Bond Sectors and

Instruments
For Study Review Only
Bond Market

Internal Bond Market

External Bond Market
Bond Market
Internal Bond Market (National
Bond Market)

1. Domestic Bond Market : Domestic
issuers.

2. Foreign Bond Market: Foreign issuers:
central governments and their
subdivisions, corporations, and
supranationals.
External Bond Market international
bond market, the offshore bond Market,
Eurobond Market

underwritten by an international syndicate.

(at issuance) offered simultaneously to investors
in a number of countries.

issued outside the jurisdiction of any single
country.

in unregistered form.
External Bond Market

Eurobonds are classified based on the
currency in which the issue is
denominated. E.g. Eurodollar bonds.
Euroyen bond.

Global bond: a debt obligation that is
issued and traded in the foreign bond
market of one or more countries and the
Eurobond market.
Sovereign Bonds

issued by a countrys central government.

Credit Risk: Sovereign ratings.

Two types of ratings to sovereign debt
 1. local currency debt rating
 2. foreign currency debt rating
Sovereign Bonds

Methods of Distributing New Government

Securities:
 1. regular auction cycle/multiple-price
method: winning bidders are allocated
securities at the yield (price) they bid.
 2. regular auction cycle/single-price
method: all winning bidders are awarded
securities at the highest yield accepted by the
government.
Sovereign Bonds

Methods of Distributing New Government

Securities:
 3. ad hoc auction method: governments
announce auctions when prevailing market
conditions appear favorable.
 4. tap method: additional bonds of a
previously outstanding bond issue are
auctioned.
Sovereign Bonds

On-the-run issue or the current issue:

the most recently.

Off-the-run issues: the securities that are
replaced by the on-the-run issue.
Sovereign Bonds

Fixed-principal Securities

Inflation Indexed Securities
Sovereign Bonds
Sovereign Bonds

Inflation-Indexed Treasury Securities.

 provide protection against inflation.
 referred to as Treasury inflation protection
securities or TIPS. (The Treasury or as
Treasury inflation indexed securities, TIIS.)
Sovereign Bonds: TIPS

inflation-adjusted principal.
 E.g.coupon rate for a TIPS is 3.5% (paid
semiannually) .
 annual inflation rate is 3% and 2%.
Period Inflation Adj.Par Coup, % Coupon
0 100,000
1 3% 101,500 3.5% 1,776.25
2 2% 102,515 3.5% 1,794.01
Sovereign Bonds

Treasury STRIPs
 issued through the Treasurys Separate
Trading of Registered Interest and Principal
Securities (STRIPS) program.
 Coupon Strips: strips created from coupon
payments.
 Principals Strips: created from the principal
payments.
Semi-government/ Agency
Bonds

Issued by an agency or organization was
established by a central government.

Federally related institutions are arms of
the federal government.

Government-sponsored enterprises
(GSEs) are privately owned, publicly
chartered entities created by Congress.
Semi-government/ Agency Bonds
Semi-government/ Agency
Bonds

U.S. Agency Debentures and Discount
Notes
 Debentures can be either notes or bonds.
 Discount notes are short-term obligations,
with maturities ranging from overnight to 360
days.
Semi-government/ Agency
Bonds

U.S. Agency Mortgage-Backed Securities
 Mortgage Loans: a loan secured by the collateral of
some specified real estate property.
 Mortgage Passthrough Securities (Passthrough)
 Collateralized Mortgage Obligations
Semi-government/ Agency
Bonds

U.S. Agency Mortgage-Backed Securities
 Mortgage Loans: a loan secured by the collateral of
some specified real estate property.

gives the lender the right, if the borrower defaults,
to foreclose on the loan and seize the property
in order to ensure that the debt is paid off.

Mortgage rate or contract rate: interest rate on
the mortgage loan.
Mortgage Loans

secured by the collateral of some specified real
estate property.

Prepayment: a payment made in excess of the
monthly mortgage payment. May be for the
entire principal outstanding principal or a partial.

