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Overview of Bond Sector
and Instruments
Understanding Yield
Spreads
Government
Agencies
Municipal
Corporation
•US Treasury
•Federally
Related
Institution
•General
Obligation
•Secured Bonds
Bank
Obligations
•Revenue
•Unsecured
Bonds
•Government
Sponsored
Enterprises
•Negotiabl e
CDs
•Special Bonds
Structure
•Medium Term
Notes
•Bankers
Acceptances
•Commercial
Paper
Sovereign Bonds
•Bonds issued by a country’s central
government
•Issued in domestic market, another country”s
foreign market, or in the Eurobonds market
•Typically issued in the currency of the issuing
country, but can be issued in other currencies
as well
Four Primary Methods of issuance
Regular cycle auction
– single price
Regular cycle auction
– multiple price
An ad hoc auction
system
A tap system
Under this method
Refers to a method
highest price (lowest
where the central
Refers to the issuance
Under this method,
yield) at which the
government auctions and auctions of bonds
winning bidders
entire issue to be
new securities when it identical to previously
receive the bonds at
issued bonds
auctioned can be sold
determines market
the price that they bid
is awarded to winning
conditions are
bidders
advantageous
US Treasury
Treasury Bills
Fixed-Principal
Treasuries
Inflation-Indexes
Treasuries (TIPSs)
Treasury Notes
Treasury Bonds
Treasury Strips
(created by
private sector)
Coupon Strips
Principal Strips
On The Run and Off The Run
• Treasury issues are divided into 2 categories based
on their vintage :
• On the run issues, the most recently auctined
Treasury issues.
• Off the run issues, older issues that have been
replaced (as most traded issue) by a more recently
auctioned issued. Issues replaced by several more
recent issues are known as well off the run issues
TIPSs
• Coupon rate reflects real rate, net of inflation, change in inflation reflected in
the principal
• TIPS Coupon payment = inflation-adjusted par value x
(stated coupon rate/2)
• Cons: if consumer prices decline, so does the principal. Also, inflation
adjustments are taxed
• Example of TIPS : A TIPS has coupon rate of 3%, par value of $100,000.
Annual inflation rate: 4%, compute the semi-annual coupon payment!
• Answer:
• Semi annual inflation = 4% x 0.5 = 2%
• Inflation-adjusted principal = $100,000 x (1+0.02) = $102,000
• Semi annual coupon payment = $102,000 x 1.5% = $1530
Treasury Strips
Principal strips
Coupon strips
Refers to strips created from
coupon payments stripped
from the original security,
denoted as ci
Refers to bond and note
principal payments with the
coupons stripped off. Those
derived from stripped bonds
are denoted bp and those from
stripped notes np
Federal Agency Debts
• Debt securities issued by various agencies and organizations
of the U.S Government
• There are two types of federal agencies :
• federal government agencies such as Ginnie Mae, TVA
• government sponsored entities (privately owned) such as
Fannie Mae, Freddie Mac, Sallie Mae
Instrumen Types
• Debentures, securities not backed by collateral
• Mortgage and Asset backed securities
Mortgage Backed Securities
Mortgage pass through
Pooling of several mortgages
Sold in the form of
participation certificates
Collateralized Mortgage
Obligations (CMOs)
Derivative of pass-through
Different tranches created
Cash flows passed through to Prepayment risk distributed
investors
across tranches
Issuer
Types
•Issued by local
government
•Tax-Backed Debt
•In US issued by
state, local
government and
entities that they
create
•Special Bonds
Structure
•Revenue Bonds
Tax-Backed Debt
General Obligation
Debt (G.O. Debt)
Unlimited Tax
Lmited Tax
Doule Barelled
Issuer has unlimited
taxing authority
Issuer has a
statutory limit on
tax increase
Backed also by
additional revenues
AppropriationBacked Obligation
(Moral Obligation
Bonds)
Public Credit
Enhanced Programs
State Issue a nonbinding pledge to
cover shortfalls
State or Federal
agency guarantees
payment
Corporate
Debt
Securities
Secured Bonds
Mortgage Debt
Corporate
Bonds
Medium Term
Notes (MTNs)
Unsecured
Bonds
Credit
Enhanced
Bonds
Collateral
Trust Bonds
Third-Party
Structured
Notes
Bank Letter of
Credit
Commercial
Paper
Directlyplaced
Dealer-placed
Considered Factors for Rating
Character, Capacity, Collateral and Covenant
The Firm Specific Factors considered
Past repayment history
Quality of management, ability to adapt to changing conditions
The industry outlook and firm strategy
Overall debt level of the firm
Operating cash flow, ability to service debt
Other sources of liquidity (cash, salable assets)
Competitive position, regulatory enviroment and union
contracts/history
Financial management and controls
Susceptibility to event risk and political risk
Factor specific to particular debt issue
Priority of the claim being rated
Value/quality of any collateral pledged to secure the debt
The covenants of the debt issue
Any guarantees or obligations for parent company support
Corporate Bonds Issues
•Corporate bond issues typically are :
•Sold all at once
•Sold on a firm commitment basis whereby an understanding
syndicate guarantees the sale of the whole issue
•Consist of bonds with a single coupon rate and maturity
Medium term Notes
•Medium term notes (MTNs) differ from a regular corporate bond
offering in all of these characteristics
Structured Notes
•A debt security created when the issuer combines a typical bond or note with derivative.
