Overview of Bond Sectors and Instruments by Frank
Overview of Bond Sectors and Instruments by Frank J. Fabozzi Power. Point Slides by David S. Krause, Ph. D. , Marquette University Copyright 2007 John Wiley & Sons, Inc. All rights reserved. Reproduction or translation of this work beyond that permitted in Section 117 of the 1976 United States Copyright Act without the express permission of the copyright owner is unlawful. Request for futher information should be addressed to the Permissions Department, John Wiley & Sons, Inc. The purchaser may make back-up copies for his/her own use only and not for distribution or resale. The Publisher assumes no responsibility for errors, omissions, or damages caused by the use of these programs or from the use of the information contained herein.
Chapter 3 Overview of Bond Sectors and Instruments • Major learning outcomes: – Understand the type of bonds issued by U. S. and other governments – Identify how stripped Treasury bonds are created – Describe mortgage-backed securities and collateralized mortgage obligations – Understand the bankruptcy process and bondholder rights – Describe the different types of corporate debt – Understand the types of asset-backed securities, including collateralized debt obligations – Describe the structure of the primary and secondary market for bonds
Chapter 3 Key Learning Outcomes • • • Explain how a country’s bond market sectors are classified. Describe a sovereign bond and explain the credit risk associated with investing in a sovereign bond. List the different methods used by central governments to issue bonds. Identify the types of securities issued by the U. S. Department of the Treasury. Outline how stripped Treasury securities are created. Describe a semi-government or government agency bond. For the U. S. bond market, explain the difference between federally related institutions and government sponsored enterprises. Describe a mortgage-backed security and identify the cash flows for a mortgage-backed security. Define prepayment and explain prepayment risk. Distinguish between a mortgage pass-through security and a collateralized mortgage obligation and explain the motivation for creating a collateralized mortgage obligation. Identify the types of securities issued by municipalities in the United States.
Chapter 3 Key Learning Outcomes • • • Summarize the bankruptcy process and bondholder rights. List the factors considered by rating agencies in assigning a credit rating to corporate debt. Describe secured debt, unsecured debt, and credit enhancements for corporate bonds. Describe a medium-term note and explain the differences between a corporate bond a medium-term note. Describe a structured note and explain the motivation for their issuance by corporations. Describe commercial paper and identify the different types of issuers. Describe the different types of bank obligations. Describe an asset-backed security. Summarize the role of a special purpose vehicle in an asset-backed securities transaction. Explain the motivation for a corporation to issue an asset-backed security. Explain a collateralized debt obligation. Describe the structure of the primary and secondary market for bonds.
Sectors of the Bond Market
Sectors of the Bond Market • The bond market of a country consists of an internal bond market (also called the national bond market) and an external bond market (also called the international bond market, the offshore bond market, or, more popularly, the Eurobond market). • There is no uniform system for classifying the sectors of the international bond market • From the perspective of an individual country, the bond market is classified as either: – Internal (domestic) – External (foreign)
Internal Bond Market • A country’s national bond market consists of the domestic bond market and the foreign bond market. – The internal bond market is referred to as the national or domestic market – It is the country’s market where the issuers are domiciled – The bonds are issued and traded in the issuer’s domestic market
Internal Foreign Bond Market • The external bond market is referred to as the foreign market. It is a market in a different country from where the issuer is domiciled. • In the U. S. , the foreign bond market is where bonds issued by non-U. S. entities are issued and then traded. – Foreign bonds in the U. S. market are nicknamed “Yankee bonds. ” – Foreign bonds in the U. K. market are nicknamed “Bulldog bonds. ” • Foreign bonds can be denominated in any currency. Foreign bond issuers can be central governments (and their agencies), corporations, and supranationals. – A supranational is an entity that is formed by two or more central governments through international treaties. – Examples would be debt issued by the International Bank for Reconstruction and Development (World Bank) and the Inter. American Development Bank
External Bond Market • The external bond market includes bonds with the following features: – They are underwritten by an international syndicate – At issuance, they are offered simultaneously to investors in various countries – They are issued outside the jurisdiction of any single country – They are unregistered
External Bond Market • The external bond market is called the international or offshore bond market – it is also known as the Eurobond market. • These bonds are classified based on the currency in which the issue is denominated. – Eurobonds denominated in US dollars are called Eurodollar bonds. – Eurobonds denominated in Japanese yen are called Euroyen bonds. • A global bond is a debt obligation issued and traded in the foreign bond market of one or more countries and the Eurobond market.
Eurobond Market Eurobonds are bonds which generally have the following distinguishing features: (1) they are underwritten by an international syndicate, (2) at issuance they are offered simultaneously to investors in a number of countries, (3) they are issued outside the jurisdiction of any single country, and (4) they are in unregistered form.
Sovereign Bonds • Bonds issued by a country’s central government are called sovereign bonds • These are often times the largest sector of a country’s bond market • A government can issue bonds in its national market or in the Eurobond market (or the foreign sector of another country’s bond market) – These bonds can be issued in any denomination
Sovereign Bonds • Sovereign debt is the obligation of a country’s central government. • Sovereign credits are rated by Standard & Poor’s and Moody’s. • There are two ratings assigned to each central government: a local currency debt rating and a foreign currency debt rating. • Historically, defaults have been greater on foreign currency denominated debt.
