Chapter 2: Debt Securities Flashcards
1
Q
Funded Debt
A
Corporate Bonds with maturities of five years or more.
2
Q
Coupon
A
Interest rate that is calculated from the bond’s par value. Interest accrues daily and is paid in semiannual installments over the life of the bond.
3
Q
Par Value (Face Value)
A
Normally $1000 per bond, meaning each bond will be redeemed for $1000 when it matures.
4
Q
Define Bond: 5M ABC J&J 15 8s ‘09
A
5M: 5 $1000 Bonds, for $5000
ABC: Issuer of the bond; corporate bonds have 3 letter names.
J&J 15: Bond pays interest on Jan 15 and July 15 each year. If there is no #, assume it is paid of the 1st of the month.
8s: The bond pays a stated rate of interest of 8% annually.
‘09: Investor will receive principal at bond’s maturity in 2009.
5
Q
3 types of Bond Maturities
A
- Term Maturity
- Serial Maturity
- Balloon Maturity
6
Q
Term Maturity
A
Structured so that the principal of the whole issue matures at once. Because they have to pay it all back at once, issuers may establish sinking fund accounts to accumulate money to retire the bonds at maturity.
7
Q
Serial Maturity
A
Schedules portions of the principal to mature at intervals over a period of years until the entire balance has been repaid.
8
Q
Balloon Maturity
A
Uses both elements of Term and Serial Maturity. Issuer repays part of the bond’s principal before the final maturity date, but pays off the major portion of the bond at maturity.
9
Q
Series Issues
A
When a company issues bonds over a period of years instead of offering them all at one time to investors, to spread out its borrowing over years.
10
Q
What does a Bond Certificate have on it?
A
- Name of Issuer
- Interest Rate & Payment Date
- Maturity Date
- Call Features
- Principal Amount
- CUSIP number
- Dated Date - Date interest starts accruing
- Reference to the bond indenture
11
Q
Are Bonds registered?
A
Yes, in varying degrees, to record ownership should a certificate be lost or stolen. This has only been common in the United States since the 1970’s.
12
Q
Coupon (bearer) Bonds
A
There is no record of who owns this bond, whoever is in possession of it and clip a “coupon” off of it and turn it in to the issuers paying agent to receive interest payment. This is where the term coupon comes from.
13
Q
Fully Registered Bond
A
Attached to both Principal and interest. A Transfer agent has a list and updates it as ownership changes. Interest payments are automatically sent to bondholders of record. When a bond is sold, the Transfer Agent cancels the seller’s certificate and issues a new one to the buyer. Most corporate bonds are done this way.
14
Q
Registered to Principal Only Bond
A
Has owners name printed on the certificate, but the coupons are in bearer form. Bonds issued to principal only are no longer issued.
15
Q
Book-Entry Bonds
A
These bond owners do not receive certificates. Rather, the transfer agent maintains the security’s ownership records. A book-entry bond owner does not receive a certificate like a Fully Registered Bond owner. Most US Government bonds are available in book-entry form only.
16
Q
Bearer Bond Denominations
A
$1000 or $5000 (remember: no longer issued)
17
Q
Registered Bond Denominations
A
$1000 denominations in multiples of $1000 up to $100,000 (Ex. $5,000, $10,000, $20,000)
18
Q
Which form must a bond be in to receive interest and principal payments by mail?
A
Fully Registered or book-entry. Either one.
19
Q
2 main things that affect a bond’s market price?
A
Interest Rates and Issuer’s Financial Stability
20
Q
Basis Point
A
1/100 of 1%
21
Q
How are corporate bond quotes commonly stated?
A
Percentages of Par in increments of 1/8.
Example: Quote of 98 1/8% = 98.125% or $981.25
22
Q
5 Criteria used to rate Corporate and Municipal Bonds
A
- Amount and composition of existing debt
- Stability of the issuer’s cash flow
- Issuer’s ability to meeting scheduled payments of interest and principal on it’s debt obligations.
