Chapter 2- Debt Securities Continued 16-25 Flashcards
US government and agency securities
How they are issued
Interest on gov securities is usually exempt from state and municipal tax
Largest borrower, best credit
Book- Entry Form= no physical security is issued
T-Bills
Short term debt issued at discount from par
Maturities of 4, 13, and 26 weeks and auctioned weekly
Example of a zero-coupon security
Treasury Notes
Pay interest every 6 months
Sold at auction every 4 weeks in denominations of $100-$5mm just like tbills
2 to 10 year maturity
Mature at par or are refunded meaning the investor receives a new security at different coupon
Traded in percentages of 1/32s
Example: Quote of 98.24 means 98.75%
Tbonds
10 to 30 years, interest every 6 months
$100-5mm
Sell same way as T-Notes
Treasury receipts
Created by brokerage firms, they are zero coupon bonds of US treasury notes and bonds
Not backed by US government
Can purchase receipts for any of the treasury payments or the principal
10yr bond would have 21 receipts available
STRIPS
Seperate Trading or Registered Interest and Principal of Securities
Backed in full by Us government
Similar in nature to a Reciept
Zero coupon bonds issued at deep discount
Treasury Inflation Protection Securities (Tips)
Fixed interest rate but the Principal is adjusted semiannually= to the amount change in CPI
Interest payment is equal to new principal times the rate
Sold at lower price
Taxable event when inflation is present
Government/private agencies that are able to issue debt securities
- Farmers Credit Administration
- Ginnie Mae (GNMA)
- Freddie Mac (FHLMC)
- Fannie Mae or FNMA
- Student Loans Sallie Mae or SLMA
Agency Issues
Higher yield than treasury obligations but lower than corporate
Mortgage backed issues are taxed at all three levels, others at Fed only
Quoted as a percentage of par and trade actively
Government National Mortgage Association (GNMA)
HIGHLY TESTED
Backed fully by government, for the department of housing and urban development
Purchase pooled mortgage loans as a security
Only backs single and multi family homes
Guarantees timely payments of monthly interest and principal
Issued with face of 25,000, but can be purchased at $1,000 minimums
Assumes repayment in 12 years and yield is stated as such
Risk associated with mortgage backed securities include prepayment and extended maturity risk, along with typical interest risk
Taxed at all levels
Example of pass through certificate and has significant reinvest risk
Farm Credit System (FCS)
Agricultural financing and credit
Raises loanable funds by selling securities
Offer discount notes, bonds and master notes ranging from 1 day to 30 years
Exempt from local and state taxes
Federal Home Loan Mortgage Corp (Freddie Mac)
Created secondary market for mortgages by packaging them into securities
Pass through security- passing interest and principal payments from mortgage holder to the investors
Two Types: Mortgage participation certs (pcs) and Guaranteed Mortgage Certs (GMCs)
Pcs= once a month Interest and principal are paid GMCs= Twice a year interest, once principal
Income is subject to All 3 tax levels
Federal National Mortgage (Fannie Mae)
Publicly traded corporation
Purchases insured mortgages from FHA and VA
Debentures, short discount notes, and mortgage backed securities
5k, 25k, 100k, 500k, 1mm
3-25 year maturity for debentures and sold in incriminates of 5000 over 10k, interest semiannual
Book-entry form
Student Loan Marketing Association
Issues discount notes and short term floating rate notes
Floaters have 6 month mature
Listed on market for trading at SLM
Interest is paid semiannually and exempt from state and local tax
Bidding for government securities
Two types of bids:
1. Competitive bids- Placed by primary dealers in US government securities. Usually large banks and are required to bid.
- Non competitive bids- Smaller banks, brokers, insurance companies, individuals
Always filled but usually pay the lowest accepted competitive bid (stop out price)
Dutch Auction
Though competitive and noncompetitive bids are made, the lowest price bid is what everyone pays
Make bids in yields
Stop out price is last bid accepted
When does settlement take place?
