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Topic 6aBonds – Capital Market Instruments

Chapter 5 (Blackwell, Griffiths and Winters) and Other Material

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Capital MarketsPurpose

To finance the acquisition of capital goodsPurchasing power is transferred from those with excess supply of funds to those with demand for funds• Capital goods are acquired to provide a stream of

earnings• Stream of earnings is used to repay the borrowed

funds and interest on those funds• Thus, the present value of the net stream of earning must

at least equal the present value of the repayment stream.IMPLICATION: Long-term borrowing is undertaken for

productive investments

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US Treasury Notes and BondsTypes

Conventional Notes: Initial maturity greater than one year and up to ten years

• Presently auction issues include: 2-, 3- 5-, 10-year notes

Conventional Bonds: Initial maturity greater than 10 years

Treasury inflation protected securities (TIPS)

Floating Rate Notes (FRN)

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US Treasury Notes and BondsPrimary Market

Auction by the Federal Reserve bank of New York as agent for the US TreasuryConventional bonds

Maturity Type Auction Frequency2-year Single price Monthly3-year Single Price Monthly5-year Single price Monthly 7.year Single Price Monthly10-year Single price Monthly, new QUSIPS in Mid-month:

Feb; May; Aug; Nov; Monthly re-opening30-year Single price Monthly: QUSIPS in Mid-month: Feb; May; Aug; Nov;

monthly reopeningTIPS

5-year Single price Annual new issue; other issues are re-opening

10-year Single price Semi-annual new issue; other issues are re-opening

30-year Single price Annual new issue; other issues are re-opening

FRN

2-year Single Price Quarterly new issues; monthly opening between quarters

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US Treasury Notes and BondsPrimary Market

Auction schedule is established to provide for orderly market

• Auctions must obtain new funds to finance the budget deficit and acquire funds to repay maturing bonds

• Each auction must replace maturing securities unless decision is made to pay down an issue

• From 1998 through 2001, Treasury raised less than the maturing amount due to the budget surplus

Recognized or primary dealers must bid in each auction

• Presently, there are 20 primary dealers

Two measures are used to assessing auction results:

• Coverage ratio: ratio of competitive bids to the total auction or the ratio of competitive bids to the securities awarded to the competitive bidders

• The larger the ratio, the more intense is the interest of institutional investors

• Noncompetitive coverage ratio: ratio of noncompetitive tenders to total auction

• The larger the ratio, the stronger is retail interest in the security

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US Treasury Notes and BondsSecondary Market

Secondary market: an OTC market

• It is very active and very liquid market

“Recognized” dealers must make a market in Treasury securities

Large banks that are not recognized dealers also have dealer operations that “make” markets in Treasury securities

Liquidity is evidence by the narrow bid-ask spread on Treasury securities

• But liquidity does differs for off-the-run compared with on-the run securities

Dealers and the secondary MarketDealer profit:

• Bid-ask spread • Appreciation • Carry

Inter-dealer trades are executes through a small group of government brokers

• Bid-ask spreads are posted with the brokers

• Brokers maintain information on screen pages and all members see the bid-ask spreads

• Benefit: speed and efficiency• Criticism/shortcoming:

• Limited dissemination outside the dealer community

• No reliable bid-ask quote displayed for general public

The Market for Treasury Securities and Reforms

Little progress in making dealer screens available to the public

Treasury agreed (1991) to allow dealers other than primary or reporting dealers to submit auction bids on behalf of customers

• Prior to that time, only primary dealers could submit tenders on behalf of customers; other dealers could only submit tenders for their own account

• Effort to reduce possibility of repeat of the Salomon scandal in 1990

• In 1993, the Government Securities Act Amendments (GSAA) began to influence the amount and usefulness of information available to the secondary market

• dealers and brokers are now required to provide the SEC with information regarding transactions

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US Treasury Notes and BondsStripped Securities

Stripped securities (notes and bonds)

• Process by which the individual cash flows of a coupon security are separated and each cash flow is treated as a separate security

• Initially done privately

• 1985, the Treasury Department decided to strip its bonds itself under the Separate Trading of Registered Interest and Principal of Securities (STRIPS) program

The process• The note or bond is delivered to the

Federal Reserve bank of New York by a securities dealer

• The FRBNY strips the bond and maintains an account for the broker/dealer

• The broker/dealer then sells the components as it would any other financial instruments

