Module 2 - Corporate Debt Securities Flashcards
1
Q
Corporate Debt Securities
A
Issued by corporations to raise CAPITAL (money) to fund their operations
2
Q
CORPORATE BONDS
A
Debt securities that have more than one year to maturity. Corporate bonds are often referred to as FUNDED DEBT to differentiate them from the short-term debt obligations of a company
3
Q
CORPORATE NOTES
A
Short-term debt securities with maturities of less than one year, usually less than 270 days
4
Q
BONDHOLDER
A
A person who holds (owns) bonds of a corporation and is considered a creditor of the issuer
5
Q
If a corporation goes bankrupt, bondholders have a claim to the assets of the corporation for repayment of their principal and interest. Secured bondholders’ claims have priority over any general creditors’ claims
A
Remember for Test
6
Q
Bondholders have no voting rights or control over management of the corporation
A
Remember for Test
7
Q
Corporations issue two types of bonds:
A
- Interest-bearing
* Non-interest-bearing, or zero-coupon bonds
8
Q
Interest-bearing bonds
A
- Corporations usually issue bonds that pay interest to the bondholder (in contrast to dividends, which are paid on stocks). Interest payments on bonds are usually made semiannually, although some will pay the interest only at the bond’s expiration, called the MATURITY DATE.
- The principal amount, known as the FACE VALUE, is paid at maturity. All bonds today have a face value of $1,000, and are sold in multiples of $1,000.
- The interest that the corporations pay is called the NOMINAL YIELD, or more commonly called the COUPON or the RATE.
- Corporations try to issue the bonds with interest rates as low as possible to keep their own capital costs as low as possible.
- Corporations usually make the bonds CALLABLE, allowing the corporation the ability to repurchase the bond before the bond matures, especially if interest rates are high at the time the bond is issued (to be discussed later in this module).

9
Q
Non-interest-bearing bonds (also known as ZERO-COUPON BONDS)
A
• Zero-coupon bonds pay no interest during their life. Instead, they pay all the interest upon maturity. ZEROS, as they are called, are sold at a discount. This means they are sold at less than face value. When the bonds mature at face value, the difference between the purchase price and the maturity price becomes the interest on the bond.
10
Q
Bonds are generally classed as follows:
A
• SHORT-TERM BONDS mature in one to five years.
• MEDIUM-TERM BONDS mature in five to 12 years.
• LONG-TERM BONDS mature in over 12 years.
Notes and bank loans are short term
11
Q
TRUST INDENTURE ACT OF 1939
A
An amendment to the Securities Act of 1933 that requires all corporate issues of $10 million or more to be issued under an INDENTURE
12
Q
TRUST INDENTURE or DEED OF TRUST
A
The indenture is a promise by the issuer. Essentially, the INDENTURE is an agreement between the issuer and the bondholders that is overseen by the trustee, who may take legal action if the issuer fails to live up to the promises (covenants) made to the bondholders
13
Q
Trust Indenture
A
States who is assigned as the trustee, and outlines what the trustee will do
14
Q
The trustee has the responsibility to protect the bondholders.
A
Remember for Test
15
Q
PROSPECTUS, or OFFERING CIRCULAR
A
- A document that is used to describe the terms of the bond, the disclosures of risk, and the use of the proceeds from selling the bonds.
- The prospectus will also include background information about the issuer
16
Q
The indenture will indicate:
A
• If the bond is callable or convertible into shares of common stock, as well as any other ownership matters pertaining to the bond
• Authorized amount issued
• Form of the bond (registered or book-entry)
• A description of the collateral backing the bond, if any
• PROTECTIVE COVENANTS (promises), SINKING FUND PROVISIONS (an account managed by the bond trustee for the purpose for repaying bonds), and conversion provisions
- Duties and privileges of the trustees, issuers, and the bondholders
17
Q
The issuer and the trustee who protects the rights of the bondholders execute the bond indenture
A
Remember for Test
18
Q
CORPORATE BONDS may be issued in one of two ways.