Thursday of that week for Tbills and Thursday of following week for tnotes
Accrued interest
Bonds are usually traded at price and interest
Starts accruing interest on the dated date
Seller will receive interest up to but not including the settlement date
2 methods to calculate:
1. 30 day month (All corporate/municipal)
Principal x interest rate x elapsed days/ 360
2. 365 day (all US gov bonds)
Principal X interest rate x elapsed/ 365
Settlement time
Settlement on a US gov bond is the next business day after a trade
The interest date is included as a day in both calculations
Never assume a leap year
Zero coupon, income bonds trade flat (no accrued interest)
Basics of a CMO
Asset backed security, usually auto loans
Are sometimes backed by government agencies so are highly rated
Structured in security classes called tranches
Repays principal to one traunch at a time
A CMOs yield and maturity is estimated by the Public Securities Association (PSA)
Cannot be compared to anything but itself
Plain Vanilla CMO
Pays interest to all tranches but only repays principal to one tranches at a time in $1000 increments
Principal only CMO (POs)
Sells at discount to par, market value is volatile
Value rises as interest rates drop
Income comes from principal payments and prepayments
Interest only CMOs (IOs)
IOs increase in value when interest rates rise and sell at discount
Raise in value when rates rise because there will be more payments
As the IO matures, the cash flows from the security will fall
Can be used to hedge against interest rate risk
Planned Amortization Class CMOs (PACs)
Retired first and offer protection against prepayment and extension risk
Lower yields than comparable TACs
Targeted Amortization Class (TACs)
Transfers prepay risk to a companion tranche but does not offer protection from extension riske
Zero Tranche CMO
No payment until all other tranches are paid
Most volatile
Inverse Floater CMO
High leverage risk
Thinly traded mortgage securities, may lose principal pay if rates rise
CMO characteristics
Not backed by US gov, but the private institutions related to
yields more than a treasury security
Rate of principal repay varies
Rate falls mean principal is paid back quicker
Rate rise means principal paid slower
Interest is subject to all 3 level tax
Issued in 1000 incraments, and large market
Must sign a suitability statement for PACs, TACs and other CMOs
Collateralized Debt Obligations
No specific type of debt, usually non mortgage loans
Different types of debt and credit risk
Each tranche has different risk allocation and maturity
The issuer of the CDO owns the asset
More suitable for institutional or Sophisticated investors
Series EE bonds
Nonnegotiable and cannot be transferred
Fixed rate of interest over 30 years
Minimum denomination of $25
Can be redeemed after 1 year
3 month interest penalty for redemption in first 5 years
All are issued electronically
Compounded semiannually, only taxed at Fed and can be deferred until redemption
Series I
Interest added monthly and paid on maturity
Grow with inflation for up to 30 years
Fixed rate of return plus a variable semiannual interest rate
Fed taxed, can be deferred and can be deducted if used to pay for school
Money Market Securities
Tbills Repurchase Agreements Reverse repurchase agreements Bankers acceptance Commercial paper Negotiable CDs Fed funds
Repurchase agreements
Reverse
Sells securities temporarily with promise to buy back later
Include a repurchase price and maturity date
Generally lower interest rate than a bank loan
Major risk is interest rate risk
Reverse= dealer agrees to buy and sell back at higher price
Bankers acceptance
Basically a post dated check or line of credit
Usually payable in 1 and 270 days
Usually paying for goods in a foreign country
Commercial Paper
Direct paper
Corporations issue Short term, unsecured promissory notes to raise cash to finance accounts receivables
Sold at discount to par
1-270 days, issued in book entry form
Direct- sold by finance companies directly to public
Certificate of Deposit (4 types)
Fixed interest rate, minimum face of 100,000
Negotiable- Time deposits to a bank, tradable in secondary, accrued interest included in price
Nonnegotiable are offered by banks and are not tradeable in secondary market
Brokered CD- Subdivided master CD issued by broker/dealer. Must be sold in market to be redeemed early. Most brokers will also put in a call feature so if interest rates drop, they can call the bond. FDIC may not insure
Step up or step down CD- fixed rate of interest for usually a year and then the rate is adjusted
Fed funds rate
What banks charge each other for overnight loans of $1 million or more
Most volatile rate in economy, listed daily
Prime Rate
What commercial banks charge credit worthy corporations for unsecured loans
Raises and lowers with money supply
Discount Rate
Rate Fed charges for short term loans to member banks
Indicates monetary policy
Only interest rate set by the Federal Reserve directly
Broker loan rate
Rate for margin account customers
Usually percentage point above other short term rates
Call money rate
Charge on loans to broker dealers
Commercial Paper
Rate on high grade unsecured notes
Quoted as a percentage of par
WILL SEE SEVERAL RATE QUESTIONS ON SERIES 7
Euro Dollars
US dollars deposited abroad
Usually overnight to 180 day deposits
Usually based on London Interbank Offered Rate
Issued outside of the Us
EuroBonds
Euro bonds are Any long term debt instrument sold outside of country currency
Eurodollar indicates it pays in US dollars/currency
US government does not issue Euro Dollar Bonds
Interbank Market
Unregulated, decentralized international market for currencies
Usually done in a spot trade which settles in a day
Fed can sell US dollar to lower the currency rate
Or buy to raise the rate of the USD
Trade Reporting and Compliance Engine (TRACE)
FINRA approved trade reporting system for corporate and gov agency bonds
Not an execution system
Both sides of trade must report, must be reported within 15 minutes of execution, and must include basic details
US treasury, debt of foreign gov, money market instruments and debt securities at not reported
TBills pricing
Quoted at yield or discount rates
Equity Linked Notes
Debt instrument where final payment is based on the return of a stock
Easily invested and divested
Unsecured debt instrument
Do not offer current interest payments or a fixed return at maturity
Capital market
Anything that has a return set for a year plus in advance
Principal protected notes
FINRA has cautioned that no one should Market that 100% of principal is protected
Primary dealers in US government securities are selected by
The Federal Reserve Board
Guarenteed bonds
Guaranteed of payment by another corporation
Euro dollar bonds registrations
Do not have to be registered with the SEC
Loose money
Interest rates fall in loose money periods
Corporate bond prices rise
If a Bond is called
The call price and the market value of the bond will converge
So it’s a question of whether the call or conversion price is higher
