Treasury, Agency, Corporate and Municipal Bonds

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1 Treasury, Agency, Corporate and Municipal Bonds 1. Treasury Bonds 2. Agency Bonds 3. Corporate Bonds 4. Municipal Bonds 5. International Bonds 1

2 Facts The second largest sector of bond market is the treasury securities market The smallest sector is agency bond market Most municipal bonds are tax-exempt Junk bonds have lower return than stocks 2

3 Different Treasury Securities Fixed-principal treasury securities (page 128) Treasury inflation protection securities (TIPS) Treasury securities that adjust for inflation First time issue is Jan. 29, 1997 Coupon rate is fixed See inflation-indexed treasury securities under Treasury Bonds, Notes and Bills in WSJ 3

4 Example Coupon rate for a TIPS is 3.5%, annual inflation is 3%. Suppose an investor purchases a bond on 1/1/2005, par value $100,000. (1) What are the par and coupon payment on 6/30/2005? (2) Suppose semi-annual inflation rate for the second 6 month period is 1%, what are the par and coupon payment on 12/31/2005? 4

5 Features of TIPS Still a fixed rate product The adjustment in coupon payments subject to federal tax Possibility of disinflation 5

6 Auction Process Treasury securities on a regular cycle: T-bills: 4 weeks, 13 weeks, 26 weeks T-notes: 2-, 5-, and 10-year It offers additional shares of outstanding securities, referred to as a reopening of an issue, mainly for 5- and 10-year issues Debt buyback plan: redeem un-matured securities through reverse auctions 6

7 Auction Process Alternative Bids (1) Noncompetitive bid: like a market order. Has limit. (2) Competitive bid: specify both the quantity and the yield at which the bidder is willing to purchase the auctioned security. Process (pages 129): (1) Deducting the total noncompetitive tenders and nonpublic (2) Stop-out yield: yield for winning bidders (3) bid-to-cover ratio (4) What about yield is 3.039%? 7

8 Types of Auctions Dutch auction: the auctioneer sets an extraordinarily high price and lowers it until someone bids on the item. Traditional auction: the price rises until one bidder is left. 8

9 Secondary market Traded in the OTC market On-the-run issues Off-the-run issues When-issued market Dealer versus Interdealer 9

10 Quotes for T-bills and T-bonds (1) Quotes for Treasury Bills (see WSJ) (2) On a bank discount basis, not on a price basis Y D 360 d F t Example: what is the quote on a bank discount basis for a Treasury bill with 100 days to maturity, a face value of $100,000, selling for $99,100? 10

11 Quotes on Treasury Coupon Securities (1) Price per $100 par; 32 nd (See WSJ) (2) Accrued interest (AI) annual _ dollar _ coupon Days _ in _ AI _ period AI 2 Days _ in _ coupon _ period To estimate the two days in the above formula, we need: a. Trade day b. Settlement day c. Actual day count convention 11

12 Stripped Treasury Securities Trademark securities Treasury receipts Strips Tax treatment: accrued interest is taxed each year, though interest is not paid. Reconstituting a bond 12

13 Agency Securities Federally Agency Institutions see page 139 Government-sponsored enterprises (GSEs) privately owned, publicly chartered entities. They were created by Congress to reduce the cost of capital for certain borrowing sectors of the economy deemed to be important enough to warrant assistance, including farmers, homeowners, and students See Government Agency and Similar Issues in WSJ. 13

14 GSEs Fannie Mae (see page 139) Freddi Mac Federal Home Loan Bank System Federal agriculture Mortgage Corporation Federal Farm Credit Bank System Student Loan Marketing Association Financing Corporation Resolution Trust Corporation Farm Credit Financial Assistance Corporation 14

15 Features of Corporate Bonds Bond indenture Security for bonds Debenture bonds Provisions Covenants For quotes: see corporate bonds in WSJ. 15

16 Provisions for Paying Off Bonds Prior to Maturity Traditional call and refund provision Make whole call provision The payment when the issuer calls a bond is determined by the present value of the remaining payments discounted at a small spread over a maturity-matched Treasury yield Sinking fund provision 16

17 Covenants Affirmative covenants Restrictive covenants Maintenance test Debt incurrence test Cash flow test 17

18 Factors Affecting Corporate Bond Ratings Quality of management Capacity to pay Collateral Covenant Quality rating schedule: see page

19 TRACE Page 152 The reporting system, the Trade Reporting and Compliance Engine (TRACE), requires that all broker/dealers who are member firms of the Financial Integrity Regulatory Authority (FINRA) report transactions to corporate bonds to TRACE. 19

20 High-yield Corporate Bond Sector AKA junk bonds, non-investment-grade bonds. They are issues with quality ratings below triple B (1) Original-issue high-yield bonds (2) Fallen angels Default rates: see Exhibit 7-4 on page 155. For quotes, see High-Yield Bonds in WSJ 20