Sovereign Bond Credit Risk • All bonds (even US Treasury securities) are subject to credit risk. – The general perception throughout the world is that the US Treasury securities carry the least amount of credit risk. They are often referred to as the risk-free or default-free bond. • Sovereign bonds are rated by the various credit rating agencies. – These are called sovereign debt ratings (Standard & Poor’s and Moody’s rate this debt). – There are two types of sovereign debt ratings: • Local currency • Foreign currency • Default risk is greater foreign currency denominated debt because the central government can more easily generate cash in its own currency to pay principal and interest, whereas it may not be able to pay in another country’s currency as easily if the exchange rates are unfavorable
Methods of Distributing New Government Securities • There are 4 methods used by central governments to distribute new bonds: – Regular auction cycle/multiple-price method – Regular auction cycle/single-price method – Ad hoc auction method – Tap method
U. S. Government Securities • In the United States, government securities are issued by the Department of the Treasury and include fixed-principal securities and inflation-indexed securities. • The most recently auctioned Treasury issue for a maturity is referred to as the on-the-run issue or current coupon issue; off-the-run issues are issues auctioned prior to the current coupon issue.
Regular auction cycle method • Multiple-price method – There is a regular auction cycle with winning bidders allocated securities at the yield (price) they bid. • Single-price method – There is a regular auction cycle and all winning bidders are awarded securities at the highest yield (lowest price) accepted by the government. • U. S. Treasury securities are issued using a regular auction cycle / single-price method
Ad hoc auction and tap system • Ad hoc auction method – Governments will announce auctions when prevailing market conditions appear favorable – Only at the time of the auction will bidders be told about the type and maturity of the bonds to be offered. – The Bank of England uses this method to distribute British bonds. • Tap method – Additional bonds of a previously outstanding bond issue are auctioned. The government is “tapping” or periodically adding a new supply. – This system has been used by the U. K. , U. S. , and the Netherlands.
U. S. Treasury Securities • The following learning outcomes are essential for understanding U. S. Treasuries: – Describe the types of securities issued by the U. S. Department of the Treasury (e. g. bills, notes, bonds, and inflation protection securities) – Differentiate between on-the-run and off-the-run Treasury securities – Discuss how stripped Treasury securities are created – Distinguish between coupon strips and principal strips
U. S. Treasury Securities
U. S. Treasury Securities • Treasury discount securities are called bills and have a maturity of one year or less. • A Treasury note is a coupon-bearing security which when issued has an original maturity between two and 10 years; a Treasury bond is a coupon-bearing security which when issued has an original maturity greater than 10 years. • The Treasury issues inflation-protection securities (TIPS) whose principal and coupon payments are indexed to the Consumer Price Index. • Zero-coupon Treasury instruments are created by dealers stripping the coupon payments and principal payment of a Treasury coupon security.
U. S. Treasury Securities • Issued under the full faith and credit of the U. S. government by the Department of the Treasury • Each primary market auction (sealed bid regular cycle) is announced 7 days in advance via a press release. Auctions are on a competitive bid basis. • The secondary market for Treasuries is an over-the-counter market with a group of dealers offering virtually around-the-clock trading of these securities. – The most recently auctioned issues are referred to as the on-the-run or the current issue. – Issues that are no longer the most current issues are referred to as off -the-run. • The U. S. Treasury issues both fixed-principal and inflation-indexed securities.
U. S. Treasury Securities • The Basics of Treasury Securities – http: //www. publicdebt. treas. gov/of/ofbasics. htm • Recent Treasury Note and Bond Auction Results – http: //wwws. publicdebt. treas. gov/AI/OFNtebnd
U. S. Treasury Securities • Fixed fixed-principal securities include bills, notes, and bonds. – T-bills are issued at a discount to par value, have no coupon rate, mature a par value, and have a maturity date of less than 12 months. The return is the difference between the price paid and par value at maturity. – T-notes are coupon securities issued with original maturities of more than one year and less than 10 years. These are issued at approximately par value and mature at par. – T-bonds are coupon securities with original maturities of more than 10 years. • Callable T-securities have not be issued since 1984.
Treasury Bill Pricing • T-bills are offered by the Treasury in minimum denominations of $10, 000. • T-bills are issued and priced at a discount from face value and are redeemed at par value. • The difference between the discounted purchase price and the face value of the T-bill is the interest income which the purchaser receives. • The yield on a T-bill is a function of this interest income and the maturity of the T-bill. • A 28 -day T-bill priced at 99. 636 will yield 4. 757%
Treasury Bond and Note Prices • Bond prices are expressed as a percent of par value and are expressed in 32 nds of a point. • A price of 100: 13 means that the bond can be sold for 100 13/32% of the face value. • For a $100, 000 par value bond, this would be $100, 406.
U. S. Treasury Securities • Inflation-indexed Treasury securities (also known as TIPS) – These are T-notes and bonds that provide inflation protection. – Issued first in 1997 – Initial maturities: 5, 10 and 30 years – Adjusted for inflation every 6 months
Treasury Inflation-Adjusted Securities • The coupon rate on a TIPS is set at a fixed rate determined by an auction. The coupon is called the real rate, because it is the rate the investor will ultimately earn above the inflation rate. – The inflation index used is the CPI-U (all item, urban consumer price index). – The Treasury Department adjusts both the dollar amount of the coupon payment and the maturity value on a semi-annual basis. – The principal is called the inflation-adjusted principal.
