Unit 2: Individual Securities - Debt Flashcards
1) What are the 3 types of bond maturities?
2) What are the 4 different yields used to describe bond yields?
3) How are changes in bond prices measured?
4) How are changes in yields measured?
The 3 types of bond maturities are:
a) Term Bonds : Term bonds are bonds who’s full principal amount matures at once at maturity.
b) Serial Bonds : Serial bonds are bonds who’s principal is scheduled to be paid back through intervals. Then when the bond matures, it repays the principal amount left.
c) Balloon bonds : Balloon bonds are a combination of term bonds and serial bonds. It repays part of the principal before maturity, but pays off the majority of the principal at maturity.
2) Yield is the interest payment the bond pays.
a) Current yield (CY) : Current yield is the annual yield the bond pays as a percentage of its current market price. CY = Annual Interest Payment / Current Bond Price
b) Nominal yield : is the interest rate that is listed on the certificate at purchase. Coupon is a fixed percentage of the bonds par value.
c) Yield to Maturity : A bond’s YTM is the annualized return of the bond if held to maturity. The YTM is the difference between what the investor paid for the bond and what principal amount they receive when it matures.
d) Yield to Call (YTC) : are for bonds that have a call feature. These bonds can be called by issuers earlier than maturity by paying back the principal amount. YTC calculations reflect the early redemption date and losses for investors if they had bought at a premium and there weren’t enough interest payments to cover the difference, or the limited profit if the bond was purchased at a discount.
3) Changes in bond prices are measured in points. Where each point is 1% of par value.
4) Yields are measured in basis points. Where one basis point is 1/100 of 1%. So if yield were to go up by 1%, it went up by 100 basis points.
1) What are the 3 institutions recognized by the SEC to be major credit rating agencies? How do they rate the debt quality of companies/institutions?
2) What is investment grade debt?
3) What are high yield bonds?
1) the three major credit rating agencies recognized by the SEC, are pitches oldies, and the S&P 500. The standard and pours rate institutions on their debt quality by giving them a AAA, AA, A, BBB, BB, B, C, D. A rating of ‘D’ means the company is in default.
2) Investment grade debt is the debt with a rating of BBB or higher. Since this debit is considered to be of higher quality, the interest payments are much lower as the investor carries less risk.
3) High yield bonds are bonds that have a debt rating of BB or lower. The issuing companies of these bonds have a higher risk of default. Therefore, they have higher returns than investment grade debt and are also known as junk bonds.
1) What features can bonds be sold with?
a) Call feature
b) Put feature
c) Convertible feature : Bonds with a convertible feature are mostly issued by corporate issuers. They give the investor the ability to convert their debt securities into common shares.
What are the 2 different categories of corporate debt? What are the different types from each category?
The 2 different categories are
1) Secured Debt
2) Unsecured Debt.
Secured Debt: Is debt that is backed by some asset as collateral incase the company defaults on interest payments or payment of the principal when the bond matures.
- Mortgage Bonds : companies place real estate that they own as collateral until they are able to pay back the debt that they issued using that real estate as collateral. If the company defaults, those real estate, assets will be liquidated and the debt will be paid off.
- Equipment Trust Certificates : companies will need to raise money for equipment or PPE. Companies will issue equipment, trust certificates, and place the title of ownership to those equipments in a trust most often and bank over the course of a couple years the corporation will pay off its debt and the title of ownership to that equipment will be transferred to the company in the case so that the corporation defaults on its payments the trust will sell the equipment and repay creditors.
- Collateral Trust Bonds : when companies don’t have Real estate or equipment to use as collateral for debt they will place any kind of securities that the company owns either their own or securities, that they own of other companies into a trust most often a bank, and will use the securities as collateral for the step. In case the company defaults, the trust will liquidate those securities in the trust, and repay the debt.
Unsecured Debt (Debentures): unsecured debt, also known as debentures our debt that is issued by corporations where there is no assets as collateral in the case of the company defaults. Generally, unsecured debt is issued based on the credit worthiness. The good faith of the company issuing the debt. Although the promise made by the company to repay the debt is as good as a mortgage bond, repayment is not guaranteed like a mortgage bond.
- Guaranteed Bonds : guaranteed bonds are dead securities issued by a company that has another larger company guaranteeing it. in the case that the issuing company defaults, the guaranteeing company takes on the responsibility of repaying the debt.
