Series 7 – Debt

Debt Securities
 Semi-annual interest
 Dated date = issue date, when interest begins to accrue
 Maturities
o Funded debt: 5+ years corporate bonds
T-Bills <1 year Issued at discount, priced at disc
T-Notes 2-10 years % of par
T-Bonds >10 years % of par
 Yield basis: 100 bps = 1%
o Serial - same issue diff maturity
o Muni, corp paper, t-bills
 % of par/$: bond point = $10 = 1% of $1,000 face value
o Term - same issue same maturity
o Muni, corp, treasury
 Registered bonds: fully registered and book-entry are the only that receive ppal and coupon on the mail
o Fully registered (most common for corp bonds): Transfer agent transfers a registered bond whenever a bond is sold by
cancelling the seller’s certificate and issuing a new one in the buyer’s name
o Book-entry (all U.S. Gov bonds): Owners don’t receive certificates; the transfer agent maintains the security’s ownership
records. Trade confirmation serves as evidence of ownership
o Principal-only registered (discontinued, still trade in secondary market): Coupons in bearer form. Owners’ names in order
on the bond certificates and on the issuer’s registration records.
 Bond rating depends on: existing debt, CF stability, meeting scheduled payments, asset protection, management capability
 Bond Safety
o U.S. Government Securities
o Government Agency (U.S. Gov does not back these, except GNMA)
o GNMA
o FFCB, Freddie Mac, Fannie Mae
o Munis
 GO  taxing power
 Revenue bonds  facility revenue
 IG / Bank grade: Banks can only purchase IG (BBB/Baa) or higher munis
 Non-IG / Speculative: BB/Ba or below
 Bond redemption: redeemed, ppal repaid
 Sinking Fund: done by lower rated securities, operated by the bond’s trustees
 Calling bond: partial call and term bonds are selected by lottery. Serial bonds are called from longest to shortest maturity (longer
tends to have higher interest rate)
 Tendering: issuer can buy bonds in the open market if the trust indenture does not have a call provision
 Refunding: raising money to call a bond
 Pre-funding/advance refunding: new issue is sold at lower coupon before the original bond issue can be called. Proceeds placed
in escrow and invested in US gov securities. Rated AAA and considered defeased (old bonds not considered part of the debt
outstanding). For non-callable bonds, proceeds are escrowed to maturity. Quoted YTC.
o Revenue stream originally pledged to refund bonds continues to be used to pay debt service.
 Putable bonds: slightly lower interest rate, investor has the right to sell back to issuer at Face Value. Protected against interest
rate risk as they will not trade much below par
Yields

 YTM (basis) = [annual interest – (premium% years to maturity) ] / avg price

 Yield curve
o Positive: yield increase with maturity. During economic expansion.
o Inverted: LT interest rate are lower than ST. Recession is expected
o Flat yield: economy is peaking
 More volatile: Lower P, Lower coupon, Longer duration/call date, Lower rating
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 Series 7 – Debt

