Types of Debt.ppt - Bull & Bear Training · Types of Debt Series #7 Types of Debt 5 Corporate...
Transcript of Types of Debt.ppt - Bull & Bear Training · Types of Debt Series #7 Types of Debt 5 Corporate...
1
Types of Debt
Series #7 Types of Debt 1
Series #7 Types of Debt 2
Actual day / Actual month
T + 1ExemptSubjectU.S. Gov’t•Cash Mngmt Bills
•T-Bills
•T-Notes
•T-Bonds•TIPS•T-STRIPS
Accrued Interest
State TaxFed. Tax
Reg. Way
Settlement
Tax Status of the Interest Rec’d
Type of Debt
1 YR
10 YRS
30 YRS
T-Receipts = Non-exempt
; non-callable
; (could be) callable
protects against inflation;
zero-coupon
a.k.a. purchasing power risk
several days up to 6 months
2
Types of Debt
Series #7 Types of Debt 3
30 / 360Varies / not tested
ExemptSubjectGov’t Agency
•Fed. Home Loan Banks
•Banks for Cooperatives
•Fed. Inter. Credit Banks
•Fed. Land Banks
Accrued Interest
State TaxFed. Tax
Reg. Way
Settlement
Tax Status of the Interest Rec’d
Type of Debt
Farmer Loans
Series #7 Types of Debt 4
30 / 360Varies / not tested
SubjectSubjectPrivatized Gov’t Agency
•Fed. Nat’l Mtg. Assn. (FNMA)
•Fed. Home Loan Mtg. Corp. (FHLMC)
•Gov’t Nat’l Mtg. Assn. (GNMA)
Accrued Interest
State TaxFed. Tax
Reg. Way
Settlement
Tax Status of the Interest Rec’d
Type of Debt
Issue Pass Through Certificates =
$25K Par
CMOs created by brokerage firms= non-exempt
= $1K par
Exempt
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Types of Debt
Series #7 Types of Debt 5
30 / 360T + 3SubjectSubjectCorporateSecured
• Mortgage Bonds
• Equipment Trust Certificates
• Collateral Trust Certificates
Unsecured•Debentures
–Convertibles
•Income / Adjustment Bonds
•Commercial Paper
Accrued Interest
State TaxFed. Tax
Reg. Way
Settlement
Tax Status of the Interest Rec’d
Type of Debt
= max maturity = 270 days= most common maturity = 30 days
= trade flat – w/o accrued interest
backed by real estate
backed by machinery/equipment
backed by securities
Three Gov’t Bonds Trade Flat
Cash Mgmt BillsT-BillsT-STRIPS
Issued by transports; common carriers
Series #7 Types of Debt 6
30 / 360T + 3Subject, BUT:
•If bought by state resident,
EXEMPT
•If issue is a territory,
EXEMPT
ExemptMunicipal•G.O.
•Revenue•Capital Appreciation Bond
•Special Tax
•Special Assessment
•Moral Obligation•Certificate of Participation
•Double Barreled
•Industrial Revenue*
•Build America*
Accrued Interest
State TaxFed. Tax
Reg. Way
Settlement
Tax Status of the Interest Rec’d
Type of Debt
1969 - Nixon - Rep. - $200K earned income – no taxes - AMT1975 - Ford - Rep. - NYC $1billion default1986 - Reagan- Rep. - $250K earned income – no taxes
Income
Earned Portfolio Passive
* Interest is federally taxable
Equities
1Bull & Bear Training Co., Inc. - Peter A. Gibowicz
Series #7 Equities 1
EQUITY - (Basics)
Series #7 Equities 2
CORPORATIONS
• NEED FINANCING
• CAN ISSUE:– EQUITY
• common stock
• preferred stock
– DEBT
Series #7 Equities 3
Equity — Common
• stockholders are the "owners" of a corporation
• each common share represents proportional ownership in the corporation– 10% of the outstanding shares are held, then the holder
owns 10% of the corporation
• pays dividends (in most cases) quarterly, if declared by the Board of Directors– dividends are taxed at a maximum rate of 15% or 20%
(with the 20% rate for individuals earning more than $400K; and couples earning more than $450K)
Series #7 Equities 4
Equity — Preferred
• preferred stock has preference over common as to the payment of dividends and as to assets upon liquidation– dividends are taxed at a maximum rate of 15%
or 20%
• before common shareholders are paid preferred shareholders are paid IF declared by the Board of Directors
Series #7 Equities 5
Debt
• bondholders are creditors of the corporation• the corporation has a legal responsibility to
pay its bondholders — interest and principal– interest is taxed at a maximum rate of 39.6%
• before the corporation pays taxes, it MUST pay its bondholders -- BTP
• if payments cannot be met, then the corporation is in default
Series #7 Equities 6
Which of the following would be considered owners of a corporation?
I Common ShareholdersII Preferred ShareholdersIII Convertible BondholdersIV Warrant Holders
A. I onlyB. I and II onlyC. I, II, III, IVD. None of the above
Equities
2Bull & Bear Training Co., Inc. - Peter A. Gibowicz
Series #7 Equities 7
COMMON STOCK• AUTHORIZED STOCK
– the fixed number of shares that may be issued
• ISSUED STOCK– a corporation doesn't "issue" all of authorized
stock so that the corporate charter doesn't have to be amended
• OUTSTANDING STOCK– stock that is in the public's hands
– shares that trade in the marketSeries #7 Equities 8
COMMON STOCK (cont.)• TREASURY STOCK
– these shares have been authorized, then issued, but they are no longer outstanding
– repurchased shares – corporation buys back its own shares in the market
– with fewer shares outstanding, earnings per share will rise
– does not vote nor receive dividends
– formula: issued — outstanding
Series #7 Equities 9
COMMON STOCK (cont.)
Series #7 Equities 10
The definition of Treasury Stock is:
A. issued shares which are outstandingB. issued shares which are no longer outstandingC. unissued shares which are outstandingD. unissued shares which are no longer outstanding
Series #7 Equities 11
COMMON STOCK (cont.)
• PAR VALUE– has no bearing on market price
– arbitrary value, usu. set low
• MARKET VALUE– based on investor expectations about the
company's future
Series #7 Equities 12
SHAREHOLDER RECORDKEEPING
• REGISTRAR– maintains record of stockholders' names and
addresses
– makes sure company doesn't issue more shares than authorized
– watchdog over transfer agent
Equities
3Bull & Bear Training Co., Inc. - Peter A. Gibowicz
Series #7 Equities 13
SHAREHOLDER RECORDKEEPING (cont.)
• TRANSFER AGENT– as trades of stock settle, the report is made to
the transfer agent who:• cancels old shares which have been sold, and issues
new shares in the name of the buyer
• keeps an accurate record of shareholders which is updated daily
• usu. handles mailings to shareholders (dividends, voting materials, corporate records,...)
Series #7 Equities 14
SHAREHOLDER RECORDKEEPING (cont.)
• TRANSFER AGENT (cont.)– BOOKENTRY CERTIFICATE
• instead of physically issuing and canceling certificates, the transfer agent keeps the ownership record along with the clearing corporation settling trade
Series #7 Equities 15
All of the following are functions of the transfer agent EXCEPT:
A. Mails dividend payments to shareholdersB. Prepares and mails proxiesC. Sets the Declaration DateD. Cancels old shares and issues new shares
Series #7 Equities 16
All of the following are the responsibilities of the registrar EXCEPT:
A. Distributing dividends, corporate reports, and voting materials
B. Acting as a watchdog over the transfer agentC. Accounting for the number of shares issuedD. Maintaining a record of all shareholder names
Series #7 Equities 17
RIGHTS OF THE COMMON SHAREHOLDERS
Series #7 Equities 18
RIGHTS OF THE COMMON SHAREHOLDERS (CONT.)
• To Vote:– must be at annual meeting to vote OR proxies
can be completed by shareholders who don't attend
– If The Corporation Wishes To:• declare a stock or reverse stock split• issue convertible bonds or preferred stock• issue stock options to officers on a preferential basis
– For The Board Of Directors
Equities
4Bull & Bear Training Co., Inc. - Peter A. Gibowicz
Series #7 Equities 19
RIGHTS OF THE COMMON SHAREHOLDERS (CONT.)
• Voting for the Board of Directors– Two Voting Methods
• 1) statutory voting
• 2) cumulative voting
Series #7 Equities 20
RIGHTS OF THE COMMON SHAREHOLDERS (CONT.)
• Voting Methods
– 1) statutory voting• 1 vote per 1 share
• i.e. 100 shrs, 3 B.O.D. to choose – 100 votes can be made for 1 Director
– 100 votes can be made for another Director
– 100 votes can be made for another Director
Series #7 Equities 21
RIGHTS OF THE COMMON SHAREHOLDERS (CONT.)
• Voting Methods (cont.)
– 2) cumulative voting• # of shares X # of Board of Directors to be
chosen• i.e. 100 shrs, 3 B.O.D. to choose
– 300 votes can be placed for 1 Director– no more votes are allowed
• considered advantageous for the smaller investor
Series #7 Equities 22
RIGHTS OF THE COMMON SHAREHOLDERS (CONT.)
• do NOT vote on: – management
– cash or stock dividends• stock dividends are distributions of 25% or
less
– rights distribution
– repurchase of shares for Treasury
Series #7 Equities 23
A corporation declares a 2:1 stock split. For a customer who owns 100 shares at $60, how many shares will he now have and at what dollar price?
A. 100 shares at $30B. 200 shares at $30C. 200 shares at $50D. 200 shares at $60
100 shrs @ $60 = $6,000
1 share now = 2 shares
100 shares = 200 shares
$60/2 = $30
200 shrs @ $30 = $6,000
Series #7 Equities 24
A corporation declares a 5:4 stock split. For a customer who owns 100 shares at $60, how many shares will he now have and at what dollar price?
A. 120 shares at $50B. 125 shares at $48C. 120 shares at $40D. 125 shares at $50
100 shrs @ $60 = $6,000
4 shares now = 5 shares
5:4 = 1.25:1
1 shr = 1.25 shrs
100 shares = 125 shares
$60/1.25 = $48
125 shrs @ $48 = $6,000
Equities
5Bull & Bear Training Co., Inc. - Peter A. Gibowicz
Series #7 Equities 25
RIGHTS OF THE COMMON SHAREHOLDERS (CONT.)
• To Inspect Books and Records– NOT the minutes of the last B.O.D.'s
meeting– i.e. 10Q; 10K
• To Transfer Ownership (negotiable = tradable)– however, mutual funds and savings bonds
are NOT negotiable, but redeemable
Series #7 Equities 26
RIGHTS OF THE COMMON SHAREHOLDERS (CONT.)
• To Maintain Proportionate Ownership if the corporation wishes to issue new shares– a.k.a. Pre-emptive Right
– if a corporation wishes to issue more shares, existing shareholders have the right to buy these new shares before anyone else does (so that the shareholder can maintain her proportional ownership)
Series #7 Equities 27
RIGHTS OF THE COMMON SHAREHOLDERS (CONT.)
• Pre-emptive Right (Cont.)– Rights Offering
• offer of these shares to existing shareholders
– Rights Agent• to handle mechanics of offering• usu. the existing transfer agent
– Standby Underwriter• used if all these shares are not picked up• ensures issuer sells entire issue and gets needed funding
– every 1 share = 1 right– rights typically expire in 30-60 days
Series #7 Equities 28
A corporation is having a rights offering where 10 rights are needed to subscribe to one additional share. A shareholder has 100 shares. How many rights does he have?
A. 1 rightB. 10 rightsC. 100 rightsD. 110 rights
Series #7 Equities 29
A company has 5MM shares outstanding and wishes to issue an additional 1MM shares. They are offering 1 right for every outstanding share. If a customer owns 500 shares, how many total shares of stock will he own if he exercises his rights?
A. 50B. 500C. 550D. 600
1MM new shares = 20% additional
Shareholder has to maintain % ownership
Series #7 Equities 30
RIGHTS OF THE COMMON SHAREHOLDERS (CONT.)
• To Receive Dividends If Declared by the B.O.D.– note dividends are taxed at a maximum
rate of 15% or 20%– A) declaration date– B) record date– C) payable date– D) ex-date
Equities
6Bull & Bear Training Co., Inc. - Peter A. Gibowicz
Series #7 Equities 31
RIGHTS OF THE COMMON SHAREHOLDERS (CONT.)
• DECLARATION DATE– date dividend is declared
• RECORD DATE– date on which corporation takes shareholder
name from transfer agent to mail dividend
– last day to buy and get the dividend is 3 business days prior to record date
Series #7 Equities 32
RIGHTS OF THE COMMON SHAREHOLDERS (CONT.)
• PAYABLE DATE– date dividend checks will be mailed by corporation's
transfer agent
• CUM DIVIDEND DATE– with dividend
• EX-DIVIDEND DATE – first day that the stock trades without the dividend – because the trade will settle after record date– the stock price is reduced by the amount of the dividend
distribution– ex-date is set at: 2 business days prior to record date
Series #7 Equities 33
June
S M T W H F S
1 2 3 4 5 6 7
8 9 10 11 12 13 14
15 16 17 18 19 20 21
22 23 24 25 26 27 28
29 30If record date is set at Thursday June 12, when is the last day to buy the stock and receive the dividend: reg. way settlement? cash settlement? when is ex-date?
Series #7 Equities 34
June
S M T W H F S
1 2 3 4 5 6 7
8 9 10 11 12 13 14
15 16 17 18 19 20 21
22 23 24 25 26 27 28
29 30
If record date is set at Wednesday, June 11, when is the last day to buy the stock and receive the dividend: reg. way settlement? cash settlement? when is ex-date?
Series #7 Equities 35
July
S M T W H F S
1 2 3 4 5 6 7
8 9 10 11 12 13 14
15 16 17 18 19 20 21
22 23 24 25 26 27 28
29 30 31If record date is set at Monday, July 9, when is the last day to buy the stock and receive the dividend: reg. way settlement? cash settlement? when is ex-date?
Series #7 Equities 36
A corporation declares a dividend on Mar 20 for those on record for owning the stock on Fri., Apr 19. The ex-date is set at Wed., Apr 17; and the payable date is Apr 30.
When is the earliest date that the stock can be sold regular way and still allow the customer to received the dividend?
A. Apr 15B. Apr 16C. Apr 17D. Apr 19
Equities
7Bull & Bear Training Co., Inc. - Peter A. Gibowicz
Series #7 Equities 37
RIGHTS OF THE COMMON SHAREHOLDERS (CONT.)
• To Assets Upon Dissolution– if corporation is dissolved, the common
stockholder is paid last• 1) Secured bondholders (BTP)
• 2) Wages, taxes, general creditors
• 3) Debentures
• 4) Subordinated debentures
• 5) Preferred stockholders
• 6) Common stockholders
Series #7 Equities 38
If a corporation liquidates, rank the priority to its assets upon dissolution
I secured bondsII debenturesIII common stockIV preferred stock
A. I, II, III, IVB. IV, III, II, IC. I, II, IV, IIID. II, I, IV, III
Series #7 Equities 39
Common stockholders have all of the following "rights" EXCEPT:
A. Right to vote for the Board of DirectorsB. Right to vote for the annual dividend rateC. Pre-emptive rightD. Rights to corporate assets upon dissolution
Series #7 Equities 40
A vote of the common stockholders is required for a corporation to do which of the following?
I Issue convertible securitiesII Accept a tender offer for the company's
sharesIII Declare a stock splitIV Declare a stock dividend
A. III and IV onlyB. I, II, IIIC. I, II, IVD. I, II, III, IV
Series #7 Equities 41
Common shareholders have the right to vote on all of the following EXCEPT:
A. Changes in the number of authorized sharesB. Cash dividendsC. Board of DirectorsD. Stock splits
Series #7 Equities 42
In a corporate liquidation, common stockholders are paid:
A. firstB. after creditors but before preferred stockholdersC. after bondholders but before preferred
stockholdersD. last
1
Series #7 Debt 1
BOND BASICS
Series #7 Debt 2
BOND • debt security which obligates issuer to pay
interest - usu. semi-annually- and repay principal amount when debt matures
• PAR VALUE– set usu. at $1,000 minimum and with a stated
rate of interest (the coupon)
• REDEMPTION– at maturity, the bond is redeemed by issuer at
par
Series #7 Debt 3
A customer buys 10 Allied Corporation 10% $1,000 par debentures, M‘25, at 90 on Monday, Oct 8. The interest payment dates are Feb 1 and Aug 1. The trade settled on Thurs., October 11. The amount of the next interest payment will be:
A. $25B. $250C. $500D. $1,000
.10 * 1000 = $100 X 10 = $1,000_____
2Series #7 Debt 4
ZERO-COUPON BOND
• stated par value (usu. $1,000 minimum) but without a stated rate of interest
• no interest payments are made - these are purchased at a discount and mature at par
• tax status?– though no income is received until maturity, the
bondholder must pay tax on the accreted value– good for what type of account?