- Income Bonds : in combines, are issued by corporations that are most often coming out of a bad financial situation. They issue debt securities with the promise that IF the corporation does well and returns profits, then they will pay back investors. This debt is issued on the good faith of the company, but repayment is not guaranteed.
What is Subordinated Debt? What is the order of liquidation in the case of bankruptcy of a company?
During a liquidation processes, there is certain types of debt that has a higher priority. The debt that has a Lower priority is known as subordinated debt. Often referred to as junior debt. Since subordinated debt have a higher risk, they have higher coupon rates.
The order of Liquidation:
1. Secured Debt
2. Debentures (unsecured debt) (senior debt) and general creditors are second in line.
3. Subordinate debentures (junior debt)
3. Preferred stock holders
4. Common Stock holders
What are the benefits and risks of owning debt securities?
Benefits:
- Income : Secured debt can offer investors a steady and reliable income through the form of interest payments.
- Priority at liquidation : Debt securities have priority at liquidation
Risks:
- Default : The biggest risk to debt securities is that the company may default and is unable to pay interest payments and/or repay the principal amount.
- Interest rate fluctuation : Changes in interest rates heavily impact bond markets and the interest they pay out.
- Purchasing power risk : When a bond pays fixed amounts of interest payments, the purchasing power of those interest payments decreases. Over a long period of time, this loss in purchasing power can be significant.
Municipal Bonds
1) What are Municipal Bonds and what are they issued for? How is interest income from these bonds taxed?
2) What are the different kinds of municipal bonds and how are they funded?
3) What are Short Term Municipal Obligations?
1) Municipal Bonds are local and state issued government bonds, and are issued for the purpose of public works and other local government activities. They are considered safe only second to U.S Treasury notes. Most interest PMTs from municipal bonds are tax free at the fed level, and could also be tax free at the local level if the investor lives in the issuing state.
2a) General Obligation Bonds (GO) : General obligation bonds are bonds that are issued by municipal governments in order to raise funds for public projects that will not have steady, direct income to the municipality. General obligation bonds use the municipalities ability to generate income through the form of taxes, fees, and license fees as collateral. State municipal bonds are backed by state, income taxes, sales, tax, and license fees. City town and county municipalities bond bond are issued with the back of property, taxes, fines, and license fees and other sources of direct income to the entity. General obligation bonds are usually limited, because municipalities have debt limits in which they cannot cross. This is meant to protect taxpayers in the municipality from rising taxes to pay for these bonds. It also limits the risk of default for the investor. If a municipality wants to borrow past their statutory debt limit, they would have to get voter approval through a public referendum.
2b) Revenue Bonds : Revenue bonds are a type of municipal bond that local and state governments will issue in order to raise funds for projects that will provide direct, stable revenue. They are known as self-supported bonds because The revenue generated is used to make interest payments and repay principal amounts.
- These are issued for things like bridges (backed by revenue from tolls).
3) Short term municipal obligations, also known as Anticipation Notes provide municipalities the ability to raise funds for near term operations expenses by issuing debt securities that are based on anticipated revenue. Types of Anticipation Notes:
- TANs
- RANs
- TRANs
- BANs
- CLNs
Treasuries
1) What are the 3 different debt securities issued the U.S Treasury and how are they different in pricing, maturing etc.?
2) What are Treasury Receipts?
3) What are STRIPS?
4) What are TIPS?
5) What are U.S treasury issued debt that are zero-coupon bonds? How are they priced?
1)
- T-Bills : T-Bills are short term debt securities issued by the U.S treasury that mature in either 4, 13, 26, or 52 weeks or less. They do not make any interest payments, but are rather issued at a discount from par value and will mature at the full face value of the bond.
- T-Notes : T-notes are intermediate term bonds. Maturity time is usually within 1 year to 10 years. They make interest payments semiannually.
- T-Bonds : T-Bonds are long term bonds, 10years plus to 30 years. These pay interest semiannually.
2) Treasury receipts are
3) STRIPS, Separate Trading of Registered Interest and Principal Securities, are short term debt securities issued by the U.S treasury that are traded on the secondary market. It is a short term debt security that matures in less than a year and is offered at a discount from par, but pays full FV at maturity.
