Fixed Income Exam 2 - Mark Olson, Test 2 study guide PDF

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Mark Olson, Test 2 study guide...

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Chapter 6 ● Treasury securities - backed by full faith of US government, have minimal risk ○ Volume and liquidity ○ Treasury market most active and liquid in world ○ Noncallable so investors not subject to call risk ○ Subject to income taxes but exempt from state and local income taxes ● Fixed principal treasury securities ○ Treasury bills - less than 1 year to maturity, issued at discount to par, have no coupon rate and mature at par value ■ No coupon interest ■ Return to investor is dif between maturity value and purchase price ○ Treasury notes - one to 10 years of maturity ○ Treasury Bonds - 10 or more years to maturity ● Floating rate note makes quarterly payments ● TIPS - Treasury inflation protected securities - securities that adjust for inflation ○ Coupon rate set as fixed rate - rate determined by an auction process ○ Coupon rate = real rate → rate investor earns above inflation rate ○ Inflation-adjusted principal - principal the Treasury Department will base both dollar amount of coupon payment and maturity value is adjusted semiannually ■ This is basis for computing coupon interest for first 6-month period ■ Can be less than initial par value of disinflation ■ Inflation adjusted principal must be calculated for settlement date ● Defined in terms of index ratio ○ US government decides tax adjustment each year making TIPS less attractive as investments in accounts of tax paying entities Treasury Auction Process ● Treasury securities sold in primary market through seal-bid dealers ● Each auction announced days in advance through press release providing details of offering, offering amount, term and type of security ● Auction for treasury securities conducted on competitive bid basis ● 2 types of bids: ○ Non-competitive bid - submitted by entity that is willing to purchase auctioned security at the yield that is determined by auction process ■ Bidder only specifies quantity sought ■ Quantity cannot exceed $5 million ○ Competitive Bid - specifies both quantity sought and yield at which bidder is willing to purchase the auctioned security ■ Bidders arranged from lowest bid yield to higher yield bid submitted ● Auctions results determined by

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First subtract noncompetitive bids and nonpublic purchases from total securities auctioned ○ Remainder amount is awarded to competitive biggers ○ Started with lowest yield bid, all competitive bids accepted until amount to be distributed to competitive bidders is completely allocated ○ Highest yield accepted is Stop-Out Yield ( high yield) ○ All US treasury auctions are single price auctions ■ All bidders awarded securities at highest yield of accepted competitive bidders Secondary Market ● Over the counter market where US govt securities dealers offer continuous bids and ask prices on outstanding treasuries ● Primary locations are NY, London, Tokyo ● On the Run issue - most recently auctioned issue ● Off the Run issue - securities replaced by the on the run issue ○ Can be more than one off the run issue with same maturity remaining as on the run ● When-Issued market (wi market) - securities trader prior to time they are issued by Treasury ● Interdealer brokers - who investing public and other dealer firms trade though to trade with each other ○ Used because speed and efficiency Price Quotes for Treasury Bonds ● Bids and offers on Treasury Bills are quoted on bank discount basis (not price basis) ○ Yield on bank discount basis: Yd = (D/F) * (360/t) D = face value - price ● Quoted yield on bank discount basis not meaningful because: ○ Measure based on face value investment instead of actual dollar amount invested ○ Yield is annualized according to 360 days a year rather than 365 days so difficult to compare Treasury bill yield with Treasury notes and bonds who use 365 day basis ● Bond equivalent yield - measure that makes treasury bill quote comparable to treasury notes and bonds ● CD equivalent yield makes quoted yield on treasury bill more comparable to yield quotations on other money market instruments that pay interest on 360-day basis ○ CD equivalent yield = (360*Yd) / (360 - t(Yd)) ● Treasury coupon securities quoted on price basis in points (one point = 1% of par) ○ Points split into 32nds, 64th and 356th ■ 96-14 → price of 96 and 14 32nds 96 + (14/32) = price ■ 91-19+ → 19 32nds and 1 64th + means 64th ■ 107- 222 → 22 32nds and 2 256ths ■ 109-066 → 6 32nds, 6 256ths