- Asset protection
- Management Capability
23
Q
3 Qualitative factors when rating bonds
A
- Industry Stability
- Quality of Management
- Regulatory Claim
24
Q
GO Bonds (in reference to municipal bonds)
A
Backed by the municipalities ability to tax. Generally safer than Rev Bonds
25
Revenue Bonds (in reference to municipal bonds)
Backed by revenue from the facility it financed.
26
Corporate Debt safety ranking
1. Secured Bonds
2. Debentures
3. Subordinated Debt
4. Income Bonds
27
8 Main factors that affect a Bond's liquidity
1. Size of Issue
2. Quality
3. Rating
4. Maturity
5. Call Features
6. Coupon Rate and Current MV
7. Issuer
8. Existence of a sinking fund
28
Debt Service
The schedule of interest and principal payments due on a bond issue.
29
Who is an issuer's Sinking Fund operated by?
The bond's trustee
30
Who typically creates a sinking fund?
Lower-rated issuers do to make their issues more marketable (liquid)
31
Call Feature
Allows the issuer to redeem a bond issue before its maturity date. Issuer notifies bondholders it will call the bonds on a particular date at a particular price. In a partial call, the bonds called are selected by lottery.
32
Call Premium
The difference between Call Price and Par. It is a price higher than par.
33
4 Advantages of a Call to the Issuer
1. If interest rates decline, the issuer can redeem bonds with a high interest rate and replace them with bonds with a lower rate.
2. The issuer can call bonds to reduce its debt.
3. The issuer can replace short-term debt with long-term debt and vice-versa.
4. Can call bonds as a means of forcing the conversion of convertible corporate bonds.
34
How are Serial Bonds called?
Usually in inverse order because longer maturities tend to have higher interest rates. Calling longer maturities lowers the issuers interest payments by the largest amount.
35
Tendering
When an issuer buys bonds back in the open market to reduce a portion of its debt.
36
Call Risk
When a bond holder is forced to replace a relatively high fixed-income investment with one that pays less. This is because bonds are typically called when general interest rates are lower than they were when the bonds were issued.
37
Non-callable Period
A newly issued bond normally has this and it is typically 5 to 10 years and provides some call risk protection to investors.
38
Call Protection Feature
An advantage investors in periods of declining interest rates.
39
What happens to a Called Bond after the call notice is issued?
It trades on the open market at a slight discount to the call price. This way the investor does not have to wait for the call date to get his money. They can also just hold and wait to redeem them to the issuer.
40
Refunding
The practice of raising funds to call a bond. Typically an issuer sells a new bond issue to generate funds to retire an existing issue. This can occur in part or in full.
41
Pre-refunding (advance refunding)
A new issue is sold at a lower coupon before the original bond issue can be called. Issuers do this to lock in a favorable interest rate. This is a form of defeasance, or termination of the issuer's obligation. Pre-refunded bonds are considered defeased and no longer part of the issuer's debt.
42
Crossover Refunding
A method of advance refunding in which the revenue stream originally pledged to secure the refunded bonds continues to be used to pay debt service on those bonds until they mature or are called in by the issuer. Then, the advance refunded dollars are used to pay off the original (refunded) bond issue, and the revenues pledged from the original issue "crossover" to now pay debt service on the new bonds.
43
5 Main Facts about Pre-refunded Bonds
1. They are AAA Rated.
2. They are considered defeased
3. The funds are escrowed in Government securities
4. The marketability of the pre-refunded bond increases.
5. Once pre-refunded, the issue is no longer considered part of the outstanding debt of the issuer.
44
Tender Offer
When an issuer offers to buy back an issue at a premium price as an inducement to get holders to tender their bonds.
45
Puttable Bonds
Bonds that include a put option, which gives the holder the right to sell the bond back to the issuer at full face value. This reduces the holders market risk (interest rate risk), and generally has a lower interest rate because of this. Most commonly found in municipal bonds.
46
Bond Yield
Expresses the cash interest payments in relation to the bond's value. Bonds can ALSO be quoted and traded in terms of their yield as well as a percentage of par.
