Asset backed securities

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• Asset Backed Debt Securities

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Chapter Outline

• 24.1 Corporate Debt
• 24.2 Other Types of Debt
• 24.3 Bond Covenants
• 24.4 Repayment Provisions

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Learning Objectives

1. Identify typical sources of debt for
   corporations.
2. Describe the bond indenture.
3. Define the following terms notes, debentures,
   mortgage bonds, and asset-backed bonds. Identify
   which of these are secured, and which are senior.
4. Identify and define the four broadly defined
   categories that comprise international bonds.
5. Define term loan and private placement, and
   contrast the two forms of private debt.

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Learning Objectives (cont'd)

1. Identify four different types of security.
2. Identify the characteristics of municipal bonds.
3. Define the term asset-backed security and give
   several examples of issuers and types of such
   securities.
4. Define the following bond terminology covenants,
   call provision, callable bond, yield to call,
   sinking fund, and convertible bonds.
5. Compare and contrast convertible and callable
   bonds with straight debt.

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24.1 Corporate Debt

• Leveraged Buyout (LBO)
• When a group of private investors purchase all
  the equity of a public corporation and finances
  the purchase primarily with debt

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Public Debt

• The Prospectus
• A public bond issue is similar to a stock issue.
• Indenture
• Included in a prospectus, it is a formal contract
  between a bond issuer and a trust company.
• The trust company represents the bondholders and
  makes sure that the terms of the indenture are
  enforced.
• In the case of default, the trust company
  represents the interests of the bond holders.

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Public Debt (cont'd)

• Corporate bonds almost always pay coupons
  semiannually, although a few corporations have
  issued zero-coupon bonds.
• Most corporate bonds have maturities of 30 years
  or less.

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Public Debt (cont'd)

• The face value or principal amount of a bond is
  denominated in standard increments, most often
  1000.
• The face value does not always correspond to the
  actual money raised because of underwriting fees
  and/or if the bond is issued at a discount.
• Original Issue Discount Bond
• Describes a bond that is issued at a discount

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Public Debt (cont'd)

• Bearer Bonds and Registered Bonds
• Bearer Bonds
• Similar to currency in that whoever physically
  holds the bond certificate owns the bond
• To receive a coupon payment, the holder of a
  bearer bond must provide explicit proof of
  ownership by literally clipping a coupon off the
  bond certificate and remitting it to the paying
  agent.

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Public Debt (cont'd)

• Bearer Bonds and Registered Bonds
• Registered Bonds
• The issuer of this type of bond maintains a list
  of all holders of its bonds.
• Coupon and principal payments are made only to
  people on this list.
• Almost all bonds today are registered bonds.

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Public Debt (cont'd)

• Types of Corporate Debt
• Unsecured Debt
• A type of corporate debt that, in the event of
  bankruptcy, gives bondholders a claim to only the
  assets of the firm that are not already pledged
  as collateral on other debt

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Public Debt (cont'd)

• Types of Corporate Debt
• Notes
• A type of unsecured corporate debt
• Notes typically are coupon bonds with maturities
  shorter than 10 years.
• Debentures
• A type of unsecured corporate debt
• Debentures typically have longer maturities than
  notes.

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Public Debt (cont'd)

• Types of Corporate Debt
• Secured Debt
• A type of corporate debt in which specific assets
  are pledged as collateral.

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Public Debt (cont'd)

• Types of Corporate Debt
• Mortgage Bonds
• A type of secured corporate debt
• Real property is pledged as collateral that
  bondholders have a direct claim to in the event
  of bankruptcy.
• All classes of securities are paid from the same
  cash flow source.

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Public Debt (cont'd)

• Types of Corporate Debt
• Asset-Backed Bonds
• A type of secured corporate debt
• Specific assets are pledged as collateral that
  bondholders have a direct claim to in the event
  of bankruptcy.
• Can be secured by any kind of asset

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Table 24.2 Types of Corporate Debt
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Public Debt (cont'd)

• Types of Corporate Debt
• Tranches
• Different classes of securities that comprise a
  single bond issue
• All classes of securities are paid from the same
  cash flow source.