Treasury Inflation-Adjusted Securities • Interest Payments – Every six months, the Treasury will pay interest based on a fixed rate of interest determined at auction. – Semi-annual interest payments are determined by multiplying the inflation-adjusted principal amount by one-half the stated rate of interest on each interest payment date. • Payment at Maturity – If at maturity, the inflation-adjusted principal is less than the par amount of the security (due to deflation), the final payment of principal of the security by Treasury will not be less than the par amount of the security at issuance (floor). – In such a circumstance, Treasury will pay an additional amount plus the inflation-adjusted principal amount, which will equal the par amount of the securities on the date of original issuance.
TIPS Example • Taxes must be paid for the principal adjustment each year – therefore these are good for tax deferred investments (IRAs, Keoghs, SEP-IRAs, etc. ). – These are not as good for taxable entities because taxes are due before cash is received. • Practice Question 1 and End-of-Chapter Question 4 require the computation of inflation-adjusted principal and the coupon payment amount.
Treasury Strips • Treasury securities are often stripped of their coupons in the private sector to create zerocoupon bonds, known as Treasury Strips. • The Treasury STRIPS program was introduced in January 1985. STRIPS is the acronym for Separate Trading of Registered Interest and Principal of Securities. – The STRIPS program lets investors hold and trade the individual interest and principal components of eligible Treasury notes and bonds as separate securities.
Treasury Strips • Strips created from the coupon payments are called coupon strips; those created from the principal payment are called principal strips. • A disadvantage for a taxable entity investing in Treasury strips is that accrued interest is taxed each year even though interest is not received.
Treasury Strips
Treasury Strips • When a Treasury fixed-principal note or bond (or a TIPS) is stripped, each interest payment and the principal payment becomes a separate zero-coupon security. – Each component has its own identifying number and can be held or traded separately. – For example, a Treasury note with 10 years remaining to maturity consists of a single principal payment at maturity and 20 interest payments, one every six months for 10 years. When this note is converted to STRIPS form, each of the 20 interest payments and the principal payment becomes a separate security. • STRIPS are also called zero-coupon securities because the only time an investor receives a payment during the life of a STRIP is when it matures.
Treasury Strips • Why do investors hold STRIPS? – STRIPS are popular with investors who want to receive a known payment at a specific future date. – For example, some state lotteries invest the present value of large lottery prizes in STRIPS to be sure that funds are available when needed to meet annual payment obligations that result from the prizes. – Pension funds invest in STRIPS to match the payment flows of their assets with those of their liabilities to make benefit payments. – – STRIPS are also popular investments for individual retirement accounts, 401(k)-type savings plans, and other income taxadvantaged accounts that permit earnings to accumulate without incurring immediate income tax consequences.
Non-U. S. Sovereign Bonds • German issues (Bunds) – 8 -30 year maturities, 10 year the largest sector of market – Fixed-rate coupon and bullet structure • United Kingdom issues (Gilts) – Many varieties, largest sector is straight-fixed coupon rate bonds • French issues (OATS and BTANs) – Most are fixed-rate, but there also floating rate issues • Italian issues (BTPs, CCTs, CTZs, CTOs) – Wide variety of maturities and coupon structures • Canadian, Australian, and Japanese issues are similar to U. S. Treasuries • Other issues of smaller countries are considered to be emerging market debt – Brady bonds
Semi-Government or Agency Bonds • The U. S. and other industrialized countries have numerous branches or agencies of the federal government that are able to issue bonds. • In some instances these semi-government or agency bonds are backed by the full faith and credit of the central government, while in other instances they are indirectly backed by the central government. • In the U. S. the federal agency securities are classified by the types of issuers: – Federally related institutions – Government sponsored enterprises (GSEs)
U. S. Agency Bonds
U. S. Federally Related Issuers (Agencies) • Federally related institutions are an arm of the U. S. federal government, they include: – – – Export-Import Bank of the U. S. Tennessee Valley Authority (TVA) Commodity Credit Corporation Farmers Housing Administration General Services Administration Government National Mortgage Association (Ginnie Mae) – Maritime Bank – Small Business Administration (SBA) – Washington Metropolitan Area Transit Authority
U. S. Federally Related Issuers • The bonds of an agency or organization established by a central government are called semi-government bonds or government agency bonds and may have either a direct or implied credit guarantee by the central government. • In the U. S. bond market, federal agencies are categorized as either federally related institutions or government sponsored enterprises.
U. S. Government Sponsored Enterprises (GSEs) • Government sponsored enterprises (GSEs) are privately owned, publicly chartered entities that were created by Congress to reduce the cost of capital for certain borrowing sectors of the economy deemed to be important enough to warrant assistance.