A
• REGISTERED BONDS — The name of the owner is listed on the bond certificate. Interest is sent to the person whose name is on the bond and registered with the issuer. These are still being
issued.
• BOOK-ENTRY BONDS — No certificate is issued to the bondholder. The trustee and the transfer agent track the owner of the bond, interest payments, and any other matters that pertain to the bond.
19
Q
The certificate shows the name of the issuer, the type of bond, the interest rate, and the maturity date. These four items must be visible and readable when a bond is presented for “good delivery.” If any or all are not readable, the bond must be sent to the trustee to be validated.
A
Remember for Test
20
Q
Bonds are issued in denominations of $1,000, and are traded in increments of $1,000. Prices, though, are quoted in terms of a percentage of par with increments of 1 point, where 1 point equals $10 (e.g., 98 would mean that the investor pays $980 for a $1,000 face value bond.)
A
Remember for Test
21
Q
SECURED BONDS
A
Backed by a specific property, such as land, buildings, or some other type of security that can be used as collateral. The most common secured bonds are the various mortgage bonds
22
Q
MORTGAGE BONDS
A
Backed by real estate owned by the company.
23
Q
Guaranteed bonds
A
Issued by one corporation but guaranteed by a second against default of interest and principal by the issuing corporation. If the issuing corporation defaults by not being able to pay interest or principal, the bondholders can rely on the second corporation as backing for the principal.
24
Q
EQUIPMENT TRUST CERTIFICATES
A
- Bonds that are backed by rolling stock (movable equipment), such as railroad cars, equipment, and airplanes.
- Risky since they are only backed by rolling stock.
25
DEBENTURE BONDS
Only backed by the “full faith and credit” of the issuing corporation
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SUBORDINATED DEBENTURE BONDS
Unsecured bonds that have no backing except the “full faith and credit” of the corporation.
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INCOME BONDS are also called ADJUSTMENT BONDS
Income bonds do not have to make interest payments unless there is sufficient income to the corporation
28
COLLATERAL BOND
Issued by a corporation when it uses the securities of another issuer as collateral to secure a bond. Often the securities have been issued by a very strong corporation
29
TRADING FLAT
- indicates that the bond issuer is not paying interest to the bondholders of the corporation
- All adjustment bonds trade flat. They do not trade with accrued interest because the corporation cannot assure bondholders that interest will be paid.
30
CALLABLE BONDS
- Can be repurchased by the issuer at a stated call price and date before maturity
- A callable bond allows the corporation to “refund” its debt at a lower interest rate.
30
CALLABLE BONDS
- Can be repurchased by the issuer at a stated call price and date before maturity
- A callable bond allows the corporation to “refund” its debt at a lower interest rate.
31
Paying off outstanding bonds with the proceeds of a new issue is called REFUNDING the issue. Bonds are called “funded debt” and when refunding is occurring, the company is “funding the debt over again.” You may know this as “refinancing.”
Remember for Test
31
CALL PROTECTION
A method of protecting the investors who have purchased the corporate bonds. Generally, the issuing corporation includes a provision in the trust indenture that the bonds cannot be called for a certain period of time (for example, the first five years). Since corporations tend to call outstanding bonds when interest rates are falling, the longer periods of call protection are more valuable to buyers.
32
SINKING FUND
A corporation may set up a SINKING FUND in which it will place excess income in order to have the cash available when the bonds can be called.
32
SINKING FUND
A corporation may set up a SINKING FUND in which it will place excess income in order to have the cash available when the bonds can be called.
33
CALL PROTECTION
A method of protecting the investors who have purchased the corporate bonds. Generally, the issuing corporation includes a provision in the trust indenture that the bonds cannot be called for a certain period of time (for example, the first five years). Since corporations tend to call outstanding bonds when interest rates are falling, the longer periods of call protection are more valuable to buyers.
