PART 3

THE IB BUSINESS OF
DEBT / FIXED INCOME
CONTENT

1 Gov securities markets

2 Corporate bonds

3 Private placements

4 Asset securitization

Chapter 9 and chapter 10

After finishing this part, you should be
able to
• Have the perspective of the fixed-income business,
the spectrum of debt alternatives
• Understand the issuance approaches and
procedures
• Understand the business of asset securitization
• Know the role of the credit rating agencies
Fixed income
▫ Refers to any type of investment under which the
borrower or issuer is obliged to make payments of
a fixed amount on a fixed schedule. For example,
the borrower may have to pay interest at a fixed
rate once a year, and to repay the principal
amount on maturity
Fixed income classification
▫ Classification by Type of issuer
 Government and government-related sector:
includes all conventional debt issued by
governments (Central Bank or Treasury)
 Municipal sector: includes debt olligations issued
under the auspices of states, cities, and other
nonfederal government entities
 Corporate sector: bank loan, convertible, corporate
bond, preferred stock
 Securitized sector: Mortgage-Backed Securities,
Asset-Backed Securities (Asset securitization)
Fixed income classification
▫ Classification by Credit quality
 Rating agencies like Moody’s, S&P, Fitch assign
credit ratings to bonds
▫ Classification by Maturity
 Money market securities: issued with a maturity that
ranges from overnight to 1 year
 Capital market securities: original maturity is usually
longer than 1 year
▫ Classification by Type of coupon
 Fixed rate: coupon rate, coupon payment are fixed
 Floating rate: coupon payment is linked to a floating
rate (reference rate + spread)
Fixed income classification
▫ Classification by Currency denomination and
Geography
 Domestic bonds: in local currency, issued by an
entity domiciled in that country
 Foreign bonds: in local currency, issued by an entity
domiciled in another country
 Eurobonds: international bond that’s denominated in
a currency other than the home currency
▫ Other classifications
 Tax-exempt bonds
 Inflation-linked bonds
1. Government securities markets
▫ Types of government securities
 Treasury bills: are short-term securities with a maturity period of
up to one year
 Treasury notes: are medium-term securities that have a maturity
of between 2 and 10 years
 Treasury bonds: are long-term securities with a maturity period of
30 years
 Floating Rate Notes (FRNs): securities with a variable interest
rate. The interest rate for an FRN is tied to a benchmark rate
 Treasury Inflation Protection Securities (TIPS): are inflation-
indexed notes and bonds. The interest rate is fixed, but the
principal is adjusted for inflation and will not be paid until maturity
 STRIPS: coupon-stripping strips the interest payment and treats
the component coupons and the principal as separate securities
1. Government securities markets
▫ Market Quotations
 Quotes on notes and bonds include the coupon rate,
maturity, bid price, asked price, change in price, and
asked yield. The price quotes are based on the
percentage of par value
 Treasury strips are also quoted in terms of price
1. Government securities markets
▫ Market Quotations
1. Government securities markets
▫ Market Quotations
1. Government securities markets
▫ The yield curve
1. Government securities markets
1. Government securities markets
▫ Auction process
 2 types of bids can be submitted – noncompetitive and competitive.
Small investors generally submit noncompetitive bids
 Example:

 After the security is awarded to A, B, and C, the remaining amount is $2 billion, so bidders D
and E will each receive a $1 billion allocation
1. Government securities markets
▫ Trading
 Treasury bills trade on a basis of discount rate