47
How is yield determined?
Yield is determined by the issuer's credit quality, prevailing interest rates, time to maturity, and call features.
48
Nominal Yield (Coupon Yield)
Set at issuance and printed on the face of the bond. It is a fixed percentage of the bond's par value. It is an annual rate, so a Coupon Yield of 6% is $60 per year (could be paid in separate payments) on a $1000 par bond.
49
Current Yield
Measures a bond's coupon payment relative to its market price.
Coupon Payment / Market Price = Current Yield
When a bond trades at a discount, current yield increases.
When a bond trades at a premium, current yield decreases
50
Yield to Maturity (AKA Basis)
Reflects the annualized return of the bond if held to maturity. This takes into account the difference between the price paid for a bond and par value.
[Annual Interest - (Premium / Years to Maturity)] / (Average Price of the Bond)
51
Bond's Average Price
[Price paid + Amount received at Maturity (Par)] / 2
52
Basis
Another term for Yield to Maturity.
| Example: A 4% bond trading on a 5% basis is trading at a price to yield 5% to maturity.
53
Yield to Call
Reflects the early redemption date and consequent acceleration of the discount gain or premium loss from the purchase price. The sooner a bond is called, the sooner the premium an investor paid is lost.
54
Yield Curve
The difference in yields between short-term and long-term bonds of the same quality.
55
Normal Yield Curve
The difference between short-term and long-term rates is about three percentage points (300 basis points) but may be much larger or smaller at any given time.
56
Inverted (Negative) Yield Curve
When long-term interest rates are lower than short-term rates.
57
Flat Yield Curve
Long-term and short-term interest rates are the same.
58
Do long-term or short-term bond prices change more with a change in interest rates?
Long-term. Think of it like a whip, the handle slightly moves and the end of it whips back and forth.
59
If two bonds have the same time to maturity, which one will move more in price as rates fall
The one with the lower coupon. Given a change in interest rates, discounts tend to move more in price than premiums.
60
2 Primary types of Corporate Bonds
Secured & Unsecured
61
Secured Bond
Issuer has identified specific assets as collateral for interest and principal payments. A trustee holds the title to the assets, and in a Default the bondholder can lay claim to the collateral.
62
Mortgage Bonds
Have the highest priority among all claims on assets pledged as collateral. Although they are considered relatively safe, individual bonds are only as secure as the assets that secure them.
63
Open-End Indentures
Permits the corporation to issue more bonds of the same class later. Subsequent issues are secured by the same collateral and have equal liens on the property.
64
Closed-End Indentures
Does not permit the corporation to issue more bonds of the same class in the future. Any subsequent issue has a subordinate claim on the collateral.
65
Prior Lien Bonds
These take seniority over 1st lien bonds, but must be approved by 1st mortgage bondholders before they can be issued. Typically used when a company is in distress
66
Collateral Trust Bonds
Issued by corporations that own securities in other companies as investments. These bonds are secured by a pledge of those securities as collateral. Typically a covenant is included requiring that a trustee hold the pledged securities.
67
What can a Collateral Trust Bond be backed by?
1. Another company's stocks and bonds.
2. Stocks and bonds of partially or wholly owned subsidiaries.
3. Pledging company's prior lien long-term bonds that have been held in trust to secure short-term bonds.
4. Installment payments or other obligations of the corporations clients.
68
Equipment Trust Certificates (ETCs, AKA Equipment Notes or Bonds)
Used by railroad, airlines, trucking companies, and oil companies to finance the purchase of capital equipment. They are issued Serially so that the amount outstanding goes down year to year in line with the depreciating value of the collateral. Titles are held in trust, usually a bank, until all certificates are paid in full.
69
Unsecured Bonds
No specific collateral backing and are classified as either debentures or subordinated debentures.
70
Debentures
Backed by the general credit of the issuing corporation, and a debenture is considered a general creditor of the company.
71
Subordinated Debentures
Paid last of all debt obligations, including general creditors, in case of liquidation. Typically offer higher yields and often have conversion features.