U. S. Government Sponsored Enterprises (GSEs) • These are privately owned, publicly chartered entities which were created by Congress to reduce the cost of borrowing for certain sectors of the economy deemed to be crucial – These entities include farmers, homeowners, and students. • GSEs can issue securities directly in the marketplace, which in recent years has turned into an active and important secondary market. • The six GSEs are: – – – Federal National Mortgage Association (Fannie Mae) Federal Home Loan Mortgage Corporation (Freddie Mac) Federal Agricultural Mortgage Corporation (Farmer Mac) Federal Farm Credit System Federal Home Loan Bank System Student Loan Marketing Association (Sallie Mae)
U. S. Agency Debentures and Discount Notes • GSEs offer two types of debt: – Debentures (either notes or bonds with maturities of 1 to 20 years) – Discount notes (short-term obligations with maturities ranging from overnight to 360 days) • GSEs are frequent issuers of securities and have various well-defined types of offerings including: – Callable bonds and notes – Notes and bonds that are eligible for stripping to create zero-coupon GSE bonds
U. S. Agency Mortgage-Backed Securities • Two of the GSEs charged with providing liquidity to the mortgage market (Fannie Mae and Freddie Mac) issue securities backed by the mortgage loans they purchase. • In other words, they use the mortgage loans they underwrite or purchase as collateral for the securities they issue. – A significant part of their earnings is derived from the difference between the yield on the mortgages they hold and the cost of funds on their debt securities. • These are called agency mortgage-backed securities and include: – Mortgage pass-through securities – Collateralized mortgage obligations (CMOs) – Stripped mortgage-backed securities
Mortgage Loans • A mortgage loan is a loan secured by the collateral of some specified real estate property. • Mortgage loan payments consist of interest, scheduled principal payment, and prepayments. – Prepayments are any payments in excess of the required monthly mortgage payment. – Prepayment risk is the uncertainty about the cash flows due to prepayments.
Mortgage Loans • A mortgage loan is secured by some specific real estate property (collateral) which obligates the borrower to make a predetermined series of payments. • The mortgage gives the right to the lender to foreclose on the loan and seize the property in the event the debt is not paid. • The interest rate on the mortgage is called the mortgage or contract rate. • There are different types of mortgages including: – – Traditional fixed-rate fully amortizing Floating rate Interest-only (fixed or floating) Partial amortizing (fixed or floating) • Exhibit 5 shows a fully amortized mortgage schedule (principal and interest)
Fully Amortized Mortgage Loan
Mortgage Loans • Investors/lenders do not always receive the amount in the amortization schedule because: – Uncertainty in the borrower’s payments – Prepayments – Servicing fees • Servicing fees are collected by a bank or mortgage company and can be as much as 50 -75 basis points • Prepayments by the borrower (especially when interest rates are dropping) can result in prepayment or reinvestment risk for the lender/investor.
Mortgage Pass-through Securities • Loans included in an agency issued mortgage-backed security are conforming loans—loans that meet the underwriting standards established by the issuing entity. • For a mortgage passthrough security the monthly payments are passed through to the certificate holders on a pro rata basis.
Mortgage Pass-through Securities • A mortgage pass-through security is created when one or more holder of the mortgages form a portfolio or pool of mortgages and sells shares or participation certificates in the pool to investors. • When mortgages in the pool are collateralized, the mortgage pool is considered to be securitized. • The cash flow received by the investor depends on the cash flow of the borrowers in the underlying pool of mortgages. (These cash flows are the principal and interest payments less any servicing fees). • Payments are made to security holders each month with the exact amount uncertain. • Ginnie Mae, Fannie Mae, and Freddie Mac mortgage loans must meet underwriting standards (conforming loans). Mortgage-back securities not issued by agencies are backed by pools of nonconforming loans. – Exhibits 6 and 7 illustrate the concept of mortgage passthroughs.
Mortgage Pass-through Securities
Mortgage Pass-through Securities
Mortgage Pass-through Securities versus Non-Callable Coupon Bonds • For a standard coupon bond, there are no principal payments prior to maturity – unlike the monthly amortization payments from a pass-through. • Payments for a pass-through are monthly, whereas the standard coupon bond pays interest semi-annually. • Passthroughs have more payment uncertainty (because of prepayments) than a standard non-callable bond. • Principal risk exits for both types of securities, however, based on the collateral and status of the conforming loans the risk levels will vary.
Collateralized Mortgage Obligations • In a collateralized mortgage obligation (CMO), there are rules for the payment of interest and principal (scheduled and prepaid) to the bond classes (tranches) in the CMO. • The payment rules in a CMO structure allow for the redistribution of prepayment risk to the tranches comprising the CMO.
Collateralized Mortgage Obligations • CMOs are a special type of agency mortgage securities. • The motivation for CMOs is to distribute prepayment risk among different classes of bonds. • Exhibit 7 shows the creation of a CMO • The exhibit shows three classes (tranches) of bonds with different levels of cash flow risk – and different return (yield) levels. – Tranche 1 might be the first level to receive principal payments, then level 2, …. . Therefore these have different levels of reinvestment risk and maturity risk. • The collateral for a CMO issued by an agency is a pool of passthrough securities which is placed in trust. • The source of the CMO’s cash flow is the pool of mortgage loans.
Collateralized Mortgage Obligations
State and Local Government Bonds • In the U. S. bond market, municipal securities are debt obligations issued by state governments, local governments, and entities created by state and local governments. • There are both tax-exempt and taxable municipal securities, where ‘‘tax-exempt’’ means that interest is exempt from federal income taxation; most municipal securities that have been issued are taxexempt. – There are basically two types of municipal security structures: tax-backed debt and revenue bonds.
