From simple corporate bonds, and government securities to derivatives, credit default swaps, and mortgaged back securities this seminar from Saunders Learning Group covers all of the details of fixed income investing. Contact at us 316-680-6482 or floyd@floydsaunders.com to arrange a seminar today.
1. Fixed Income
Investing
Covering Chapter Nine of the book
“Figuring Out Wall Street”
Saunders Learning Group, Newton, KS
May 2012
Part
of
the
Common
Sense
Investor
Series
2. All About Figuring Out Wall Street ...
Saunders Learning Group, Newton, KS
Everything
has
changed
in
the
financial
services
industry
and
it
effects
your
financial
well-‐being.
From
bank
failures,
to
record
unemployment,
home
foreclosures
and
panic
around
the
world,
Figuring
Out
Wall
Street,
is
the
concise
guide
to
help
everyone
from
first
Cme
investors
to
veterans
of
banking
understand
what
to
do
to
persevere
and
restore
our
faith
in
our
financial
systems.
2
This presentation is from Chapter Nine of Figuring Out Wall Street
3. Summary of Book
Saunders Learning Group, Newton, KS
Figuring Out Wall Street Consumer’s
Guide To Financial Markets
By Floyd Saunders
Publisher: Saunders Learning Group
ISBN: 978-0-9824019-0-3
available from Amazon, B&N, and
http://www.figuringout wallstreet.com
or www.floydsaunders.com
Author Contact
email: floyd@floydsaunders.com
Blog: www/money/floydsaunders.com
Twitter @floydsaunders
LinkedIn: http://www.linkedin.com/profile/view?
id=14740656&trk=tab_pro
Facebook: Figuring Out Wall Street
Sideshare: http://www.slideshare.net/FloydSaunders
Book summary: From bank failures to home foreclosures and panic
around the world, Figuring Out Wall Street, is the concise guide to help
everyone understand how this latest crisis happened, who was responsible and
what to do now to restore our financial systems. Written in an easy to
understand manner, even the most complex financial concepts are easy to
digest. This book provides help to monitor investments with a review of
investment products, financial regulators and economic indicators. Learn how
the stock market exchanges work and the world of investment banking, hedge
funds, venture capital and private equity. Every chapter includes action plans
for investing.
4. Saunders
Learning
Group
provides
a
variety
of
training
programs,
workshops
and
seminars
targeted
to
the
financial
services
industry.
Programs
are
available
in
a
wide
range
of
topics,
and
we
are
specialists
in
developing
custom
programs
that
are
targeted
to
your
needs.
Contact
the
founder,
Floyd
Saunders
at
316-‐680-‐6482
or
at
floyd@floydsaunders.com
for
more
informaCon.
Saunders Learning Group, Newton, KS
4
Training from Saunders Learning Group
5. Saunders Learning Group, Newton, KS
This presentation is designed to
give participants information that
will enhance their understanding
of bonds, how they are issued,
how to invest in them and how
they are redeemed.
Introduction
6. What is a Bond?
Saunders Learning Group, Newton, KS
! In
financial
terms
a
bond
is
a
debt
security,
in
which
the
authorized
issuer
owes
the
holders
a
debt
and,
depending
on
the
terms
of
the
bond,
is
obliged
to
pay
interest
(the
coupon)
and/or
to
repay
the
principal
at
a
later
date,
termed
maturity.
! A
bond
is
a
formal
contract
to
repay
borrowed
money
with
interest
at
fixed
intervals.
7. Issuing bonds
! Bonds
are
issued
by
public
authoriCes,
credit
insCtuCons,
companies
and
supranaConal
insCtuCons
in
the
primary
markets.
! The
most
common
process
of
issuing
bonds
is
through
underwriCng.
! In
underwriCng,
one
or
more
securiCes
firms
or
banks,
forming
a
syndicate,
buy
an
enCre
issue
of
bonds
from
an
issuer
and
re-‐sell
them
to
investors.
! The
security
firm
takes
the
risk
of
being
unable
to
sell
on
the
issue
to
end
investors.
Saunders Learning Group, Newton, KS
8. Features of bonds
Saunders Learning Group, Newton, KS
!
Bonds
have
a
number
of
characterisCcs
that
play
a
role
in
determining
the
value
of
a
bond.
! Principal
! Coupon
! Price
! Yield
!
maturity
! credit
quality
9. Principal
The
Principal
is
the
amount
of
money
the
issuer
will
repay
the
bondholder
at
the
maturity
of
bond
Issuer
Bondholder
Saunders Learning Group, Newton, KS
10. Coupon (The Interest Rate)
Saunders Learning Group, Newton, KS
! The
coupon
is
the
amount
the
bondholder
will
receive
as
interest
payments.
— It's
called
a
"coupon"
because
someCmes
there
are
physical
coupons
on
the
bond
that
you
tear
off
and
redeem
for
interest.
— Now
records
are
more
likely
to
be
kept
electronically.
! Most
bonds
pay
interest
every
six
months,
but
it's
possible
for
them
to
pay
monthly,
quarterly
or
annually.
! The
coupon
is
expressed
as
a
percentage
of
the
par
value.
11. Price
The
price
of
the
a
bond
depends
on
four
factors:
"
Market
interest
rates
"
Credit
quality
"
Maturity
"
Supply
&
demand
Saunders Learning Group, Newton, KS
12. Price of a Bond Varies
Saunders Learning Group, Newton, KS
Bond
discount
Par value
premium
Above par value
Below par value
Bond
13. Bond Yield
The
yield
of
a
bond
is
the
rate
of
return
received
from
invesCng
in
the
bond,
is
based
on
the
price
paid
for
the
bond
and
the
coupon
payment.
current
yield=Annual
coupon/
Price
Rate of return on investment
price Coupon payment
Saunders Learning Group, Newton, KS
15. Bond Maturity
! The
maturity
date
is
the
date
in
the
future
on
which
the
investor's
principal
will
be
repaid.
! As
long
as
all
payments
have
been
made,
the
issuer
has
no
more
obligaCon
to
the
bond
holders
a`er
the
maturity
date.
