LEARNING OUTCOMES

After reading Chapter 1 you should be able to:

• describe the basic features of a bond (e.g., maturity, par value, coupon rate, bond redeeming provisions, currency denomination, issuer or investor granted options).

• describe affirmative and negative covenants.

• identify the various coupon rate structures, such as fixed rate coupon bonds, zero-coupon bonds, step-up notes, deferred coupon bonds, floating-rate securities.

• describe the structure of floating-rate securities (i.e., the coupon formula, interest rate caps and floors).

• define accrued interest, full price, and clean price.

• describe the provisions for redeeming bonds, including the distinction between a nonamortizing bond and an amortizing bond.

• explain the provisions for the early retirement of debt, including call and refunding provisions, prepayment options, and sinking fund provisions.

• differentiate between nonrefundable and noncallable bonds.

• explain the difference between a regular redemption price and a special redemption price.

• identify embedded options (call option, prepayment option, accelerated sinking fund option, put option, and conversion option) and indicate whether each benefits the issuer or the bondholder.

• explain the importance of options embedded in a bond issue.

• identify the typical method used by institutional investors to finance the purchase of a security (i.e., margin or repurchase agreement).

SUMMARY OVERVIEW

• A fixed income security is a financial obligation of an entity (the issuer) who promises to pay a specified sum of money at specified future dates.

• Fixed income securities fall into two general categories: debt obligations and preferred stock.

• The promises of the issuer and the rights of the bondholders are set forth in the indenture.

• The par value (principal, face value, redemption value, or maturity value) of a bond is the amount that the issuer agrees to repay the bondholder at or by the maturity date.

• Bond prices are quoted as a percentage of par value, with par value equal to 100.

• The interest rate that the issuer agrees to pay each year is called the coupon rate; the coupon is the annual amount of the interest payment and is found by multiplying the par value by the coupon rate.

• Zero-coupon bonds do not make periodic coupon payments; the bondholder realizes interest at the maturity date equal to the difference between the maturity value and the price paid for the bond.

• A floating-rate security is an issue whose coupon rate resets periodically based on some formula; the typical coupon formula is some reference rate plus a quoted margin.

• A floating-rate security may have a cap, which sets the maximum coupon rate that will be paid, and/or a floor, which sets the minimum coupon rate that will be paid.

• A cap is a disadvantage to the bondholder while a floor is an advantage to the bondholder.

• A step-up note is a security whose coupon rate increases over time.

• Accrued interest is the amount of interest accrued since the last coupon payment; in the United States (as well as in many countries), the bond buyer must pay the bond seller the accrued interest.

• The full price (or dirty price) of a security is the agreed upon price plus accrued interest; the price (or clean price) is the agreed upon price without accrued interest.

• An amortizing security is a security for which there is a schedule for the repayment of principal.

• Many issues have a call provision granting the issuer an option to retire all or part of the issue prior to the stated maturity date.

• A call provision is an advantage to the issuer and a disadvantage to the bondholder.

• When a callable bond is issued, if the issuer cannot call the bond for a number of years, the bond is said to have a deferred call.

• The call or redemption price can be either fixed regardless of the call date or based on a call schedule or based on a make-whole premium provision.

• With a call schedule, the call price depends on when the issuer calls the issue.

• A make-whole premium provision sets forth a formula for determining the premium that the issuer must pay to call an issue, with the premium designed to protect the yield of those investors who purchased the issue.

• The call prices are regular or general redemption prices; there are special redemption prices for debt redeemed through the sinking fund and through other provisions.

• A currently callable bond is an issue that does not have any protection against early call.

• Most new bond issues, even if currently callable, usually have some restrictions against refunding.

• Call protection is much more absolute than refunding protection.

• For an amortizing security backed by a pool of loans, the underlying borrowers typically have the right to prepay the outstanding principal balance in whole or in part prior to the scheduled principal payment dates; this provision is called a prepayment option.

• A sinking fund provision requires that the issuer retire a specified portion of an issue each year.

• An accelerated sinking fund provision allows the issuer to retire more than the amount stipulated to satisfy the periodic sinking fund requirement.

• A putable bond is one in which the bondholder has the right to sell the issue back to the issuer at a specified price on designated dates.

• A convertible bond is an issue giving the bondholder the right to exchange the bond for a specified number of shares of common stock at a specified price.