State and Local Government Bonds • Non-central government entities (states, counties, cities, school districts, sanitation districts, etc. ) are referred to as municipal bonds. • In the U. S. there are both tax-exempt and taxable municipal securities. The tax exemption applies to interest income and not capital appreciation. • Most municipal bonds are tax-exempt and trade in an over-the-counter secondary market. • Like other non-Treasury securities, municipal investors are exposed to credit risk. • There are two types of municipal securities: – Tax-backed debt – Revenue bonds
State and Local Government Bonds
Tax-Backed Municipal Bonds • There are three types of tax-backed debt issues in the U. S. municipal securities market: – General obligation debt – Appropriation-backed obligations (also known as moral obligation bonds) – Public credit enhanced programs
Municipal Bonds • There are basically two types of municipal security structures: taxbacked debt and revenue bonds. – Tax-backed debt obligations are instruments secured by some form of tax revenue. – Tax-backed debt includes general obligation debt (the broadest type of tax-backed debt), appropriation-backed obligations, and debt obligations supported by public credit enhancement programs. • Revenue bonds are issued for enterprise financings that are secured by the revenues generated by the completed projects themselves, or for general public-purpose financings in which the issuers pledge to the bondholders the tax and revenue resources that were previously part of the general fund. – Insured bonds, in addition to being secured by the issuer’s revenue, are backed by insurance policies written by commercial insurance companies.
General Obligation Municipal Debt • This is the broadest and most commonly issued type of tax-backed debt. • Unlimited tax general obligation debt is secured by the issuer’s (municipality’s) unlimited taxing power. – The tax revenue source can include corporate and individual income taxes, sales taxes, and property taxes. – The debt is backed by the full faith and credit of the issuer. • Limited tax general obligation debt is a limited tax pledge which might involve a statutory limit on tax rate increases that the issuer may levy to service the debt. • “Double-barreled in security” bonds are a highly secure form of municipal debt backed not only by the full faith and credit of the issuer, but also might have provisions to be funded by certain fees, grants, and other special charges from sources outside the municipality’s general fund.
Appropriation-Backed Obligation Municipal Debt • Agencies or special authorities of some states have issued bonds that are backed by the state’s ability to cover any shortfalls. • The use of funds from the state’s general tax revenue must be approved by the state legislature. • Debt obligations backed by the state are not legally binding and are called moral obligation bonds. • Because legislative approval is required, these are classified as appropriation-backed obligations.
Municipal Obligations Supported by Public Credit Enhancement Programs • Unlike the moral obligation debt obligations backed by the state, which are not legally binding, these bonds carry some form of public credit enhancement that is legally enforceable. • These bonds are backed by a state or federal guarantee to use funding to pay any defaulted debt service by the municipality. • These are often used for debt obligations of a state’s school systems. • Some state and local governments have issued bonds where the debt service is paid from dedicated revenue sources, such as sales taxes or tobacco settlement fees.
Revenue Municipal Bonds • Revenue bonds are issued for organizations that are secured by the revenues generated by the financed projects – or specific revenue streams from the general fund are designed to cover the debt obligations of the financed project. • Revenue bonds typically involve the following type of projects: – – Utility and transportation Housing and higher education Health care, sports, and convention centers Seaports and industrial parks
Insured Municipal Bonds • In addition to being secured by the issuer, these are also backed by insurance policies written by commercial insurance companies. • This bond insurance requires the insurance company (underwriter) to pay any debt obligations if the municipality is unable. • This insurance lasts for the life of the municipal bond.
Prerefunded Municipal Bonds • If interest rates have dropped and a municipality wants to refinance, but the terms of the municipal bond do not allow for immediate refunding, it is possible to do a “prerefunded” or “advanced refunding” offering. • Basically, a second financing is undertaken (at a lower cost) and the proceeds are invested to be used at the time at which the original (higher cost) financing can be called (refunded). – Zero-coupons are often used to match coupon and principal payments of the original bonds. • Prerefunded bonds with structured maturity dates are known as “escrowed-to-maturity” bonds. This is a form of structured financing.
Corporate Debt • Corporations have two sources of debt financing: bank borrowing and the issuance of debt securities. • Exhibit 10 displays the many different types of corporate debt securities. • Even a company in a country that does not have a welldeveloped bond market can issue debt by issuing securities in foreign markets. • The U. S. and U. K. corporate debt markets are the most developed in the world.
Corporate Debt
U. S. Bankruptcy and Bondholder Rights • In the United States, the Bankruptcy Reform Act of 1978 as amended governs the bankruptcy process. – Chapter 7 of the bankruptcy act deals with the liquidation of a company; Chapter 11 of the bankruptcy act deals with the reorganization of a company. • In theory, creditors should receive distributions based on the absolute priority rule to the extent assets are available; this rule means that senior creditors are paid in full before junior creditors are paid anything • Generally, the absolute priority rule holds in the case of liquidations and is typically violated in reorganizations.
U. S. Bankruptcy and Bondholder Rights • Each country has their own contract and securities laws that govern the rights of bondholders. • The bankruptcy code covers the treatment of bondholders in the case of a bankruptcy. • Bondholders in the U. S. have priority over equity owners of a firm involved in a bankruptcy proceeding.
