Chapter 8 - Debt Securities - 5.7% Flashcards
Why invest in Debt Securities?
- Income
- Safety
- Diversification
- Returns
Who are the Issuers of Debt Securities?
Issuers: I - Government Issuers: a) Government of Canada: - Fixed-coupon marketable bonds - Treasury bills - Real-return bonds - Canada Savings Bonds - Canada Premium Bonds b) Federal Agencies and Crown Corporations c) Provincial Government - T-bills - Fixed-coupon marketable bonds - Savings bonds d) Municipal Governments
II - Non-Government Issuers:
a) Corporations
b) Asset-Backed Securities
c) Foreign Bonds and Eurobonds
Foreign Bonds are issued and sold in a domestic market by a non-domestic government or corporation.
Eurobonds are issued in a foreign market and are denominated in a currency other than that of the market where the bonds are issued.
What are the features of debt securities?
Every debt security represents a contract between a borrower (issuer) and a lender (investor). Each contract is normally documented in what is known as an indenture, which outlines the features of the security, the obligations of the issuer, and the rights of the investor under the contract. An indenture will specify, among other things, the following variables: • Amount • Principal repayment provisions • Interest payment provisions • Options
What are two special call features common in the Canadian market?
Fixed-floater bonds: These bonds are frequently issued by Canadian banks and insurance companies to meet specific capital financing needs. They offer a fixed coupon payment
for an initial period, usually five or ten years. After that time, if not called by the issuer, they become floating-rate notes, with the coupon rate reset quarterly, normally at a full
percentage point above the yield of current three-month Bankers’ Acceptances (BAs). Because banks and insurance companies can typically borrow at a floating rate roughly
equivalent to the three-month BA rate, these bonds have never been extended by the issuers beyond the call date.
• Canada yield calls (sometimes known as doomsday calls): This feature allows the issuer to call a bond at a price based on the greater of (a) par or (b) the price based on the yield of an equivalent-term Government of Canada bond plus a specified yield spread. Generally, this spread is less than the spread was when the bond was issued and remains constant throughout the term of the issue. Therefore, if the bond is called prior to maturity and yield spreads remained constant, bondholders benefit from the narrower spread specified by the call. If the bond is not called before maturity and spreads remain constant, the bond’s yield
will closely track Canada benchmark bond yields. If the underlying issue’s spread narrows to less than its Canada call spread, bondholders would still receive the benefit of the spread narrowing, as reflected in its increased value relative to the benchmark.
What is the Ranking of Corporate Liabilities?
In the capital structure of a corporation, an important consideration for debt holders is the order in which liabilities are repaid in the case of bankruptcy and liquidation. Corporate liabilities are normally ranked in the following order:
- First Mortgage Liabilities and Asset-Backed Securities: These liabilities are secured by fixed assets (such as property) and have first right to claim that asset ahead of all other debt holders.
- Secured Debt: These loans are made on the understanding that they will be given first preference in the case of bankruptcy. This normally applies to bank debt, deposit notes, and other secured loans.
- Unsecured Debentures: These debt securities are not secured and are backed only by the corporation’s guarantee and protective covenants. Within this category there can be additional rankings between different debt issues, such as senior and subordinate.
- Capital Securities: This indebtedness ranks below all other indebtedness of the issuer but above equity stakeholders. (Capital securities are discussed later in this chapter.)
- Preferred Shares: These equity stakeholders have first claim on residual assets after all debt holders have been repaid. Their claim is based on the original par value of the preferred share investment.
- Common Shares: These are the final stakeholders in the company.
What are the types of Money Market Securities?
-MONEY MARKET SECURITIES
1. Treasury Bills
Treasury bills (T-bills) are the shortest-term marketable debt instrument issued by governments. They are purchased by investors at a price less than their face value, with the difference between the purchase price and maturity value representing the return to the investor. T-bills trade in $1,000 multiples and are marketable, meaning they can be sold prior to maturity. Government of Canada T-bills are issued by auction, with terms to maturity of approximately three, six, or twelve months.