34
CONVERTIBLE BONDS
- Can be converted into shares of common stock if the bondholder chooses to do so
- If the underlying stock has appreciated above the conversion price and the corporation calls the convertible bonds, holders of these bonds convert them to stock instead of accepting the call price. This is known as FORCED CONVERSION
38
ANTIDILUTION CLAUSE
To ensure that the company will always increase the conversion ratio and decrease the conversion price, the indenture of a convertible bond should contain an ANTIDILUTION CLAUSE.
39
YIELD
The amount of investment return earned on debt instruments expressed as a percentage
40
For bonds, there are four yields to consider:
* Nominal yield
* Current yield
* Yield to maturity
* Yield to call
41
Nominal Yield
- Also known as the NOMINAL RATE, COUPON, or COUPON RATE, is the amount of interest per $1,000 the bond pays every year to the bondholders, expressed as a percent
- The amount paid yearly in two payments
- The rate of interest is stated on the face of the bond and is a fixed annual rate. Remember, the bond interest is paid semiannually
42
CURRENT YIELD
- The effective yield based on the price of the bond
- an indication of the amount an investor receives in relation to the actual cost of the bond based on its current market price. Remember, the current yield is “what you currently get for what you would currently pay!”
- The current yield is CALCULATED by dividing the amount the investor receives each year in interest by the current market price.
43
YIELD TO MATURITY (YTM)
- The yield an investor receives based upon: The amount of interest being paid each year, the gain or loss over a period of years, and the cost of the bond. (This formula is not tested; however, the relationship of yield to maturity to other yield measurements is tested.)
- Yield to maturity is more often referred to as “basis” than as yield to maturity (or YTM).
44
Remember that yield to maturity and current yield move in the same direction, but yield to maturity moves to a greater degree when the price of the bond changes
Remember for Test
45
For a bond trading at a premium, the order of the yields from high to low is nominal, current, and basis (think it as being in inverse alphabetical order: N, C, B — Nominal, Current, Basis).
Remember for Test
46
For a bond trading at a discount, the order of the yields from low to high is also nominal, current and basis (again, think of it as being in inverse alphabetical order: N, C, B — Nominal, Current, Basis).
Remember for Test
47
YIELD TO CALL
Calling a bond (unless it is trading at par) will affect the investor's yield, because the call is effectively changing the maturity date.
You need to know the following three points:
1.The yield to call will move in the same direction as the yield to maturity, but will move further in yield, up or down.
2.When a bond trades for less than par (at a discount price), the YTM will be higher than the nominal yield (a profit at maturity that must be taken into consideration), and the yield to call (YTC) will be higher than the YTM.
3.When a bond trades for more than par (at a premium price), the YTM will be lower than the nominal yield (there will be a loss at maturity), and the YTC will be lower than the YTM.
48
For a bond trading at a premium, the order of the yields from high to low is nominal, YTM, and YTC (think it as being in inverse alphabetical order: N, M, C — Nominal, Maturity, Call).
Remember for Test
49
For a bond trading at a discount, the order of the yields from low to high is also Nominal, YTM, and YTC (again, think it as being in inverse alphabetical order, N, M, C – Nominal, Maturity, Call).
Remember for Test
50
YIELD ON PAR BONDS
- The current yield and the yield to maturity (basis) of a bond purchased at PAR will be equal to the coupon rate (nominal yield). Since the purchase price is the same as the maturity price, there is no gain or loss due to the lower or higher cost in the case of a premium or discount priced bond. So all four yields will be the same:
- NOMINAL YIELD = CURRENT YIELD = YIELD TO MATURITY = YIELD TO CALL
51
The order of all four yields will be: N, C, B, M, C — Nominal, Current, Basis, YTM, YTC.
Remember for Test
52
Remember: High quality = Higher price and lower yield.
Remember for Test
53
If the present interest rate is higher than the nominal yield (coupon rate) of the existing bond, the demand for the bond will be lower, and the price will decrease.
Remember for Test
54
If the present interest rate is lower than the coupon rate of the existing bond, the bond will be in greater demand and its price will increase.