Accrued interest - amount buyer must pay seller for coupon interest earned from time of last coupon payment to settlement date of bond ○ 3 pieces of information to calculate accrued interest: ■ Number days in accrued interest period → (this is # days over investor earns interest) ■ Number days in coupon period ■ Dollar amount of coupon payment AI = (annual dollar coupon / 2) * (days in AI period/days in coupon period) ● Trade date - date transaction executed ● Settlement date - date transaction completed ● Actual/actual day count convention - actual number of days between settlement date and next coupon payment date Stripped Treasury Securities ● Treasury does not issue zero coupon notes or bonds ○ Because demand for zero coupon instruments with no credit risk, private sector created securities ● Zero coupon treasury securities - identify with particular dealer that created them so reduce liquidity ○ Involved legal and Insurance costs ● STRIPS - Separate Trading of Registered Interest and Principal of Securities - program to facilitate strippping of treasury securities ○ All treasury notes and bonds eligible for stripping ○ On quote sheets, STRIPS identified by whether cash flow is created from: ■ coupon (ci) ■ Treasury bond bp ■ Principal from treasury note, np ● Coupon strips - strips created from coupons ● Principal strips - strips created from principal ○ Difference between coupon and principal strips due to tax treatment ● all fixed principal notes and bonds that pay interest on same dates are assigned same CUSIP number ● Tax Treatment ○ Disadv of taxable entity investing in stripped Treasury is accrued interest is taxed each year even through interest not paid ■ Negative cash flow instruments until maturity date since tax payments on interest earned but not yet received in cash must be made ○ Distinguish between coupon and principal strips is foreign buyer have preference for principal strips ■ Due to tax treatment of interest in their home country → treat interest from principal as capital gain Reconstructing a Bond ● Reconstitution - process of purchasing a package of zero coupon treasury securities so that the cash flow of the package of securities replicates the cash flow of mispriced ●

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coupon treasury security so investor realizes yield higher than yield on coupon Treasury security Process of coupon strippping and reconstitution that will prevent actual spot rate curve observed on zero coupon Treasuries from departing significantly from theoretical spot rate curve

Federal Agency Securities ● Federal agency securities - securities issued by government-charted entities ○ Entities either federally related institutions of govt sponsored enterprises (GSE) ○ GSE - privately owned, publicly chartered entities ■ Instrumentalities, not agencies, of US govt that provide them privileges not granted to public sector ● Major issuers: ○ Fannie Mae - federal national mortgage association ○ Freddie Mac - Federal Home Loan Mortgage Corporation ○ Federal Home loan bank ● Credit quality - implicit ability to borrow from US treasury, but no explicit or implicit guarantee ● Because of credit risk, federal agency securities trade at higher yield in market than US treasury securities ○ Trading volume less than US treasury market ● Debenture - typical bond used by other issuers in bond market ● Mortgage-backed security - more known, security backed by pool of residential mortgage pans Fannie Mae & Freddie Mac ● Fannie Mae - issued benchmark bills/notes/bonds, callable benchmarked notes, subordinated benchmark notes, investment notes, callable securities, structured notes ○ Benchmark notes and bonds noncallable ○ 2,3,5,10 and 30 year securities issued ● Freddie Mac - issued reference bills, discount notes, medium term notes, reference notes and bonds, callable reference notes, global bonds, euro reference bonds ○ Reference bills and discount notes issued with one yer or less maturities ○ Reference notes and bonds have 2-30 year maturity ○ Callable reference notes have 2-10 year maturity ● Federal Housing Finance Agency FHFA has complete control over the operations and asset of these two GSEs Federal Farm Credit Bank System ● FFCBS - created to facilitate supply of credit to agricultural sector ● 3 Entities: ○ Federal Land Banks ○ Federal Intermediate Credit Banks ○ Bank for Cooperatives ● Interest income generally exempt from state and local income taxes ● Farm credit issues debt:

○ Farm credit discount notes - 1-365 day maturities like US treasury bills ○ Farm credit designated bonds - callable or noncallable, 2-10 year maturity ○ Can be customized for institutional investors as structured notes Federal Agricultural Mortgage Corporation ● Provides secondary market for first mortgage agricultural real estate loans ● Farmer Mac raises funds by selling debentures and mortgage backed securities backed by loans purchased ○ These loans are agricultural mortgage backed securities Federal Home Loan Bank System ● Cnosits 12 Federal Home Loan Banks and their member banks ● Each member bank issues consolidated debt obligations, which are joint ○ Debt obligation are discount notes with maturities 1-360 days and longer term debt that include issues with bullet maturity, callable and floating rate interest Tennessee Valley Authority ● Created by congress to flood control, navigation and agricultural and industrial development ● TVA largest public power system in US ● Self funded agency of US govt it obtains funds from operating revenue and capital markets by issuing debt obligation ● Issues debt only for power program purposes ● Not guaranteed by US govt but debt obligations are triple A rated because US govt owned and has financial strengths ● TVS Discount Notes - 1 year or less maturity ○ Offerened on continuous basis ● TVS Power Bonds - can have maturity up to 50 years, variety of structure in 2 programs ○

