Fin431x (Ch 6&7&8&9) 1

Treasury, Agency, Corporate and Municipal Bonds

1. Treasury Bonds

2. Agency Bonds

3. Corporate Bonds

4. Municipal Bonds

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FactsThe 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

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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

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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?

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Features of TIPS

• Still a fixed rate product

• The adjustment in coupon payments subject to federal tax

• Possibility of disinflation

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Auction ProcessTreasury securities on a regular cycle:T-bills: 4 weeks, 13 weeks, 26 weeksT-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

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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(3) bid-to-cover ratio(4) What about yield is 3.039%?

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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.

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Secondary market

Traded in the OTC market

On-the-run issues

Off-the-run issues

When-issued market

Dealer versus Interdealer

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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

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?

tF

DYd

360

Fin431x (Ch 6&7&8&9) 11

Quotes on Treasury Coupon Securities(1) Price per $100 par; 32nd (See WSJ)(2) Accrued interest (AI)

To estimate the two “days” in the above formula, we need:a. Trade dayb. Settlement dayc. Actual day count convention

periodcouponinDays

periodAIinDayscoupondollarannualAI

___

___

2

__

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Stripped Treasury Securities

Trademark securities

Treasury receipts

Strips

Tax treatment: accrued interest is taxed each year, though interest is not paid.

Reconstituting a bond

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Agency SecuritiesFederally 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.

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GSEsFannie Mae (see page 139)Freddi MacFederal Home Loan Bank SystemFederal agriculture Mortgage CorporationFederal Farm Credit Bank SystemStudent Loan Marketing AssociationFinancing CorporationResolution Trust CorporationFarm Credit Financial Assistance Corporation

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Features of Corporate Bonds

Bond indenture

Security for bonds

Debenture bonds

Provisions

Covenants

For quotes: see “corporate bonds” in WSJ.

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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

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Covenants

Affirmative covenants

Restrictive covenants

Maintenance test

Debt incurrence test

Cash flow test

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Factors Affecting Corporate Bond Ratings

Quality of management

Capacity to pay

Collateral

Covenant

Quality rating schedule: see page 154.

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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.

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High-yield Corporate Bond SectorAKA 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

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High-Yield Bonds

Do junk bonds provide extremely high returns?

Exhibit 7-6, page 169.

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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 415

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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

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Bankruptcy and Credit Rights

Liquidation – chapter 7 of the bankruptcy act

Reorganization -- chapter 11 of the bankruptcy act

Absolute priority

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Municipal Securities

Issued by Municipality, including state or local governmentThe exemption of interest income from federal taxationShort-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

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Types of Municipal Bonds

Tax-backed debt (page 182)• General obligation debt• Appropriation-back obligation• Debt obligations supported by public credit

enhancement programRevenue Bonds (page 183-187)• Airport revenue bonds• College and university revenue bonds• Water revenue bonds

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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.

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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.

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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

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Yield of Municipal Bonds

ratetaxinalm

yieldexempttaxyieldtaxableequivalent

__arg1

___

bondTreasurymaturitysameonyield

bondmunicipalonyieldratioyield

_____

____

See “Bond yield” under “Bond Market Data Bank” in WSJ.

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Taxable Municipal BondsPurposes: (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 tax-exempt municipal bonds.

• U.S. tax code restrict arbitrage opportunities that a municipality can realize

• Different investor base

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Non-US Bonds

Internal Market versus External Market• Internal market includes domestic and foreign bonds

– Yankee bonds, bulldog bonds• External market: offshore bond market or Eurobonds

(page 208)

By trading bloc• Dollar bloc• European bloc• Japan • Emerging markets

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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 216

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Sovereign Bond Ratings

Sovereign debt is the obligation of a country’s central government.

U.S. government debt is not rated by any nationally recognized statistical rating organization, the debt of other national governments is rated.

S&P, Moody’s and Fitch all assign ratings to sovereign bonds.

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Distribution of New Government Issues (page 215)

Regular calendar auction/Dutch style

Regular calendar auction/minimum price

Ad hoc auction system

Tap system

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Major other 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 220

Emerging Market Bonds: also known Brady bonds, issued in Latin America, Asia and Eastern Europe. Page 221