Module 2: Debt Securities Flashcards
Ways a bond can be issued
registered form, bearer form, and book-entry form.
Registered Form
payments will be made to the owner of record
Bearer form
payments will be made to whoever holds or possesses the bond
Book-Entry form
its record of ownership is held electronically in a central depository, allowing for greater efficiency in bond transactions
Bond Indenture
Formal agreement, or contract, between the issuer and the bondholder
Sinking Fund
A separate fund established and funded each year by the bond issuer; it is designed to accumulate an amount required to pay off the debt at maturity.
OID Bond
A bond that is issued at.a discount
Secured Bond
pledges specific assets that may be sold by the bond purchaser in the event that the bond issuer defaults in paying
Debenture
An bond that pledges no specific assets. Unsecured
Investment Grade
BBB- or higher by SP
High Yield Bond
BB+ or lower
Term vs. Serial Obligation Bond
Term Bond - single maturity date
Serial Obligation Bond - series of maturity dates, each maturity date being a subset of the original issue.
Types of Risk Associated with Bonds (8)
Interest Rate Risk Reinvestment Rate Risk Call Risk Financial Risk Default (Credit) Risk Purchasing Power Risk Liquidity Risk Event Risk
Reinvestment Rate Risk
There is a risk that you are reinvesting the coupon payments at a lower interest rate than the bond you’re receiving the coupon payments from. Zero-Coupon Bonds are not subject to reinvestment rate risk.
Financial Risk
Associated with the level of debt an issuer has outstanding.
Liquidity Risk
MEasured by the spread between the bid price and the ask price quoted by a dealer. The wider the spread, the more liquidity risk.
Event Risk
The possibility that a bond issue will be affected by an unanticipated and damaging event.
Types of Bond Issuer
Federal Government Federal Government Agencies Municipalities Corporations International Issuers
US Treasury Notes
Maturity Dates of 2,3,5,7,10 years
US Treasury Bonds
Maturity of 30 years
US Government Notes and Bonds
Issued at their stated par value and provide semiannual coupon payments. Sold in increments of $100 with a $100 minimum purchase.
- Competitive and Noncompetitive Yield Bids
- Exempt from taxation at both state and local levels, but taxable as ordinary income rates for federal tax purposes.
Competitive yield bids
the Treasury determines the highest yield it must offer to achieve its sales goals
Bond Tax Characterstics (OID)
Original Issue Discount (OID) must be calculated for anyone who did not pay more than the Face Value for their bond. This is considered phantom income, and the investors basis is then increased by the amount of the OID included in income each year.
Types of US Government Securities
- Notes and Bonds
- Treasury STRIPS
- TIPS
- Savings Bonds
- US Government Agency Securities
Treasury STRIPS
zerp-coupon bonds created by separating the semiannual coupon payments and the principal repayment portions of a U.S T-note or T-Bond. Purchased through financial institutions and government securities broker dealers; are not purchased directly fromt he US Treasury.
- Interest onf STIPS is taxed at ordinary income as it accrues, even though no actual interst is paid until the bond matures.
STRIPS Calculation Process
FV = Face Value of the STRIP I/YR = Interest Rate divided by 2 N = Number of years * 2
The reason they are broken down /2 and *2 is because a STRIP is a bond that is broken up into 6 month portions, so we must change the calculation to a twice a year event
TIPS
Marketable security whose principal is adjusted by changes in the CPO. 5,10,30 year maturity issues. The interest payments are determined by ultiplying the inflation adjusted principal value by half of the fixed interest rate. So the coupon rate stays the same but the principal is changed by inflation. At maturity the investor will receive the greater of the original principal r the adjusted principal.
- Tax free at the state and local levels
- Interest and increase in principal via CPI adjustements is taxed at ordinary income federal
TIPS Calculation Process
FV * (1+inflation rate) = New FV
New FV * Fixed interest Rate = new interest rate
Repeat
Savings Bond
Series E, EE, H, HH< and I bonds.
Series EE
Fixed interest rate for life, able to earn interest for 30 years, must be held for a 12 month minimum, 3-month penalty assesed if the bond is redeemed within 5 years of issue. Interest may be excluded from income tax if the proceeds are used for higher education costs.
Series HH Bond
Only be obtained by exchanging EE bonds that were at least 6 months old. Pay semiannual interest in cash for up to 20 years, with no penalty for early redemption.
Series I Bond
inflation indexed with a fixed rate that remains the same for the life of the bond and a semiannual inflation rate based on the changes of the CPI during the previous 6-month preiod. May be redeemed at any time 12 months after the issue date for the principal plus interest accrued. If redeemed with 5 years, there is a 3-month interest penalty. Interest may be excluded from income tax if the proceeds are used for higher education costs.