• The presence of embedded options makes the valuation of fixed income securities complex and requires the modeling of interest rates and issuer/borrower behavior in order to project cash flows.

• An investor can borrow funds to purchase a security by using the security itself as collateral.

• There are two types of collateralized borrowing arrangements for purchasing securities: margin buying and repurchase agreements.

• Typically, institutional investors in the bond market do not finance the purchase of a security by buying on margin; rather, they use repurchase agreements.

• A repurchase agreement is the sale of a security with a commitment by the seller to repurchase the security from the buyer at the repurchase price on the repurchase date.

• The borrowing rate for a repurchase agreement is called the repo rate and while this rate is less than the cost of bank borrowing, it varies from transaction to transaction based on several factors.

PROBLEMS

1. Consider the following two bond issues.

Bond A: 5% 15-year bond

Bond B: 5% 30-year bond

Neither bond has an embedded option. Both bonds are trading in the market at the same yield.

Which bond will fluctuate more in price when interest rates change? Why?

2. Given the information in the first and third columns, complete the table in the second and fourth columns:

3. A floating-rate issue has the following coupon formula:

1-year Treasury rate + 30 basis points with a cap of 7% and a floor of 4.5%

The coupon rate is reset every year. Suppose that at the reset date the 1-year Treasury rate is as shown below. Compute the coupon rate for the next year:

	1-year Treasury rate	Coupon rate
First reset date	6.1%	?
Second reset date	6.5%	?
Third reset date	6.9%	?
Fourth reset date	6.8%	?
Fifth reset date	5.7%	?
Sixth reset date	5.0%	?
Seventh reset date	4.1%	?
Eighth reset date	3.9%	?
Ninth reset date	3.2%	?
Tenth reset date	4.4%	?

4. An excerpt from the prospectus of a $200 million issue by Becton, Dickinson and Company 7.15% Notes due October 1, 2009:

OPTIONAL REDEMPTION We may, at our option, redeem all or any part of the notes. If we choose to do so, we will mail a notice of redemption to you not less than 30 days and not more than 60 days before this redemption occurs. The redemption price will be equal to the greater of: (1) 100% of the principal amount of the notes to be redeemed; and (2) the sum of the present values of the Remaining Scheduled Payments on the notes, discounted to the redemption date on a semiannual basis, assuming a 360-day year consisting of twelve 30-day months, at the Treasury Rate plus 15 basis points.

a. What type of call provision is this?

b. What is the purpose of this type of call provision?

5. An excerpt from Cincinnati Gas & Electric Company’s prospectus for the 10 1/8% First Mortgage Bonds due in 2020 states,

The Offered Bonds are redeemable (though CG&E does not contemplate doing so) prior to May 1, 1995 through the use of earnings, proceeds from the sale of equity securities and cash accumulations other than those resulting from a refunding operation such as hereinafter described. The Offered Bonds are not redeemable prior to May 1, 1995 as a part of, or in anticipation of, any refunding operation involving the incurring of indebtedness by CG&E having an effective interest cost (calculated to the second decimal place in accordance with generally accepted financial practice) of less than the effective interest cost of the Offered Bonds (similarly calculated) or through the operation of the Maintenance and Replacement Fund.

What does this excerpt tell the investor about provisions of this issuer to pay off this issue prior to the stated maturity date?

6. An assistant portfolio manager reviewed the prospectus of a bond that will be issued next week on January 1 of 2000. The call schedule for this $200 million, 7.75% coupon 20-year issue specifies the following:

The Bonds will be redeemable at the option of the Company at any time in whole or in part, upon not fewer than 30 nor more than 60 days’ notice, at the following redemption prices (which are expressed in percentages of principal amount) in each case together with accrued interest to the date fixed for redemption:

If redeemed during the 12 months beginning January 1, provided, however, that prior to January 1, 2006, the Company may not redeem any of the Bonds pursuant to such option, directly or indirectly, from or in anticipation of the proceeds of the issuance of any indebtedness for money borrowed having an interest cost of less than 7.75% per annum.

2000 through 2005	104.00%
2006 through 2010	103.00%
2011 through 2012	101.00%
from 2013 on	100.00%

The prospectus further specifies that

The Company will provide for the retirement by redemption of $10 million of the principal amount of the Bonds each of the years 2010 to and including 2019 at the principal amount thereof, together with accrued interest to the date of redemption. The Company may also provide for the redemption of up to an additional $10 million principal amount ... annually, ... such optional right being non-cumulative.

