Study Seesion 15

A bond indeture is a contract that specifies all the rights and obligations of the issuer and owner of a fixed incoem security.

Negative Covenants are restricions on what an issuer can do: you can't issue more debt, you can't do stuff

Affirmative Covenant are things the issuer must do. They must have a liquidity ratio over X, etc.

Zero coupon bond is a non interest paying bond. Instead sells at a discount.

Step up note is a bond that pays incrementally higher coupon over time, and this rate is specified.

Deferred Coupon Bond - is a bond that delays the payment of several interest payments for a later date. For example won't pay 2nd 3rd and 4th year coupon until 5th year.

Floating Rate Security - is a bond with the coupon that floats with market interest rates or index. These bonds have coupons that reset periodically. The coupon rate is just a reference rate +- quoted margin.

Inverse floater - is a floating rate security with coupon payments that are inverse with the reference rate.

-Cap, puts a maximum on interest rate paid. Floor puts a minimum on interest received. Collar is onliy when both are present.

-When buy or sell bond between interest payments, intereset accrues for seller.

-Amount buyer pays seller is the agreed upon price of bond (The clean price) plus any accrued interest.

-Dirty price is amount buyer pays seller including accrued interest which is known as full or dirty price.

• -cum coupon, which is a bond trading with the next coupon attached (happens in the US)
• -Ex coupon, bond trades without next coupon attached.

Full price =clean price+Accrued Interest

Trading flat when the bond is in default, not paying any obligatory payments, and no interest will accrue

-Amortizing loans pay the principal as well as the interest in each payment, whicle non amortizing are like treasury issued securities that pay principal at the end.

-Prepayment (mortgages) is when the issuer has the right to pay down the entire principal, or accelerate principal repayment.

-Call provision - allows for issuer to call all outstanding $ at a set price. This pushes security to run as a discount compared to a non embedded secrutiy bc call provision gives power to the issuer.

-Call protection protects the investor for the issuer calling on the bomb for a specified amount of time.

-Nonrefundable bonds prevent issuers from repaying the principal for any reason other than refunding at a lower rate.

-Sinking fund is a repayment of principal through a series of payments over the life of an issue. Two ways are cash delivery and delivery of securities.

In cash delivery, issuer pays straight cash, and bonds are retired at par value.

In bond delivery, firm buys securities in open market and delivers to sinking fund to be retired.

Cash is better when securities price are higher/yield is lower, and bond delivery better when prices are lower/yield is higher.

Regulare redemption prices, are when bonds redeemed uner call provicion specified in bond indenture. However, when bonds redeemed to comply with sinking fund or forced to sell by government or some other entity, typically bought at par value

Owner Options - Put Provision, Conversion proviosn, Floor

Issuer Provision - call provision, Repayment, Cap, Accelerated sinking fund.

Margin buying is purchasing a security using the underlying security as collateral. This is regulated bc amount of $/value is set by fed.

Repo is a repurcdhase agrremnt. Sell something with agreement to buyback within several days. Interest rate is amount of money must payback at end. Interest coverage is typically less, and margin is not regulated.

Interest rate risk - Duration. Amount of change on price by change in yield. The higher the amount of time for investment horizon, and the smaller the yield means higher interest rate risk. Lower yield, means higher price. change in yield means bigger variation of price change compared to an initially higher yield security.

yield curve risks - Possibilliyt of changes in shape of hyield curve.


call risk- risk that security may be called when rates drop, and investor can reinvest at lower rate.

prepayment risk - chance that rates drop and investor wants to payback entire principal of loan, for amortizing .

reinvestment risk - risk of when market rates fall, and call/prepayment provision activiated, must reinvest at a lower rate. (Zero coupon does not have reinvestment.

credit risk - Risk that issuer may default

liquidity risk - risk of immediatley selling the security and taking a lower price bc of tough to sell non liquid security.

exchange rate risk - risk apparent when investing in securities of differnt country and interest rates might move against you. If home currency appreciates, the investment is worth less.