Government Agency Securities
- Farm Credit Administration
- GNMA or Ginnie Mae - Mortgage backed securities
- PRIVATE: FHLMC or Freddie Mac, FNMA or Fannie Mae, SLMA, or Sallie Mae (indirect backing and guarantee of the federal government)
- Taxable at both federal, state and local levels
Government National Mortgage Association (GNMA)
- Buys Federal Housing Admin and VA mortgages and auctions them to a private lenders who create pass-through certificates for sale to investors.
Federal Home Loan Mortgage Corporation (FHLMC)
- Was created to promote the development of a nationwide secondary market in mortgages by purchasing conventional mortgages from financial institutions and packaging them into mortgage-backed securities for sale to investors.
Federal National Mortgage Association (FNMA)
Competes with FHLMC for investor money int he secondary marketplace. But FNMA is a gonverment-sponsored corporation that is owned entirely by private stockholders.
Mortgage Association Agencies Risks
- When interest rates fall, people refinance, creating a prepayment risk, which means the actual price of the security won’t go up when interest rates go down like a normal bond.
- Reinvestment Rate Risk
- Extension Risk - results from the slowing down of expected prepayments when interest rates increase, which extends the average life of a mortgage and therefore delays the receipt of any rpeviously expected principal.
Mortgage Association Taxability
Part of each monthly payment from the pass-through represents a return of the investor’s own principal. So unless the investor reinvests that portion of each monthly payment, they can unknowingly lose their base of investment capital.
Types of Municipal Bonds
- General Obligation Bonds
- Revenue Bonds
General Obligation Bonds
Issued to finance capital improvements benefiting the community. These improvements do not produce revenues so the principal and interest on the obligation must be paid by the revenues of hte muni issuer. “Full faith and credit” bonds and require taxpayer vote to approve new issues.
Revenue Bonds
Used to finance any muni facility that generates sufficient income to satisfy the ongoing debt obligation. These are more risky the GOs and therefore offer higher yields for similar maturities.
Types of Revenue Bonds
- Industrial development revenue bonds
- Special assessment bonds
- Special Tax Bonds
- New housing Authority Bonds
Industrial Development Bonds
Issued by governments to assist companies with specific projects
Special Assessment Bonds
Financed by those directly benefiting from the project
Special Tax Bonds
Used for specific projects and repaid by special assessments, ad volarem taxes or excise taxes
New Housing Authority Bonds
used to finance rehab or construction of affordable housing
Private Activity (Private Purpose) Bonds
Part of a stat eor local government bond issue, more than 10% of hte proceeds of the issue are used for a private business purpose (like a sports stadium).
Qualified Private Activity Bonds
tax-exempt bonds issed by a local or state government, the proceeds of which are used for a defined qualified purpose by an entity other than the government issuing the bonds. For it to be tax exempt 95% or more of the net bond proceeds must be used for one of several qualified purposes as described in the Internal Revenue Code.
Tax-Equivalent Yield Calculation
Tax-exempt Yield/1-Marginal Tax Rate
After-Tax Yield Calculation
Pretax Return * (1-marginal tax rate)
Corporate Bonds Segments
- Industrials
- Public Utilities
- Transportation Issues
- Financial Issues
Corporate Bonds
Most bonds issued are subordinated int security or safety to all other corporate creditors so they tend to feature higher coupon rates than secured bonds, muni bonds, or US Treasury Securities.
Types of Secured Corporate Bonds
- Mortgage Bonds
- Collateral Trust Bonds
- Equipment Trust Certificates
Yankee Bonds
- Foreign Bonds payable in U.S Dollars (e.g., bonds issued by Deutsche Bank in the United States)
Eurodollar Bonds
- U.S. Pay bond, but do not have to be registered with the SEC. (e.g., bonds issued by Toyota in Japan in U.S. dollars)
Eurobonds
bonds denominated in a currency not native to the country where they are issued.
Promissory Note
-Promise to pay a certain sum of money or make a series of payments to others, usually individuals. All of the interest from a promissory note is taxable to the investor at ordinary income rates in the year earned.
Convertible Bonds
Corporate bonds that may be exchanged for a fixed number of shares of the issuing company’s common stock. They are typically issued by younger, less-established companies. Conversion is excercised at the direction of the investor.
Conversion Price
The stock price at which a convertible bond can be echanged for shares of the issuer’s common stock.
Conversion Ratio
Par Value of Convertible Security / Conversion Price
Conversion Value
= conversion ratio * market price of common stock
Investment Value of Convertible Bond
This is the same as its intrinsic value as a straight bond. Calculate the present value of cash flows from receipts of semiannuel interest payments and from the face value received at maturity
Investment Premium for Convertible Bond
The amount that someone is willing to pay as a premium to have the convertible security over the ‘investment value’ of the bond
Conversion Premium for Convertible Bond
the difference between the market price of the convertible bond and the conversion value. How much more are you willing to pay for the bond than it’s convertible value is worth.