Rules During Bankruptcy • Liquidation of a firm means that all assets will be distributed to claim holders of the firm – which will not survive the bankruptcy. • A reorganization results in a new corporate entity at the end of the bankruptcy proceeding. Some security holders will receive cash, while others may receive new securities (or some combination of the two). • The bankruptcy law has numerous chapters: – Chapter 7 deals with liquidation – Chapter 11 deals with the reorganization of a company
Credit Ratings • Based on the prospects of default, organizations with outstanding debt are issued credit ratings. • Credit rating agencies, such as Standard & Poor’s and Moody’s (and others), conduct detailed credit examinations based on the 4 C’s: – – Character Capacity Collateral Covenants • Rating agencies provide ratings (i. e. A, BBB, etc. ) based on individual debt offerings – therefore it is possible for an organization to have outstanding debt that receives different credit rating scores.
Credit Rating Factors • Character – the analysis of the quality of an organization’s management. • Capacity – the ability of the company to pay, which includes detailed financial statement and industry analysis. • Collateral – the quality of the pledged and general assets (tangible and intangible) of the organization. • Covenants – limitations and restrictions on the borrower’s activities: – Affirmative covenants require the borrower to do certain things (i. e. provide financial statements in a timely manner, pay taxes and other obligations, maintain assets, etc. ) – Restrictive or negative covenants require the borrower not to take certain actions (i. e. sell off assets, take on more debt, etc. )
Secured, Unsecured, and Credit Enhanced Corporate Bonds • Secured debt has some form of collateral pledged to ensure payment of the debt obligation. • An obligation without any pledged collateral is unsecured debt. • Some debt can be secured with a third-party guarantee, called a credit enhancement. – Note: secured and credit enhanced debt still does not prevent bondholders in all cases from suffering financial loss.
Secured Corporate Bonds • Secured debt has some form of real or personal property pledged as collateral to ensure payment of the debt obligation. – Mortgage debt grants the bondholders a lien against pledged assets. (A lien is the legal right to sell mortgaged property to cover unpaid debt obligations). – Mortgage debt gives the bondholders a stronger position than other creditors in the event of a reorganization. • Companies with no real property to pledge can offer financial assets as security – these are called collateral trust bonds. • Mortgage bonds go by different names: – – First mortgage bonds First and general mortgage bonds First refunding mortgage bonds First mortgage and collateral trust bonds • When firms cannot issue first mortgage bonds because of existing covenants, they may issue secured bonds called secondary or general and refunding mortgage bonds.
Unsecured Corporate Bonds • Debt with no security or pledges are referred to in the U. S. as debenture bonds. • Debenture bondholders have the claim of general creditors on all assets of the issued not pledged to secured debts or loans. • Subordinated debenture bonds are issues that rank below secured and debenture bonds with regard to claims on assets in bankruptcy or liquidation. • The negative pledge clause provides protection for unsecured bondholders by prohibiting the firm from creating new debt or assuming any lien to secure a debt issue without equally securing the unsecured issue.
Credit Enhanced Corporate Bonds • This is a bond issue that has another company or thirdparty securing or guaranteeing the debt. – The use of credit guarantees by the parent company is used to secure the debt of special projects or affiliates. • A second credit enhancing feature is the letter of credit (LOC), which is issued by a bank. – The bank receives an annual fee for providing the LOC, which requires it to stand behind the debt of the issuer in the event of any missed debt obligations. – Some insurance companies also lend their credit standing to support corporate debt. – In these cases, the credit rating of the bond is usually the same as the credit rating of the guarantor. – Note that the credit analyst might have to evaluate the creditworthiness of two organizations as the result of the credit enhanced letter of credit.
Historical Performance of Corporate Bond Issuers • There are two measures of the overall historical performance of corporate issuers: – The default rate – Default loss rate • A portfolio of corporate bonds can outperform a portfolio of Treasury bonds even with some defaults – provided the yield spread is sufficiently high enough to offset the loss from defaults. – This occurs because during default, bondholders typically do not suffer total loss from their investments. – The percentage of the face amount versus par value received by a bondholder in a default event is call the default loss rate – therefore it is important to understand the actual recovery rate rather than just the percentage of firms in a corporate bond portfolio that default.
Default Rates • The default rate is simply measured as the number of issuers that default during a period of time divided by the total number of issuers at the beginning of the period – this is the issuer default rate. – Moody’s and S&P’s report this statistic • Another measure is the dollar default rate – which is the par value of all bonds defaulting in a period divided by the total par value of all bonds outstanding during the period. – Bond rating agencies report on the trend of this statistic, as well as the default rate. • Not surprisingly, bonds with lower credit rating have higher default rates. – Studies place the annual dollar default rates for all high-yield bonds to be between 3% and 5%.
S&P’s Downgrade and Default Ratios • • According to S&P, the stability of credit quality seen in previous years should begin a gradual slide in the second half of 2006 and continuing into 2007. The default rate for high-yield issuers at the end of 2005 stood at 1. 9%, indicating an improvement over year-end 2004, when it was 2. 3%. – S & P analysts forecast the rate to rise to about 3% at the end of 2006 and in 2007, the speculative-grade default rate will likely approach its long-term average of 4. 7% according to S&P.