! The
length
of
Cme
unCl
the
maturity
date
is
o`en
referred
to
as
the
term
or
tenor
or
maturity
of
a
bond.
! There
are
three
groups
of
bond
maturiCes:
— short
term
(bills):
maturiCes
up
to
one
year
— medium
term
(notes):
maturiCes
between
one
and
ten
years
— long
term
(bonds):
maturiCes
greater
than
ten
years
! A
bond
that
matures
in
one
year
is
much
more
predictable
and
thus
less
risky
than
a
bond
that
matures
in
20
years.
Therefore,
in
general,
the
longer
the
Cme
to
maturity,
the
higher
the
interest
rate.
! All
things
being
equal,
a
longer
term
bond
will
fluctuate
more
than
a
shorter
term
bond.
Saunders Learning Group, Newton, KS
16. Issuer
Saunders Learning Group, Newton, KS
! Who
is
issuing
a
bond
is
important
to
review,
as
the
issuer's
stability
is
your
main
assurance
of
gebng
paid
back.
! For
example,
the
U.S.
government
is
far
more
secure
than
any
corporaCon.
Its
default
risk
(the
chance
of
the
debt
not
being
paid
back)
is
extremely
small
-‐
so
small
that
U.S.
government
securiCes
are
known
as
risk-‐free
assets.
! The
general
view
is
that
a
government
will
always
be
able
to
bring
in
future
revenue
through
taxaCon.
! A
company,
on
the
other
hand,
must
conCnue
to
make
profits,
which
is
far
from
guaranteed.
! This
added
risk
means
corporale
bonds
must
offer
a
higher
yield
in
order
to
enCce
investors
-‐
this
is
the
risk/return
tradeoff
in
acCon.
17. Credit Quality
The
credit
raCng
of
a
bond
is
important
to
investors
as
it:
! Provides
a
standardized
measures
of
relaCve
credit
quality
! Provides
an
imparCal
view
of
credit
quality
of
the
issue
! Allows
the
investor
to
compare
issues
of
similar
credit
quality
Saunders Learning Group, Newton, KS
18. credit rating
credit risk Moody's standard & Poor's Fitch IBCA
highest quality Aaa AAA AAA
highest quality (very strong) Aa AA AA
upper mediam grade(strong) A A A
medium grade Baa BBB BBB
lower mediam grade Ba BB BB
(some what speculative)
lower grade (speculative) B B B
poor quality (may default) Caa CCC CCC
most speculative Ca CC CC
no interest in being paid or C C C
bankruptcy petition filed
in default C D D
Saunders Learning Group, Newton, KS
19. Types of bonds
! Fixed
rate
bonds
have
a
coupon
that
remains
constant
throughout
the
life
of
the
bond.
! FloaCng
rate
notes
(FRNs)
have
a
variable
coupon
that
is
linked
to
a
reference
rate
of
interest,
such
as
LIBOR
or
Euribor.
! InflaCon
linked
bonds.
in
which
the
principal
amount
and
the
interest
payments
are
indexed
to
inflaCon.
The
interest
rate
is
normally
lower
than
for
fixed
rate
bonds
with
a
comparable
maturity.
!
Asset-‐backed
securiCes
are
bonds
whose
interest
and
principal
payments
are
backed
by
underlying
cash
flows
from
other
assets.
Saunders Learning Group, Newton, KS
20. Types of bonds
! Subordinated bonds are those that have a lower priority than other
bonds of the issuer in case of liquidation.
! Perpetual bonds are also often called perpetuities or Perps'. They
have no maturity date.
! Bearer bond is an official certificate issued without a named holder.
In other words, the person who
has the paper certificate can claim the value of the bond. Often they
are registered by a number to
prevent counterfeiting, but may be traded like cash. Bearer bonds
are very risky because they can be
lost or stolen.
! War bond is a bond issued by a country to fund a war.
Saunders Learning Group, Newton, KS
21. How To Read A Bond Table
Saunders Learning Group, Newton, KS
Column 1: Issuer - This is the company, state (or
province) or country that is issuing the bond.
Column 2: Coupon - The coupon refers to the fixed
interest rate that the issuer pays to the lender.
Column 3: Maturity Date - This is the date on
which the borrower will repay the investors their
principal. Typically, only the last two digits of the
year are quoted: 25 means 2025, 04 is 2004, etc.
Column 4: Bid Price - This is the price someone is
willing to pay for the bond. It is quoted in relation
to 100, no matter what the par value is. Think of
the bid price as a percentage: a bond with a bid of
93 is trading at 93% of its par value.
Column 5: Yield - The yield indicates annual return
until the bond matures. Usually, this is the yield to
maturity, not current yield.
22. Bond Issuing & Investing
! CorporaCons
issue
bonds
to
provide
for
a
number
of
financing
needs.
Some
of
this
financing
could
be
in
the
form
of:
!
commercial
paper
(normally
issued
for
less
than
30
days)
and
used
to
fund
things
like
accounts
payable,
payrolls
etc.
! Short-‐term
bonds
(less
than
a
year)
used
to
fund
capital
requirements
and
provide
addiConal
cash
flow
! Long-‐term
bonds
(more
than
a
year)
used
to
fund
capital
expenses
like
new
buildings
and
equipment.
! Sovereign
govt.
issue
bonds
to
cover
a
shorfall
between
taxaCon
revenue
and
expenditure
! Govt.
agencies,
municipal,
&
local
govt.
authoriCes
issue
bonds
to
fund
their
service
and
operaCons
Saunders Learning Group, Newton, KS
23. Investment Banks
(commonly called the Underwriter)
Role of the Underwriter
# To purchase the district’s bonds directly from the district and re-offer (sell)
them to investors.
Types of Bond Sales
Negotiated sale - District hires an investment banking firm (or firms) to underwrite
its bonds at a negotiated price. The financing structure is determined in
accordance with the district’s specific needs or requirements relative to I&S tax
rate preferences and/or refunding objectives.
# Size of negotiated underwriting team
# With exception of financings under $10, most issuers will hire a team of
from 2 to 6 investment banking firms (depending on the size of the issue).