Inflation risk - Unexpected inflation/ change in purcahsing power.

• volatility risk - Present for fixed income securities that HAVE EMBEDDED options. Risk that changes in interest rate volatility will change price of security.
• event risk - Risk outside risk of finacial markets, such as risks posed by natural disaster and corporate takeover.
• soverign risk - Risk that a soverign bond of a country, when country defaults.

• Call option - Interest Rate risk is lower duration is lower
• Put option - Intereset rate risk is Lower, duration is lower
• Higher coupon- Interest rate risk is lower - duration is lower
• Maturity Up - Duration is higher, Interest Rate risk is higher

It has less bc the change in copuon rate should allow for no change in price.

right after an interest payment has been made/ rate has been adjusted, is the duration the highest bc time until next payment is longest.

A cap, or cap risk can hugely increase the duration if the interest rate goes above a ceratin point, there is no way for the bond to adjust to compensate for the increased market rate besides trading at a discount.

Duration =- (% Change in bond price/% change in Yield)

Yield curve is measured in Yield and maturity. Paralel shift is an increase or decrease in the bond yield with no change between the differences in yields commanded by different maturitys. Once the differences between periods begins to get skewed then unparalel shift arises.

Call feature included, higher coupon rate, amortizing secruity, prepayment option,

Credit spread is increased, bc of flight to quality.

Decrease

Normal securities do not have volatility risk.

Increased volatility does have an affect on prices of callable and putable bonds, but in an inverse way. Volatility decreases price of callable security, but increases price of putable security

with incresed inflation, future value of cash flows are decreased and bond values fall.

• -Regulary cycle oprtion - single price - Dutch auction, debt is auctioned with lowest yield (highest price) at which entire issue can be sold.
• -Regulare cycle option - Multiple price - Debt is sold to winning bidders on the price that they bid.
• -Ad Hoc auction system - refers to a method where the central government auctions securities when it determines market condistion are favorable.
• -Tap system refers to issuance of bonds identical to prveiously issued bonds, and are sold periodically, not according to a regular cycle.

• -28,91,182 days.
• -Maturity is 2,3,5, up to 10 years.
• -means prices are 103% + 5/32%. The second number is expressed as x/32%.
• -TIPS are Inflation protected bonds. first find inflation change. Then mulpily by stated coupon rate/2 bc of semiannual payment.

take long term t bonds and make each individual payment into zero coupon bond. Turn long term into T-bill. For exampel a 10 year t0note has 20 coupon and one principal paymetn. These 21 flows repackaged and sold as 21 different zero coupon securities.

For example, let's imagine a 20-year bond with a face value of $20,000 and a 10% interest rate. A brokerage could purchase a receipt for the bond and strip the principal from its 40 semiannual interest payments. It would then sell to investors 41 separate zero-coupon securities, each with different maturities based on when the interest payments on the Treasury bond were due. The zeros would be discounted to the present value using the prevailing interest rate and term to maturity. If the principal unit of $20,000 was discounted by 10% for 20 years, it would sell for $2,973 (ignoring any markup or commissions). Upon maturity, the principal would be worth $20,000, and each of the interest-backed securities would pay $1,000 (one half the annual interest on the bond). The brokerage would use its earnings from its Treasury bond to pay the holders of the STRIPS as they mature.

Fedderally related institutions owned by government exempt from SEC registration.

Government sponsored enterprises (GSE's) - Fannie mae freddie mac, etc. Privatley owned but publicly chartered organizations created by congress. More credit risk than federally related instituions.

Debenture are secruties not backed by collateral, GSE's commonly issue.

Passes the payments made on a pool of morgages throupgh proportionally to each security holder. If you own 1% you get 1% of cash flows. Not tranched.


CMO Is tranched which are different types of claims on the cash flows from pool of mortgages.

Tranches shortest term receive all interest on outstanding principal, as well as all principal payments (including prepayments) on outstanding principal.

