CHAPTER 3
OVERVIEW OF BOND SECTORS AND INSTRUMENTS
I. INTRODUCTION
Thus far we have covered the general features of bonds and the risks associated with investing in bonds. In this chapter, we will review the major sectors of a country’s bond market and the securities issued. This includes sovereign bonds, semi-government bonds, municipal or province securities, corporate debt securities, mortgage-backed securities, asset-backed securities, and collateralized debt obligations. Our coverage in this chapter is to describe the instruments found in these sectors.
II. SECTORS OF THE BOND MARKET
While there is no uniform system for classifying the sectors of the bond markets throughout the world, we will use the classification shown in Exhibit 1. From the perspective of a given country, the bond market can be classified into two markets: an internal bond market and an external bond market.
A. Internal Bond Market
The internal bond market of a country is also called the national bond market. It is divided into two parts: the domestic bond market and the foreign bond market. The domestic bond market is where issuers domiciled in the country issue bonds and where those bonds are subsequently traded.
The foreign bond market of a country is where bonds of issuers not domiciled in the country are issued and traded. For example, in the United States. the foreign bond market is the market where bonds are issued by non-U.S. entities and then subsequently traded in the United States. In the U.K., a sterling-denominated bond issued by a Japanese corporation and subsequently traded in the U.K. bond market is part of the U.K. foreign bond market. Bonds in the foreign sector of a bond market have nicknames. For example, foreign bonds in the U.S. market are nicknamed “Yankee bonds” and sterling-denominated bonds in the U.K. foreign bond market are nicknamed “Bulldog bonds.” Foreign bonds can be denominated in any currency. For example, a foreign bond issued by an Australian corporation in the United States can be denominated in U.S. dollars, Australian dollars, or euros.
EXHIBIT 1 Overview of the Sectors of the Bond Market
Issuers of foreign bonds include central governments and their subdivisions, corporations, and supranationals. A supranational is an entity that is formed by two or more central governments through international treaties. Supranationals promote economic development for the member countries. Two examples of supranationals are the International Bank for Reconstruction and Development, popularly referred to as the World Bank, and the Inter-American Development Bank.
B. External Bond Market
The external bond market includes bonds with the following distinguishing features:
• they are underwritten by an international syndicate
• at issuance, they are offered simultaneously to investors in a number of countries
• they are issued outside the jurisdiction of any single country
• they are in unregistered form.
The external bond market is referred to as the international bond market, the offshore bond market, or, more popularly, the Eurobond market.15 Throughout this book we will use the term Eurobond market to describe this sector of the bond market.
Eurobonds are classified based on the currency in which the issue is denominated. For example, when Eurobonds are denominated in U.S. dollars, they are referred to as Eurodollar bonds. Eurobonds denominated in Japanese yen are referred to as Euroyen bonds.
A global bond is a debt obligation that is issued and traded in the foreign bond market of one or more countries and the Eurobond market.
III. SOVEREIGN BONDS
In many countries that have a bond market, the largest sector is often bonds issued by a country’s central government. These bonds are referred to as sovereign bonds. A government can issue securities in its national bond market which are subsequently traded within that market. A government can also issue bonds in the Eurobond market or the foreign sector of another country’s bond market. While the currency denomination of a government security is typically the currency of the issuing country, a government can issue bonds denominated in any currency.
A. Credit Risk
An investor in any bond is exposed to credit risk. The perception throughout the world is that the credit risk of bonds issued by the U.S. government are virtually free of credit risk. Consequently, the market views these bonds as default-free bonds. Sovereign bonds of non-U.S. central governments are rated by the credit rating agencies. These ratings are referred to as sovereign ratings. Standard & Poor’s and Moody’s rate sovereign debt. We will discuss the factors considered in rating sovereign bonds later.
The rating agencies assign two types of ratings to sovereign debt. One is a local currency debt rating and the other a foreign currency debt rating. The reason for assigning two ratings is, historically, the default frequency differs by the currency denomination of the debt. Specifically, defaults have been greater on foreign currency denominated debt. The reason for the difference in default rates for local currency debt and foreign currency debt is that if a government is willing to raise taxes and control its domestic financial system, it can generate sufficient local currency to meet its local currency debt obligation. This is not the case with foreign currency denominated debt. A central government must purchase foreign currency to meet a debt obligation in that foreign currency and therefore has less control with respect to its exchange rate. Thus, a significant depreciation of the local currency relative to a foreign currency denominated debt obligation will impair a central government’s ability to satisfy that obligation.
B. Methods of Distributing New Government Securities
Four methods have been used by central governments to distribute new bonds that they issue: (1) regular auction cycle/multiple-price method, (2) regular auction cycle/single-price method, (3) ad hoc auction method, and (4) tap method.
With the regular auction cycle/multiple-price method, there is a regular auction cycle and winning bidders are allocated securities at the yield (price) they bid. For the regular auction cycle/single-price method, there is a regular auction cycle and all winning bidders are awarded securities at the highest yield accepted by the government. For example, if the highest yield for a single-price auction is 7.14% and someone bid 7.12%, that bidder would be awarded the securities at 7.14%. In contrast, with a multiple-price auction that bidder would be awarded securities at 7.12%. U.S. government bonds are currently issued using a regular auction cycle/single-price method.
In the ad hoc auction system, governments announce auctions when prevailing market conditions appear favorable. It is only at the time of the auction that the amount to be auctioned and the maturity of the security to be offered is announced. This is one of the methods used by the Bank of England in distributing British government bonds. In a tap system, additional bonds of a previously outstanding bond issue are auctioned. The government announces periodically that it is adding this new supply. The tap system has been used in the United Kingdom, the United States, and the Netherlands.
1. United States Treasury Securities U.S. Treasury securities are issued by the U.S. Department of the Treasury and are backed by the full faith and credit of the U.S. government. As noted above, market participants throughout the world view U.S. Treasury securities as having no credit risk. Because of the importance of the U.S. government securities market, we will take a close look at this market.
Treasury securities are sold in the primary market through sealed-bid auctions on a regular cycle using a single-price method. Each auction is announced several days in advance by means of a Treasury Department press release or press conference. The auction for Treasury securities is conducted on a competitive bid basis.
The secondary market for Treasury securities is an over-the-counter market where a group of U.S. government securities dealers offer continuous bid and ask prices on outstanding Treasuries. There is virtually 24-hour trading of Treasury securities. The most recently auctioned issue for a maturity is referred to as the on-the-run issue or the current issue. Securities that are replaced by the on-the-run issue are called off-the-run issues.
Exhibit 2 provides a summary of the securities issued by the U.S. Department of the Treasury. U.S. Treasury securities are categorized as fixed-principal securities or inflation-indexed securities.
a. Fixed-Principal Treasury Securities Fixed principal securities include Treasury bills, Treasury notes, and Treasury bonds. Treasury bills are issued at a discount to par value, have no coupon rate, mature at par value, and have a maturity date of less than 12 months. As discount securities, Treasury bills do not pay coupon interest; the return to the investor is the difference between the maturity value and the purchase price. We will explain how the price and the yield for a Treasury bill are computed in Chapter 6.
EXHIBIT 2 Overview of U.S. Treasury Debt Instruments
Treasury coupon securities issued with original maturities of more than one year and no more than 10 years are called Treasury notes. Coupon securities are issued at approximately par value and mature at par value. Treasury coupon securities with original maturities greater than 10 years are called Treasury bonds. While a few issues of the outstanding bonds are callable, the U.S. Treasury has not issued callable Treasury securities since 1984. As of this writing, the U.S. Department of the Treasury has stopped issuing Treasury bonds.
b. Inflation-Indexed Treasury Securities The U.S. Department of the Treasury issues Treasury notes and bonds that provide protection against inflation. These securities are popularly referred to as Treasury inflation protection securities or TIPS. (The Treasury refers to these securities as Treasury inflation indexed securities, TIIS.)
TIPS work as follows. The coupon rate on an issue is set at a fixed rate. That rate is determined via the auction process described later in this section. The coupon rate is called the “real rate” because it is the rate that the investor ultimately earns above the inflation rate. The inflation index that the government uses for the inflation adjustment is the non-seasonally adjusted U.S. City Average All Items Consumer Price Index for All Urban Consumers (CPI-U).
The principal that the Treasury Department will base both the dollar amount of the coupon payment and the maturity value on is adjusted semiannually. This is called the inflation-adjusted principal. The adjustment for inflation is as follows. Suppose that the coupon rate for a TIPS is 3.5% and the annual inflation rate is 3%. Suppose further that an investor purchases on January 1, $100,000 of par value (principal) of this issue. The semiannual inflation rate is 1.5% (3% divided by 2). The inflation-adjusted principal at the end of the first six-month period is found by multiplying the original par value by (1 + the semiannual inflation rate). In our example, the inflation-adjusted principal at the end of the first six-month period is $101,500. It is this inflation-adjusted principal that is the basis for computing the coupon interest for the first six-month period. The coupon payment is then 1.75% (one half the real rate of 3.5%) multiplied by the inflation-adjusted principal at the coupon payment date ($101,500). The coupon payment is therefore $1,776.25.
Let’s look at the next six months. The inflation-adjusted principal at the beginning of the period is $101,500. Suppose that the semiannual inflation rate for the second six-month period is 1%. Then the inflation-adjusted principal at the end of the second six-month period is the inflation-adjusted principal at the beginning of the six-month period ($101,500) increased by the semiannual inflation rate (1%). The adjustment to the principal is $1,015 (1% times $101,500). So, the inflation-adjusted principal at the end of the second six-month period (December 31 in our example) is $102,515 ($101, 500 + $1, 015). The coupon interest that will be paid to the investor at the second coupon payment date is found by multiplying the inflation-adjusted principal on the coupon payment date ($102,515) by one half the real rate (i.e., one half of 3.5%). That is, the coupon payment will be $1,794.01.
As can be seen, part of the adjustment for inflation comes in the coupon payment since it is based on the inflation-adjusted principal. However, the U.S. government taxes the adjustment each year. This feature reduces the attractiveness of TIPS as investments for tax-paying entities.
Because of the possibility of disinflation (i.e., price declines), the inflation-adjusted principal at maturity may turn out to be less than the initial par value. However, the Treasury has structured TIPS so that they are redeemed at the greater of the inflation-adjusted principal and the initial par value.
