Fin431x (Ch 6&7&8&9) 1 Treasury, Agency, Corporate and Municipal Bonds 1. Treasury Bonds 2. Agency...
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Transcript of Fin431x (Ch 6&7&8&9) 1 Treasury, Agency, Corporate and Municipal Bonds 1. Treasury Bonds 2. Agency...
Fin431x (Ch 6&7&8&9) 1
Treasury, Agency, Corporate and Municipal Bonds
1. Treasury Bonds
2. Agency Bonds
3. Corporate Bonds
4. Municipal Bonds
Fin431x (Ch 6&7&8&9) 2
FactsThe second largest sector of bond market is the treasury securities market
The smallest sector is agency bond market
Most municipal bonds are tax-exempt
Junk bonds have lower return than stocks
Fin431x (Ch 6&7&8&9) 3
Different Treasury Securities
Fixed-principal treasury securities (page 128)
Treasury inflation protection securities (TIPS)• Treasury securities that adjust for inflation• First time issue is Jan. 29, 1997• Coupon rate is fixed• See “inflation-indexed treasury securities” under
“Treasury Bonds, Notes and Bills” in WSJ
Fin431x (Ch 6&7&8&9) 4
Example
Coupon rate for a TIPS is 3.5%, annual inflation is 3%. Suppose an investor purchases a bond on 1/1/2005, par value $100,000.
(1) What are the par and coupon payment on 6/30/2005?
(2) Suppose semi-annual inflation rate for the second 6 month period is 1%, what are the par and coupon payment on 12/31/2005?
Fin431x (Ch 6&7&8&9) 5
Features of TIPS
• Still a fixed rate product
• The adjustment in coupon payments subject to federal tax
• Possibility of disinflation
Fin431x (Ch 6&7&8&9) 6
Auction ProcessTreasury securities on a regular cycle:T-bills: 4 weeks, 13 weeks, 26 weeksT-notes: 2-, 5-, and 10-year
It offers additional shares of outstanding securities, referred to as a “reopening” of an issue, mainly for 5- and 10-year issues
Debt buyback plan: redeem un-matured securities through reverse auctions
Fin431x (Ch 6&7&8&9) 7
Auction Process
Alternative Bids(1) Noncompetitive bid: like a market order. Has limit.(2) Competitive bid: specify both the quantity and the yield at
which the bidder is willing to purchase the auctioned security.
Process (pages 129):(1) Deducting the total noncompetitive tenders and nonpublic(2) Stop-out yield(3) bid-to-cover ratio(4) What about yield is 3.039%?
Fin431x (Ch 6&7&8&9) 8
Types of Auctions
Dutch auction: the auctioneer sets an extraordinarily high price and lowers it until someone bids on the item.
Traditional auction: the price rises until one bidder is left.
Fin431x (Ch 6&7&8&9) 9
Secondary market
Traded in the OTC market
On-the-run issues
Off-the-run issues
When-issued market
Dealer versus Interdealer
Fin431x (Ch 6&7&8&9) 10
Quotes for T-bills and T-bonds
(1) Quotes for Treasury Bills (see WSJ)
(2) On a bank discount basis, not on a price basis
Example: what is the quote on a bank discount basis for a Treasury bill with 100 days to maturity, a face value of $100,000, selling for $99,100?
tF
DYd
360
Fin431x (Ch 6&7&8&9) 11
Quotes on Treasury Coupon Securities(1) Price per $100 par; 32nd (See WSJ)(2) Accrued interest (AI)
To estimate the two “days” in the above formula, we need:a. Trade dayb. Settlement dayc. Actual day count convention
periodcouponinDays
periodAIinDayscoupondollarannualAI
___
___
2
__
Fin431x (Ch 6&7&8&9) 12
Stripped Treasury Securities
Trademark securities
Treasury receipts
Strips
Tax treatment: accrued interest is taxed each year, though interest is not paid.
Reconstituting a bond
Fin431x (Ch 6&7&8&9) 13
Agency SecuritiesFederally Agency Institutions
see page 139
Government-sponsored enterprises (GSEs)privately owned, publicly chartered entities. They were created by Congress to reduce the cost of capital for certain borrowing sectors of the economy deemed to be important enough to warrant assistance, including farmers, homeowners, and students
See “Government Agency and Similar Issues” in WSJ.
Fin431x (Ch 6&7&8&9) 14
GSEsFannie Mae (see page 139)Freddi MacFederal Home Loan Bank SystemFederal agriculture Mortgage CorporationFederal Farm Credit Bank SystemStudent Loan Marketing AssociationFinancing CorporationResolution Trust CorporationFarm Credit Financial Assistance Corporation
Fin431x (Ch 6&7&8&9) 15
Features of Corporate Bonds
Bond indenture
Security for bonds
Debenture bonds
Provisions
Covenants
For quotes: see “corporate bonds” in WSJ.
Fin431x (Ch 6&7&8&9) 16
Provisions for Paying Off Bonds Prior
to Maturity Traditional call and refund provision
Make whole call provision• The payment when the issuer calls a bond is determined
by the present value of the remaining payments discounted at a small spread over a maturity-matched Treasury yield
Sinking fund provision
Fin431x (Ch 6&7&8&9) 17
Covenants
Affirmative covenants
Restrictive covenants
Maintenance test
Debt incurrence test
Cash flow test
Fin431x (Ch 6&7&8&9) 18
Factors Affecting Corporate Bond Ratings
Quality of management
Capacity to pay
Collateral
Covenant
Quality rating schedule: see page 154.