Terminology• Treasury strips created from

coupon payment are called coupon strips

• those created from the principal are called principal strips

The process can be reversed• Broker/dealer delivers the corpus of a

note or bond the necessary number and dollar value of coupons and the Federal reserve “reconstitutes” a coupon note or bond

US Treasury Notes and BondsStripped Securities

Identification of cash flows in stripped Treasury securities

• CUSIP is assigned to coupon payment; however coupons payable on same date from different stripped securities have the same CUSIP

• Corpus or face value has its own individual CUSIP

The financial incentive: • If the price of the separate pieces is

greater that the price of the combined parts the broker/dealer will profit by stripping the security

Business incentive:• Clients need certain parts of a strip

security for specific needs• Strip securities form part of the

portfolio for principal protected funds

Advantages over Coupon Issues • Lock in the yield to maturity since

there is no reinvestment risk of the principal

• Tax advantages in some countries depending on the treatment of accrued interest

• Widens the financial instruments available which improves financial efficiency

Tailored uses: provide for structured products

• Used in principal protected equity mutual funds

• Used to manage duration of bond funds• Speculate on direction of interest rates

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Treasury Inflation Protected Securities (TIPS)

This class of securities was added in January 1997• These securities pay a fixed rate on a principal value that

increases daily by a formula linked to movement in the CPI

• I.e., the principal increases in tandem with inflation as measured by the CPI

• The inflation adjusted principal is paid at maturity to the holder of the security

• Coupon payments rise by the inflation rate since they are equal to the fixed real rate times the nominal (or accrued) principal, and the accrued principal moves with the CPI

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Federal AgenciesGovernment Enterprises

An executive department, and independent federal establishment or corporation or other entity which owned in whole or part by the US government.

If it issues its own debt, it would be guaranteed by the full faith and credit of the US government

Typically, Federal Agencies do not borrow directly from the public.• They may borrow from the Federal

Financing Bank who borrows in turn from the US Treasury

• The institution may purchase the obligation that are issued, sold or guaranteed by a Federal agency

• It cannot lend to (i.e., buy the obligations) of sponsored Federal agencies

)

However, some do borrow from the public:• TVA• GNMA (mortgage-backed securities

Federal Agencies / Gov’t Enterprises• Federal Housing Authority (FHA)• Government National Mortgage

Association (GNMA)• Farmers Home Administration• Government Services Administration• Small Business Association• Tennessee Valley Authority (TVA)• Washington Metro Area Transit

Authority• Maritime Administration

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Sponsored Federal Agenciesor Government Sponsored Enterprises (GSEs)

Privately owned, but publicly chartered entities

Create by Congress to reduce borrowing costs of sectors deemed important

Mostly agriculture- and real-estate related, though student lending is also important.

GSE’s do involve credit risk• Federal Farm Credit System

neared failure in 1984• FNMA and FHLMC taken under

conservatorship by Treasury in 2008

GSEs• Federal farm Credit Banks• Farm Credit Financial Assistance

Corp• Federal Home Loan Bank

(FHLB)• Federal Home Loan Mortgage

Corporation (FHLMC)• Federal National Mortgage

Association (FNMA)• Student Loan Marketing

Association (SLMA)• Finance Corporation• Resolution Trust Corporation• Resolution Funding Corporation

(RefCo

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Corporate Bonds

Classified by types of issuers• Industrial• Utilities• Transportation• Bank and Finance Companies

Terms of the bond (responsibilities of issuer and rights of buyer) are spelled out in contracts called bond indenture

Maturity:• Term bonds:

• These run for a term of years• Repaid at end of the term or

prior if permitted• most are due in 20-30 years

but are often repaid prior to maturity

• Serial bonds:• Specific principal amounts

come due at specific points in time

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Security

Secure BondsReal or personal property may be

pledgedTypes:

• Mortgage bonds: lien against pledge property

• Collateral trust bond: stocks, notes or bonds pledged as collateral

• Equipment trust certificates: used to finance rolling stock

Unsecured BondsDebentures:

• No specific assets pledged• Holder has claim of general

creditor on all assets not pledged

Subordinated debentures:• These rank after secured debt,

debentures and often after general creditors

Guaranteed bond:• Guaranteed by another entity

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Payoff Provisions

Most corporate bonds have the right to redeem all or part prior to maturity

• Bonds typically contain provisions preventing this for 5-10 years

Procedures

• Call: paid off with source of funds other than cheaper funds

• Refund: paid off with cheaper source of funds

• Sinking fund: some portion of the issue must be retired periodically

Refund: redeem with funds acquired by issuing lower yielding debt, but other sources of funds may also be used