An inflation-adjusted principal must be calculated for a settlement date. The inflation-adjusted principal is defined in terms of an index ratio, which is the ratio of the reference CPI for the settlement date to the reference CPI for the issue date. The reference CPI is calculated with a 3-month lag. For example, the reference CPI for May 1 is the CPI-U reported in February. The U.S. Department of the Treasury publishes and makes available on its web site (www.publicdebt.treas.gov) a daily index ratio for an issue.
c. Treasury STRIPs The Treasury does not issue zero-coupon notes or bonds. However, because of the demand for zero-coupon instruments with no credit risk and a maturity greater than one year, the private sector has created such securities.
To illustrate the process, suppose $100 million of a Treasury note with a 10-year maturity and a coupon rate of 10% is purchased to create zero-coupon Treasury securities (see Exhibit 3). The cash flows from this Treasury note are 20 semiannual payments of $5 million each ($100 million times 10% divided by 2) and the repayment of principal (“corpus”) of $100 million 10 years from now. As there are 21 different payments to be made by the Treasury, a receipt representing a single payment claim on each payment is issued at a discount, creating 21 zero-coupon instruments. The amount of the maturity value for a receipt on a particular payment, whether coupon or principal, depends on the amount of the payment to be made by the Treasury on the underlying Treasury note. In our example, 20 coupon receipts each have a maturity value of $5 million, and one receipt, the principal, has a maturity value of $100 million. The maturity dates for the receipts coincide with the corresponding payment dates for the Treasury security.
Zero-coupon instruments are issued through the Treasury’s Separate Trading of Registered Interest and Principal Securities (STRIPS) program, a program designed to facilitate the stripping of Treasury securities. The zero-coupon Treasury securities created under the STRIPS program are direct obligations of the U.S. government.
Stripped Treasury securities are simply referred to as Treasury strips. Strips created from coupon payments are called coupon strips and those created from the principal payment are called principal strips. The reason why a distinction is made between coupon strips and the principal strips has to do with the tax treatment by non-U.S. entities as discussed below.
A disadvantage of a taxable entity investing in Treasury coupon strips is that accrued interest is taxed each year even though interest is not paid until maturity. Thus, these instruments have negative cash flows until the maturity date because tax payments must be made on interest earned but not received in cash must be made. One reason for distinguishing between strips created from the principal and coupon is that some foreign buyers have a preference for the strips created from the principal (i.e., the principal strips). This preference is due to the tax treatment of the interest in their home country. Some country’s tax laws treat the interest as a capital gain if the principal strip is purchased. The capital gain receives a preferential tax treatment (i.e., lower tax rate) compared to ordinary income.
EXHIBIT 3 Coupon Stripping: Creating Zero-Coupon Treasury Securities
2. Non-U.S. Sovereign Bond Issuers It is not possible to discuss the bonds/notes of all governments in the world. Instead, we will take a brief look at a few major sovereign issuers.
The German government issues bonds (called Bunds) with maturities from 8-30 years and notes (Bundesobligationen, Bobls) with a maturity of five years. Ten-year Bunds are the largest sector of the German government securities market in terms of amount outstanding and secondary market turnover. Bunds and Bobls have a fixed-rate coupons and are bullet structures.
The bonds issued by the United Kingdom are called “gilt-edged stocks” or simply gilts. There are more types of gilts than there are types of issues in other government bond markets. The largest sector of the gilt market is straight fixed-rate coupon bonds. The second major sector of the gilt market is index-linked issues, referred to as “linkers.” There are a few issues of outstanding gilts called “irredeemables.” These are issues with no maturity date and are therefore called “undated gilts.” Government designated gilt issues may be stripped to create gilt strips, a process that began in December 1997.
The French Treasury issues long-dated bonds, Obligation Assimilable du Trésor (OATS), with maturities up to 30 years and notes, Bons du Trésor á Taux Fixe et á Intérét Annuel (BTANs), with maturities between 2 and 5 years. OATs are not callable. While most OAT issues have a fixed-rate coupon, there are some special issues with a floating-rate coupon. Long-dated OATs can be stripped to create OAT strips. The French government was one of the first countries after the United States to allow stripping.
The Italian government issues (1) bonds, Buoni del Tresoro Poliennali (BTPs), with a fixed-rate coupon that are issued with original maturities of 5, 10, and 30 years, (2) floating-rate notes, Certificati di Credito del Tresoro (CCTs), typically with a 7-year maturity and referenced to the Italian Treasury bill rate, (3) 2-year zero-coupon notes, Certificati di Tresoro a Zero Coupon (CTZs), and (4) bonds with put options, Certificati del Tresoro con Opzione (CTOs). The putable bonds are issued with the same maturities as the BTPs. The investor has the right to put the bond to the Italian government halfway through its stated maturity date. The Italian government has not issued CTOs since 1992.
The Canadian government bond market has been closely related to the U.S. government bond market and has a similar structure, including types of issues. Bonds have a fixed coupon rate except for the inflation protection bonds (called “real return bonds”). All new Canadian bonds are in “bullet” form; that is, they are not callable or putable.
About three quarters of the Australian government securities market consists of fixed-rate bonds and inflation protections bonds called “Treasury indexed bonds.” Treasury indexed bonds have either interest payments or capital linked to the Australian Consumer Price Index. The balance of the market consists of floating-rate issues, referred to as “Treasury adjustable bonds,” that have a maturity between 3 to 5 years and the reference rate is the Australian Bank Bill Index.
There are two types of Japanese government securities (referred to as JGBs) issued publicly: (1) medium-term bonds and (2) long-dated bonds. There are two types of medium-term bonds: bonds with coupons and zero-coupon bonds. Bonds with coupons have maturities of 2, 3, and 4 years. The other type of medium-term bond is the 5-year zero-coupon bond. Long-dated bonds are interest bearing.
The financial markets of Latin America, Asia with the exception of Japan, and Eastern Europe are viewed as “emerging markets.” Investing in the government bonds of emerging market countries entails considerably more credit risk than investing in the government bonds of major industrialized countries. A good amount of secondary trading of government debt of emerging markets is in Brady bonds which represent a restructuring of nonperforming bank loans to emerging market governments into marketable securities. There are two types of Brady bonds. The first type covers the interest due on these loans (“past-due interest bonds”). The second type covers the principal amount owed on the bank loans (“principal bonds”).
IV. SEMI-GOVERNMENT / AGENCY BONDS
A central government can establish an agency or organization that issues bonds. The bonds of such entities are not issued directly by the central government but may have either a direct or implied government guarantee. These bonds are generically referred to as semi-government bonds or government agency bonds. In some countries, semi-government bonds include bonds issued by regions of the country.
Here are a few examples of semi-government bonds. In Australia, there are the bonds issued by Telstra or a State electric power supplier such as Pacific Power. These bonds are guaranteed by the full faith and credit of the Commonwealth of Australia. Government agency bonds are issued by Germany’s Federal Railway (Bundesbahn) and the Post Office (Bundespost ) with the full faith and credit of the central government.
In the United States, semi-government bonds are referred to as federal agency securities. They are further classified by the types of issuer—those issued by federally related institutions and those issued by government-sponsored enterprises. Our focus in the remainder of this section is on U.S. federal agency securities. Exhibit 4 provides an overview of the U.S. federal agency securities market.
Federally related institutions are arms of the federal government. They include the Export-Import Bank of the United States, the Tennessee Valley Authority (TVA), the Commodity Credit Corporation, the Farmers Housing Administration, the General Services Administration, the Government National Mortgage Association (Ginnie Mae), the Maritime Administration, the Private Export Funding Corporation, the Rural Electrification Administration, the Rural Telephone Bank, the Small Business Administration, and the Washington Metropolitan Area Transit Authority. With the exception of securities of the TVA and the Private Export Funding Corporation, the securities are backed by the full faith and credit of the U.S. government. In recent years, the TVA has been the only issuer of securities directly into the marketplace.
Government-sponsored enterprises (GSEs) are privately owned, publicly chartered entities. They were created by Congress to reduce the cost of capital for certain borrowing sectors of the economy deemed to be important enough to warrant assistance. The entities in these sectors include farmers, homeowners, and students. The enabling legislation dealing with a GSE is reviewed periodically. GSEs issue securities directly in the marketplace. The market for these securities, while smaller than that of Treasury securities, has in recent years become an active and important sector of the bond market.
Today there are six GSEs that currently issue securities: Federal National Mortgage Association (Fannie Mae), Federal Home Loan Mortgage Corporation (Freddie Mac), Federal Agricultural Mortgage Corporation (Farmer Mac), Federal Farm Credit System, Federal Home Loan Bank System, and Student Loan Marketing Association (Sallie Mae). Fannie Mae, Freddie Mac, and the Federal Home Loan Bank are responsible for providing credit to the residential housing sector. Farmer Mac provides the same function for farm properties. The Federal Farm Credit Bank System is responsible for the credit market in the agricultural sector of the economy. Sallie Mae provides funds to support higher education.
EXHIBIT 4 Overview of U.S. Federal Agency Securities
A. U.S. Agency Debentures and Discount Notes
Generally, GSEs issue two types of debt: debentures and discount notes. Debentures and discount notes do not have any specific collateral backing the debt obligation. The ability to pay debtholders depends on the ability of the issuing GSE to generate sufficient cash flows to satisfy the obligation.
Debentures can be either notes or bonds. GSE issued notes, with minor exceptions, have 1 to 20 year maturities and bonds have maturities longer than 20 years. Discount notes are short-term obligations, with maturities ranging from overnight to 360 days.
Several GSEs are frequent issuers and therefore have developed regular programs for the securities that they issue. For example, let’s look at the debentures issued by Federal National Mortgage Association (Fannie Mae) and Freddie Mac (Federal Home Loan Mortgage Corporation). Fannie Mae issues Benchmark Notes, Benchmark Bonds, Callable Benchmark Notes, medium-term notes, and global bonds. The debentures issued by Freddie Mac are Reference Notes, Reference Bonds, Callable Reference Notes, medium-term notes, and global bonds. (We will discuss medium-term notes and global bonds in Section VI and Section VIII, respectively.) Callable Reference Notes have maturities of 2 to 10 years. Both Benchmark Notes and Bonds and Reference Notes and Bonds are eligible for stripping to create zero-coupon bonds.
B. U.S. Agency Mortgage-Backed Securities
The two GSEs charged with providing liquidity to the mortgage market—Fannie Mae and Freddie Mac—also issue securities backed by the mortgage loans that they purchase. That is, they use the mortgage loans they underwrite or purchase as collateral for the securities they issue. These securities are called agency mortgage-backed securities and include mortgage passthrough securities, collateralized mortgage obligations (CMOs), and stripped mortgage-backed securities. The latter two mortgage-backed securities are referred to as derivative mortgage-backed securities because they are created from mortgage passthrough securities.