# Selection process
# Recommendation
# Request For Proposals
# Request For Qualifications
Saunders Learning Group, Newton, KS
24. Investment Banking Specialist
# Investment banking firm specialists involved in the underwriting process
$ The “banker” – called an investment banker, this specialist is part of
the investment banking team.
$ “Bankers” generally have broad knowledge of the capital markets, debt instruments,
debt structuring, document preparation, and marketing/distribution procedures.
$ One of their responsibilities is to solicit potential issuers with the goal of being
included as a member of the issuer’s underwriting team.
$ Once their firm is hired they serve as the key contact/liaison person and coordinate
with all parties to the financing to execute the underwriting.
$ The “underwriter” – an investment banking firm’s specialist who is
directly responsible for pricing a district’s bond issue; i.e.,
determining the lowest possible combination of coupons and yields
that will “sell” in the marketplace at the time of pricing.
$ The “sales representatives” – the persons who actually contact
potential investors and sell the district’s bonds to those investors.
Saunders Learning Group, Newton, KS
25. Steps in the Negotiated Underwriting Process
1. Structuring - the lead investment banking firm (senior managing
underwriter) is usually involved in the initial structuring and/or
determining the plan of finance.
2. Hiring of underwriter’s counsel - the senior managing underwriter, the
financial advisor and the issuer will jointly agree on a firm via
consultation among themselves.
3. Documentation process.
4. Net Designations or Group Net
5. Pre-sale marketing activities by sales force.
6. Pre-sale pricing calls among the underwriters, the FA and the issuer.
7. Order period - usually 2 hours during which the bonds are sold.
8. Sign bond purchase agreement - the district and the senior managing
underwriter.
Saunders Learning Group, Newton, KS
26. HOW BOND MARKETS WORK
Saunders Learning Group, Newton, KS
subtitle 26 date
27. Bond Trading Activity
! Largely an OTC market—no primary physical
location
! Low trading volume relative to stocks
! Par value: face amount, usually $1,000
! Round lot: $1 million of par value
! Relatively illiquid for small investors
Saunders Learning Group, Newton, KS
29. Bond Markets
Primary
market
–
New bonds
Issuer
Investor
Saunders Learning Group, Newton, KS
30. Secondary Market
bonds bonds
Sells
Buys
Investor
A
Broker
Investor
B
Saunders Learning Group, Newton, KS
31. Bond Market Players
! Bond: promise to pay back principal at some future date, plus periodic
interest payments for use of investor’s money
! Bond issuers: entities that supply new bonds
! Bond investors: individuals and institutions that purchase bonds for
interest income and long-term capital gains
! Bond dealers: intermediaries between bond issuers and investors
! Primary bond market: new bonds only; issuer-to-investor
! Secondary bond market: previously issued bonds; investor-to-investor
Saunders Learning Group, Newton, KS
32. U.S. Bond Market
! Market
value
=
$36
trillion
! BOND
MARKET
RELATIVE
TO
STOCK
MARKET
# Average
Daily
Trading
Volume
# U.S.
Bond
Markets
=
$814.0
Billion
# Stock
Market
=
$104.9
Billion
! One
of
largest
securiCes
markets
in
world
! Quickly
reflects
changes
in
credit
quality
and
in
aggregate
economic
condiCons,
including
interest
rates
! Very
efficient
market
mechanism
! Expensive
place
to
trade
for
small
investors
Saunders Learning Group, Newton, KS
33. Tracking Interest Rates
! Federal Funds Rate: overnight bank
lending rate; lowest but most volatile
money market rate
! Discount Rate: interest rate charged by the Federal
Reserve to its member banks; key instrument of
monetary policy
! Eurodollar Rate: interest rate charged for dollar-denominated
loans in European banks
! LIBOR: London Interbank Offered Rates; London fed
funds rate
Saunders Learning Group, Newton, KS
35. Types of bonds
! Fixed
rate
bonds
have
a
coupon
that
remains
constant
throughout
the
life
of
the
bond.
! FloaCng
rate
notes
(FRNs)
have
a
variable
coupon
that
is
linked
to
a
reference
rate
of
interest,
such
as
LIBOR
or
Euribor.
! InflaCon
linked
bonds.
in
which
the
principal
amount
and
the
interest
payments
are
indexed
to
inflaCon.
The
interest
rate
is
normally
lower
than
for
fixed
rate
bonds
with
a
comparable
maturity.
Saunders Learning Group, Newton, KS
!
Asset-‐backed
securiCes
are
bonds
whose
interest
and
principal
payments
are
backed
by
underlying
cash
flows
from
other
assets.
! Subordinated
bonds
are
those
that
have
a
lower
priority
than
other
bonds
of
the
issuer
in
case
of
liquidaCon.
! Perpetual
bonds
are
also
o`en
called
perpetuiCes
or
Perps'.
They
have
no
maturity
date.
! Bearer
bond
is
an
official
cerCficate
issued
without
a
named
holder.
In
other
words,
the
person
who
has
the
paper
cerCficate
can
claim
the
value
of
the
bond.
O`en
they
are
registered
by
a
number
to
prevent
counterfeiCng,
but
may
be
traded
like
cash.
Bearer
bonds
are
very
risky
because
they
can
be
lost
or
stolen.
! War
bond
is
a
bond
issued
by
a
country
to
fund
a
war.
36. Types Of Bonds
$ Callable Bonds - A bond that can be redeemed by the
issuer prior to its maturity. The main cause of a call is a
decline in interest rates
$ Convertible Bonds – A bond that can be converted into a
predetermined amount of the company's equity at certain
times during its life
$ Eurodollar Bonds - U.S.-dollar denominated bond issued by an overseas company and held in
a foreign institution outside both the U.S. and the issuer's home nation. Chinese bank held
dollar-denominated bonds issued by a Japanese company, this would be considered a
eurodollar bond.
