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Fixed Income

Overview of Bond Sectors and Instruments

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Fixed Income

Overview of Bond Sectors and Instruments


The candidate should be able to:
a. Describe features, credit risk characteristics, and distribution methods for government securities;
b. Describe the types of securities issued by the U.S. Department of the Treasury (e.g. bills, notes, bonds,
and inflation protection securities), and distinguish between on-the-run and off-the-run Treasury
securities;
c. Describe how stripped Treasury securities are created and distinguish between coupon strips and
principal strips;
d. Describe the types and characteristics of securities issued by U.S. federal agencies;
e. Describe the types and characteristics of mortgage-backed securities and explain the cash flow and
prepayment risk for each type;
f. State the motivation for creating a collateralized mortgage obligation;
g. Describe the types of securities issued by municipalities in the United States and distinguish between
tax-backed debt and revenue bonds;
h. Describe the characteristics and motivation for the various types of debt issued by corporations
(including corporate bonds, medium-term notes, structured notes, commercial paper, negotiable CDs,
and bankers acceptances);
i. Define an asset-backed security, describe the role of a special purpose vehicle in an asset-backed
securitys transaction, state the motivation for a corporation to issue an asset-backed security, and
describe the types of external credit enhancements for asset-backed securities;
j. Describe collateralized debt obligations;
k. Describe the mechanisms available for placing bonds in the primary market and distinguish between
the primary and secondary markets for bonds.

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Sovereign bonds.
Sovereign bond is the obligation of a country's central government. Government can raise funds by issuing
foreign bonds, Eurobonds and domestic bonds, or by borrowing from banks through syndicated bank loans.

Fixed Income

Credit Risk
Bonds issued by the US government are viewed as default-free, as they are backed by the full faith and
credit of the U.S. government. Sovereign bonds of non-US central governments are rated by the credit
rating agencies.
Sovereign ratings refer to the ratings of foreign (i.e. non-U.S.) government debt. Both quantitative and
qualitative analyses are employed in assessing sovereign risk with ratings performed in both local currency
and foreign currency. It is important to evaluate the ratings in both currencies since historically the default
rate on foreign currency debt has been greater than the default rate on local (or domestic) currency debt:
there is different risk in the two ratings. Generally, if an issuer is planning to default, it is more likely to do
so with a foreign currency issue as has less control with respect to its exchange rate. Thus, the ratings need
to be performed for both types of issues.

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Sovereign bonds.
Distribution Methods

Fixed Income

Governments use the following methods to issue new bonds:

Regular auction cycle/single-price method: this is the same method used by the U.S. Treasury.

Regular auction cycle/multiple-price method: this method is similar to the one used by the U. S.
Treasury, except that winning bidders are awarded securities at the yield they bid, not at the stop

yield.

Ad hoc auction method: auctions are announced when market conditions are favorable.

Tap method: bonds from a previously outstanding issue are auctioned.U.S.

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U.S. Treasury securities.

Fixed Income

Treasury securities are issued by the U.S. Department of Treasury, and are backed by the full faith and credit of the
U.S. government. They are considered as having no credit risk.
There are two types of T-securities: discount and coupon securities. Treasury coupon securities come in two forms:
fixed rate and variable-rate securities.

T-Bills are also called discount securities. They have the following features:
o Issued at a discount to par value.
o No coupon rate.
o Mature within a year or less. There are three initial maturities: 91 days (3-month), 182 days (6month), and 364-days (1-year).
o The return to the investor is the difference between the maturity value (par value) and the purchase
price.

As you can see they have the same characteristics of zero-coupon bonds. The bills have initial maturities of 3months, 6-months and 1-year.

T-Notes and T-Bonds. All securities with initial maturities of two years or more are issued as Treasury
coupon securities. They have are issued at approximately par, have a coupon rate, and mature at par value.
o T-Notes are issued with maturities of more than one year and no more than 10 years.
o There are three initial maturities: 2 year, 5 year and 10 years. T-notes are identified with an "n" on
quote sheets.
o T-Bonds are issued with maturities greater than 10 years. The initial maturity is 30 years.
o None of the currently issued Treasury coupon securities are callable, although there are outstanding
T-bonds that are callable.

