Debt Instruments: Qualitative Aspects Chapter 8

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Debt InstrumentsQualitative AspectsChapter 8

• Sources of Risk
• Non Marketable vs. Marketable
• Short-Term, Long-Term Instruments
• Mortgage Backed Securities
• Bankruptcy

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Sources of Risk

• Default probability of not getting all of the
  promised interest and principal.
• Price changes in prices as interest rates change
  over time.
• Purchasing Power effects on inflation on buying
  power of coupon income.
• Liquidity inability to buy or sell at intrinsic
  value due to inactive market or small float.

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Non-Marketable Debt

• Certificates of Deposit
• 3 months to 2 years
• Decision Criterion Expectations for rates
• Keep maturities short if rates expected to rise
• Money Market Fund Balances
• Invested in S-T instruments
• Savings Bonds (U.S. Treasury)
• EE S.B. (zero-coupon bond)
• I-Bonds (rates reset 2x a year),

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Marketable Debt

• Treasury Bills
• 13- and 26-week maturities sold weekly
• 52-week bills once a month
• Buy from treasury, online, or from bank
• Sold at a discount
• Dealer-dominated secondary market
• BDY (Face Price)/Face (360/DTM)
• BEY (365 BDY) / 360 (DTM BDY)

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Marketable Debt

• Commercial Paper
• 270 day max maturity
• Sold at discount
• 1,000,000 is typical Face Value
• Financial companies are biggest issuers
• Monet market funds most significant buyer
• Negotiable CD
• May be bearer or registered
• Partially insured by BIF

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Marketable Debt

• Bankers Acceptances
• Finance imports
• Significant documentation
• Traded in secondary markets
• Eurodollar Deposits
• USD-denominated liabilities of foreign banks
• Rates paid typically gt US rates
• Repatriation risks

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Term Structurehttp//online.wsj.com/mdc/public/pa
ge/2_3020-moneyrate.html

• Discount Rate
• Charged by Federal Reserve Bank on loans to banks
• Federal Funds Rate
• Charged by banks to each other for lending
  federal funds
• LIBOR
• Charged by London banks on loans to each other
• Prime Rate
• Indexed
• Used by banks to price loans

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US Government Debt Securities

• Notes
• Max maturities 10 years
• Bonds
• Max maturities 30 years
• General Features
• Very liquid
• Registered
• Semi-annual interest payments

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US Government Debt Securities

• STRIPS
• Separate Trading of Registered Interest
  Principal Securities
• Sell semi-annual coupons as one security and sell
  maturity value as separate security.
• Prices set by YTM
• TIPS
• Treasury Inflation-Protected Securities
• Lower coupon rates

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Off Balance Sheet Debt

• GSE Issuers (largest)
• FNMA (fannie mae)
• FHLMC (freddie mac)
• Federal Agencies (Guaranteed by US)
• EXIM Bank
• GNMA
• TVA

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Municipal Debt

• Issued by State, County, or City Govt
• General Obligation Bonds
• Revenue Bonds
• Tax preferences (interest exempt from Fed taxes)

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Corporate Debt

• Indenture Agreement
• Agreement between lender and borrower
• Specifies and Restrictive Covenants
• May require sinking funds or serial redemption
• Grace period specified (curing a default)
• Appoints the trustee a fiduciary responsible for
  guarding the lenders' interests.
• Provides for legal remedies if terms conditions
  of indenture are not met.
• Sets timing and rate of interest payments

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Corporate Debt

• Market Trading
• OTC dominates
• Quotes include
• Coupon rate
• Maturity
• Current Yield
• Volume
• Last price (change)

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Corporate Debt

• Collateralized Debt
• Mortgage Bonds
• Equipment Trust Certificates
• Un-Collateralized Debt
• Debentures
• Senior
• Subordinated
• Notes
• Fixed or floating rate

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Collateralized Debt

• Other Important Features
• Callable bonds
• Call price includes premium
• Yield-to-First-Call impact of call premium
• Convertible bonds
• Convertible to common stock
• C-bond is may be characterized as an
  interest-paying call option on the underlying
  stock

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Credit Ratings

• Several Companies specialize in rating debt
  issues
• Ratings (SP schema)
• Prime or High Quality (AAA)
• Investment Grade (meets legal list requirements)
• AA, A, BBB
• Speculative Grade
• BB, B
• High Risk
• CCC, CC, C
• Default
• DDD, etc.

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Corporate Bankruptcy

• Definitions of Failure
• Economic Failure revenues do not cover expenses
• Business Failure termination resulting in loss
  to creditors
• Technical Insolvency firm cannot meet maturing
  obligations
• Technical Bankruptcy Value of assets lt value of
  liabilities,
• Legal Bankruptcy Acts of Bankruptcy
• Firm admits inability to pay (voluntary).
• Composition of creditors petitions court
  (involuntary).
• Concealment or improper transfer of assets to
  avoid attachment or repossession.

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Corporate Bankruptcy

• Out-of-Court Remedies
• Extension postpone due date.
• Composition creditors agree to take less.
• Necessary conditions
• Debtor is good moral risk.
• Debtor must show ability to make a recovery.
• General business conditions must be favorable.
• Creditor committees lenders assume management.
• Assignment Requires agreement as to liquidation
  values, and priority.

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Corporate Bankruptcy

• Chapter 7 Liquidation
• Provide safeguards against fraud during
  liquidation.
• Provide equitable distribution of assets to
  creditors.
• Discharge all obligations debtors can restart
  without burden of former debt.
• Some claims settled in cash, others in assignment
  of assets.

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Corporate Bankruptcy

• Rule of Absolute Priority Chapter 5, Section 507
  (1978 law)
• Secured creditors
• Trustee expenses
• Back wages for employees (max 2000)
• Customer deposits (unsecured max 900)
• Federal and State taxes
• Unfunded Pension Liabilities
• General (unsecured) creditors
• Stockholders (preferred, common)

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Corporate Bankruptcy

• Chapter 11 Reorganization
• Reorganization of repayment schedules lengthen
  maturities
• Some debt may be permanently dismissed.
• Debt frequently has interest rates lowered.
• Evaluates current management.
• Determining if merger with healthy firm is best.

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Asset/Mortgage Backed Securities

• Securitization
• Turning non-marketable securities into marketable
• Example mortgages, credit card balances,
  accounts receivable
• Provides claims on assets not otherwise available
  to ordinary investors
• Mortgage-backed Securities (MBS)
• Cash flows to investors principal interest
• VA and FHA are insured

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Mortgage Backed Securities

• Pass-Throughs
• PI less fee sent to investor
• Many issuers Fannie, Freddie, Ginnie
• Collateralized Mortgage Obligations
• Cash flows are sequenced (Tranches)
• More risk for buyers of later tranches

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Other Debt Securities

• Foreign Bonds
• State-issued
• Corporate issues
• Forex and Political risk important factors
• Insurance Investments
• Guaranteed Investment Contracts
• Annuities
• Single-premium deferred
• Flexible-premium deferred

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Annuity Payout Options

• Straight life annuity
• Life income with period certain annuity
• Life with cash or installment refund annuity
• Joint and survivor life annuity
• Fixed period annuity
• Fixed amount annuity