$ Eurobond – An international bond that is denominated in a currency not native to the
country where it is issued
$ Yankee Bond - A bond denominated in U.S. dollars that is publicly issued in the U.S. by
foreign banks and corporations
$ Bulldog Bond - A sterling denominated bond that is issued in London by a company that is
not British
Maple Bond - A bond denominated in Canadian dollars that is sold in Canada by foreign
financial institutions
$ Matilda/Kangaroo Bond - An bond denominated in the Australian dollar and issued on
the Australian market by a foreign entity
$ Samurai Bond - Yen-denominated bond issued in Tokyo by a non-Japanese company
Saunders Learning Group, Newton, KS
36
37. Corporate Bonds
Uses of Corporate Debt
! Corporations must raise money to finance investments:
— inventory,
— plant and equipment,
— research and development,
— general business expansion.
! Corporations can issue equity securities (stocks), debt securities
(bonds), or a combination of both
! Firms wish to minimize their cost of capital.
! Firms match their financing requirements with investor needs to issue
a wide variety of debt instruments.
! Most corporate bonds bought by underwriters--no certificate issued,
just book-entry form
Saunders Learning Group, Newton, KS
39. Government Debt
Government Sources of Funds:
$ Collect tax revenues
$ Print more money
$ Issue public debt
$ Treasury Bills: Maturities with 6,12 & 18 months duration
$ Issued by the government Treasury department
$ Always issued at discount
$ Treasury Notes: 1-10 year maturities
$ Treasury Bonds: long term; 10-30 year maturities
$ Fixed interest rate with annual coupon payments
$ Government-Sponsored Enterprises
$ Pools
$ Mortgage Securities /Securitization
$ GNMA
$ Fannie Mae
$ Freddie Mac
Saunders Learning Group, Newton, KS
U.S. TREASURY SECURITIES
$ Implement monetary policy—
Federal Reserve System trades
through its New York branch.
$ Increase money supply:
buys Treasuries
$ Decrease money supply:
sells Treasuries
$ Efficient means to finance
federal deficit
$ Treasury issues bonds, notes, bills
through regularly scheduled
public auctions to primary
dealers
$ Dealers obligated to bid at
every auction
$ Must maintain bids, offers
and inventories for
secondary market
40. Treasury Securities Secondary Market
Secondary
Market
for
U.S.
Treasury
SecuriCes
$ Safest
bonds
in
circulaCon
$ Enormous
trading
volume:
$190.7
billion
per
day;
most
liquid
market
in
world
$ T-‐bills:
$ mature
in
less
than
one
year,
usually
3
and
6
months
$ face
values
of
$10,000
to
$1
million
$ do
not
pay
interest;
traded
at
discount
from
par
$ T-‐notes:
$ maturiCes
1-‐10
yrs
$ semiannual
interest
$ face
values
of
$5,000
to
$1
million
$ T-‐bonds:
10
to
30
yr.
maturiCes
Saunders Learning Group, Newton, KS
Agency
&
Asset-‐Backed
SecuriCes
Markets
$ Government-‐sponsored
enterprises:
private
corporaCons
with
public
purposes
$ Pools:
diversified
loan
porfolios
$ Mortgage
securiCzaCon:
creaCng
pools
of
mortgages
and
selling
shares
of
pools
$ Ginnie
Maes,
Fannie
Maes,
Freddie
Macs
$ Ac1ve
secondary
market
provides
liquidity
$ Pay
low
semiannual
interest
$ Other
asset-‐backed
securiCes:
$ credit
card
debt,
auto
loans,
home
equity
loans,
equipment
leases
$ Repo
market:
dealers
lend
securiCes
short
term
41. U.S. Treasury Securities Secondary Market
Secondary
Market
for
U.S.
Treasury
SecuriCes
$ Safest
bonds
in
circulaCon
$ Enormous
trading
volume:
$190.7
billion
per
day;
most
liquid
market
in
world
$ T-‐bills:
$ mature
in
less
than
one
year,
usually
3
and
6
months
$ face
values
of
$10,000
to
$1
million
$ do
not
pay
interest;
traded
at
discount
from
par
$ T-‐notes:
$ maturiCes
1-‐10
yrs
$ semiannual
interest
$ face
values
of
$5,000
to
$1
million
$ T-‐bonds:
10
to
30
yr.
maturiCes
Saunders Learning Group, Newton, KS
Agency
&
Asset-‐Backed
SecuriCes
Markets
$ Government-‐sponsored
enterprises:
private
corporaCons
with
public
purposes
$ Pools:
diversified
loan
porfolios
$ Mortgage
securiCzaCon:
creaCng
pools
of
mortgages
and
selling
shares
of
pools
$ Ginnie
Maes,
Fannie
Maes,
Freddie
Macs
$ Ac1ve
secondary
market
provides
liquidity
$ Pay
low
semiannual
interest
$ Other
asset-‐backed
securiCes:
$ credit
card
debt,
auto
loans,
home
equity
loans,
equipment
leases
$ Repo
market:
dealers
lend
securiCes
short
term
42. THE MONEY MARKET
$ Buying and selling short-term debt securities; quick cash conversion
$ Safety: short maturities and diversification
$ Include Private Paper:
$ Commercial paper
$ Bankers’ acceptances (Bas)
$ Jumbo CDs
$ State & Local Governments: Project Notes
$ tax anticipation notes
$ bond anticipation notes
$ revenue anticipation notes
Saunders Learning Group, Newton, KS
43. Municipal Securities
$ Municipal
Bonds
$ Bonds
anCcipaCng
future
cash
$ Tax-‐AnCcipaCon
Notes
$ Bond-‐anCcipaCon
Notes
$ Revenue-‐AnCcipaCon
Notes
$ Clientele
Effect
$ High
tax
bracket
investors
Saunders Learning Group, Newton, KS
$ Limited Tax Bonds
$ Payable from cash
generated by specific
tax
$ Revenue
Bonds
$ Industrial
Revenue
Bonds
$ Backed
by
Good
Name
of
Municipality
$ Moral
ObligaCon
Bonds
$ General
ObligaCon
(GO)
Bonds
$ Double-‐Barreled
Bonds
$ Backed
by
2+
sources
of
funds
44. Fixed Income Products
$ Repo
–
Repurchase
Agreements
$ Is
a
contract
in
which
a
security
is
sold
with
an
agreement
to
repurchase
the
security
at
a
higher
price
$ Reverse
Repo
is
a
contract
in
which
a
security
is
borrowed
with
an
agreement
to
replace
the
security
at
a
higher
price
$ Secured
lending
and
borrowing
Saunders Learning Group, Newton, KS
45. Fixed Income Products
$ Commercial Paper – An unsecured,
short-term debt instrument issued
by a corporation, typically for the
financing of accounts receivable,
inventories and meeting short-term
liabilities.