•Types of structured notes include :
•Step up notes, coupon rate increases over time on a preset schedule.
•Inverse Floaters, coupon rate increases when the reference rate decreases and
decreases when the reference rate increases.
•Deleveraged Floaters, coupon rate equals a fraction of the reference rate plus a
constant margin.
•Dual Indexed Floaters, coupon rate is based on the difference between two reference
rates.
•Range Notes, coupon rate equals the reference rate if the reference rate falls within a
specified range, or zero if the reference rate falls outside that range.
•Index amortizing Notes, coupon rate is fixed but some principal is repaid before
maturity with the amount of principal prepaid based on the level of the reference rate.
Commercial paper
•A short term unsecured debt instrument used by corporations to
borrow money at rates lower than bank rates.
•Directly placed paper , commercial paper that is sold to large
investors without going through an agent or broker dealer.
Large issuers will deal with a select group of regular commercial
paper buyers who customarily buy very large amounts.
•Dealer placed paper, sold to purchasers through a commercial
paper dealer. Most large investment firms have commercial
paper desk to serve their customers’ needs for short term cash
management products.
Negotiable Certificate of deposit
• Certificate of deposit, promise by the bank to repay a
certain amount plus interest with specific and for
specific periods of time, that can be trade on the
secondary market
Bankers Acceptances
• Guarantees by a bank that a loan will be rapaid.
Created as part of commercial transaction, especially
international trade
Special Purpose Vehicle/Corporation
• a separate legal entity to which a corporation transfers the financial assets
for an ABS issue.
• The Motivation for a corporation to issue asset backed securities to reduce
borrowing costs. By transferring the assets into a separate entity, the entity
can issue the bonds and receive a higher rating than the unsecured debt of
the corporation.
• External Credit Enhancements :
• Corporate guarantees, which may be provided by the corporation creating
the ABS or its parent.
• Letters of credit, which may be obtained from a bank for a fee
• Bond Insurance, which may be obtained from an insurance company or a
provider specializing in underwriting such structures. This is also referred
to as an insurance wrap
Collateralized Debt Obligation (CDO)
•A debt instrument where the collateral for
the promise to pay is an underlying pool of
other debt obligations and even other CDOs
•Tranches of CDO are created based on the
seniority of the claim to the cash flows of
underlying assets, and given different credit
rating based on seniority
Primary Market
• The Primary Market for debt typically used an investment
banker to involved in advising the debt issuer and in
distributing (selling) the debt securities to investors.
• Two type of underwriting : firm commitment and best effort.
Secondary Market
• The Secondary Market for debt securities includes
exchanges, an over the counter dealer market and electronic
trading networks
Exercise 1
• A treasury note (T-note) principal strip has six months remaining to
maturity. How is its price likely to compare to a 6 month treasury bill (T-bill)
that has just been issued ? The T-note price should be :
• A. lower
• B. higher
• C. the same
Exercise 2
• Which of the following statements about treasury securities is most accurate?
• A. Treasury principal strips are usually created from treasury bills
• B. Treasury bonds may be used to create treasury coupon strips
• C. Treasury coupon strip make lower coupon payments than treasury
principal strips
Exercise 3
• Which of the following municipal bonds typically has the greater risk
and is issued with higher yields ?
• A. Revenue bonds
• B. Limited tax general obligation bonds
• C. Unlimited tax general obligation bonds
Exercise 4
• A debt security that is collateralized by a pool of the sovereign debt
of several developing countries is most likely a (n) :
• A. CMO
• B. CDO
• C. ABS
Exercise 5
•Activities in the primary market for
debt securities would least likely
include :
•A. market making
•B. a best efforts offering
•C. a firm commitment
Thank You and Success
Agus Salim
CFA
0811990573
[email protected]