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Fixed Income

Treasury Inflation Protection Securities (TIPS) are T-notes or T-bonds that are adjusted for
inflation. TIPS works as follows:
o The coupon rate on an issue is set at a fixed rate. The rate is called the real rate since it is the
rate that the investor ultimately earns above the inflation rate.
o Every six months some adjustments are made.
o The principal that the Treasury Department will base both the dollar amount of the coupon
payment and the maturity value is adjusted: adjusted principal = principal before adjustment
x ( 1 + inflation rate). This is called inflation-adjusted principal.
o The coupon payment is determined as: coupon payment = inflation-adjusted principal x
fixed coupon rate.

Because of the possibility of disinflation (price declines), the inflation-adjusted principal at maturity may
turn out to be less than the initial par value. However, TIPS are structured to be redeemed at the greater of
the inflation-adjusted principal and the initial par value.
For example, an investor purchases on January 1 $100,000 of par value of a TIPS issue with a coupon rate
of 3.5%. For the first six months the annual inflation is 3% and thus the semiannual inflation rate is 1.5%.
At the end of the first six-month period the inflation adjusted principal is $100,000 x ( 1 + 1.5%) =
$101,500. The coupon payment is then $101,500 x 1.75% = $1,776.25. At the end of the second six-month
period (suppose the semiannual inflation rate has been changed to 1%), the inflation-adjusted principal is
then $101,500 x ( 1 + 1%) = $102,515. The coupon payment is then $102,515 x 1.75% = $1,794.01.

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The treasury auction process, secondary market and price quotes of Treasury securities

Fixed Income

Treasury bills and coupon securities are auctioned on a regular basis. They are all issued on a\ competitive
bid basis in a single-price auction (Dutch auction). All winning bidders are awarded securities at the same
yield (the highest yield of accepted competitive tenders).

On the announcement date, the Treasury announces the amount of each issue to be auctioned, the
auction date, and the maturities to be issued.

A competitive bid specifies both the quantity sought and the yield at which the bidder is willing to
purchase the auctioned security. A non-competitive bid is specifies only the quantity sought, and
the non-competitive bidder will accept the yield determined by the auction. A bidder can submit a
bid of either type.

The bids are arranged from the lowest yield bid to the highest yield bid (equivalent to arranging the
bids from the highest price to the lowest price). The highest yield accepted by the Treasury is
referred to as the stop yield.

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Treasury strips.

Fixed Income

The Treasury does not issue zero-coupon notes or bonds, but the private sector has created such securities using
coupon stripping - a process of dealers stripping the coupon payments and principal payment of a Treasury coupon
security. Investment dealers purchase Treasury bonds and deposit them in a bank custody account, and then issue
receipts representing an ownership interest in each coupon payment and maturity value on the underlying Treasury
bond.
If you imagine a note with a 10-year maturity, a coupon rate of 5% and a principal of $100 million, there will be 20
semiannual payments of $2.5 million and the repayment of the principal at the end of $100 million These 21
payments can be split out into 21 zero-coupon securities million. These 21 payments can be split out into 21 zerocoupon securities.
Strips created from the coupon payments are called coupon strips, or simply corpus (denoted ci). Strips created
from the principals are called principal strips (denoted np if principal is from a T-note, and bp if principal is from a
T-bond). The distinction is made due to different tax treatment by non-U.S. entities.
In the past, Treasury strips were created by private entities such as investment banks. These treasury strips were
direct obligations of the private entities that issued these strips. The issuers held the original Treasury securities to
back their obligations. Today, these zero-coupon instruments are issued through the Treasury's Separate Trading of
Registered Interest and Principal Securities (STRIPS) program and become the direct obligations of the U.S.
government. Private entities no longer issue Treasury strips.
A disadvantage of a taxable entity investing in Treasury strips is that accrued interest is taxed each year even
though interest is not received. Thus the instruments result in cash outflows in the form of tax until the maturity
date.

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Federal agency securities

Fixed Income

Agency securities are obligations issued by the government through various political sub divisions. Most
federal agency securities are not obligations of the US Treasury. Government sponsored enterprise (GSE)
are privately owned, publicly chartered entities.

They were created by Congress to help students, farmers and homeowners.

The five GSEs that issue debentures are the Federal Farm Credit System, Federal Home

Loan Bank System, Federal National Mortgage Association, Federal Home Loan Bank

Corporation, and Student Loan Marketing Association.

With the exception of the securities issued by the Federal Farm Credit Financial Assistance

Corporation, GSE securities are not backed by the full faith and the credit of the U.S. government
and thus investors are exposed to (but very little) credit risk.