Series #7 Debt 5
1 zero coupon, $1,000 par, purchased at $200 with 10 years to maturity
•how much will the bond's accreted value be after the first year?
•what is the amount of interest that would be taxed?
1 zero coupon, $1,000 par, purchased at $800 with 5 years to maturity
•how much will the bond's accreted value be after the first year?
•what is the amount of interest that would be taxed?
$280
$80
$840
$40
$800 / 10 years = $80 a year
$200 / 5 years = $40 a year
Series #7 Debt 6
VARIABLE RATE BOND
• interest rate is reset periodically based on prevailing market interest rates
2
Series #7 Debt 7
BOND ISSUE STRUCTURE
• TERM BONDS– all the bonds are issued on the same date and
they mature on the same date• every bond has same interest rate and maturity
– quoted on a percentage of par basis, meaning on a dollar price basis
– a.k.a. dollar bonds
Series #7 Debt 8
BOND ISSUE STRUCTURE• Term Bonds (cont.)
– most corporate, government, and any municipal issues which are term bonds are quoted on a percentage of par basis
– $1,000 par Corporate bonds are quoted as a percentage of par value with minimum 1/8 point
• i.e. 101 3/8 = $ ; i.e. 98 1/4 = $
– $1,000 par U.S. Gov't bonds are quoted as a percentage of par value with minimum 1/32 point
• i.e. 99.24 = $ ; i.e. 101.16 = $ • these are much more actively traded than corporate bonds
101.375% X 1,000 = $1,013.75
98.25% X 1,000 = $982.50
99.24/32% = 99.75% X 1,000 = $997.50
101.16/32% = 101.5% X 1,000 = $1,015
Series #7 Debt 9
BOND ISSUE STRUCTURE (cont.)
• SERIAL BONDS– all of the bonds are issued on the same date, but they
mature on differing dates• differing maturities will require different interest rates
– most municipal bonds and corporate equipment trust certificates
– Balloon Maturity• most of the bond matures in the later years
• each maturity has a different interest rate– the longer the maturity, the higher the interest rate
$20MM issued in 2016
$2MM matures
2026
$2MM matures
2031
$16MM matures
2036
Series #7 Debt 10
BOND ISSUE STRUCTURE (cont.)
• SERIES BOND– all the bonds have the same maturity, but
different dates of issuance• this is done because, perhaps, all of the money is not
needed immediately– thus, instead of floating a $10MM bond at once, the issuer
can maybe sell $4MM one year, $3MM the next year, and $3MM the following year
• by phasing in the bonds, the issuer’s total interest cost is reduced
– are rarely issued
Series #7 Debt 11
A bond issue with the same day of issuance but with differing maturities is a:
A. term bond offeringB. series bond offeringC. serial bond offeringD. combined serial and term bond offering
Series #7 Debt 12
A bond issue where every bond has the same interest rate and maturity is a:
A. term bond offeringB. series bond offeringC. serial bond offeringD. combined serial and term bond offering
3
Series #7 Debt 13
A bond issue where the bonds have the same maturity but different dates of issuance is a:
A. term bond offeringB. series bond offeringC. serial bond offeringD. combined serial and term bond offering
Series #7 Debt 14
BOND PRICE QUOTES• U.S. Gov'ts and Agencies
– quoted as a percentage of par in 32nds
– most active trading market, therefore bid-ask spreads could be as narrow as 1/32nd
– EXAMPLE: 6% Coupon; $1,000 Par Bond; Quoted At 92.16; Price = ?
Series #7 Debt 15
BOND PRICE QUOTES • Corporates and Municipal
Term Bonds– quoted as a percentage of par in
8ths– less active trading market than
gov'ts, therefore bid-ask spreads are wider
– municipal term bonds are often called "dollar" bonds because they are quoted on a dollar price basis
– EXAMPLE: 10% Coupon; $1,000 Par Bond; Quoted At 94 3/8; Price = ?
Series #7 Debt 16
BOND PRICE QUOTES
• Value of a Point Movement– EXAMPLE: 10% Coupon; $1,000 Par Bond;
Quoted At 94– Price = ?
• 94% X 1000 = $940
– The Dealer Raises The Price To 95 = ?• 95% X 1000 = $950
– Therefore A Change In Price Of 1 Point = ?• $10
Series #7 Debt 17
BOND PRICE QUOTES • Value of Bid / Ask Spread
– EXAMPLE: Dealer Quotes A U.S. Gov't Bond At:
– Dealer Is Willing To Buy At The Bid And Sell At The Ask
– 90:16 Bid = ?• 90 16/32nds = 90.50% = $905
– 90:24 Ask = ?• 90 24/32nds = 90.75% = $907.50
– Bid / Ask Spread = 8/32nds = .25% = $2.50 per $1,000 Bond
Bid Ask90:16 90:24
Series #7 Debt 18
Corporate bonds which are term bonds are quoted on what basis?
A. yield to maturity basisB. series basisC. serial basisD. percentage of par basis
4
Series #7 Debt 19
Municipal dollar bonds are generally:
A. Term bondsB. Series basisC. Serial bondsD. Short term maturities
Series #7 Debt 20
BOND PRICE QUOTES (CONT.)• Basis Quotes
– municipal serial bonds are quoted on yield basis
– Why? • because a single issue can have 20-30 different maturities
• each maturity represents a different amount of interest received and a different principal repayment date
– therefore each maturity would have a separate dollar price
– it is much easier quoting these in terms of yield
Series #7 Debt 21
What is the term for the excess of par over the purchase price of a municipal bond?
A. discountB. premiumC. spreadD. reallowance
Series #7 Debt 22
The amount by which the purchase price of a municipal bond exceeds the par value of the bond is termed the:
A. spreadB. discountC. premiumD. takedown
Series #7 Debt 23
BOND PRICE QUOTES (CONT.)
• U.S. Treasury Bills– quoted on a yield basis as are all other money market
instruments– original issue discount obligations– yield or basis represents the discount from face value– EXAMPLE: Dealer Quotes A U.S. Gov't T-Bill At:
– Unlike Dollar Price Bonds, These Quotes Are In Terms Of Yield Or Basis
Bid Ask5.0 4.90
Series #7 Debt 24
BOND PRICE QUOTES (CONT.)
• VALUE OF A BASIS POINT MOVEMENT– A Change Of .01% = 1 Basis Point = $.10
– A Change Of .10% = 10 Basis Point = $1.00
– A Change Of 1% = 100 Basis Point = $10.00
5
Series #7 Debt 25
A 7% general obligation bond matures in 1 year. A municipal dealer quoting the bond has just changed his quote from a 6.85 basis to a 6.95 basis. The approximate dollar change in price per $1,000 bond is:
A. $.10B. $1.00C. $10.00D. $100.00
6.85 VS 6.95 = 10 B.P.
If 1 B.P. = 10 cents
10 B.P. = $1.00
Series #7 Debt 26
Which of the following would be a quote for a U.S. Government Bond?
A. 99:50B. 99:16C. 99 1/2D. 99 8/16
Series #7 Debt 27
Bonds quoted on a yield to maturity basis are generally:
A. Term bondsB. Series bondsC. Serial bondsD. Short term maturities
Series #7 Debt 28
Bond Price Volatility
Large PremiumSmall Premium
Large DiscountSmall Discount
PremiumDiscount
High CouponLow Coupon
Long MaturityShort Maturity
MACAULAY DURATION
• a measure of bond price volatility
• duration is the weighted average term-to-maturity of a security’s cash flows– though the formula for duration is NOT tested,
it is found that the longer maturity; and the lower coupon bonds have the greater/biggest duration
Series #7 Debt 29 Series #7 Debt 30
Regarding bond price volatility and interest rate movements, which of the following are true?
I the shorter the maturity, the greater the bond's price volatility
II the longer the maturity, the greater the bond's price volatility
III the lower the coupon rate, the greater the bond's price volatility
IV the higher the coupon rate, the greater the bond's price volatility
A. I and IIIB. I and IVC. II and IIID. II and IV
6
Which statements are true regarding the effect of interest rate movements on bond price volatility?
I Bonds with the lowest price volatility will be ones with the lowest coupon rates
II Bonds with the lowest price volatility will be ones with the highest coupon rates
III Bonds with the highest price volatility will be ones with the lowest coupon rates
IV Bonds with the highest price volatility will be ones with the highest coupon rates
A. I and III B. I and IV C. II and III D. II and IV
Series #7 Debt 31 Series #7 Debt 32
CALL/PUT FEATURES
• calls occur when interest rates drop• CALL PROTECTION
– number of years an investor has before issuer can call bond; typically 10 years
– call price sets ceiling on market price - the bond price will never go above the call price
• The reason: why would someone pay a premium for an issue that is likely to be called off the market?
Series #7 Debt 33
CALL/PUT FEATURES (cont.)
• PUT FEATURE– puts occur when interest rates rise because (for
the bondholder) the proceeds can be reinvested at higher interest rates
• put price is usu. at par• put price sets a floor on market price
– The reason: if the price fell below the put price, customers would buy as many of the bonds as possible in the market and "put" them to the issuer at par for a capital gain
Series #7 Debt 34
A corporate bond was issued on Jan 1, 2000 that matures on Jan 1, 2020. The trust indenture allows the corporation to call the bond starting in 2010 at a price equaling 100 1/2 plus an additional 1/8 point premium for every 6 month period remaining until maturity. If the bond is called on Jan 1, 2016, the redemption price will be:
A. 102 1/2B. 102C. 101 1/2D. 100 1/2
20161/8 + 1/8
100 1/2 +
20171/4
20181/4
20191/4
1 = 101 1/2
Series #7 Debt 35
A 20 year bond is issued in 2005 with the following call schedule:
Redemption Date Redemption Price2015 1042016 1032017 1022018 1012019 and after 100
This issue has how many years of "call protection"?
A. 0B. 10C. 11D. 20
Series #7 Debt 36
RISKS WITH BONDS
• CREDIT RISK– risk that issuer cannot make interest and
principal payments on an issue
– ratings agencies rate bonds for credit risk
7
Series #7 Debt 37
RISKS WITH BONDS (cont.)
• Bond Ratings Services– Standard and Poor's
– Moody's
– Fitch's
Series #7 Debt 38
S&P Moody's
AAA Aaa
AA Aa
A A
BBB Baa
BB Ba
B B
CCC Caa
CC Ca
C C
Investment
Grade
Speculative
Grade
Series #7 Debt 39
essentially the top 2 are investment grade
SG ("Speculative Grade")
NP ("Not Prime")
MIG3P3
MIG2P2
MIG1P1
Municipal Short Term Note Ratings
Commercial Paper Ratings
Series #7 Debt 40
What is the highest investment grade?
A. AAA+B. AAAC. AAD. A
Series #7 Debt 41
A bond is rated BBB by Standard and Poors. The bond is:
A. Highest Quality Investment GradeB. High Quality Investment GradeC. Lowest Quality Investment GradeD. Highest Level Speculative Grade
Series #7 Debt 42
The lowest investment grade rating is:
A. BaaB. BaC. CCCD. C
8
Series #7 Debt 43
At which rating is a bond first considered to be speculative?
A. BaaB. BaC. CCCD. C
Series #7 Debt 44
Below which rating is a bond first considered to be speculative?
A. BaaB. BaC. CCCD. C
Series #7 Debt 45
Which of the following ratings applies to commercial paper?
A. MIG1B. P3C. BbD. A+
Series #7 Debt 46
RISKS WITH BONDS (cont.)
• INTEREST RATE RISK / MARKET RISK– risk that rising interest rates will cause bond prices to fall– applies to fixed rate securities only
• PURCHASING POWER RISK– risk that inflation will lower value of bond– EXAMPLE:
1980s 1990s 2010sYld Long Term Treasuries 14% 10% 4%Inflation Rate 11% 7% 1%Real Interest Rate 3% 3% 3%
– Note That The Real Interest Rate Is Unchanged Over The Past 30 Years
– The Real Interest Rate = Nominal Rate - Inflation Rate
Series #7 Debt 47
RISKS WITH BONDS (cont.)
• MARKETABILITY RISK– risk that it'll be difficult to sell
• LIQUIDITY RISK– risk that security can only be sold by incurring
large transaction costs
– longer the term, the lower the quality, the lesser the liquidity
Series #7 Debt 48
RISKS WITH BONDS (cont.)
• LEGISLATIVE RISK– risk that the new laws reduce value of security
• CALL RISK– risk that bonds may be redeemed prior to
maturity
9
Series #7 Debt 49
RISKS WITH BONDS (cont.)
• REINVESTMENT RISK– risk that when interest is received and reinvested, it has
to be invested in a lower yielding security because interest rates have fallen
• EXCHANGE RATE RISK– risk that the value of the foreign currency, in which the
investment is denominated, weakens
• POLITICAL RISK– risk of investing in foreign countries that have weak
political/legal systemsSeries #7 Debt 50
Purchasing power risk is the risk that:
A. the issuing corporation will defaultB. the security will be difficult to sellC. the security will be called prior to it maturingD. inflation will reduce the value of future
interest payments
Series #7 Debt 51
U.S. Treasury securities are subject to which of the following risks?
A. default riskB. marketability riskC. purchasing power riskD. credit risk
Series #7 Debt 52
Which of the following securities is the safest and has the lowest level of credit risk?
A. Equipment Trust CertificateB. General Obligation BondC. Industrial Revenue BondD. Treasury Bond
Series #7 Debt 53
A risk that rising interest rates will cause bond prices to fall is:
A. Credit riskB. Purchasing Power riskC. Legislative riskD. Interest Rate risk
Series #7 Debt 54
Securities subject to reinvestment risk are those that:
I make periodic payments to investorsII do not make periodic payments to investorsIII are held for short time horizonsIV are held for long time horizons
A. I and IIIB. I and IVC. II and IIID. II and IV
10
Series #7 Debt 55
Which of the following investments has the lowest level of reinvestment risk?
A. Preferred StockB. Municipal BondC. Collateralized Mortgage ObligationD. Treasury Bill
Exchange rate risk is a factor to consider when investing in foreign debt issues and the:
I U.S. dollar depreciates in value II U.S. dollar appreciates in value III foreign currency depreciates in value IV foreign currency appreciates in value
A. I and III B. I and IV C. II and III D. II and IV
Series #7 Debt 56
Series #7 Debt 57
Registration of Bonds
• Bearer form– no longer issued in the U.S.; interest and principal are
payable to the holder (bearer) of the bonds• Registered as to Principal Only form
– also no longer issued in U.S.; principal is registered; interest is in bearer form
• Fully Registered form– physical certificate is issued
• Book Entry form– transfer agent keeps a record of who should receive
principal and interest
Series #7 Debt 58
New issues of short term municipal notes and bonds are available in which forms?
I BearerII Book EntryIII Registered to Principal and Interest
A. I B. IIC. IIID. I, II, III
Series #7 Debt 59
New issues of Treasury Notes are issued in:
A. book entry only formB. bearer formC. fully registered formD. registered to principal only form
Series #7 Debt 60
YIELD CURVE
• shows market rates of interest for bonds of different maturities with similar credit ratings
11
Series #7 Debt 61
YIELD CURVE (cont.)• NORMAL
– yields increase as maturities lengthen
– because investors demand premium for the extra risk associated with longer term
– when monetary policy is loosened
– occurs during economic expansion
Series #7 Debt 62
YIELD CURVE (cont.)
• FLAT – when monetary policy
is tightened
– as short term rates rise closer to long term levels
– occurs when economy is peaking
Series #7 Debt 63
YIELD CURVE (cont.)
• INVERTED – when short term rates
rise above long term rates
– occurs when short term credit is severely tightened by the Federal Reserve
Series #7 Debt 64
Rank the yields from highest to lowest.