Corporate Bonds
Secured bonds
 A trustee holds the title to the collateral assets
 Mortgage bonds: highest priority on claims
o Open-end indentures: permits subsequent issues secured by same property with equal liens
o Closed-end indenture (sr lien bonds): subsequent issues are subordinated
o Prior lien bonds: distressed firms issue more senior mortgage bonds, needs consent from first-mortgage bondholders
(unlikely)
 Collateral trust bonds: secured by stock/bonds from another company’s or partially owned subsidiary or accounts receivable
 ETC (Equipment Trust Certificates): issue serially, outstanding amount goes down every year in line with depreciation of
collateral. Title of the equipment held in trust (bank), until all certificates have been paid
Guaranteed bonds
 Backed by another company (e.g. parent company)
Income/adjustment bonds
 Pays interest only if the corporation has enough income to meet interest payments and it is declared by BOD. Missed payments
are not accumulated. Risky.
Zero-coupon bond
 Bought at a discount, suitable for anticipated future expenses such as college / retirement
 More volatile than traditional bonds
 Each year you owe income tax (phantom income). Discount is accreted and added to cost basis. If held to maturity no capital gain
(cost basis = par)
 No reinvestment risk, locks in a rate of return
Trust Indenture
 Contract between issuers and trustee representing the bondholders (also monitors covenant compliance)
 Required for corp bonds $50+ m, with maturities >270 days, publicly offered, sold interstate
Convertibles Bonds
 Pay lower rates than non-convertibles and generally trade in line with common stock
 Less volatile than common stock (interest income is more stable)
 Can covert to take advantage of capital appreciation of common stock
 At issuance conversion price is higher than mkt price of common stock. Conversion is not taxable.
 Conversion ratios always start calculating the conv ratio!
o Conv bonds: # of shares = $1,000 / conversion price
o Conv preferred stock: # of shares = $100 / conversion price
 Price Parity – Value of bond = Value of conversion of bonds to stock
o Price parity of common stock = mkt price of bond / conversion ratio (# of shares)
o Price parity of convertible = mkt price of common x conversion ratio (# of shares)
 Anti-dilution covenant: Convertible bondholders are protected by antidilution covenants that adjust the conv. Price for stock
splits/dividends and stock issuances
 Forced conversion: when an issuer calls its convertible bonds and it is clearly in the best interest of bondholders to convert their
bonds rather than let them be called away. As soon as the call is announced, the bond price will more quickly to the conversion
value.
U.S. Government Securities Bi-annual interest!
 Exempt from state and municipal taxation, but subject to general taxation
 Settlement: T+1
 T-Bills: auctioned weekly by the U.S. Treasury
 T-Notes:, auctioned every 4 weeks
 T-Notes & Bonds trade 100.16 = 100 16/32  over 32!
 T-Notes & Bonds fall into MM category when less than a year to maturity
 If it has “n” it is note, nothing means it is a bond
 T-Receipts (CATS/TIGRS): zero-coupon bonds created by brokerage firms where U.S. Treasury notes and bonds are placed in a
trust. Not backed by U.S Gov.!
 STRIPS: backed in full by U.S. Gov
o CAT and STRIPS are quoted in yield

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 Series 7 – Debt

 TIPS: backed by U.S Gov. Issued with a fixed rate, principal adjusted semi-annually based on CPI. Lower interest rate because of
this feature. Reportable income for the year principal is adjusted (even though the increase is not received until maturity).
Taxable at federal level only.
Nonmarketable US Gov Securities
 No secondary mkt, bought directly from US Treasury
 Series EE bonds: fixed return
 Series I: linked to inflation index
Issuance of Gov Securities – Dutch Auction
 Competitive bids: placed by primary dealers in US Gov securities (BB banks). Not always filled.
 Noncompetitive bids: always filled. They pay the lowest accepted COMPETITIVE bid (stop out price)
Agency Issues
 Settlement: T + 2
 Mortgage securities are taxed at three levels. FCA and Sallie Mae at Federal level only
 MBS have reinvestment and extended maturity risk. They are passthrough certificates
o Ginnie Mae  only one backed by U.S. Gov and pays MONTHLY interest and principal. $1,000 minimums
o Freddie Mac
 Participation certificates (PCs): interest and ppal 1/month
 Guaranteed mortgage certificates (GMCs): interest 2/year and ppal 1/year
o Fannie Mae  only one public
 Semi-annual interest
o Sallie Mae: issues discount notes and ST floaters with 6 months maturities
Accrued Interest:
 If day N.A. assume 1 day of the month
st