$ Short term with maturities 1,3,
6,12 & 18 months
$ Maturities on commercial paper rarely
range any longer than 270 days
$ Placed in the primary market through
competitive auctions
$ Convertible/Exchangeable Bonds
$ Enables a financial asset to be transformed into other
$ Certificate of Deposit or CD is a time deposit, a financial product
commonly offered to consumers by banks, thrift institutions, and credit
unions
$ Held until maturity
Saunders Learning Group, Newton, KS
51. Interest Rate Swap
$ Interest rate swap is a
derivative in which one
party exchanges a stream
of interest payments for
another party's stream of
cash flows
$ Fixed for floating/Vanilla
Interest Rate Swaps
$ Often use LIBOR as
reference rates
$ Hedging/Speculation on
interest & FX rates
Saunders Learning Group, Newton, KS
51 Understanding Fixed Income
Instruments
53. Swaps
$ A swap is an option granting its owner the
right but not the obligation to enter into
an underlying swap
$ A payer swap gives the owner of
the swap the right to enter into a
swap where they pay the fixed leg
and receive the floating leg.
$ A receiver swap gives the owner of
the swap the right to enter into a
swap where they will receive the
fixed leg, and pay the floating leg.
Saunders Learning Group, Newton, KS
54. Conclusion
! Bonds
are
just
like
lOUs.
Buying
a
bond
means
you
are
lending
out
your
money.
! Bonds
are
also
called
fixed-‐income
securiCes
because
the
cash
flow
from
them
is
fixed.
! The
issuers
of
bonds
are
governments
and
corporaCons.
! A
bond
is
characterized
by
its
face
value,
coupon
rate,
maturity
and
issuer.
! Yield
is
the
rate
of
return
you
get
on
a
bond.
! When
price
goes
up,
yield
goes
down,
and
vice
versa.
! When
interest
rates
rise,
the
price
of
bonds
in
the
market
falls,
and
vice
versa.
! Bills,
notes
and
bonds
are
all
fixed-‐income
securiCes
classified
by
maturity.
! Government
bonds
are
the
safest
bonds,
followed
by
municipal
bonds,
and
then
corporate
bonds.
! Bonds
are
not
risk
free.
It's
always
possible
-‐
especially
in
the
case
of
corporate
bonds
-‐
for
the
borrower
to
default
on
the
debt
payments.
Saunders Learning Group, Newton, KS
56. Reference Material
Saunders Learning Group, Newton, KS
Figuring Out Wall Street Consumer’s Guide To
Financial Markets
By Floyd Saunders
Publisher: Saunders Learning Group
ISBN: 978-0-9824019-0-3
available from Amazon, B&N, and http://
www.figuringout wallstreet.com
or www.floydsaunders.com
Book summary: From bank failures to home foreclosures and panic
around the world, Figuring Out Wall Street, is the concise guide to help
everyone understand how this latest crisis happened, who was responsible and
what to do now to restore our financial systems. Written in an easy to
understand manner, even the most complex financial concepts are easy to
digest. This book provides help to monitor investments with a review of
investment products, financial regulators and economic indicators. Learn how
the stock market exchanges work and the world of investment banking, hedge
funds, venture capital and private equity. Every chapter includes action plans
for investing.
57. Glossary of Bond Finance Terms - A
Accrued interest. Coupon interest accumulated on a bond or other obligation since the last interest payment or, for a new
issue, from the dated date to the date of delivery. Usually interest on municipal bonds is payable semi-annually, every six
months. When you buy a bond in mid-term you are only entitled to the interest the bond earns after you buy it. The interest
earned previously, the accrued interest, belongs to the seller.
Ad Valorem Tax. A state or local government tax based on the value of real property as determined by the county tax assessor.
Advanced Refunded Bonds. A municipality or school district may sell a second bond issue at a lower interest rate cost, placing
the proceeds of the issue in an escrow account from which the first issue's principal and interest will be repaid when due.
Amortization of Debt. The annual reduction of principal through the use of serial bonds or term bonds with a sinking fund.
Arbitrage. The interest rate differential that exists when proceeds from a municipal bond - which is tax-free and carries a lower
yield - are invested in taxable securities with a yield that is higher. The 1986 Tax Reform Act made this practice by municipalities
illegal solely as a borrowing tactic, except under certain safe-harbor conditions.
Assessed Valuation. A municipality's worth in dollars based on real estate and/or other property for the purpose of taxation,
sometimes expressed as a percent of the full market value of the community.
Authorizing Ordinance. A law that when enacted allows the unit of government to sell a specific bond issue or finance a specific
project.
Average Life. The average length of time an issue of serial bonds and/or term bonds with mandatory sinking funds and/or
estimated prepayments is expected to be outstanding. It also can be the average maturity of a bond portfolio.
Saunders Learning Group, Newton, KS
58. Glossary of Bond Finance Terms - B
Balloon Maturity. An inordinately large amount of bond principal maturing in any single year. This is also referred to as a Term Bond.
Bond Anticipation Note. A short-term security, one year or less, used for interim financing to be repaid from the proceeds of a planned
long-term bond issue.
Basis Point. One one-hundredth of one percent (1/100 % or 0.01 percent). Thus 25 basis points equal one-quarter of one percent, 100
basis points equal one percent. This is typical in-group, professional bond talk.
Bid. An offer to buy at a fixed price or yield. As opposed to Ask, which is an offering to sell.
Bond or note. A security whereby an issuer borrows money from an investor and agrees and promises, by written contract, to pay a
fixed principal sum on a specified date (maturity date) and at a specified rate of interest.