I AAA CorporatesII GovernmentsIII AAA Municipal
A. I, II, IIIB. I, III, IIC. II, I, IIID. III, II, I
10%, $1000 Gov't 20% Tax Bracket
10% X 1,000 = $100 annually
$20 tax
$80 after tax return
8% Muni = 10% Gov't
given a 20% tax bracket
Series #7 Debt 65
YIELD CURVE THEORIES
• Liquidity Preference– since investors prefer liquidity, short term
issues (which more liquid) should trade at lower yields
Series #7 Debt 66
YIELD CURVE THEORIES (cont.)
• Market Segmentation– investors are restricted to making investments
for when they need their money• i.e. pension funds buy long term issues to fund
future pension liabilities
12
Series #7 Debt 67
YIELD CURVE THEORIES (cont.)
• Expectations– yield curve shape shows investor expectations
as to the future of interest rates • i.e. a positive curve indicates interest rates will rise;
a negative curve indicates they will fall
Series #7 Debt 68
YIELD CURVE THEORIES (cont.)
• the yield curve shapes are really driven by a combination of all of these factors
• yield curves tend to be ascending, showing investors' liquidity preference– if the curve shows unusual dips or rises, it means that the yield and
hence the demand for that maturity is unusually low or high, as compared to other bonds
• i.e. there may be a big demand for 10 year Treasury Bonds by Japanese investors, causing yields for that maturity to drop below those of less popular 15 year bonds
– this validates the market segmentation theory
• also, inflation fears tend to steepen the yield curve, while disinflation would flatten or even invert the yield curve, validating the expectations theory
Series #7 Debt 69
EFFECT OF FEDERAL RESERVE ACTIONS ON YIELD CURVE
SHAPE• 4 TOOLS OF THE FEDERAL RESERVE ("DORM")
– 1. Discount Rate
– 2. Open Market Operations
– 3. Reserve Requirements
– 4. Margin
– 1. Discount Rate• rate at which Fed lends to member banks
• to tighten credit, Fed can raise the rate
• to loosen credit, Fed can lower the rate
Series #7 Debt 70
EFFECT OF FEDERAL RESERVE ACTIONS ON YIELD CURVE
SHAPE– 2. Open Market Operations
• Federal Open Market Committee (FOMC) meets about every 6 weeks to evaluate economic conditions
• at the direction of the FOMC the Federal Reserve trading desk in New York (which trades every day with the 20 or so primary Gov't dealers) will:
Series #7 Debt 71
EFFECT OF FEDERAL RESERVE ACTIONS ON YIELD CURVE
SHAPE– buy U.S. Gov't securities from the primary dealers with
an agreement to sell them back on the next day• overnight repurchase agreement injects cash to the primary
dealers and loosens credit; and interest rates go down: or
– sell U.S. Gov't securities to the primary dealers with an agreement to buy them back on the next day
• overnight reverse repurchase agreement drains cash from the primary dealers and tightens credit; and interest rates go up
Series #7 Debt 72
To loosen credit the Federal Reserve will:
A. sell US Government securities to bank dealers with an agreement to buy them back at a later date
B. buy US Government securities from bank dealers with an agreement to sell them back at a later date
C. sell Foreign Government securities to bank dealers with an agreement to buy them back at a later date
D. buy Foreign Government securities from bank dealers with an agreement to sell them back at a later date
13
Series #7 Debt 73
EFFECT OF FEDERAL RESERVE ACTIONS ON YIELD CURVE
SHAPE– 3. Reserve Requirements
• Federal Reserve establishes the portion of a deposit that banks must maintain on reserve; the balance can be lent out by the bank
– to loosen credit, the Fed can lower the requirement
– to tighten credit, the Fed can raise the requirement
• almost never changed due to the impact of the money multiplier
Series #7 Debt 74
EFFECT OF FEDERAL RESERVE ACTIONS ON YIELD CURVE
SHAPE– 4. Margin on Securities
• Reg T of the Federal Reserve establishes margin on securities
• currently 50% for listed equities– to loosen credit, the Fed can lower the requirement
– to tighten credit, the Fed can raise the requirement
– NOTE: if the Fed changes any rates, all of the money rates would be effected
Series #7 Debt 75
MONEY RATES
• Prime Rate– the rate banks charge their best corporate
clients for loans
• Broker (Call) Loan Rate– the rate banks charge brokerages for margin
accounts
Series #7 Debt 76
MONEY RATES (cont.)
• Federal Funds Rate– the rate banks charge other banks for overnight
loans (for those other banks to meet reserve requirements)
Series #7 Debt 77
MONEY RATES (cont.)
• highest to lowest:– Prime Rate Prime
– Broker Rate Beef
– Discount Rate Does
– Federal Funds Rate Fine
Series #7 Debt 78
Which of the following rates is the highest?
A. Prime RateB. Broker RateC. Federal Funds RateD. Discount Rate
14
Series #7 Debt 79
Which of the following rates is the lowest?
A. Prime RateB. Broker RateC. Federal Funds RateD. Discount Rate
Series #7 Debt 80
All of the following rates are set by banks EXCEPT:
A. Prime Rate
B. Broker Rate
C. Federal Funds Rate
D. Discount Rate
= bank TO best corporate client
= bank TO broker
= bank TO bank
Series #7 Debt 81
YIELD CURVE SHAPES / COMPARISONS
• if the Fed tightens, it exerts its influence at the short end of the curve
• open market operations conducted daily will cause member banks to change their Fed Funds rate (overnight loans of reserves from member to member)– this will cause a shift in short term yields; long
term yields are minimally affected by Fed actions
Series #7 Debt 82
YIELD CURVE SHAPES / COMPARISONS (cont.)
• EXAMPLE: If The Federal Reserve Conducts Reverse Repurchase Agreements With The Primary Dealers, Then This Tightens Credit And Short Term Interest Rates Will Rise And The Yield Curve Will Shift As Follows:
Series #7 Debt 83
YIELD CURVE SHAPES / COMPARISONS (cont.)
• Yield Curve Flattens As Fed Tightening Raises Short Term Rates
• Long Term Rates Don't Move Much Since They Are Determined By Long Term Expectations Of Inflation And Economic Output
Series #7 Debt 84
YIELD CURVE SHAPES / COMPARISONS (cont.)
• EXAMPLE (Cont.): If The Federal Reserve Keeps Tightening, Then Short Term Rates Will Be Pushed Higher Than Long Term Rates And The Yield Curve Inverts
15
Series #7 Debt 85
YIELD CURVE SHAPES / COMPARISONS (cont.)
• The Expectations Theory Of The Yield Curve Shape Now Begins To Make Sense – When The Curve Is Inverted:
• This Shows That The Fed Is Tightening To Slow Down The Economy (Maybe Sending It Into A Recession)
– From This Point, Things Can Only Get Better (Meaning Rates Will Drop As The Fed Starts To Loosen)
– When The Curve Is Ascending:• This Shows That The Fed Is Pursuing A Loose Money Policy
Done To Stimulate The Economy– From This Point, Things Can Only Get Worse (Meaning Rates
Will Rise As The Fed Starts To Tighten)
YIELDS VS PRICES
Series #7 Debt 86
• note, while long term bond prices are more volatile, short term YIELDS are more volatile than long term yields– long term bond prices are more volatile because bonds represent a
series of cash-flows (interest payments) over time plus a final principal payment at maturity
• since long bonds have more interest payments over time AND a final principal payment at the end, there is a bigger change to the value of the bond when interest rates are changed
– short term yields are more volatile because the fed actions effect the “short end” of the yield curve more than the “long end” (to prevent things like inflation)
Series #7 Debt 87
Which statements are true regarding interest rate movements?
I Actions of the Federal Reserve tend to affect short-term rates more than long-term rates
II Actions of the Federal Reserve tend to affect long-term rates more than short-term rates
III Short-term rates are more volatile than long-term rates
IV Long-term rates are more volatile than short-term rates
A. I and IIIB. I and IVC. II and IIID. II and IV
Series #7 Debt 88
COMPARATIVE YIELD CURVES
• used to compare yield curves for issuers in different risk categories
• Yield Spread– difference between
Gov't and AAA-rated corporate yields
Series #7 Debt 89
COMPARATIVE YIELD CURVES (cont.)
• WIDENING spread indicates coming RECESSION– i.e. so investor sells corp. bonds (raising yields)
and buys Gov't bonds (lowering yields)
• NARROWING spread indicates coming EXPANSION– i.e. so investor sells Gov't bonds (raising yields)
and buys corp. bonds (lowering yields)
Series #7 Debt 90
If an analysis of the yield curve indicates a coming expansion, which of the following would hold true?
I investors would be selling government bondsII investors would be selling corporate bondsIII investors would be buying government bondsIV investors would be buying corporate bonds
A. I and IIIB. I and IVC. II and IIID. II and IV
16
Series #7 Debt 91
When it is expected that a recession will occur, which of the following statements are true?
I investors sell corporate bondsII investors buy corporate bondsIII investors sell government bondsIV investors buy government bonds
A. I and IIIB. I and IVC. II and IIID. II and IV
Series #7 Debt 92
CORPORATE DEBT
Series #7 Debt 93
CHARACTERISTICS OF CORPORATE DEBT
• corporations issue debt in order to raise capital
• trades settle -> T + 3
• interest is fully taxable
Series #7 Debt 94
CHARACTERISTICS OF CORPORATE DEBT (cont.)
• TRUST INDENTURE– bond contract which spells out interest rate,
maturity, collateral, call or put provisions, and all other relevant features
– all corporate issues of $50,000,000+ must have a Trust Indenture as specified in the Act of 1939
Series #7 Debt 95
The trust indenture of a bond would specify which of the following?
I interest rateII maturityIII collateral backing the issueIV call provisions
A. III and IV onlyB. I, II, IIIC. I, II, IVD. I, II, III, IV
Series #7 Debt 96
Which of the following issues must have a Trust Indenture as specified by the Trust Indenture Act of 1939?
I a corporate issue of $5,000,000II a U.S. Government Agency issue of
$5,000,000III a municipal issue of $50,000,000IV a corporate issue of $50,000,000
A. IV onlyB. I and IV onlyC. II and III onlyD. I, II, III, IV
17
Series #7 Debt 97
CHARACTERISTICS OF CORPORATE DEBT (cont.)
• FUNDED DEBT– long term corporate debt is referred to as
"funded" debt since issuer has use of funds for a long time before repayment is due (not applicable to commercial paper)
Series #7 Debt 98
"Funded debt" refers to which of the following issues:
A. Commercial Paper with under 270 days to maturity
B. Revenue bond with at least 5 years to maturityC. Corporate debt with at least 5 years to maturityD. T-Bond with at least 5 years to maturity
Series #7 Debt 99
SECURED CORPORATE DEBT
• specific collateral is pledged to back the issue– because of this extra protection, it can be sold at
lower interest rates than unsecured bonds
• if Trust Indenture is "open end", the corporation can sell additional bonds having equal status
Series #7 Debt 100
SECURED CORPORATE DEBT (cont.)
• Additional Bonds Test– usu. there is an "additional bonds test" which
tests to make sure earnings before interest expense for the preceding period exceed both current interest expense plus projected expense on additional bonds sold -- this test must be met before new bonds are sold
– if "closed end", new bonds can be issued only if they are issued as junior to (have a lower status than) existing bonds
Series #7 Debt 101
TYPES OF SECURED CORPORATE DEBT
• MORTGAGE BONDS – most common form of corporate debt
– backed by real estate/property• bondholder has a lien on real estate
– usu. issued by utilities which get a high rating because of the collateral
Series #7 Debt 102
TYPES OF SECURED CORPORATE DEBT (cont.)
• EQUIPMENT TRUST CERTIFICATE– backed by equipment or machinery
– commonly issued by transportation companies (common carriers)
– these are serial issues, requiring the issuer to repay a portion of principal each year until bonds are retired
18
Series #7 Debt 103
TYPES OF SECURED CORPORATE DEBT (cont.)
• COLLATERAL TRUST CERTIFICATE – backed by a portfolio of marketable securities
– used when a parent company pledges the securities of a subsidiary
Series #7 Debt 104
Which of the following corporate bonds are secured?
I collateral trust certificateII subordinated debentureIII second mortgage bondIV equipment trust certificate
A. II and III onlyB. II and IV onlyC. I, III, IVD. I, II, III, IV
Series #7 Debt 105
UNSECURED CORPORATE DEBT• simply backed by issuer's promise to pay• COMMERCIAL PAPER
– very short maturities; usu. 14 to 90 days; 30 days most common
• will never exceed 270 days because then it'd be SEC registered (which is expensive and time consuming)
– sold at a discount maturing at par– sold in units $100,000 up to $1,000,000– sold in book entry form– purchasers are large institutions with excess cash to
invest– limited trading as investors hold them to maturity
Series #7 Debt 106
UNSECURED CORPORATE DEBT (cont.)
• DEBENTURE– intermediate and long term corporate debt
backed solely by full faith and credit
– issued by "Blue Chip" organizations with high credit ratings or lower credit rated companies in the form of high yield or "junk" bonds
Series #7 Debt 107
UNSECURED CORPORATE DEBT (cont.)
• SUBORDINATED DEBENTURE– holders agree to a lower status than debentures
in a corporate liquidation
– interest rate is increased to induce customers to buy
– gets paid AFTER the debentures if the corporation liquidates
Series #7 Debt 108
UNSECURED CORPORATE DEBT (cont.)
• GUARANTEED BOND– typically issued by a subsidiary, with the
corporate parent guaranteeing the interest and principal as due
• these bonds take on the credit rating of the guarantor
19
Series #7 Debt 109
UNSECURED CORPORATE DEBT (cont.)
• INCOME / ADJUSTMENT BONDS– issued when corporation is about to go bankrupt —
done to replace existing bonds– only obligates issuer to pay if it has sufficient earnings– bondholders are likely to accept this new instrument
because they're receiving nothing anyway– interest is only paid if corporation returns to
profitability– trade flat - without accrued interest (because bonds are
not currently paying interest)
Series #7 Debt 110
Which of the following best describes a bond which is trading "flat"?
A. the bond is purchased at parB. the bond is purchased without accrued
interestC. the bond is purchased to receive interest
payments annuallyD. the bond is purchased at a discount and
matures at par
Series #7 Debt 111
Which of the following bonds trades "flat"?
A. Unsecured bondsB. Income bondsC. Reset bondsD. Mortgage bonds
Series #7 Debt 112
A corporate bond which obligates the issuer to pay interest only if the company meets specified earnings tests is a(n):
A. guaranteed bondB. subordinated bondC. income bondD. collateral trust certificate
Series #7 Debt 113
A corporate bond which is backed solely by the full faith and credit of the issuer is known as a:
A. debentureB. income bondC. mortgage bondD. general obligation bond
Series #7 Debt 114
A short term corporate bond which is backed solely by the full faith and credit of the issuer is known as:
A. commercial paperB. income bondC. mortgage bondD. general obligation bond
20
Series #7 Debt 115
CONVERTIBLE CORPORATE DEBT
• can be converted, at the option of the holder, into common stock
• at the time of issuance, the conversion price is set per share
• bond can be converted into a fixed number of common shares based on par value
Series #7 Debt 116
ARBITRAGE
• trader buys the lower priced security and simultaneously sells equivalent higher priced security to lock in profit
Series #7 Debt 117
CONVERTIBLE BOND ADVANTAGES AND DISADVANTAGES
• ADVANTAGE TO ISSUER– benefit to issuer is that investor will accept lower
interest rate since there's potential price appreciation based on converting bond if stock price rises
– Forced Conversion• when bonds are called, the issuer can replace bonds with equity
securities and this relieves issuer of interest payment burden
• DISADVANTAGE TO ISSUER– tax deductible interest payments for corporation are
replaced by nondeductible dividends
Series #7 Debt 118
CONVERTIBLE BOND ADVANTAGES AND DISADVANTAGES (cont.)
• ADVANTAGE TO BONDHOLDER– benefit to bondholder is the possibility of capital gains
• DISADVANTAGE TO BONDHOLDER– Dilution Of Earnings
• when conversion occurs, existing stockholders' equity is diluted
• bondholders receive lower interest rates and possible dilutive effect of a large conversion
• in order to issue convertible bonds, shareholder approval is necessary
• once convertible securities are issued, bondholder is protected by an antidilutive covenant
– conversion ratio is adjusted for stock dividends and splits
Series #7 Debt 119
CONVERTIBLE CORPORATE DEBT (cont.)
