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Chapter 8 Debt Instruments Descriptive Issues Debt Instruments Non-marketable CDs MMDAs Savings Bonds Marketable Money Market Instruments Long-Term Instruments Depository Institution Any institution that holds deposits and makes loans

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Chapter 8

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chapter 8
Chapter 8

Debt Instruments

Descriptive Issues

debt instruments
Debt Instruments
  • Non-marketable
    • CDs
    • MMDAs
    • Savings Bonds
  • Marketable
    • Money Market Instruments
    • Long-Term Instruments
Depository Institution
  • Any institution that holds deposits and makes loans
  • Includes bank, savings and loans, and credit union
  • Depository Insurance
    • Accounts, up to $100,000, at most banks, mutual
    • savings banks, and savings and loans are insured
    • by the Federal Deposit Insurance Corporation
    • (FDIC)
Certificates of Deposit (CDs)
  • Issued by a bank and other depository institution
  • Brokered CDs
  • Special terms

Money Market Deposit Accounts

  • Withdrawals limited to specified number
  • Carry nontrivial minimum balance requirement

Savings Bonds

  • Low-denomination Treasury issue
  • Designed to appeal to small investor
  • Types: Series EE, HH, I
  • Ability to convert securities to cash at a price similar to price of previous trade in security
  • Assumes no significant new information has arrived since previous trade
  • Also ability to sell an asset quickly without having to make substantial price concession
money market debt securities
Money Market Debt Securities
  • Available in large denominations that appeal primarily to large investors
    • Yields move together
  • Examples
    • Treasury bills
    • Commercial paper
    • Negotiable Certificates of Deposit
    • Banker’s acceptances
    • Eurodollar deposits
treasury bills
Treasury Bills
  • Sold at discount to par
  • Interest—difference between purchase and selling price (or maturity value)
  • Competitive and non-competitive bids

Days to AskMaturity Mat.BidAskChg.Yld. Jun 01 ’07   29 2.64  2.60 –0.04 2.64

Example: Treasury Bill Quotation

  • Maturity: date on which Treasury bill will be paid off
  • Days to Mat.: number of days remaining (from the previous trading day) until T-bill matures
  • Bid: price (as a discount percentage) that a dealer is willing to pay for the T-bill



Example: Treasury Bill Quotation


Days to AskMaturity Mat.BidAskChg.Yld. Jun 01 ’07   29 2.64  2.60 –0.04 2.64

Days to AskMaturity Mat.BidAskChg.Yld. Jun 01 ’00   49 5.64  5.60 –0.04 5.72

  • Ask: price (as a discount percentage) that dealer is willing to sell T-bill for
  • Chg.: change between bid price as listed in bid column and bid price from previous trading day (which is two trading days previous)
    • In example, –0.04 indicates a decrease of 4/100
  • Ask Yld.: bond equivalent yield for T-bill based on its ask price
dealer s spread
Dealer’s Spread
  • Difference between dealer’s ask price and bid price
t bill yields
T-Bill Yields

Bank Discount Yield

BDY = [(10,000 – Price)/10,000] x (360/DTM)

where BDY = bank discount yield

Price = actual T-bill price

DTM = days to maturity

Bond Equivalent Yield

BEY=((10,000 – Price)/Price) x (365/DTM)

where BEY = bond equivalent yield

commercial paper
Commercial Paper
  • Short-term IOUs issued by large corporations with solid credit ratings
  • Maximum maturity 270 days, but most commercial paper issued with a shorter maturity
  • Corporations can borrow at a lower rate from investors than from bank
negotiable cds
Negotiable CDs
  • Only interest bearing money market security
  • Trades have minimum denomination of $1,000,000
  • Trading ceases when 14 or fewer days to maturity
banker s acceptances
  • Two-name paper
    • Substitutes credit-worthiness of bank for local merchant
  • Result of international trade
eurodollar deposits
Eurodollar Deposits
  • Dollar-denominated liabilities of banks located outside of the US, usually Europe
  • Slightly higher than other MM rates
    • Less regulatory constraints on these banks
    • Smaller spread => higher deposit rates & lower loan rates
rates related to money market rates
Rates Related to Money Market Rates
  • Prime Rate
    • Indexed
    • Used by banks to price loans
  • Discount Rate
    • Charged by Federal Reserve Bank on loans to banks
  • Federal Funds Rate
    • Charged by banks to each other for lending federal funds
    • Charged by London banks on loans to each other
securities related to money market securities
Securities Related to Money Market Securities
  • Repurchase Agreements (Repos) and Reverse Repos
  • Short-term Municipals
  • Money Market Mutual Funds
  • Short-Term Unit Investment Trusts
long term debt instruments
Long-Term Debt Instruments
  • Treasury Securities
    • Treasury notes and bonds
    • Treasury strips
    • Treasury Inflation-Protected securities
  • Agency Issues
  • Mortgage Related Securities