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Public Debt (cont'd)

• Seniority
• Seniority
• A bondholders priority in claiming assets not
  already securing other debt
• Most debenture issues contain clauses restricting
  the company from issuing new debt with equal or
  higher priority than existing debt.

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Public Debt (cont'd)

• Seniority
• Subordinated Debentures
• Debt that, in the event of a default, has a lower
  priority claim to the firms assets than other
  outstanding debt

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Public Debt (cont'd)

• Bond Markets
• International Bonds
• Domestic Bonds
• Bonds issued by a local entity and traded in a
  local market, but purchased by foreigners
• They are denominated in the local currency.
• Foreign Bonds
• Bonds issued by a foreign company in a local
  market and intended for local investors
• They are denominated in the local currency.

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Public Debt (cont'd)

• Bond Markets
• International Bonds
• Foreign Bonds
• Yankee Bonds
• Foreign bonds in the United States
• Samurai Bonds
• Foreign bonds in Japan
• Bulldogs
• Foreign bonds in the United Kingdom

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Public Debt (cont'd)

• Bond Markets
• International Bonds
• Eurobonds
• International bonds that are not denominated in
  the local currency of the country in which they
  are issued
• Global Bonds
• Bonds that are offered for sale in several
  different markets simultaneously
• Global bonds can be offered for sale in the same
  currency as the country of issuance (unlike
  Eurobonds).

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Private Debt

• Private Debt
• Debt that is not publicly traded
• Has the advantage that it avoids the cost of
  registration but has the disadvantage of being
  illiquid

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Private Debt (cont'd)

• Term Loans
• Term Loan
• A bank loan that lasts for a specific term
• Syndicated Bank Loan
• A single loan that is funded by a group of banks
  rather than just a single bank
• Revolving Line of Credit
• A credit commitment for a specific time period,
  typically two to three years, which a company can
  use as needed

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Private Debt (cont'd)

• Private Placements
• Private Placement
• A bond issue that is sold to a small group of
  investors rather than the general public
• Because a private placement does not need to be
  registered, it is less costly to issue than
  public debt.
• In 1990, the SEC issued Rule 144A, which allows
  private debt issued under this rule to be traded
  by large financial institutions among themselves.
• Because this debt is tradeable between financial
  institutions, it is only slightly less liquid
  than public debt.

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24.2 Other Types of Debt

• Sovereign Debt
• Sovereign Debt
• Debt issued by national governments
• U.S. Treasury securities represents the single
  largest sector of the U.S. bond market.

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Sovereign Debt

• The U.S. Treasury issues
• Treasury Bills
• Pure discount bonds with maturities up to 26
  weeks
• Treasury Notes
• Semi-annual coupon bonds with maturities of 2 to
  10 years

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Sovereign Debt (cont'd)

• TIPS (Treasury-Inflation-Protected Securities)
• An inflation-indexed bond issued by the U.S.
  Treasury with maturities of 5, 10, and 20 years
• They are standard fixed-rate coupon bonds with
  one difference The outstanding principal is
  adjusted for inflation.

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Sovereign Debt (cont'd)

• Treasury securities are sold by auction.
• Two types of bids are allowed.
• Competitive
• Competitive bidders submit sealed bids in terms
  of yields and the amount of bonds they are
  willing to purchase. The Treasury then accepts
  the lowest-yield (highest-price) competitive bids
  up to the amount required to fund the deal.

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Sovereign Debt (cont'd)

• Treasury securities are sold by auction.
• Two types of bids are allowed.
• Non-Competitive
• Noncompetitive bidders (usually individuals) just
  submit the amount of bonds they wish to purchase
  and are guaranteed to have their orders filled at
  the auction.