Conversion Ratio =Par Value
Conversion Price
Conversion Ratio =Bond' s Market / Parity Price
Stock' s Market / Parity Price
Series #7 Debt 120
CONVERTIBLE CORPORATE DEBT (cont.)
• EXAMPLE: A 10%, $1,000 Par Convertible Bond Is Issued When The Market Price Of The Common Stock Is $40 Per Share. The Conversion Price Per Share Is Set At $50 Per Share. The Conversion Ratio Is:
1,000 = C.R.
C.P.
1,000 = C.R.
$50
1,000 = 20:1
$50
21
Series #7 Debt 121
CONVERTIBLE CORPORATE DEBT (cont.)
• EXAMPLE: A 10%, $1,000 Par Convertible Bond Is Issued When The Market Price Of The Common Stock Is $40 Per Share. The Conversion Price Per Share Is Set At $50 Per Share. Currently The Market Price Of The Stock Is $60 Per Share. The Parity Price Of The Bond Is:
X = 20
$60
1,200 = 20
$60
Series #7 Debt 122
CONVERTIBLE CORPORATE DEBT (cont.)
• EXAMPLE: A 10%, $1,000 Par Convertible Bond Is Issued When The Market Price Of The Common Stock Is $40 Per Share. The Conversion Price Per Share Is Set At $50 Per Share. Currently The Market Price Of The Bond Is $1,400. The Parity Price Of The Stock Is:
1,400 = 20
X
1,400 = 20
$70
Series #7 Debt 123
A customer bought a $1,000 par convertible subordinated debenture at par, convertible into common at $25 per share. If the bond's market price increases by 20%, the parity price of the stock will be:
A. 25B. 30C. 40D. 48
1000 = C.R. ; 1000 = 40:1
C.P. $25
1200 = 40 ; 1200 = 40:1
P.P. $30
Series #7 Debt 124
A convertible debenture is convertible into common at $40 per share. If the market price of the bond rises to a 10 point premium over par, which statements are true?
I The conversion ratio is 20:1II The conversion ratio is 25:1III The parity price of the stock is $44IV The parity price of the stock is $50
A. I and IIIB. I and IVC. II and IIID. II and IV
1000 = C.R. ; 1000 = 25:1
C.P. $40
1100 = 25 ; 1100 = 25:1 ; 1100 = 25
P.P. X $44
Series #7 Debt 125
A corporation has issued 10%, $1000 par convertible debentures, convertible at $40. The common stock is currently trading at $45. If the bond and the common are trading at parity, a customer purchasing 5M of the bonds will pay:
A. $4,950B. $5,000C. $5,625D. $6,550
1000 = C.R. ; 1000 = 25:1
C.P. $40
Bond's Price = 25 ; Bond's Price = 25 X 45
45
Series #7 Debt 126
ABC has 10%, $1,000 par convertible bonds outstanding convertible at a 40:1 ratio. The common stock is currently trading at $24.75. If the bond is currently trading at 101, at what market price of the common stock would an arbitrage possibility exist between the convertible bond and the stock into which it is convertible?
A. 24B. 25C. 25.25D. 26
1010 = 40 ; 1010 = 40P.P. $25.25
22
Series #7 Debt 127
Corporate bonds are issued with an "anti-dilutive" covenant. If the corporation declares a 5% stock dividend, which statements are true?
I The conversion price is reduced II The conversion price is increasedIII The number of common shares is reducedIV The number of common shares is
increased
A. I and IIIB. I and IVC. II and IIID. II and IV
Series #7 Debt 128
CORPORATE DEBT RETIREMENT PROVISIONS• RETIRING DEBT
– corporate bonds may be redeemed at maturity or if a call provision is included in Trust Indenture, it may be called under terms of this
– sinking fund• money is deposited into a fund periodically (usu.
annually) and the funds are used to retire bonds at maturity or retire a portion of them each year on a random order basis after a specified date
Series #7 Debt 129
CORPORATE DEBT RETIREMENT PROVISIONS (cont.)
• REFUNDING DEBT– instead of retiring debt, corporation may simply
roll it over in part or in full (they'll issue new debt to replace the debt that's maturing)
• PRE-REFUNDING DEBT– issued when interest rates have dropped
• done to retire expensive debt and replace it with lower interest rate debt
Series #7 Debt 130
Other Debt Retirement Provisions
• Advance Refunding (mainly applicable to munis)– municipalities advance refund bonds when interest rates have dropped;
and they have bonds they would like to call in, but the call date is years in the future
– i.e. municipal G.O. bonds are subject to debt limits• if a municipality is at its limit, and interest rates have dropped, the municipality would
like to issue bonds, but can’t
– in the municipal bond contract is a “defeasance covenant” which allows a municipality to replace the backing of the bond with escrowed Treasurys, Agencies, or sometimes Bank CDs
• the municipality buys these securities that mature at the upcoming call date, escrow them with a trustee, and these back the old bonds, making them self supporting and taking them out of the debt limit
• the outstanding debt is considered void (defeased) either legally or in substance
Series #7 Debt 131
Which of the following corporate bonds would most likely be refunded by the issuer?
A. 5%, M'36, callable in 2016 at parB. 6%, M'36, callable in 2016 at 102C. 8%, M'36, callable in 2016 at 102D. 8%, M'36, callable in 2016 at par
1
Series #7 Debt 1
Debt Securities II
Series #7 Debt 2
EFFECTS OF INTEREST RATE MOVEMENTS ON BOND PRICES
• DISCOUNT BOND
• PREMIUM BOND
• PAR BOND
Series #7 Debt 3
BOND YIELDS• NOMINAL YIELD = stated
rate of interest (the coupon)
• CURRENT YIELD
• YIELD TO MATURITY = takes into account both market price and gains/losses if held to maturity
• YIELD TO CALL/PUT = takes into account both market price and the price at which the bond is called (or put)
Series #7 Debt 4
Discount $800
$1,000 Par, 10 %, w/ 10 years to maturity
Interest rates going up
Series #7 Debt 5
Discount $800
$1,000 Par, 10 %, w/ 10 years to maturity
Interest rates going up
Current Yield = 12.5%
Series #7 Debt 6
Discount $800
$1,000 Par, 10 %, w/ 10 years to maturity
Interest rates going up
Current Yield = 12.5%
Yield to Maturity = 13.3%
2
Series #7 Debt 7
+20
+20
+20
Series #7 Debt 8
Discount $800
$1,000 Par, 10 %, w/ 10 years to maturity
Interest rates going up
Current Yield = 12.5%
Yield to Maturity = 13.3%
Yield to Call = 15.5%
Series #7 Debt 9
+40
+40
+40
Series #7 Debt 10
Discount $800
$1,000 Par, 10 %, w/ 10 years to maturity
Interest rates going up
Current Yield = 12.5%
Yield to Maturity = 13.3%
Yield to Call = 15.5%
YTC > YTM > CY > Coupon for a discount bond
Series #7 Debt 11
Premium $1,200
$1,000 Par, 10 %, w/ 10 years to maturity
Interest rates going down
Series #7 Debt 12
Premium $1,200
$1,000 Par, 10 %, w/ 10 years to maturity
Interest rates going down
Current Yield = 8.3%
3
Series #7 Debt 13
Premium $1,200
$1,000 Par, 10 %, w/ 10 years to maturity
Interest rates going down
Current Yield = 8.3%
Yield to Maturity = 7.27%
Series #7 Debt 14
-20-20
-20
Series #7 Debt 15
Premium $1,200
$1,000 Par, 10 %, w/ 10 years to maturity
Interest rates going down
Current Yield = 8.3%
Yield to Maturity = 7.27%
Yield to Call = 5.5%← Bond must be priced here
Series #7 Debt 16
-40
-40
-40
Series #7 Debt 17
Premium $1,200
$1,000 Par, 10 %, w/ 10 years to maturity
Interest rates going down
Current Yield = 8.3%
Yield to Maturity = 7.27%
YTC < YTM < CY < Coupon for a premium bond
Yield to Call = 5.5%← Bond must be priced here
Series #7 Debt 18
Premium $1,200
$1,000 Par, 10 %, w/ 10 years to maturity
Current Yield = 8.3%
Yield to Maturity = 7.27%
Current Yield = 12.5%
Yield to Maturity = 13.3% ← Bond must be priced here
Yield to Call = 15.5%
Discount $800
interest rates
Yield to Call = 5.5%← Bond must be priced here
4
Series #7 Debt 19
A corporation has issued 10% AA rated sinking fund debentures at par. Three years later, similar issues are being offered in the primary market at 12%. Which are true statements about the outstanding 10% issue?
I The current yield will be higher than the nominal yield
II The current yield will be lower than the nominal yield
III The dollar price of the bond will be at a premium to par
IV The dollar price of the bond will be at a discount to par
A. I and III
B. I and IV
C. II and III
D. II and IV
Discount
$1,000 Par
Current Yield
Yield to Maturity
Yield to Call
YTC > YTM > CY > NY
Series #7 Debt 20
When the price of a bond increases, which of the following statements regarding yields are true?
I Current yield increasesII Current yield decreasesIII Yield to maturity increasesIV Yield to maturity decreases
A. I and IIIB. I and IVC. II and IIID. II and IV
Premium
$1,000 Par
Current Yield
Yield to Maturity
Yield to Call <- Bond must be priced here
YTC < YTM < CY < NY
Premium
$1,000 Par
Current Yield
Yield to Maturity
Yield to Call <- Bond must be priced here
YTC < YTM < CY < NY
Series #7 Debt 21
A customer buys 5 GMAC 10% debentures, M‘30. The interest payment dates are Feb 1 and Aug 1. The bonds are callable as of 2020 at 103. The current yield on the bonds is 11.76%. The bond is trading:
A. at a premiumB. at a discountC. at parD. in the money
Series #7 Debt 22
A customer buys 5 GMAC 10% debentures, M‘30 at 150. The interest payment dates are Feb 1 and Aug 1. The bonds are callable as of 2020 at 103. The current yield on the bonds is:
A. 6.7%B. 8.7%C. 10%D. 11.4%
100 = 6.7%
1500
Series #7 Debt 23
A premium bond must be quoted to a customer based on the bond’s:
A. Nominal YieldB. Current YieldC. Yield to MaturityD. Yield to Call
Series #7 Debt 24
A discount bond must be quoted to a customer based on the bond’s:
A. Nominal YieldB. Current YieldC. Yield to MaturityD. Yield to Call
5
Series #7 Debt 25
A municipality issues a 30-year zero-coupon bond at deep discount. The bond is callable at 103. The bond is called in Year 10 when its current accreted value is $500. The bondholder will receive:
A. $500 B. $515C. $1,000 D. $1,030
103% X 500 = 515
Series #7 Debt 26
Which bond, having the following yields, must be priced "Yield to Call"?
A. nominal yield = 6%; current yield = 7%B. nominal yield = 6%; current yield = 6%C. nominal yield = 6%; current yield = 5.5%D. nominal yield = 6%; current yield = 6.5%
Series #7 Debt 27
A customer buys a 10% G.O. bond at par. The issue is callable in 5 years at par and matures in 10 years. Which statement is true?
A. The yield to call is higher than the yield to maturity
B. The yield to call is lower than the yield to maturity
C. The yield to call is the same as the yield to maturity
D. The nominal yield is higher than either the yield to call or yield to maturity
Series #7 Debt 28
The following revenue bonds have the same maturity. Which of the following will cost the greatest amount?
A. 5% bond quoted on a 5.25 basisB. 5 ¼% bond quoted on a 5.00 basisC. 5 ½% bond quoted on a 5.50 basisD. 5 ¼% bond quoted on a 5.50 basis
Series #7 Debt 29
A customer buys an 8% $1,000 par bond with 15 years to maturity at 101. What is the yield to maturity?
A. 7.89%B. 8%C. 8.32%D. 8.69%
Premium
$1,000 Par
Current Yield
Yield to Maturity
Yield to Call <- Bond must be priced here
YTC < YTM < CY < NY
Premium
$1,000 Par
Current Yield
Yield to Maturity
Yield to Call <- Bond must be priced here
YTC < YTM < CY < NY
Approximating the Price of a Long Term Bond
• by using the current yield formula, one can get an approximate price of a long term bond issue
• note, that Current Yield = Annual Income
Market Price
• thus, to solve for Market Price = Annual Income
(Current) Yield
Series #7 Debt 30
$800 $1,200
• approximating a 4%, 1000 par bond trading on a 5% basis
• approximating a 6%, 1000 par bond trading on a 5% basis40 =
.0560 =.05
6
Series #7 Debt 31
TRADING OF CORPORATE DEBT
• TRACE (Trade Reporting And Compliance Engine)– trade reporting system that reports corporate bond trades within
15 minutes of execution
• DEALER PAPER - sold thru dealers• DIRECT PAPER - sold by issuer• NYSE Trading
– computerized system which matches trades– bonds of companies that are listed on the exchange are traded here– round lot is 5 $1,000 par bonds quoted as a % of par in 1/8ths
Series #7 Debt 32
Trades of which of the following would be reported through TRACE?
I U.S. Government BondsII Investment Grade Corporate BondsIII Non-Investment Grade Corporate BondsIV Money Market Instruments
A. I and IIB. II and IIIC. III and IVD. I and IV
Series #7 Debt 33
SETTLEMENT AND ACCRUED INTEREST
• REGULAR WAY • CASH• SELLER'S OPTION - seller can’t settle in 3• WHEN ISSUED - no idea of settlement• ACCRUED INTEREST – 30/360 basis• TRADING FLAT - w/o accrued interest• ODD FIRST INTEREST PAYMENT
– first interest payment is not 6 months– the bond is issued on a day other than one of the
interest payment dates
Series #7 Debt 34
ABC Corporation is issuing $100MM of bonds paying interest on February 1 and August 1 of each year until maturity. The dated date of the issue is July 1, 2016. The first payment will be made on February 1, 2017. A bondholder purchases the issue at the offering. The first interest payment will cover a period of:
A. 1 monthB. 5 monthsC. 6 months D. 7 months
A new issue corporate bond has a dated date of September 1st. The bond is assigned by the issuer to the underwriter on August 31st. Accrued interest on the bond will be calculated based on how manydays in a year?
A. 359B. 360C. 364D. 365
Series #7 Debt 35 Series #7 Debt 36
SETTLEMENT AND ACCRUED INTEREST (cont.)• if a customer buys a bond in between
interest payments, the buyer must pay the seller accrued interest because on the next interest payment date he receives 6 months worth of interest, regardless of him having held the bond for 6 months
7
Series #7 Debt 37
SETTLEMENT AND ACCRUED INTEREST (cont.)• For a new issue bond:
– accrued interest starts accruing from dated date (the very first day the bond trades in the market) up to but NOT including settlement
• For a secondary bond:– accrued interest starts accruing from the
morning of the last interest payment, up to but NOT including settlement
Series #7 Debt 38
SETTLEMENT AND ACCRUED INTEREST (cont.)• EXAMPLE: A 10%, $1,000 Par Bond Pays
Interest Feb 1 and Aug 1. A customer buys the bond on Tuesday, May 15 In A Regular Way Trade. How Many Days Of Accrued Interest Does The Buyer Owe The Seller? Feb 30
Mar 30
Apr 30
May 17
107 days
Series #7 Debt 39
A customer buys a 10%, $1,000 par bond M’20 which pays interest Jan 1 and Jul 1 on Mar 15. How many months of interest will the buyer receive at the next interest payment?
A. 3
B. 3 1/2
C. 4 1/2
D. 6
Series #7 Debt 40
A customer buys 10 Allied Corporation 8% debentures, M'20, at 90 on Wednesday, April 19. The interest payment dates are Mar 1 and Sept 1. The trade settled on Monday, April 24. How many days of accrued interest will the buyer pay to the seller?
A. 23B. 52C. 53D. 54
Mar 30
Apr 23
53 days
Series #7 Debt 41
A 10%, $1,000 par corporate bond which matures Jan 1, ‘20 is purchased on Tuesday, October 24. How many days of accrued interest will the buyer pay the seller?
A. 113B. 114C. 116D. 117
Jul 30
Aug 30
Sep 30
Oct 26
116 daysSeries #7 Debt 42
A 10%, $1,000 par corporate bond which pays interest Jan 15 and Jul 15 is purchased with settlement occurring on Tuesday, April 24. How many days of accrued interest will the buyer pay the seller?