The assistant portfolio manager made the following statements to a client after reviewing this bond issue. Comment on each statement. (When answering this question, remember that the assistant portfolio manager is responding to statements just before the bond is issued in 2000.)

a. “My major concern is that if rates decline significantly in the next few years, this issue will be called by the Company in order to replace it with a bond issue with a coupon rate less than 7.75%.”

b. “One major advantage of this issue is that if the Company redeems it for any reason in the first five years, investors are guaranteed receiving a price of 104, a premium over the initial offering price of 100.”

c. “A beneficial feature of this issue is that it has a sinking fund provision that reduces the risk that the Company won’t have enough funds to pay off the issue at the maturity date.”

d. “A further attractive feature of this issue is that the Company can accelerate the payoff of the issue via the sinking fund provision, reducing the risk that funds will not be available at the maturity date.”

e. In response to a client question about what will be the interest and principal that the client can depend on if $5 million par value of the issue is purchased, the assistant portfolio manager responded: “I can construct a schedule that shows every six months for the next 20 years the dollar amount of the interest and the principal repayment. It is quite simple to compute—basically it is just multiplying two numbers.”

7. There are some securities that are backed by a pool of loans. These loans have a schedule of interest and principal payments every month and give each borrower whose loan is in the pool the right to payoff their respective loan at any time at par. Suppose that a portfolio manager purchased one of these securities. Can the portfolio manager rely on the schedule of interest and principal payments in determining the cash flow that will be generated by such securities (assuming no borrowers default)? Why or why not?

a. What is an accelerated sinking fund provision?

b. Why can an accelerated sinking fund provision be viewed as an embedded call option granted to the issuer?

9. The importance of knowing the terms of bond issues, especially those relating to redemption, cannot be emphasized. Yet there have appeared numerous instances of investors, professional and others, who acknowledge that they don’t read the documentation. For example, in an Augusts 14, 1983 article published in The New York Times titled “The Lessons of a Bond Failure,” the following statements were attributed to some stockbrokers: “But brokers in the field say they often don’t spend much time reading these [official] statements,” “I can be honest and say I never look at the prospectus.... Generally, you don’t have time to do that,” and “There are some clients who really don’t know what they buy.... They just say, ‘That’s a good interest rate.’ ” Why it is important to understand the redemption features of a bond issue?

10. What is meant by an embedded option?

11.

a. What is the typical arrangement used by institutional investors in the bond market: bank financing, margin buying, or repurchase agreement?

b. What is the difference between a term repo and an overnight repo?

CHAPTER 2

RISKS ASSOCIATED WITH INVESTING IN BONDS

LEARNING OUTCOMES

After reading Chapter 2 you should be able to:

• explain the various risks associated with investing in bonds (e.g, interest rate risk, call and prepayment risk, yield curve risk, reinvestment risk, credit risk, liquidity risk, exchange-rate risk, inflation risk, volatility risk, and event risk).

• explain why there is an inverse relationship between changes in interest rates and bond prices.

• identify the relationships among a bond’s coupon rate, yield required by the market, and price relative to par value (i.e., discount, premium, or par value).

• explain how features of a bond (maturity, coupon, and embedded options) affect its interest rate risk.

• identify the relationship among the price of a callable bond, the price of an option-free bond, and the price of the embedded call option.

• explain how the yield level impacts the interest rate risk of a bond.

• explain the interest rate risk of a floating-rate security and why its price may differ from par value.

• compute the duration of a bond given its price changes when interest rates change.

• interpret the meaning of the duration of a bond.

• use duration to approximate the percentage price change of a bond and calculate the new price if interest rates change.

• explain yield curve risk and explain why duration does not account for yield curve risk for a portfolio of bonds.

• explain key rate duration.

• identify the factors that affect the reinvestment risk of a security.

• explain the disadvantages of a callable and prepayable security to an investor.

• explain why prepayable amortizing securities expose investors to greater reinvestment risk than nonamortizing securities.

• describe the types of credit risk: default risk, credit spread risk, and downgrade risk.

• explain a rating transition matrix.

• distinguish between investment grade bonds and noninvestment grade bonds.

• explain what a rating agency does and what is meant by a rating upgrade and a rating downgrade.

• explain why liquidity risk is important to investors even if they expect to hold a security to the maturity date.