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Sovereign Debt (cont'd)

• STRIPS (Separate Trading of Registered Interest
  and Principal Securities)
• Zero-coupon Treasury securities with maturities
  longer than one year that trade in the bond
  market
• The Treasury itself does not issue STRIPS.
  Instead, investment banks purchase Treasury notes
  and bonds and then resell each coupon and
  principal payment separately as a zero-coupon
  bond.

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Sovereign Debt (cont'd)

• Stop-Out Yield
• The highest yield competitive bid that will fund
  a particular Treasury security issue when all
  successful bidders (including the non-competitive
  bidders) are awarded this yield

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Municipal Bonds

• Municipal Bonds (Munis)
• Bonds issued by state and local governments
• They are not taxable at the federal level (and
  sometimes at the state and local level as well).
• Sometimes referred to as tax-exempt bonds

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Municipal Bonds (cont'd)

• Municipal Bonds (Munis)
• Most pay semi-annual interest
• Fixed Rate
• Has the same coupon over the life of the bond
• Floating Rate
• The coupon of the bond is adjusted periodically

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Municipal Bonds (cont'd)

• Serial Bonds
• A single issue of municipal bonds that are
  scheduled to mature serially over a period of
  years
• General Obligation Bonds
• Bonds backed by the full faith and credit of the
  local government

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Municipal Bonds (cont'd)

• Revenue Bonds
• Municipal bonds for which the local or state
  government can pledge as repayment revenues
  generated by specific projects
• Double-Barreled
• Describes municipal bonds for which the issuing
  local or state government has strengthened its
  promise to pay by committing itself to using
  general revenue to pay off the bonds

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Asset-Backed Securities

• Securities made up of other financial securities
• Securitys cash flows come from the cash flows of
  the underlying financial securities that back
  it.
• Asset securitization
• The process of creating an asset-backed security

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Asset-Backed Securities (cont'd)

• Mortgage-backed security
• Largest sector of the asset-backed security
  market
• Backed by home mortgages
• Largest issuers are U.S. government agencies and
  sponsored enterprises, such as the Government
  National Mortgage Association (GNMA).

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Asset-Backed Securities (cont'd)

• GNMA-issued mortgage-backed securities are
  explicitly guaranteed against default risk by the
  government.
• Investors still have pre-payment risk
• The risk that the bond will be partially (or
  wholly) repaid earlier than expected.

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Asset-Backed Securities (cont'd)

• Other government sponsored enterprises issuing
  mortgage backed securities
• Federal National Mortgage Association (FNMA)
• Federal Home Loan Mortgage Corporation (FHLMC or
  Freddie Mac)
• Student Loan Marketing Association (Sallie Mae)
• Asset-backed securities backed by student loans

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Asset-Backed Securities (cont'd)

• The entities on the previous slide are not
  explicitly backed by the full faith and credit of
  the government, but many believe there is an
  implicit guarantee.

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Asset-Backed Securities (cont'd)

• Private organizations, such as banks, also issue
  asset-backed securities.
• Backed by home mortgages, auto loans, credit card
  receivables, and other consumer loans.
• Collateralized debt obligation (CDO)
• A re-securitization of other asset-backed
  securities.
• Often divided into tranches that are assigned
  different repayment priority.

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24.3 Bond Covenants

• Covenants
• Restrictive clauses in a bond contract that limit
  the issuers from undercutting their ability to
  repay the bonds
• For example, covenants may
• Restrict the ability of management to pay
  dividends
• Restrict the level of further indebtedness
• Specify that the issuer must maintain a minimum
  amount of working capital

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24.4 Repayment Provisions

• A bond issuer typically repays its bonds by
  making coupon and principal payments as specified
  in the bond contract. However, the issuer can
• Repurchase a fraction of the outstanding bonds in
  the market
• Make a tender offer for the entire issue
• Exercise a call provision

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24.4 Repayment Provisions (cont'd)

• Callable Bonds
• Bonds that contain a call provision that allows
  the issuer to repurchase the bonds at a
  predetermined price

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Call Provisions

• A call feature allows the issuer of the bond the
  right (but not the obligation) to retire all
  outstanding bonds on (or after) a specific date
  (the call date), for the call price.
• The call price is generally set at or above, and
  expressed as a percentage of, the bonds face
  value.