Recovery Rates • The measurement of the recovery rate is challenging because it may take years to determine the true default loss or recovery rate. – Determining the present value of the recovery is difficult, thus making historical measures tricky to compare across time. • Moody’s has reported that the recovery rate is about 38% of par value for all defaulted bonds – and that the higher the credit rating, the higher the recovery rate.
Medium-Term Notes (MTN) • A medium-term note is a debt instrument with the unique characteristic that notes are offered continuously to investors by an agent of the issuer. – Maturities can vary from under 1 year to 30 years. – The issue is registered with the Securities and Exchange Commission under Rule 415 (shelf registration). • This rule gives an issuer the maximum flexibility for issuing securities on a continuous basis. • MTNs can be flexible: – They can be fixed or floating rate. – Issued in U. S. or other currency. – They can have the same features as other corporate bonds (i. e. call provisions).
The Primary Market for MTNs • Unlike traditional corporate bonds that are underwritten and distributed by an investment banker, MTNs are often sold on a “best efforts” basis. – Either broker/dealers or investment banks will be paid a fee by the issuer to help sell the MTNs. • An organization seeking to issue MTNs will file a shelf registration (Rule 415) with the SEC. – MTN offerings are between $100 and $1 billion. – Once approved by the SEC the shelf registration covers a two year period. – The registration includes a list of the investment banking firms that will serve as agents to distribute the MTNs. – The issue posts rates over a range of maturities from 1 year on up – usually posted as a spread over a Treasury security with a comparable maturity. – The rate offering schedule can change as market conditions change.
Structured MTN Offerings • The traditional MTN used to be a fixed-rate non-callable coupon bond. • Today, the MTNs are more complex with many creative features (i. e. options, caps, floating rates, floors, etc). • MTNs created when the issuer simultaneously transacts in the derivative markets is called a structured note. – The most common derivative instrument used to create a structured note is a swap. • A swap is an exchange of streams of payments over time according to specified terms. The most common type is an interest rate swap, in which one party agrees to pay a fixed interest rate in return for receiving a adjustable rate from another party. – Structured offering (which involve the use of derivative instruments) allow issuers to create investment vehicles that are customized to the needs of institutional investors to satisfy their investment objectives.
Structured MTN Offerings • Some structured notes can be highly innovative, including coupon rates that adjust to changes in foreign exchange rates, stock market levels, and commodity prices. • “Rule busters” MTNs allow investors to participate indirectly in asset classes forbidden by their investment policy • More common structured MTNs include: – – – Step-up notes Inverse floaters Deleveraged floaters Dual-indexed floaters Range notes Index amortizing notes
Structured MTN Offerings • Deleveraged Floaters – This is a floater that has a coupon formula where the coupon rate is computed as a fraction of the reference rate plus a quoted margin Coupon rate = b x (reference rate) + quoted margin, where b is a value between 0 and 1.
Structured MTN Offerings • Dual-Indexed Floaters – The coupon rate is typically a fixed percentage plus the difference between two reference rates. Note: a reset period (i. e. quarterly) needs to be established. Coupon rate = (reference rate 1 – reference rate 2) + quoted margin
Structured MTN Offerings • Range Note Floater – A type of floater whose coupon rate is equal to the reference rate (as long as the reference rate is within a certain rate at the reset date). – If the reference rate falls outside the range, the coupon rate is zero for the period. • Index Amortizing Notes – A structured note with a fixed coupon whose principal payments change according to changes in an underlying interest rate.
Commercial Paper • Commercial paper is a short-term unsecured promissory note issued in the open market by a corporation in need of short-term funding. – Most commercial paper has a maturity of 50 days, but it can be as much as 270 days. – Commercial paper is commonly ‘rolled over, ’ meaning that retiring paper is funded with the issuance of new commercial paper. – There is little secondary market trading.
Commercial Paper • Commercial paper is usually issued by financial companies: – Captive finance companies (which are usually subsidiaries of manufacturing companies (GMAC, GECC)) issue commercial paper to secure financing for customers of the parent company. – These are the largest players in the market. • Commercial paper is classified as: – Directly placed – sold by the issuing firm without an agent or intermediary. Most financial company commercial paper is placed in this manner. – Dealer-placed – requires the services of an agent to sell an issuer’s commercial paper. • Exhibit 11 shows the various commercial paper credit ratings
Commercial Paper
Bank Obligations • Commercial banks issue two types of debt obligations: – Negotiable CDs (certificates of deposit) – Bankers acceptances (instruments to help facilitate commercial trade transactions) • These are used by banks to raise shortterm funds.
Negotiable CDs • A certificates of deposit is a financial asset issued by a bank that indicates a specific amount of money has been deposited. The CD has: – A set maturity date – A specific interest rate – No set denomination • CDs in the U. S. are insured by Federal Deposit Insurance Corporation (FDIC) up to $100, 000 per customer per bank. • Non-negotiable CDs have penalties for early withdrawal. Negotiable CDs allows the initial depositor to sell the CD in the open market prior to maturity. • Negotiable CDs are usually issued in denominations of $1 million or greater.
Negotiable CDs • The Eurodollar CD is dollar denominated and issued primarily in London by U. S. , European, Canadian, and Japanese banks. • The interest paid on Eurodollar CDs is viewed as the global cost of bank borrowing and is watched closely in the world financial markets. – This is due to the fact that these interest rates represent the rates at which major banks offer to pay each other to borrow money. The interest rate paid is called the London interbank offered rate (LIBOR). • Eurodollar CDs rank in maturities from overnight to 5 years. Reference to the 1 -month LIBOR indicates the interest rates that major international banks are offering to pay to other banks over a 1 month period. • LIBOR is the reference rate used for most loans and floating-rate securities.
