Corporate debt securities outline
Yield to call
1. The
YTC will move in the same direction as the yield to maturity but will move
further up or down
2. When
a bond trades less than par-at a discount the YTM will be higher>nominal
yield because of a profit at maturity that must be taken into consideration.
YTC will be > YTM
3. When
a bond trades for more than par-at a premium price-the YTM will be lower than
the nominal yield-there will be a loss at maturity and the YTC will be < YTM
Premium bond
i.
High to low: Nominal, maturity, call (N,M,C)
Discount bond
ii.
Low to high: Nominal, Maturity, call (N,M,C)
Yield on par bonds
a. Buy
at par: Current yield= yield to maturity (basis) = coupon rate (nominal yield)
= yield to call
b. Purchase
price=maturity price
Bond changes in price
a. To
a discount or to a premium, current yield, YTM and YTC will change inversely
b. Current
yield will move least
c. YTC
will move most
d. YTM
will move more the current but less than YTC
e. Order
of yields: N,C,B,M,C-nominal, current, basis, yield to maturity, yield to call
What is the current yield of a 9% corporate bond selling for
$900 in the marketplace? $90/$900=10%
Bond prices
a. Higher
quality, higher price, lower yield
b. If
present interest rate increases above nominal yield/coupon rate of bond, demand
will be lower, price will decrease. Decrease in price will increase effective
yield-current yield and yield to maturity
c. If
present interest rate decreases below coupon rate, bond will be in greater
demand and its price will increase. Increase in price will decrease effective
yield-yield to maturity of outstanding bond
d. When
interest rates go up, bond prices down
e. When
interest rates down, bond prices up
f. Teeter
totter-interest rates rise, bond prices fall to a discount price
g. Interest
rates fall, price rises to premium price
h. Exception:
convertible bonds-can be converted into shares of stock of the issuing
corporation, prices do not reflect outside interest rates, priced to maintain
parity with the underlying stock, parity: when price of bond=same value of
converted shares if bond were converted
Premium bond
a. Price-above
par
b. If
par is 100, premium would sell at 103 or 110
c. Calculate
price-% x 1,000
Discount bond
a. Priced
at a discount
b. Price-below
bar
c. If
par 100, sells for 8, 86, 65
What is the relationship of bond prices to bond yields?
·
They have an inverse relationship. If bond
prices fall, bond yields increase. If bond prices increase, bond yields
decrease
Corporate bond quotes
a. Found
on exchanges or the Yellow Sheets publication
b. Yellow
sheets-list of over the counter OTC bonds which are not on NYSE, corporate
bonds published by the National Quotation Bureau
c. Yellow
sheets exclude corporate bonds that trade on New York Stock Exchange and other
exchanges
d. Yellow
sheets-unlisted corporate bonds
e. Pink
sheets-unlisted corporate stocks
Quotes
a. 96.55
quote, trading at 96.55% of par, price is 965.50
b. Move
decimal to the right one place
c. 96.55
and interest means $965.50 + accrued interest
d. 96.55
flat: price is 965.50 without accrued interest-issuer is not making interest
payments
A quote for a corporate bond is 107.15. What is the price of
the bond?
a. 1071.50.
107.15 is 107.15%o or $107.15 per $100. Bonds are 1,000 increments. Decimal
place must be moved to the right. With 10,000, decimal place is moved two
places. With 100,000 decimal point-moved three places
Convertible bond conversion formula
·
Conversion formula-compares value of convertible
bond vs. the value of the underlying stock
·
Convertible bonds may be converted by investors
into shares of stock of the corporation at any time until maturity date or date
bonds are called
·
If investors don’t want stock, can hold bonds
until maturity, turn them in, receive principal
·
Conversion ratio, bonds can be converted into a
set # of stock shares
·
Convertible bonds issued at lower prices,
investors buy because stock can increase in price, they can convert bond into
stock later
·
Convertible bond arbitrage, if bond is at a
discount to stock parity or stock is at a premium to bond parity
·
Stock decreases in price, bond decreases in
price. But bond will only decrease to level that would make it competitive
·
The conversion ratio of a bond that is
convertible at $20. $1000/$20=50 shares/bond
Conversion ratio
·
Bond can be converted into # shares
·
Parity: sale price stock = bond price
·
Number of shares x share price=bond price
·
A company issues a convertible bond that is
convertible at $40 per share. If the stock is presently selling for $50 per
share, what is the parity price of the stock? $1000/40=25. 25x50=$1250
·
A company issues a convertible bond that is
convertible at $50. If the bond is selling for $900 what is the parity price of
the stock? $1000/50=20 shares. 900/20 shares=$45
·
What is the conversion ratio of a bond that is
priced at $900 and is convertible at $50 per share? 1000/50=20 shares.