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TVA Electronotes program - target individual investors ■ Bonds issue monthly, up to 30 year maturity, standard callable bonds with put option “estate feature: ■ Estate feature - put option allows bonds to be redeemed at par value plus accrued interest if death of bondholder Putable Automatic Rate Reset Securities (PARRS) Program - target individual investors ■ Noncallable bonds issued with fixed coupon rate for first 5 years, then annual reset provision that provides reduction in issue’s coupon rate under certain conditions ■ Bondholder has right to put the bond at par value plus accrued interest if and when coupon rate reduced

Chapter 6 HW problems 1,2,5-8, 11-17 1. Treasury Bill - maturity of one year or less, discounted to par value when issued

→ have zero coupon rate Treasury Note - one to 10 year maturity, pay coupon, issued at par Treasury Bond - has original maturity greater than 10 years, also pay coupon payments 2. TIPS a. Real rate is the coupon rate → the rate investors earns above the inflation rate i. Coupon rate remains constant throughout, but principal changes due to inflation b. Inflation-adjusted principal - is principal the treasury department will base both dollar amount of coupon payment and maturity value on is adjusted semi-annually i. Take coupon payment, based on principal and coupon rate (which remains the same). Principal takes into account inflation and makes the adjustment for inflation to our principal c. Coupon rate 3%, $10,000 par value, semiannual inflation of 1% i.) Dollar coupon interest paid in cash at the end of the first 6 month? 10,000(1.01) = $10,100 .03/2 = .015 10,100(.015) = $151.50 ii.) inflation adjusted principal at end of 6 months $10,000 principal (1.01) = 10,100 If go another period at 1% inflation 10,100 *(1.01) = 10,201 $10,201(.015) = $153.015 d. Buy 5 year TIPS and deflation for the whole period. The principal paid by Department of Treasury at maturity date is principal greater than the initial par value or the maturity value adjusted for inflation → Principal paid will be $10,000 - can go up but nothing less than initial principal Always receive the greater of our principal e. Daily index ratio - look at what kind of inflation we experienced -- look at CPI and see how much inflation i. 3 month lag here -- how we come up with inflation and how we will adjust principal f. Interest income on TIPS at federal level of tax → adjust for inflation so get $150

Get another 150 (1.50 of ajustement) that is taxed as well 5. Yd = D/F (360/t) =20,000/1,000,000 (360/90) = 8% 6. T-bill quoted at 5.91% and 5.89% Quote these based on yields Price for security at 5.91 will be lower than 5.89 because inverse relationship between price and yield 7. a. 84.14 84 +14/32 = 84,437 b. 84.14+ 84 + 14/32 + 1/64 = 84,458.13 c. 103.284 103 + 28/32 + 4/256 = 103,890.63 d. 105.059 105+0/32 + 9/256 = 105,191.41

8. Noncompetitive bidder - does specify how much want to buy, but not asking for specific bid, just set up for whatever austin process sets yield at High-yield - the stop bid → highest yield they run through and don't go higher

EXAMPLE = offering = Non competitive bid Competitive offering Bids 1. 2.998% 3.5 b 2. 2.999% 2.5 b 3. 3% 3b 4. 3% 3 bi 5. 3.001% 2b 6. 3.002 3b

$11,000,000,000 - $1,000,000,000 10,000,000,000 (10-3.5) = 6.5 (6.4-2.5)= 4b STOP OUT YIELD thes both get 2 b **everyone will get 3% yield since high yield

11. Purchases april 8, last coupon Feb 15 a. HOw many days in accrued interest period: i. Feb 15-28 14 March 1-31 31 April 1-7 7 52 days ii. AI = annual dollar coupon/2 * (days of AI/days in coupon period) 1m(.07) = 70,000 Days in coupon period - 6 months from feb 15th is august 15th So 181 days in this = 70,000/2 * (52/181) = $10,055.25 12. A. coupon stripping - process of separating interest on a bond from underlying principal Separate each to get cash flows, annuity Ex. 500m, 5% coupon , 10 years

20 periods, 12.5 payments each period Many different securities -- ****each one will have dif interest rate