• describe the exchange rate risk an investor faces when a bond makes payments in a foreign currency.

• explain inflation risk.

• explain yield volatility, how it affects the price of a bond with an embedded option, and how changes in volatility affect the value of a callable bond and a putable bond.

• describe the various forms of event risk.

• describe the components of sovereign risk.

SUMMARY OVERVIEW

• The price of a bond changes inversely with a change in market interest rates.

• Interest rate risk refers to the adverse price movement of a bond as a result of a change in market interest rates; for the bond investor typically it is the risk that interest rates will rise.

• A bond’s interest rate risk depends on the features of the bond—maturity, coupon rate, yield, and embedded options.

• All other factors constant, the longer the bond’s maturity, the greater is the bond’s price sensitivity to changes in interest rates.

• All other factors constant, the lower the coupon rate, the greater the bond’s price sensitivity to changes in interest rates.

• The price of a callable bond is equal to the price of an option-free bond minus the price of any embedded call option.

• When interest rates rise, the price of a callable bond will not fall by as much as an otherwise comparable option-free bond because the price of the embedded call option decreases.

• The price of a putable bond is equal to the price of an option-free bond plus the price of the embedded put option.

• All other factors constant, the higher the level of interest rate at which a bond trades, the lower is the price sensitivity when interest rates change.

• The price sensitivity of a bond to changes in interest rates can be measured in terms of (1) the percentage price change from initial price or (2) the dollar price change from initial price.

• The most straightforward way to calculate the percentage price change is to average the percentage price change due to the same increase and decrease in interest rates.

• Duration is a measure of interest rate risk; it measures the price sensitivity of a bond to interest rate changes.

• Duration can be interpreted as the approximate percentage price change of a bond for a 100 basis point change in interest rates.

• The computed duration is only as good as the valuation model used to obtain the prices when interest rates are shocked up and down by the same number of basis points.

• There can be substantial differences in the duration of complex bonds because valuation models used to obtain prices can vary.

• Given the duration of a bond and its market value, the dollar price change can be computed for a given change in interest rates.

• Yield curve risk for a portfolio occurs when, if interest rates increase by different amounts at different maturities, the portfolio’s value will be different than if interest rates had increased by the same amount.

• A portfolio’s duration measures the sensitivity of the portfolio’s value to changes in interest rates assuming the interest rates for all maturities change by the same amount.

• Any measure of interest rate risk that assumes interest rates change by the same amount for all maturities (referred to as a “parallel yield curve shift”) is only an approximation.

• One measure of yield curve risk is rate duration, which is the approximate percentage price change for a 100 basis point change in the interest rate for one maturity, holding all other maturity interest rates constant.

• Call risk and prepayment risk refer to the risk that a security will be paid prior to the scheduled principal payment dates.

• Reinvestment risk is the risk that interest and principal payments (scheduled payments, called proceeds, or prepayments) available for reinvestment must be reinvested at a lower interest rate than the security that generated the proceeds.

• From an investor’s perspective, the disadvantages to call and prepayment provisions are (1) the cash flow pattern is uncertain, (2) reinvestment risk increases because proceeds received will have to be reinvested at a relatively lower interest rate, and (3) the capital appreciation potential of a bond is reduced.

• Reinvestment risk for an amortizing security can be significant because of the right to prepay principal and the fact that interest and principal are repaid monthly.

• A zero-coupon bond has no reinvestment risk but has greater interest rate risk than a coupon bond of the same maturity.

• There are three forms of credit risk: default risk, credit spread risk, and downgrade risk.

• Default risk is the risk that the issuer will fail to satisfy the terms of indebtedness with respect to the timely payment of interest and principal.

• Credit spread risk is the risk that the price of an issuer’s bond will decline due to an increase in the credit spread.

• Downgrade risk is the risk that one or more of the rating agencies will reduce the credit rating of an issue or issuer.

• There are three rating agencies in the United States: Standard & Poor’s Corporation, Moody’s Investors Service, Inc., and Fitch.

• A credit rating is an indicator of the potential default risk associated with a particular bond issue that represents in a simplistic way the credit rater’s assessment of an issuer’s ability to pay principal and interest in accordance with the terms of the debt contract.

• A rating transition matrix is prepared by rating agencies to show the change in credit ratings over some time period.

• A rating transition matrix can be used to estimate downgrade risk and default risk.