Reverse convertible securities
·
Reverse convertible bonds-issuer can exercise
·
Short term, high yield debt issues that can
convert into stock or cash worth less than original price of bond
·
Issuers have right to convert to a specified
number of shares of common stock of another company, bonds of a company, cash
·
Risk: issuer can convert bond to stock that has
decreased in price, bond holder owns less value
·
High yield, high risk
Interest on bonds
·
Corporate bonds-30 day, 360 day year (30-360)
·
Bondholders accumulate interest every day
·
Accrued interest, earned interest isn’t paid
because bonds sold before ex interest date
·
Buyer pays seller for all days of accrued
interest from and including the previous interest date up to but not including
the settlement date
·
Buy corporate bond, pay within 3 business days
·
Trade on W,Th,F, settlement is M, Tu, We or 5
days from purchase date
·
Bonds usually pay interest every 6mo to holder
·
Buyer must pay seller purchase price + accrued
interest
·
Buyer will receive coupon payment with interest
that was due the seller for time seller owned bond
Determining Accrued interest
·
Includes last date of interest due and
settlement day
·
Trade date + 3 business days (+2 if weekend) –
previous interest date=(# months x 30+# days)
·
For a bond that pays interest on May 1 and Nov 1
and trades on Tues, August 8th. 8/8 trade date + 3 days-regular
way=8/11 – 5/1=3/10. 3/10 or 3mo +10 days=90+10=100 days
·
Mon, Tues-+3 days
·
Wed-Friday, +5 days
·
If interest date in middle of month, borrow one
mo-30 days, add to settlement day
·
A corporate bond has interest dates that are Feb
15 and Aug 15. If an investor buys bond on Thu, July 4, how many days of
accrued interest would the buyer pay the seller?
·
Prime rate: rate U.S> money center commercial
banks calculate interest charges on short-term secured corporate loans. Leading
indicator of all interest rates
·
Call rate: interest rate banks charge
broker/dealers for money that will be lent to customers by broker/dealers for
the purchase of securities. A.k.a. margin
·
Discount rate: rate the Federal Reserve “The
Fed” charges for loans to member banks
·
Federal funds rate: the rate that one bank
charges another bank for overnight lending to meet the Fed’s reserve
requirement
Leverage
·
Using borrowed money to make more money>
interest on borrowed money
·
Companies borrow by issuing bonds and notes, use
$ to expand facilities to make more goods, provide more services
·
Leverage: expect to make $> interest payments
·
Most companies-bond debt>stock a.k.a.
“trading on equity”
·
Public utilities-lot of debt, highly leveraged
·
Highly affected by interest rate changes,
interest increases
·
High interest affects earnings and dividends
·
More revenues, more earnings likely, more
dividends likely
·
More speculative to invest in highly leveraged
companies
Debt service:
·
Aka fixed charges coverage
·
Debt service coverage= (total
income-expenses)/(principal + interest)
·
Debt service=principal + interest
·
What is the debt service coverage for ABC Co?