72
Hierarchy of claims on a company's assets (7)
1. Unpaid Wages
2. IRS (Taxes)
3. Secured Debt
4. Unsecured Liabilities & General Creditors
5. Subordinated Debt
6. Preferred Stockholders
7. Common Stockholders
73
Guaranteed Bonds
Backed by a company other than the issuer, such as a parent company.
74
Income Bonds (AKA Adjustment Bonds)
Typically used when a company is coming out of bankruptcy. They pay interest only if the corporation has enough income to meet the interest payment and if the BOD declares a payment. Payments do not accumulate, so they are not suitable for customers seeking income.
75
Zero-Coupon Bonds
Issuer's debt that do not make regular interest payments. They are issued at a deep discount to their face value and mature at par.
Issued by corporations, municipalities, and the US Treasury and may be created by broker/dealers from other types of securities.
76
Return (accreted interest) of a Zero-Coupon Bond
Full face value at maturity - Discounted purchase price
77
Price of a Zero-Coupon Bond
Reflects the general interest rate climate for similar maturities.
78
Zero-Coupon Bond: Advantages
- Requires a smaller investment because of discounted price.
- Offer a way for investors to speculate on interest rate environment.
79
Zero-Coupon Bond: Disadvantages
- Because they sell at a deep discount and offer no cash interest payments, they are substantially more volatile than traditional bonds. Prices fluctuate wildly with changes in market rates.
- The longer the time to maturity, the greater the volatility.
80
Zero-Coupon Bond: Taxation
Even though no interest payments are made, investors owe income tax each year on the amount by which bonds have accreted. Income tax is due regardless of direction of the market price.
81
Which security has no reinvestment risk?
Zero-Coupon Bonds, because with no interest payments to reinvest, the investor has no reinvestment risk. Because there is no reinvestment risk, buying a Zero is the only way to lock in a rate of return.
82
Trust Indenture Act of 1939
-Requires a corporation to appoint a trustee, usually a commercial bank or trust company, for its bonds.
-Trustee must monitor the compliance with the covenants of the indenture and may act on behalf of the bondholders if the issuer defaults.
-Requires corporate bond issues of $5 million or more
sold interstate to be issued under a trust indenture.
83
Trust Indenture
A legal contract between the bond issuer and a trustee representing bondholders. The trust indenture specifies the issuer's obligation to bondholders' rights.
*NOT a contract between the issuer and the bondholders. *
84
Trust Indenture Act of 1939: Exemptions
Federal and Municipal governments are exempt, although muni's are typically still issued with a trust indenture to make them more marketable.
85
Trust Indenture: 7 Basic Protective Convenants
The debtor corporation agrees to:
1. Pay the interest and principal of its bonds
2. Specify where bonds can be presented for payment
3. Defend the legal title to the property
4. Maintain the property to ensure that business can be conducted
5. Insure the mortgage property against fire and other losses
6. Pay all taxes and assessments (property, income and franchise)
7. Maintain its corporate structure and the right to do business.
- Others may be included as needed
86
Senior Lien Bond
The same thing as a Closed-End Indenture Bond.
87
Where do most corporate bonds trade?
In the OTC market
88
Convertible Bonds
Corporate bonds that may be exchanged for a fixed number of shares of the issuing company's common stock. They pay lower interest rates than nonconvertible and generally trade in-line with common stock. They have fixed interest payments and maturity dates so they are less volatile than common stock.
89
Convertible Securities: Advantages to the Issuer (5)
1. They can be sold with a lower coupon rate than nonconvertibles.
2. Can eliminate a fixed interest charge as conversion takes place, reducing debt.
3. Conversion normally occurs over time, so its does not have an adverse effect on stock price.
4. Avoids immediate dilution of primary EPS.
5. At issuance, conversion price is higher than MP of CS.
90
Convertible Securities: Disadvantages to the Issuer (4)
1. When bonds are converted, shareholders equity is diluted.
2. CS has a voice in the company, so a substantial conversion could cause a change in the control of the company.
3. Reducing corporate debt through conversion means a loss of leverage.
4. A decrease in deductible interest costs raises the corporations taxable income.
91
Convertible Bonds: Advantages to the Investor (6)
1. Pays interest at a fixed rate and is redeemable at its face value. Interest income is higher than dividend income on underlying CS.