• Liquidity risk is the risk that the investor will have to sell a bond below its indicated value.

• The primary measure of liquidity is the size of the spread between the bid and ask price quoted by dealers.

• A market bid-ask spread is the difference between the highest bid price and the lowest ask price from among dealers.

• The liquidity risk of an issue changes over time.

• Exchange rate risk arises when interest and principal payments of a bond are not denominated in the domestic currency of the investor.

• Exchange rate risk is the risk that the currency in which the interest and principal payments are denominated will decline relative to the domestic currency of the investor.

• Inflation risk or purchasing power risk arises from the decline in value of a security’s cash flows due to inflation, which is measured in terms of purchasing power.

• Volatility risk is the risk that the price of a bond with an embedded option will decline when expected yield volatility changes.

• For a callable bond, volatility risk is the risk that expected yield volatility will increase; for a putable bond, volatility risk is the risk that expected yield volatility will decrease.

• Event risk is the risk that the ability of an issuer to make interest and principal payments changes dramatically and unexpectedly because of certain events such as a natural catastrophe, corporate takeover, or regulatory changes.

• Sovereign risk is the risk that a foreign government’s actions cause a default or an adverse price decline on its bond issue.

PROBLEMS

1. For each of the following issues, indicate whether the price of the issue should be par value, above par value, or below par value:

2. Explain why a callable bond’s price would be expected to decline less than an otherwise comparable option-free bond when interest rates rise?

a. Short-term investors such as money market mutual funds invest in floating-rate securities having maturities greater than 1 year. Suppose that the coupon rate is reset everyday. Why is the interest rate risk small for such issues?

b. Why would it be improper to say that a floating-rate security whose coupon rate resets every day has no interest rate risk?

4. John Smith and Jane Brody are assistant portfolio managers. The senior portfolio manager has asked them to consider the acquisition of one of two option-free bond issues with the following characteristics:

Issue 1 has a lower coupon rate than Issue 2
Issue 1 has a shorter maturity than Issue 2

Both issues have the same credit rating.

Smith and Brody are discussing the interest rate risk of the two issues. Smith argues that Issue 1 has greater interest rate risk than Issue 2 because of its lower coupon rate. Brody counters by arguing that Issue 2 has greater interest rate risk because it has a longer maturity than Issue 1.

a. Which assistant portfolio manager is correct with respect their selection to the issue with the greater interest rate risk?

b. Suppose that you are the senior portfolio manager. How would you suggest that Smith and Brody determine which issue has the greater interest rate risk?

5. A portfolio manager wants to estimate the interest rate risk of a bond using duration. The current price of the bond is 82. A valuation model found that if interest rates decline by 30 basis points, the price will increase to 83.50 and if interest rates increase by 30 basis points, the price will decline to 80.75. What is the duration of this bond?

6. A portfolio manager purchased $8 million in market value of a bond with a duration of 5. For this bond, determine the estimated change in its market value for the change in interest rates shown below:

a. 100 basis points

b. 50 basis points

c. 25 basis points

d. 10 basis points

7. A portfolio manager of a bond fund is considering the acquisition of an extremely complex bond issue. It is complex because it has multiple embedded options. The manager wants to estimate the interest rate risk of the bond issue so that he can determine the impact of including it in his current portfolio. The portfolio manager contacts the dealer who created the bond issue to obtain an estimate for the issue’s duration. The dealer estimates the duration to be 7. The portfolio manager solicited his firm’s in-house quantitative analyst and asked her to estimate the issue’s duration. She estimated the duration to be 10. Explain why there is such a dramatic difference in the issue’s duration as estimated by the dealer’s analysts and the firm’s in-house analyst?

8. Duration is commonly used as a measure of interest rate risk. However, duration does not consider yield curve risk. Why?

9. What measure can a portfolio manager use to assess the interest rate risk of a portfolio to a change in the 5-year yield?

10. For the investor in a callable bond, what are the two forms of reinvestment risk?

11. Investors are exposed to credit risk when they purchase a bond. However, even if an issuer does not default on its obligation prior to its maturity date, there is still a concern about how credit risk can adversely impact the performance of a bond. Why?