Remember for Test
55
In effect, when interest rates go up, bond prices go down. When interest rates go down, bond prices go up. This is known as the inverse relationship of bond yields and bond prices, or as we call it, the teeter-totter effect.
Remember for Test
56
PREMIUM BOND
Bond that is priced at a premium, sells for more than par.
57
When interest rates drop, bond prices increase due to high demand.
Remember for Test
58
When interest rates increase, bond prices decrease due to low demand.
Remember for Test
59
DISCOUNT BOND
Bond that is priced at a discount, sells for less than par
60
The YELLOW SHEETS
- A daily list of all Over-the-Counter or OTC, (bonds not listed on the NYSE), corporate bonds and are published by the National Quotation Bureau.
- The list has some quotes from the previous day, but for the most part, the Yellow Sheets are simply information sheets that tell the trading desk which various broker/dealers are willing to trade the particular OTC bond
61
Yellow Sheets
Unlisted corporate bonds
62
Pink Sheets
Unlisted corporate stocks
63
Corporate bonds are quoted in dollars and cents as a percent of par
Remember for Test
64
Although a bond price is quoted in decimal form, it represents a percentage of par that translates into dollars and cents. For example, a bond quote of 96.55 means the bond is trading at 96.55% of $1,000, meaning the price of this bond is $965.50. To convert a decimal quote to the price of the bond, just move the decimal to the right one decimal place
Remember for Test
65
CONVERSION FORMULA for CONVERTIBLE BONDS
Compares the value of a convertible bond and the value of the underlying stock of that corporation. CONVERTIBLE BONDS may be converted into shares of stock of the corporation at any time after the bonds are issued up until the maturity date or the date the bonds are called, but only at the direction of the investors
66
The bonds are convertible into a set number of shares of common stock, called the CONVERSION RATIO, at a set CONVERSION PRICE. No matter what the price of the bond is in the open market, the bondholder will always be able to receive a set number of shares per bond
Remember for Test
67
CONVERTIBLE BOND ARBITRAGE
- If the bond does not increase in value, investors can buy the bond at a low price, convert the bond to stock, and sell the stock in the open market at a price that would be higher than the value of the bond. This would be a CONVERTIBLE BOND ARBITRAGE.
- A convertible bond arbitrage can only happen when the bond is at a discount to stock parity or the stock is at a premium to bond parity.
68
CONVERSION PRICE
- The price at which the bond can be converted into stock.
69
The conversion price is divided into 1,000, the face value of the bond, to determine the number of shares for each bond (called the CONVERSION RATIO).
Remember for Test
70
CONVERSION RATIO
- Conversion ratio: NUMBER OF SHARES × SHARE PRICE = BOND PRICE
- The number of shares into which the bond can be converted. Most convertible bonds state the conversion price, but sometimes a corporation will simply assign the number of shares of stock into which the bond is convertible without stating the conversion price.
- In instances where a conversion ratio is given, the number of shares that the bond can convert to will allow you to determine the conversion price
71
Reverse convertible bonds
- Similar investment vehicle to a convertible bond, except they are convertible for the issuer to exercise
- Reverse convertible bonds are short-term, high-yielding debt issues that could turn into stock or cash and are worth far less than the original purchase price of the bond.
72
Issuers of reverse convertible bonds have the right, but not the obligation, to convert the bonds at a pre-set date into:
- A specified number of shares of common stock of another company
- Bonds of a specified company
- Cash
- There is tremendous risk because if the bond is coming due and the issuer converts the bonds into the specified stock which has dropped to a very low price, the holder of the bond will now own those shares of stock that are worth far less than was paid for the bond.
- Reverse convertible bonds are usually very high yielding compared to other bonds issued by the same company because of the high risk that the bondholder is taking.
73
INTEREST FOR CORPORATE BONDS
- Computed using 30-day months and a 360-day year
74
Corporate bonds trade and settle in 3 business days.
Remember for Test
75
- The buyer of a corporate bond pays the seller of the bond for all the days of accrued interest from and including the previous interest date, up to but not including the settlement date.
