Chapter 4: Debt Instruments Flashcards
Moody’s and S&P’s Ratings
S&P Moody’s
AAA Aaa Investment Grade - can be purchased by banks
AA Aa
A A
BBB Baa
BB Ba Non-investment Grade
B B
C Caa
D
S&P uses a plus and minus scale on their ratings.
For example, A+ is better than an A rating and A- is lower than an A rating.
Moody’s uses a 1, 2, 3 scale.
For example, A1 is better than A2 and A2 is better than A3
Credit risk
The risk that an issuer may become unable to meet interest or principal payment on its bonds.
A.k.a. business risk or default risk.
Evaluate risk by checking credit rating, the Moodys or S&P
Inflation risk
The risk that an investment value is negatively affected by inflation.
A.k.a. purchasing power risk or constant dollar risk.
Reinvestment risk
The risk that in a falling interest rate environment, bond proceeds must be reinvested at lower rates, reducing the investor’s yield.
Example: as bonds in a bond fund mature, if current rates are lower than preceding rates, new bonds are purchased with a lower return. Reduces income.
Zero-coupon bonds and risk
Bonds that are purchased at a steep discount, and then are paid out at par at maturity. There are no payments throughout the term of the bond. Guarantees a yield over the life of the bond, thus eliminates some types of risk.
Call risk
The risk that a callable bond will be redeemed by the issuer before maturity
Currency risk
The risk that changes in the US dollar/foreign currency exchange rate negatively impact to security.
Applies to a security market value is denominated in a foreign currency, or who’s interest are dividends are paid in a foreign currency.
Liquidity risk
The risk that an asset cannot be sold quickly, or that selling quickly will result in a substantial loss.
Infrequently traded securities have more liquidity risk than heavily trading securities, because there is a smaller market for them.
Marketability risk
The risk of being unable to buy or sell a security that’s sustaining a loss. Applies to thinly traded securities.
Similar to liquidity risk, except that market ability is not concerned with the price, more the ability to buy and sell.
Legislative risk
The risk that changes in the law will negatively impact the value of security.
Example: an adverse ruling by the FDA concerning a new drug and caused the stock of the drugs manufacturer to decline in value.
A.k.a. legal risk or legislative risk.
Term bonds
All bonds are issued at once, and mature at once. Priced as a percentage /points of par value.
Example: term bond quote of 98 means 98% of par value, or $980.
Serial bonds
All of the bonds are issued at once, but they mature in increments over several years. Example: a $1 million bond matures at $200,000 increments over five years.
Can be quoted, as either percentage yield or basis points.
Note that bonds of differing maturity dates in the same issue, may have different yields based on the number of years to maturity.
Nominal yield, a.k.a. coupon rate, a.k.a. stated rate
The rate which the issuing corporation has contracted to pay interest throughout the life of the bond. Never changes. Will pay the stated interest rate until the bond matures and is extinguished.
Current yield
Divide the annual interest by the current market value, rather than the par value of the bond. Example:
$1000 face value, current yield 10%, price $900
Current yield = $100/$900 = 11.11%
Yield to maturity
Is a percentage. Total return that would be realized if the bond were held until the maturity date. A.k.a., the overall return for the investor measures the total performance of the bond.
Yield to call
The performance of a callable bond from purchase to the call date. 
YMCA
Y - current yield
M - yield to maturity
CA - yield to call
Quoting bond rates to customers
Must quote the lowest rate to a customer. Remember YMCA.
Lowest will be:
-Yield to call for bond trading at a premium
-Nominal yield for bond trading at a discount
Standardized yield (a.k.a. SEC yield)
Measure of the current net market yields on a bond’s investment portfolio. Based on the net investment income for the 30 day period ending on the last day of the previous month, divided by the highest offering price on that last day,
OR
The SEC yield is a standard yield calculation developed for fair comparison of bonds. The yield calculation shows investors what they would earn in yield over the course of a 12-month period if the fund continued earning the same rate for the rest of the year.
Accrued interest
Bond interest is paid in arrears in six month periods.
If a bond is sold somewhere in the middle of the six month period, the buyer owes the seller the first portion of the interest within that period. Thus, the buyer is paying the seller for the bond plus accrued interest from the current six month period.
Accrual period is the last interest payment date up to, but not including, the settlement date.
Bond settlements and accrual period differences
Corporate, municipal, and government agency bonds = T+2. To calculate the accrual period, every month is considered to have 30 days in every year has 360 days.