Curtailment: prepayment not for the entire
amount.

Typically, no penalty for prepaying a mortgage
loan.

Prepayment risk
Mortgage Passthrough Securities
(Passthrough)

a security created when one or more
holders of mortgages form a collection.

(pool) of mortgages and sell shares or
participation certificates in the pool.

mortgages that is used as collateral for a
passthrough, the mortgage is said to be
securitized.
Collateralized Mortgage
Obligations (CMO)

Motivation for creation of a CMO is to
distribute prepayment risk among different
classes of bonds.
State and Local Governments

Municipal securities or municipal bonds: issued
by non-central government entities (local
governments and entities that they create.)

could be tax-exempt (common) or taxable
municipal securities.

Two types of municipal security structures:
 tax-backed debt
 revenue bonds.
 special Bond Structures
General Obligation Bond

Double-barreled in security: Certain general
obligation bonds are secured by
 issuers general taxing powers to create revenues
accumulated in a general fund, and
 certain identified fees, grants, and special charges,
which provide additional revenues from outside the
general fund.
Revenue bonds

issued for enterprise financings that are

secured by the revenues generated by the
completed projects themselves.
Special Bond Structures

Insured bonds: in addition to being secured by
the issuers revenue, are also backed by
insurance policies written by commercial
insurance companies.

Prerefunded bonds: originally issued as either
revenue or general obligation bonds, municipals
are sometimes prerefunded.
Corporate Debt Securities
Bankruptcy

Liquidation: all the assets will be distributed to
the claim holders of the corporation and no
corporate entity will survive.

Reorganization: a new corporate entity will
emerge. Some security holders will receive cash
in exchange for their claims, others may receive
new securities in the corporation that results
from the reorganization, and others may receive
a combination.
Bankruptcy

The absolute priority rule: the principle that

senior creditors are paid in full before
junior creditors are paid anything.
Factors Considered in
Assigning a Credit Rating

the four Cs of creditcharacter,
capacity, collateral, and covenants.
Character

analysis involves the analysis of the

quality of management.
Capacity

assessing the ability of an issuer to pay

(i.e., capacity), the analysts conduct
financial statement analysis.
Collateral
Covenants

Affirmative covenants: those call upon the

debtor to make promises to do certain
things.

Negative covenants: those which require
the borrower not to take certain actions.
Corporate Bonds

Secured Debt
 mortgage debt
 collateral trust bonds

Unsecured Debt
 debenture bonds
 subordinated debenture bonds

Credit Enhancements
 third-party guarantee
 letter of credit (LOC) issued by a bank
Default Rates and Recovery
Rates

Issuer Default Rate: number of issuers
that default divided by the total number of
issuers at the beginning of the year.

Dollar Default Rate: par value of all
bonds that defaulted in a given calendar
year, divided by the total par value of all
bonds outstanding during the year.
Default Rates and Recovery
Rates

Recovery Rates: The recovery rate is the
trading price at that time divided by the par
value.
A medium-term note (MTN)

Note are offered continuously to investors by an
agent of the issuer.

Investors can select from several maturity
ranges: 9 months to 1 year, more than 1 year to
18 months, more than 18 months to 2 years, and
so on up to 30 years.

The Primary Market: sold in relatively small
amounts on either a continuous or an
intermittent basis.
A medium-term note (MTN)

Note are offered continuously to investors by an
agent of the issuer.

Several maturity ranges: 9 months to 1 year,
more than 1 year to 18 months, more than 18
months to 2 years, and so on up to 30 years.

The Primary Market: sold on a best-efforts
basis in relatively small amounts on either a
continuous or an intermittent basis.
Structured MTNs

offered with transactions in the derivative
markets (options, futures/forwards, swaps, caps,
and floors) so they may create debt obligations
with more complex risk/return features.