long term debt instruments continued
Long-Term Debt Instruments(continued)
  • Municipal bonds
  • Corporate bonds
  • Promissory notes
  • Mortgage Related Securities
  • Insurance-based contracts
    • Guaranteed investment contracts
    • Annuities
Maturity AskRateMo./Yr.BidAskChg.Yld.6 1/3 May 10n 112:05 112:09 –5 4.16 7 June 10-15 110:02 110:05 …. 4.20

Treasury Note and Bond Quotations:Sample Quotes from the OTC Market

  • Rate: coupon rate at which interest is paid as percentage of par value
  • Maturity Mo./Yr.: month and year in which note/bond will be paid off
    • small n after maturity date identifies the security as a note
    • range of years given as maturity date identifies security as callable bond
  • Bid: price (in 32nds) that dealer is willing to pay for note/bond



Treasury Note and Bond Quotations:Sample Quotes from the OTC Market


Maturity AskRateMo./Yr.BidAskChg.Yld.6 1/3 May 10n 112:05 112:09 –5 4.16 7 June 10-15 110:02 110:05 …. 4.20

  • Ask: price (in 32nds) that dealer is willing to sell note/bond for
  • Chg.: change (in 32nds) between bid price as listed in bid column (see Bid above) and the bid price from the previous trading day (which is really 2 trading days previous)
    • Example: a –1 means a decrease of 1/32
  • Ask Yld.: yield to maturity for note/bond based on its ask price
treasury strips
Treasury STRIPS
  • Government program that allows a financial institution, government securities broker, or government securities dealer to convert an eligible Treasury security into interest and principal components
treasury inflation protected securities
Treasury Inflation-Protected Securities
  • Coupon rate set lower than on bonds without inflation protection
  • Par value of bond adjusted on a semiannual basis by amount of inflation rate to compensate for lower coupon rate
    • Inflation rate reported by BLS in its CPI
  • Coupon rate applied to par value to determine interest payment due
agency issues
Agency Issues
  • Slightly higher returns than Treasury bonds of comparable maturity
    • Lack full faith and credit guarantee of Treasury
    • Less marketable
  • Wider bid-ask spreads
municipal bonds
Municipal Bonds
  • Revenue bond
    • municipal bond backed only by revenues of project that it finances
  • General obligation bond
    • municipal bond secured by issuer’s full faith and credit and taxing power
corporate bonds
Corporate Bonds
  • Corporations are the largest issuers of bonds
  • More complex than government bonds and have varying degrees of risk

Corporate Bond Indentures

  • Legal contract between the issuer of the bond and the investor

Typical Indenture Provisions

  • Principal and maturity
  • Coupon
  • Collateral
  • Full faith and credit (debenture)
  • Subordination
  • Call provisions
  • Dividend restrictions
  • Current ratio minimum
  • Me-first rule
  • Trustee
  • Sinking fund
  • Grace Period

Examples: Corporate Bond Quotations

Cur. NetBondsYld.Vol.CloseChg.Att6s09 6.6    4 90 1/2 – 1/8 Hilton5s06 cv 130 82 – 1 Polaroid11 ½ f 489 14 1/2 – 1/2
  • Bonds: name of company issuing bond, interest or coupon rate as a percentage of face or par value (typically $1,000), and year in which the bond will be paid off
    • s that sometimes appears separates interest rate from year of maturity when interest rate does not include a fraction
    • Other letters used described in explanatory notes in financial media
  • Cur. Yld.: current yield or annual percentage return to purchaser at current price
    • Calculated by dividing coupon amount by current price
    • Flat bonds show no current yield
    • Convertible bonds have the letters cv listed



Examples: Corporate Bond Quotations


Cur. NetBondsYld.Vol.CloseChg.Att6s09 6.6    4 90 1/2 – 1/8 Hilton5s06 cv 130 82 – 1 Polaroid11 ½ f 489 14 1/2 – 1/2