While we confine our discussion to the U.S. mortgage-backed securities market, most developed countries have similar mortgage products.
1. Mortgage Loans A mortgage loan is a loan secured by the collateral of some specified real estate property which obliges the borrower to make a predetermined series of payments. The mortgage 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. The interest rate on the mortgage loan is called the mortgage rate or contract rate.
There are many types of mortgage designs available in the United States. A mortgage design is a specification of the mortgage rate, term of the mortgage, and the manner in which the borrowed funds are repaid. For now, we will use the most common mortgage design to explain the characteristics of a mortgage-backed security: a fixed-rate, level-payment, fully amortizing mortgage.
The basic idea behind this mortgage design is that each monthly mortgage payment is the same dollar amount and includes interest and principal payment. The monthly payments are such that at the end of the loan’s term, the loan has been fully amortized (i.e., there is no mortgage principal balance outstanding).
Each monthly mortgage payment for this mortgage design is due on the first of each month and consists of:
1. interest of 
of the fixed annual interest rate times the amount of the outstanding mortgage balance at the end of the previous month, and
of the fixed annual interest rate times the amount of the outstanding mortgage balance at the end of the previous month, and2. a payment of a portion of the outstanding mortgage principal balance.
The difference between the monthly mortgage payment and the portion of the payment that represents interest equals the amount that is applied to reduce the outstanding mortgage principal balance. This amount is referred to as the amortization. We shall also refer to it as the scheduled principal payment.
To illustrate this mortgage design, consider a 30-year (360-month), $100,000 mortgage with an 8.125% mortgage rate. The monthly mortgage payment would be $742.50.16 Exhibit 5 shows for selected months how each monthly mortgage payment is divided between interest and scheduled principal payment. At the beginning of month 1, the mortgage balance is $100,000, the amount of the original loan. The mortgage payment for month 1 includes interest on the $100,000 borrowed for the month. Since the interest rate is 8.125%, the monthly interest rate is 0.0067708 (0.08125 divided by 12). Interest for month 1 is therefore $677.08 ($100,000 times 0.0067708). The $65.41 difference between the monthly mortgage payment of $742.50 and the interest of $677.08 is the portion of the monthly mortgage payment that represents the scheduled principal payment (i.e., amortization). This $65.41 in month 1 reduces the mortgage balance.
The mortgage balance at the end of month 1 (beginning of month 2) is then $99,934.59 ($100,000 minus $65.41). The interest for the second monthly mortgage payment is $676.64, the monthly interest rate (0.0066708) times the mortgage balance at the beginning of month 2 ($99,934.59). The difference between the $742.50 monthly mortgage payment and the $676.64 interest is $65.86, representing the amount of the mortgage balance paid off with that monthly mortgage payment. Notice that the mortgage payment in month 360—the final payment—is sufficient to pay off the remaining mortgage principal balance.
As Exhibit 5 clearly shows, the portion of the monthly mortgage payment applied to interest declines each month and the portion applied to principal repayment increases. The reason for this is that as the mortgage balance is reduced with each monthly mortgage payment, the interest on the mortgage balance declines. Since the monthly mortgage payment is a fixed dollar amount, an increasingly larger portion of the monthly payment is applied to reduce the mortgage principal balance outstanding in each subsequent month.
To an investor in a mortgage loan (or a pool of mortgage loans), the monthly mortgage payments as described above do not equal an investor’s cash flow. There are two reasons for this: (1) servicing fees and (2) prepayments.
Every mortgage loan must be serviced. Servicing of a mortgage loan involves collecting monthly payments and forwarding proceeds to owners of the loan; sending payment notices to mortgagors; reminding mortgagors when payments are overdue; maintaining records of principal balances; administering an escrow balance for real estate taxes and insurance; initiating foreclosure proceedings if necessary; and, furnishing tax information to mortgagors when applicable. The servicing fee is a portion of the mortgage rate. If the mortgage rate is 8.125% and the servicing fee is 50 basis points, then the investor receives interest of 7.625%. The interest rate that the investor receives is said to be the net interest.
Our illustration of the cash flow for a level-payment, fixed-rate, fully amortized mortgage assumes that the homeowner does not pay off any portion of the mortgage principal balance prior to the scheduled payment date. But homeowners do pay off all or part of their mortgage balance prior to the scheduled payment date. A payment made in excess of the monthly mortgage payment is called a prepayment. The prepayment may be for the entire principal outstanding principal balance or a partial additional payment of the mortgage principal balance. When a prepayment is not for the entire amount, it is called a curtailment. Typically, there is no penalty for prepaying a mortgage loan.
EXHIBIT 5 Amortization Schedule for a Level-Payment, Fixed-Rate, Fully Amortized Mortgage (Selected Months)
Thus, the cash flows for a mortgage loan are monthly and consist of three components: (1) net interest, (2) scheduled principal payment, and (3) prepayments. The effect of prepayments is that the amount and timing of the cash flow from a mortgage is not known with certainty. This is the risk that we referred to as prepayment risk in Chapter 2.17
For example, all that the investor in a $100,000, 8.125% 30-year mortgage knows is that as long as the loan is outstanding and the borrower does not default, interest will be received and the principal will be repaid at the scheduled date each month; then at the end of the 30 years, the investor would have received $100,000 in principal payments. What the investor does not know—the uncertainty—is for how long the loan will be outstanding, and therefore what the timing of the principal payments will be. This is true for all mortgage loans, not just the level-payment, fixed-rate, fully amortized mortgage.
2. Mortgage Passthrough Securities A mortgage passthrough security, or simply passthrough, is 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. A pool may consist of several thousand or only a few mortgages. When a mortgage is included in a pool of mortgages that is used as collateral for a passthrough, the mortgage is said to be securitized.
The cash flow of a passthrough depends on the cash flow of the underlying pool of mortgages. As we just explained, the cash flow consists of monthly mortgage payments representing net interest, the scheduled principal payment, and any principal prepayments. Payments are made to security holders each month. Because of prepayments, the amount of the cash flow is uncertain in terms of the timing of the principal receipt.
To illustrate the creation of a passthrough look at Exhibits 6 and 7. Exhibit 6 shows 2,000 mortgage loans and the cash flows from these loans. For the sake of simplicity, we assume that the amount of each loan is $100,000 so that the aggregate value of all 2,000 loans is $200 million.
An investor who owns any one of the individual mortgage loans shown in Exhibit 6 faces prepayment risk. In the case of an individual loan, it is particularly difficult to predict prepayments. If an individual investor were to purchase all 2,000 loans, however, prepayments might become more predictable based on historical prepayment experience. However, that would call for an investment of $200 million to buy all 2,000 loans.
Suppose, instead, that some entity purchases all 2,000 loans in Exhibit 6 and pools them. The 2,000 loans can be used as collateral to issue a security whose cash flow is based on the cash flow from the 2,000 loans, as depicted in Exhibit 7. Suppose that 200,000 certificates are issued. Thus, each certificate is initially worth $1,000 ($200 million divided by 200,000). Each certificate holder would be entitled to 0.0005% (1/200,000) of the cash flow. The security created is a mortgage passthrough security.
EXHIBIT 6 Mortgage Loans
EXHIBIT 7 Creation of a Passthrough Security
Let’s see what has been accomplished by creating the passthrough. The total amount of prepayment risk has not changed. Yet, the investor is now exposed to the prepayment risk spread over 2,000 loans rather than one individual mortgage loan and for an investment of less than $200 million.
Let’s compare the cash flow for a mortgage passthrough security (an amortizing security) to that of a noncallable coupon bond (a nonamortizing security). For a standard coupon bond, there are no principal payments prior to maturity while for a mortgage passthrough security the principal is paid over time. Unlike a standard coupon bond that pays interest semiannually, a mortgage passthrough makes monthly interest and principal payments. Mortgage passthrough securities are similar to coupon bonds that are callable in that there is uncertainty about the cash flows due to uncertainty about when the entire principal will be paid.
Passthrough securities are issued by Ginnie Mae, Fannie Mae, and Freddie Mac. They are guaranteed with respect to the timely payment of interest and principal.18 The loans that are permitted to be included in the pool of mortgage loans issued by Ginnie Mae, Fannie Mae, and Freddie Mac must meet the underwriting standards that have been established by these entities. Loans that satisfy the underwriting requirements are referred to as conforming loans. Mortgage-backed securities not issued by agencies are backed by pools of nonconforming loans.
3. Collateralized Mortgage Obligations Now we will show how one type of agency mortgage derivative security is created—a collateralized mortgage obligation (CMO). The motivation for creation of a CMO is to distribute prepayment risk among different classes of bonds.
The investor in our passthrough in Exhibit 7 remains exposed to the total prepayment risk associated with the underlying pool of mortgage loans, regardless of how many loans there are. Securities can be created, however, where investors do not share prepayment risk equally. Suppose that instead of distributing the monthly cash flow on a pro rata basis, as in the case of a passthrough, the distribution of the principal (both scheduled principal and prepayments) is carried out on some prioritized basis. How this is done is illustrated in Exhibit 8.
The exhibit shows the cash flow of our original 2,000 mortgage loans and the passthrough. Also shown are three classes of bonds, commonly referred to as tranches,19 the par value of each tranche, and a set of payment rules indicating how the principal from the passthrough is to be distributed to each tranche. Note that the sum of the par value of the three tranches is equal to $200 million. Although it is not shown in the exhibit, for each of the three tranches, there will be certificates representing a proportionate interest in a tranche. For example, suppose that for Tranche A, which has a par value of $80 million, there are 80,000 certificates issued. Each certificate would receive a proportionate share (0.00125%) of payments received by Tranche A.
The rule for the distribution of principal shown in Exhibit 8 is that Tranche A will receive all principal (both scheduled and prepayments) until that tranche’s remaining principal balance is zero. Then, Tranche B receives all principal payments until its remaining principal balance is zero. After Tranche B is completely paid, Tranche C receives principal payments. The rule for the distribution of the cash flows in Exhibit 8 indicates that each of the three tranches receives interest on the basis of the amount of the par value outstanding.
The mortgage-backed security that has been created is called a CMO. The collateral for a CMO issued by the agencies is a pool of passthrough securities which is placed in a trust. The ultimate source for the CMO’s cash flow is the pool of mortgage loans.