 Coupon Treasuries trade on a price basis. The

invoice price (dirty price) consists of the quoted price
(clean price) plus the accrued interest
1. Government securities markets
▫ Trading - A dealer’s profits are generated from
several sources
 The bid-asked spread: depends on liquidity, volatility,
and remaining maturity
 A favorable market movement: appreciation in the
securities that the dealer is long and depreciation in
the securities that the dealer has a short position
 From carry: the difference between the interests
earned on the securities held in inventory and the
financing costs
2. Corporate bonds
▫ Definition: Corporate bonds are debt obligations
issued by corporations to raise capital and
operating cash
▫ Yield: Corporate bonds usually offer higher yields
than government bonds or certificates of deposit,
reflecting higher risk
▫ Credit rating: Many corporate bonds are rated by
agencies (Moody's, Standard & Poor's). Ratings
reflect the agencies' assessment of the
creditworthiness of the issuer and its ability to
make timely payments of principal and interest
2. Corporate bonds
▫ Corporate bond underwriting – brings significant
fee income for IBs
▫ Various types of corporate debt securities are
available to allow corporations to match their
financing requirements with investor needs
2. Corporate bonds
▫ The creation of corporate bonds is similar to the
creation of stocks. Generally, a firm that wants to
issue bonds will go to an IB for one or more of the
following services:
 Expertise and advise in creating the issue, including
determining the yield and maturity;
 The IB may buy the whole issue as firm commitment
underwriting, or may use a best efforts approach to
sell the bonds;
 The IB may form a syndicate and/or a selling group
to help sell the bonds to their institutional investors
and to the public
2. Corporate bonds
▫ Underwriting spread (gross spread) – the
difference between the price paid by the buyers
and the proceeds to the company
▫ The gross spread ranges from 1 to 3 percent
▫ The lead underwriter typically collects a
management fee of 20 percent. Syndicate
members and selling dealers get the remaining 80
percent of the gross spread. Dealers who are not
syndicate members but are part of the selling
group get the selling commission of about 50 to
55 percent of the gross spread
2. Corporate bonds
▫ Underwriting spread
3. Private Placements
▫ Private placements differ structurally from the
registered public deals because they are highly
negotiated in covenants and pricing, and they do
not go through the SEC /SSC registration process
▫ A private issue can save substantial amounts of
legal and registration expenses against a
comparable public issue
▫ Additional benefits are a high degree of flexibility
in the amount of financing, lower costs and
quicker form of raising funds
3. Private Placements
▫ The private placement of debt market is rapidly
growing and accounts for a significant portion of
the debt market
▫ Privately placed debt tends to have a shorter
maturity. Insurance companies, pension funds,
and finance companies are big lenders in this
market
▫ Covenants are an essential part of the private
placement transactions. There are two principal
types of debt covenants:
 those limiting the percentage of long-term debt to
total capitalization
 those restricting the short-term debt
4. Asset securitization
▫ Asset securitization is the issuance of securities
using a pool of similar assets as collateral. There
are mortgage-backed securities (MBS) and asset-
backed securities (ABS)
▫ Asset securitization converts illiquid individual
loans and other debt instruments into liquid
marketable securities
▫ Asset types used in securitization include
mortgages, automobile loans, credit card
receivables, equipment leases, high-yield bonds…
▫ Securitization generates fee income for bankers
and provides them with additional trading
opportunities
4. Asset securitization
4. Asset securitization

Securitization structure
▫ A solid infrastructure is essential to success
 A standardized contract gives all participants the
confidence
 The banker’s due diligence research provides parties
the nature of risk and a proper valuation
 A database of historical statistics enables participants
to determine how the securities would perform
 Standards specifying the quality of servicers
 The bankruptcy of the servicer or the sale of servicing
rights cannot expose investors to loss
 A reliable supply of credit enhancements
 Computer modeling to track cash flows and
transactions data
4. Asset securitization

Securitization structure
4. Asset securitization

Securitization structure

Illustrative Timetable for a Securitization Transaction

4. Asset securitization

Securitization structure
▫ Originator and Collateral
 The originator may be a bank, a finance company, a
credit card issuer, or a securities firm
 It is essential that the originator achieve a true sale
in the transfer of assets to the trust holding the
collateral, called special purpose vehicle (SPV)
▫ Servicing
 The servicer collects money from debtors and
distributes the funds, net of fees, to the SPV and to
investors
 Many securitization programs retain the
originatorastheservicer
4. Asset securitization
Securitization structure
▫ Special Purpose Vehicle (SPV)
 Also called a bankruptcy-remote entity. A tax-exempt
company or trust formed for the specific purpose of
funding the assets
 The originator has transferred ownership of the assets to
the SPV in a true sale
▫ Credit Enhancement (CE)
 In order to mitigate the potential loss arising from the
credit risk of the underlying assets
 The amount and type of CE depend on the historical loss
experience of similar loans and the rating
 Internal CE: overcollaterization, excess spread, reserve
account
 External CE: a bank letter of credit, a surety bond
4. Asset securitization

Securitization structure
Benefits and Costs
▫ Advantages to issuer (originator)
 Reduces funding costs
 Lower capital requirements
 Transfer risks
 Off balance sheet
 Liquidity
▫ Disadvantages to issuer (originator)
 Costs
 Disclosure of asset data
 Size limitations
 Risks
4. Asset securitization

Securitization structure
Benefits and Costs
▫ Advantages to investors
 New investment opportunities
 Portfolio diversification
 Isolation of credit risk from the parent entity
▫ Disadvantages to investors
 Risks: credit/default risk, liquidity risk, event risk
4. Asset securitization

Securitization structure
Benefits and Costs
4. Asset securitization
▫ Mortgage-Backed Securities (MBS) - are debt
instruments backed by residential or commercial
mortgages. The MBS market has been the largest
market for securitized instruments. Through the
MBS market, mortgage lenders can access a
larger reservoir of capital that makes financing
available to homebuyers at a lower cost
▫ Types
 Mortgage Pass-Throughs
 Collateralized Mortgage Obligations
 Stripped Mortgage-Backed Securities
4. Asset securitization
▫ Asset-Backed Securities (ABS) - refer to
securities backed by non-mortgage assets such
as installment loans, leases, receivables, home
equity loans, tax liens, revolving credit,
commercial loans, and high-yield bonds/loans
▫ Types
 Credit Card Receivables
 Automobile Loan Receivables
 Sports Facility Finance
 Student Loans
 Tax Liens
4. Asset securitization