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Financial Securities
Financial Securities
Learning Objectives
You will discover the different types of fixed-income securities. You will understand the fundamental features of bonds. You will learn about the different types of securities issued by the Treasury. You will be able to show how zero-coupon Treasury securities are created. You will study the provisions for paying off a corporate bond issue prior to the maturity date. You will investigate the different credit ratings for a corporate bond issue.
Learning Objectives
You will understand the two types of municipal bonds: general obligation bonds and revenue bonds. You will be able to identify types of securities issued in the Eurobond market. You will discover the characteristics of preferred stock. You will study the cash flow characteristics of a mortgage loan and the meaning of prepayment risk. You will explore the three types of mortgage-backed securities: mortgage pass-through securities, collateralized mortgage obligations, and stripped mortgage-backed securities. You will investigate the different types of asset-backed securities.
Introduction
In this chapter we turn to another major asset class, fixed-income securities. We will describe basic features and then discuss the variety of investment vehicles available in this asset group. This serves as an introduction to the rest of Section V.
Bond fundamentals
Some definitions Fixed income security issuer (borrower) agrees to make income payments fixed by contract Bonds (debt obligations) borrower makes interest payments Preferred stock an equity issue with fixed income payments of dividends Term to maturity date when debt ceases, with maturity being that exact date and term denoting the number of years till that date Par value (maturity value, face value) amount issuer agrees to pay at maturity Coupon periodic interest payment made to bondholders Coupon rate rate of interest usually paid semiannually for U.S. issues; multiplied by par value yields dollar value of coupon
Bond fundamentals
Zero-coupon bonds no periodic interest payments; principal and interest paid at term Floating rate security coupon rate is reset periodically Insert Table 22-1
Treasury inflation protection securities (TIPS) principal is indexed to CPI- U with real rate being fixed
Except for farm related securities, these are not backed by the U.S. government.
Corporate bonds
The issuer agrees to make coupon payments and repay the principal value of the bond at maturity. If the institution cannot pay, it is in default. Bondholders have first claim to the income and assets of a corporation. Embedded option options are embedded in the bond issue Bare option trades separately from the underlying security Term bonds (bullet) can be retired by payment at final maturity or paid off earlier if so stated in the bond indenture or contract Serial bonds specified principal amounts are due on specified dates Medium-term notes continuously offered to investors over a period of time
Sinking-fund provision
Indenture requires issuer to retire a specified portion of an issue each year in order to reduce credit risk if only part is paid, remainder is a balloon maturity Sinking fund can be satisfied by -Making a cash payment of the face amount of the bond to be retired to the corporate trustee who then calls bonds using a lottery system -Delivering bonds to the trustee with a total face value = amount that must be retired from bonds purchased in the open market Embedded option issuer can accelerate repayment of principal
Credit ratings
Insert Table 22-3 Ratings apply to the issue, not the issuer and are an opinion as to the issuers ability to meet its obligations.
Municipal securities
These debt obligations are issued by state and local governments. Their structures are either serial maturity or term maturity. Serial maturity portion of the debt is retired each year Term maturity - debt is retired in maturities ranging from 20-40 years with sinking fund provisions beginning 5 10 years prior to maturity
Revenue bonds
These are bonds issued for project or enterprise financings where the revenues from the project are promised to the bondholders. Examples include airports, universities, sports complex bonds and water revenue bonds. All revenues from the enterprise are placed in a revenue fund with disbursements to funds covering -operation and maintenance fund -sinking fund -debt service reserve fund -renewal and replacement fund -reserve maintenance fund -surplus fund
Eurobonds
A Eurobond is 1.underwritten by an international syndicate 2.offered, at issuance, simultaneously to investors in a number of countries 3.issued outside the jurisdiction of any single country 4.mostly traded in OTC market Euro straights fixed-rate coupon bond with annual coupons Dual currency issues interest and principal are paid in different currencies Convertible Eurobond can be converted to another asset Many Eurobonds trade with attached warrants.
Preferred stock
Preferred stock is not a debt instrument, but a senior security with dividends set at a percentage of par value (dividend rate). -Dividends are a distribution of earnings. However, 70% of this income is exempt from federal taxation if the recipient is a qualified corporation. -Promised returns to holders of preferred are fixed -Preferred holders have priority over common stockholders for dividends and liquidation distributions Cumulative preferred if issuer cannot make a payment, the dividend accrues until fully paid Non-cumulative preferred if issuer cannot make a payment, owner forgos the payment Perpetual preferred issues without a maturity date
Mortgages
A mortgage is a loan secured by the collateral of some specified real estate property which obliges the borrower to make a predetermined series of payments. The lender can foreclose on the borrower is the debt is paid. Interest rate = mortgage rate Conventional mortgage loan is based on the credit of the borrower and the collateral for the mortgage (a residence).
Types of pass-throughs
Agency pass-throughs -Government National Mortgage Association (Ginnie Mae) -Federally related institution, so is based on full faith and credit of U.S. government -Federal Home Loan Mortgage Corporation (Freddie Mac) -Federal National Mortgage Association (Fannie Mae) Agency can guarantee two ways: -Fully modified - timely payment of both interest and principal -Modified - timely payment of interest only, with principal payment simply guaranteed Non-agency pass throughs -Conventional pass throughs -Private-label pass-throughs
Asset-backed securities
Securities backed by Credit card receivables Auto loans Home equity loans Manufactured housing loans These account for about 95% of the total market.
Credit risk
In analyzing the risk of asset-backed securities we focus on: 1.Credit rating of the collateral 2.Quality of the seller/servicer 3.Cash flow stress and payment structure 4.Legal structure
Rating companies analyze structure to determine if the collaterals cash flow meets the necessary payments.
Legal structure
Bankruptcy-remote special purpose corporation (SPC) SPC is the issuer of the asset-backed security; underlying loans are used for collateral for a debt instrument rater than general credit of issuer with the corporate entity retaining some interest. If the issuer enters bankruptcy, the SPC will avert a bankruptcy court consolidation of the collateral with the assets of the seller. SPC is a wholly-owned subsidiary of the seller of the collateral. Collateral sold to SPC SPC sells to the trust Trust holds collateral for investors SPC hold the interest retained by seller of collateral
Auto loan
Issued by Financial subsidiaries of auto manufacturers Commercial banks Independent finance companies Cash flow Scheduled monthly loan payments (interest and principal); amortized Prepayments resulting from Sales and trade-ins requiring full pay off Repossession and resale Loss or destruction of vehicle Cash payoff to save on interest cost Refinancing of loan at lower interest cost
Auto loan
Pass through structure senior tranche and subordinated trance with an interest-only class (used for smaller deals) Pay through structures senior pieces tranched to create a range of lives with untranched subordinated piece (larger deals) Credit enhancement Senior/subordinated structure: cash reserves or overcollateralization