Most bonds have lockout period for refund but once past the lockout, bonds may be called any time

Call protection stronger than refund protection. Call protection prevent redemption for any reason during the lockout, unless there is a sinking fund provision

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Payoff Provisions

Long-term industrial: typically 10-years of refund protection, then immediately callable

Utilities: typically 5-years of refund protection

Corporate bonds are callable at a premium above par which declines as bond approaches maturity

Premium is expressed as amount of interest

Bonds are selected randomly, if less than entire issue is involved

Sinking fund:• Specified portion must be retired

each year which indirectly creates an pseudo-amortization schedule

• Industrial bonds include sinking fund provisions

• Finance company bonds do not include sinking fund provision

• Utilities: presence of sinking fund varies

Mechanics of the sinking fund• Deposit cash with trustee equal to

face value of bonds that must be called and the trustee call the bonds on a random basis

• Buy the needed amount of the securities in the market and deposit these securities with the trustee

Conversions

Convertible bonds:

• Convert bonds into stock of the company

• Amounts to a call options sold to the bond holder

• Also, the bonds can be called by the issuer, and they might be called when the stock price reaches an acceptable level

• Bond is a package: the bond, a call option on stock sold to the investor by the firm and a short call option on the bond sold by the investor to issuer; the bonds price must reflect the costs of these options

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Instrument Specific Risk

Credit or Default Risk Analysis of the ability of an issuer to service

the debt is known as credit analysisRating agency: broad classification:

• Investment grade: • Gilt edge through lower medium

grade• Moody (Aaa through Baa3)• S&P (AAA through BBB-)

• Distinctly speculative: low credit worthiness

• Predominately speculative: substantial risk of default

Nonivestment grade are often termed junk bonds

Call Risk • Right to call a bond is a call option

that the bondholder granted to the issuer

• The call option has a value• The bond price can be broken into a

package of noncallable bonds and a call option sold to the issuer

• price of callable bond = price of noncallable bond

lessprice of call option

Event Risk: • Natural or other disaster

• Casualty insurance companies• Nuclear accident

• Takeovers and restructuring• Example RJR-Nabisco

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Primary Market

Underwriting

Competitive

Noncompetitive

Private Placement (SEC rule 144A)

No SEC registration and exempted from disclosure requirements

Sold only to large sophisticated investors, typically insurance companies

Restrictions:

• Fewer than 35 investors in each issue

• Cannot change ownership for two years which has been liberalized with SEC Rule 144a

These bonds are unrated

• As such, they are often classified as junk bonds, even though the issuer could be of high quality

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Corporate BondsThe Secondary Market

Bulk is OTC• It is a thin market which means

secondary market trade are infrequent

Corporate Bonds are very heterogeneous• The diversity of credit quality and

features discourages market makers (dealers)

• Each firm is different• Call/refunds• Sinking funds• Covenants

Hence, corporate bonds lack the liquidity that Treasury and Agency bonds possess

Electronic trading is developing in the corporate bond world. These are summarized on the next two slides

Secondary MarketNYSE Bonds

The NYSE Bonds trading platform provides an efficient and transparent way to trade corporate bonds.

The platform is based on the NYSE Arca’s matching technology

It allows NYSE Members to enter orders to buy and sell bonds electronically.

Securities eligible to trade consist of

a) the corporate debt of any NYSE listed equity or preferred and their wholly owned subsidiaries

b) debt securities listed on the Exchange.

It claims it is the largest centralized corporate bond market in the U.S.

The NYSE Bonds platform has established the Bonds Liquidity Provider (BLP) program.

The program matches corporate bond issuers with select member dealers who will be obligated to meet quoting requirements.

The program currently covers over 2800 debt securities issued by approximately 560 corporate issuers.

The program is designed to promote better market transparency and liquidity for investors

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Seconday MarketMarketAxess

An electronic trading platform that enables institutional investors and broker-dealers in North America, Europe, Latin America and Asia to efficiently trade corporate bonds and other types of fixed-income securities

Through its platform, U.S. institutional market participants around the world can request and receive simultaneous, competitive and executable bids or offers from multiple global and regional dealers, and other liquidity providers

Over 1000 investor and broker-dealer firms are active users of the MarketAxess trading platform.