In addition to debentures (debt securities that are not backed by a collateral), Fannie Mae and
Freddie Max issue mortgage-backed securities, securities backed by a pool of residential mortgage
loans.

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Fixed Income

Federal related institutions are arms of the federal government.

They generally do not issue securities directly in the marketplace.

They are exempt from SEC regulation.

The institutions obtain financing from the Federal Financing Bank.

The securities are for import-export, rural telephone, small business, etc.

Generally these securities are backed by the full faith and credit of the U.S. government, and
therefore most FRI securities essentially have no credit risk.

The major issuers have been the Tennessee Valley Authority (TVA) and the Ginnie Mae.

Agency mortgage-backed securities are issued by Fannie Mae, Freddie Mac and Ginnie Mae, with pools of
mortgage loans as collaterals. Each month the total of all interest and principal payments made by the
mortgage loans in the pool, less a servicing spread, goes to the security holders. Therefore the cash flows
from a mortgage-backed security are determined by cash flows from the underlying mortgage loans.

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Mortgage Backed Securities

Fixed Income

Note that the cash flows of a mortgage-backed security are different from the monthly mortgage payments
of the underlying mortgage loans. There are two factors that cause the discrepancy:
1.

Servicing fees. These are administrative costs of servicing (collecting monthly payments,
maintaining records, etc) the mortgage loans. If the mortgage rate is 8.125% and the service fee is
50 basis points, then the investor receives interest of 7.625%. The interest rate that the investor
receives is called net interest.

2.

Prepayments. A payment made in excess of the monthly mortgage payment is called a


prepayment. When a prepayment is not for the entire amount it is called a curtailment. Typically
there is no penalty for prepaying a mortgage loan. Prepayment is caused when:

A home owner sells his/her home.


The market rate falls.
A homeowner becomes default and the property is sold.
The property is destroyed by fire and the insurer pays off the mortgage.

Therefore the monthly cash flows of a mortgage-backed security have three components: net interest,
scheduled principal repayment and prepayment.

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Fixed Income

There are two types of mortgage-backed securities:


1. A mortgage pass through security is a security created when one or more holders of mortgages form a
collection of mortgages and sell shares or participation certificates in the pool. The mortgage is said to
be securitized if it is included in such a pool. Loans that meet the requirements of Fannie Mae, Freddie
Mac and Ginnie Mae's are called conforming loans.
The cash flow of a pass through depends on the cash flow of the underlying pool of mortgages.
Because of prepayments, the amount of the cash flow is uncertain in terms of the timing of the
principal repayment. However, an investor of a pass through gains the diversification benefits -- the
prepayment risk now is spread over a pool of mortgages. The monthly payments are passed through to
the certificate holders on a pro rata basis.
2.

Collateralized Mortgage Obligations (CMO): A CMO is similar to a pass through security as described
above. The difference is that different tranches are created which have different rules for the payment
of principal and interest.
CMOs are bond classes (called tranches) created by redirecting the cash flows of mortgage related
products (pass-through and whole loans) so as to mitigate prepayment risk.

Principal component (both scheduled principal repayments and prepayments) of the monthly cash flows from
the underlying mortgage loans are distributed to each tranche on a prioritized basis. In another word, it can
transfer (not eliminate) the various forms of this risk among different classes of bondholders so that a CMO
class has a different coupon rate from that for the underlying collateral. Investors can select the tranches of a
CMO based on their cash flow and risk-return preferences. However, the CMO, the pass through securities,
and the pool of underlying mortgage loans have the same amount of total prepayment risk.

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As an example, consider a CMO created from a pool of mortgages. To start with, the assets (the mortgages)
are placed in a trust to serve as collateral for the CMO. Assume that three tranches are created each with
their own payment profile. Each of the tranches receives interest payments based on their outstanding par
values but will have different rules for the payment of principal as follows:

Fixed Income

Tranche
A
B
C

Net interest
Pay each month based on par amount
outstanding
Pay each month based on par amount
outstanding
Pay each month based on par amount
outstanding

Principal
Receives all monthly principal
until completely paid off
After Tranche A is paid off,
receives all monthly principal
After Tranche B is paid off,
receives all monthly principal

The effect is that although the overall risk of prepayment still exists, Tranche A receives the risk first,
followed by Tranche B and then Tranche C. The result is that not all of the holders will experience the risk
at the same time, and depending on what the investors' needs are they can decide to purchase A, B or C.
A CMO is thus a derivative of a past through security with a payment structure that redistributes the
prepayment risk among different investors.
CMOs will be dealt with in more depth in Level II. For the purposes of the Level I exam you are required
to understand the structure and the reason for which they were created.
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Municipal securities.