A. 98 B. 99C. 102D. 103
Jan 16
Feb 30
Mar 30
Apr 23
99 days
8
Series #7 Debt 43
U.S. GOV'T DEBT
Series #7 Debt 44
U.S. GOV'T DEBT IS SOLD AT AUCTION
• short term CMBs and Treasury Bills, intermediate Treasury Notes, and long term Treasury Bonds are issued in book entry form (since 1983)
• Treasury Bills are sold at the weekly auction
• Treasury Notes & Bonds – monthly
• TIPS - quarterly
CASH MANAGEMENT BILLS (CMBs)
• these are the shortest term Treasurys auctioned irregularly (i.e. not according to any schedule), when the Gov’t needs money
• they are issued at a discount from $100 par and mature at par
Series #7 Debt 45 Series #7 Debt 46
TREASURY BILLS
• issued with 4-week, 13-week, 26-week, and 52-week (as of 6/08) maturities
• issued at a discount from par - $100 minimum - and mature at par
• quoted on a discount yield basis
• trades settle next business day
Series #7 Debt 47
Treasury Notes
• maturities range from 2 to 10 years• issued in multiples of $100 par value• trades settle next business day• pay interest semi-annually • accrued interest is based on a
actual/actual basis• quoted in 32nds• are non-callable
Series #7 Debt 48
Treasury Bonds• maximum maturity is 30 years
• multiples of $100 par
• trades settle next business day
• pay interest semi-annually
• accrued interest is based on an actual/actual basis
• quoted in 32nds
• long-term Treasury Bonds are usu. callable 5 years prior to maturity– i.e. if interest rates have dropped
9
Series #7 Debt 49
REPACKAGED U.S. GOVERNMENT DEBT
• Treasury Receipts– i.e brokerage firm buys a large basket of 20
year T-Bonds and deposits them with a trustee• the bonds are then stripped of their coupons and
units are sold representing the repayment of principal at maturity
Series #7 Debt 50
Treasury Receipts (cont.)
• these are zero coupons which are NOT subject to reinvestment risk because of their fixed rate of return– rate is locked in by amount of discount at purchase
• zero coupons are subject to greater degree of liquidity risk than regular gov'ts, but the dealer will them buy back at any time
• rated AAA because of their backing• extremely volatile price swings (as these are zeros),
but the purchaser doesn't worry since the securities are usu. held to maturity
Series #7 Debt 51
Which of the following statements are true about Treasury Receipts?
I the interest income on the Receipts is subject to Federal income
tax each year
II the investor "locks in" a rate of return that is free from
reinvestment risk if the Receipt is held to maturity
III the underlying bonds are held by a trustee for the beneficial
owners
IV the Receipts are issued by broker-dealers, who maintain a
secondary market in these securities
A. I and II
B. I and III
C. II, III, IV
D. I, II, III, IVSeries #7 Debt 52
TREASURY STRIPS
• Separate Trading of Registered Interest and Principal of Securities
• zero-coupon Treasuries issued directly by the U.S. Gov't
• available in book entry form
Series #7 Debt 53
TIPS• Treasury Inflation Protection Securities
– TIPS mechanics• the interest rate on TIPS is fixed at issuance
and approximates the real interest rate• the principal amount is adjusted every 6
months by an amount equal to the change in consumer price index
• the fixed interest rate times the adjusted principal amount equals to the interest payment to be received
Series #7 Debt 54
TIPS (cont.)
EXAMPLE: 2010sYield On Long Term Treasuries 4%Inflation Rate 1%Real Interest Rate = TIPS Coupon 3%
– whereas a long-term Treasury Bond issued in 2014 has a nominal interest rate of 4%, the equivalent maturity TIPS has a coupon of 3%
– the difference is that TIPS adds an extra annual return equal to that year's inflation rate.
– thus, the yield on a TIPS = the real interest rate plus the inflation rate
10
Series #7 Debt 55
TIPS (cont.)• as inflation increases, the return on TIPS increases
– since the principal amount is adjusted upwards with inflation, the fixed interest rate times the adjusted principal amount equals a higher dollar amount of interest received
– at maturity, the bondholder receives the higher principal amount
– because of the principal amount being adjusted, these securities are not subject to purchasing power risk.
• note that if there is deflation, the principal amount is adjusted downwards– therefore, the interest payment received will decrease– however, at maturity, the investor gets par, not the lowered
principal amount.
TIPS (cont.)
• TIPS Mechanics:– i.e. a customer buys a 3% $1,000 par TIPS
– in the first year the customer gets 3% of $1,000 = $30 of interest
– assume in Year 1 that inflation runs at the rate of 2%• the principal amount is adjusted to $1,000 x 1.02 = $1,020.
– in Year 2, the customer gets interest of 3% of $1,020 = $30.60• assume that inflation rose to 4% that year
• now the principal amount is adjusted to $1,020 x 1.04 = $1,060.80
– in Year 3, the customer gets interest of 3% of $1,060.80 = $31.82• assume that inflation rose to 6% that year
• now the principal amount is adjusted to $1,060.80 x 1.06 = $1,124.45
– Etc…
Series #7 Debt 56
Series #7 Debt 57
Which of the following are true statements regarding both Treasury Bills and Treasury Receipts?
I Both securities are sold at a discountII Both securities are issued by the U.S.
GovernmentIII Both securities pay interest at maturityIV Both securities are money market instruments
A. I and IIIB. II and IVC. I, II, IIID. I, II, III, IV
Series #7 Debt 58
Which statements are true when comparing Treasury Notes to Treasury Bills?
I Treasury Bills have a longer initial maturityII Treasury Notes have a longer initial maturityIII Treasury Bills pay interest semi-annuallyIV Treasury Notes pay interest semi-annually
A. I and IIIB. I and IVC. II and IIID. II and IV
Series #7 Debt 59
Which statements are true when comparing Treasury Notes to Treasury STRIPS?
I Treasury Notes pay interest semi-annuallyII Treasury Notes pay interest at maturityIII Treasury STRIPS pay interest semi-annuallyIV Treasury STRIPS pay interest at maturity
A. I and IIIB. I and IVC. II and IIID. II and IV
Which Treasury security is NOT sold on a regular auction schedule?
A. CMBsB. T-BillsC. T-NotesD. T-Bonds
11
Series #7 Debt 61
Agency Debt
Series #7 Debt 62
GOVERNMENT SPONSORED ENTITIES (GSEs)
• created by Congress to reduce the cost of credit to targeted borrowing sectors, like agriculture, home finance, and education
• these entities are set up as:– Government Agencies: Government National Mortgage
Association (Ginnie MAE) which is a division of the government whose securities are backed by the full faith and credit of the United States government
– Regional Bank Systems: • Federal Home Loan Banks and Federal Farm Credit Banks; and
– privately owned corporations: Student Loan Marketing Association (Sallie MAE); Federal National Mortgage Association (Fannie MAE); and Federal Home Loan Mortgage Corporation (Freddie MAC)
Series #7 Debt 63
Which of the following statements are true for both government and agency securities?
I They are exempt from registration under the Securities Act of 1933
II Interest bearing obligations are quoted in 32ndsIII Trades settle in Federal FundsIV They are eligible for trading in Federal Reserve
open market operations
A. I and IIIB. I and IVC. II and IIID. I, II, III, IV
Series #7 Debt 64
Farmer Loans• FED. FARM CREDIT
CONSOLIDATED SYSTEM– to provide funding to farmers for short term
loans for planting and harvesting; intermediate term loans for equipment; and long term loans to buy land and buildings
Series #7 Debt 65
U.S. GOV'T PROMOTES HOME OWNERSHIP THROUGH
ACTIVITIES OF:• Federal Home Loan Banks
• Federal National Mortgage Association -Fannie Mae
• Government National Mortgage Association -Ginnie Mae
• Federal Home Loan Mortgage Corporation -Freddie Mac
FEDERAL HOME LOAN BANKS
(FHLB)• loan funds to Savings and Loans Institutions with main
collateral being S&L mortgages
• issues:– Discount Notes
• short term obligations of 1 year or less, sold at a discount from $100,000 face with $1,000 increments thereafter
– Bonds• $10,000 face callable bonds with up to a 30 year maturity paying
interest semi-annually
• note that non-callable bonds are also issued and known as “Bullet Bonds” because they are identified in dealer offering listings with a “bullet” next to the listing, indicating a non-callable bond
Series #7 Debt 66
12
Series #7 Debt 67
Mortgage Mess
• note that despite the Federal Gov't "takeover" of Fannie and Freddie, these securities are still NOT directly government guaranteed
Series #7 Debt 68
Which of the following agencies is directly backed by the U.S. Government?
A. FNMAB. FHLMCC. FLBD. GNMA
Series #7 Debt 69
Features of Mortgage Backed Pass Through Certificates
• each agency continuously buys mortgages from originating banks, giving the banks “new” funds to lend out for new mortgages
• once a sufficient amount of mortgages have been bought, they are placed into a “pool”
• the agency divides the pool in $25K mortgage backed pass through certificates and sells them to investors
Features of Mortgage Backed Pass Through Certificates (cont.)
– as mortgage payments are received from the pooled mortgages, the payments are “passed thru” to the certificate holders
• payments, made monthly, represent a portion of principal and interest with the certificates “self-liquidating” as the mortgages are paid off
Series #7 Debt 70
Series #7 Debt 71 Series #7 Debt 72
FEATURES OF MORTGAGE BACKED PASS THROUGH CERTIFICATES (CONT.)
• if interest rates drop substantially, homeowners prepay their mortgages and the curve looks like:
Prepayment Risk
13
Series #7 Debt 73
FEATURES OF MORTGAGE BACKED PASS THROUGH CERTIFICATES (CONT.)
• the prepayments received result in the certificates being paid off much sooner than the expected life of 15 years – i.e. the principal is repaid faster than the Prepayment Speed Assumption
• since interest rates have dropped, if an investor uses the prepayments received to buy new mortgage backed pass through certificates, he or she will earn the lower current market rate– thus, prepayment risk has been passed through to the
certificate holder
Series #7 Debt 74
FEATURES OF MORTGAGE BACKED PASS THROUGH CERTIFICATES (CONT.)
• if interest rates rise substantially, homeowners will not move and will stay in their homes longer than expected and the curve looks like: Extension Risk
Series #7 Debt 75
FEATURES OF MORTGAGE BACKED PASS THROUGH CERTIFICATES (CONT.)
• the principal payments are received much later than the expected life of 15 years
• since interest rates have risen, the investor winds up holding a security that is giving a lower market rate of interest for a much longer period of time than they ever expected– this is known as extension (or extended
maturity) risk
Series #7 Debt 76
FEATURES OF MORTGAGE BACKED PASS THROUGH CERTIFICATES (CONT.)
• To Summarize– these are $25,000 certificates which makes them expensive
for the average investor– the expected maturity is not fixed
• if interest rates drop after issuance, homeowners prepay their mortgage and the maturities shorten (prepayment risk)
• if interest rates rise after issuance, homeowners pay off their mortgage slower than expected and the maturities lengthen (extension risk)
– the next generation of securities based on mortgages attempted to address these problems and minimize these risks
– the very first "collateralized mortgage obligation" was created in 1981
Series #7 Debt 77
COLLATERALIZED MORTGAGE OBLIGATIONS
• CMOs are created by brokerage firms that purchase a block of Ginnie Mae, Fannie Mae, or Freddie Mac certificates and place them into trust
• units of the trust are sold to investors in $1,000 minimum denominations, making these securities accessible to the smaller investor
• unlike the underlying mortgage backed pass through certificates that pass through monthly payments as received, to the certificate holders, CMOs change the way in which payments are made to investors
Series #7 Debt 78
COLLATERALIZED MORTGAGE OBLIGATIONS (CONT.)
• CMOs divide the mortgage repayment curve into separate securities called "tranches"– a single security backed by 30 year mortgages
is divided into 10 separate maturities each having a different yield (a normal yield curve -shorter maturities yield less, longer maturities yield more - average across the whole is the same as the mortgage backed pass throughs)
14
Series #7 Debt 79
COLLATERALIZED MORTGAGE OBLIGATIONS (CONT.)
Series #7 Debt 80
COLLATERALIZED MORTGAGE OBLIGATIONS (CONT.)
– PLAIN VANILLA CMO• interest is paid "pro-rata" to all the tranches;
principal repayments are paid sequentially to the first, then second, then third, etc…
– PLANNED AMORTIZATION CLASS (PAC)
• principal repayments made later than expected are applied here
• the PAC has a more certain maturity date than the Companion Class
• protects against prepayment risk and extension risk
Series #7 Debt 81
COLLATERALIZED MORTGAGE OBLIGATIONS (CONT.)
– TARGETED AMORTIZATION CLASS (TAC)
• a TAC bond pays a "target" amount of principal each month
• like the PAC, it protects against prepayment risk, however, it does NOT protect against extension risk
Series #7 Debt 82
COLLATERALIZED MORTGAGE OBLIGATIONS (CONT.)
– COMPANION CLASS• principal repayments received which are
above what was required are applied here
• has a high level of prepayment risk if interest rates fall
• has a high level of extension risk if interest rates rise
COLLATERALIZED MORTGAGE OBLIGATIONS (CONT.)
• Z-tranche– receives the interest and principal payments
only after the other tranches in the CMO have been filled
– essentially these are zero-coupons, having the greatest volatility of all tranches
– investors in these seek minimum reinvestment and call risk
• but they have the greatest interest rate risk
Series #7 Debt 83
COLLATERALIZED MORTGAGE OBLIGATIONS (CONT.)
• Floating Rate Tranches– CMO tranches that have interest rates tied to a
recognized index, like the London Interbank Offered Rate (LIBOR)
• as the LIBOR moves, the interest rate of the tranche moves in tandem, subject to a maximum cap and minimum floor, thus market risk is minimized
Series #7 Debt 84
15
COLLATERALIZED MORTGAGE OBLIGATIONS (CONT.)
• Principal Only / Interest Only Securities– created by breaking apart the interest stream
from the principal repayments generated by the underlying collateral
• they can be created from the mortgage backed security or in the form of a CMO tranche
Series #7 Debt 85
COLLATERALIZED MORTGAGE OBLIGATIONS (CONT.)
• Principal Only (PO) Security – pays out based on principal payments, so
smaller amounts in earlier years and larger amounts in later years
• it sells at a deep discount and has great price volatility (like all zeroes)
• if interest rates rise, prepayment speeds decrease and the maturity lengthens, so the bond’s price decreases
• If interest rates fall, prepayment speeds increase and the maturity shortens, so the bond’s price increases
Series #7 Debt 86
COLLATERALIZED MORTGAGE OBLIGATIONS (CONT.)
• Interest Only Security– only pays out based on the interest payments
made, so larger amounts in the early years and smaller amounts in the later years
• it also sells at a discount, but since most payments are in the early years, it exhibits lesser price volatility
Series #7 Debt 87
COLLATERALIZED MORTGAGE OBLIGATIONS (CONT.)
• Interest Only Security (cont.)– IO prices move in the same direction as interest
rates!• if market interest rates rise, prepayment speeds
decrease and the maturity lengthens– thus, the holder receives interest for a greater period of time,
so the price of the IO rises as well
• if market interest rates fall, prepayment speeds increase and the maturity shortens
– thus, the holder receives interest for a shorter period of time, so the price of the IO falls as well
Series #7 Debt 88
PRIVATE CMOs• private institutions, like subsidiaries of investment banks, financial
institutions, and home builders, also issue mortgage securities
• when issuing CMOs, they often use agency mortgage pass-through securities as “collateral”; however, they also use collateral which includes different types of mortgage loans or mortgage loan pools, letters of credit, or other types of credit enhancements
– these CMOs are the sole obligation of their issuer
• to the extent that private-label CMOs use only agency mortgage pass-through securities as collateral, their agency collateral carries the respective agency’s guarantees (essentially AAA).
• private CMOs are assigned credit ratings by independent credit agencies based on their structure, issuer, collateral, and any other guarantees or outside factors (which could be less than AAA)
Series #7 Debt 89
COLLATERALIZED DEBT OBLIGATION (CDO)
• whereas a CMO holds underlying mortgages and then slices the mortgage payments into cash flows to create different tranches, the CDO takes this process a step further– the CDO is a special purpose entity (SPE) that buys
tranches of “private label” CMOs which were created from sub-prime mortgages and NOT Fannie, Freddie, or Ginnie based mortgages
Series #7 Debt 90
16
Series #7 Debt 91
Regarding interest rates and their effect on the expected maturity of a CMO, which of the following are true?