The trading system supports electronic trading in U.S. high-grade corporate bonds, Eurobonds, high yield/ crossover bonds,emerging market bonds, U.S. agency securities, and credit default swaps

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Secondary MarketsTradeWeb

In June 2014, Banks including Goldman Sachs and JPMorgan Chase announced they are creating a new trading platform for US corporate bonds as they seek to maintain their hold on the business of trading US companies’ debt while boosting liquidity in the $10tn market.

The platform is due to launch next month after at least 10 banks signed up for the new trading technology in partnership with Tradeweb, a trading hub owned by Thomson Reuters and a group of banks.

Banks have agreed to create the venue, which includes new functions for exchanging large amounts of corporate bonds

This is at atime when their revenues from trading fixed-income products have fallen sharply thanks to a combination of low volatility, new regulation and competition from non-bank trading platforms such as Bloomberg and MarketAxess.

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Credit Risk and the Corporate Debt Rating

Yield on corporate debt is made up of:

• yield on a similar maturity Treasury issue

• premium to compensate for the additional risks associated with the debt

• premium for the credit risk is the credit spread

• risk that an issuer’s debt obligation will decline due to an increase in the credit spread is called the credit spread risk

• The is part of the overall quality spread discussed in an earlier topic

Credit analysis is the analysis of credit risk

Firms as Moody’s and Standard and Poor’s do credit analysis

Improvement in the credit quality of an issuer or issuer is rewarded with a better credit rating, an upgrade

Potential decrease in price of a debt due to a downgrade is called downgrade risk

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Credit Risk and the Corporate Debt Rating

Rating agencies generally look at three areas:

• The protections afforded to debt holders

• The collateral available for the debt holder

• The ability of an issuer to make the contractual payments to debt holders.

There are three primary risks that agencies analyze

• Business risk • corporate governance risk • Financial risks

Corporate Debt Credit Rating•The prime rating is triple A •Double A is high quality, and single A is upper medium grade

•Bond issues assigned a rating in the top four categories are referred to as investment grade bonds

•Issues that carry a rating below the top four categories are referred to as noninvestment grade bonds, or high yield or junk bond

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The Secondary Market and Private Placements

In the secondary market, corporate bonds are therefore acquire through brokers, and there is a absence of strong dealers/market maker

Until SEC Rule 144a, there was no practical secondary market in privately place bonds

SEC 144a allowed secondary trading of privately placed bonds by large institutional investors

This version of the secondary market functions as an investor to investor trade, it does not involve a market maker

Recently, platform for issuing and trading private placement securities has been introduced

Acts as the primary market in the issuance

Once issued, trading through the platform

Keeps tract of the number of investors once trading begins

Initially designed for stock, but could be extended to include bonds

FINRA and 144a Bonds

In June, the Financial Industry Regulatory Authority (FINRA) began publicly disseminating Rule 144A transaction data in corporate debt securities

This brought transparency to a market that had previously operated in the dark.

144A transactions—resales of restricted corporate debt securities to large institutions called qualified institutional buyers (QIBs)—account for a significant portion of the volume in corporate debt securities.

In the first quarter of 2014, 144A transactions comprised nearly 13 percent of the average daily volume in investment-grade corporate debt, and nearly 30 percent of the average daily volume in high-yield corporate debt.

144A transactions comprised nearly 20 percent of the average daily volume in the corporate debt market as a whole.

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Innovations

Junk Bonds: • Any unrated bond or bond

rated as below investment grade

Problem: particularly difficult to market

Market for unrated bonds expanded in 1980s because appetite for direct placement securities by insurance companies waned.

