FI: Bond sectors and instruments

Question 1

Sovereign debt =

4 methods of issuance

Answer 1

local vs external currency issuance: local is often higher rated given ability to ‘print’ money to pay obligations

regular cycle auction - single price: highest price that the entire issue can be sold at is given to all bidders (used for UST)

regular cycle auction - multiple price: winning bids receive the price that they bid.

ad hoc auction: auction when advantageous for the government

tap system: issuance and auction of bonds identical to previously issued bonds - bonds will be sold periodically, not on a cycle.

Question 2

T bills =

Answer 2

less than one year maturity, pure discount securities/implicit interest ie there are no coupon payments.

4 week (28 days), 3 month (91), 6 month (182) - variable by one day due to holidays.

Question 3

T notes and bonds =

Answer 3

2, 3, 5, 10, 20, 30yrs (20 & 30 are bonds)

semi annual coupon payments

callable bonds have not been issued since 1984

quoted in 32nds of a percent on the 2nd market

Question 4

TIPS =

Answer 4

5, 10, 20 yrs.

semi annual coupon payments at a fixed rate (of the inflation adjusted par value)

par value of the bond is adjusted semi-annually by CPI

increase in par from adjustment is taxed as income

principal paid at maturity will be the final inflation adjusted par value, unless below 1000 - this is the minimum repayment amount.

Question 5

Off and On the run =

Answer 5

off the run issues are older issues that have been replaced by more recently (on the run) issued bonds

well off the run means even older bonds.

distinction is that on the run issues are more actively traded and thus more liquid - providing better info about current yields

Question 6

Strips =

SEPARATE TRADING OF INTEREST AND PRINCIPAL SECURITIES

Answer 6

1985 treasury began allowing dealers to buy large amounts of notes and bonds and strip them apart.

this allows the creation of zero coupon bonds from ALL OF THE COUPON PAYMENTS AND THE PRINCIPAL PAYMENT

coupon strips: separated coupon payments

principal strips: separated principal payments (bp for bonds, np for notes)

strips are taxed at their implicit interest rate - results in negative cash flows in years prior to maturity (tax is owed on the implied income, even if not received until maturity)

Question 7

AGENCY securities =

Federally related institutions

GSEs - govt sponsored enterprises

+

Debentures

Answer 7

FRI - such as ginnie mae and TVA - in general these securities are backed by the full faith and credit of the US govt, if not they are free from credit risk.

GSEs - include federal farm credit system, Fannie Mae, Freddie Mac, Sallie Mae. Privately owned but publicly chartered organizations - provide exposure to minimal credit risk.

Debentures - securities not backed by collateral (unsecured), commonly issued by GSEs - can be coupon paying or discount securities.

Question 8

MBS =

Answer 8

pools of mortgage loans provide collateral and cash flows.

Issued by gnma/fnma/fhlma as passthroughs, CMOs and stripped MBS - who guarantee cash flows (by having criteria of mortgages they purchase)

SECURITIZATION combines obligations together to make MBS - primary reason is to make the debt more attractive to investors and to increase availability of funds for mortgages.

Payments are either 1) periodic interest 2) scheduled repayment of principal 3) prepayment above 2

Question 9

Pass throughs =

Answer 9

passes payments made on the mortgage through the security holder

has prepayment risk, but significant diversificiation

however, when rates FALL holders of pass throughs can expect increased prepayment

Question 10

CMOs =

Answer 10

created from mortgage pass through certificates - aka derivative MBS as they are derived from simpler MBS strucuture.

has TRANCHES - where some tranches may not receive any principal repayment until others have been completely paid off (although will receive interest payments)

tranches can be used to group cash flows primarily (un) affected by prepayment risk to sell to investors that want to have exposure to or avoid prepayment risk.

can also be used to group different maturities into specific pools.

Question 11

stripped MBS =

Answer 11

PO or IO - prepayment or interest only.

Interest only MBS will receive less total payments in the case of prepayments as there will be a smaller outstanding principal on which interest payments need to be paid.

Question 12

Munis =

serial bonds

taxable/exempt

Answer 12

serial bonds are when a larger issue is split up into different coupons/maturites

capital gains are not tax exempt - coupon payments can be

if bonds meet certain criteria they are FEDERALLY TAX EXEMPT

most states treat their own bonds as TAX EXEMPT (for residents that own them)

Question 13

Munis #2 =

GO - limited and unlimited tax

• double barrelled*
• appropriation backed*
• public credit enhancement program*

Revenue bonds

Answer 13

unlimited tax is the most secure GO bond - state can raise any taxes to make payments

db - backed by the issuing authority’s taxing power and additional measures

apr. backed - backed by ‘moral obligation’ of the state

PCEP - guaranteed by state or fed govt, normally funding improvement in state’s school system

Rev - do not require voter approval, fall outside any GO bond debt limits. if project does not generate enough revenue then the issuer is not obligated to pay - thus more risk (generally)

Question 14

Munis: Pre-re’s and Insured bonds =

Answer 14

Insured bonds: guaranteed by a third party, normally improves credit rating/liquidity. More common in rev bonds and smaller GO issuers.