I if interest rates rise, then the expected maturity will lengthen
II if interest rates rise, then the expected maturity will shorten
III if interest rates fall, then the expected maturity will lengthen
IV if interest rates fall, then the expected maturity will shorten
A. I and IIIB. I and IVC. II and IIID. II and IV
Series #7 Debt 92
When comparing CMOs' Companion Class and Planned Amortization Class (PAC), one finds:
I the PAC has a more certain maturity dateII the Companion Class has a more certain maturity dateIII the PAC has a higher level of prepayment risk if
interest rates fallIV the Companion Class has a higher level of
prepayment risk if interest rates fall
A. I and IIIB. I and IVC. II and IIID. II and IV
Series #7 Debt 93
Which statements are true regarding PACs and the Companion class?
I PAC yields are higher than Companion class yieldsII Companion class yields are higher than PAC yieldsIII the PAC has a lower level of prepayment and
extension risks than the Companion classIV the Companion class has a lower level of
prepayment and extension risks than the PAC
A. I and IIIB. I and IVC. II and IIID. II and IV
When comparing a CMO Planned Amortization Class (PAC) to a CMO Targeted Amortization Class (TAC), all of the following statements are true EXCEPT:
A. Both PACs and TACs offer the same degree of protection against extension risk
B. PACs differ from TACs in that TACs do not offer protection against a decrease in prepayment speeds
C. PACs are similar to TACs in that both provide call protection against increasing prepayment speeds
D. TAC pricing will be more volatile compared to PAC pricing during periods of rising interest rates
Series #7 Debt 94
Series #7 Debt 95
Rank the following yields from highest to lowest:
I PACII Companion ClassIII TAC
A. I, II, IIIB. II, III, IC. II, I, IIID. III, II, I
Private CMOs are:
A. rated AAA because the underlying mortgages are government backed
B. assigned credit ratings by independent credit agencies based on their structure, issuer, and collateral
C. not rated by independent credit agencies because they are private placements that cannot be traded in the market
D. not rated by independent credit agencies because of the uncertainty surrounding the quality of the mortgage loans collateralizing the issue
Series #7 Debt 96
17
Series #7 Debt 97
Which of the following statements are true regarding the CMO Z tranche? The Z tranche receives:
I interest before all other tranchesII interest after all other tranchesIII principal before all other tranchesIV principal after all other tranches
A. I and III B. I and IVC. II and IIID. II and IV
Which CMO tranche has the greatest interest rate risk?
A. Floating rate trancheB. PACC. TACD. Z-Tranche
When comparing lOs to POs, which statements are TRUE when market interest rates rise?
I IO prices move upII IO prices move downIII PO prices move upIV PO prices move down
A. I and IIIB. I and IVC. II and IIID. II and IV
A special purpose entity that typically invests in Sub-prime CMO tranches is a(n):
A. CDOB. MBSC. ARSD. CMB
Which CMO tranche has the lowest level of interest rate risk?
A. Floating rate trancheB. PACC. TACD. Z-Tranche
Series #7 Debt 102
OTHER AGENCY SECURITIES
• Student Loan Marketing Association - Sallie Mae
– purchases insured student loans from qualified lending institutions
– loans purchased from colleges, universities, state agencies, national banks, and other financial institutions
– sells normal debentures backed by these loans
18
Series #7 Debt 103
Sallie Mae buys:
A. FHA insured mortgages from banks
B. VA insured mortgages from banks
C. student loans from state agencies
D. conventional mortgages
Series #7 Debt 104
TRADING OF GOV'T AND AGENCY DEBT• OTC - NO trading on exchange floors
• participants include large commercial banks, foreign banks, U.S. Gov't security dealers, full service brokerage firms, as well as Federal Reserve itself
Series #7 Debt 105
SETTLEMENT AND ACCRUED INTEREST
• T-Bills, Notes, and Bonds are settled regular way on next business day after trade date
• trades of Agency securities aren't tested
• cash settlement for U.S. Gov't and Agency trades is same business day before 2:30 p.m.
• trades settle in Federal Funds (vs. thru a Clearing House)
• accrued interest on Gov't issues is computed on actual day/month/year
Series #7 Debt 106
A 5 year 4 1/2% Treasury Note is quoted at 101.04 - 101.08. The note pays interest on Jan 1 and Jul 1. If a customer buys 5 T-Notes on Friday, April 4, how many days of accrued interest are owed to the seller? (It is not a leap year.)
A. 94B. 95C. 96D. 97
Jan 31
Feb 28
Mar 31
Apr 6
96 Days
Series #7 Debt 107
A customer buys a 5 1/2% Treasury Bond, maturing July 1, 2019, at 104.16 on Thursday, February 6th. The bond pays interest on January 1 and July 1. How many days of accrued interest are due?
A. 37B. 38C. 39D. 40
Jan 31
Feb 6
37 Days
Series #7 Debt 108
MUNICIPAL DEBT
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Series #7 Debt 109
MUNICIPAL BONDS• FULLY REGISTERED FORM• BOOK ENTRY• BEARER FORM (issued until mid-1983)• LEGAL OPINION
– all municipal issues have a legal opinion printed on the bond
– a bond counsel is retained and will examine the issue for its validity, legality, and tax exempt status
– an unqualified opinion is required, meaning everything is A-OK
Series #7 Debt 110
Regarding the legal opinion of a new municipal bond issue, which of the following statements are true?
I all municipal bonds have a legal opinionII only municipal revenue bonds have a legal
opinionIII municipal issuers desire a qualified opinionIV municipal issuers desire an unqualified
opinion
A. I and IIIB. I and IVC. II and IIID. II and IV
Series #7 Debt 111
A "qualified" legal opinion is one which:
A. Gives a conditional affirmation of the legality of the securities
B. Gives an unconditional affirmation of the legality of the securities
C. Is given by a qualified bond counselD. Qualifies the issue for a federal tax exemption
from taxation
Series #7 Debt 112
MUNICIPAL ISSUES• General Obligation Bonds
– backed by the full faith, credit, and taxing power of the municipality
• State GO bonds are backed by income, sales, and excise taxes• Local GO bonds are backed by ad valorem (property) taxes
– muni have Statutory & Constitutional Debt limits imposed (they can’t keep raising tax rates to pay off debt!)
• to exceed the limit, a public referendum (vote) is required
– overlapping debt• regional school
– MIL RATE; 1 Mil = .001; based on assessed property valuation, NOT market value
MUNICIPAL ISSUES (cont.)
– Capital Appreciation Bond (CAB)• a municipal zero coupon bond whereby
the discount is treated as the “principal” on the municipality’s debt statement
– thus this, rather than the actual par, is considered when determining the debt limit of the municipality!
Series #7 Debt 113 Series #7 Debt 114
Which of the following projects would be financed by a general obligation bond issue?
A. the construction of a new subway lineB. the construction of a new junior high schoolC. the construction of a new hydroelectric
generating plantD. the construction of a new sewage treatment
plant
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Series #7 Debt 115
A municipality has a tax rate of 12 mils. A piece of real property in the municipality is assessed at $225,000 and has a fair market value of $250,000. The annual tax liability on the property is:
A. $120B. $300C. $2,700D. $3,000
12 X .001 X 225,000 = $2,700
When does an investor receive payment of interest and principal on a Capital Appreciation Bond (CAB)?
A. Both interest and principal payments are made semi-annually
B. Interest is paid semi-annually and principal is paid at maturity
C. Principal is paid semi-annually and interest is paid at maturity
D. Both interest and principal are paid at maturity
Series #7 Debt 116
Series #7 Debt 117
MUNICIPAL ISSUES (cont.)
• Revenue Bonds– self-supporting debt (no Constitutional Debt
Limit)
– backed by tolls, user fees, rents, and leases
– though muni debt is exempt, these bonds will most likely have a Trust Indenture because it is difficult to sell the bonds without one
Series #7 Debt 118
Revenue Bonds (cont.)
• Backing– backed by a pledge of revenues from an enterprise
activity– these are self-supporting debts - the project pays its way
from revenue collections
• No Debt Limit– these are NOT carried on the backs of the taxpayers and
as long as the project can be justified, the bonds can be sold
– therefore, issuance of revenue bonds requires the performance of a feasibility study
Series #7 Debt 119
Revenue Bonds (cont.)
• Feasibility Study– performed by an independent consultant who projects
anticipated revenue collections versus the costs of operating the facility and paying for debt service
• Default Risk– if the revenue projections in the feasibility study prove
over-optimistic, then there may be a revenue shortfall and the bondholders may not be paid
– unlike G.O. bonds that are backed by unlimited taxing power, these bonds are only backed by the revenues and thus have a greater default risk than G.O. bondsand their yields reflect this
Series #7 Debt 120
Revenue Bonds (cont.)
• Bond Contract and Trust Indenture– the bond counsel (bond attorney):
• writes the bond contract (contract between issuer and bondholder)
• writes the trust indenture (contract between issuer and trustee)
• opines on the bonds; the opinion covers the:– validity of the issue– legality of the issue– tax exempt status of the issue
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Series #7 Debt 121
A bond counsel opines on all of the following EXCEPT:
A. ValidityB. LegalityC. Tax Exempt StatusD. Feasibility
Series #7 Debt 122
Revenue Bonds (cont.)• In the Trust Indenture, there would be a Bond
Resolution which is the contract between the issuer and the bondholder; in this, it would specify the covenants of the bond issue:– maintenance covenant – rate covenant– segregation of funds covenant– books & records covenant – no sale covenant – additional bonds covenant – insurance covenant – defeasance covenant– catastrophe call covenant
Which of the following information would be found in a municipal bond resolution?
I Any restrictive covenants to which the issuer must adhere II Any call provisions providing for redemption prior to maturity as specified in the contract III The credit rating assigned to the issue by a nationally recognized ratings agency IV The compensation received by the underwriters for selling the issue to the public
A. I and IIB. III and IVC. I and IIID. II and IVSeries #7 Debt 123 Series #7 Debt 124
A municipal revenue bond trust indenture includes an "additional bonds test". This means that:
A. the issuer is prohibited from issuing new debt under any circumstance
B. the issuer is prohibited from issuing new debt unless the facility's revenues are sufficient to pay for existing and additional debt
C. the issuer is prohibited from issuing new debt unless outstanding bonds are called
D. additional debt can be issued without any problem
Series #7 Debt 125
In a municipal bond contract, a "covenant of defeasance" would allow the issuer to:
A. redeem the issue in part or full at predetermined dates and prices
B. advance refund the issue under the terms specified in the bond contract
C. omit interest or principal repayments if coverage ratios decline below specified limits
D. reset interest rates periodically at predetermined dates based upon recognized interest rate indices
Series #7 Debt 126
The most complete information about a municipal bond's call provision would be found in the:
A. Bond ResolutionB. Official Notice of SaleC. Moody's Bond GuideD. Daily Bond Buyer
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Series #7 Debt 127
A municipality would defease its debt with all of the following EXCEPT:
A. U.S. Government securitiesB. U.S. Government agency securitiesC. AAA Municipal securitiesD. Bank certificates of deposits
Series #7 Debt 128
Revenue Bonds (cont.)
• Flow of Funds: – how collected monies are used to pay expenses
– there can be a Gross or Net revenue pledge• Gross Revenue Pledge
– debt service is paid before anything else
• Net Revenue Pledge – operations and maintenance are paid first and THEN debt
service
Series #7 Debt 129
GROSS REVENUE PLEDGE
$ $ $ $
1st Payment
2nd Payment
RevenueFund
Sinking Fund
Oper. & Maint.
NET REVENUE PLEDGE
$ $ $ $
1st Payment
2nd Payment
RevenueFund
Oper. & Maint.
Sinking Fund
Series #7 Debt 130
Under a gross revenue pledge, bondholders have claim to:
A. gross revenuesB. gross revenues minus operations and
maintenanceC. gross revenues minus debt service reserve
fundD. gross revenues minus deposits to the sinking
fund
Series #7 Debt 131
Under a net revenue pledge, once operations and maintenance costs are paid, what is the next item that is paid?
A. insurance fundB. reserve maintenance fundC. debt service expenseD. renewal replacement
Series #7 Debt 132
Under the flow of funds in a revenue bond trust indenture, net revenue is defined as gross revenue minus:
A. Sinking fund expensesB. Debt service reserve expensesC. Debt service expensesD. Operation and maintenance expenses
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Series #7 Debt 133
As stated in the flow of funds found in a revenue bond issue's trust indenture, monies to meet debt service requirements are deposited to the:
A. Revenue FundB. Debt Service Reserve FundC. Sinking FundD. Surplus Fund
Series #7 Debt 134
SPECIAL TYPES OF MUNICIPAL DEBT
• SPECIAL TAX BONDS– bonds of political subdivisions that are backed by a tax
other than ad valorem tax– these are typically excise taxes such as alcohol, gas,
tobacco taxes
• SPECIAL ASSESSMENT BONDS– bonds of political subdivisions where a localized
improvement is made• all of the properties in the improved area are assessed additional
taxes to pay for the improvement
Series #7 Debt 135
SPECIAL TYPES OF MUNICIPAL DEBT
• MORAL OBLIGATION BONDS– invented in 1975 for NY city whose bonds' credit rating fell below
investment grade so the city could not refund its debt– the state could not back the city's bond issues because the state was at its
debt limit• instead, bonds were issued where the "state legislature has the authority, but
not the obligation, to apportion the funds to service the debt"• thus, the state is "morally" obligated to pay if the city cannot, but not legally
obligated to pay– more recent moral obligation bonds have been revenue bonds used to
build costly stadiums• the projected revenues may not cover the debt service, so a state
agency/authority secures the bond with a non-binding covenant which says that any deficiency in pledged revenues will be included in the budget of the state legislature (which MAY appropriate the funds to make up the revenue short-fall)
Series #7 Debt 136
SPECIAL TYPES OF MUNICIPAL DEBT (cont.)
• CERTIFICATE OF PARTICIPATION (COP)– these allow municipalities to issue a tax-exempt security that
pledges the revenue from a project, like a university dorm, prison, municipal office building,…
– the lease payment is made based upon the governing body making an annual appropriation from tax collections
• the governing body is NOT “legally” obligated to make the annual appropriation, so it is not a G.O. bond
– however, the appropriation will be made, or else the issuer’s credit rating is diminished
– the credit rating on these is a notch or two below the agency's general obligation rating
Series #7 Debt 137 Series #7 Debt 138
SPECIAL TYPES OF MUNICIPAL DEBT (cont.)
• DOUBLE-BARRELED BOND– a revenue bond whose feasibility study is "shaky", that is,
it appears that the facility may not be able to "throw off" enough net revenues to pay the bondholder
• the issue can be made saleable by having the issuer "double-barrel" the issue
• in addition to the revenue pledge, the issuer backs the bonds with ad valorem taxing power
– ratings agencies rate these like G.O. bonds since the taxpayers are ultimately responsible for the debt service
– treated as a non-self-supporting debt in the municipality debt statement
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Series #7 Debt 139
SPECIAL TYPES OF MUNICIPAL DEBT (cont.)
• INDUSTRIAL DEVELOPMENT BOND – bonds issued to build facilities that will be leased to a
corporation
– the source of revenue is the corporation's lease payments
– under the Tax Reform Act of 1986, these bonds are a "non-essential use, private purpose" issue and the interest income is federally taxable (as opposed to essential public use issues where the interest income is exempt from federal tax)
SPECIAL TYPES OF MUNICIPAL DEBT (cont.)
• Build America Bonds (BABs)– Congress passed the "American Recovery and Reinvestment
Act" in 2009 which included a number of stimulus (tax & spend) provisions to help the market recover after the market meltdown in 2008
– municipalities can now issue taxable "Build America Bonds"
– the municipality issuing the bonds gets a 35% interest rate credit from the federal government
• if a municipality issues a 10% BAB, it gets a payment from the federal government of 3.5%
– thus the issuer's net cost is 6.5%Series #7 Debt 140
SPECIAL TYPES OF MUNICIPAL DEBT (cont.)