Let’s look now at what has been accomplished. Once again, the total prepayment risk for the CMO is the same as the total prepayment risk for the 2,000 mortgage loans. However, the prepayment risk has been distributed differently across the three tranches of the CMO. Tranche A absorbs prepayments first, then Tranche B, and then Tranche C. The result of this is that Tranche A effectively is a shorter term security than the other two tranches; Tranche C will have the longest maturity. Different institutional investors will be attracted to the different tranches, depending on the nature of their liabilities and the effective maturity of the CMO tranche. Moreover, there is less uncertainty about the maturity of each tranche of the CMO than there is about the maturity of the pool of passthroughs from which the CMO is created. Thus, redirection of the cash flow from the underlying mortgage pool creates tranches that satisfy the asset/liability objectives of certain institutional investors better than a passthrough. Stated differently, the rule for distributing principal repayments redistributes prepayment risk among the tranches.
The CMO we describe in Exhibit 8 has a simple set of rules for the distribution of the cash flow. Today, much more complicated CMO structures exist. The basic objective is to provide certain CMO tranches with less uncertainty about prepayment risk. Note, of course, that this can occur only if the reduction in prepayment risk for some tranches is absorbed by other tranches in the CMO structure. A good example is one type of CMO tranche called a planned amortization class tranche or PAC tranche. This is a tranche that has a schedule for the repayment of principal (hence the name “planned amortization”) if prepayments are realized at a certain prepayment rate.20 As a result, the prepayment risk is reduced (not eliminated) for this type of CMO tranche. The tranche that realizes greater prepayment risk in order for the PAC tranche to have greater prepayment protection is called the support tranche.
EXHIBIT 8 Creation of a Collateralized Mortgage Obligation
We will describe in much more detail PAC tranches and supports tranches, as well as other types of CMO tranches in Chapter 10.
V. STATE AND LOCAL GOVERNMENTS
Non-central government entities also issue bonds. In the United States, this includes state and local governments and entities that they create. These securities are referred to as municipal securities or municipal bonds. Because the U.S. bond market has the largest and most developed market for non-central government bonds, we will focus on municipal securities in this market.
In the United States, there are both tax-exempt and taxable municipal securities. “Taxexempt” means that interest on a municipal security is exempt from federal income taxation. The tax-exemption of municipal securities applies to interest income, not capital gains. The exemption may or may not extend to taxation at the state and local levels. Each state has its own rules as to how interest on municipal securities is taxed. Most municipal securities that have been issued are tax-exempt. Municipal securities are commonly referred to as tax-exempt securities despite the fact that there are taxable municipal securities that have been issued and are traded in the market. Municipal bonds are traded in the over-the-counter market supported by municipal bond dealers across the country.
Like other non-Treasury fixed income securities, municipal securities expose investors to credit risk. The nationally recognized rating organizations rate municipal securities according to their credit risk. In later chapters, we look at the factors rating agencies consider in assessing credit risk.
There are basically two types of municipal security structures: tax-backed debt and revenue bonds. We describe each below, as well as some variants.
A. Tax-Backed Debt
Tax-backed debt obligations are instruments issued by states, counties, special districts, cities, towns, and school districts that are secured by some form of tax revenue. Exhibit 9 provides an overview of the types of tax-backed debt issued in the U.S. municipal securities market. Tax-backed debt includes general obligation debt, appropriation-backed obligations, and debt obligations supported by public credit enhancement programs. We discuss each below.
EXHIBIT 9 Tax-Backed Debt Issues in the U.S. Municipal Securities Market
1. General Obligation Debt The broadest type of tax-backed debt is general obligation debt. There are two types of general obligation pledges: unlimited and limited. An unlimited tax general obligation debt is the stronger form of general obligation pledge because it is secured by the issuer’s unlimited taxing power. The tax revenue sources include corporate and individual income taxes, sales taxes, and property taxes. Unlimited tax general obligation debt is said to be secured by the full faith and credit of the issuer. A limited tax general obligation debt is a limited tax pledge because, for such debt, there is a statutory limit on tax rates that the issuer may levy to service the debt.
Certain general obligation bonds are secured not only by the issuer’s general taxing powers to create revenues accumulated in a general fund, but also by certain identified fees, grants, and special charges, which provide additional revenues from outside the general fund. Such bonds are known as double-barreled in security because of the dual nature of the revenue sources. For example, the debt obligations issued by special purpose service systems may be secured by a pledge of property taxes, a pledge of special fees/operating revenue from the service provided, or a pledge of both property taxes and special fees/operating revenues. In the last case, they are double-barreled.
2. Appropriation-Backed Obligations Agencies or authorities of several states have issued bonds that carry a potential state liability for making up shortfalls in the issuing entity’s obligation. The appropriation of funds from the state’s general tax revenue must be approved by the state legislature. However, the state’s pledge is not binding. Debt obligations with this nonbinding pledge of tax revenue are called moral obligation bonds. Because a moral obligation bond requires legislative approval to appropriate the funds, it is classified as an appropriation-backed obligation. The purpose of the moral obligation pledge is to enhance the credit worthiness of the issuing entity. However, the investor must rely on the best-efforts of the state to approve the appropriation.
3. Debt Obligations Supported by Public Credit Enhancement Programs While a moral obligation is a form of credit enhancement provided by a state, it is not a legally enforceable or legally binding obligation of the state. There are entities that have issued debt that carries some form of public credit enhancement that is legally enforceable. This occurs when there is a guarantee by the state or a federal agency or when there is an obligation to automatically withhold and deploy state aid to pay any defaulted debt service by the issuing entity. Typically, the latter form of public credit enhancement is used for debt obligations of a state’s school systems.
Some examples of state credit enhancement programs include Virginia’s bond guarantee program that authorizes the governor to withhold state aid payments to a municipality and divert those funds to pay principal and interest to a municipality’s general obligation holders in the event of a default. South Carolina’s constitution requires mandatory withholding of state aid by the state treasurer if a school district is not capable of meeting its general obligation debt. Texas created the Permanent School Fund to guarantee the timely payment of principal and interest of the debt obligations of qualified school districts. The fund’s income is obtained from land and mineral rights owned by the state of Texas.
More recently, states and local governments have issued increasing amounts of bonds where the debt service is to be paid from so-called “dedicated” revenues such as sales taxes, tobacco settlement payments, fees, and penalty payments. Many are structured to mimic the asset-backed bonds that are discussed later in this chapter (Section VII).
B. Revenue Bonds
The second basic type of security structure is found in a revenue bond. 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. This latter type of revenue bond is usually created to allow issuers to raise debt outside general obligation debt limits and without voter approval.
Revenue bonds can be classified by the type of financing. These 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.
C. Special Bond Structures
Some municipal securities have special security structures. These include insured bonds and prerefunded bonds.
1. Insured Bonds Insured bonds, in addition to being secured by the issuer’s revenue, are also backed by insurance policies written by commercial insurance companies. Insurance on a municipal bond is an agreement by an insurance company to pay the bondholder principal and/or coupon interest that is due on a stated maturity date but that has not been paid by the bond issuer. Once issued, this municipal bond insurance usually extends for the term of the bond issue and cannot be canceled by the insurance company.
2. Prerefunded Bonds Although originally issued as either revenue or general obligation bonds, municipals are sometimes prerefunded and thus called prerefunded municipal bonds. A prerefunding usually occurs when the original bonds are escrowed or collateralized by direct obligations guaranteed by the U.S. government. By this, it is meant that a portfolio of securities guaranteed by the U.S. government 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. For example, suppose that a municipality has a 7% $100 million issue with 12 years remaining to maturity. The municipality’s obligation is to make payments of $3.5 million every six months for the next 12 years and $100 million 12 years from now. If the issuer wants to prerefund this issue, a portfolio of U.S. government obligations can be purchased that has a cash flow of $3.5 million every six months for the next 12 years and $100 million 12 years from now.
Once this portfolio of securities whose cash flows match those of the municipality’s obligation is in place, the prerefunded bonds are no longer secured as either general obligation or revenue bonds. The bonds are now supported by cash flows from the portfolio of securities held in an escrow fund. Such bonds, if escrowed with securities guaranteed by the U.S. government, have little, if any, credit risk. They are the safest municipal bonds available.
The escrow fund for a prerefunded municipal bond can be structured so that the bonds to be refunded are to be called at the first possible call date or a subsequent call date established in the original bond indenture. While prerefunded bonds are usually retired at their first or subsequent call date, some are structured to match the debt obligation to the maturity date. Such bonds are known as escrowed-to-maturity bonds.
VI. CORPORATE DEBT SECURITIES
Corporations throughout the world that seek to borrow funds can do so through either bank borrowing or the issuance of debt securities. The securities issued include bonds (called corporate bonds), medium term notes, asset-backed securities, and commercial paper. Exhibit 10 provides an overview of the structures found in the corporate debt market. In many countries throughout the world, the principal form of borrowing is via bank borrowing and, as a result, a well-developed market for non-bank borrowing has not developed or is still in its infancy stage. However, even in countries where the market for corporate debt securities is small, large corporations can borrow outside of their country’s domestic market.
Because in the United States there is a well developed market for corporations to borrow via the public issuance of debt obligations, we will look at this market. Before we describe the features of corporate bonds in the United States, we will discuss the rights of bondholders in a bankruptcy and the factors considered by rating agencies in assigning a credit rating.
A. Bankruptcy and Bondholder Rights in the United States
Every country has securities laws and contract laws that govern the rights of bondholders and a bankruptcy code that covers the treatment of bondholders in the case of a bankruptcy. There are principles that are common in the legal arrangements throughout the world. Below we discuss the features of the U.S. system.
EXHIBIT 10 Overview of Corporate Debt Securities
The holder of a U.S. corporate debt instrument has priority over the equity owners in a bankruptcy proceeding. Moreover, there are creditors who have priority over other creditors. The law governing bankruptcy in the United States is the Bankruptcy Reform Act of 1978 as amended from time to time. One purpose of the act is to set forth the rules for a corporation to be either liquidated or reorganized when filing bankruptcy.
The liquidation of a corporation means that all the assets will be distributed to the claim holders of the corporation and no corporate entity will survive. In a reorganization, a new corporate entity will emerge at the end of the bankruptcy proceedings. Some security holders of the bankrupt corporation 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 of both cash and new securities in the resulting corporation.
Another purpose of the bankruptcy act is to give a corporation time to decide whether to reorganize or liquidate and then the necessary time to formulate a plan to accomplish either a reorganization or liquidation. This is achieved because when a corporation files for bankruptcy, the act grants the corporation protection from creditors who seek to collect their claims. The petition for bankruptcy can be filed either by the company itself, in which case it is called a voluntary bankruptcy, or be filed by its creditors, in which case it is called an involuntary bankruptcy. A company that files for protection under the bankruptcy act generally becomes a “debtor-in-possession” and continues to operate its business under the supervision of the court.