2. Priority over CS in event of liquidation
3. The MP tends to be more stable during periods of declines in the market than the underlying CS.
4. Market price tends to move upward as the stock price moves upward.
5. A conversion of a senior security is not considered a purchase and sale, so it is not a taxable transaction.
6. In a stable rate environment, convertibles tend to be the move volatile because of their tie to CS.
92
Conversion Price
The stock price at which a convertible bond can be exchanged for shares of CS.
93
Conversion Ratio (Conversion Rate)
The number of shares of stock a bond may be converted into.
94
Where are conversion terms stated?
In the indenture agreement, either as a conversion ratio or a conversion price.
95
How can a Convertible Bondholder lose their privileges?
If a merger, consolidation, or dissolution occurs.
96
Parity
Two securities are of equal dollar value.
97
Parity Price of Common Stock
Market Price of the Bond / Conversion Ratio (# of shares)
98
Parity Price of Convertible
Market Price of Common x Conversion Ratio
99
Convertibles: Antidilution Convenant
Found in the trust indenture. Requires an adjustment to the conversion price for stock splits, stock dividends, and the issuance of new shares.
100
Forced Conversion
This occurs when an issuer calls its convertible bonds and it is clearly in the best interest of bondholders to convert their bonds rather than let them be called.
101
Reverse Convertibles
Debt instruments with imbedded put options that allow the issuer the right, but not the obligation, to convert the bonds principal into shares of equity at a predetermined set date.
Occurs when the underlying shares fall below a set price.
Bondholders would receive the equity shares rather than their principal when the bond matures.
Yields tend to be higher due to additional risk.
Basically puts the conversion feature in the issuers hands instead of the investors.
102
Who can tax U.S. Government securities interest?
Only the federal government.
103
T-Bills
Short term obligations issued at a discount from par. Rather than making regular cash interest payments, bills trade at a discount from par. They are zero-coupon securities.
104
T-Bill denominations
Issued in denominations of $100 to $5 million, and have maturities of 4, 13, and 26 weeks.
105
T-Bill quotes
Because they are quoted in yield (i.e., 1.15 bid, 1.12 ask), a T-bill quote has a bid higher than its asked. Higher yield on the bid side translates into a lower dollar price.
106
T-notes
Pays interest every six months, and sold at auction every four weeks.
107
T-note denominations
Issued in denominations of $100 to $5 million, and mature in 2 to 10 years. They mature at par or can be refunded. If they are refunded the government offers a new security with a new interest rate and maturity as an alternative to a cash payment.
108
T-note pricing
Issued, quoted, and traded as a percentage of par in 1/32's.
109
T-note quote of 98.24 translates into:
98-24 or 98:24 on a $1000 note means the note is selling for 98 24/32% of its $1000 par value. Therefor a quote of 98.24 equals 98.75% or $987.50
110
T-bonds
Long term securities (10-30 years) that pay interest every six months.
111
T-bond denominations
Issued in denominations of $100 to $5 million and mature in more than 10 years from issue date.
112
Treasury Receipts
A type of zero-coupon bond created from US treasury notes and bonds. BDs buy treasury securities and place them in trust with a bank and sell seperate receipts against the principal and coupon payments. NOT backed by the full faith and credit of the US government.
113
STRIPS
Separate Trading of Registered Interest and Principal of Securities. The 1984 designation of of certain treasury issues that the Treasury Department says are suitable for stripping into interest and principal components. STRIPS are backed by the U.S Government, receipts are not. Both quoted in yield.