Government notes and bonds = T+1. To calculate the accrual period, assume the actual number of days in the month and actual number of days in the year.
Secured corporate bonds
Are backed by collateral. Ex: Mortgage bonds are backed by liens or mortgages on real property.
– Open-end bond: allows the corporation to issue subsequent bonds secured by the same property at a later time. New bonds have equal claim to the collateral, so more bonds have claim to the same collateral, thus are more risky.
- Closed-end bond: specify maximum indebtedness issued against the same lien. Are considered safer.
Bond trust indenture
Contract between the issuer and the trustee, who acts on behalf of the bond holders. Must designate open versus closed end bonds.
Equipment trust certificates
Bonds are secured by equipment, usually railroads and airlines. Are historically secure.
Collateral trust certificates
Backed by securities of a different issuer. Example: Dell owns shares of Intel stock. Dell might use the Intel stock to secure the bond.
Unsecured bond (a.k.a., debentures)
No collateral, backed by full faith and credit of the issuer.
Subordinated debentures
Junior in claim to all other bonds during bankruptcy. Since they have reduced claim right, they are riskier and thus have a higher yield
Guaranteed bond
A debenture bond. Has been cosigned by another entity, who guarantees the bond in the event of default by the issuer.
Is essentially backed by two promises, rather than one.
Convertible bond
Convertible into common stock of the issue were at the bond holders discretion. Thus, value of the bond ends up tied to the stock price, and they are proportionally impacted.
Come with an established, unchanging conversion ratio. Thus, the number of shares that are available never changes.
Step up bond (a.k.a. step coupon bond)
Initial nominal rate increases to a pre-specified higher rate at a certain time. Example: 10 year bond pays 4% for the first three years, then increases to 6% for the remainder.
Income bond
Created by debt renegotiation or bankruptcy proceeding. Not suitable for most investors.
Renegotiated bond terms that no longer pays semi annual interest and won’t unless the issue are returned to profitability. They have no accrued interest. Highly speculative.
Treasury securities
Consist of treasury bills, treasury notes, and treasury bonds.
Considered very safe. Can be marketable, or non-marketable. Non-marketable do not trade in the secondary market and are only redeemed by the issuer.
Treasury bills (T bills)
-Sold at a discount. Mature at par.
– Maturities are maximum of a year. Can be four weeks, 13 weeks, 26 weeks and 52 weeks.
– sold via auctions. Four, 13 and 26 is our auction weekly. 52 auction monthly.
– On secondary market, bid will be higher than the ask. The quotes represent a discount from par, so they represent how much is taken off of the par value of the bond to account for her accrued interest.
Example: if the ask is 7.30, the bond is discounted at $73 from par, this the ask price is $927.
Treasury notes (T notes)
– Two, three, five and 10 year maturities.
-$1000 par, purchased in denominations of $100
– pay semi annual interest
– 1/32 increments.
Treasury bonds (T bonds)
End maturity is greater than 10 years
– $1000 par value, sold in $100 denominations.
– pay semi-annual interest
-quoted in 1/32.
Example: quote of 102.20 is $1026.25
TIPS (treasury inflation protected Security)
-Principal is adjusted for inflation per CPI semi annually
– Taxed as ordinary income in year it is adjusted for inflation.
– Five, 10 and 30 year maturities.
The face value is adjusted for inflation and the interest rate is fixed. Assume $1000 TIPS with a 4% interest rate. If inflation is 12%, the face value is adjusted up by $120. 4% interest is paid on $1120. Both the increase in face value and interest earned are taxed. Both the inflation adjustment to the face value and the interest are paid semiannually.
STRIPS (Separate Trading of Registered Interest and Principal of Securities)
– Zero coupon bond sold at a discount.
- Sold directly from the US Treasury
-Sold at discount, mature at par
– Accrete in value
– increase in value is considered income
- Backed by full faith and security of the US government
Treasury receipts (TRs)
- zero coupon bonds
- sold by broker/dealers
- sold at discount, mature at par
- not backed by full faith and security of US government
GNMA
- Government National Mortgage Association
- Buys FHA, VA and Farmer’s Home Administration insured mortgages
- Bonds: Modified mortgage-backed securities with $25k minimum
- Quotes in 1/32s, settle T+2, use 30 days/mo
- Interest: monthly
Government owned within HUD. Only agency that is government guaranteed.