The bankruptcy act is comprised of 15 chapters, each chapter covering a particular type of bankruptcy. Chapter 7 deals with the liquidation of a company; Chapter 11 deals with the reorganization of a company.
When a company is liquidated, creditors receive distributions based on the absolute priority rule to the extent assets are available. The absolute priority rule is the principle that senior creditors are paid in full before junior creditors are paid anything. For secured and unsecured creditors, the absolute priority rule guarantees their seniority to equity holders. In liquidations, the absolute priority rule generally holds. In contrast, there is a good body of literature that argues that strict absolute priority typically has not been upheld by the courts or the SEC in reorganizations.
B. Factors Considered in Assigning a Credit Rating
In the previous chapter, we explained that there are companies that assign credit ratings to corporate issues based on the prospects of default. These companies are called rating agencies. In conducting a credit examination, each rating agency, as well as credit analysts employed by investment management companies, consider the four C’s of credit—character, capacity, collateral, and covenants.
It is important to understand that a credit analysis can be for an entire company or a particular debt obligation of that company. Consequently, a rating agency may assign a different rating to the various issues of the same corporation depending on the level of seniority of the bondholders of each issue in the case of bankruptcy. For example, we will explain below that there is senior debt and subordinated debt. Senior debtholders have a better position relative to subordinated debtholders in the case of a bankruptcy for a given issuer. So, a rating agency, for example, may assign a rating of “A” to the senior debt of a corporation and a lower rating, “BBB,” to the subordinated debt of the same corporation.
Character analysis involves the analysis of the quality of management. In discussing the factors it considers in assigning a credit rating, Moody’s Investors Service notes the following regarding the quality of management:
Although difficult to quantify, management quality is one of the most important factors supporting an issuer’s credit strength. When the unexpected occurs, it is a management’s ability to react appropriately that will sustain the company’s performance.21
In assessing management quality, the analysts at Moody’s, for example, try to understand the business strategies and policies formulated by management. Moody’s considers the following factors: (1) strategic direction, (2) financial philosophy, (3) conservatism, (4) track record, (5) succession planning, and (6) control systems.22
In assessing the ability of an issuer to pay (i.e., capacity), the analysts conduct financial statement analysis. In addition to financial statement analysis, the factors examined by analysts at Moody’s are (1) industry trends, (2) the regulatory environment, (3) basic operating and competitive position, (4) financial position and sources of liquidity, (5) company structure (including structural subordination and priority of claim), (6) parent company support agreements, and (7) special event risk.23
The third C, collateral, is looked at not only in the traditional sense of assets pledged to secure the debt, but also to the quality and value of those unpledged assets controlled by the issuer. Unpledged collateral is capable of supplying additional sources of funds to support payment of debt. Assets form the basis for generating cash flow which services the debt in good times as well as bad. We discuss later the various types of collateral used for a corporate debt issue and features that analysts should be cognizant of when evaluating an investor’s secured position.
Covenants deal with limitations and restrictions on the borrower’s activities. Affirmative covenants call upon the debtor to make promises to do certain things. Negative covenants are those which require the borrower not to take certain actions. Negative covenants are usually negotiated between the borrower and the lender or their agents. Borrowers want the least restrictive loan agreement available, while lenders should want the most restrictive, consistent with sound business practices. But lenders should not try to restrain borrowers from accepted business activities and conduct. A borrower might be willing to include additional restrictions (up to a point) if it can get a lower interest rate on the debt obligation. When borrowers seek to weaken restrictions in their favor, they are often willing to pay more interest or give other consideration. We will see examples of positive and negative covenants later in this chapter.
C. Corporate Bonds
In Chapter 1, we discussed the features of bonds including the wide range of coupon types, the provisions for principal payments, provisions for early retirement, and other embedded options. Also, in Chapter 2, we reviewed the various forms of credit risk and the ratings assigned by rating agencies. In our discussion of corporate bonds here, we will discuss secured and unsecured debt and information about default and recovery rates.
1. Secured Debt, Unsecured Debt, and Credit Enhancements A corporate debt obligation may be secured or unsecured. Secured debt means that there is some form of collateral pledged to ensure payment of the debt. Remove the pledged collateral and we have unsecured debt.
It is important to recognize that while a superior legal status will strengthen a bondholder’s chance of recovery in case of default, it will not absolutely prevent bondholders from suffering financial loss when the issuer’s ability to generate sufficient cash flow to pay its obligations is seriously eroded. Claims against a weak borrower are often satisfied for less than par value.
a. Secured Debt Either real property or personal property may be pledged as security for secured debt. With mortgage debt, the issuer grants the bondholders a lien against pledged assets. A lien is a legal right to sell mortgaged property to satisfy unpaid obligations to bondholders. In practice, foreclosure and sale of mortgaged property is unusual. If a default occurs, there is usually a financial reorganization of the issuer in which provision is made for settlement of the debt to bondholders. The mortgage lien is important, though, because it gives the mortgage bondholders a strong bargaining position relative to other creditors in determining the terms of a reorganization.
Some companies do not own fixed assets or other real property and so have nothing on which they can give a mortgage lien to secure bondholders. Instead, they own securities of other companies; they are holding companies and the other companies are subsidiaries. To satisfy the desire of bondholders for security, the issuer grants investors a lien on stocks, notes, bonds or other kind of financial asset they own. Bonds secured by such assets are called collateral trust bonds. The eligible collateral is periodically marked to market by the trustee to ensure that the market value has a liquidation value in excess of the amount needed to repay the entire outstanding bonds and accrued interest. If the collateral is insufficient, the issuer must, within a certain period, bring the value of the collateral up to the required amount. If the issuer is unable to do so, the trustee would then sell collateral and redeem bonds.
Mortgage bonds have many different names. The following names have been used: first mortgage bonds (most common name), first and general mortgage bonds, first refunding mortgage bonds, and first mortgage and collateral trusts. There are instances (excluding prior lien bonds as mentioned above) when a company might have two or more layers of mortgage debt outstanding with different priorities. This situation usually occurs because companies cannot issue additional first mortgage debt (or the equivalent) under the existing indentures. Often this secondary debt level is called general and refunding mortgage bonds (G&R). In reality, this is mostly second mortgage debt. Some issuers may have third mortgage bonds.
Although an indenture may not limit the total amount of bonds that may be issued with the same lien, there are certain issuance tests that usually have to be satisfied before the company may sell more bonds. Typically there is an earnings test that must be satisfied before additional bonds may be issued with the same lien.
b. Unsecured Debt Unsecured debt is commonly referred to as debenture bonds. Although a debenture bond is not secured by a specific pledge of property, that does not mean that bondholders have no claim on property of issuers or on their earnings. Debenture bondholders have the claim of general creditors on all assets of the issuer not pledged specifically to secure other debt. And they even have a claim on pledged assets to the extent that these assets generate proceeds in liquidation that are greater than necessary to satisfy secured creditors. Subordinated debenture bonds are issues that rank after secured debt, after debenture bonds, and often after some general creditors in their claim on assets and earnings.
One of the important protective provisions for unsecured debt holders is the negative pledge clause. This provision, found in most senior unsecured debt issues and a few subordinated issues, 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).
c. Credit Enhancements Some debt issuers have other companies guarantee their loans. This is normally done when a subsidiary issues debt and the investors want the added protection of a third-party guarantee. The use of guarantees makes it easier and more convenient to finance special projects and affiliates, although guarantees are also extended to operating company debt.
An example of a third-party (but related) guarantee was U.S. West Capital Funding, Inc. 8% Guaranteed Notes that were due October 15, 1996 (guaranteed by U.S. West, Inc.). The principal purpose of Capital Funding was to provide financing to U.S. West and its affiliates through the issuance of debt guaranteed by U.S. West. PepsiCo, Inc. has guaranteed the debt of its financing affiliate, PepsiCo Capital Resources, Inc., and The Standard Oil Company (an Ohio Corporation) has unconditionally guaranteed the debt of Sohio Pipe Line Company.
Another credit enhancing feature is the letter of credit (LOC) issued by a bank. A LOC requires the bank make payments to the trustee when requested so that monies will be available for the bond issuer to meet its interest and principal payments when due. Thus, the credit of the bank under the LOC is substituted for that of the debt issuer. Specialized insurance companies also lend their credit standing to corporate debt, both new issues and outstanding secondary market issues. In such cases, the credit rating of the bond is usually no better than the credit rating of the guarantor.
While a guarantee or other type of credit enhancement may add some measure of protection to a debtholder, caution should not be thrown to the wind. In effect, one’s job may even become more complex as an analysis of both the issuer and the guarantor should be performed. In many cases, only the latter is needed if the issuer is merely a financing conduit without any operations of its own. However, if both concerns are operating companies, it may very well be necessary to analyze both, as the timely payment of principal and interest ultimately will depend on the stronger party. Generally, a downgrade of the credit enhancer’s claims-paying ability reduces the value of the credit-enhanced bonds.
2. Default Rates and Recovery Rates Now we turn our attention to the various aspects of the historical performance of corporate issuers with respect to fulfilling their obligations to bondholders. Specifically, we will review two aspects of this performance. First, we will review the default rate of corporate borrowers. Second, we will review the default loss rate of corporate borrowers. From an investment perspective, default rates by themselves are not of paramount significance: it is perfectly possible for a portfolio of bonds to suffer defaults and to outperform Treasuries at the same time, provided the yield spread of the portfolio is sufficiently high to offset the losses from default. Furthermore, because holders of defaulted bonds typically recover some percentage of the face amount of their investment, the default loss rate is substantially lower than the default rate. Therefore, it is important to look at default loss rates or, equivalently, recovery rates.
a. Default Rates A default rate can be measured in different ways. A simple way to define a default rate is to use the issuer as the unit of study. A default rate is then measured as the number of issuers that default divided by the total number of issuers at the beginning of the year. This measure—referred to as the issuer default rate—gives no recognition to the amount defaulted nor the total amount of issuance. Moody’s, for example, uses this default rate statistic in its study of default rates. The rationale for ignoring dollar amounts is that the credit decision of an investor does not increase with the size of the issuer. The second measure—called the dollar default rate—defines the default rate as the 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. With either default rate statistic, one can measure the default for a given year or an average annual default rate over a certain number of years.
There have been several excellent studies of corporate bond default rates. All of the studies found that the lower the credit rating, the greater the probability of a corporate issuer defaulting.