114
TIPS
Treasury Inflation Protection Securities. Used to protect investors against purchasing power risk. Issued with a fixed interest rate, but the principal amount is adjusted semiannually by an amount equal to the change in the CPI. In times of inflation, interest payments rise and vice versa. (Set % times fluctuation principal)
115
TIPS Taxation
Only taxable by federal government. EXCEPTION: In years of inflation where the principal is adjusted, the increase is considered reportable income for that year despite the increase not being received until the note matures.
116
Which 5 Agencies are authorized by the federal government to issue debt securities?
1. Farm Credit Administration
2. Government National Mortgage Association (GNMA)
3. Federal Home Loan Mortgage Corporation (FHLMC)
4. Federal National Mortgage Association (FNMA)
5. Student Loan Marketing Association (SLMA)
117
How are Agency Securities settled?
Regular way (3 business days)
118
Taxation of Government Agency Issues
Issued backed by mortgages are taxed at the federal, state, and local levels. Others are only taxed at the federal level.
119
Government National Mortgage Association
Ginnie Mae. Government owned corporation that supports the Department of Housing and Urban Development. The only agency securities backed by the full faith and credit of the federal government. Page 76**
120
GNMA Taxation
Interest earned on GNMA Certificates is taxable at the federal, state, and local levels.
121
Farm Credit System
National network of lending institutions that provides agricultural financing and credit. This system is privately-owned, but government sponsored. It raises loanable funds through the sale of Farm Credit Securities to investors.
122
Who oversees the Farm Credit System?
The Farm Credit Administration (FCA). It is a government agency.
123
Federal Home Loan Mortgage Corporation
Freddie Mac is a public corporation created to promote the development of a nationwide secondary market in mortgages by buying residential mortgages from financial institutions and packaging them into mortgage-backed securities for sale to investors.
124
Pass-Through Certificate
Created by pooling a group of mortgages and selling certificates representing interests in the pool. "Pass-through" represents the homebuyers interest and principal payments passing from the mortgage holders to the investors.
125
The 2 pass-through securities FHLMC sells
1. Mortgage Participation Certificates (PCs)
| 2. Guaranteed Mortgage Certificates (GMCs)
126
Federal National Mortgage Association
Fannie Mae is a publicly held corporation that provides mortgage capital. FNMA purchases conventional and insured mortgages from agencies such as FHA and VA. Backed by FNMA's general credit.
127
FNMA Issues
Issued Debentures, short-term discount notes, and mortgage backs securities. Interest is paid semiannually. Book entry form only.
128
FNMA denominations
$5000, $25000, $100000, $500000, $1000000. If maturity is between 3-25 years the minimum denomination is $10000 with $5000 incrementally.
129
Student Loan Marketing Association
Sallie Mae issued discount notes and short-term floating rate notes. Floaters have six-month maturities. Proceeds from securities are used to provide funds for higher education. Interest paid on securities is taxable at federal level, but exempt at most states. SLM stock is listed for trading.
130
Competitive Bids
Bids in a treasury auction that are placed by primary dealers in US government securities. (ex. J.P. Morgan, Citigroup, Banc of America Securities) They are required to bid at treasury auctions.
131
Noncompetitive Bids
Placed by other market participants. Smaller banks and broker/dealers, insurance companies, and individuals. They are always filled, but the price paid is the lowest accepted competitive bid called the "stop out price". Made in yield, not dollar, price.
132
and interest
The way that most bonds trade. It means that a buyer pays a seller the bond's market price, plus any accrued interest since the last interest payment. The buyer then receives the full amount of the next interest payment.
133
Coupon Dates
Bond interest payments, that typically happen every six months, on the 1st or 15th of the specified months.
134
Dated Date
For a new bond issue, this is the day from which interest accrual begins. Even if a bond is issued at a later date, the bond starts accruing interest on the dated date.
135
Accrued Interest
Calculated from the last interest payment date up to but not including the settlement date. The buyer owns the bond on the settlement date, which means that the interest for that day belongs to the buyer.