21 High-Yield Bonds Do junk bonds provide extremely high returns? Exhibit 7-6, page

22 Medium-Term Notes (MTN) A corporate debt instrument, with the unique characteristic that notes are offered continuously to investors by an agent of the issuer. Maturity ranges 9m 1y 1y 18m 18m 2y So on up to 30 years Register with SEC under Rule

23 Commercial Papers Short term unsecured promissory note that is issued in the open market and that represents the obligation of the issuing corporation. Ranges in maturity from 1 day to 270 days Bridge financing 23

24 Bankruptcy and Credit Rights Liquidation chapter 7 of the bankruptcy act Reorganization -- chapter 11 of the bankruptcy act Absolute priority 24

25 Municipal Securities Issued by Municipality, including state or local government The exemption of interest income from federal taxation Short-term notes: to cover seasonal and temporary imbalance between outlays for expenditure and inflow from taxes. Long-term bonds: to finance long-term capital projects such as schools, bridges, and airports; long term budget deficit from current operation. For Quotes: see Tax-exempt Bonds under Bond Market Data Bank in WSJ 25

26 Types of Municipal Bonds Tax-backed debt (page 182) General obligation debt Appropriation-back obligation Debt obligations supported by public credit enhancement program Revenue Bonds (page ) Airport revenue bonds College and university revenue bonds Water revenue bonds 26

27 Redemption Features of Municipal Bonds (page 191) Serial maturity structure: a portion of debt obligation to be retired each year Term maturity structure: provides for the debt obligation to be repaid on a final date, typically through a sinking fund provision that begin 5 to 10 years before the final term maturity. Catastrophe call provision: requires the issuer to call the entire issue if the facility is destroyed. 27

28 Floater/Inverse Floater A municipal dealer can buy a fixed-rate municipal bond and place it in a trust, then the trust issues a floater and an inverse floater The investors in the inverse floater can purchase the corresponding floater at auction and combine two positions to effectively own the underlying fixed-rate bonds. 28

29 Risk Exposures of municipal bonds Credit risk Interest rate Reinvestment risk Tax risk Decrease in tax A tax-exempt issue may eventually be declared to be taxable by the IRS 29

30 Yield of Municipal Bonds equivalent _ taxable _ yield tax exempt _ yield 1 marg inal _ tax _ rate yield _ ratio yield yield _ on _ municipal _ bond _ on _ same_ maturity _ Treasury _ bond See Bond yield under Bond Market Data Bank in WSJ. 30

31 Taxable Municipal Bonds Purposes: (1) local sports facilities, (2) investor-led housing projects, (3) advanced refunding of issues that are not permitted to be refunded, and (4) underfunded pension With taxable municipal bonds, a municipality needs to pay a higher yield than if it issued a tax-exempt municipal bond. Why does it want to do this? Tax Reform Act 1986 imposes restrictions on what type of projects and the upper limit could be financed with taxexempt municipal bonds. U.S. tax code restrict arbitrage opportunities that a municipality can realize Different investor base 31

32 Non-US Bonds Internal Market versus External Market Internal bond market includes domestic and foreign bonds (US and non-us for each) Domestic bonds (see figure 9-4 page 201 for outstanding amount) Foreign bonds are those whose issuers are not domiciled in the country where bonds are issued and traded Yankee bonds American bonds issued by non-us entities Samurai bonds Yen-denominated issued by non Japanese entities bulldog bonds foreign bonds in UK Rembrandt bonds Netherlands Matador bonds -- Spain External bond market: offshore bond market or Eurobonds Underwritten by an international syndicate; offered simultaneously to investors in a number of countries; issued outside the jurisdiction of any single country 32

33 Another bond categorization By trading bloc Dollar bloc European bloc Euro zone market bloc Non-euro zone market bloc (Norway, Denmark, and Sweden) Japan Emerging market 33

34 Non-US Government Bond Markets The two largest non-u.s. government bond markets are those in Japan and Germany: Japan (JGB), Germany (Bunds) Inflation-indexed bonds page 215 Sovereign Bond page

35 Distribution of New Government Issues (page 204) Regular calendar auction/dutch style: you get what you bid Regular calendar auction/minimum price: same as treasury bond offering Ad hoc auction system: UK system Tap system: additional bonds of a previously outstanding bond issue are auctioned 35

36 Sovereign Bond Ratings Consider two sets of risks (page ) Economic Risk the ability of a government to satisfy its obligations Political risk the willingness of government to satisfy its obligations U.S. government debt is rated as AAA S&P, Moody s and Fitch all assign ratings to sovereign bonds. 36

37 Other major bonds Pfandbriefe market bonds: issued by mortgage banks in Germany; the largest asset in the European bond market and the sixth largest in the world. Page 206 Emerging Market Bonds: also known Brady bonds, issued in Latin America, Asia and Eastern Europe. Pages

38 Credit Risk of Emerging Country Government Bonds Pages Macroeconomic fundamentals 1. Serviceability 2. Solvency 3. structure Political risk 1. Election 2. Systems/institutions 3. Geopolitical significance 38

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