There have been extensive studies focusing on default rates for non-investment grade corporate bonds (i.e., speculative-grade issuer or high yield bonds). Studies by Edward Altman suggest that the annual default rate for speculative-grade corporate debt has been between 2.15% and 2.4% per year.24 Asquith, Mullins, and Wolff, however, found that nearly one out of every three speculative-grade bonds defaults.25 The large discrepancy arises because researchers use three different definitions of “default rate”; even if applied to the same universe of bonds (which they are not), the results of these studies could be valid simultaneously.26
Altman defines the default rate as the dollar default rate. His estimates (2.15% and 2.40%) are simple averages of the annual dollar default rates over a number of years. Asquith, Mullins, and Wolff use a cumulative dollar default rate statistic. While both measures are useful indicators of bond default propensity, they are not directly comparable. Even when restated on an annualized basis, they do not all measure the same quantity. The default statistics reported in both studies, however, are surprisingly similar once cumulative rates have been annualized. A majority of studies place the annual dollar default rates for all original issue high-yield bonds between 3% and 4%.
b. Recovery Rates There have been several studies that have focused on recovery rates or default loss rates for corporate debt. Measuring the amount recovered is not a simple task. The final distribution to claimants when a default occurs may consist of cash and securities. Often it is difficult to track what was received and then determine the present value of any non-cash payments received.
Here we review recovery information as reported in a study by Moody’s which uses the trading price at the time of default as a proxy for the amount recovered.27 The recovery rate is the trading price at that time divided by the par value. Moody’s found that the recovery rate was 38% for all bonds. Moreover, the study found that the higher the level of seniority, the greater the recovery rate.
D. Medium-Term Notes
A medium-term note (MTN) is a debt instrument, with the unique characteristic that notes 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. Medium-term notes are registered with the Securities and Exchange Commission under Rule 415 (the shelf registration rule) which gives a borrower (corporation, agency, sovereign, or supranational) the maximum flexibility for issuing securities on a continuous basis. As with corporate bonds, MTNs are rated by the nationally recognized statistical rating organizations.
The term “medium-term note” used to describe this debt instrument is misleading. Traditionally, the term “note” or “medium-term” was used to refer to debt issues with a maturity greater than one year but less than 15 years. Certainly this is not a characteristic of MTNs since they have been sold with maturities from nine months to 30 years, and even longer. For example, in July 1993, Walt Disney Corporation issued a security with a 100-year maturity off its medium-term note shelf registration. From the perspective of the borrower, the initial purpose of the MTN was to fill the funding gap between commercial paper and long-term bonds. It is for this reason that they are referred to as “medium term.”
Borrowers have flexibility in designing MTNs to satisfy their own needs. They can issue fixed- or floating-rate debt. The coupon payments can be denominated in U.S. dollars or in a foreign currency. MTNs have been designed with the same features as corporate bonds.
1. The Primary Market Medium-term notes differ from bonds in the manner in which they are distributed to investors when they are initially sold. Although some corporate bond issues are sold on a “best-efforts basis” (i.e., the underwriter does not purchase the securities from the issuer but only agrees to sell them),28 typically corporate bonds are underwritten by investment bankers. When “underwritten,” the investment banker purchases the bonds from the issuer at an agreed upon price and yield and then attempts to sell them to investors. This is discussed further in Section IX. MTNs have been traditionally distributed on a best-efforts basis by either an investment banking firm or other broker/dealers acting as agents. Another difference between bonds and MTNs is that when offered, MTNs are usually sold in relatively small amounts on either a continuous or an intermittent basis, while bonds are sold in large, discrete offerings.
An entity that wants to initiate a MTN program will file a shelf registration29 with the SEC for the offering of securities. While the SEC registration for MTN offerings are between $100 million and $1 billion, once completely sold, the issuer can file another shelf registration for a new MTN offering. The registration will include a list of the investment banking firms, usually two to four, that the borrower has arranged to act as agents to distribute the MTNs.
The issuer then posts rates over a range of maturities: for example, nine months to one year, one year to 18 months, 18 months to two years, and annually thereafter. In an offering rate schedule, an issuer will post rates as a spread over a Treasury security of comparable maturity. Rates will not be posted for maturity ranges that the issuer does not desire to sell.
The agents will then make the offering rate schedule available to their investor base interested in MTNs. An investor who is interested in the offering will contact the agent. In turn, the agent contacts the issuer to confirm the terms of the transaction. Since the maturity range in an offering rate schedule does not specify a specific maturity date, the investor can chose the final maturity subject to approval by the issuer.
The rate offering schedule can be changed at any time by the issuer either in response to changing market conditions or because the issuer has raised the desired amount of funds at a given maturity. In the latter case, the issuer can either not post a rate for that maturity range or lower the rate.
2. Structured MTNs At one time, the typical MTN was a fixed-rate debenture that was noncallable. It is common today for issuers of MTNs to couple their offerings 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 than are available in the corporate bond market. Specifically, an issue can have a floating-rate over all or part of the life of the security and the coupon formula can be based on a benchmark interest rate, equity index, individual stock price, foreign exchange rate, or commodity index. There are MTNs with inverse floating coupon rates and can include various embedded options.
MTNs created when the issuer simultaneously transacts in the derivative markets are called structured notes. The most common derivative instrument used in creating structured notes is a swap, an instrument described in Chapter 13. By using the derivative markets in combination with an offering, issuers are able to create investment vehicles that are more customized for institutional investors to satisfy their investment objectives, but who are forbidden from using swaps for hedging or speculating. Moreover, it allows institutional investors who are restricted to investing in investment grade debt issues the opportunity to participate in other asset classes such as the equity market. Hence, structured notes are sometimes referred to as “rule busters.” For example, an investor who buys an MTN whose coupon rate is tied to the performance of the S&P 500 (the reference rate) is participating in the equity market without owning common stock. If the coupon rate is tied to a foreign stock index, the investor is participating in the equity market of a foreign country without owning foreign common stock. In exchange for creating a structured note product, issuers can reduce their funding costs.
Common structured notes include: step-up notes, inverse floaters, deleveraged floaters, dual-indexed floaters, range notes, and index amortizing notes.
a. Deleveraged Floaters A deleveraged floater is a floater that has a coupon formula where the coupon rate is computed as a fraction of the reference rate plus a quoted margin. The general formula for a deleveraged floater is: where b is a value between zero and one.
coupon rate = b × (reference rate) + quoted margin
b. Dual-Indexed Floaters The coupon rate for a dual-indexed floater is typically a fixed percentage plus the difference between two reference rates. For example, the Federal Home Loan Bank System issued a floater whose coupon rate (reset quarterly) as follows:
(10-year Constant Maturity Treasury rate) − (3-month LIBOR) + 160 basis points
c. Range Notes A range note is 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 the reference rate is outside of the range, the coupon rate is zero for that period. For example, a 3-year range note might specify that the reference rate is the 1-year Treasury rate and that the coupon rate resets every year. The coupon rate for the year is the Treasury rate as long as the Treasury rate at the coupon reset date falls within the range as specified below:
If the 1-year Treasury rate is outside of the range, the coupon rate is zero. For example, if in Year 1 the 1-year Treasury rate is 5% at the coupon reset date, the coupon rate for the year is 5%. However, if the 1-year Treasury rate is 7%, the coupon rate for the year is zero since the 1-year Treasury rate is greater than the upper limit for Year 1 of 6.5%.
d. Index Amortizing Notes 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.
From our understanding of reinvestment risks, we can see the risks associated with investing in an IAN. Since the coupon rate is fixed, when interest rates rise, an investor would prefer to receive principal back faster in order to reinvest the proceeds received at the prevailing higher rate. However, with an IAN, the rate of principal repayment is decreased. In contrast, when interest rates decline, an investor does not want principal repaid quickly because the investor would then be forced to reinvest the proceeds received at the prevailing lower interest rate. With an IAN, when interest rates decline, the investor will, in fact, receive principal back faster.
E. Commercial Paper
Commercial paper is a short-term unsecured promissory note that is issued in the open market and represents the obligation of the issuing corporation. Typically, commercial paper is issued as a zero-coupon instrument. In the United States, the maturity of commercial paper is typically less than 270 days and the most common maturity is 50 days or less.
To pay off holders of maturing paper, issuers generally use the proceeds obtained from selling new commercial paper. This process is often described as “rolling over” short-term paper. The risk that the investor in commercial paper faces is that the issuer will be unable to issue new paper at maturity. As a safeguard against this “roll-over risk,” commercial paper is typically backed by unused bank credit lines.
There is very little secondary trading of commercial paper. Typically, an investor in commercial paper is an entity that plans to hold it until maturity. This is understandable since an investor can purchase commercial paper in a direct transaction with the issuer which will issue paper with the specific maturity the investor desires.
Corporate issuers of commercial paper can be divided into financial companies and nonfinancial companies. There has been significantly greater use of commercial paper by financial companies compared to nonfinancial companies. There are three types of financial companies: captive finance companies, bank-related finance companies, and independent finance companies. Captive finance companies are subsidiaries of manufacturing companies. Their primary purpose is to secure financing for the customers of the parent company. For example, U.S. automobile manufacturers have captive finance companies. Furthermore, a bank holding company may have a subsidiary that is a finance company, providing loans to enable individuals and businesses to acquire a wide range of products. Independent finance companies are those that are not subsidiaries of equipment manufacturing firms or bank holding companies.
EXHIBIT 11 Commercial Paper Ratings
Commercial paper is classified as either directly placed paper or dealer-placed paper. Directly placed paper is sold by the issuing firm to investors without the help of an agent or an intermediary. A large majority of the issuers of directly placed paper are financial companies. These entities require continuous funds in order to provide loans to customers. As a result, they find it cost effective to establish a sales force to sell their commercial paper directly to investors. General Electric Capital Corporation (GE Capital)—the principal financial services arm of General Electric Company—is the largest and most active direct issuer of commercial paper in the United States. Dealer-placed commercial paper requires the services of an agent to sell an issuer’s paper.
The three nationally recognized statistical rating organizations that rate corporate bonds and medium-term notes also rate commercial paper. The ratings are shown in Exhibit 11. Commercial paper ratings, as with the ratings on other securities, are categorized as either investment grade or noninvestment grade.
F. Bank Obligations
Commercial banks are special types of corporations. Larger banks will raise funds using the various debt obligations described earlier. In this section, we describe two other debt obligations of banks—negotiable certificates of deposit and bankers acceptances—that are used by banks to raise funds.