  • Vol.: number of bonds traded
  • Close: price
    • percentage of par value
  • Net Chg.: difference between closing price as listed in close column and closing price from whatever day bond previously traded—usually the previous trading day, two trading days previous
trading flat
Trading Flat
  • Trading of bonds for price that does not reflect any accrued interest
  • Collateralized Bonds
  • Debentures
  • Mortgage Bonds
  • Equipment Trust Certificates
  • Long-term debt obligation that gives lender only general claim against borrower’s assets
    • Unlike a collateralized bond
  • Holder has no claim against any specific assets in a default
mortgage bonds
Mortgage Bonds
  • Plant and equipment pledged as collateral

– Subordination: property pledged as collateral on more than one bond issue, with the claims of one set of bondholders subordinate to the claims of a second set of bondholders

– Senior debt: nomenclature for the second set of bondholders

equipment trust certificates
Equipment Trust Certificates
  • Certificates used to purchase an asset and lease to a lessee
  • Lessee payments used to pay off certificates, at which point title and ownership of asset transfers to the lessee
coupon rates of bonds
Coupon Rates of Bonds
  • Zero-coupon bonds
  • Original-issue discount bonds
  • Split coupon bonds
  • Floating-rate notes, Adjustable rate securities, Reset bonds
  • Calls and Collars
  • Step-up notes
  • Income bonds
maturity provisions
Maturity Provisions
  • Convertible bonds: can be converted in shares of stock
  • Call Features

– Call price

– Call premium

– Forced conversion

  • Sinking Fund
bond ratings
Bond Ratings
  • Investment Grade
    • AAA to BBB (or Aaa to Baa)
  • Junk bonds
    • BB & lower (or Ba & lower)
  • Plusses & minuses used for further definition
corporate bankruptcy
Corporate Bankruptcy
  • An issuer is in technical default whenever any of the indenture provisions are violated
  • Filing for Bankruptcy

– Chapter XI reorganization

– Chapter VII liquidation: assets distributed

according to absolute-priority-of-claims principle

collateral status
Collateral Status
  • Senior
    • Must be paid first with proceeds from property pledged as collateral
    • Become general creditors for the balance
    • May receive Sub Debs or pref. stock
  • Junior
    • Can’t be paid till seniors paid in full
    • May receive common stock or warrants
  • Turning non-marketable securities into marketable
    • pass-through vehicles or collateral on bonds
  • Provides claims on assets not otherwise available to ordinary investors
mortgage loans
Mortgage Loans
  • FNMA: purchases mortgages from original mortgage lenders with the proceeds of its own debt security sales
  • GNMA: bundles packages of similar mortgages
  • FHLMC: purchases conventional mortgages, pools them, and sells participations
  • Can be FHA insured and VA guaranteed
mortgage backed securities
Mortgage-Backed Securities
  • Cash flow is dependent on the cash flows of an underlying pool of mortgages

– Mortgage Pass-Throughs

– Collateralized Mortgage Obligations

– Stripped Mortgage-Backed Securities

domestic foreign and euro bonds
Domestic, Foreign and Euro Bonds
  • Foreign bonds are issued and traded within a country, in local currency, by borrower located in a different country

– Yankee bonds is denominated in U.S. dollars and issued in the United States by foreign banks and corporations

  • Eurobonds

– Underwritten by an international syndicate and traded in multiple domestic markets

– Euro refers to offshore, not that the bond is traded in Euros

private placements
Private Placements
  • Debt instruments sold privately to a few large buyers
  • Do not have to comply with SEC disclosure requirements
promissory note
Promissory Note
  • Formal loan agreement
  • Used if loan amount significant
  • Examples:
    • Business issues to investor when borrowing money
    • Business issues to officers or key employees when lending money
guaranteed investment contracts
Guaranteed Investment Contracts
  • Stable value contract
  • Available in 401(k) retirement plans, profit-sharing plans, IRAs, and mutual funds
  • Investment choice provided by plan sponsor, but contract between insurance company and employee
  • Specified maturity date and rate of return guaranteed through maturity by insurance company
  • Not insured
  • Qualified Annuity is purchased through a tax sheltered program
  • Non-qualified annuity is purchased outside a tax-sheltered program
  • Accumulation value is the annuity value before any surrender charges have been deducted
  • Surrender value is the account value after surrender charges have been deducted
types of annuities
Types of Annuities
  • Single premium deferred annuities (SPDAs)
  • Flexible premium deferred annuities (FPDAs)
  • CD-type annuities
  • Single premium immediate annuities (SPIAs)
payout options
Payout Options
  • Straight life annuity
  • Life income with period certain annuity
  • Life with cash or installment refund annuity
  • Joint and survivor life annuity
  • Fixed period annuity
  • Fixed amount annuity