Bond Fund (Tax-Exempt). A Bond Fund is a portfolio of municipal bonds sponsored or administered by registered investment companies.
These companies offer shares to investors either through (1) closed-end funds or unit investment trusts, which offer shares of a fixed
portfolio of municipal bonds; or (2) open-end or managed funds, which offer shares in a managed portfolio of municipal bonds whose
size will vary as shares are purchased or redeemed.
Bond Insurance. Insurance issued by a private insurance company for either an entire issue or specific maturities that guarantees to
pay principal and interest when due.
Bond Premium. The amount at which a bond or note is bought or sold above its par value or face value without including accrued
interest.
Bonded Debt. The portion of an issuer's debt structure represented by outstanding bonds, sometimes limited by constitutional or
legislative restraints.
Book Entry. A system of security ownership in which the ownership is held as a computer entry on the records of a central company for
its owner. The bond owner gets a computer printout as proof of ownership.
Broker. Technically a broker is a bond trader in the secondary market buying from and selling to bond dealers. Its most common usage
is as a description of a bond salesperson.
Saunders Learning Group, Newton, KS
59. Glossary of Bond Finance Terms - C
Callable Bond. A bond or note that is subject to redemption at the option of the issuer prior to its stated maturity.
The call date and call premium, if any, is stated in the offering statement or broker's confirmation.
Certificates of Participation (COPs). A form of a lease revenue bond that permits the investor to participate in a
stream of installment payments, lease payments or loan payments relating to the acquisition or construction of
specific equipment, land or facilities. COPs are not viewed legally as "debt" because payment is tied to an annual
appropriation by the government body. As a result, COPs are seen by investors as providing weaker security and
often carry ratings that are a notch or two below an agency's general obligation rating.
Coupon. The Coupon is the detachable part of a bond that displays the rate of interest due, and the interest
payment date. When there were bearer bonds, coupons were often detached from the bonds and presented to
the paying agent for payment just as one might cash a government check.
Coupon Rate. The specified annual interest rate payable to the bond or note holder as printed on the bond. This
term is still used even though there are no coupon bonds anymore.
Covenant. A legally binding commitment by the issuer of municipal bonds to the bondholder. This is the issuer’s
promise to perform or repay, conversely, an impairment of a covenant can lead to a Technical Default.
Current Refunding. A refunding transaction where the municipal securities being refunding will all mature or be
redeemed within 90 days or less from the date of issuance of the refunding issue.
Current Yield. The ratio of the coupon rate on a bond to the dollar purchase price expressed as a percentage.
Cushion Bonds. Bonds selling at a premium are called "cushion" bonds because they cushion the price volatility in
an up and down market. A premium bond, by definition, has a higher-than-market coupon interest rate. The dollar
price movement of a high interest rate bond is less than that of a lower interest rate bond of the same maturity
when general interest rates move up or down a few basis points.
Saunders Learning Group, Newton, KS
60. Glossary of Bond Finance Terms - D
Dated Date. The date carried on the face of a bond or note from which interest normally begins to accrue, the
“dated date”.
Dealer. A dealer is a corporation or partnership that buys and sells and maintains an ongoing position in bonds
and/or notes. They are also authorized to underwrite new issues.
Debt Limited. The debt limit is the maximum statutory or constitutional amount of debt that the general
obligation bond issuer can either issue or have outstanding at any time.
Debt Ratio. The ratio of the issuer's general obligation debt to a measure of value, like real property valuations,
personal income, general fund resources, or population.
Debt Service. Required payments for principal and interest.
Default. Failure to pay in a timely manner principal and/or interest when due, or a Technical Default, the
occurrence of an event as stipulated in the Indenture of Trust resulting in an abrogation of that agreement. A
Technical Default can be a warning sign that a default on debt service is coming, however in the real world actual
debt service interruption does not always occur if the problems are resolved in time.
Defeased Bonds. Refunded bonds for which the payment of principal and interest has been assured through the
structuring of a portfolio of government securities, the principal and interest on which will be sufficient to pay
debt service on the refunded, outstanding bonds. When a bond issue is defeased, the claim on the revenues of the
issuer is usually eliminated.
Saunders Learning Group, Newton, KS
61. Glossary of Bond Finance Terms - D
Delivery. Delivery and payment must be in three business days for bonds bought or sold in the secondary market.
For new issues, the time when payment is made to, and the executed bonds and notes are received from, the
issuer. New-issue delivery takes place several weeks after the sale to allow the bonds and notes to be printed and
signed.
Denomination. The face or par amount - normally $1000 or $5000 but can be $100,000 or more in the case of a
note - that the issuer promises to pay at a specific bond or note maturity.
Direct Debt. In general obligation bond analysis, the amount of debt that a particular local unit of government has
incurred in its own name or assumed through annexation.
Discount. The amount of dollars by which market value of a bond is less than par value or face value.
Discount Bonds. Bonds which sell at a dollar price below par in which case the yield would exceed the coupon
rate. The difference between the discount price and the maturity price is subject to federal capital gains tax
except in the case of Original Issue Discount Bonds.
Dollar Bond. Generally a term bond that is quoted and traded in dollars rather than in yield-to-maturity. They are
well known issues of well known names in the market.
Saunders Learning Group, Newton, KS
62. Glossary of Bond Finance Terms – E to F
Escrow Fund. A fund that contains monies that only can be used to pay debt service.
Escrowed to Maturity. Also called an “Advanced Refunded” bond. When interest rates fall, an issuer may chose to
sell a new issue called a refunding issue and use the proceeds of the second issue to pay off the original issue,
much the same as a home owner refinancing a mortgage in an effort to save interest costs. The proceeds of the
refunding issue are used to structure a portfolio of U.S. government securities, the principal and interest
payments of which exactly match the principal and interest payments of the refunded bonds. The portfolio is
placed in escrow at the paying agent and the bond issue is said to be fully defeased and escrowed to maturity. In
actual practice the bonds are usually called on the first call date. Because of the U.S. Treasury backing, advanced
refunded or escrowed to maturity bonds are considered the safest municipal bonds available and trade on the
market as a rich triple-A.
