Debt Instruments

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
• Bankers acceptances
• Eurodollar deposits

7
Treasury Bills

• Sold at discount to par
• Interestdifference between purchase and selling
  price (or maturity value)
• Competitive and non-competitive bids

8
Days
to Ask Maturity  Mat. Bid Ask C
hg. 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 Ask Maturity  Mat. Bid Ask C
hg. Yld. Jun 01 07   29 2.64  2.60 0.04 2.64
Days to Ask Maturity  Mat. Bid Ask Chg. Yl
d. 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
Dealers Spread

• Difference between dealers ask price and bid
  price

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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
Bankers Acceptances

• 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 gt higher deposit rates lower
  loan rates

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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 Ask Rate  Mo./Yr. Bid Ask Chg. Yld.
6 1/3 May 10n 11205 11209 5 4.16 7 June
10-15 11002 11005 . 4.20
Treasury Note and Bond QuotationsSample 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 QuotationsSample Quotes
from the OTC Market (continued)
Maturity Ask Rate  Mo./Yr. Bid Ask Chg. Yld.
6 1/3 May 10n 11205 11209 5 4.16 7 June
10-15 11002 11005 . 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 issuers 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

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• 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
Cur. Net Bonds Yld. Vol. Close Chg. Att6s09 6.
6    4 90 1/2 1/8 Hilton5s06 cv 130 82
1 Polaroid11 ½ f 489 14 1/2 1/2
Examples Corporate Bond Quotations

• 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)

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Examples Corporate Bond Quotations (continued)
Cur. Net Bonds Yld. Vol. Close Chg. 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 tradedusually the
  previous trading day, two trading days previous

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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 borrowers 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

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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

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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
• Cant 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

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Types of Annuities

• Single premium deferred annuities (SPDAs)
• Flexible premium deferred annuities (FPDAs)
• CD-type annuities
• Single premium immediate annuities (SPIAs)

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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