Medium term then takes up all interest of outstanding and all payments on pricipal after short term principal obligations are met.

Prepayment are good for principal, bc you get the $ back quicker. Interest, you lose out bc there are less total payments bc interest is only paid outstanding principal

a GO is a tax backed bond

• -Limited tax GO is subject ot a statutory limit on taxes
• -Unlimited tax GO debt - most comon, secured b the full faith and credit of borrower backed by unlimiting tax authority.
• -Double barreled bonds - Not only backed by issuing authority's taxing powers, but also grants fees, an dspecial charges.
• -Appropriation back states back up soruce of funds from issuers during times of shortfall, however states obligation is not legally binding. "moral pledge" enhances security of bonds.
• -Public credit enhancement program possess a guarantee by the state or federal government which is a legally enforceable contract used to help education system

Revenue Bonds are supported only through revenue generated projects funded with help of original bond issue. fall outside of GO Debt libmits and do not require voter approval. issuer is only obligated to pay if revenue of a project is sufficient. Therefore, Revenue bonds are much riskier.

prerefunded are bonds which Treasury securities have been purchased and put in an escrow account in ammount suffices requried bond payment.

-Insured bonds are backed by a 3rd party.

character of issuer, collateral posted, capacity to repay, and covenants of debt issue

Secured ebt is backed by collateral/assets

Bonds back bey financial assets are called collateral trust bonds.

-Subordinated debenture have claims that are satisfied after claims of senior debt.

Corporate bond issues are -sold all at once - sold on a firm commitment basis where underwriting syndicat guarantees sale of issues - conssit of bonds with a single coupon rate and maturity

Medium term notes - registered with SEC rule 415, which means they dont' have to be sold all at once. various maturites ranging from 9 months to 100 years. Quoted typically as a spred to cmoparable maturity treasury issues. -MTN's done on a best effort basis meaning underwriter does not guarantee sale.

Debt secuity created when issuer combines a typical bond or note with a derivative.

Example is if instutationl investor prhoibted from owning equity or derivative structures. Issuer could create a structured note where the periodic coupon payments were based on performance of an equity security or an equity index. Mechanics of creating wouldbe to issue a debt secruity and create an equity swap.

• Dual indexed floaters - coupon rate is based on difference btwn two refernce rates
• Delveraged floaters - coupon rate equals a fraction of the refernce rate plus a constand margin
• -Range notes - coupon rate equals referenc rate if refecnce rate falls within specifid range, or zero if falls outside of range
• Index amortizing notes - coupon is fixed but some principal is repaid before maturity, with amot of principal prepaid based on refernce level

Permit Owner to sell the CD in the secondary market

- guarantees by a bank that a loan will be repaid.

• -Banks reserve requirement on Funds
• -Discount Rate banks can borrow from fed
• -Open market operation
• -influence banks to tighten or loosen credit policies

-most used are market operations

Pure expectations theory, is that changes in yields for maturitys are based on the expected short term rates in the future.

Liquidity preference theory are that yields for maturitys are based on both expected shor term rates int eh future and the required risk premium for holding longer term bonds.

Marekt segmentation is that investors and borrowers have preferenc for maturity ranges.Supply and demand affect equilibrium yields for various maturities.Different banks and ivnestors have different preferences for different maturity sercurities.

Prefered habitat theory, yields also depeond on supply and demand for various maturity ranges, but investors can be induced to move from preferred maturity range when yields are sufficient.

discount rates for yields on zero coupon bonds that have only a ginle cash flow int he futrure. Discount individual cash flows by individual spot rates.

Ansolut yield spread are difference between yields on two bonds.

Relative yield spread is absolute yield spread/yield on benchmark bond

Yield Ratio is Subject bond yield/Benchmark bond yield.

Most common is absolute yield spread, but issue is that absolute yield spread may not change if rates move together. Both relative yield ratio and yield ratio reflect this.

taxable yield x 1-marginal tax rate

an investor who borrows to finance investment position