 Includes last int pay date, but not settlement date. If interest payment date is settlement date, accrued interest is $0
o Corporates, agency and munis: T+2, 30 day month, 360 day year.
o Settle 4/3
o Last int paid 2/15
o 2 mo–12 days = 2x30-12=48
o Gov securities: T+1, actual day month, 365 day year
o Trades flat (w/o accrued int): T-bills, STRIPS, T-receipts, zeros, commercial paper, BA (banker’s acceptance) and defaulted
bonds
CMOs – Collateralized Mortgage Obligations
 Pool of MBS; pass-through certificates; taxed at all levels; pays interest and principal MONTHLY; subject to interest rate, market,
pre-payment, liquidity and extension risk
 PSAx2: riskier prepayment risk
 Customer required signing a suitability agreement before buying. Complex ones not suitable for individual investor. Performance
may not be compared to any other investment vehicle
o Plain vanilla CMO (sequential): pays interest on all tranches simultaneously and ppal only one tranche at a time.
Subsequent ppal payments are made to the next tranche in line until it is paid off
o Principal-Only (PO): sold at a discount
o Interest-Only (IO): used to hedge interest rate risk. When interest rise, P of IOs rise
o Planned Amortization Class (PACs): reduced prepayment/extension risk (most predictable maturity date) and lower yields
than TACs. Changes in prepayment /extension are transferred to SUPPORT tranches (one for each)
nd
o Targeted Amortization Class (TACs): CF certainty and fixed ppal payment, prepayment risk protection (not extension). 2
least degree of prepay. Increased reinvestment and extension risk (less predictable maturity dates) and higher yields
o Zero-Tranche: most volatile/longest, does not receive payment until all other tranches are paid. Unpredictable timing of
payment
CDOs
 Backed by non-mortgages (pools of bonds, auto loans, leases, credit card debt, or recievables)
 Not suitable for individual investor, for inst/sophisticated
Money Markets (<1 year maturity, highly liquid)
 Gov - T-Bills
 Commercial Paper (promissory notes): unsecured, maturity <270 days (Trust Indenture 1939 does not apply). Finance account
receivables and seasonal inventory gluts. Sold at disc. and matures at par
o Prime paper: sold by finance comp directly to the public

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 Series 7 – Debt

o Dealer paper: sold by issuers through dealers

 Banks
o Repos: typically, between a bank and FRB. Bank raises cash by temporarily selling some securities with an agreement to buy
them back. Includes a purchase price and maturity date (fixed or open/callable any time). Repo rate is generally lower than
bank loan rates. Can be resold. Interest rate risk
o Reverse repos: dealer buys securities from an investor and sell them back later at a higher price
o Banker’s acceptance: used to finance international trade, secured by goods. Maturity <270 days. Sold at a discount and
mature at par.
o Negotiable CDs (jumbos): $100,000 min Face Value. Unsecured note guaranteed by issuing bank. Mature <1 year.
 Non- Negotiable CDs are not MM securities and are not traded in sec mkt
o Fed funds loans:
Interest Rates (ordered from lowest to higher int)
 Discount Rate: FRB to member banks
 Federal Funds Rate: bank to bank, overnight loans of >$1 mm, MOST VOLATILE rate in the economy
 Broker / Call loan rate: banks to B/D for margin account customers. Callable on 24-hour notice
 Prime Rate: large U.S. banks to most creditworthy corp customers for unsec loans
Foreign
 Yankee bond: foreign issuer selling a bond in U.S. subject to SEC registration and foreign country withholding tax
 Eurodollar deposits: USD in banks outside US. Higher risk/yield than US deposits
 Eurobonds: issued outside country and currency of issuer. Yearly interest in any currency. Not subject to SEC reg. Subject to
withholding tax.
o Eurodollar bonds: any issuer except US Gov. Yearly interest in USD. Bearer form. Not subject to withholding tax
Interbank Market
 Unregulated, decentralized international mkt for various currencies. Actively traded currencies settle T+1, other T+2
TRACE (Trade Reporting and Compliance Engine)
 Trade-reporting system only. Does not accept quotations, nor does it provide settlement and clearance functions
 Both sides of transaction must report
 Trades must be reported ASAP, no later than 15 min of execution
 Execution date, time, Q, P, yield, commission
 Exclusions form reporting: foreign gov debt, MM instruments, debt securities that are not depository trust eligible
ELN/ILN- Equity/Index Linked Notes
 Linked to performance of something else (not interest). Creditworthiness of issuer.
 Not suitable for most investors
 PPNs: principal protected notes
 ETNs: exchange traded notes (not all are exchange traded)
Debt Strategies
 Bond laddering: reduces interest rate and reinvestment risk; maintain CF and increased liquidity. Good for safety of ppal and
current income, not good for portfolio growth
Taxation of Bonds
Corporate Muni
OID Discount MUST accrete MUST accrete (tax-free interest)
OID Premium May amortize MUST amortize
Secondary Discount May accrete (no one does) May accrete – increase in interest taxed
as ordinary income
Secondary Premium May amortize MUST amortize

Recording of sales
 RTRS: munis
 ACES 9consol. Tape): stock exchange listed
 TRACE: corp bonds & treasuries
Docs
 Non-exempt offering (common stock): prospectus / red herring
 Options: risk disclosure doc
 Reg D / private placement: offering memo
 Reg A or Rule 147 interstate: offering circular
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