Convertible Bond Downside Risk
If the market price of the underlying stock falls greatly, so could the value of the bond itself. The downside risk of a convertible bond is the dollar or percentage decline from the current market price of the convertible bond to the investment value of the bond. In other words, the investment premiium is the measure of this bonds downside risk.
Forced Conversion
- Because these bonds can have a call option, a company can call the bond at an amount that’s less than the conversion value, forcing the bond holder to either take the worse call value or the better conversion value.
Portfolio Immunization
Interest rate management technique, whih offsets interest rate risk against reinvestment risk. Used by insitiutional investor who have future funding needs targeted by your over a long time horizon. Full immunization takes place when the duration of the portfolio is equal to the investor’s time horizon.
Bond Ladders
Long-term strategy for diversifying and staggering the maturity dates in a client’s bond portfolio.
Bond Barbells
Buying only short and long-term bond issues, which requires active management by the portfolio manager.
Bond Bullets
A strategy for having several bonds mature at the same time, thus minimizing interest rate risk.
Bond Swaps
The process of selling one debt security and replacing it with another. Hopefully to incrase the YTM on the bond portfolio, save on income taxes, or reduce the overall interest rate risk of the portfolio.
Types of Bonds Swaps
- Substitution Swaps
- Intermarket Spread Swap
- Rate anticipation swap
- Pure yield pickup swap
- Tax Swap
Substitution Swap
selling bonds with identical characteristics but different selling prices, price arbitrage
Intermarket Spread Swaps
exchange one type of bond for another type of bond. This happens when an investor believes that ont ype of bond is currently mispriced
Rate anticipation swap
takes advantage of expected changes in interest rates. If rates are going up, switch LT bonds for ST bonds
Pure Yield Pickup Swap
a bond with a lower YTM is exchanged for a bond with a higher YTM.
Tax Swap
motivated by current tax law. One such swap involves gaining from a capital loss by sellin a previously purchased bond at a loss due to rising interest rates.
The smaller a bond coupon rate
the greater its relative price fluctuation
Yield Curve
A graph of interest rate yields for bonds of the same quality, ranging in maturity from 31 days to 30 years. In a normal yeild curve, the difference between ST and LT interest rates is typically 300 basis points
Normal Yield Curve
occurs during period of economic expansion and gnenerally predicts that market intrest rates will rise in the future
Flat yield curve
Occurs when the economy is peaking and, therefore, no change in future interest rates is expected
Inverted Yield Curve
Occurs when the federal reserve has tightened credit in an inflationary economy; it predicts that interest rates will fall and sometimes, it can signal an upcoming economic recession
Term structure of interest rates
AKA the yield curve, is a theory that relates the term to maturity of a sample of same-quality bonds to their YTM at any given point in time.
Yield Curve Theories
- unbiased expectations theory
- liquidity preference theory
- Market segmentation theory
Unbiased Expectations Theory
states that long-term interest rates consist of many short-term rates and that long-term rates will be the average of short-term rates.
Liquidity Preference Theory
Based on the unbiased expectations theory but incorporates a liquidity premium into the model. The thoery holds that long-term bonds should provide higher returns than shorter-term obligations because investors are willing to sacrifice some yield to invest in shot-term bonds in order to avoid the higher price volatility of long term issues.
Market Segmentation Theory
Relies on the laws of supply and demand for various maturities of borrowing and lending. Lenders in each market from commercial banks to life insurance companies need to match their assets, or lending, with their liabilities or debts. The idea being that the shape of the yield curve is ultimately only a function of the investment policies of major institutional investors.
Preferred Stock
A hybrid security with characteristics of both debt and equity securities. Not guarenteed to receive the dividends on the par value of the preferred stock. Corporation must pay dividends to the preferred shreholder before paying a dividend to the common stock shareholder.
Preferred Stock Deduction
In the case of a corporation, there will be allowed as a deduction on amount equal to 70% of the amount received as dividends from a domestic corporation.
Intrinsic Value Calculation
When the dividend is expected to remain constant, the no-growth dividend discount odel may be used to calculate the stocks intrinsic value: V = Dividend0/r
Convertible Preferred Stock
Can be exchanged for commong stock at a conversion ratio determined when the shares are originally issued
Advantages of Convertible Preferred Stock
- The preferred dividend is higher than a common dividend
- The firm is profitable, the investor can share int he profits by converting the shares into common stock
- The conversion option becomes more valuable when the common stock price increases
- Preferred shares have less risk than common shares because the dividend is stable and they have priority over common stock in receiving dividends an din the event of liquidation of the firm
