CFA Level I

Study Session 15 Reading 52

Reading 53
Reading 54
Reading 55
Features of Debt Securities
Risks Associated with Investing in Bonds
Overview of Bond Sectors and Instruments
Understanding Yield Spreads
 CFA Level I: Fixed Income
LOS 54:
Overview of bond sectors and instruments
• Describe features, Credit risk characteristics and distribution methods of
government securities.
• describe the types of securities issued by the U.S. Department of the treasury (e.g.
bills, notes, bonds, and inflation protection securities), and differentiate between
on-the-run and off-the-run Treasury securities
• Describe how stripped treasury securities are created and differentiate between
coupon strips and principal strips
• describe the types and characteristics of securities issued by U.S. federal agencies.
• describe the types and characteristics of mortgage-backed securities and explain
the cash flow, prepayments, and prepayment risk for each type
• state the motivation for creating a collateralized mortgage obligation
 CFA Level I: Fixed Income
LOS 54:
Overview of bond sectors and instruments
• describe the types of securities issued by municipalities in the United States and
distinguish between tax-backed debt and revenue bonds
• describe the characteristics and motivation for the various types of debt issued by
corporations
• define an asset-backed security, describe the role of a special purpose vehicle in an
asset-backed security's transaction, state the motivation for a corporation to issue
an asset-backed security, and describe the types of external credit enhancements
for asset-backed securities
• describe collateralized debt obligations
• describe the mechanisms available for placing bonds in the primary market and
differentiate the primary and secondary markets in bonds
Government bonds
The U.S. Government issues four types of securities:

Treasury Bills - maturity of less than 12 months and are issued at a discount to par value. Return is the difference
between the purchase price and the maturity price.

Treasury Notes - maturity of one to ten years, coupon rate set by the market place at issue, issued at par value and
mature at par value.

Treasury Bonds - Treasury bonds are the same as treasury notes except that they have maturities that are greater
than ten years.

Treasury Inflation Protected Securities (TIPS) - TIPS are issued as notes or bonds and help to protect the investor
against inflation risk.

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On the run & off the run

On-the-run securities are the most current security issued by the U.S. Treasury Department. These issues tend to be
more liquid in the marketplace.

Off-the-run securities are the securities that are replaced by the on-the-run securities. These issues tend to be less
liquid in the marketplace.

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Stripped Treasury securities

Stripped treasury security is a zero coupon bond created from treasury notes and bonds.
• No credit risk
• Maturity greater than one year

Strips created from coupon payments are called coupon strips.

Strips created from principal payments are called principal strips.

Coupon strips accrue interest and are taxed each year even though interest is not paid until maturity. This causes
negative cash flows for a taxable entity. Foreign investors often like principal strips because of the preferred tax
treatments they can receive in their home countries.

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Federal agencies securities

• Federally related institutions – GNMA, TVA

• Government sponsored enterprises – Fannie Mae, Freddie Mac, Sallie Mae

• Debentures

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Mortgage backed securities

An investment instrument that represents ownership of an undivided interest in a group of mortgages.

Principal and interest from the individual mortgages are used to pay investors' principal and interest on the MBS.

 Mortgage passthrough securities

 Collateralized mortgage obligation (created from mortgage passthrough)

 Created to distribute prepayment risk
 To create different maturity ranges

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Municipality securities
Municipal bonds – debt securities issued by state and local government. These are tax-exempt bonds.

Two types of municipal bonds:

1. Tax – backed debt(general obligation)- backed by full faith, taxing power of the issuer.
1. Limited tax GO debt
2. Unlimited tax GO debt

2. Revenue bonds – backed only by the revenues generated through the project.

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Special bond structures
Insured bonds - carry the guarantee of a third party that all principal and interest
payments will be made in a timely manner. The third-party guarantee (insurance)
typically cannot be cancelled.

Pre-refunded bonds are bonds for which Treasury securities have been purchased and
placed in a special escrow account in an amount sufficient to make all the remaining
required bond payments.

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Corporate securities

• Corporate bonds
– Secured bonds (mortgage debt, collateral trust bonds)
– Credit enhanced bonds (third party guarantee, LOC)
– Unsecured bonds (debentures)

• Medium term notes

• Commercial paper
– Directly - placed
– Dealer - placed

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Asset backed securities
An ABS is a security that is backed by a pool of loans or receivables. These include: auto loans, consumer loans,
commercial assets (planes, receivables), credit cards, home equity loans, and manufactured housing loans.

ABS sells its assets to special purpose vehicle(SPV)

• finance a large project without putting the entire firm at risk

• to move some illiquid asset off the balance sheet.
• enhanced credit rating

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Credit enhancement

• Internal enhancements
– Reserve funds
– Over collateralization
– Senior/subordinate structures

• External enhancements
– Corporate guarantee
– Letter of credit
– Bond insurance

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Collateralized debt obligations

A CDO is a product backed by a diversified pool of one or more of the following types of debt obligations:

• U.S. domestic investment-grade and high-yield corporate bonds

• U.S. domestic bank loans.
• emerging market bonds
• special situation loans and distressed debt
• foreign bank loans
• asset-backed securities
• Residential and commercial mortgage- backed securities
• Other CDOs

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Primary and secondary markets
• The primary market is where new bonds are distributed and sold. Investors purchase bonds directly from issuers
or their agents.
– Firm commitment
– Best effort basis
– Private placement

• The secondary market is where bonds are traded between investors after issue on the primary market. Investors
can liquidate their bonds before maturity here.(OTC, electronic trading networks)

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