CHAPTER 8

ANSWERS TO "DO YOU UNDERSTAND?" TEXT QUESTIONS

DO YOU UNDERSTAND?

1. Why do businesses use the capital markets?

Answer: Businesses use the capital markets to finance long-term investments and to provide a
"market value" evaluation of company performance. The use of long-term securities allows issuers to
be certain of the cost of funds for the life of the investment and reduces refinancing problems.

2. How do T-bills, T-notes, and T-bonds differ?

Answer: There are two major factors that differentiate T-bill, T-notes, and T-bonds: term and interest
payments. T-bills are offered in maturities of four, 13, and 26 weeks and are zero-coupon securities
selling at a discount relative to the face value. T-notes are intermediate-term coupon-paying securities
with original maturities of two, five, and ten years. T-bonds have maturities greater than 10 years and,
similar to T-notes, pay interest regularly.

3. Explain how coupon rates on TIPS are determined and how interest payments are computed.

Answer: The coupon rate on TIPS is determined similarly to non-TIPS notes and bonds it is
the highest accepted rate in the Treasury auction rounded to the nearest one eighths of one
percent at which the note or bond trades below par. The principal amount adjusts according to
the change in the Consumer Price Index for All Urban Consumers (CPI-U). For example, if
CPI-U increases by 1% over the six-month period preceding the coupon payment, the
principal of a TIPS note or bond also increases by 1%. The coupon rate is paid on the adjusted
principal.

4. What is a STRIPS? Explain how these securities are created.

Answer: A Separate Trading of Registered Interest and Principal of Securities (STRIPS) is a

Treasury security that has been separated into its component parts: each interest payment and the
principal payment become separate zero-coupon securities. Treasury securities dealers buy Treasury
securities whole at auction and then create STRIP components to meet customer demands. Each newly
created zero-coupon security is registered with the Treasury upon the dealers request.

5. Explain how STRIPS can be used to immunize portfolios against interest rate risk.

Answer: STRIPS are zero-coupon bonds and a portfolio of STRIPS will have its duration equal to its
maturity. If a bond is held to its duration, the realized YTM equals the expected YTM, eliminating
reinvestment and price risk.

DO YOU UNDERSTAND?

1. Explain why sinking funds on corporate bond issues play the same role as the serial structure found on
municipal bond issues.

Answer: Sinking funds, an old term dating back to the days when companies accumulated funds to
pay off bonds at maturity, today effectively pay off bonds periodically (called or purchased in the
 market). Serial bonds are bonds issued with varying maturities, so that part of the bond issue matures
every year, beginning in a certain year.

2. When buying bonds, explain why investors should always make a tax-exempt and taxable comparison.
What are the ground rules for making the comparison?

Answer: Everything else the same, the investor is seeking the higher after-tax return. To determine
which bond offers the higher after-tax return, calculate the after-tax return of the corporate using the
investor's marginal tax rate and compare it to the rate on the municipal bond.

3. Why are individuals the major investors in municipal bonds and commercial banks are not?

Answer: The Tax Reform Acts of 1986 eliminated much of an incentive for commercial banks to
invest in munis. Households in high tax brackets are the major investor in munis, either directly or
through mutual funds. Property and casualty insurance companies have high tax exposure and also
often seek tax sheltering via preferred stocks and muni bonds. Life insurance companies, with
considerable tax shelters coming from whole life policies, invest in taxable corporate bonds.

4. What is your marginal tax rate if you are indifferent between investing in a corporate bond
with a 6% coupon and a tax-exempt municipal bond of similar risk, maturity, and liquidity with a
4.2% coupon rate?

Solution: Solve for t in Equation 6.4: iat = ibt(1 t): 4.2% = 6%(1 t);
t = 1 4.2%/6% = 30%.

5. How do the secondary markets differ between municipal bonds and corporate bonds?

Answer: The secondary market for municipals is a dealer market and is quite thin, as are many
corporate bond issues. There are more large-issue corporate bonds, some listed on exchanges, which
trade more frequently in dealer markets.

6. Explain how and why the junk bond market had an impact on commercial bank lending.

Answer: Prior to the development of the junk bond market, low credit quality firms depended on
bank loans for their funds. Banks would only offer short-term or variable rate medium-term loans
regardless of the borrowers need, thus passing on any interest rate risk to the borrower. These firms
had no alternative until the junk bond market developed and allowed them to replace bank loans with
marketable debt with longer maturities matching their cash flow needs.

DO YOU UNDERSTAND?

1. Why have asset-backed securities become important in capital markets?

Answer: ABS are created through securitization of loans. Many ABS have characteristics that many
capital market investors found valuable, such as financial guarantees, seemingly predictable cash
flows, or floating rates, and thus were willing to pay a premium for them. This was especially
true in the mortgage market where high credit ratings assigned even to subprime
mortgage-backed securities created an impression of low credit risk for many
investors. Since these characteristics were highly desirable, more ABS were being created.
However, securitization transfers risk but does not eliminate it. In 2007, major concerns arose
 about the quality of assets that backed some ABS, especially subprime mortgage-backed and
loan-backed securities. With subprime loan defaults increasing substantially, either investors
or insurers of these securities took large losses. As a result, the issuance of asset-backed
securities fell dramatically in 2007 and 2008. Credit rating agencies, such as Moodys and
Standard and Poor, were criticized for assigning unjustifiably high ratings (in the opinion of
critics) to structured asset-backed securities. The main lesson is that securitization and ABS
have a negative side: They may spread the risk to the point where the whole financial system
becomes vulnerable.

2. Why are financial guarantees become increasingly important in financial markets? Why are guaranteed
securities not default risk-free?

Answer: Investors need only to ascertain the creditworthiness of the guarantor and not the
creditworthiness of each underlying asset. Because of the reduction in default risk, guaranteed
securities are more marketable than non-guaranteed securities and enable issuers to pay lower yields.
These securities are not default risk-free because even the strongest guarantor may default if a large
proportion of the securities it has guaranteed defaults.
The 2007-2009 financial crisis showed that most if not all ABS investors had either taken for granted
that insurers of financial assets were strong enough to withstand large losses to the insured securities
or underestimated risk exposures of the insurers. A prominent example is American International
Group (AIG), a company whose London division insured a large volume of ABS called collateralized
debt obligations (CDOs), including CDOs backed by subprime (low credit quality) loans. The
company reported over $13 billion in losses in the first two quarters of 2008, and its credit rating was
downgraded from AAA to AA in mid-September. A top-notch credit rating is extremely important for
insurers of credit risk, and AIG suffered a liquidity crisis and would have filed for bankruptcy on
September 17, 2008, had it not been provided an $85 billion emergency loan by the Federal Reserve.

3. What types of credit enhancement can be obtained to make asset-backed securities more desirable?

Answer: Financial guarantees such as bond insurance, standby letters of credit, the use of cash
collateral accounts, the use of subordinated tranches that enhance senior tranches by bearing the
default risk, and setting aside profits and servicing fee accruals to protect buyers of tranches against
future losses all make ABS more desirable.

4. Why are financial markets regulated, and who is the principal U.S. regulator?

Answer: Financial markets are regulated so people will retain confidence in them and continue to supply
money to them. The Securities and Exchange Commission (SEC), established in 1933 after the Great
Depression, is the principal regulator at the federal level. There are also regulators at the state level in
every state who focus on consumer protection issues. In addition, there are self-regulatory bodies like the
National Association of Securities Dealers (NASD) which were established to protect the integrity of the
markets and the industries involved.