Financial Advisor. Generally an independent consulting firm, an investment-banking company, individual, or bank
that advises the issuer on financial matters regarding a proposed issue and is not part of the underwriting
syndicate.
Fiscal Agent. Also known as the Paying Agent, the bank, designated by the issuer, to pay interest and principal to
the bondholder.
Fiscal Year. A 12-month time horizon by which state and local governments annually budget their respective
revenues and expenditures. Often this time horizon is from July to June but can vary.
Flow of Funds. The annual legal sequence by which enterprise revenues are paid out for operating and
maintenance costs, debt service, sinking fund payments, and so on.
Full Faith and Credit. The pledge of "the full faith and credit and taxing power without limitation as to rate or
amount." This phrase is generally used regarding General Obligation bonds to express the pledge of utilizing all
taxing powers and resources, if necessary, to pay the bond holders.
Saunders Learning Group, Newton, KS
63. Glossary of Bond Finance Terms – G, H , I
General Obligation Bond. (G.O.) A bond secured by a pledge of the issuer's taxing powers (limited or unlimited).
Considered the most secure of all municipal debt. General obligation bonds of local governments are paid from ad
valorem property taxes and other general revenues.
Guaranteed Yield: The guaranteed yield is a school finance plan in which the state specifies a revenue yield that
it will guarantee in terms of revenue per student per penny of local tax effort. Districts adopt tax rates and levy
taxes. The state makes up the difference between what each district levies locally per student and the guaranteed
yield per student. High-wealth districts may raise all of their guaranteed yield revenue from local tax sources.
Hold Harmless: Hold harmless provisions are common when a significant change is made to a formula or funding
source. "Hold harmless" is a term used to describe a provision in new law that is designed to protect a school
district from a loss of local revenue or state aid.
Indenture of Trust. A legal document describing in specific detail the terms and conditions of a bond offering, the
rights of the bondholder, and the obligations of the issuer to the bondholder; such document is alternatively
referred to as a bond resolution.
Interest and Sinking Fund (I&S) Tax Rate: Also referred to as the debt service tax rate, the I&S taxes pay for
bonded indebtedness, facilities, and other capital needs.
Interim Borrowing. (1) Short-term loans to be repaid from general revenues or tax collections during the current
fiscal year (TRANs or RANs); (2) short-term loans in anticipation of bond issuance or grant receipts (BANs).
Investment Grade. Bond issues that the three major bond rating agencies, Moody's, Standard & Poor's, and Fitch
rate BBB or Baa or better. Many fiduciaries, trustees, some mutual fund managers can only invest in securities with
an investment grade rating.
Saunders Learning Group, Newton, KS
64. Glossary of Bond Finance Terms – J & L
Junk Bonds. Most non-rated bonds and bonds rated below investment grade.
Legal Opinion. A written opinion from bond counsel that an issue of bonds was duly authorized and issued. The
opinion usually includes the statement, "interest received thereon is exempt from federal taxes and, in certain
circumstances, from state and local taxes."
Letter of Credit. A form of supplement or, in some cases, direct security for a municipal bond under which a
commercial bank or private corporation guarantees payment on the bond under certain specified conditions.
Level Debt Service. Principal and interest payments that, together, represent more or less equal annual payments
over the life of the loan. Principal may be serial maturities or sinking fund installments.
Lien. A claim on revenues, assessments or taxes made for a specific issue of bonds.
Limited Tax Bond. A bond secured by a pledge of a tax that is limited as to rate or amount.
Saunders Learning Group, Newton, KS
65. Glossary of Bond Finance Terms – M & N
Maximum Annual Debt Service. The maximum amount of principal and interest due by a revenue bond issuer on
its outstanding bonds in any future fiscal year. This is sometimes the amount to be maintained in the Debt Service
Reserve Fund.
Municipal Bond. Bonds issued by any of the 50 states, the territories and their subdivisions, counties, cities,
towns, villages and school districts, agencies, such as authorities and special districts created by the states, and
certain federally sponsored agencies such as local housing authorities. Historically, the interest paid on theses
bonds has been exempt from federal income taxes and is generally exempt from state and local taxes in the state
of issuance.
Municipal Securities Rulemaking Board (MSRB). An independent self-regulatory organization established by
Congress in 1975 which is charged with primary rulemaking authority - under the SEC - over dealers, dealer banks,
and brokers in the municipal securities industry.
Net Bonded Debt. Gross general obligation debt minus self-supporting general obligation debt, housing bonds,
water revenue bonds, etc.
Net Interest Cost (NIC). In general, issuers award competitive bond sales to the underwriter bidding the lowest
NIC. This represents the average coupon rate weighted to reflect the time until repayment of principal and
adjusted for the premium or discount.
Net Revenue Available for Debt Service. Usually, gross operating revenues of an enterprise less operating and
maintenance expenses but exclusive of depreciation and bond principal and interest. Thus, net revenue is defined
to determine coverage on revenue bond issues.
Saunders Learning Group, Newton, KS
66. Glossary of Bond Finance Terms - O
Official Statement (OS) or Offering Circular (OC). A document or prospectus circulated for an issuer prior to a
bond sale with relevant facts pertaining to the proposed financing. Usually there are two OSs, the first of which is
known as the preliminary, or "red herring" - so named because some of the type on its cover is printed in red. The
prospectus or red herring is supposed to be available to the investor prior to the sale often used to determine
interest from investors.
Original Issue Discount. Certain maturities of a new bond issue may have an offering price substantially below
par. The appreciation from the original price to par over the life of the bonds is treated as tax-exempt income
and is not subject to capital gains tax. Pleas see Zero Coupon Bond.
O.T.C. Over The Counter. Not on an exchange. OTC refers to the buying and selling method used in the
secondary market for municipal bonds and unlisted stocks.
Overlapping Debt. Overlapping debt is the proportionate share of the general obligation bonds of local
governments located wholly or in part within the limits of the reporting governmental entity that must be paid by
property owners within the unit.