Fixed Income

Municipal securities (or simply munis) are debt obligations issued by state governments, local governments
and entities created by local governments.
There are both tax-exempt AND taxable municipal securities, where "tax-exempt" means that interest on a
municipal security is exempt from federal income taxation. Capital gains are still subject to federal income
taxation. Whether interest income on a municipal security is tax-exempt at the state and local levels
depends on the specific tax laws in each state.
Different from Treasury securities, municipal securities have credit risk.

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There are basically two types:

Fixed Income

Tax-backed debt obligations are instruments issued by states, countries, special district, cities, towns and
school districts that are secured by some form of tax revenue. There are three types of tax-backed debt:
o General Obligation Debt (GO): these securities are backed by the issuer's unlimited taxing power, and
its full faith and credit. However, there is a statutory limit on the tax rates that the issuer can levy to
repay the debt. Certain GOs are secured not only by the issuer's general taxing powers but also by
certain identified fees, grants and special charges. Such bonds are known as double-barreled in
security.
o Appropriation-Backed Obligations: in addition to being backed by the issuer's revenue, these
securities are also backed by a non-binding appropriation of funds from the state's general tax
revenue. Since the state's pledge is not binding, these securities are also called moral obligation
bonds. The purpose is to enhance the credit worthiness of the issuing entity.
o Debt Obligations Supported by Public Credit Enhancement Programs: there are two common forms
of credit enhancements which are legally binding: a guarantee by the state or a federal agency, or an
obligation of the state to withhold and use state aid to pay the issuer's unpaid debt.
Revenue bonds are issued for enterprise financings that are secured by the revenues generated by the
completed projects themselves, or for general public-purpose financings in which the issuers pledge to the
bondholders the tax and revenue resources that were previously part of the general fund. They include utility
revenue bonds, transportation revenue bonds, housing revenue bonds, higher education revenue bonds,
health care revenue bonds, sports complex and convention center revenue bonds, seaport revenue bonds and
industrial revenue bonds. Different from a tax-backed debt, the issuer of a revenue bond has the obligation to
repay the debt only if the underlying project generates sufficient revenue. If not, the issuer does not have to
make additional payment.

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Fixed Income

Some municipal securities have special structures.

Insured bonds are backed by insurance policies written by commercial insurance companies, and
by the credit of the issuer's revenue. Insurance companies are required to pay any unpaid debt
obligations of the issuer. Once insured, insurance policies cannot be canceled by insurance
companies. Insurance enhances the security's credit rating and consequently lowers its interest rate.

Pre refunded bonds (also called Refunded bonds) originally may have been issued as general
obligation or revenue bonds, but that are now secured by an "escrow fund". This means that a
portfolio of securities is placed in a trust. The portfolio of securities is assembled such that the cash
flows from the securities match the obligations that the issuer must pay. Therefore the municipal
bond is no longer backed by the issuer's tax revenue project revenues. Instead, it's backed by cash
flows from the portfolio of securities held in an escrow fund. If escrowed with securities
guaranteed by the U.S. government, refunded bonds are the safest municipal bonds available.

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Bankruptcy and bond holder rights.

Fixed Income

A bankruptcy petition can be filed in the court by the company itself (voluntary bankruptcy), or by one of the
creditors (involuntary bankruptcy). After the bankruptcy filing, the company becomes a "debtor inpossession", and continues its business under the court's supervision.
The Bankruptcy Reform Act of 1978 governs the bankruptcy process in the U.S. The purpose of the act is to set
forth the rules for a corporation to be either liquidated or reorganized.

The liquidation of a corporation (Chapter 7 bankruptcy) means that the company's business is
terminated, all the assets are sold and distributed to the holders of claims of the organization and no
corporate should survive

In a reorganization, a new corporate entity will result. This is also known as Chapter 11 bankruptcy. In
this case, a plan is created to restructure a company's business and restore its financial health.
Bondholders may receive cash and/or new securities in exchange for their claims. The absolute priority
rule (explained below) may not hold in reorganizations.
Another purpose of the Act is to allow the corporation time to decide whether to reorganize or liquidate and
then also give them time to formulate a plan to accomplish the reorganization or liquidation. This is achieved
through stopping creditors from seeking to have their claims paid once the company has filed for bankruptcy.
The holder of a corporate debt instrument has priority over the equity owners in a bankruptcy proceeding. In
theory, creditors should receive distribution based on the absolute priority rule to the extent assets are available;
this rule means that senior creditors are paid in full before junior creditors are paid anything. Generally, the
absolute priority rule holds in the case of liquidation and is typically violated in reorganizations.

