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Chapter 8

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  1. Chapter 8 Debt Instruments Descriptive Issues

  2. Debt Instruments • Non-marketable • CDs • MMDAs • Savings Bonds • Marketable • Money Market Instruments • Long-Term Instruments

  3. 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)

  4. 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

  5. Liquidity • 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

  6. 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

  7. Treasury Bills • Sold at discount to par • Interest—difference between purchase and selling price (or maturity value) • Competitive and non-competitive bids

  8. 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 (continued)

  9. Example: Treasury Bill Quotation (continued) 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

  10. Dealer’s Spread • Difference between dealer’s ask price and bid price

  11. 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

  12. 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

  13. 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

  14. Banker’sAcceptances • Two-name paper • Substitutes credit-worthiness of bank for local merchant • Result of international trade

  15. 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

  16. 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 • LIBOR • Charged by London banks on loans to each other

  17. Securities Related to Money Market Securities • Repurchase Agreements (Repos) and Reverse Repos • Short-term Municipals • Money Market Mutual Funds • Short-Term Unit Investment Trusts

  18. Long-Term Debt Instruments • Treasury Securities • Treasury notes and bonds • Treasury strips • Treasury Inflation-Protected securities • Agency Issues • Mortgage Related Securities (continued)

  19. Long-Term Debt Instruments(continued) • Municipal bonds • Corporate bonds • Promissory notes • Mortgage Related Securities • Insurance-based contracts • Guaranteed investment contracts • Annuities

  20. 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 (continued)

  21. Treasury Note and Bond Quotations:Sample Quotes from the OTC Market (continued) 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

  22. 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

  23. 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

  24. 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

  25. 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

  26. 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

  27. 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

  28. 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 (continued)

  29. Examples: Corporate Bond Quotations (continued) 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

  30. Trading Flat • Trading of bonds for price that does not reflect any accrued interest • Collateralized Bonds • Debentures • Mortgage Bonds • Equipment Trust Certificates

  31. Debenture • 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

  32. 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

  33. 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

  34. 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

  35. Maturity Provisions • Convertible bonds: can be converted in shares of stock • Call Features – Call price – Call premium – Forced conversion • Sinking Fund

  36. Bond Ratings • Investment Grade • AAA to BBB (or Aaa to Baa) • Junk bonds • BB & lower (or Ba & lower) • Plusses & minuses used for further definition

  37. 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

  38. 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

  39. Securitization • Turning non-marketable securities into marketable • pass-through vehicles or collateral on bonds • Provides claims on assets not otherwise available to ordinary investors

  40. 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

  41. 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

  42. 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

  43. Private Placements • Debt instruments sold privately to a few large buyers • Do not have to comply with SEC disclosure requirements

  44. 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

  45. 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

  46. Annuities • 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

  47. Types of Annuities • Single premium deferred annuities (SPDAs) • Flexible premium deferred annuities (FPDAs) • CD-type annuities • Single premium immediate annuities (SPIAs)

  48. 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