Debt Instruments:

Qualitative Aspects
Chapter 8

Sources of Risk
Non Marketable vs. Marketable
Short-Term, Long-Term Instruments
Mortgage Backed Securities
Bankruptcy
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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.
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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
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
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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)
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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
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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
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Term Structure
http://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
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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
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US Government Debt
Securities
Notes
Max maturities = 10 years

Bonds
Max maturities = 30 years

General Features
Very liquid
Registered
Semi-annual interest payments
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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
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Off Balance Sheet Debt

GSE Issuers (largest)
FNMA (fannie mae)
FHLMC (freddie mac)

Federal Agencies (Guaranteed by US)

EXIM Bank
GNMA
TVA

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Municipal Debt
Issued by State, County, or City Govt
General Obligation Bonds
Revenue Bonds
Tax preferences (interest exempt from
Fed taxes)

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

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Corporate Debt
Collateralized Debt
Mortgage Bonds
Equipment Trust Certificates

Un-Collateralized Debt
Debentures
Senior
Subordinated

Notes (promissory)
Fixed or floating rate
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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)
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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.
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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.
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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.
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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.
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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)
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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.
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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.

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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
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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

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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
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Guaranteed Investment
Contracts
Stable value contract
Available in 401(k) retirement plans, profitsharing 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
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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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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
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