Cfa Reading 62: Overview Of Bond Sectors And Instruments

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Sovereign Debt

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Bonds issued by a country's central government

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US Sovereign Debt

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US Treasury securities,

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Places of issue for Sovereign Debt

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1. Country's own domestic market
2. Another country's foreign bond market
3. The Eurobond market

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Sovereign Debt Ratings

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Bond ratings are done based on PERCEIVED Credit risk. Higher ratings given to sovereign debt denominated in home currency vs. foreign currency

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4 Methods used by central governments to issue sovereign debt

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1. Regular Cycle auction--single price
2. Regular cycle auction--multiple price
3. Ad Hoc Auction System
4. Tap System

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Regular Cycle Auction--Single Price

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US Treasury system: Debt is auctioned according to a cycle and the highest price (lowest yield) at which the entire issue to be auctioned to all bidders.

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Regular Cycle Auction--Multiple Price

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Winning bidders receive the bonds at the price that they bid

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Ad Hoc Auction System

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When the central government auctions new securities when it determines market conditions are advantageous

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Tap System

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issuance and auction of bonds identical to previously issued bonds. Bonds are sold periodically and not according to a regular cycle

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US Treasury Securities

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Tbills, Tnotes, Tbonds

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TNotes

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28, 91, 182 days, aka. 1, 3, 6 month. Pay only the face at mauturity and are sold at a discount to face. Implicit interest

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TNotes and TBonds

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pay semiannual coupon interest at a fixed rate.

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Quoting TBond and TNotes

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quoted in 32nds. for example 101:5=101% plus 5/32% of par

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TIPS

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1. Make semi annual payments at a fixed rate
2. Par value begins at $1000 and and is adjusted semiannualy for changes in the CPI. Adjusted DOWN for deflation
3. Income from inflation is taxed as income in the year of the adjustment

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1

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uno

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TIPS at maturity

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If the adjusted par value is higher than initial face then holder gets that. In a deflationary environment holder gets min. of $1000/bond. CANT LOSE MONEY

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On the Run Issues

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Most recently issued/auctioned treasury securities

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Off the Run

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Older issues that have been replaced by a more recently auctioned issue

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Distinction between on the run and off the run

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on the run are more actively traded and more liquid. Market prices of on the run issues provide better info about current market yields

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Treasury Strips

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Coupon Strips and Principal strips. Basically make a zero by repackaging zeros

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Taxation of STRIPS

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Taxed on their implicit interest, which for fully taxable investors creates a negative cash flow in years prior to maturity

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Federal Agency Securities

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Debt securities issued by various agencies and organizations of the US Government. MOST Issues ARE NOT obligations of US Treasury

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2 Types of Federal Agencies

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1. Federally related institutions
2. Goverment sponsored Enterprises ( GSEs)

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Federally Related Institutions

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Owned by the US Government and are exempt from SEC registration. Backed by the full faith and credit of the US Gov. ex. Ginnie Mae

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Government Sponsored Enterprises

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Privately owned but publicly chartered organizations. Created by the US Congress. Securities issued direct to the market ex. Fannie Mae, Sallie Mae

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Debentures

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Debt securities not backed by collateral. Commonly issued by GSEs. Can be coupon paying or discount securities

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Mortgage Back Securities (MBS)

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Backed by pools of mortgages that provide collateral and cash flows to service the debt

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Mortgage Passthrough securities

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passes the payments on pools of mortgages directly on to the holders. Each holder owns a percentage of the pool and receives payments of interest and principal repayment

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Mortgage Passthrough risks

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1. prepayment risk (despite some diversification)
2. Falling interest rates -- as rates fall, people refi and speed up early pay off

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Collateralized Mortgage Obligations

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Created from mortgage pass throughs and are broken up into tranches that each have a different claim to the cash flows from the pool. Usually in time period intervals.

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Stripped Mortgage backed securities

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creating a zero from pass through securities. Can be Interest Only or Principal only

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Prepayment of Stripped MBS
1. Interest Only
2. Pricipal Only

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1. Lose because less interest
2. Win because less time to get full pricipal

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Motivation for creating a CMO

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1. To redistribute the prepayment risk inherent in mortgage passthroughs
AND / OR
2. Create securities with various maturity ranges

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General rule of CMO creation

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to satisfy a broader range of investor risk/return preferences making MBS investing available to a wider audience and decreasing borrowing costs

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Municipal Bonds

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Usually tax free

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Tax Backed Bonds i.e. GO Bonds

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backed by the full faith, credit and TAXING POWER of the issuer. Issued by school districts, towns cities counties states, and special districts.

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Limited Tax GO

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statuatory limit on taxes

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Unlimted Tax GO

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No limit on how much tax can be levied to pay off debt

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Double Barrelled Bonds

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Special class of GOs that are backed by:
1. issuing authorities taxing power
2. additional resources that can fall outside of the general fund

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Appropriation backed Obligatinos AKA moral obligation bonds

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State acting as a backstop in a non-binding fashion.

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Tax Backed Bonds i.e. GO Bonds

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backed by the full faith, credit and TAXING POWER of the issuer. Issued by school districts, towns cities counties states, and special districts.

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Limited Tax GO

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statuatory limit on taxes

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Unlimted Tax GO

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No limit on how much tax can be levied to pay off debt

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Double Barrelled Bonds

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Special class of GOs that are backed by:
1. issuing authorities taxing power
2. additional resources that can fall outside of the general fund

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Appropriation backed Obligatinos AKA moral obligation bonds

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State acting as a backstop in a non-binding fashion.

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Public Credit Enhancement programs

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have a guarantee from the state or federal government. Legally enforcable contract and used to assist school systems

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Revenue Bonds

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Do not require voter approval and fall outside GO limits. fund projects that will service the debt with revenues

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Risk of Revenue Bonds vs. GOs

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Revenue bonds need to generate a certain amount of revenue to service the debt. Thus, they necessitate a higher yield

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Insured Bonds

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carry the guarantee of a third party to ensure all interest and principal payments are met. Usually get rated AAA and are most common in Revenue Bonds. Some small municipalities will use insurance also. Improves liquidity

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Prerefunded Bonds

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Treasuries are put in a seperate account and made sufficient to make all remaining payments. Little or no credit risk. Usually AAA

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Rating Agencies

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Use both Qualitative and Quantitative factors to rate debt issues

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Primary Factors of Rating Agencies

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Character of the issuer, Capacity to repay, Collateral provided, Covenants of the debt issue

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Secured Debt on Corp Bonds

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Debt that is secured by the pledge of assets/collateral which can take the following form: 1. Personal Property 2. Real Property 3. Financial Assets

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Unsecured Debt on Corp Bonds

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not backed by any collateral. Called Debentures. represent a general claim on assets that haven't been pledged for anything else.

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Subordinated Debentures

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claims that are satisfied after claims of senior debt.

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Credit Enhancements

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guarantees of others that the corporate debt obligation will be paid in a timely manner

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Forms of Credit Enhancemets

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1. Letters of Credit
2. Bond Insurance

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Letters of Credit

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issued by banks and guarantee that the bank will advance funds to service the corporation's debt.

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Medium Term Notes (MTN)

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Registed under SEC Rule 415 and given shelf registration. Need not be sold all at once. Sold to the market over time with each sale satisfying amount needed to raise by the issuer

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Sale process of MTNs

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Take indications of interest at various maturities / coupons via agent and then accept if it works

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Structured Note

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Combining a normal debt instrument with a derivative to create equity like returns for institutions and lower borrowing costs for the issuer

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Commercial Paper

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Pure discount security with maturity of 270 days or less. Can be placed directly or through a dealer