US Treasury Debt Overview:

• Characteristics
  • Issued directly by the US Government
  • Highly liquid; no credit risk 
• Taxation of Interest
  • Interest taxable at federal level
  • Interest exempt at state and local levels

T-Bills, T-Notes, and T-Bonds:

• Treasury securities are considered marketable securities since they are traded in the secondary market after issuance
• T-bonds, and T-Notes are interest-bearing securities that have all of the attributes of traditional fixed-income investments
• Each pays a fixed rate of interest semi-annually and the investors receive the face value at maturity 

• Book Entry: No physical certificate printed. You go on record as owning the bonds
• T-Bills Issued discount, mature at face value, the difference is your interest

Pricing of Government Securities:

• Government bonds such as T-Notes, T-Bonds, and Agency Securities trade in increments of 1/32 of a point
• However, T-Bills are quoted on a discount yield basis, not dollar
  • In a T-bill dealer’s quotation, the bid’s higher yield represents a lower price; the ask’s lower yield is a higher price
• BID: 2.94%
• ASK: 2.90%
• The Bid is how much the buyer is willing to buy for a discount of 2.94%

TIPS:

• How can treasury investors protect themselves from inflation?
  • Acquire protection by investing in Treasury Inflation-Protected Securities (TIPS)
    • TIPS Offer a Stated Coupon with Interest paid Semi-Annually
    • Adjust Principal for inflation and deflation, based on CPI
    • You get the adjusted principal back, however if there is deflation, you will at MOST get your par value back, it won’t go below.

T-STRIPS: Non-interest bearing

• Created in the secondary market by broker dealers and banks 
• Issued at a discount and mature at face value
• Forms of zero-coupon debt created from T-Notes and T-Bonds
• Issued with a variety of maturities 

Bidding at the Auction:

• Auction: The government sells Treasuries through auctions conducted by the US Treasury
• Competitive Bids:
  • Placed by large financial institutions
  • Indicate both quantity and price
• Non-competitive Bids
  • Placed by the public
  • Indicate quantity only
  • Are filled first
  • Bidder agrees to pay the lowest price (highest yield) of the accepted competitive bids 
• T-Bills
  • Settle on the Thursday following the auction (Typically auctioned off Monday also Tuesday)

Bidding Example:

• $100M bond offering at 4.5% coupon
• Bids:
  • $20M (non-competitive)
    • Will be filled first, but we’re not sure of the price yet. So, we look at the competitive prices
  • $40M at 4.9%
    • FILLED because willing to pay lower yield and higher price
  • $40M at 5%
    • FILLED
  • $30M at 5.1%
    • NOT FILLED
• The Result?
  • The highest bid is 5%; therefore, all bidders get a 5% yield and the auction clears at 5%

Agency Securities:

• Debt instruments issued and/or guaranteed by federal agencies and GSEs (Government Sponsored Enterprises)
• Exempt from state and federal registration 
• Quoted in 32nds
• Accrued interest based on 30 days in the month, rather than using actual number of days 
• Issued in book-entry form

Farming Loans & Mortgage-backed Securities:

• Federal Farm Credit Bank (FFCB)
  • Provides agricultural loans to farmers
  • Subject to federal tax, but exempt from state and local taxes
• Mortgage-backed Securities represent an interest in a pool of mortgages
  • Monthly payments consist of interest and principal
  • Interest portion is fully taxable (federal, state, local)
  • Subject to prepayment risk
    • Risk you might get principal paid back quicker than originally expected. Because homeowners can prepay mortgages (if they move houses OR because interest rates fell and homeowners can refinance their mortgage)
    • If the mortgage is at 6% but rates fell to 4%, they would refinance to get the 4%. The person who bought into the MBS at 6% gets their money back quicker
    • If rates fall, prepayment increases. These pass-throughs offer a higher yield though
• Agencies that issue mortgage-backed securities include:
  • GNMA or Ginnie Mae (guaranteed by government entity)
  • FNMA or Fannie Mae (government agency)
  • FHLMC or Freddie Mac (government agency)
• Note: The most common security issued by government agencies is a mortgage-backed pass-through certificate. Pass-throughs provide excellent credit quality and a slightly higher yield than Treasuries; they are often used to supplement retirement income

Questions:

• Although agency securities are not direct obligations of the US government, their credit risk is still considered low
• Agency securities are exempt from state and federal restrictions
• The Federal Farm Credit Bank (FFCB) is an example of a GSE or non-mortgage backed entity
• Ginnie Mae, Fannie Mae, and Freddie Mac are examples of mortgage-backed securities
• Mortgage-backed securities represent an interest in a pool of mortgages
• Prepayment risk is unique to mortgage-backed securities
• Agency pass-throughs provides excellent credit quality and a slightly higher yield than Treasuries

Municipal Bonds and their Issuers:

• States and political subdivisions
  • Cities, counties, school districts
• Public agencies and authorities
  • Transit systems, housing authorities, water, sewer, and electric systems
• Territories
  • Puerto Rico, Guam, US Virgin Islands 

Types of Municipal Bonds:

• General Obligation (GO) Bonds:
  • Purpose:
    • Issued for general purposes to meet any need of the issue
  • Sources for payment of debt service
    • Taxes
    • Issuer’s full faith and credit
  • State level
    • Sales tax, income taxes
  • Local level
    • Ad Valorem (property taxes)
      • Assessed value * millage (tax) rate = tax bill (1 mill = 0.001)
      • parking/licensing fees 
• Revenue Bonds:
  • Purpose:
    • Issued to fund a specific project
  • Sources for payment of debt service
    • Revenue (user fees) from a specific project
      • You go over a bridge, you have to pay a toll, that’s how this is being backed. NOT backed by taxes. If revenue is insufficient, these bonds can default
  • Typical projects
    • Toll roads, bridges, stadiums, airports
  • Considered:
    • Self-supporting debt (revenue produced facility that it’s being used to finance)