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Fixed Income

Factors considered in assigning a credit rating.


There are companies called rating agencies that assign credit ratings to corporate issues based on the
prospect of default. A credit analyst must consider four C's of credit:
1. Character relates to the ethical reputation as well as the business qualifications and operating
record of the board of directors, management, and executives responsible for the use of the
borrowed funds and its repayment. It covers many aspects such as strategic direction, financial
philosophy, conservatism, track record, succession planning, control systems, etc.
2. Capacity deals with the ability of an issuer to repay its obligations. It covers such aspects as
industry trends, regulatory environment, operating and competitive position, financial conditions,
company structure, parent company support agreements, and special event risk.
3. Collateral involves not only the traditional pledging of assets to secure the debt, but also the quality
and value of those un-pledged assets controlled by the issue.
4. Covenants deal with limitations and restrictions on the borrower's activities. They are important
because they impose restrictions on how management operates the company and conducts its
financial assets. It covers both affirmative and negative covenants.
It is important to understand that a credit analysis can be for an entire company or a particular debt
obligation of that company.

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Fixed Income

Corporate debt instruments: secured debt, unsecured debt, credit enhancements, and
medium term notes.
A corporate debt issue is said to be secured debt if there is some form of collateral that is pledged to ensure
repayment of the debt. The collateral can be personal property, real property, or financial assets such as
stocks, bonds, etc.

Mortgage debt is debt secured by real property such as plant and equipment. With mortgage debt
the issuer has granted the bondholders a lien against the pledged assets. A lien is a legal right to sell
mortgaged property to satisfy unpaid obligations to bondholders. Sometimes the issuer can issue an
additional layer of mortgage debt secured by the same asset. This secondary mortgage debt is
called general and refunding mortgage bond (G&R), and is junior to the first mortgage bond.

Collateral trust debentures, bonds and notes are secured by financial assets such as cash,
receivables, other notes, debentures or bonds, and not by real property.
Unsecured debt comes in several different layers or levels of claim against the corporation's assets and
subordination of the debt instrument might not be apparent from the issue's name. Debenture bonds are not
secured by a specific pledge of property, and bondholders have the claim of general creditors on all assets
of the issuer not pledged specifically to secure other debt. One of the important protective provisions for
unsecured debt holders is the negative pledge clause which prohibits a company from creating or assuming
any lien to secure a debt issue without equally securing the subject debt issue(s) (with certain exceptions).

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Fixed Income

Some debt issues are credit enhanced by having other companies guarantee their loans. Small companies
with low credit ratings issue commercial papers by means of credit support from a firm with high credit
rating (credit-supported commercial paper) or by collateralizing the issue with high quality assets (assetbacked commercial paper). They can also take letter of credit from banks or surety bond from insurance
companies. Both the issuer and the provider of credit enhancements should be evaluated for their ability to
satisfy financial obligations.
Medium-term notes (MTN) are corporate debt obligations offered to investors continually over a period of
time by an agent of the issuer.

They are offered to the public under SEC Rule 415 (the self registration rule). This rule allows
issuers to sell securities on a continuous basis so that issuers have the flexibility to issue securities
in favorable market conditions.

They are priced at a spread to the Treasury yield curve at the time of the offering and typically
issued at par.

The maturities vary from 9 months to 30 years. Note that the term "medium-term notes" is not
related to the term to maturity of the securities.

Borrowers can issue fixed- or floating-rate MTNs.