136
2 Methods to calculate Accrued Interest
1. 30-day-month (360 days)
| 2. Actual-calendar-days (365 days)
137
Accrued Interest Calc: 360 day year
(Principal x interest rate x elapsed days)/360 days
138
Trading Flat
When a bond trades without accrued interest. Examples are Zero-Coupon bonds, income bonds, and bonds in default.
139
Collateralized Mortgage Obligations
CMOs are asset-backed securities who are backed by various types of loans such as mortgages. Issued by private sector financing corporations and are often backed by Ginnie Mae, Fannie Mae, and Freddie Mac pass-trhough securities. Must repay investors principal in one tranche before investors in the next tranche receive payments.
140
Tranches
A pool of mortgages or loans.
141
How are CMOs yield and maturity estimated?
They are based on historical data or projections of mortgage prepayments from the Public Securities Association (PSA).
142
6 Common CMO types
1. Principal Only
2. Interest Only
3. Planned Amortization Class
4. Targeted Amortization Class
5. Zero-Tranche CMO
6. Inverse Floater CMO
143
Principal-Only CMOs (POs)
The income stream comes from principal payments on the underlying mortgages- both scheduled mortgage principal payments and prepayments. It sells at a discount from par and ultimately repays its entire face value to the investor. Value falls when interest rates rise and prepayment declines.
144
Interest-Only CMOs (IOs)
The by-product of POs. An IO also sells at a discount, and its cash flow declines over time, the same way the interest payment portion of a mortgage declines over time. IOs increase in value when interest rates rise. These can be used to hedge a portfolio against interest rate risk. There is prepayment risk, because if a prepayment occurs the interest payments stop, so the owner does not know how long the payments will continue.
145
Planned Amortization Class CMOs (PACs)
Have targeted maturity dates. They are the first ones retired and offer protection from prepayment risk, and extension risk (slower principal payments than expected). Changes in prepayments are transferred to companion tranches.
146
Targeted Amortization Class CMOs (TACs)
Transfers prepayment risk only to a companion tranche and does not offer protection from extension risk. Investors accept the extension risk and the resulting greater price risk in exchange for a slightly higher interest rate.
147
Zero-Tranche CMO (Z-Tranche)
Receives no payment until all preceding CMO Tranches are retired (most volatile CMO tranches)
148
Inverse Floater CMO
Volatile and Risky. Contains thinly traded mortgage securities that are highly leveraged and vulnerable to a high degree of price volatility. The reduction in the repayment of principal extends he maturity date, sometimes up to 30 years.
149
3 Main CMOs Risks
1. The rate of principal repayment varies
2. If interest rates fall and homeowner refinancing increases, principal is received sooner than anticipated (prepayment risk)
3. If interest rates rise and refinancing declines, the CMO investor may have to hold the investments longer than anticipated (extended maturity risk).
150
CMO Yield
More that treasury securities and normally pay investors interest and principal monthly. Principal repayments are made in $1000 increments to one tranche at a time before moving to the next one.
151
CMO Taxation
Federal, State, and Local
152
CMO Liquidity
Active secondary market. More complex CMOs may have no secondary market.
153
CMO Denomination
Issued in $1000 denominations
154
CMO Suitability
Investors are required to fill out a suitability statement before buying any CMO. CMOs may not be compared to any other investment vehicle.
155
Collateralized Debt Obligations (CDOs)
Typically consists of non-mortgage loans or bonds that are pooled together. Also contains tranches.
156
Series EE Bonds
Savings bonds with fixed rates of interest for 30 years. They are issued at face value with a minimum denomination of $25. Used to be physical certificates, but are now only issued electronically. Interest is added to the bond monthly, and compounded semiannually. Tax exempt on state and local levels. Tax is deferred until they redeem the bonds or stop earning interest (30 years)
157
Series HH Bonds
These used to be issued in exchange for maturing EE bonds. US Treasury eliminated the exchange so they are no longer issued. These bonds are issued at face value and pay interest every six months at a fixed rate. Current Income security. (Interest is paid to the bondholder and is taxable at the federal level during the year received.
