bond holder and trustee, not automatically supplied
Federal and municipal bonds are exempt
Trustee
Usually a commercial bank or trust company
Monitors covenants of the indenture
Closed end covenants vs open end
Have senior claim on the underlying assets, sometimes called senior lien bonds
Open- permits subsequent issues to be secured by same property
NYSE
Central marketplace for trading corporate bonds
NYSE Bonds also provides investors with a cost effective, autonomous way to trade
Most still trade in OTC market
Convertible bonds
Bond that is able to be converted into a fixed amount of common shares
Pay lower interest rates, trade in line with common stock, have fixed interest payment and maturity dates so less volatile than common stock
More stable pricing if stock devalues
Advantage of Convertibles for issuer
Disadvantages
Can be sold with lower coupon
Can eliminate fixed interest rate upon conversion
Does not have an adverse impact on stock price due to conversion happening over time
Disadvantages:
Shareholders equity is diluted when converted
Substantial conversion could cause voting problems
Loss of leverage in conversions
Interest is deductible so conversion increases tax liability
Conversion ratio
Expressed the number of shares of stock a bond may be converted into
Conversion price of $40, face of $1000
25:1 conversion ratio
Stated in the indenture agreement
Preferred stock usually has a face of $100
Convertible bonds are protected by an antidilution covenant. Conversion price changes with a stock split or stock dividend
Parity
The two securities are worth the same price
Market price of bond
/ = parity price
Conversion ratio (Shares)
Market price of common x conversion ratio=
Parity price
Forced conversion
Issuer calls the bonds and it is in the best interest of bondholders to convert
If market price for the bond is selling at a premium to the conversion price, the market will quickly remove the premium after conversion is announced
Reverse convertibles
Imbedded put options allows the bond issuer to convert the bonds to common stock at predetermined date
Higher interest rate for the bond holder
Used to back collateralized loan obligations
Freddie Mac
Ginnie Mae
Fannie Mae
Wall Street journal quoting
The Wall Street journal quotes yield as current yield
Corporate bonds
Quoted as a percentage of par in 1/8ths