4)
5) The only zero-coupon DS issued by the U.S treasury are T-Bills and STRIPS.
Agency Issues and Taxation
1) Other than the U.S Treasury, what other government agencies issue debt securities? What are their functions?
2) How are the interest income from these debt securities taxed federally, state/local, and how frequently?
1) Other than the U.S treasury, congress allows other federal government agencies to issue debt securities:
a) Farmer Credit Administraiton : Privately owned, government sponsored entity.
b) Government National Mortgage Association (ginniMae. GNMA) : Is the only federal government owned agency that issues debt securities. Pays interest monthly.
c) Federal National Mortgage Association (FNMA, Fannie Mae) : Publicially owned federal government agency. Pays interest semi-annually
d) xxxx (FHLMC, Freddie Mac) : Publicly owned federal government Agency. Pays interest semi-annually.
e) Sallie Mae : Student Loan Marketing Association (SLMA)
Money Markets
1) In the financial market, what are the two different markets? What are the differences between them?
2) What are 4 examples of money market instruments? Describe their qualities.
3) What are Federal Funds Loans? Terms?
1a) Capital Markets : Provide financing through intermediate to long term securities
1b) Money Markets : Money market securities are fixed income debt securities that trade on the secondary market. They are shorter term debt securities that offer organizations/individuals to raise funds for near term obligations.
2) Examples of money market instruments include:
Certificates of Deposits (CDs) :
- CDs are short term DS offered by banks in which investors have to deposit their money in the bank and withdrawal is restricted until the date of maturity which is decided during the agreement. The bank will pay interest, at a rate agreed on during agreement, at maturity so there are no regular int PMTs made. There are minimum deposit amounts that banks set. CDs that aren’t retail CDs that trade on the secondary market are known as jumbo CDs.
- The bank provides a promissory note saying they will pay back, and is based on the good faith and credit rating of the bank. So it is unsecured debt.
Banker’s Acceptance (BAs) :
-
Commercial Paper (Prime Paper, promissory notes):
- Commercial paper is short term unsecured debt securities issued by corporations known as Promissory notes, to finance near term operations such as inventory and accounts payable etc.
- Commercial Paper typically matures between 1 - 270 days, but most mature at 90 days.
REPOs (Repurchase Agreements) :
- A REPO agreement between 2 entities facilitates a sale of assets from company A to B for a specified amount, with company A promising to repurchase the assets from company B at a later specified date and at a higher specified amount than what they sold for.
- REPO agreements are short term, and provide cashflow for short term obligations.
3) Federal Reserve Board (FRB) sets a minimum amount of money that FR member banks must have in reserve at any given time. Any cash that is excess of this is used to lend to other member banks which are borrowing to maintain that reserve amount. These loans can happened over night.
Asset Backed and Mortgage Backed Securities
1) What is securitization? What does it do to risk?
2) What are CMOs?
3) What Are CDOs?
1) Securitization refers to the pooling of assets to be able to sell them in the secondary market. It diversifies the risk in a portfolio because each security represents on a fraction of the total value of the entire pool of assets.
2) Collateralized Mortgage Obligations (CMOs) are a kind of asset-backed securities. The backing securities are mortgages in this case. They are supported by the income that is generated from mortgage payments, and are issued by private sector financing companies.
- CMOs pool together mortgages, mostly of single family residences and sell them on the secondary market.
- They are divided into groups based on their time to maturity, these groups being known as Tranches.
- CMOs are most often backed by government agencies such as Ginnie Mae, Fannie Mae, and Freddie Mac. So they have historically been rated high.
- CMOs repay principal and interest from the mortgage pool monthly, but it only makes principal payments to one tranche at a time.
- Investors in short term tranches must receive their full principal amounts before any principal amounts are paid back to the next tranche.
3) Collateralized Debt Obligations (CDOs) are another kind of asset backed security, but don’t specialize in any one kind of debt like CMOs but mostly make up of non-mortgage loans and bonds. CDOs are backed by assets such as car loans, credit card debt, a company’s receivables, leases, or any other derivative products if the assets listed.
- CDOs are put into groups based on the type of debt and its credit risk, these groups are known as tranches or slices.
- Each tranche has its own maturity and risk associated with it. The higher the risk, the more the CDO pays.