- You must also know that when investors buy a corporate bond, they must pay for it within three business days. If the trade is on Wednesday, Thursday or Friday, the settlement day is the following Monday, Tuesday, or Wednesday, respectively, or five calendar days from the purchase date.
- Bonds generally pay interest every six months to the bondholder of record
Remember for Test
76
DETERMINING THE NUMBER OF DAYS OF ACCRUED INTEREST
TRADE DATE + 3 BUSINESS DAYS (Plus 2 more for a weekend between trade and settlement dates) - PREVIOUS INTEREST DATE
= (NUMBER OF MONTHS × 30 PLUS NUMBER OF DAYS)
Or
= TOTAL DAYS OF ACCRUED INTEREST OWED
77
Many rates affect the interest rates of corporate bonds. They include:
* Prime rate
* Call rate
* Discount rate
* Federal funds rate
78
PRIME RATE
- The base rate upon which U.S. money-center commercial banks compute interest charges on short-term secured corporate loans. When the prime rate rises, bond rates can also be expected to rise; therefore, market prices are expected to drop. The prime rate is considered to be the leading indicator of all the interest rates
79
CALL RATE
The interest rate banks charge broker/dealers for money that will be lent to customers by the broker/dealers for the purchase of securities
80
DISCOUNT RATE
The rate the Federal Bank (“the Fed”) charges for loans to member banks.
81
FEDERAL FUNDS RATE
The rate that one bank charges another bank for overnight lending to meet the Fed’s reserve requirement. This rate is considered the MOST VOLITILE rate because it is frequently a target that the Fed uses to implement monetary policy
82
Financial LEVERAGE
Defined as using borrowed money to make more money than the borrowed money costs in interest
83
- Utility companies are always considered leveraged companies, because they almost always have a large amount of debt in their capitalization.
- Leveraged companies are highly affected by interest rate changes, because the amount of interest they must pay increases as interest rates increase.
Remember for Test
84
DEBT SERVICE COVERAGE
Also known as the fixed charges coverage. This is a ratio comparing the amount of income that will be available for (or cover) the principal and interest payments coming due in a particular year.
DEBT SERVICE COVERAGE = TOTAL INCOME MINUS EXPENSES DIVIDED BY
PRINCIPAL PLUS INTEREST
It is important to remember that:
DEBT SERVICE = PRINCIPAL + INTEREST
85
MONEY MARKET INSTRUMENT
- Any high-quality, readily marketable debt security that will mature in one year or less
- These securities are highly rated investments, which means they are usually low-risk and easily marketable
- Since these securities are short-term and easily marketable (traded in the secondary market), they are called LIQUID SECURITIES and are sought for short-term investing by banks, money market mutual funds, pension funds, corporations, and some individuals. They are not part of the capital market, nor are they considered “funded debt” to a corporation. The only purchasers are investors or other entities with spare cash who want a means of short-term investing.
86
The rating agencies on these short-term debt securities are the same as for long-term debt and municipal debt. They are:
- Standard and Poor’s Rating Service
- Moody’s Rating Service
- Fitch’s Rating Service
- Best’s Rating Service, the one rating company that evaluates insurance companies instead of bonds
87
Types of money market instruments include:
- Negotiable certificates of deposit
- Banker’s acceptances
- Commercial paper
- Repurchase agreements
- Eurodollars and Eurodollar bonds
88
NEGOTIABLE CERTIFICATES OF DEPOSIT (CD'S)
NEGOTIABLE CERTIFICATES OF DEPOSIT (CDs) are bank-issued, short-term debt instruments that are negotiable in the secondary market and can be sold if the holder needs the money. They are issued in amounts from $100,000 to $1,000,000 or more.
- They are issued in bearer form only, for a set period of time.
- To be shown on Nasdaq, they must have a minimum duration of 14 days
- They are quoted in terms of yield.
89
Step-up certificates of deposit
Have fixed interest rates that change at set periods.