Pre refunded bonds: Treasury securities have been purchased and placed in escrow to back future payments - thus likely to have little or no credit risk.

Question 15

Credit ratings of corporate debt =

Answer 15

based on 4 Cs:

CHARACTER of issuer

CAPACITY to repay

COLLATERAL provided

COVENANTS of debt issue

factors considered are quant and qual, for both the firm and the specific debt issue

Question 16

Secured debt =

Answer 16

backed by plege of assets/collateral, such as personal property, real property, financial assets (collateral trust bonds)

bondholders hold a LIEN on pledged property.

Question 17

Unsecured debt =

Answer 17

not backed by pledge of specific collateral, but a general claim against assets - they are aka debentures

if assets sold generate more than the funds required to pay back secured bondholders, this excess will pay back unsecured holders

can be covered by credit enhancements: third party guarantee (such as from a parent company), letters of credit, bond insurance

Question 18

Medium-term notes =

not necessarily medium term or notes!

MTNs

Answer 18

MTNs do not need to be sold all at once (registered under SEC rule 415 - shelf registration)

they can have different maturities/coupons

sold on a best efforst basis by an agent

these differ from a typical corporate bond issue - sold all at once, underwriter guarantees sale of complete issue, one coupon rate and maturity

Question 19

Structured notes =

Answer 19

bond + derivative

ie structured note that has return characteristics of an equity by adding an equity swap

allows inst investors to get around limitations on what they can purchase and reduces borrowing costs of issuers

Types include:

step up notes -

inverse floaters -

deleveraged floaters - coupon rate equals a fraction of the reference rate plus a spread

dual-indexed floaters - coupon based on the difference between two reference rates

range notes - coupon equals the reference rate if it is within a range, otherwise coupon is 0

index amortizing notes - some principal is paid off before maturity based on the level of the ref rate

Question 20

CP: directly vs dealer placed =

Answer 20

Commercial paper is short term unsecured debt issued by corporations - allows them to borrow cheaper than from a bank.

<270 day maturity is exempt from SEC reg.

no active secondary market in CP.

typically pure discount security.

issuers will often have open lines of credit in case they cannot reissue and need to borrow to pay off outstanding paper.

DIRECTLY PLACED: large issuers will deal directly with a group of regular large scale CP buyers.

DEALER PLACED: sold to purchasers through a cp dealer.

Question 21

Negotiable CDs =

Answer 21

CDs are issued by banks and sold to their customers. Similar to a bank deposit in that they pay back the initial amount plus interest.

there is normally a PENALTY for early withdrawal - although NEGOTIABLE CDs can be sold on the secondary market at any time.

negotiable CDs issued by US banks are termed DOMESTIC CDs, as opposed to EURODOLLAR CDs, issued by non US banks in USD - which pay interest of LIBOR!!

Question 22

Bankers’ Acceptances =

Answer 22

guarantees by a bank that a loan will be repaid - used as part of a commercial transaction, especially international trade.

not typically traded on the secondary market, thus not that liquid and typically held to maturity.

discount instrument based on the amount to be paid in X days - will trade at the discounted present value.

credit risk of a BA is that the bank guaranteeing and/or the party they are guaranteeing do not make their promised payment.

Question 23

ABS =

SPV

Reason for issuing an ABS

Answer 23

similar to MBS but backed with (typically) auto and bank loans and corporate receivables.

a SPECIAL PURPOSE VEHICLE is used to hold the collateral assets - a legal transfer of assets - potential to increase credit rating as the bankruptcy of the issuing corporation won’t affect cashflows - BANKRUPTCY REMOTE ENTITY

allows a company to issue debt that is HIGHER RATED than the company’s unsecured debt - which decreases borrowing costs.

Question 24

CDOs =

Answer 24

debt instrument that uses other debt obligations as collateral/source of cash flows.

has TRACHES like a CMO

issued as an ARBITRAGE CDO - where the issuer aims to profit on the spread between the cash flows from the underlying assets and the amount promised to the CDO holder.

or as A BALANCE SHEET CDO - for companies trying to reduce loan eposure on its balance sheet.

Question 25

Placing bonds in the primary market =

FIRM COMMITMENT

BEST EFFORTS

NEGOTIATIED OFFERING VS AUCTION PROCESS

Answer 25

firm commitment vs best efforts

FC is aka a bought deal - syndicate can pre sell to institutional clients to reduce risk, and hedge interest rate risk for the period they anticipate holding any excess securities for.

in a negotiated offering the issuing company and lead investment bank agree on price.

an auction process is when investment banks bid a yield/price they can sell the new issue at - lowest yield will win

Question 26

Placing bonds in the primary market: 144A =

Answer 26

144A securities are PRIVATE PLACEMENT as opposed to underwritten and sold publicly.

avoidance of SEC registration, as in the case of 144As, is valuable to the issuer.

a slightly higher interest rate is required as compensation for the lower liquidity in private placement issues.

Question 27

Secondary market =

Answer 27

includes OTC, exchanges and electronic trading networks

Traditionally most secondary market activity was transacted in dealer markets

More bonds are now traded electronically due to the capital required to fund bond trading and (apparently) decreased spreads for dealers.