12. Using the hypothetical rating transition matrix shown in Exhibit 4 of the chapter, answer the following questions:

a. What is the probability that a bond rated BBB will be downgraded?

b. What is the probability that a bond rated BBB will go into default?

c. What is the probability that a bond rated BBB will be upgraded?

d. What is the probability that a bond rated B will be upgraded to investment grade?

e. What is the probability that a bond rated A will be downgraded to noninvestment grade?

f. What is the probability that a AAA rated bond will not be downgraded at the end of one year?

13. Suppose that the bid and ask prices of five dealers for Issue XYX is 96 plus the number of 32nds shown:

What is the market bid-ask spread for Issue XYX?

14. A portfolio manager is considering the purchase of a new type of bond. The bond is extremely complex in terms of its embedded options. Currently, there is only one dealer making a market in this type of bond. In addition, the manager plans to finance the purchase of this bond by using the bond as collateral. The bond matures in five years and the manager plans to hold the bond for five years. Because the manager plans to hold the bond to its maturity, he has indicated that he is not concerned with liquidity risk. Explain why you agree or disagree with the manager’s view that he is not concerned with liquidity risk.

15. Identify the difference in the major risks associated with the following investment alternatives:

a. For an investor who plans to hold a security for one year, purchasing a Treasury security that matures in one year versus purchasing a Treasury security that matures in 30 years.

b. For an investor who plans to hold an investment for 10 years, purchasing a Treasury security that matures in 10 years versus purchasing an AAA corporate security that matures in 10 years.

c. For an investor who plans to hold an investment for two years, purchasing a zero-coupon Treasury security that matures in one year versus purchasing a zero-coupon Treasury security that matures in two years.

d. For an investor who plans to hold an investment for five years, purchasing an AA sovereign bond (with dollar denominated cash flow payments) versus purchasing a U.S. corporate bond with a B rating.

e. For an investor who plans to hold an investment for four years, purchasing a less actively traded 10-year AA rated bond versus purchasing a 10-year AA rated bond that is actively traded.

f. For a U.S. investor who plans to hold an investment for six years, purchasing a Treasury security that matures in six years versus purchasing an Italian government security that matures in six years and is denominated in lira.

16. Sam Stevens is the trustee for the Hole Punchers Labor Union (HPLU). He has approached the investment management firm of IM Associates (IMA) to manage its $200 million bond portfolio. IMA assigned Carol Peters as the portfolio manager for the HPLU account. In their first meeting, Mr. Stevens told Ms. Peters:

“We are an extremely conservative pension fund. We believe in investing in only investment grade bonds so that there will be minimal risk that the principal invested will be lost. We want at least 40% of the portfolio to be held in bonds that will mature within the next three years. I would like your thoughts on this proposed structure for the portfolio.”

How should Ms. Peters respond?

17.

a. A treasurer of a municipality with a municipal pension fund has required that its in-house portfolio manager invest all funds in the highest investment grade securities that mature in one month or less. The treasurer believes that this is a safe policy. Comment on this investment policy.

b. The same treasurer requires that the in-house portfolio municipality’s operating fund (i.e., fund needed for day-to-day operations of the municipality) follow the same investment policy. Comment on the appropriateness of this investment policy for managing the municipality’s operating fund.

18. In January 1994, General Electric Capital Corporation (GECC) had outstanding $500 million of Reset Notes due March 15, 2018. The reset notes were floating-rate securities. In January 1994, the bonds had an 8% coupon rate for three years that ended March 15, 1997. On January 26, 1994, GECC notified the noteholders that it would redeem the issue on March 15th at par value. This was within the required 30 to 60 day prior notice period. Investors who sought investments with very short-term instruments (e.g., money market investors) bought the notes after GECC’s planned redemption announcement. The notes were viewed as short-term because they would be redeemed in six weeks or so. In early February, the Federal Reserve started to boost interest rates and on February 15th, GECC canceled the proposed redemption. Instead, it decided to reset the new interest rate based on the indenture at 108% of the three-year Treasury rate in effect on the tenth day preceding the date of the new interest period of March 15th. The Wall Street Journal reported that the notes dropped from par to 98 ($1,000 to $980 per note) after the cancellation of the proposed redemption.¹ Why did the price decline?

19. A British portfolio manager is considering investing in Japanese government bonds denominated in yen. What are the major risks associated with this investment?

20. Explain how certain types of event risk can result in downgrade risk.

21. Comment on the following statement: “Sovereign risk is the risk that a foreign government defaults on its obligation.”