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Fixed Income

Structured notes may be used prudently to mitigate the risks to a portfolio of a systemic shock. An example
would be to insulate against the effect on the Canadian dollar of a win in a referendum on sovereignty by
Quebec Separatists. A structured note could be purchased with an embedded Canadian dollar put versus the
U.S. dollar. It would be prudent to hedge the currency risk of this event with a structured note along these
lines. The premium would be considered insurance, as opposed to speculation.
Structured notes may also be used by investors to expose their portfolios to asset classes or markets in
which they cannot directly invest due to investment mandates and regulatory restrictions. Due to the fact
that the note looks, and smells like a bond, with a credit exposure that makes it appear a solid credit, many
investors utilize them to get involved with asset classes and markets outside of their general scope of
business.
For example, Uncle Pipeline issues a structured product, the Fin Pipe 16.50% Six-Month Note. The
investor takes the credit risk of a major financial institution (the stalwart Financial Pipeline!), giving the
note a AA (H) credit rating. The investor actually owns a leveraged exposure to the equity of a TSE 300
basket of stocks.
The concept underlying the note is that in a time of market uncertainty the investor may realize a cash
benefit from the high premiums for options on individual stocks or a basket of stocks. The payoff is either
16.50%, or common stock if the stock is at or below a certain level. If, however, the market rallies, the
coupon payoff decreases significantly.

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Fixed Income

Common structured notes include step-up notes, inverse floaters, deleveraged floaters, dual-indexed
floaters, range notes, and index amortizing notes. Most of these have been discussed in Section A (Features
of Debt Securities), Subject c (Wide range of coupon rate structures) and d (Floating-rate securities ). In
this instance, the focus is reviewing index-amortizing notes (IAN).
An IAN is a note that repays principal over a period of time that lengthens or shortens according to an
amortization schedule linked to a specific index, usually LIBOR. As interest rates increase, the IAN's
maturity extends longer, an effect similar to what happens to a collateralized mortgage obligation when
prepayment rates decrease. Conversely, if the designated index is at or below the trigger level, the IAN's
principal will quickly amortize, leading to a shorter average life. The outstanding principal balance will
vary according to the schedule at each redemption date. One may equate the amortization of the note to the
retirement (call) of some portion of the principal. As the amortization quickens, more and more of the note
is "called.
When interest rates rise, an investor would want to receive principals back faster to reinvest the proceeds at
the prevailing higher rate. However, with an IAN, the time to maturity is increase in this situation, and the
rate of principal repayment is decreased. The opposite is also true. Therefore, an investor faces greater reinvestment risk with an IAN.

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Fixed Income

Commercial paper and bank obligations


Commercial paper is a short-term unsecured promissory note issued in the open market that represents the
obligation of the issuing entity. It is an alternative to bank borrowing for large corporations and
municipalities with strong credit ratings.

It is sold on a discount basis (zero-coupon instrument).

Its maturity is typically less than 270 days.

It is typically backed by unused bank credit lines.

It is typically held to maturity so there is no active secondary market and little liquidity in the
commercial paper market.

In general it is paid off with funds obtained from issuing new commercial paper. Investors face the
roll-over risk as the issuer may not able to issue new commercial paper at maturity.
Corporate issuers of commercial paper include financial companies and nonfinancial companies.
It can be classified as either direct paper (sold by the issuing firm directly to investors without the help of
an intermediary) or dealer paper (an agent sells the paper to investors), depending on its sales channel.

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Banks can raise funds using various corporate debt obligations discussed earlier. Here two other types will
be discussed:

Fixed Income

1.

Negotiable CDs
Banks issue interest-bearing certificates called certificates of deposit (CDs). Usually, if you deposit
money into a CD, you must leave it there for a specific number of days to get a stated interest rate
(although some CDs have variable rates). Because your money is expected to stay on deposit until
maturity, you may be assessed a penalty if you withdraw your money from it early. Usually, the
penalty is three to six month's interest.
The Federal Deposit Insurance Corporation (FDIC) provides insurance for CDs up to $100,000.
Negotiable certificates of deposit are issued in denominations over $100,000 and sold on the open
market. The secondary market is where investors can sell their CDs to other investors before maturity
if they need cash. These CDs must be $1 million or more in value to be traded.
One type of negotiable CD is the Eurodollar CD, a U.S. dollar denominated CD issued primarily in
London by U.S., European, Canadian, and Japanese banks. The interest rate paid on a Eurodollar CD
is viewed globally as the cost of bank borrowing and is called the LIBOR. There are different
maturities for the Eurodollar CD, from overnight to five years.
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Fixed Income

2.