Saunders Learning Group, Newton, KS
67. Glossary of Bond Finance Terms - P
Par Value. Par Value is the principal or face value of a bond, usually $5,000 due the holder at maturity. It has no
relation to the market value. It is considered to be 100 for pricing purposes.
Parity Bonds. Revenue bonds that have an equal lien on the revenues of the issuer.
Paying Agent. Also Fiscal Agent. Generally a bank that performs the function of paying interest and principal for
the issuing body.
Premium. A premium is the amount by which the price exceeds the principal amount (par value) of a bond. The
current yield of a premium bond will be less than its coupon rate.
Price to Call. The yield of a bond priced to the first call date rather than maturity.
Primary Market. The new issue market
Principal. The face value of a bond, not including interest.
Put Bond. A put bond that can be redeemed by the bondholder on a date or on a date or dates prior to the stated
maturity date.
Saunders Learning Group, Newton, KS
68. Glossary of Bond Finance Terms Q & R
Qualified Legal Opinion. Conditional affirmation of the legal basis for the bond or note issue. The average
investor should avoid any but the strongest opinion by the most recognized bond approving attorneys.
Rate Covenant. A legal commitment by a revenue bond issuer to maintain rates at levels to generate a specified
debt-service coverage.
Ratings. Various alphabetical and numerical designations used by institutional investors, Wall Street underwriters,
and commercial rating companies to give relative indications of bond and note creditworthiness. Standard &
Poor's and Fitch Investors Service Inc. use the same system, starting with their highest rating of AAA, AA, A, BBB,
BB, B, CCC, CC, C, and D for default. Moody's Investors Services uses Aaa, Aa, A, Baa, Ba, B, Caa, Ca, C, and D .
Recapture: Also referred to as the “Robin Hood” provision. Recapture is a characteristic of school finance where
local districts give the state locally collected property tax revenues for reallocation through the Foundation School
Program. Chapter 41 of the Texas Education Code is where the recapture provision can be found and is a
significant feature of the Texas school finance equalization system.
Red Herring. A preliminary offering statement, subject to final change and update upon completion of sale of
bonds. The name comes from the red type along the side on the cover.
Redemption. Process of retiring existing bonds prior to maturity from excess earnings or proceeds of refunding
bonds. It also refers to redeeming shares in a mutual fund by selling the shares back to the sponsor.
Refunding Bond. The issuance of a new bond for the purpose of retiring an already outstanding bond issue.
Registered Bond. A non-negotiable instrument in the name of the holder either registered as to principal or as to
principal and interest.
Saunders Learning Group, Newton, KS
69. Glossary of Bond Finance Terms - S
Security. The legally available revenues and assets that are used to pay the bond holders. This is the key
component that supports debt service.
Serial Bond. As opposed to a Term Bond, which is a large block of bonds maturing in a single year, a serial bond is
an issue that features maturities every year, annually or semiannually over a period of years.
Short Term. Bonds or notes sold on an interim basis with tax-exempt securities for a period of from one to five
years.
Sinking Fund. A sinking fund is where monies are escrowed on a periodic basis to retire term bonds at or prior to
maturity.
Sinking Fund Schedule. A schedule of payments required under the original revenue bond resolutions to be placed
each year into a special fund, called the sinking fund, and to be used for retiring a specified portion of a term
bond issue prior to maturity.
Special Assessment Bond. A bond secured by a levy of special assessments, as opposed to property taxes, made by
a local unit of government on certain properties to pay the cost of local improvements and/or services that
represents the specific benefit to the property owner resulting from the improvement.
Street Name. Street name refers to the registration of bonds in the name of a dealer or other third party instead
of the owner, usually for custodial or safe keeping purposes.
Swap. The exchange of one bond for another. Generally, the act of selling a bond to establish an income tax loss
and replacing the bond with a new item of comparable value.
Saunders Learning Group, Newton, KS
70. Glossary of Bond Finance Terms - T
Tax Base. The total resource of the community that is legally available for taxation.
Taxable Equivalent Yield. The yield an investor would have to obtain on a taxable corporate or U.S. government bond to
match the same after-tax yield on a municipal bond.
Tax-exempt Bond. Bonds exempt from federal income, state income, or state tax and local personal property taxes. This
tax exemption results from the theory of reciprocal immunity: States do not tax instruments of the federal government
and the federal government does not tax interest of securities of state and local governments.
Technical Default. Failure by the issuer to meet the requirements of a bond covenant. These defaults do not necessarily
result in losses to the bond holder. The default may be cured by simple changes of policy or actions by the issuer.
Tender. The act of offering bonds to a sinking fund.
Term Bond. A large block of bonds of long maturity. They may be part of a serial Bond issue; there may be more than one
term bond in an issue or a single maturity. Some are subject to a sinking fund redemption.
Tombstone. An advertisement placed for information purposes, after bonds or notes are sold, that describes certain
details of the issue and lists the managing underwriters and or the members of the underwriting syndicate.
Trustee. A bank designated as the custodian of funds and official representative of bondholders. Trustees are appointed to
insure compliance with the trust indenture and represents bondholders to enforce their contract with the issuer.
Saunders Learning Group, Newton, KS
71. Glossary of Bond Finance Terms U to Z
Underwrite. An agreement to purchase an issuer's unsold securities at a set price, thereby guaranteeing the issuer
proceeds and a fixed borrowing cost.
Variable Rate Bond. A bond whose yield is adjusted periodically according to a prescribed formula.
Yield Curve. Graph depicting the relationship between yields and current maturity for securities with identical
default risk.
Yield-to-call. Return available to call date taking into consideration the current value of the call premium, if any.
Yield-to-maturity. (YTM) Return available taking into account the interest rate, length of time to maturity, and
price paid. It is assumed that the coupon reinvestment rate for the life of the bonds will be the same as the yield-to-
maturity.
Zero-coupon Bonds. A deep discount municipal bond on which no current interest is paid. Instead, at bond
maturity, the investor receives compounded interest at a specified rate. The difference between the discount
price at purchase and the accreted value at maturity is not taxed as a capital gain but is considered tax-exempt
interest. Often used for college savings bonds.
Saunders Learning Group, Newton, KS
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