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Debt Instruments: Qualitative Aspects Chapter 8. Sources of Risk Non Marketable vs. Marketable Short-Term, Long-Term Instruments Mortgage Backed Securities Bankruptcy. Sources of Risk. Default ; probability of not getting all of the promised interest and principal.

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debt instruments qualitative aspects chapter 8

Debt Instruments:Qualitative AspectsChapter 8

Sources of Risk

Non Marketable vs. Marketable

Short-Term, Long-Term Instruments

Mortgage Backed Securities


sources of risk
Sources of Risk
  • Default; probability of not getting all of the promised interest and principal.
  • Price; changes in prices as interest rates change over time.
  • Purchasing Power; effects on inflation on buying power of coupon income.
  • Liquidity: inability to buy or sell at intrinsic value due to inactive market or small float.
non marketable debt
Non-Marketable Debt
  • Certificates of Deposit (Depos. Inst.)
    • 3 months to 2 years (may carry special terms)
    • Decision Criterion: Expectations for rates
    • May be Brokered
  • Money Market Fund Balances
    • Invested in S-T instruments
    • Many have check writing priviledges
  • Savings Bonds (U.S. Treasury)
    • EE S.B. (“zero-coupon bond”)
    • I-Bonds (rates reset 2x a year)
    • Low denominations available
marketable debt
Marketable Debt
  • Key Attribute: 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: narrow bid-ask spread
      • Dealer Spread = Ask – Bid
marketable debt1
Marketable Debt
  • Treasury Bills
    • 13- and 26-week maturities sold weekly
    • 52-week bills once a month
    • Buy from treasury, online, or from bank
    • Sold at a discount
      • competitive and non competitive bids
    • Dealer-dominated secondary market
    • BDY = [(Face – Price)/Face] * (360/DTM)
    • BEY = [(Face – Price)/Price] * (365/DTM)
marketable debt2
Marketable Debt
  • Commercial Paper
    • 270 day max maturity
    • Sold at discount
    • $1,000,000 is typical Face Value
    • Financial companies are biggest issuers
    • Money market funds most significant buyers
  • Negotiable CD
    • May be bearer or registered
    • Partially insured by BIF
marketable debt3
Marketable Debt
  • Bankers’ Acceptances
    • Finance imports
    • Significant documentation
    • Traded in secondary markets
  • Eurodollar Deposits
    • USD-denominated liabilities of foreign banks
    • Rates paid typically > US rates
    • Narrow spreads: rate paid vs loan rate
    • Repatriation risks, lower regulatory oversight
term structure http online wsj com mdc public page 2 3020 moneyrate html
Term Structure
  • Discount Rate
    • Charged by Federal Reserve Bank on loans to banks
  • Federal Funds Rate
    • Charged by banks to each other for lending excess reserves (“Fed Funds”)
    • Charged by London banks on loans to each other
  • Prime Rate
    • Indexed
    • Used by banks to price loans
other mm arrangements
Other MM Arrangements
  • Repurchase Agreements (Repos) and Reverse Repos
    • Repo effectively a short term loan
    • Reverse Repo – buy for resale contract
  • Short-term Municipals
  • Money Market Mutual Funds
  • Short-Term Unit Investment Trusts
us government debt securities
US Government Debt Securities
  • Notes
    • Max maturities = 10 years
  • Bonds
    • Max maturities = 30 years
  • General Features
    • Very liquid
    • Registered
    • Semi-annual interest payments
us government debt securities1
US Government Debt Securities
    • Separate Trading of Registered Interest & Principal Securities
    • Sell semi-annual coupons as one security and sell maturity value as separate security.
    • Prices set by YTM
  • TIPS
    • Treasury Inflation-Protected Securities
    • Lower coupon rates - $ coupon fixed
    • Par values adjusted – vary yields
off balance sheet debt
Off BalanceSheet Debt
  • GSE Issuers (largest)
    • FNMA (fannie mae)
    • FHLMC (freddie mac)
  • Federal Agencies (Guaranteed by US)
    • EXIM Bank
    • GNMA
    • TVA
municipal debt
Municipal Debt
  • Issued by State, County, or City Gov’t
    • General Obligation Bonds
    • Revenue Bonds
    • Tax preferences (interest exempt from Fed taxes)
corporate debt
Corporate Debt
  • Indenture Agreement
    • Agreement between lender and borrower
      • Specifies and Restrictive Covenants
      • May require sinking funds or serial redemption
      • Grace period specified (curing a default)
    • Appoints the trustee; a fiduciary responsible for guarding the lenders' interests.
    • Provides for legal remedies if terms & conditions of indenture are not met.
    • Sets timing and rate of interest payments
corporate debt1
Corporate Debt
  • Market Trading
    • OTC dominates