Banker's acceptances

A banker's acceptance is a short-term credit investment created by a non-financial firm and guaranteed by
a bank. It is a time draft drawn on and accepted by a bank. Before acceptance, the draft is not an
obligation of the bank; it is merely an order by the drawer to the bank to pay a specified sum of money on
a specified date to a named person or to the bearer of the draft. Upon acceptance, which occurs when an
authorized bank employee stamps the draft "accepted" and signs it, the draft becomes a primary and
unconditional liability of the bank. If the bank is well known and enjoys a good reputation, the accepted
draft may be readily sold in an active market in an active market.
Acceptances arise most often in connection with international trade: U.S. imports and exports and trade
between foreign countries. An American importer may request acceptance financing from its bank when,
as is frequently the case in international trade, it does not have a close relationship with and cannot obtain
financing from the exporter it is dealing with. Once the importer and bank have completed an acceptance
agreement, in which the bank agrees to accept drafts for the importer and the importer agrees to repay any
drafts the bank accepts, the importer draws a time draft on the bank. The bank accepts the draft and
discounts it; that is, it gives the importer cash for the draft but gives it an amount less than the face value
of the draft. The importer uses the proceeds to pay the exporter. The bank may hold the acceptance in its
portfolio or it may sell, or rediscount, it in the secondary market. In the former case, the bank is making a
loan to the importer; in the latter case, it is in effect substituting its credit for that of the importer, enabling
the importer to borrow in the money market. On or before the maturity date, the importer pays the bank
the face value of the acceptance. If the bank rediscounted the acceptance in the market, the bank pays the
holder of the acceptance the face value on the maturity date.

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Asset-backed securities.

Fixed Income

Asset-backed securities (ABS) are securities backed by a pool of loans or receivables (not real estate). An
important feature of ABS involves securitizing debt. This substantially increases the liquidity of these
individual debt instruments. The process is:

Create a separate legal entity, known as a special purpose vehicle (SPV).

Sell certain assets (e.g. receivables) to the SPV.

The SPV issues securities backed by the underlying assets. The underlying assets are used as
collateral for the securities. Cash flows generated from the underlying assets will be used to service
the debt obligations on the securities.

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Fixed Income

This market is dominated by securities backed by automobile loans and credit card receivable.

A.

Certificates for Automobile Receivables. Securities collateralized by loans made to individuals to


finance the purchase of cars. They are self-amortizing, with monthly payments and relatively short
maturities. The expected actual life is typically shorter than the specified maturity because of early
payoffs when cars are sold or traded in.

B.

Credit Card Receivables. The fastest growing segments of the ABS market. They are considered
revolving credit ABS, in contrast to installment contract ABS (e.g. CARs) because of the nature of the
loan. The principal payments are not paid to the investors but are retained by the trustee to reinvest in
additional receivables. This allows the issuer to specify a maturity for the security that is consistent
with the needs of the issuer and the demand of the investors.

The motivation for issuers to issue an asset-backed security rather than a traditional debt obligation is that there
is the opportunity to reduce funding cost by separating the credit rating of the issuer from the credit quality of
the pool of loans or receivables. This is accomplished by means of a special purpose vehicle or special purpose
corporation.
The special purpose vehicle plays a critical role in the ability to create a security -- an asset-backed security that separates the assets used as collateral from the corporation that is seeking financing. It makes possible that
the ABS has a higher credit rating than the parent company. With a SPV, the parent company can increase the
credit quality of the ABS by placing the highest quality assets into the SPV and/or using credit enhancement
mechanisms. The higher credit rating of the ABS will result in lower cost of funds.

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Collateralized debt obligations.

Fixed Income

Collateralized debt obligations (CDOs) are securitized interests in pools of assets - generally nonmortgage
assets. Assets, called collateral, usually comprise loans or debt instruments. A CDO may be called a
collateralized loan obligation (CLO) or collateralized bond obligation (CBO) if it holds only bank loans or
bonds, respectively.
Investors bear the credit risk of the collateral. Multiple tranches of securities are issued by the CDO,
offering investors various maturity and credit risk characteristics. Tranches are categorized as senior,
mezzanine, and subordinated/equity, according to their degree of credit risk. If there are defaults or the
CDO's collateral otherwise underperforms, scheduled payments to senior tranches take precedence over
those of mezzanine tranches, and scheduled payments to mezzanine tranches take precedence over those to
subordinated/equity tranches. Senior and mezzanine tranches are typically rated, with the former receiving
ratings of A to AAA and the latter receiving ratings of B to BBB. The ratings reflect both the credit quality
of underlying collateral as well as how much protection a given tranche is afforded by tranches that are
subordinate to it.