Common structured notes include: step-up
notes, inverse floaters, deleveraged floaters,
dual-indexed floaters, range notes, and index
amortizing notes.
Structured MTNs

Deleveraged floater
coupon rate = b x(reference rate) + quoted
margin

Dual-Indexed Floaters
E.g. Coupon rate = (10-year Constant Maturity
Treasury rate) (3-month LIBOR) + 160 basis
points
A range note

a type of floater whose coupon rate is equal to
the reference rate as long as the reference rate
is within a certain range at the reset date.

If not, the coupon rate is zero for that period.
An index amortizing note (IAN)

is a structured note with a fixed coupon rate but
whose principal payments are made prior to the
stated maturity date based on the prevailing
value for some reference interest rate.

The principal payments are structured so that
the time to maturity of an IAN increases when
the reference interest rate increases and the
maturity decreases when the reference interest
rate decreases.
Commercial paper

a short-term unsecured promissory note that is
issued in the open market

Typically, commercial paper is issued as a zero-
coupon instrument.

maturity is typically (in US) less than 270 days
and the most common maturity is 50 days or
less.
Commercial paper

issuers generally use the proceeds from selling
new commercial paper to pay off holders of
maturing paper rolling over short-term paper.
Roll-over risk - unable to issue new paper at
maturity.

typically backed by unused bank credit lines.

very little secondary trading of commercial
paper.
Commercial paper

Typically, investors plans to hold it until maturity.

Corporate issuers: financial companies and
nonfinancial companies.

greater use of commercial paper by financial
companies (captive finance companies, bank-
related finance companies, and independent
finance companies).
Commercial paper

Directly placed paper or dealer-placed

paper.
Commercial Paper
Bank Obligations

Certificate of deposit (CD) is issued by a bank
(or other deposit-accepting entity) and indicates
a specified sum of money has been deposited at
the issuing depository institution.

Negotiable CDs: allows the initial depositor (or
any subsequent owner of the CD to sell the CD
in the open market prior to the maturity date.

Eurodollar CD
Bank Obligations

bankers acceptance: a vehicle created to
facilitate commercial trade transactions.
 used to finance a commercial transaction
acceptance financing.
 sold on a discounted basis just as Treasury bills and
commercial paper
 a bank accepts the ultimate responsibility to repay a
loan to its holder.
Asset-backed Securities

backed by a pool of loans or receivables.

The key to a corporation issuing a security
with a higher credit rating than the
corporations own credit rating is using
SPV Corp. (special purpose vehicle or
special purpose corporation) as the
issuer.
Asset-backed Securities

External credit enhancements: third-

party guarantees.
a corporate guarantee,
 a letter of credit,
 bond insurance
Asset-backed Securities

Internal credit enhancements

 reserve funds,
 over collateralization, and
 senior/subordinate structures
Collateralized Debt Obligations

backed by a diversified pool of one or more of the
following types of debt obligations:
 U.S. domestic investment-grade and high-yield corporate bonds
 U.S. domestic bank loans
 emerging market bonds
 special situation loans and distressed debt
 foreign bank loans
 asset-backed securities
 residential and commercial mortgage-backed securities
 other CDOs
Collateralized Debt Obligations

Collateralized bond obligation (CBO): backed by
pool of debt obligations consists of bond-type
instruments

Collateralized loan obligation (CLO): underlying
pool of debt obligations are bank loans.
Collateralized Debt Obligations

Motivation of the sponsor

 Arbitragetransaction
 Balance sheet transaction
Primary Market for Bonds

Investment bankers work with issuers to
distribute newly issued securities.

investment bankers perform one or more of the
three functions:
 1. advising the issuer on the terms and the
timing of the offering,
 2. buying the securities from the issuer, and
 3. distributing the issue to the public.
Primary Market for Bonds

Bought Deal or Auction Process.

Private Placement Vs Public Offering
Secondary Market for Bonds

On an exchange or In an over-the-counter
market

Traditionally, bond trading has taken place
predominately in the over-the-counter
market where broker-dealer trading desks
take principal positions to fill customer buy
and sell orders.
Secondary Market for Bonds

Two different major types of exchange systems
are
 continuous trading and
 Call auctions