GO Bonds have higher credit than Revenue Bonds because they’re backed by taxes 

• Only ones that are subject to taxes are subject to debt limitations

Types of Revenue Bonds:

Municipal Notes:

• Municipal notes, or Tax-Free Anticipation Notes, are short-term issues that are normally issued to assist in financing a project or to assist a municipality in managing its cash flow
  • Issued in anticipation of some future event that’ll be used to pay off the notes
• Types include:
  • Tax Anticipation Notes (TANs)
  • Revenue anticipation notes (RANs)
  • Bond Anticipation Notes (BANs)
  • Grant anticipation notes (GANs)
• These notes are short-term, generally 1 year or less

Ratings for Municipal Notes:

• Make sure you know that MIG Ratings are for Municipal Notes
• MIG 1 through 3 are all investment grade
  • The IG in MIG stands for investment grade

Municipal Bond Underwriting:

Interest on Municipal Bond is EXEMPT from Federal Taxes, so they might offer a lower yield

• If you bought a municipality from a different state, you may have to pay taxes. Depends on the state

Corporate Bonds:

• Corporations that issue bonds use the proceeds from the offering for many purposes – from building facilities and purchasing equipment to expanding their business
• The advantage is that the corporation does not give up any control or portion of its profits
• The disadvantage is that the corporation is required to repay the money that was borrowed + interest
• Although buying corporate bonds put an investor’s capital at less risk than purchasing stock of the same company, bonds typically don’t offer the same potential for capital appreciation as common stocks

Types of Corporate Bonds

• Corporate bonds are divided into two major categories – secured and unsecured
• Although all debt that is issued by a corporation is backed by the issuer’s full faith and credit, secured bonds are additionally backed by specific corporate assets 

Unsecured bonds are sometimes called debentures

Secured Bonds:

• Mortgage bonds
  • Mortgage bonds are secured by a first or second mortgage on real property
  • Bondholders are given a lien on the property as additional security for the loan
  • Collateral: real estate 
• Equipment Trust Certificates
  • Secured by a specific piece of equipment that’s owned by the company and used in its business
  • Trustee holds legal title to the equipment until the bonds are paid off
  • Usually issued by transportation companies and backed by the company’s rolling stock
  • Collateral: planes, trains, trucks 
• Collateral Trust bonds
  • Secured by third-party securities that are owned by the issuer
  • Securities (stocks and/or bonds of other issuers) are placed in escrow as collateral for the bonds
  • Collateral: securities (stocks, bonds) of other companies

Unsecured Bonds

• When corporate bonds are backed by only the corporation’s full faith and credit, they are referred to as debentures. If the issuer defaults, the owner of these bonds have the same claim on the company’s assets as any other general creditor
• Occasionally, companies issue unsecured bonds that have a junior claim on their assets compared to its other outstanding unsecured bonds. These bonds are referred to as subordinated debentures
  • In case of default, the owner’s claims are subordinate to those of the other bondholder. Therefore, the owners of subordinated debentures will be paid after all of the other bondholders, but still before stockholders

Liquidation proceedings:

• Secured creditors, including secured bonds 
• Administrative expenses claims (taxes, current wages, lawyer and accountant fees)
• General creditors (unsecured creditors or debentures)
• Subordinated creditors (subordinated debentures)
• Preferred stockholders
• Common stockholders

Other Types of Corporate Bonds

• Income bonds
  • Normally issued by companies in reorganization
  • Issuer promises to repay the principal amount at maturity, but NOT interest unless it has sufficient earnings 
• Eurodollar bonds
  • Pay their principal and interest in USD, but are issued outside of the US (primarily in Europe)
  • Issuers include foreign corporations, foreign governments, and international agencies, such as the World Bank
• Yankee bonds
  • Allow foreign entities to borrow money in the US marketplace
  • Registered with the SEC and sold primarily in the US
• Eurobonds
  • Sold in one country, but denominated in the currency of another
  • Issuer, currency, and primary market may all be different 
  • Japanese issuer, issuing Euro denominated bonds, in South America

Which of these statements are TRUE with regards to corporate bonds?

• Buying corporate bonds put an investor’s capital at less risk than purchasing stock
• With corporate bonds, the corporation gives up control as well as a portion of profits
• Interest must be paid on bonds before dividends are paid on stock
• The corporation is required to repay the money that was borrowed plus interest 

Matching:

• Income bonds: issuer makes no promise of interest payments
• Eurodollar: bond issued outside the US, but pays debt service in US dollars
• Yankee: bond issued in the US by a foreign entity 
• Unsecured: corporate bond backed only by the corporation’s full faith and credit
• Collateral trust: secured by third-party securities that are owned by the issuer

Money Market Instruments

• Characteristics:
  • Short-term debt instruments (one year or less to maturity)
  • Provide safety of principal and liquidity
  • Suitable for investors who seek safety when intending to make a purchase in the near future or while evaluating different investment options
• Principal types:
  • T-bills – short-term Treasury debt
  • Banker’s Acceptances (BAs) – facilitate foreign trade (import/export)
  • Commercial Paper – unsecured corporate debt
  • Negotiable Certificates of Deposit (CDs) – unsecured bank debt ($100,000 minimum)
    • Negotiable means it trades in the secondary market
    • FDIC insures up to $250,000
  • Repurchase Agreement (Repos) – a dealer selling securities to another dealer with the agreement to repurchase at a slightly higher price
    • Difference is your interest

Matching:

• Banker’s acceptance (used for foreign trade)
• REPO (involves two transactions)
• CD (unsecured bank debt)
• Commercial paper (unsecured corporate debt)
• T-Bill (Treasury debt)