    • Quotes include:
      • Coupon rate
      • Maturity
      • Current Yield
      • Volume
      • Last price (change)
corporate debt2
Corporate Debt
  • Collateralized Debt
    • Mortgage Bonds
    • Equipment Trust Certificates
  • Un-Collateralized Debt
    • Debentures
      • Senior
      • Subordinated
    • Notes (promissory)
      • Fixed or floating rate
corporate debt issues
Corporate Debt Issues
  • Other Important Features
    • Callable bonds
      • Call price includes premium
      • Yield-to-First-Call – impact of call premium
    • Convertible bonds
      • Convertible to common stock
      • C-bond is may be characterized as an interest-paying call option on the underlying stock
      • Conversions may be forced
    • Trading Flat: price does not include accrued interest
    • Zero Coupon Bonds (pure discount bonds)
corporate debt issues1
Corporate Debt Issues
  • Other Important Features (continued)
    • Original-issue discount bonds
      • “Zero” + coupon rate below market
    • Split coupon bonds: from Zero to “regular”
    • Floating rate securities (notes, bonds)
    • Step-up notes: scheduled changes in rate paid
    • Sinking Funds: Indenture requires issuer to set aside funds each year – assures payoff funds available at maturity.
credit ratings
Credit Ratings
  • Several Companies specialize in rating debt issues
  • Ratings (S&P schema)
    • Prime or High Quality (AAA)
    • Investment Grade (meets legal list requirements)
      • AA, A, & BBB
    • Speculative Grade
      • BB, B
    • High Risk
      • CCC, CC, C
    • Default
      • DDD, etc.
corporate bankruptcy
Corporate Bankruptcy
  • Definitions of Failure
    • Economic Failure; revenues do not cover expenses
    • Business Failure; termination resulting in loss to creditors
    • Technical Insolvency: firm cannot meet maturing obligations
    • Technical Bankruptcy: Value of assets < value of liabilities,
  • Legal Bankruptcy: Acts of Bankruptcy
    • Firm admits inability to pay (voluntary).
    • Composition of creditors petitions court (involuntary).
    • Concealment or improper transfer of assets to avoid attachment or repossession.
corporate bankruptcy1
Corporate Bankruptcy
  • Out-of-Court Remedies
    • Extension; postpone due date.
    • Composition; creditors agree to take less.
    • Necessary conditions;
      • Debtor is good moral risk.
      • Debtor must show ability to make a recovery.
      • General business conditions must be favorable.
    • Creditor committees; lenders assume management.
    • Assignment; Requires agreement as to liquidation values, and priority.
corporate bankruptcy2
Corporate Bankruptcy
  • Rule of Absolute Priority; Chapter 5, Section 507 (1978 law)
    • Secured creditors
    • Trustee expenses
    • Back wages for employees (max $2000)
    • Customer deposits (unsecured – max $900)
    • Federal and State taxes
    • Unfunded Pension Liabilities
    • General (unsecured) creditors
    • Stockholders (preferred, common)
corporate bankruptcy3
Corporate Bankruptcy
  • Chapter 7; Liquidation
    • Provide safeguards against fraud during liquidation.
    • Provide equitable distribution of assets to creditors.
    • Discharge all obligations: debtors can restart without burden of former debt.
    • Some claims settled in cash, others in assignment of assets.
corporate bankruptcy4
Corporate Bankruptcy
  • Chapter 11; Reorganization
    • Reorganization of repayment schedules; lengthen maturities
    • Some debt may be permanently dismissed.
    • Debt frequently has interest rates lowered.
    • Evaluates current management.
    • Determining if merger with healthy firm is best.
asset mortgage backed securities
Asset/Mortgage Backed Securities
  • Securitization
    • Turning non-marketable securities into marketable
      • Example: mortgages, credit card balances, accounts receivable
    • Provides claims on assets not otherwise available to ordinary investors
  • Mortgage-backed Securities (MBS)
    • Cash flows to investors = principal & interest
    • VA and FHA are insured
mortgage backed securities
Mortgage Backed Securities
  • Pass-Throughs
    • P&I less fee sent to investor
    • Many issuers: Fannie, Freddie, Ginnie
  • Collateralized Mortgage Obligations
    • Cash flows are sequenced (Tranches)
    • More risk for buyers of later tranches
other debt securities
Other Debt Securities
  • Foreign Bonds
    • State-issued
    • Corporate issues
    • Forex and Political risk important factors
  • Insurance Investments
    • Guaranteed Investment Contracts
    • Annuities
      • Single-premium deferred
      • Flexible-premium deferred
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)
annuity payout options
Annuity 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