1. Negotiable CDs A certificate of deposit (CD) is a financial asset issued by a bank (or other deposit-accepting entity) that indicates a specified sum of money has been deposited at the issuing depository institution. A CD bears a maturity date and a specified interest rate; it can be issued in any denomination. In the United States, CDs issued by most banks are insured by the Federal Deposit Insurance Corporation (FDIC), but only for amounts up to $100,000. There is no limit on the maximum maturity. A CD may be nonnegotiable or negotiable. In the former case, the initial depositor must wait until the maturity date of the CD to obtain the funds. If the depositor chooses to withdraw funds prior to the maturity date, an early withdrawal penalty is imposed. In contrast, a negotiable CD allows the initial depositor (or any subsequent owner of the CD) to sell the CD in the open market prior to the maturity date. Negotiable CDs are usually issued in denominations of $1 million or more. Hence, an investor in a negotiable CD issued by an FDIC insured bank is exposed to the credit risk for any amount in excess of $100,000.
An important type of negotiable CD is the Eurodollar CD, which is a U.S. dollar-denominated CD issued primarily in London by U.S., European, Canadian, and Japanese banks. The interest rates paid on Eurodollar CDs play an important role in the world financial markets because they are viewed globally as the cost of bank borrowing. This is due to the fact that these interest rates represent the rates at which major international banks offer to pay each other to borrow money by issuing a Eurodollar CD with given maturities. The interest rate paid is called the London interbank offered rate (LIBOR). The maturities for the Eurodollar CD range from overnight to five years. So, references to “3-month LIBOR” indicate the interest rate that major international banks are offering to pay to other such banks on a Eurodollar CD that matures in three months. During the 1990s, LIBOR has increasingly become the reference rate of choice for borrowing arrangements—loans and floating-rate securities.
2. Bankers Acceptances Simply put, a bankers acceptance is a vehicle created to facilitate commercial trade transactions. The instrument is called a bankers acceptance because a bank accepts the ultimate responsibility to repay a loan to its holder. The use of bankers acceptances to finance a commercial transaction is referred to as “acceptance financing.” In the United States, the transactions in which bankers acceptances are created include (1) the importing of goods; (2) the exporting of goods to foreign entities; (3) the storing and shipping of goods between two foreign countries where neither the importer nor the exporter is a U.S. firm; and (4) the storing and shipping of goods between two U.S. entities in the United States. Bankers acceptances are sold on a discounted basis just as Treasury bills and commercial paper.
The best way to explain the creation of a bankers acceptance is by an illustration. Several entities are involved in our hypothetical transaction:
• Luxury Cars USA (Luxury Cars), a firm in Pennsylvania that sells automobiles
• Italian Fast Autos Inc. (IFA), a manufacturer of automobiles in Italy
• First Doylestown Bank (Doylestown Bank), a commercial bank in Doylestown, Pennsylvania
• Banco di Francesco, a bank in Naples, Italy
• The Izzabof Money Market Fund, a U.S. mutual fund
Luxury Cars and IFA are considering a commercial transaction. Luxury Cars wants to import 45 cars manufactured by IFA. IFA is concerned with the ability of Luxury Cars to make payment on the 45 cars when they are received.
Acceptance financing is suggested as a means for facilitating the transaction. Luxury Cars offers $900,000 for the 45 cars. The terms of the sale stipulate payment to be made to IFA 60 days after it ships the 45 cars to Luxury Cars. IFA determines whether it is willing to accept the $900,000. In considering the offering price, IFA must calculate the present value of the $900,000, because it will not be receiving payment until 60 days after shipment. Suppose that IFA agrees to these terms.
Luxury Cars arranges with its bank, Doylestown Bank, to issue a letter of credit. The letter of credit indicates that Doylestown Bank will make good on the payment of $900,000 that Luxury Cars must make to IFA 60 days after shipment. The letter of credit, or time draft, will be sent by Doylestown Bank to IFA’s bank, Banco di Francesco. Upon receipt of the letter of credit, Banco di Francesco will notify IFA, which will then ship the 45 cars. After the cars are shipped, IFA presents the shipping documents to Banco di Francesco and receives the present value of $900,000. IFA is now out of the picture.
Banco di Francesco presents the time draft and the shipping documents to Doylestown Bank. The latter will then stamp “accepted” on the time draft. By doing so, Doylestown Bank has created a bankers acceptance. This means that Doylestown Bank agrees to pay the holder of the bankers acceptance $900,000 at the maturity date. Luxury Cars will receive the shipping documents so that it can procure the 45 cars once it signs a note or some other type of financing arrangement with Doylestown Bank.
At this point, the holder of the bankers acceptance is Banco di Francesco. It has two choices. It can continue to hold the bankers acceptance as an investment in its loan portfolio, or it can request that Doylestown Bank make a payment of the present value of $900,000. Let’s assume that Banco di Francesco requests payment of the present value of $900,000. Now the holder of the bankers acceptance is Doylestown Bank. It has two choices: retain the bankers acceptance as an investment as part of its loan portfolio or sell it to an investor. Suppose that Doylestown Bank chooses the latter, and that The Izzabof Money Market Fund is seeking a high-quality investment with the same maturity as that of the bankers acceptance. Doylestown Bank sells the bankers acceptance to the money market fund at the present value of $900,000. Rather than sell the instrument directly to an investor, Doylestown Bank could sell it to a dealer, who would then resell it to an investor such as a money market fund. In either case, at the maturity date, the money market fund presents the bankers acceptance to Doylestown Bank, receiving $900,000, which the bank in turn recovers from Luxury Cars.
Investing in bankers acceptances exposes the investor to credit risk and liquidity risk. Credit risk arises because neither the borrower nor the accepting bank may be able to pay the principal due at the maturity date. When the bankers acceptance market was growing in the early 1980s, there were over 25 dealers. By 1989, the decline in the amount of bankers acceptances issued drove many one-time major dealers out of the business. Today, there are only a few major dealers and therefore bankers acceptances are considered illiquid. Nevertheless, since bankers acceptances are typically purchased by investors who plan to hold them to maturity, liquidity risk is not a concern to such investors.
VII. ASSET-BACKED SECURITIES
In Section IVB we described how residential mortgage loans have been securitized. While residential mortgage loans is by far the largest type of asset that has been securitized, the major types of assets that have been securitized in many countries have included the following:
• auto loans and leases
• consumer loans
• commercial assets (e.g., including aircraft, equipment leases, trade receivables)
• credit cards
• home equity loans
• manufactured housing loans
Asset-backed securities are securities backed by a pool of loans or receivables. Our objective in this section is to provide a brief introduction to asset-backed securities.
A. The Role of the Special Purpose Vehicle
The key question for investors first introduced to the asset-backed securities market is why doesn’t a corporation simply issue a corporate bond or medium-term note rather than an asset-backed security? To understand why, consider a triple B rated corporation that manufactures construction equipment. We will refer to this corporation as XYZ Corp. Some of its sales are for cash and others are on an installment sales basis. The installment sales are assets on the balance sheet of XYZ Corp., shown as “installment sales receivables.”
Suppose XYZ Corp. wants to raise $75 million. If it issues a corporate bond, for example, XYZ Corp.’s funding cost would be whatever the benchmark Treasury yield is plus a yield spread for BBB issuers. Suppose, instead, that XYZ Corp. has installment sales receivables that are more than $75 million. XYZ Corp. can use the installment sales receivables as collateral for a bond issue. What will its funding cost be? It will probably be the same as if it issued a corporate bond. The reason is if XYZ Corp. defaults on any of its obligations, the creditors will have claim on all of its assets, including the installment sales receivables to satisfy payment of their bonds.
However, suppose that XYZ Corp. can create another corporation or legal entity and sell the installment sales receivables to that entity. We’ll refer to this entity as SPV Corp. If the transaction is done properly, SPV Corp. owns the installment sales receivables, not XYZ Corp. It is important to understand that SPV Corp. is not a subsidiary of XYZ Corp.; therefore, the assets in SPV Corp. (i.e., the installment sales receivables) are not owned by XYZ Corp. This means that if XYZ Corp. is forced into bankruptcy, its creditors cannot claim the installment sales receivables because they are owned by SPV Corp. What are the implications?
Suppose that SPV Corp. sells securities backed by the installment sales receivables. Now creditors will evaluate the credit risk associated with collecting the receivables independent of the credit rating of XYZ Corp. What credit rating will be received for the securities issued by SPV Corp.? Whatever SPV Corp. wants the rating to be! It may seem strange that the issuer (SPV Corp.) can get any rating it wants, but that is the case. The reason is that SPV Corp. will show the characteristics of the collateral for the security (i.e., the installment sales receivables) to a rating agency. In turn, the rating agency will evaluate the credit quality of the collateral and inform the issuer what must be done to obtain specific ratings.
More specifically, the issuer will be asked to “credit enhance” the securities. There are various forms of credit enhancement. Basically, the rating agencies will look at the potential losses from the pool of installment sales receivables and make a determination of how much credit enhancement is needed for it to issue a specific rating. The higher the credit rating sought by the issuer, the greater the credit enhancement. Thus, XYZ Corp. which is BBB rated can obtain funding using its installment sales receivables as collateral to obtain a better credit rating for the securities issued. In fact, with enough credit enhancement, it can issue a AAA-rated security.
The key to a corporation issuing a security with a higher credit rating than the corporation’s own credit rating is using SPV Corp. as the issuer. Actually, this legal entity that a corporation sells the assets to is called a special purpose vehicle or special purpose corporation. It 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.30
Why doesn’t a corporation always seek the highest credit rating (AAA) for its securities backed by collateral? The answer is that credit enhancement does not come without a cost. Credit enhancement mechanisms increase the costs associated with a securitized borrowing via an asset-backed security. So, the corporation must monitor the trade-off when seeking a higher rating between the additional cost of credit enhancing the security versus the reduction in funding cost by issuing a security with a higher credit rating.
Additionally, if bankruptcy occurs, there is the risk that a bankruptcy judge may decide that the assets of the special purpose vehicle are assets that the creditors of the corporation seeking financing (XYZ Corp. in our example) may claim after all. This is an important but unresolved legal issue in the United States. Legal experts have argued that this is unlikely. In the prospectus of an asset-backed security, there will be a legal opinion addressing this issue. This is the reason why special purpose vehicles in the United States are referred to as “bankruptcy remote” entities.
B. Credit Enhancement Mechanisms
Later, we will review how rating agencies analyze collateral in order to assign ratings. What is important to understand is that the amount of credit enhancement will be determined relative to a particular rating. There are two general types of credit enhancement structures: external and internal.