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Call Provisions (cont'd)

• A firm may choose to call a bond issue if
  interest rates have fallen.
• The issuer can lower its borrowing costs by
  exercising the call on the callable bond and then
  immediately refinancing the issue at a lower
  rate.
• Note If rates rise after a bond is originally
  issued, there is no need to refinance.

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Call Provisions (cont'd)

• Holders of callable bonds understand that the
  issuer will exercise the call option only when
  the coupon rate of the bond exceeds the
  prevailing market rate.
• If a bond is called, investors must reinvest the
  proceeds when market rates are lower than the
  coupon rate they are currently receiving.
• This makes callable bonds relatively less
  attractive to bondholders than identical
  non-callable bonds.
• A callable bond will trade at a lower price (and
  therefore a higher yield) than an otherwise
  equivalent non-callable bond.

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Call Provisions (cont'd)

• Consider what happens to a bond that is callable
  at par on only one specific date. On the call
  date
• If the yield of the callable bond is less than
  the coupon, the callable bond will be called, so
  its price is its par value.
• If this yield is greater than the coupon, then
  the callable bond will not be called, so it has
  the same price as the non-callable bond.
• Note The callable bond price is capped at par
  The price can be low when yields are high, but
  does not rise above the par value when the yield
  is low.

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Figure 24.2 Prices of Callable and Non-callable
Bonds on the Call Date
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Call Provisions (cont'd)

• Prior to the call date
• When market yields are high relative to the bond
  coupon, investors anticipate that the likelihood
  of exercising the call is low and the bond price
  is similar to an otherwise identical non-callable
  bond.

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Call Provisions (cont'd)

• Prior to the call date
• When market yields are low relative to the bond
  coupon, investors anticipate that the bond will
  likely be called, so its price is close to the
  price of a non-callable bond that matures on the
  call date.

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Figure 24.3 Prices of Callable and Non-callable
Bonds Prior to the Call Date
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Call Provisions (cont'd)

• Yield to Call (YTC)
• The yield of a callable bond calculated under the
  assumption that the bond will be called on the
  earliest call date

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Sinking Funds

• Sinking Fund
• A method of repaying a bond in which a company
  makes regular payments into a fund administered
  by a trustee over the life of the bond
• These payments are then used to repurchase bonds.
• This allows the firm to retire some of the
  outstanding debt without affecting the cash flows
  of the remaining bonds.

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Sinking Funds (cont'd)

• If the bonds are trading at a discount, the
  company will repurchase the bonds in the market.
• If the bonds are trading above its face value,
  the bonds are repurchased at par.
• Which bonds are repurchased is decided by a
  lottery.

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Sinking Funds (cont'd)

• Balloon Payment
• A large payment that must be made on the maturity
  date of a bond
• Some sinking funds require equal payments over
  the life of the bond. In other cases, the sinking
  fund payments are not sufficient to retire the
  entire issue and the company must make a balloon
  payment.

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Convertible Provisions

• Convertible Bond
• A corporate bond with a provision that gives the
  bondholder an option to convert each bond owned
  into a fixed number of shares of common stock
• Conversion Ratio
• The number of shares received upon conversion of
  a convertible bond, usually stated per 1000 of
  face value

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Convertible Provisions (cont'd)

• Conversion Price
• The face value of a convertible bond divided by
  the number of shares received if the bond is
  converted

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Convertible Provisions (cont'd)

• Often companies issue convertible bonds that are
  callable.
• With these bonds, if the issuer calls them, the
  holder can choose to convert rather than let the
  bonds be called.

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Figure 24.4 Convertible Bond Value
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Convertible Provisions

• Warrant
• A call option written by the company itself on
  new stock
• When a holder of a warrant exercises it and
  thereby purchases stock, the company delivers
  this stock by issuing new stock.
• Convertible debt carries a lower interest rate
  because it has an embedded warrant.