• Build America Bonds (BABs) (cont.)– the municipalities can now sell bonds in the broader
"taxable" bond market and still get low interest financing costs due to the tax credit
– the program ended in 2010 and only allowed bond issues to be sold where the proceeds are used for infrastructure projects that would normally be financed with a tax-free bond issue
Series #7 Debt 141 Series #7 Debt 142
A double barreled municipal issue is:
I a general obligation issueII a revenue issueIII backed by U.S. Government subsidiesIV backed by the municipality's taxing
power
A. I and IIIB. I and IVC. II and IIID. II and IV
Series #7 Debt 143
A type of municipal bond that would be used to finance the construction of public schools would be a:
A. revenue bondB. special tax bondC. moral obligation bondD. general obligation bond
Series #7 Debt 144
The income source backing a special tax bond issue would be:
I Excise taxesII Sales taxesIII Ad valorem taxesIV Income taxes
A. I onlyB. II onlyC. I, II, IVD. I, II, III, IV
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Series #7 Debt 145
Municipality imposed debt limits are required for which of the following?
A. General obligation bondB. Special tax bondC. Industrial revenue bondD. Moral obligation bond
Series #7 Debt 146
The proceeds of a "Build America Bond" may be used for all of the following EXCEPT:
A. public buildings B. transportation infrastructure C. water and sewer projects D. prerefunding outstanding Issues
Series #7 Debt 147
BABs are:
I subject to Federal income tax II exempt from Federal income tax III issued in the taxable bond market IV issued in the tax-exempt bond market
A. I and III B. I and IV C. II and IIID. II and IV
Who guarantees an Industrial Development Bond?
A. Municipal issuing authorityB. Corporate lesseeC. MBIAD. AMBAC
Series #7 Debt 148
Series #7 Debt 149
SHORT TERM MUNICIPAL NOTES
• CATEGORIZED IN 2 TYPES – SHORT TERM FINANCING:– 1) for a building project– 2) used to "pull forward" income source & use money before
collected
– 1) short term financing for a building project• Bond Anticipation Notes – BANs
– used as the "bridge loan" to obtain the funds necessary to buy gov'ts that will be escrowed with a trustee in a defeasance
• Construction Loan Notes – used by municipalities to fund construction projects which typically take 2-5
years to build which also is the life of the notes– when the building is completed and all costs are known, a long term bond
issue is floated and the proceeds are used to retire the CLN
Series #7 Debt 150
SHORT TERM MUNICIPAL NOTES (cont.)
– 2) short term financing used to "pull forward" income source & use money before collected
• Tax Anticipation Notes – TANs– states typically collect income taxes once a year– political subdivisions typically collect property taxes twice a year– if an issuer runs short of money in between tax collection periods, the
issuer can borrow against upcoming expected tax receipts with a TAN– used by a municipality to smooth out their cash flow
• Revenue Anticipation Notes – RANs– political subdivisions typically receive payments from the state and from
the Federal Gov't to support essential services such as public transit– if an issuer runs short of money, it can borrow against upcoming
revenues expected to be received from the state or from the Federal Gov't with a RAN
26
Series #7 Debt 151
SHORT TERM MUNICIPAL NOTES (cont.)
– 2) short term financing used to "pull forward" income source & use money before collected (cont.)
• Tax & Revenue Anticipation Notes – TRANs– combination of the TAN and RAN
• Grant Anticipation Notes - GANs– issued in anticipation of receiving grant monies from the
Federal Gov't for things like pollution control, mass-transit, energy conservation,…
Series #7 Debt 152
During its fiscal year, New York state is experiencing a temporary cash flow shortage, expected to last for 5 months. To meet current obligations, the state would most likely issue:
A. BANB. TANC. RAND. TRAN
Series #7 Debt 153
To obtain short term funds in anticipation of a subsequent long term debt financing, a municipality will issue a:
A. BANB. TANC. RAND. TRAN
Series #7 Debt 154
To smooth out cash flow, a municipality will issue all of the following EXCEPT:
A. BANB. RANC. TAND. TRAN
Series #7 Debt 155
Other Short Term Municipal Financing
• Tax Exempt Commercial Paper– replacing the "anticipation notes"– backed by a bank line of credit
• Variable Rate Demand Notes– a.k.a. Step-Up/Step-Down Notes– a renewable note where the interest rate is reset periodically
("stepped-up" or "stepped down") based on a market index – at the reset date, the holder can renew for the next time frame
(which could be 1 day or 1 week); or can demand payment• because the interest rate is reset, the market price will remain near or
at par
Series #7 Debt 156
Variable rate municipal notes are NOT subject to which of the following risks?
A. legislative riskB. default riskC. marketability riskD. interest rate risk
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Series #7 Debt 157
Municipal variable rate demand notes have all of the following risks EXCEPT:
A. market risk B. marketability riskC. default riskD. legislative risk
Series #7 Debt 158
Bank Qualified Munis
• smaller GO bond issues (limited in size to $10MM) are “bank qualified” -- they are purchased by a bank as an investment– bank is allowed to deduct 80% of interest
carrying costs to buy the bonds
– bank receives 100% tax-free interest income
Series #7 Debt 159
Bank Qualified Munis (cont.)
– i.e. bank gets $10MM deposits on which it pays 10% interest (interest expense = $1MM)
• bank uses the funds to buy a 9% bank qualified bond (it receives $900K)
• bank deducts 80% ($800k) of the 10% interest cost ($1mm), thus only paying $200K interest expense --bank receives 9% interest on bonds free of tax ($900K - $200K = $700K - known as “positive carry”)
Series #7 Debt 160
The interest expense on monies used to buy bank qualified municipal bonds is:
A. 20% deductible for bank investorsB. 80% deductible for bank investorsC. 20% deductible for individual investorsD. 80% deductible for individual investors
Series #7 Debt 161
A bank wishes to make an investment in municipal bonds. The most advantageous security for this investor is a:
A. banker's acceptanceB. bank qualified municipal bondC. BAND. bearer bond
Series #7 Debt 162
ANALYZING MUNICIPAL DEBT
G.O. BOND ANALYSIS
28
Series #7 Debt 163
ANALYZING MUNICIPAL DEBT (cont.)
REVENUE BOND ANALYSIS
Series #7 Debt 164
New Jersey Turnpike AuthorityStatement of Revenues And Expenses
Year Ending 12/31/20XXCollected Tolls: $100,000,000
Interest on Reserve Funds: $10,000,000
Collected Rents: $10,000,000
Gross Revenues: $120,000,000
Operations and Maintenance: $80,000,000
Net Revenues: $40,000,000
Debt Service $20,000,000
Addition to Reserves: $20,000,000
QUESTION 1: If This Is A Gross Revenue Pledge Bond, How Much In Revenues Are Pledged To The Bondholders?Answer: $120,000,000
QUESTION 2: If This Is A Net Revenue Pledge Bond, How Much In Revenues Are Pledged To The Bondholders? Answer: $40,000,000
QUESTION 3: If This Is A Net Revenue Pledge, What Is The Debt Service Coverage Ratio?
Answer: $40,000,000 = 2:1$20,000,000
Series #7 Debt 165
The ratio of total direct plus overlapping debt to assessed valuation is used to:
I analyze general obligation bondsII analyze revenue bondsIII determine the municipality's self-supporting debtIV determine the municipality's debt to be paid from
taxing power
A. I and IIIB. I and IVC. II and IIID. II and IV
Series #7 Debt 166
General obligation bond analysis would consider which of the following?
I Protective covenants in the trust indentureII Trend of assessed valuation of propertyIII Ratio of total debt per capitaIV Record of tax collections
A. I and III onlyB. I, II, IVC. II, III, IVD. I, II, III, IV
Series #7 Debt 167
Which of the following would be evaluated when analyzing a General Obligation Bond?
I debt to assessed valuation ratioII debt to per capita ratioIII tax collection ratioIV debt service coverage ratio
A. II and IVB. I, III, IVC. I, II, IIID. I, II, III, IV
Series #7 Debt 168
The ratio of pledged revenues to debt service requirements would be used to analyze which of the following municipal issues?
A. School District Bonds B. Hospital Revenue BondsC. Special Tax BondsD. General Obligation Bonds
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Series #7 Debt 169
When analyzing municipal general obligation bonds of different issuers, it is difficult to use the ratio of Overall Debt / Assessed Valuation because:
A. the ratio does not consider a municipality's ability to collect the taxes levied on all real propertyB. municipalities differ in their method of computing overall debtC. municipalities differ in their method of computing assessed value of propertiesD. the ratio does not consider the management capabilities of municipal government
Series #7 Debt 170
Which of the following ratio tests are applicable when analyzing a school district bond issue?
I Debt service coverage ratioII Collection ratioIII Debt per capitaIV Debt to assessed valuation
A. I and IIB. III and IVC. II, III, IVD. I, II, III, IV
The most commonly used measure to evaluate the ability of a revenue bond issuer to pay interestand repay principal is the ratio of:
A. Gross Revenues / Debt ServiceB. Net Revenues / Debt ServiceC. Overall Net Debt / PopulationD. Overall Net Debt / Assessed Value
Series #7 Debt 171 Series #7 Debt 172
MUNICIPAL BOND INSURERS
• AMBAC - American Municipal Bond Assurance Corporation
• MBIA - Municipal Bond Insurance Association Corporation
• FGIC - Financial Guaranty Insurance Corporation
• FSA - Financial Security Assurance Corporation
Series #7 Debt 173
All of the following insure municipal bonds EXCEPT:
A. FGICB. FSAC. FDICD. AMBAC
Series #7 Debt 174
Which of the following insures municipal bonds?
A. FRBB. SIPCC. FDICD. MBIA
30
Series #7 Debt 175
Trading of Municipal Debt
• municipal debt trades OTC (NOT on the exchange floor)
• it is a very thin market, mainly due to the bond interest being exempt from all taxes if purchased by a resident of the state of issuance– thus there are relatively little short sales
Series #7 Debt 176
Trading of Municipal Debt (cont.)
• Bloomberg– an electronic service which posts gov't, corp, and
municipal offerings• KennyWeb / Broker's Wire
– trading info on munis can also be found on this, which is a service provided by S&P
– KENNYBASE• a fixed income database containing descriptions on
muni and corporate securities– firms can track new bond issues, monitor called/refunded
bonds, see reoffering yields and prices as well as sinking fund schedules,…
Series #7 Debt 177
Trading of Municipal Debt (cont.)
• Municipal Trading Terminology– if a customer wishes to buy a bond, municipal dealers must
make a firm offer to the customer • because the market is thin and there is delayed reporting for municipal
bond trades, if this is the first price the customer is getting, the customer doesn’t know whether it is a "good" price
• the buyer (customer) wishes to shop around and tells the offering dealer that he will call him back
• the dealer responds: "I will offer the bonds firm at 90 for a ½ hour with a 5 minute recall"
• the dealer has the given the customer ½ hour to shop around and will hold the price at $900; however, the dealer reserves the right to call up the customer during that ½ hour and can say, "Someone else wants the bonds. You have 5 minutes to make a buy decision."
• thus, these bonds have been offered "firm for ½ hour with a 5 minute recall"
Series #7 Debt 178
Municipal bonds are offered out "firm" by one dealer to another. All of the following are true regarding this EXCEPT:
A. the buying dealer has control over the bonds for a specified time period
B. the buying dealer is able to renegotiate the priceC. the buying dealer can sell the bonds before
actually purchasing themD. the selling dealer will not change the price for a
specified time period
Series #7 Debt 179
Trading of Municipal Debt (cont.)
• Municipal Trading Terminology (cont.)– if a customer wishes to sell a bond, a municipal dealer
who is contacted by the customer will bid for the bond• the buying dealer will give the customer a "workable" quote
(an indication of a likely price at which the dealer will buy)
• the customer will shop the market by collecting workables from a number of dealers
• the customer will go back to the dealer giving the best "workable" (likely bid) to "nail down" a firm price
Series #7 Debt 180
Trading of Municipal Debt (cont.)
• Municipal Broker's Broker– to handle large transactions– acts as agent – doesn’t carry an inventory– doesn’t deal with the public– i.e. Citibank wants to sell a very large block of NYC
G.O. bonds• pressure is put on Citibank to drop price• instead, Citibank can use a broker's broker to obtain bids for
the bonds• a broker's broker will call up other dealers and offer small
portions of issue, keeping Citibank anonymous
31
Series #7 Debt 181
A municipal broker's broker does all of the following EXCEPT:
A. obtain quotes from other dealers B. trade for its own accountC. execute trades as agent for other dealersD. execute trades as agent for institutional clients
Series #7 Debt 182
Trading of Municipal Debt (cont.)
• Secondary Market Joint Accounts– to handle large municipal transactions;
used to purchase or distribute a large block of bonds
– similar to new issue syndicates - manager is appointed to manage account
– only one quote is allowed to be published
RTRS
• trades in municipal bonds must be reported on a real-time basis via this system within 15 minutes of execution
Series #7 Debt 183
ELECTRONIC MUNICIPAL MARKET ACCESS – EMMA
• created by the MSRB for retail customer use
• it gives investors access to municipal disclosure documents and price reporting for free
• information found on EMMA includes:– official statements for new municipal issues, including 529 plans;
– pre-refunded bond information;
– disclosure by municipalities regarding their finances; and
– real-time price and yield info for municipal bonds trades as reported through RTRS and SHORT (SHort-term Obligation Rate Transparency system)
• other things found on the site includes info on: 529 plans, auction rate securities, and variable demand obligations
Series #7 Debt 184
Series #7 Debt 185
Which statements are true?
I SHORT information is found within EMMAII EMMA information is found within SHORT III RTRS information is found within EMMA IV EMMA information is found within RTRS
A. I and III B. I and IV C. II and III D. II and IV
Series #7 Debt 186
SETTLEMENT AND ACCRUED INTEREST
• same as corporates
32
Series #7 Debt 187
TAX STATUS OF MUNICIPAL DEBT INTEREST
• 1) exempt from Federal tax; subject to state and local tax -- * the most important for the exam
• 2) triple tax free -- * the most important for the investor– i.e. a resident purchasing his own municipality's bonds OR– a U.S. resident purchasing a bond issued by a territory or
possession of the U.S. (Guam, Puerto Rico, Virgin Islands,…)
• 3) fully taxable– for a non-essential use, private purpose facility– i.e. sports stadium/complex, convention center
Series #7 Debt 188
A customer purchases a NY state G.O. bond. How will the bond interest be taxed?
A. exempt from Federal; subject to state and local
B. exempt from state and local; subject to Federal
C. triple tax freeD. fully taxable
Series #7 Debt 189
A resident of NY purchases a NY state G.O. bond. How will the bond interest be taxed?
A. exempt from Federal; subject to state and local
B. exempt from state and local; subject to Federal
C. triple tax freeD. fully taxable
Series #7 Debt 190
Which of the following municipal issues would NOT be exempt from taxation of interest by the Federal Government?
A. San Francisco, CA – Convention Center Revenue Bond
B. Miami, FL – Sewer and Water Revenue BondC. Nassau County, NY – Pollution Control BondD. Des Monies, IA – School District Bond
Series #7 Debt 191
TAX STATUS OF MUNICIPAL DEBT INTEREST (cont.)
• when we talk about muni bond interest, we look at the interest as being exempt from Fed. tax
• if you're in the 20% tax bracket and you purchase an 10% corporate, what is the equivalent tax-free (municipal) yield?– 10% X $1,000 = $100 annual interest
– tax is 20% or -$20 tax
– After tax return = $80; thus 8% Muni = 10% Corp. given a 20% T.B.
Series #7 Debt 192
An investor in the 31% tax bracket buys a 7% municipal bond quoted on a 6.25 basis. To calculate the equivalent taxable yield:
A. divide 6.25% by 69%B. multiply 6.25% by 69%C. divide 7% by 69%D. multiply 7% by 69%
.0625
100% - 31%
33
Series #7 Debt 193
A municipal investor is considering the purchase of a 10 year, 6% G.O. bond with a 5 3/4% yield to maturity. The investor is in the 31% tax bracket. The equivalent taxable yield is:
A. 8.3%B. 8.69%C. 16.9%D. 19.35%
.0575
100% - 31%= 8.3%
Series #7 Debt 194
A customer residing in California is in the 30% Federal Tax bracket and 10% State Tax bracket. She wishes to make a bond investment with the following bonds available:
The best recommendation for the customer is:
A. AAA Corporate Bond
B. U.S. Treasury Bond
C. AAA Federal Home Loan Bank Bond
D. AAA California Bond
Yield
AAA Corporate Bond 6.50%
U.S. Treasury Bond 4.50%
AAA Federal Home Loan Bank Bond 5.00%
AAA California Bond 4.00%
= .60 X .065 = 3.9%
= .70 X .045 = 3.15%
= .70 X .05 = 3.5%
= 4%
Series #7 Debt 195
MONEY MARKET DEBT / STRUCTURED PRODUCTS
Series #7 Debt 196
TYPES OF MONEY MARKET INSTRUMENTS
• TREASURY BILLS
• COMMERCIAL PAPER
• BANKER'S ACCEPTANCE– used to facilitate trading of imports and exports
– PRIME B.A.• a B.A. eligible for Federal trading
• NEGOTIABLE CDs
Series #7 Debt 197
An importer wants to finance the purchase of $10,000,000 of Nigerian cocoa. The importer can use:
A. commercial paperB. Eurodollar bonds C. banker's acceptanceD. foreign currency option
Series #7 Debt 198
TYPES OF MONEY MARKET INSTRUMENTS (cont.)