External credit enhancements come in the form of third-party guarantees. The most common forms of external credit enhancements are (1) a corporate guarantee, (2) a letter of credit, and (3) bond insurance. A corporate guarantee could be from the issuing entity seeking the funding (XYZ Corp. in our illustration above) or its parent company. Bond insurance provides the same function as in municipal bond structures and is referred to as an insurance “wrap.”
A disadvantage of an external credit enhancement is that it is subject to the credit risk of the third-party guarantor. Should the third-party guarantor be downgraded, the issue itself could be subject to downgrade even if the collateral is performing as expected. This is based on the “weak link” test followed by rating agencies. According to this test, when evaluating a proposed structure, the credit quality of the issue is only as good as the weakest link in credit enhancement regardless of the quality of the underlying loans. Basically, an external credit enhancement exposes the investor to event risk since the downgrading of one entity (the third-party guarantor) can result in a downgrade of the asset-backed security.
Internal credit enhancements come in more complicated forms than external credit enhancements. The most common forms of internal credit enhancements are reserve funds, over collateralization, and senior/subordinate structures.
VIII. COLLATERALIZED DEBT OBLIGATIONS
A fixed income product that is also classified as part of the asset-backed securities market is the collateralized debt obligation (CDO). CDOs deserve special attention because of their growth since 2000. Moreover, while a CDO is backed by various assets, it is managed in a way that is not typical in other asset-backed security transactions. CDOs have been issued in both developed and developing countries.
A CDO is a product 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
When the underlying pool of debt obligations consists of bond-type instruments (corporate and emerging market bonds), a CDO is referred to as a collateralized bond obligation (CBO). When the underlying pool of debt obligations are bank loans, a CDO is referred to as a collateralized loan obligation (CLO).
In a CDO structure, an asset manager is responsible for managing the portfolio of assets (i.e., the debt obligations in which it invests). The funds to purchase the underlying assets (i.e., the bonds and loans) are obtained from the issuance of a CDO. The CDO is structured into notes or tranches similar to a CMO issue. The tranches are assigned ratings by a rating agency. There are restrictions as to how the manager manages the CDO portfolio, usually in the form of specific tests that must be satisfied. If any of the restrictions are violated by the asset manager, the notes can be downgraded and it is possible that the trustee begin paying principal to the senior noteholders in the CDO structure.
CDOs are categorized based on the motivation of the sponsor of the transaction. If the motivation of the sponsor is to earn the spread between the yield offered on the fixed income products held in the portfolio of the underlying pool (i.e., the collateral) and the payments made to the noteholders in the structure, then the transaction is referred to as an arbitrage transaction. (Moreover, a CDO is a vehicle for a sponsor that is an investment management firm to gather additional assets to manage and thereby generate additional management fees.) If the motivation of the sponsor is to remove debt instruments (primarily loans) from its balance sheet, then the transaction is referred to as a balance sheet transaction. Sponsors of balance sheet transactions are typically financial institutions such as banks and insurance companies seeking to reduce their capital requirements by removing loans due to their higher risk-based capital requirements.
IX . PRIMARY MARKET AND SECONDARY MARKET FOR BONDS
Financial markets can be categorized as those dealing with financial claims that are newly issued, called the primary market, and those for exchanging financial claims previously issued, called the secondary market.
A. Primary Market
The primary market for bonds involves the distribution to investors of newly issued securities by central governments, its agencies, municipal governments, and corporations. Investment bankers work with issuers to distribute newly issued securities. The traditional process for issuing new securities involves investment bankers performing one or more of the following 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. The advisor role may require investment bankers to design a security structure that is more palatable to investors than a particular traditional instrument.
In the sale of new securities, investment bankers need not undertake the second function—buying the securities from the issuer. An investment banker may merely act as an advisor and/or distributor of the new security. The function of buying the securities from the issuer is called underwriting. When an investment banking firm buys the securities from the issuer and accepts the risk of selling the securities to investors at a lower price, it is referred to as an underwriter. When the investment banking firm agrees to buy the securities from the issuer at a set price, the underwriting arrangement is referred to as a firm commitment. In contrast, in a best efforts arrangement, the investment banking firm only agrees to use its expertise to sell the securities—it does not buy the entire issue from the issuer. The fee earned from the initial offering of a security is the difference between the price paid to the issuer and the price at which the investment bank reoffers the security to the public (called the reoffering price).
1. Bought Deal and Auction Process Not all bond issues are underwritten using the traditional firm commitment or best effort process we just described. Variations in the United States, the Euromarkets, and foreign markets for bonds include the bought deal and the auction process. The mechanics of a bought deal are as follows. The underwriting firm or group of underwriting firms offers a potential issuer of debt securities a firm bid to purchase a specified amount of securities with a certain coupon rate and maturity. The issuer is given a day or so (maybe even a few hours) to accept or reject the bid. If the bid is accepted, the underwriting firm has “bought the deal.” It can, in turn, sell the securities to other investment banking firms for distribution to their clients and/or distribute the securities to its clients. Typically, the underwriting firm that buys the deal will have presold most of the issue to its institutional clients. Thus, the risk of capital loss for the underwriting firm in a bought deal may not be as great as it first appears. There are some deals that are so straightforward that a large underwriting firm may have enough institutional investor interest to keep the risks of distributing the issue at the reoffering price quite small. Moreover, hedging strategies using interest rate risk control tools can reduce or eliminate the risk of realizing a loss of selling the bonds at a price below the reoffering price.
In the auction process, the issuer announces the terms of the issue and interested parties submit bids for the entire issue. This process is more commonly referred to as a competitive bidding underwriting. For example, suppose that a public utility wishes to issue $400 million of bonds. Various underwriters will form syndicates and bid on the issue. The syndicate that bids the lowest yield (i.e., the lowest cost to the issuer) wins the entire $400 million bond issue and then reoffers it to the public.
2. Private Placement of Securities Public and private offerings of securities differ in terms of the regulatory requirements that must be satisfied by the issuer. For example, in the United States, the Securities Act of 1933 and the Securities Exchange Act of 1934 require that all securities offered to the general public must be registered with the SEC, unless there is a specific exemption. The Securities Acts allow certain exemptions from federal registration. Section 4(2) of the 1933 Act exempts from registration “transactions by an issuer not involving any public offering.”
The exemption of an offering does not mean that the issuer need not disclose information to potential investors. The issuer must still furnish the same information deemed material by the SEC. This is provided in a private placement memorandum, as opposed to a prospectus for a public offering. The distinction between the private placement memorandum and the prospectus is that the former does not include information deemed by the SEC as “non-material,” whereas such information is required in a prospectus. Moreover, unlike a prospectus, the private placement memorandum is not subject to SEC review.
In the United States, one restriction that was imposed on buyers of privately placed securities is that they may not be sold for two years after acquisition. Thus, there was no liquidity in the market for that time period. Buyers of privately placed securities must be compensated for the lack of liquidity which raises the cost to the issuer of the securities. SEC Rule 144A, which became effective in 1990, eliminates the two-year holding period by permitting large institutions to trade securities acquired in a private placement among themselves without having to register these securities with the SEC. Private placements are therefore now classified as Rule 144A offerings or non-Rule 144A offerings. The latter are more commonly referred to as traditional private placements. Rule 144A offerings are underwritten by investment bankers.
B. Secondary Market
In the secondary market, an issuer of a bond—whether it is a corporation or a governmental unit—may obtain regular information about the bond’s value. The periodic trading of a bond reveals to the issuer the consensus price that the bond commands in an open market. Thus, issuers can discover what value investors attach to their bonds and the implied interest rates investors expect and demand from them. Bond investors receive several benefits from a secondary market. The market obviously offers them liquidity for their bond holdings as well as information about fair or consensus values. Furthermore, secondary markets bring together many interested parties and thereby reduces the costs of searching for likely buyers and sellers of bonds.
A bond can trade 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. In recent years, however, there has been an evolution away from this form of traditional bond trading and toward electronic bond trading. This evolution toward electronic bond trading is likely to continue.
There are several related reasons for the transition to the electronic trading of bonds. First, because the bond business has been a principal business (where broker-dealer firms risk their own capital) rather than an agency business (where broker-dealer firms act merely as an agent or broker), the capital of the market makers is critical. The amount of capital available to institutional investors to invest throughout the world has placed significant demands on the capital of broker-dealer firms. As a result, making markets in bonds has become more risky for broker-dealer firms. Second, the increase in bond market volatility has increased the capital required of broker-dealer firms in the bond business. Finally, the profitability of bond market trading has declined since many of the products have become more commodity-like and their bid-offer spreads have decreased.
The combination of the increased risk and the decreased profitability of bond market trading has induced the major broker-dealer firms to deemphasize this business in the allocation of capital. Broker-dealer firms have determined that it is more efficient to employ their capital in other activities such as underwriting and asset management, rather than in principal-type market-making businesses. As a result, the liquidity of the traditionally principal-oriented bond markets has declined, and this decline in liquidity has opened the way for other market-making mechanisms. This retreat by traditional market-making firms opened the door for electronic trading. In fact, the major broker-dealer firms in bonds have supported electronic trading in bonds.
Electronic trading in bonds has helped fill this developing vacuum and provided liquidity to the bond markets. In addition to the overall advantages of electronic trading in providing liquidity to the markets and price discovery (particularly for less liquid markets) is the resulting trading and portfolio management efficiencies that have been realized. For example, portfolio managers can load their buy/sell orders into a web site, trade from these orders, and then clear these orders.
There are a variety of types of electronic trading systems for bonds. The two major types of electronic trading systems are dealer-to-customer systems and exchange systems. Dealer-to-customer systems can be a single-dealer system or multiple-dealer system. Single-dealer systems are based on a customer dealing with a single, identified dealer over the computer. The single-dealer system simply computerizes the traditional customer-dealer market-making mechanism. Multi-dealer systems provide some advancement over the single-dealer method. A customer can select from any of several identified dealers whose bids and offers are provided on a computer screen. The customer knows the identity of the dealer.
In an exchange system, dealer and customer bids and offers are entered into the system on an anonymous basis, and the clearing of the executed trades is done through a common process. Two different major types of exchange systems are those based on continuous trading and call auctions. Continuous trading permits trading at continuously changing market-determined prices throughout the day and is appropriate for liquid bonds, such as Treasury and agency securities. Call auctions provide for fixed price auctions (that is, all the transactions or exchanges occur at the same “fixed” price) at specific times during the day and are appropriate for less liquid bonds such as corporate bonds and municipal bonds.
..................Content has been hidden....................
You can't read the all page of ebook, please click here login for view all page.