2. Bankers’ Acceptances
BA is a commercial draft (i.e., a written instruction to make payment) drawn by a borrower for payment on a specified date. A BA is guaranteed at maturity by the borrower’s bank. As with T-bills, BAs are sold at a discount and mature at their face value, with the difference representing the return to the investor. They trade in $1,000 multiples, with a minimum initial investment of $25,000, and generally have a term to maturity of 30 to 90 days, although some may have a maturity of up to 365 days. BAs may be sold before maturity at prevailing market rates, generally offering a higher yield than Canada T-bills.
3. Commercial Paper
Commercial paper is an unsecured promissory note issued by a corporation or an asset-backed security backed by a pool of underlying financial assets. Issue terms range from less than three months to one year. Most corporate paper trades in $1,000 multiples, with a minimum initial investment of $25,000. Like T-bills and BAs, commercial paper is sold at a discount and matures at face value.
What are the different types of Bond Market Instruments?
- Bonds and Debentures:
Bonds and debentures are debt securities issued with a term to maturity greater than one year. Market convention refers to both bonds and debentures by the generic term bonds. These securities represent a contractual promise to repay a principal amount on a specified future date (the maturity date), as well as a predetermined method of paying interest (coupon payments). A bond is secured by physical assets in a trust deed written into the bond contract. Debentures are not secured by a physical asset. Rather, they are guaranteed by a legal contract and have a claim on the residual assets of the issuer only in the case of bankruptcy. - Strip Coupons and Residuals
Since the residual and each coupon represent an obligation of the issuer, it is possible to detach each portion of the physical bond – a practice known as stripping the coupons from the residual – and sell them individually. Under the book-based system, stripping is performed by depositing bonds with a trustee that then separates the bond into its individual components, which are traded as individual securities. When the trustee receives the interest and principal repayments on the original coupon bond, it directs the funds to the individual holders of the stripped coupons and residual. Coupons and residuals are purchased at a discount and mature at their face value, with the difference representing the return to the investor. Because coupons and residuals pay no cash until maturity, they normally offer higher yields than bonds of similar term and credit quality and have the added benefit of eliminating reinvestment risk.
(Take note of Formula)
What are Special Structures?
- Real Return Bonds
An RRB resembles a conventional bond because it pays interest throughout the life of the bond and repays the original principal amount on maturity. Unlike conventional bonds, however, the coupon payments and principal repayment are adjusted for inflation.RRBs have a fixed real coupon rate.6 At each interest payment date, the real coupon rate is applied to a principal balance that has been adjusted for the cumulative level of inflation since the date the bond was issued. On each interest payment date, investors receive a coupon payment equal to the real coupon rate multiplied by the sum of the original principal and the inflation compensation. At maturity, investors are repaid their original principal plus the inflation compensation. The inflation compensation for Government of Canada RRBs is based on the Consumer Price Index (CPI), which is published monthly by Statistics Canada.
When
RRB trades settle on any day other than the first of the month, the current CPI reading is calculated by linear interpolation between the CPI reading from the third previous month and the CPI reading from the second preceding month. - Mortgage-Backed Securities
Mortgage-backed securities (MBSs) are investments that represent ownership of the cash flow from a group of mortgages. In Canada, these mortgages are either residential mortgages insured by the Canada Mortgage and Housing Corporation (CMHC), in which case they are referred to as NHA (National Housing Act) MBSs, or commercial mortgages secured by loans with a first lien (a first claim on the property) and over-collateralization (there are more assets in the pool than the amount of debt issued against the pool). - Commercial Mortgage-Backed Securities
In a CMBS structure, the mortgage pool is divided up into tranches and each tranche has a differing claim on the cash flow of the underlying pool. For example, most CMBS tranches are arranged in different maturity classes. In a typical CMBS structure, every tranche of the CMBS receives interest payments, while only the first pool receives principal prepayments, if any. Once the first tranche’s principal is paid off, the second tranche begins to receive principal prepayments. This occurs sequentially until the principal has been repaid for all tranches. - Issuer Extendible Notes
Issuer extendible notes are debt instruments for which the issuer has the right at certain points (normally the anniversary date of issue) either to allow the bond to mature or to extend the maturity. Essentially, issuer extendible notes are bonds with several embedded issuer call options. Because of the embedded options, most issuer extendible notes provide higher yields relative to bonds of similar term and credit quality.