CHAPTER 3

OVERVIEW OF BOND SECTORS AND INSTRUMENTS

LEARNING OUTCOMES

After reading Chapter 3 you should be able to:

• explain how a country’s bond market sectors are classified.

• describe a sovereign bond and explain the credit risk associated with investing in a sovereign bond.

• list the different methods used by central governments to issue bonds.

• identify the types of securities issued by the U.S. Department of the Treasury.

• outline how stripped Treasury securities are created.

• describe a semi-government or government agency bond.

• for the U.S. bond market, explain the difference between federally related institutions and government sponsored enterprises.

• describe a mortgage-backed security and identify the cash flows for a mortgage-backed security.

• define prepayment and explain prepayment risk.

• distinguish between a mortgage passthrough security and a collateralized mortgage obligation and explain the motivation for creating a collateralized mortgage obligation.

• identify the types of securities issued by municipalities in the United States.

• summarize the bankruptcy process and bondholder rights.

• list the factors considered by rating agencies in assigning a credit rating to corporate debt.

• describe secured debt, unsecured debt, and credit enhancements for corporate bonds.

• describe a medium-term note and explain the differences between a corporate bond and a medium-term note.

• describe a structured note and explain the motivation for their issuance by corporations.

• describe commercial paper and identify the different types of issuers.

• describe the different types of bank obligations.

• describe an asset-backed security.

• summarize the role of a special purpose vehicle in an asset-backed securities transaction.

• explain the motivation for a corporation to issue an asset-backed security.

• explain a collateralized debt obligation.

• describe the structure of the primary and secondary market for bonds.

SUMMARY OVERVIEW

• The bond market of a country consists of an internal bond market (also called the national bond market) and an external bond market (also called the international bond market, the offshore bond market, or, more popularly, the Eurobond market).

• A country’s national bond market consists of the domestic bond market and the foreign bond market.

• Eurobonds are bonds which generally have the following distinguishing features: (1) they are underwritten by an international syndicate, (2) at issuance they are offered simultaneously to investors in a number of countries, (3) they are issued outside the jurisdiction of any single country, and (4) they are in unregistered form.

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

• Sovereign credits are rated by Standard & Poor’s and Moody’s.

• There are two ratings assigned to each central government: a local currency debt rating and a foreign currency debt rating.

• Historically, defaults have been greater on foreign currency denominated debt.

• There are various methods of distribution that have been used by central governments when issuing securities: regular auction cycle/single-price system; regular auction cycle/multiple-price system, ad hoc auction system, and the tap system.

• In the United States, government securities are issued by the Department of the Treasury and include fixed-principal securities and inflation-indexed securities.

• The most recently auctioned Treasury issue for a maturity is referred to as the on-the-run issue or current coupon issue; off-the-run issues are issues auctioned prior to the current coupon issue.

• Treasury discount securities are called bills and have a maturity of one year or less.

• A Treasury note is a coupon-bearing security which when issued has an original maturity between two and 10 years; a Treasury bond is a coupon-bearing security which when issued has an original maturity greater than 10 years.

• The Treasury issues inflation-protection securities (TIPS) whose principal and coupon payments are indexed to the Consumer Price Index.

• Zero-coupon Treasury instruments are created by dealers stripping the coupon payments and principal payment of a Treasury coupon security.

• Strips created from the coupon payments are called coupon strips; those created from the principal payment are called principal strips.

• A disadvantage for a taxable entity investing in Treasury strips is that accrued interest is taxed each year even though interest is not received.

• The bonds of an agency or organization established by a central government are called semi-government bonds or government agency bonds and may have either a direct or implied credit guarantee by the central government.

• In the U.S. bond market, federal agencies are categorized as either federally related institutions or government sponsored enterprises.

• Federally related institutions are arms of the U.S. government and, with the exception of securities of the Tennessee Valley Authority and the Private Export Funding Corporation, are backed by the full faith and credit of the U.S. government.

• Government sponsored enterprises (GSEs) are privately owned, publicly chartered entities that 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.

• A mortgage loan is a loan secured by the collateral of some specified real estate property.

• Mortgage loan payments consist of interest, scheduled principal payment, and prepayments.

• Prepayments are any payments in excess of the required monthly mortgage payment.

• Prepayment risk is the uncertainty about the cash flows due to prepayments.

• Loans included in an agency issued mortgage-backed security are conforming loans—loans that meet the underwriting standards established by the issuing entity.