Bankers Acceptances • A bankers acceptance is a money market instrument - a short-term discount instrument that usually arises in the course of international trade. • Bankers acceptances are typically used to finance international transactions in goods and services, and currently represent an estimated of over $5 billion market.
Bankers Acceptances • A bankers acceptance starts as an order to a bank by a bank's customer to pay a sum of money at a future date, typically within six months. – At this stage, it is like a postdated check. When the bank endorses the order for payment as "accepted", it assumes responsibility for ultimate payment to the holder of the acceptance. – At this point, the acceptance may be traded in secondary markets much like any other claim on the bank. • Bankers acceptances are considered very safe assets, as they allow traders to substitute the bank's credit standing for their own. – They are used widely in foreign trade where the creditworthiness of one trader is unknown to the trading partner. – Banker acceptances sell at a discount from face value of the payment order, just as T-bills sell at a discount from par value.
Asset-Backed Securities • Asset-backed securities are obligations backed by a pool of loans or receivables. • Residential mortgages are the largest segment of the asset-backed market, the other major type of assets that are securitized include: – Auto loans and leases – Consumer loans – Commercial assets (aircraft, CNC machines, trade receivables) – Credit cards – Home equity loans – Manufactured housing loans
Asset-Backed Securities • Corporations that have a significant amount of receivables or loans on their balance sheet, and who need to raise funds, can issue asset-backed obligations at favorable rates. – The firm must create a separate entity that holds the receivables/loans. Special purpose corporations. – The separate entity can issue an asset-backed debt obligation with the receivables/loans pledged as collateral. – The credit risk of the standalone entity with only the receivables/loans on its balance sheet may have a stronger credit rating that the other firm (not a parent company). – To obtain even a higher credit rating (and lower cost of money), the firm can credit enhance the asset-backed obligations. • These third-party guarantees can be in the form of a guarantee by the firm, a letter of credit, or bond insurance.
Collateralized Debt Obligations • Another segment of the asset-backed securities market is the collateralized debt obligation (CDO), which has grown significantly the past few years. • The CDO is structured in a similar manner as the collateralized mortgage obligation (CMO), except that rather than mortgages the assets pledged as collateral are: – – – Domestic and foreign bonds Bank loans Distressed debt Foreign bank loans Asset-backed securities Commercial and residential mortgage-backed securities
Collateralized Debt Obligations • Like CMOs, CDOs can be packaged to provide unique income streams and risk levels (tranches) • Investment companies and hedge funds (and other sponsors of CDOs) seek arbitrage returns by bundling together a pool of similar debt obligations and selling them to institutional investors and accredited investors who have unique investment objectives. – The investment company or hedge fund or earns a fixed return or spread on the cost of the obligations versus the repackaging into a CDO.
The Process of Issuing Bonds • Investment Banks help companies and governments issue debt (and equity) The leading investment banks including Merrill Lynch, Salomon Smith Barney, Morgan Stanley Dean Witter, Citigroup, JP Morgan, Bank of America, and Goldman Sachs are said to be in the bulge bracket. • Other investment banks are regionally oriented or situated in the middle market (e. g. Baird). • Others are small, specialized firms called boutiques which might be oriented toward smaller issues, municipal debt, M&A advisory, or program trading.
Primary Market for Bonds • The traditional process for issuing new bonds involves investment bankers performing one or more of the following: – Advising the issuer on the terms and timing of the offering; – Buying the securities from the issuer; and – Distributing the issue to the public. • Underwriting (risk assumption) and ‘best efforts’ offerings
Bought Deal and Auction Process • Bought deals work as follows: – The underwriters offer a potential issuer of debt securities a firm bid to purchase a specified amount of securities with a certain coupon rate and maturity. – The issuer is given up to a day to accept or reject the bid. • If accepted, the underwriters have ‘bought the deal’ and can sell the securities to other investment firms and institutional investors that it has pre-sold the deal (reducing the risk to the underwriter). Hedging strategies can also be employed to reduce the risk. • The ‘auction process’ involves the issuer announcing the terms and soliciting interested underwriters to submit a bid – this is also known as a competitive bidding underwriting. – The investment banking syndicate that bids the lowest yield wins the entire offering.
Private Placement of Securities • Public and private offerings of securities have different regulatory requirements under the Securities Act of 1933 and Securities Exchange Act of 1934. – All securities issued to the general public must be registered with the SEC. – Section 4(2) of the 1933 Act exempts registration for “transactions by an issuer not involving any public offering. ” – The exception does not mean that the issuer need not disclose information important to the investor. The material must be provided in a private placement memorandum, as opposed to a prospectus for a public offering.
Secondary Market • The periodic trading of outstanding bonds occurs in the open market (either an exchange or over-the-counter (OTC)). • The market provides liquidity and pricing information. • Bond trading has been moving toward electronic trading. The two major systems are: – Dealer-to-customer (bids and asks are provided electronically virtually) – Exchange (dealer and customer bids are entered into a system and order clearing is done through a common, anonymous process).
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