Debt Instruments: Qualitative Aspects Chapter 8

1. Debt Instruments:Qualitative AspectsChapter 8 Sources of Risk Non Marketable vs. Marketable Short-Term, Long-Term Instruments Mortgage Backed Securities Bankruptcy

2. 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.

3. 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

4. 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

5. 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)

6. 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

7. 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

8. Term Structurehttp://online.wsj.com/mdc/public/page/2_3020-moneyrate.html • 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”) • LIBOR • Charged by London banks on loans to each other • Prime Rate • Indexed • Used by banks to price loans

9. 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

10. US Government Debt Securities • Notes • Max maturities = 10 years • Bonds • Max maturities = 30 years • General Features • Very liquid • Registered • Semi-annual interest payments

11. US Government Debt Securities • STRIPS • 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

12. Off BalanceSheet Debt • GSE Issuers (largest) • FNMA (fannie mae) • FHLMC (freddie mac) • Federal Agencies (Guaranteed by US) • EXIM Bank • GNMA • TVA

13. Municipal Debt • Issued by State, County, or City Gov’t • General Obligation Bonds • Revenue Bonds • Tax preferences (interest exempt from Fed taxes)

14. 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

15. Corporate Debt • Market Trading • OTC dominates • Quotes include: • Coupon rate • Maturity • Current Yield • Volume • Last price (change)

16. Corporate Debt • Collateralized Debt • Mortgage Bonds • Equipment Trust Certificates • Un-Collateralized Debt • Debentures • Senior • Subordinated • Notes (promissory) • Fixed or floating rate

17. 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)

18. 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.

19. 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.

20. 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.

21. 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.

22. 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)

23. 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.

24. 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.

25. 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

26. 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

27. 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

28. 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

29. 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

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

31. 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