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Fixed Income

A CDO has a sponsoring organization, which establishes a special purpose vehicle to hold collateral and issue
securities. Sponsors can include banks, other financial institutions or investment managers. Expenses associated
with running the special purpose vehicle are subtracted from cash flows to investors. Often, the sponsoring
organization retains the most subordinate equity tranche of a

CDO. One important distinction is that between balance-sheet CDOs and arbitrage CDOs. These names
correspond to respective motivations of the sponsoring organization. With a balance sheet deal, the
sponsoring organization is a bank or other institution that holds - or anticipates acquiring - loans or debt
that it wants to remove from its balance sheet. Similar to a traditional ABS, the CDO is a vehicle for it to
do so.

Arbitrage deals are motivated by the opportunity to add value by repackaging collateral into tranches. This
is the same motivation for most CMOs. In finance, the law of one price suggests that the securities of a
CDO should have the same market value as its underlying collateral. In practice, this is often not the case.
Accordingly, a CDO can represent a theoretical arbitrage.

Much of the "arbitrage" in a CDO arises from a persistent market imperfection related to the somewhat arbitrary
distinction between investment grade and junk debt. Many institutional investors face limits on their ability to hold
below-investment-grade debt. This can take the form of regulations, capital requirements, and investment
restrictions imposed by management. Insurance companies, pension plans, banks and mutual funds can all face
some sorts of limitations. As a result, junk often trades at spreads to investment grade debt that are wider than might
be explained purely by credit considerations. With a CDO, a portfolio of below-investment-grade debt can be
repackaged into tranches, some of which receive investment grade - and even AAA - ratings.
CDOs are mostly about repackaging and transferring credit risk. While it is possible to issue a CDO backed entirely
by high-quality bonds, the structure is more relevant for collateral comprised partially or entirely of marginal
obligations.

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Primary market and secondary market for bonds.


There are really two markets for bonds: the primary market and the secondary market.

Fixed Income

1.

Primary Market
The primary market is when the bond is first issued. In the primary market the bond is purchased
directly from the issuer (central governments, its agencies, municipal governments, and corporations).
Investment bankers perform one or more of the three functions in the primary market:
1. Advising the issuer on the terms and the timing of the offering.
2. Buying the securities from the issuer.
3. Distributing the issue to the public.

The function of buying the securities from the issuer is called the underwriting.

Firm commitment offering. An arrangement in which an underwriter assumes the risk of bringing
a new securities issue to market, by buying the issue from the issuer and guaranteeing sale of a
certain number of bonds to investors.

Best efforts offering. An underwriting in which an investment bank, acting as an agent, agrees to
do its best to sell the offering to the public, but does not buy the securities outright and does not
guarantee that the issuing company will receive any set amount of money. It is less common than
a firm commitment offering.

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Fixed Income

Bought deal. A new bond issue that is bought entirely by one underwriter to resell to investors. An
underwriter will only do a bought deal if it is confident there is enough demand for the bond.
Auction process. The issuer announces the terms of the issue and interested parties submit bids for the
entire issue.
Private placement. A private placement bond is a non-underwritten, unregistered corporate bond sold
directly to a single investor or a small group of investors.
o In the U.S., all securities offered to the public must be registered with the SEC. An exemption
is allowed, however, if the issue does not involve any public offering.
o The issuer of a privately placed bond must still disclose the same information deemed material
by the SEC to potential investors. However, it does not need to disclose "nonmaterial"
information.
o Rule 144 A is a SEC rule modifying a two-year holding period requirement on privately
placed securities to permit qualified institutional buyers to trade these positions among
themselves. This has substantially increased the liquidity of the securities affected because
institutions can trade these securities amongst themselves, side-stepping limitations that are
imposed to protect the public.

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2.

Secondary Market

The secondary market occurs later, when bonds are sold from one bondholder to another.

Fixed Income

A bond can trade on an exchange or in an over-the-counter market.

In the over-the-counter market, broker-dealer trading desks take principal positions to fill
customer buy and sell order. There are several factors that cause the secondary bond market to
evolve toward electronic bond trading:
o

Making markets in bonds has become more risky for broker-dealer firms as they most
likely need to risk their own capital instead acting merely as an agent or broker.

The increase in bond market volatility has increased the capital required of broker
dealer firms in the bond business.

The profitability of bond market trading has declined since many of the products are
similar, and their bid-ask spreads have decreased.

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