Response: Drexel Burnham Lambert agreed to act as a dealer for bond that they underwrote

Other recent innovationsHybrid BondsTrust-Preferred Bonds“No-No” Bonds

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High-Yield Corporate Bonds

Replaces• Bank loans

• Shifts risks from banks to bond holders which shifts risk from public to bond holders since risk of junk bonds not borne by deposit insurance fund

• Offers fixed rate debt to borrower; bank debt is typically floating rate

• Private placement bonds• Life insurance companies need for

private placement bonds dropped in early 1980s

Could make credit available to some who might not otherwise have access

• Most firms do not issue bonds• If these firms were to issue bonds they

would likely be beneath investment grade

Early structure

Early forms were conventional coupon structure

But, interest became a problem, so various structures were developed to provide breathing room for issuer

• Deferred interest bonds• Sell at deep discount• Do not pay interest for some fixed

period (3- to 7-year lockout)• Step-up bonds• Payment in kind• Extendable reset: coupon adjusted to keep

price at preset level

Current structure: high yield bonds• Corporate• Emerging market countries• Input to CBO, CDOs, and high-yield

mutual funds

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Eurobonds

Securities have the following characteristics• Underwritten by international syndication

• Offered simultaneously to investors in a large number of countries

• Issued outside the jurisdiction of a single country

• Unregistered

Eurodollar bonds: denominated in dollars

Secondary market• Registered on some exchanges

• Primarily OTC

Floating rate notes• Coupon adjusted periodically based on a mark-up over an index rate

• LIBOR (ask), LIBID (bid), LIMEAN (average)

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Securities Issued byState and Local Governments

Types of Securities

• General Obligation Bonds• To provide basic services

• Security• Unlimited taxing power

• Limited-tax GO bonds

• Revenue Bonds• To finance revenue producing

projects

• Secured by the projects revenue

• Hybrid and Special bonds

Term:

• Serial bonds

• Term bonds• These come with sinking

fund provisions after 5-10 years

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Revenue Bonds

Types• Airport bonds• College and University bonds• Hospital bonds• Single-family bonds• Multi-family bonds• Industrial bonds• Public power bonds• Resource recovery bonds• Seaport bonds• Sports complex and convention center

bonds• Student loan bonds• Toll road and gas tax bonds• Water bonds

Credit Risk•In-house evaluation•Commercial ratings

• Debt structure• Ability and political discipline to

maintain sound budget policies• Specific taxes and

intergovernmental transfers and collection

• Overall socioeconomic environment• Employment and income

trends, employment distribution, property value trends

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Markets

Primary

• Underwritten

• Competitive

• Negotiated

• Private placement

Secondary

• OTC

• Size and dealers

• General names—larger issuers

• Local general credits—smaller issuers

• Interdealer brokers

• Quoted in terms of yield to maturity or yield to call

• Known as basis price

• This differes from Treasury and corporate bonds

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Yields

Compared with Treasury securities, yield is affected by

• Quality spreads

• Maturity spreads

• Taxes• Federal taxes

• In state versus out of state when state income tax rates differ

Rate on tax exempt bonds equals

rate on taxable securities

times

one minus the tax rate

or

im = it(1-t)

The appropriate taxable security must be used.

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Revenue Bonds and Taxes and Regulation

Tax Reform Act of 1986

Lowered the top marginal tax rate to 28%

Lowered the top corporate rate to 34%

Eliminated the interest deduction by banks on funds used to finance tax exempt sec

Restricted use of private purpose tax exempt bonds

• Access eliminated for many private use purposes

• Volume restriction ($150 mm per organization) on private universities and nonprofit firms other than hospital

• Volume restrictions on mortgage revenue bonds

• Overall limit of $50 per capita or $150 mm per state

RegulationLimited until Securities Act Amendment of 1975

• Places dealers and underwriters in municipal securities under the Securities Exchange Act of 1934

• SEC establishes a Municipal Securities Rule Making Board• Independent, self-regulatory

agency• Responsibilities

• Develop rules governing activities of banks, brokers and dealers

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Medium Term Notes

Characteristics• Offered continuously to investors by an agent of the issuer• Maturity ranges are typically between commercial paper and

bond • 9 - 12 months

• 12-month -18 months

• 18 -24 months

• up to 30 years

• Registered under rule 415• This is the “shelf registration” rule which allows for the

continuous offering of MTNs

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Medium Term Notes

Primary Market

Different from corporate bonds

•Corporate -- typically underwritten

•MTN -- typically best effort basis

• Investment banker or broker/dealer acting as agent

Issuer posts rates over maturity range

•Quoted as spread over Treasury

• Schedule made available by agent or investment banker

•Schedule can be changed at any time by the issuer

Secondary Market• Limited secondary market• This market depends on the

issuing dealers• Dealer could buy back the note

and re-sell it or hold it in inventory

Structure• Early version: fixed and noncallable• Today: MTN can be converted into a

structured security through integration with a derivative instrument