• Long Term CDs– can have a longer maturity than 1 year
– issued by brokerage firms, not banks
– sometimes called "brokered" CDs as a brokerage firm will buy, for instance, a $10,000,000 CD from a bank and then sell, let's say, 1,000 units of $10,000 of this to different customers
34
Series #7 Debt 199
Long Term CDs (cont.)
• when a retail customer buys a long term CD, the customer must be told that:– the security is subject to fluctuations in market price and interest
rates– selling before maturity may be for less than the purchase price– a secondary market for the instrument may be limited– the CD may be callable and if it is called and the proceeds are
reinvested, it may be at lower current market interest rates– if the CD is a "step-up" or "step-down" instrument:
• the initial CD rate may change;• may not reflect the current market interest rates; and • does not reflect the yield to maturity
Series #7 Debt 200
Long Term CDs (cont.)
• ownership title of the CD determines whether the instrument is FDIC insured– if it's in the customer's name, it would be insured;– if it's in the broker-dealer's name, it would not be insured
• CD prices on customer statements must reflect the current market price and NOT face value
• finally, there is no possibility for early redemption and as such, there are no prepayment penalties – the only way for the holder to "cash out" prior to maturity is to sell the instrument in the secondary market
Series #7 Debt 201
On customer account statements, long-term negotiable certificates of deposit must be shown at:
A. market valueB. market value plus accrued interestC. face valueD. face value plus accrued interest
Series #7 Debt 202
Long-term negotiable certificates of deposit are subject to which of the following risks?
I Interest rate riskII Call riskIII Reinvestment riskIV Marketability risk
A. I and II onlyB. III and IV onlyC. I, II, IIID. I, II, III, IV
Series #7 Debt 203
STRUCTURED PRODUCTS
• securities that derive their value from a basket of securities, an index, other commodities, or currencies
• generally, these securities consist of a "bond" component, which pays interest based on the performance of a well-known index like the S&P 500– they also have a derivative component that
allows the holder to sell the security back to the issuer at par at maturity
Series #7 Debt 204
MARKET INDEX LINKED CD• ties the investment return to an equity index like the S&P 500• customers who invest must be aware that the securities are
subject to:– market risk – if redeemed prior to maturity, there could be a principal
penalty for early withdrawal– liquidity risk – most of these CDs allow redemption only on pre-set
quarterly dates (most cannot be redeemed on demand, and are not tradable)
– credit risk – these are only backed by the full faith and credit of the issuing bank, and there may not be an underlying pool of securities that can be claimed if the issuer goes bankrupt!
– a cap on investment return – some of these CDs place a cap on the amount that can be earned
– tax issues – despite the returns being tied to an equity index, the returns are taxed as interest income (max. of 39.6%) versus the tax rate on dividends and long-term gains of 15%-20%
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Series #7 Debt 205
INDEX LINKED / STRUCTURED PRODUCTS SUITABILITY
• FINRA requires firms to perform a "reasonable basis" suitability determination to evaluate the product's risks and rewards relative to other similar products offered by other firms– once this has been completed, the firm can offer
the structured product only to its customers who are suitable for that investment
• FINRA encourages firms to use the same suitability and approval standards as it uses for options accounts when recommending these structured products
Series #7 Debt 206
A customer wants to know the principal difference between a market index linked CD and a regular CD. As the registered representative, you should inform the customer that:
A. Market index linked CDs give a rate of return tied to the S & P 500 Index, whereas regular CDs give a rate of return tied to market interest rates
B. Market index linked CDs can have a loss of principal if held to maturity whereas regular CDs cannot have a loss of principal if held to maturity
C. Market index linked CDs do not qualify for FDIC insurance whereas regular CDs do qualify for FDIC insurance subject to the $250,000 limit
D. Market index linked CDs have a minimum life of 10 years, whereas there is no minimum life for regular CDs
EXCHANGE TRADED NOTE (ETN)
• a variation of a “structured product” created to minimize the liquidity risk inherent to structured products
• this gives a return linked to a market index, has a set maturity, and is backed by the credit rating of the issuing bank
• while it is a debt instrument, the ETN does NOT make periodic payments– rather, the value rises based upon the performance of the underlying
index• and if sold for more than for what it was bought, the capital gain is taxed
at 15%-20% maximum (versus the max rate for interest of 39.6%)
Series #7 Debt 207
EXCHANGE TRADED NOTE (ETN) (cont.)
• the main advantages of an ETN versus a structured product are: – no liquidity risk; and
– tax efficiency
• investors in ETNs have access to several investment strategies– i.e. there are ETNs that give returns tied to
commodity indexes or indexes based on the performance of stocks in Third World countries
Series #7 Debt 208
EXCHANGE TRADED NOTE (ETN) (cont.)
• note the ETN is NOT an ETF (discussed later)– an ETF is an investment company product where
the shareholders own a piece of the underlying portfolio
– an ETN has no underlying portfolio• the issuer is promising to give a return tied to the
index, but the investments in that index may or may not be owned by the issuer
• the ETN is only backed by the credit rating of the issuing bank
Series #7 Debt 209 Series #7 Debt 210
All of the following statements are TRUE about ETNs EXCEPT:
A. ETNs can be traded in the market like any other stock
B. ETNs offer an investment return tied to a benchmark index
C. ETNs are an equity security D. ETNs are tax-advantaged
36
REVERSE CONVERTIBLE NOTE
• created for customers wanting a higher yield in a low interest rate environment
• the note is linked to the price movements of an underlying stock (or index)– at maturity, the holder receives par value as long as the
price of the reference security is above the "knock-in" price which is typically 70-80% of the initial reference price
• if, at maturity, the reference security falls below the "knock-in" price, the holder receives shares of the stock
Series #7 Debt 211
REVERSE CONVERTIBLE NOTE (CONT.)
• the max. gain is earning the coupon rate and getting 100% of the principal back at maturity
• the max. loss is getting the reference security at maturity and the stock is now worthless!
Series #7 Debt 212
REVERSE CONVERTIBLE NOTE (CONT.)
• investors accept the risk to these because they get a higher coupon rate and believe this compensates them for the risk of principal loss if the stock price declines
• the market sentiment is neutral or slightly bullish and is seeking a fixed coupon from a security that offers a higher level of income
• just like other structured products, these are an obligation of the issuing bank and they are only as good as the credit of the issuing bank
Series #7 Debt 213 Series #7 Debt 214
A customer buys a reverse convertible note. Under which scenario will the customer receive less than par value at maturity?
A. the market price of the reference security has declined, but is not below the knock-in price
B. the market price of the reference security has declined, and is below the knock-in price
C. the market price of the reference security has risen above the knock-in price but is below par
D. the market price of the reference security has risen above the knock-in price and is above par
Series #7 Debt 215
A customer buys a $1,000 par reverse convertible note with a one-year maturity at a 6% coupon rate. At the time of purchase, the reference stock is trading at $50 and the knock-in price is set at $40. If, at maturity, the reference stock is trading at $25, the customer will receive:
A. $1,000 parB. 20 shares of the reference stockC. 25 shares of the reference stockD. 40 shares of the reference stock
Series #7 Debt 216
Auction Rate Securities
• a derivative that is a sold as a short-term debt security with a long-term nominal maturity– the interest rate is reset, usually weekly, via a
Dutch Auction• here, the bids are in terms of interest rates and the
amount of bonds for sale are auctioned from lowest interest rate bid on up until the whole amount of the sale is filled
37
Series #7 Debt 217
Auction Rate Securities (cont.)
• however, the winning bidders are filled at the highest interest rate that completed the sale (known as the "clearing rate")– this rate is the lowest rate the purchasers are willing to
buy all of the securities offered for sale in the auction– interest rates HIGHER than the clearing rate will not be
filled • i.e. if the clearing rate is 4%, and a customer bid 3.8%, that bid
is filled at the auction and the customer receives a 4% interest rate
• i.e. if the clearing rate is 4%, and a customer bid 4.2% (which is what the customer wishes to earn), the bid will NOT be filled
Series #7 Debt 218
Auction Rate Securities (cont.)
• these securities give issuers a benefit of lower short-term interest rates on what is really a long term security
• available for corporate and municipal bonds usually in $25,000 minimum denominations, making them unattractive to unsophisticated investors
Series #7 Debt 219
Auction Rate Securities (cont.)
• ARSs Are Issued With Minimum And Maximum Interest Rates– the minimum rate is a default rate that is set very low
and will be paid to the ARS holders if the auction fails– if interest rate bids at the auction are very high (i.e.
excessively high interest costs to the issuer) and are above the "clearing rate", then the auction is canceled and the holders will continue to hold the securities, earning the default (low) interest rate until the next week, when another auction will be attempted
Series #7 Debt 220
Auction Rate Securities (cont.)• Failed Auctions
– until 2008, if there were not enough bidders at the weekly auction, the sponsoring broker-dealers would bid for their own accounts and buy the ARSs into their own inventory
– as credit conditions worsened in 2008, these broker-dealers stopped bidding (i.e. buying) at these auctions
– this lack of bids created failed auctions where sellers could not find buyers – this meant that would-be sellers could not find buyers and were locked into holding their positions until a buyer could be found
• Note, while the seller is "stuck" holding the ARS, they are still earning interest, but cannot get their principal back!
Series #7 Debt 221
Auction Rate Securities:
I have the interest rate reset weekly via Dutch auction
II have a fixed interest rate for the life of the issue set by competitive bid auction
III have an embedded put option IV do not have an embedded put option
A. I and III B. I and IV C. II and III D. II and IV
The “essential” difference between an ARS and a VRDO is:
A. weekly reset of interest rate B. long-term security with short-term interest rate C. embedded put option D. money market instrument similarity
38
Series #7 Debt 223
All of the following statements are true about Auction Rate Securities EXCEPT:
A. Auction Rate Securities have an interest rate that steps up or steps down with the market
B. The Dutch Auction method is used to set the interest rate
C. Failure of an auction is not possible because of broker-dealer bidding
D. Auction Rate Securities are issued by corporations and municipalities
CREDIT DEFAULT SWAPS (CDS)
• a financial agreement allowing a creditor/lender to reduce its potential loss if there is a default– essentially, the creditor/lender buys insurance
from another entity which is usually another bank or institutional investor to protect itself from default
Series #7 Debt 224
CREDIT DEFAULT SWAPS (CDS)
• in this case the creditor/lender is insured that they will be protected if the other party defaults on the loan– in this arrangement, the creditor/lender pays the seller regular (usu.
quarterly) premium payments over the life of the CDS which is typically 1-10 years
– when times are good and default rates are low, banks and insurance companies that sell these collect premiums as additional income and have little risk
– HOWEVER, when times are bad, sellers can experience default rates that outweigh any collected premiums
Series #7 Debt 225
CREDIT DEFAULT SWAPS (CDS)
• naked CDS– buyers that have not made loans can buy these
without owning the loan of the “reference company” – done purely for speculative purposes
• these contracts trade OTC in an unregulated market with the largest participants being large commercial banks and insurance companies
Series #7 Debt 226
CREDIT DEFAULT SWAPS (CDS)
• SUMMARY
– CDS Buyer• is either hedging an existing loan; or for naked CDSs, it is the bet that
the loan will default
• pays an annual premium for the contact
• if the loan defaults, the buyer receives a cash payment equal to the face amount of the loan
– CDS Seller• receives the annual premium and is betting that the loan will NOT
default
• if the loan defaults, the seller pays the face amount of the loan to the buyer, and the seller takes title to the underlying defaulted loan
Series #7 Debt 227 Series #7 Debt 228
Customer "A" buys a Credit Default Swap (CDS) from Customer "B," with the reference loan being one made to Corporation "C." If Corporation "C" defaults, then:
A. Customer A benefitsB. Customer B benefitsC. Customer C benefits D. any benefit to a specific party is based on the
terms of the contract
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Series #7 Debt 229
Customer "A" buys a Credit Default Swap (CDS) from Customer "B," with the reference loan being one made to Corporation "C." If Corporation "C" continues to pay interest and principal on a timely basis, then:
A. Customer A benefits B. Customer B benefits C. Customer C benefits D. any benefit to a specific party is based on the
terms of the contract
Series #7 Debt 230
Which of the following statements are true about a Credit Default Swap (CDS)?
I The buyer of the CDS pays an annual premiumII The seller of the CDS pays an annual premiumIII The buyer of the CDS agrees to pay the face
amount of the loan if the reference loan defaultsIV The seller of the CDS agrees to pay the face
amount of the loan if the reference loan defaults
A. I and III B. I and IV C. II and III D. II and IV
Series #7 Debt 231
TYPES OF MONEY MARKET INSTRUMENTS (cont.)
• EURODOLLARS– LIBOR is charged
• Repo's and Reverse Repo's
Series #7 Debt 232
OPEN MARKET OPERATIONS
• Fed buys money market instruments– REPURCHASE AGREEMENT
• used to inject cash in money supply
• Fed buys securities injecting money into the money supply, loosening credit
• interest rates go down as there is more money available to be borrowed
Series #7 Debt 233
OPEN MARKET OPERATIONS (cont.)
• Fed sells money market instruments– REVERSE REPURCHASE AGREEMENT
• used to take money out of the money supply
• to tighten money supply
• interest rates go up as there is less money available to be borrowed
• only the “safest” securities are eligible for Fed trading
Series #7 Debt 234
Which of the following statements are true regarding reverse repurchase agreements?
I The Federal Reserve is tightening creditII The Federal Reserve is loosening creditIII Banks have less money to loan out for individuals
who need loansIV Banks have more money to loan out for individuals
who need loans
A. I and IIIB. I and IVC. II and IIID. II and IV
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Series #7 Debt 235
Which of the following are eligible for Fed trading?
I Treasury Bonds
II Prime Banker's Acceptances
III Treasury Bills
IV Commercial Paper
A. II and IV only
B. I, II, III
C. I, III, IV
D. I, II, III, IV
Series #7 Debt 236
Which of the following money market instruments is eligible for Fed trading?
A. A 30-year T-Bond which matures within a yearB. Negotiable CDC. Commercial PaperD. Banker's Acceptances
Series #7 Debt 237
EURODOLLAR DEBT • larger than U.S. corporate bond market,
centered in London, with global trading • bonds are denominated in U.S. dollars• underwritten by international syndicate• issued outside U.S. - NOT registered for sale
in U.S.• typically range from 5 - 10 years, in Bearer
Form (necessary when selling in Europe)• not subject to withholding taxes• pay interest once a year
Series #7 Debt 238
EURODOLLAR DEBT (cont.)
• U.S. Corporations find this market attractive because:– no foreign exchange risk for U.S. issuers
– lower interest rates (than domestic rates)
– lower issuance expenses (doesn't have to be SEC registered since sold outside U.S.)
Series #7 Debt 239
EURODOLLAR DEBT (cont.)
• EURODOLLAR BOND– Issuers Include:
• “everyone” EXCEPT U.S. Gov’t
Series #7 Debt 240
Eurodollar bonds:
I are issued in bearer formII are issued in fully registered formIII pay interest which is subject to withholding taxesIV pay interest which is NOT subject to withholding taxes
A. I and IIIB. I and IVC. II and IIID. II and IV
41
Series #7 Debt 241
U.S. Corporations issuing Eurodollar bonds are:
I subject to foreign currency exchange risk
II not subject to foreign currency exchange risk
III subject to filing as required by the SEC
IV not subject to filing as required by the SEC
A. I and III
B. I and IV
C. II and III
D. II and IV
Series #7 Debt 242
Which of the following would be purchasers of Eurodollar bonds?
I United States investors
II British investors
III French investors
IV Japanese investors
A. I only
B. II and III only
C. II, III, IV
D. I, II, III, IV