158
Series I
Used to protect the purchasing power of their investment and earn a real rate of return. This is an accrual security. Sold at face value and they grow in value with the inflation-indexed interest for up to 30 years. Based on CPI. Tax can be deferred until redemption or 30 years is up.
159
I and EE Bond taxation
If an investor falls within annual income guidelines, the interest income on them can be tax free as long as the proceeds from redemption are used to pay tuition and related fees at eligible colleges or universities. This is not available to high income individuals.
160
Capital Market
Serves as a source of intermediate-term to long-term financing, usually in the form of equity or debt securities with maturities of more than one year.
161
Money Market
Provides very short-term funds to corporation, banks, broker/dealers, and the US Government. Debt issues with maturities of one year or less.
162
Money Market Securities
Treasury Bills, Repurchase Agreements, Reverse repurchase agreements, banker's acceptances, commercial paper, negotiable certificates of deposit, federal funds.
163
Repurchase Agreement (repo)
An agreement between a buyer and a seller to conduct a transaction (sale), and then to reverse that transaction (repurchase) in the future. A repurchase price and a maturity date are included in the contract if it is a fixed agreement. It is an Open Repo if there is no maturity date specified and is callable at any time. Biggest risk is Interest
164
Reverse Repurchase Agreement (reverse repo)
A dealer agrees to sell its securities to a lender and then buy them back at a higher price in the future.
165
Banker's Acceptances (BA)
Short-term time draft with a specified payment date drawn on a bank. Payment is normally between 1 and 270 days. They are usually used to pay for goods and services in a foreign country. It is secured because it includes a lien on the trade goods. Quoted in yield, sold at a discount and mature at par.
166
Commercial Paper (promissory note)
Corporations issue these to raise cash to finance accounts receivables and seasonal inventory gluts. Maturities range from 1-270 days. Interest rates are lower than bank loan rates. Primary buyers are money market funds, commercial banks, pension funds, insurance companies, corporations, and non-governmental agencies. Quoted in Yield, sold at discount, matures at par.
167
Direct Paper
Commercial paper sold by finance companies directly to the public without the use of a dealer. If it is high quality it is called "prime paper".
168
Interest
The cost of money
169
Federal Funds Rate
The rate the commercial money center banks charge each other for overnight loans of $1 million or more. It helps predict the direction of short term interest rates. It is listed in newspapers daily and is the most volatile rate in the economy.
170
Prime Rate
The interest rate that large US money center commercial banks charge their most creditworthy corporate borrowers for unsecured loans. Each bank sets its own prime rate.
171
Discount Rate
The rate the Federal Reserve charges for short-term loans to member banks. Also indicates the direction of FRB monetary policy (increasing rate indicates tightening FRB policy).
172
Broker Loan Rate (Call Loan/Money Rate)
The interest rate banks charge BDs on money they borrow to lend to margin account customers. These are callable on 24 hour notice. This is usually a percentage point or so above other short-term rates.
173
Eurodollars
US dollars deposited in banks outside the United States. Deposits remain denominated in US dollars.
174
Eurobond
Any long-term debt instrument issued and sold outside the country of the currency in which it is denominated. The US government does not use Eurobonds.
175
Eurodollar Bonds
A bond issued outside of the United States, but pays in dollars. Issued in bearer form, interest is paid once a year and holders are not subject to withholding tax.
176
Interbank Market
Developed to consolidate foreign currency deposits. It is an unregulated, decentralized international market that deals in various major world currencies.
177
Currency Appreciation
When a currency is rising in value in comparison to other currencies on the foreign exchange market.
178
TRACE reporting rules
1. Both sides of the transaction must report.
2. Trades must be reported within 15 minutes of execution or are deemed to be late.
3. Execution date, time of trade, quantity, price, yield, and if price reflects a commission charged are all reportable and displayed.
179
TRACE excluded debt securities
1. Foreign country and foreign government debt.
2. Mortgage and Asset-backed securities.
3. Collateralized mortgage securities
4. Money market instruments.
5. Municipal securities
6. Convertible corporate bonds