A client would like to purchase a mortgage-backed security (MBS) that offers a predictable and consistent cash flow stream. What type of MBS would you recommend? A. Fixed MBS. B. Open MBS. C. Straight MBS. D. Closed MBS.
D is correct.
Mortgage-backed securities are identified by two pool types – open or closed. In a closed MBS, early prepayments of principal are not allowed and this makes the monthly payment predictable and consistent. In contrast, mortgagors (i.e., borrowers) in an open MBS do have the opportunity to make early principal prepayments in addition to the regularly scheduled principal and interest payments. Consequently, the monthly cash flow stream in an open MBS is less predictable than the income stream in a closed MBS.
What is true about foreign bonds and Eurobonds?
I. Foreign bonds are sold in a foreign market.
II.Eurobonds are sold in the domestic market.
III.Foreign bonds are issued by a foreign issuer.
III only.
Foreign bonds are issued and sold in a domestic market by a non-domestic government or corporation. Eurobonds are issued in a foreign market and are denominated in a currency other than that of the market where the bonds are issued.
In what way do capital trust securities differ from regular bonds? A. Call features. B. Fixed coupon. C. Par values. D. Repayment features.
D is correct.
Capital securities are considered subordinated debentures that rank below all other indebtedness of the issuer. Although capital trust securities resemble bond issues (they trade in the bond market and have $1,000 par values), they differ from regular bonds in that the repayment of principal can be in the form of preferred shares. Regular bonds do not have this feature.
A client would like to sell her position in XYZ bonds. The current bid/offer spread is quite wide. Other things being equal, what type of risk is demonstrated by the spread on the XYZ bond? A. Timing risk. B. Marketability risk. C. Event risk. D. Volatility risk.
B is correct.
Marketability risk refers to the ease with which a debt security can be sold prior to maturity at or near its true value. The spread on the bid and offer prices is an indication of the overall liquidity of the issue.
If the Province of Alberta issues a U.S.-dollar denominated bond in the United Kingdom, what type of bond issue is this considered? A. Domestic issue. B. Foreign issue. C. Eurobond issue. D. National issue.
C is correct.
Eurobonds are issued in a foreign market and are denominated in a currency other than that of the market where the bonds are issued.
Which of the following represents the correct ranking of corporate liabilities from most to least secure?
A. Secured debt, unsecured debentures, common shares, capital securities.
B. First mortgage liabilities, capital securities, preferred shares, unsecured debentures
C. Capital securities, secured debt, first mortgage liabilities, common shares.
D. First mortgage liabilities, secured debt, capital securities, preferred shares.
D is correct.
Debtholders have the first claim on a company’s assets, while common shareholders have the residual claim. Liabilities secured with fixed assets or property is ranked ahead of unsecured liabilities and capital securities. Given preferred shares’ preference as to assets in the even of bankruptcy, they rank ahead of common shareholders.
Why are first mortgage liabilities normally ranked ahead of other types of corporate liabilities?
A. Because they are secured by fixed assets.
B. Because they have a shorter term and are more liquid.
C. Because they are backed by the corporation’s guarantee.
D. Because they are backed by stringent protective covenants.
A is correct.
In terms of debt holder protection, different types of debt offer various degrees of protection. First mortgage liabilities and asset-backed securities rank ahead of other types of liabilities because they are secured by a pledge of fixed assets or property.