Fin431x (Ch 6&7&8&9) 19
TRACE
Page 152
The reporting system, the Trade Reporting and Compliance Engine (TRACE), requires that all broker/dealers who are member firms of the Financial Integrity Regulatory Authority (FINRA) report transactions to corporate bonds to TRACE.
Fin431x (Ch 6&7&8&9) 20
High-yield Corporate Bond SectorAKA junk bonds, non-investment-grade bonds. They
are issues with quality ratings below triple B
(1) Original-issue high-yield bonds
(2) Fallen angels
Default rates: see Exhibit 7-4 on page 155.
For quotes, see “High-Yield Bonds” in WSJ
Fin431x (Ch 6&7&8&9) 21
High-Yield Bonds
Do junk bonds provide extremely high returns?
Exhibit 7-6, page 169.
Fin431x (Ch 6&7&8&9) 22
Medium-Term Notes (MTN)
A corporate debt instrument, with the unique characteristic that notes are offered continuously to investors by an agent of the issuer.
Maturity ranges• 9m – 1y• 1y – 18m• 18m – 2y• So on up to 30 years
• Register with SEC under Rule 415
Fin431x (Ch 6&7&8&9) 23
Commercial Papers
Short term unsecured promissory note that is issued in the open market and that represents the obligation of the issuing corporation.
Ranges in maturity from 1 day to 270 days
Bridge financing
Fin431x (Ch 6&7&8&9) 24
Bankruptcy and Credit Rights
Liquidation – chapter 7 of the bankruptcy act
Reorganization -- chapter 11 of the bankruptcy act
Absolute priority
Fin431x (Ch 6&7&8&9) 25
Municipal Securities
Issued by Municipality, including state or local governmentThe exemption of interest income from federal taxationShort-term notes: to cover seasonal and temporary
imbalance between outlays for expenditure and inflow from taxes.
Long-term bonds: to finance long-term capital projects such as schools, bridges, and airports; long term budget deficit from current operation.
For Quotes: see “Tax-exempt Bonds” under “Bond Market Data Bank” in WSJ
Fin431x (Ch 6&7&8&9) 26
Types of Municipal Bonds
Tax-backed debt (page 182)• General obligation debt• Appropriation-back obligation• Debt obligations supported by public credit
enhancement programRevenue Bonds (page 183-187)• Airport revenue bonds• College and university revenue bonds• Water revenue bonds
Fin431x (Ch 6&7&8&9) 27
Redemption Features of Municipal Bonds (page 191)
• Serial maturity structure: a portion of debt obligation to be retired each year
• Term maturity structure: provides for the debt obligation to be repaid on a final date, typically through a sinking fund provision that begin 5 to 10 years before the final term maturity.
• Catastrophe call provision: requires the issuer to call the entire issue if the facility is destroyed.
Fin431x (Ch 6&7&8&9) 28
Floater/Inverse Floater
• A municipal dealer can buy a fixed-rate municipal bond and place it in a trust, then the trust issues a floater and an inverse floater
• The investors in the inverse floater can purchase the corresponding floater at auction and combine two positions to effectively own the underlying fixed-rate bonds.
Fin431x (Ch 6&7&8&9) 29
Risk Exposures of municipal bonds
Credit risk
Interest rate
Reinvestment risk
Tax risk
• Decrease in tax
• A tax-exempt issue may eventually be declared to be taxable by the IRS
Fin431x (Ch 6&7&8&9) 30
Yield of Municipal Bonds
ratetaxinalm
yieldexempttaxyieldtaxableequivalent
__arg1
___
bondTreasurymaturitysameonyield
bondmunicipalonyieldratioyield
_____
____
See “Bond yield” under “Bond Market Data Bank” in WSJ.
Fin431x (Ch 6&7&8&9) 31
Taxable Municipal BondsPurposes: (1) local sports facilities, (2) investor-led housing
projects, (3) advanced refunding of issues that are not permitted to be refunded, and (4) underfunded pension
With taxable municipal bonds, a municipality needs to pay a higher yield than if it issued a tax-exempt municipal bond. Why does it want to do this?
• Tax Reform Act 1986 imposes restrictions on what type of projects and the upper limit could be financed with tax-exempt municipal bonds.
• U.S. tax code restrict arbitrage opportunities that a municipality can realize
• Different investor base
Fin431x (Ch 6&7&8&9) 32
Non-US Bonds
Internal Market versus External Market• Internal market includes domestic and foreign bonds
– Yankee bonds, bulldog bonds• External market: offshore bond market or Eurobonds
(page 208)
By trading bloc• Dollar bloc• European bloc• Japan • Emerging markets
Fin431x (Ch 6&7&8&9) 33
Non-US Government Bond Markets
The two largest non-U.S. government bond markets are those in Japan and Germany: Japan (JGB), Germany (Bunds)
Inflation-indexed bonds – page 215
Sovereign Bond – page 216
Fin431x (Ch 6&7&8&9) 34
Sovereign Bond Ratings
Sovereign debt is the obligation of a country’s central government.
U.S. government debt is not rated by any nationally recognized statistical rating organization, the debt of other national governments is rated.
S&P, Moody’s and Fitch all assign ratings to sovereign bonds.
Fin431x (Ch 6&7&8&9) 35
Distribution of New Government Issues (page 215)
Regular calendar auction/Dutch style
Regular calendar auction/minimum price
Ad hoc auction system
Tap system
Fin431x (Ch 6&7&8&9) 36
Major other bonds
Pfandbriefe market bonds: issued by mortgage banks in Germany; the largest asset in the European bond market and the sixth largest in the world. Page 220
Emerging Market Bonds: also known Brady bonds, issued in Latin America, Asia and Eastern Europe. Page 221