14. Federal tax income on accrued interest on stipped treasury is AI is taxed even though interest is not paid Only gain is from discount, Ex. earn 500m in 10 years or 20 periods from now Big discount - so gain is from discount, maybe for $400m, and it matures to 500, so 100m earned in interest over 10 years. receive no income until period 20, so earning income, paying tax on income, have neg CF Paying but paying for neg CF for all periods and then in period 20 you receive 100m 15. Gov’t sponsored enterprise - privately owned enterprises ● Privately owned, publicly chartered Freddie Mae, Fannie Mac Treasury not backed by full faith and credit of the US govt, but ability to borrow have access to treasury so minimalal but above zero default risk or credit risk Publicly owned shareholder corporations

16. None explicitly guaranteed by full faith and credit of US govt, but have menial default risk because access to treasury 17. Treasury Bills - under a year, discount, but not coupon payments So pay more than par but not paying coupon payment - buy for 102 and in year get $100 Buy premium at yield is low (so low yield neg0 Buy premium, no coupon payments - coupon rate is 0, so yield is less than 0 → earning a neg yield In times of turmoil limit losses with neg yield, maybe promote ppl to put money elsewhere Short term - not locked in forever (and do not want to be if neg) *can limits losses, yields will go up

Chapter 7 ●

Corporate debt instruments - financial obligations of corporation that have priority over its common stock and preferred stock in base of bankruptcy ○ Classified as: corporate bonds, medium-term notes, commercial paper, bank loans, convertible corporate bonds and asset-backed securities

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3 sectors of corporate bonds: ○ Utilities - include investor-owned companies that are involved in generation, transmission and distribution of electric, gas, water ○ Financials - bonds of wide range of financial institutions - banks, insurance companies, securities firms, mortgage and brokerage firms ○ Industrials - include companies that are not utilities or financials Classified based on credit risk Optimal capital structure - capital structure that will maximize market value of equity Priority of Creditors: ○ Senior secured debt - back by or secured by some form of collateral beyond issuer’s general credit standing ○ Senior unsecured debt ○ Senior subordinated debt ○ Subordinated debt Mortgage bond - grants creditor a lien against the pledged assets ○ Creditor has legal right to sell mortgaged property to satisfy unpaid obligations that are owed Mortgage lien important since give mortgage bondholders stronger bargaining position relative to other creditors in determining terms of any reorganization Collateral trust bonds - bonds secured by assets like stocks, notes, bonds or any obligations bondholder owns Debenture bonds - unsecured debt Senior unsecured debt - debt not secured by specific pledge of property ○ Creditor has claim of general creditors on all assets of issuer not pledged specifically to secure other debt Subordinated debt - after senior secured creditors, senior unsecured creditors and after some general creditors in claim on assets and earnings ○ 2 categories: ■ Some creditors who have priority in claims relative to other subordinated debt holders → class of debt with seniority within ranks of subordinated debt is senior subordinated debt Liquidation - all assets distributed ○ Distributed to holders of claims of the corporation and no corporate entity will survive Reorganization - new corporate entity created ○ Some holders will receive cash in exchange for their claims, others receive new securities in new corporation created or receive combo of these two Debtor in Possession (DIP) - company that filed for protection under bankruptcy act and continue to operate business under supervision of court Chapter 7 - deals with liquidation of a company Chapter 11 deals with reorganization of a company Once company files bankruptcy interest and principal payments no longer paid to creditors and no dividends paid to stockholders Case trustee - bankruptcy trustee - manages and administers bankruptcy estate

Company ceases to exist after it is liquidated and distributed all assets to creditors Absolute priority rule - principle that senior creditors paid in full before junior creditors paid anything ○ Guarantees seniority of secured and unsecured creditors before equity holders ● Chapter 7 - creditors prefer this and liquidation because more likely to recover some of the amount owed than stockerholders are to receive their investment ● Absolute priority rule - distribution of all assets to creditors when a company is liquidated ○ After company distributes all assets in liquidation it ceases to exist ○ Principle that senior creditors are paid in full before junior creditors paid anything ○ Guarantees seniority to equity holders ○ Chapter 7 creditors more likely to recover some (if not all) amount owed than stockholders are to receive in their investment ● Credit analysis - techniques to analyze info on companies and bond issues in order to estimate ability of issuer to live up to its future obligations ● 3 Major NRSROs ○ Moody’s INvestors Services ○ Standard and Poor’s rating services (S&P) ○ Fitch ● High grade - lowe credit risk, high probability of future payments ● Prime - triple A debt obligations ● High quality - double A ● Upper medium grade - single A issues ● Medium grade - triple B issues ● Investment grade - debt obligations assigned rating in top 4 categories ● Non-investment grade/ Junk Debt/ High-Yield Debt - rating below top 4 categories Corporate Bonds ● Term bonds -...