Has $46,000,000 in revenues, $18,0000 in expenses, $20,000,000 in maintenance
costs, and $4,000,000 in debt service? 46-18-20=8/4=2X
Money market instruments
·
High quality readily marketable debt security,
mature in 1yr or less
·
Rated by Standard & Poor’s, Moody’s,
Fitch’s, Best’s (rates insurance co. not bonds)
Negotiable certificates of deposit
1. Bank
issued, short term debt instruments
2. Negotiable
in the secondary market
3. Can
be sold if holder needs money
4. Issued
in amounts from $100,000 to $1,000,000 or more
5. Issued
in bearer form only for a set period of time
6. Must
have a minimum duration/maturity of 14 days to be shown on Nasdaq
7. 14-60
days
Non negotiable CDs
1. Cannot
be sold in the marketplace
2. Issued
by banks
Step up CDs
1. Have
market risk
2. As
interest rates change, value changes
3. Fixed
rate of interest which rises 3 or 4 times during its life
4. Issued
to investors who want safety of bank CD but want rates to rise, believe in same
rise in rates from other debt securities
5. Purchased
for institutional accounts & for individuals
6. Issued
in 1,000-99,000, cannot be redeemed to issuing bank prior to maturity
Step down CDs
·
Yields decrease over life
Bankers acceptances
·
Short term notes to facilitate foreign trade in
the U.S.
·
Issued by bank
·
Extension of a letter of credit for importers
·
Collateral time deposit
·
90-180 days
·
Only collateralized money market instruments
Commercial paper
1. Unsecured
note issued by a corporation to raise cash for a short period of time
2. Maturity
max-270 days.
3. 30-89
days
4. 90-119
days
5. 120-179
days
6. 180-270
days
7. Issued
in multiples of $1,000 from $5,000 to 5,000,000
8. Issued
through General Motors Acceptance Corp. and issued by any corporation in need
of cash for a short period of time
9. Purchased
by other corporations, banks, insurance companies, mutual funds or any big
investor who wishes to invest it
10. Sold
at discount, does not pay interest
11. Issued
in book entry form, corporation keeps buyers name on their books
12. Max
maturity 270 days because Securities Act of 1933 exempts corporate issues of
270 days or less from
13. SEC registration
requirements
14. Registering
with SEC is time consuming and would take longer than time by which corporation
needs $
15. Since
commercial paper is not registered it cannot be held for more than 270 days
Repurchase agreements
1. Agreement
where a bank sells a broker/dealer a money market instrument usually a T-bill
with the agreement to buy it back at a higher price
2. Broker/dealers
(B/D) make arrangements between buyers and sellers
3. Corporations-have
money or need to borrow $
4. Banks-may
need $ overnight to meet their reserve requirement or may have extra cash
5. The
Fed-controls $ invested for short term investing
6. Advantages-no
interest rate risk
7. No
market risk
8. Pay
interest=the Fed funds rate
Auction Rate Securities
1. Debt
securities-corporate or municipal or preferred stock that have their interest
rates change
2. Max
maturity, 1 yr
3. Interest/dividend
resets after 1 yr
4. Most
ARS reset 7,14,28, 35 day intervals
5. Some
reset periods 91 days-twice year or once
a year for next auction
6. Bond
or preferred stock has a Dutch auction offering
7. Issuer
wants to sell shares at x price
8. Underwriter
believes price must be lower to get issue sold
9. Too
few buyers, reduced price, sold again
10. Issuer
will reduce price until all issue sold
11. Google
started at $122 per share, wasn’t all sold until sold at $88 per share
12. Price
constant, investors bid on dividend rate: interest rate
13. Investors
who bid lowest get first securities
14. All
bidders will win securities at highest of accepted bids, clearing rate
15. Failed
auction, too few bids to cover all securities sold
16. Failed
auction, some security holders cannot sell securities. Hold on and are given
the maximum rate/failed auction rate set by issuer, a multiple of LIBOR (London
Interbank Offered Rate)