90
Step-up CDs are negotiable certificates of deposit that are issued by a bank and can be bought and sold between two investors. Step-up CDs:
- Have market risk, since they can be bought and sold between investors, and as interest rates change, so does their value
- Have a fixed rate of interest for a period of time, and then it rises three or four times during the life of the CD
- Are issued to investors who want the safety of a bank CD, but want the rates to rise, as they are expecting the same rise in rates from other debt securities.
- Are purchased not only by individuals, but by institutional accounts as well.
- Are issued in $1,000 increments up to $99,000 and cannot be redeemed to the issuing bank prior to maturity.
91
BANKER’S ACCEPTANCES
- A short-term note used to facilitate foreign trade in the United States
- The banker’s acceptances are a collateralized time deposit, meaning that they are issued for a period of time, usually 90 to 180 days, and are technically backed by the collateral for which they were issued
92
COMMERCIAL PAPER
- An unsecured note issued by a corporation to raise cash for a short period of time. The maturity is for a maximum of 270 days, but can be for 30 to 89 days, 90 to 119 days, 120 to 179 days, or 180 to 270 days.
- Commercial paper notes are issued in multiples of $1,000, ranging from $5,000 to $5 million, with some even exceeding that amount. Two types are issued — those issued through GMAC (General Motors Acceptance Corp.), and those issued directly by any corporation in need of cash for a short period of time.
- Commercial paper is purchased by other corporations, banks, insurance companies, mutual funds, or any big investor who has a large amount of cash for a short period of time and wishes to invest it.
- Commercial paper is sold at a discount so it does not pay interest. The registered owners redeem the paper at face value at maturity.
- Commercial paper is issued in book-entry form; the name of the owner is kept on the books of the corporation.
93
REPURCHASE AGREEMENT (REPO)
An agreement whereby a bank sells a broker/dealer a money market instrument, usually a T-bill, with the agreement to buy it back in a certain period of time for a specific (higher) price. Repurchase agreements are generally issued for overnight or up to 10 days, though some are issued for longer durations. There is no maximum duration for repurchase agreements.
94
The main players in repurchase agreements are:
- Broker/dealers — make arrangements between buyers and sellers
- Corporations — either have money or need to borrow money
- Banks — may need money overnight to meet their reserve requirement, or, conversely, may have extra cash
- The Fed — probably the biggest player since it controls an enormous amount of cash invested for short-term investing
95
The overnight repurchase agreements that are traded between banks are especially good because they:
- Have no interest-rate risk
- Have no market risk
- Pay interest equal to the Fed funds rate
96
AUCTION RATE SECURITIES
Debt securities (either corporate or municipal) or preferred stock that have their interest rates change periodically. The shares have varying maturing periods, with a maximum term of one year, after which the interest or dividend, is re-set at a new rate.
- Most ARS are re-set at 7-, 14-, 28-, or 35-day intervals.
- Some have re-set periods that go out to 91 days — semiannual or annual for the next auction
97
ARS have three rates:
1. The maximum rate
2. The Clearing Rate
3. The minimum Rate
97
A Dutch auction offering occurs when:
- An issuer wants to sell shares at a particular price
- The underwriter working with the issuer feels the price will not be well received in the market and suggests a lower price based on the market price for similar securities.
98
Eurodollar deposits are large deposits of U.S. dollars in foreign depositories. Often, because of the stability of the U.S. dollar, these deposits are used to fund international foreign trade
Remember for Test
99
EURODOLLAR BONDS, also called EUROBONDS,
All interest and principal payments are calculated in U dollars. Issuers of Eurodollar bonds include foreign and U.S. corporations and even U.S. state and municipal governments (not, however, the U.S. government)
100
Taxation on Discount and Premium Bonds
- If a bondholder of an interest-bearing bond purchased it in the secondary market and holds it to maturity, two different taxation scenerios develop, depending upon the price paid. The bondholder could have ordinary income, if the bond was purchased at a discount, or a deduction from each year’s interest, if purchased at a premium.