• For a mortgage passthrough security the monthly payments are passed through to the certificate holders on a pro rata basis.

• In a collateralized mortgage obligation (CMO), there are rules for the payment of interest and principal (scheduled and prepaid) to the bond classes (tranches) in the CMO.

• The payment rules in a CMO structure allow for the redistribution of prepayment risk to the tranches comprising the CMO.

• In the U.S. bond market, municipal securities are debt obligations issued by state governments, local governments, and entities created by state and local governments.

• There are both tax-exempt and taxable municipal securities, where “tax-exempt” means that interest is exempt from federal income taxation; most municipal securities that have been issued are tax-exempt.

• There are basically two types of municipal security structures: tax-backed debt and revenue bonds.

• Tax-backed debt obligations are instruments secured by some form of tax revenue.

• Tax-backed debt includes general obligation debt (the broadest type of tax-backed debt), appropriation-backed obligations, and debt obligations supported by public credit enhancement programs.

• Revenue bonds are issued for enterprise financings that are secured by the revenues generated by the completed projects themselves, or for general public-purpose financings in which the issuers pledge to the bondholders the tax and revenue resources that were previously part of the general fund.

• Insured bonds, in addition to being secured by the issuer’s revenue, are backed by insurance policies written by commercial insurance companies.

• Prerefunded bonds are supported by a portfolio of Treasury securities held in an escrow fund.

• In the United States, the Bankruptcy Reform Act of 1978 as amended governs the bankruptcy process.

• Chapter 7 of the bankruptcy act deals with the liquidation of a company; Chapter 11 of the bankruptcy act deals with the reorganization of a company.

• In theory, creditors should receive distributions based on the absolute priority rule to the extent assets are available; this rule means that senior creditors are paid in full before junior creditors are paid anything.

• Generally, the absolute priority rule holds in the case of liquidations and is typically violated in reorganizations.

• In analyzing a corporate bond, a credit analyst must consider the four C’s of credit—character, capacity, collateral, and covenants.

• Character relates to the ethical reputation as well as the business qualifications and operating record of the board of directors, management, and executives responsible for the use of the borrowed funds and their repayment.

• Capacity deals with the ability of an issuer to pay its obligations.

• Collateral involves not only the traditional pledging of assets to secure the debt, but also the quality and value of unpledged assets controlled by the issuer.

• Covenants impose restrictions on how management operates the company and conducts its financial affairs.

• A corporate debt issue is said to be secured debt if there is some form of collateral pledged to ensure payment of the debt.

• Mortgage debt is debt secured by real property such as land, buildings, plant, and equipment.

• Collateral trust debentures, bonds, and notes are secured by financial assets such as cash, receivables, other notes, debentures or bonds, and not by real property.

• Unsecured debt, like secured debt, comes in several different layers or levels of claim against the corporation’s assets.

• Some debt issues are credit enhanced by having other companies guarantee their payment.

• One of the important protective provisions for unsecured debt holders is the negative pledge clause which prohibits a company from creating or assuming any lien to secure a debt issue without equally securing the subject debt issue(s) (with certain exceptions).

• Investors in corporate bonds are interested in default rates and, more importantly, default loss rates or recovery rates.

• There is ample evidence to suggest that the lower the credit rating, the higher the probability of a corporate issuer defaulting.

• Medium-term notes are corporate debt obligations offered on a continuous basis and are offered through agents.

• The rates posted for medium-term notes are for various maturity ranges, with maturities as short as nine months to as long as 30 years.

• Common structured notes include: step-up notes, inverse floaters, deleveraged floaters, dual-indexed floaters, range notes, and index amortizing notes.

• Commercial paper is sold on a discount basis and has a maturity less than 270 days.

• Asset-backed securities are securities backed by a pool of loans or receivables.

• The separation of the pool of assets from the issuer is accomplished by means of a special purpose vehicle or special purpose corporation.

• There are two general types of credit enhancement structures: external and internal.

• The asset manager in a collateralized debt obligation is responsible for managing the portfolio of assets (i.e., the debt obligations backing the transaction) and there are restrictions imposed on the activities of the asset manager.

• Collateralized debt obligations are categorized as either arbitrage transactions or balance sheet transactions, the classification being based on the motivation of the sponsor of the transaction.

• A bond can be placed privately with an institutional investor rather than issued via a public offering.

• Bonds typically trade in the over-the-counter market.