17. Holders
cannot sell or put back to issuer
18. If
you want to hold ARS, submit bid at reset date
19. Not
a liquid investment, do earn dividend rate at end of reset period
20. Shares
trade at set price, interest paid at end of reset period, new dividend rate set
at reset period
21. Issuer
determined maximum rate allowed
22. Biggest
problem: liquidity
23. Failed
auction: too few bids
24. Failed
auction: bid is above maximum issuer set
25. Buy-new
order to purchase some
26. Sell-an
order to sell at re-set bidding
27. Hold-keep
ARS regardless of rate
Eurodollars and Eurodollar bonds
1. Foreign
bank accepts U.S. dollars and keeps in U.S> dollars
2. Large
deposits of U.S. dollars in foreign banks
3. Used
to fund international foreign trade because of stability of U.S. dollar
4. Deposits
may be loaned or used to buy bonds
5. U.S.
banks will borrow Eurodollars instead of federal funds market @ better rate
6. Interest
calculations-in U.S. $
7. LIBOR:
London Inter Bank Offered Rate
8. Interbank
System, similar to Over The Counter Market with electronic communications
network-participants buy and sell currencies 24 hours a day on supply and
demand
9. Multinational
corporations use Interbank, international banks and governments use Interbank
10. Unregulated
but manipulated-by governments-marketplace
Eurodollar bonds
1. Also
called Eurobonds
2. Bonds
issued in a foreign country and purchased with or collateralized by Eurodollar
deposits
3. All
interest and principal payments in U.S> dollars
4. Foreign
corporations, U.S. corporations, U.S state governments, U.S. municipal
governments issue Eurodollar bonds
5. Advantage-avoid
SEC registration requirements, lower interest rates abroad
6. Foreigners
purchase bonds
Which of the following is used to keep track of interest
rates put out by foreign banks for Eurodollar bonds worldwide? The Interbank
System-this is the system for keeping track of interest rates put out by
foreign banks for Eurodollar bonds worldwide.
Corporate bond interest
1. Double
tax-subject to federal income tax and state income tax
2. Highest
interest rates of corporate, government, municipal bonds-payout is lower when
taxes are added
Taxation of discount and premium bonds
·
Bond purchased at discount, taxed as ordinary
income
·
Bond purchased at premium, tax deduction from
each year’s interest
·
Ex. Buy $50,000 of a 10% corporate bond pays
90-90% of par or $45,000 (90% of 50,000) It will generate $5,000 of ordinary income
·
Ex. Buy $50,000 of a 10% corporate bond for
110-110% of par or $55,000 (110% of 50,000) If held to maturity, no loss is
taken. Investor can deduct amortized amount from interest received-if this
doesn’t occur-no loss allowed at maturity
Taxation of zero coupon bonds
1. Buy
bond at discount, discount is treated as interest at maturity
2. Accrete
(amortize up) the amount of discount and year and claim it as portfolio income,
add to taxable income, pay tax on money they do not see but no capital
gain/ordinary income at maturity
3. No
capital gain if bond held to maturity
4. Held
for one year and sold above accreted value, ordinary income and capital gain
5. Compound
accreted value (CAV) is determined by accreting the zero-coupon bond based on
principal and interest compounded over time bond is held
6. Needed:
dated date-date interest starts to accrue, maturity date, time bond has been
held
7. CAV
increases with what would be accrued interest
8. If
a holder a zero coupon sells bond before maturity gain or loss-determined by
accreted amount
9. Ex.
A holder of a zero coupon buys bond at $400 for 10 years to maturity. The
investor holds the bond for one year and sells it for $500. What type of
taxation? Ans: ordinary income and capital gain. Ordinary income-interest for
year-$60 ($600 discount/10 years) Capital gain is the amount above 460 to 500
($400 +$60 interest)
10. All
of the following are true of the taxation of interest bearing corporate bonds
except? All bonds bought at a discount that mature have a capital gain. Instead
all of the gain is ordinary income. Premium can be amortized each year to
offset interest paid. An investor cannot deduct a capital loss if the premium
bond is held to maturity and the investor has not amortized the premium over
the time the bond has been held. If a discount bond is sold prior to maturity
the bond is accreted, a new cost basis found, new cost basis-sale price>
determine gain/loss or if appreciation is ordinary income
No comments:
Post a Comment