Intermediary and International Debt Securities

1
Chapter 7

• Intermediary and International Debt Securities

2
Intermediary Securities

• The intermediary financial market consist of
  commercial banks, insurance companies, mutual
  funds, mortgage bankers, and other financial
  institutions and intermediaries.
• These intermediaries sell financial claims to
  investors, then use the proceeds to purchase debt
  and equity claims. In this process, intermediate
  securities are created
• Types Certificates of deposit (CDs), mutual fund
  shares, mortgage backed securities, payroll
  retirement plans, bankers acceptances, etc.

3
Certificates of Deposit

• Negotiable Certificates of Deposit (CDs) are
  Marketable short-term bank bonds.
• Features
• Minimum denomination 100,000 average
  denomination 1M
• Maturity 90 days to one year.
• Zero-Coupon Notes Technically CDs pay a
  principal and interest at maturity longer-term
  CDs pay coupon

4
Certificates of Deposit

• 4. Yield Yields on CDs gt yield on T-bills.
• 5. Yields on CDs of large banks (prime CDs) are
  less than the yields on CDs of smaller banks
  (nonprime CDs).
• Primary and secondary (OTC) markets are handled
  by approximately 25 dealers.

5
Certificates of Deposit

• 7. Special CDs
• Long-term (5-year maturity) variable rate CDs
• Bull and bear CDs rates tied to stock market
  indices
• Eurodollar CDs
• Jumbo CDs large-denomination CDs
• Yankee CDs dollar-denominated CDs sold in US by
  foreign banks

6
Secondary CD Market History

• In 1961, First Bank of NY issued a CD that was
  accompanied by an announcement by First Boston
  Corporation and Salomon Brothers that they would
  stand ready to buy the CD before its maturity.
• This announcement marked the beginning of the
  secondary CD market.
• At the time, the maximum rates on CDs were set by
  the FRS (Regulation Q) with longer-term CDs
  usually greater than shorter-term CDs.
• Because of Regulation Q, bank CDs were often not
  competitive with T-bills, CP, and other money
  market securities as a short-term investment for
  corporations and other investors.

7
Secondary CD Market History

• The existence of a secondary market meant that if
  yield curve were positively sloped and did not
  change, an investor could earn a rate higher than
  either the shorter- or longer-term CD by buying
  the longer-term CD and selling it later in the
  secondary market at the higher price associated
  with the lower rate on the shorter-term maturity.
  

8
Secondary CD Market History

• Example
• Suppose
• 6-month CDs yielded 5 (P 100/(1.05).5 97.59)
• 1-year CD yielded 6 (P 100/1.06 94.3396)
• An investor could
• Buy the 1-year CD for 94.3396
• Hold it for six months
• Sell it for 97.59 (given the yield curve did not
  change) to realized an annualized yield of 7
• R (97.59/94.3396)1/.5 1 .07

9
Secondary CD Market History

• Given the Fed did not change Regulation Q very
  often and the rates on longer-term CDs were
  higher than shorter-term ones, the secondary
  market for CDs provided a way for banks to
  increase their CD yields to investors without
  violating Regulation Q.
• Following First Bank of New York, Salomon
  Brothers, and First Boston's lead, other banks,
  brokers, and dealers quickly entered into the
  market for negotiable CDs, creating the secondary
  CD market.

10
Website

• Yields on CDs and Eurodollar CDs can be found at
  www.federalreserve.gov/releases

11
Bankers Acceptances

• Bankers Acceptances (BAs) are time drafts
  (post-dated check) that are drawn on a bank
  (usually by an exporter) and are guaranteed by
  the bank. The guarantee improves the credit
  quality of the bank, making the BAs marketable.
• Features
• Zero-Coupon Bonds
• Maturity 30 days - 1 year
• Purchased by banks, corporations, money market
  funds, central banks, etc.

12
Bankers Acceptances Example

• Consider the case of a U.S. oil refinery that
  wants to import 80,000 barrels of crude oil at
  25 per barrel (2M) from an oil producer in
  South America.
• Suppose the South American oil exporter wants to
  be paid before shipping, while the U.S. importer
  wants the crude oil before payment.
• To facilitate the transaction, suppose they agree
  to finance the sale with a BA in which the U.S.
  importers banks will guarantee a 2M payment 60
  days from the shipment date.
• With this understanding, the U.S. oil importer
  would obtain a letter of credit (LOC) from his
  bank.
• The LOC would say that the bank would pay the
  exporter 2M if the U.S. importer failed to do
  so.

13
Bankers Acceptances Example

• The LOC would then be sent by the U.S. bank to
  the South American bank of the exporter.
• Upon receipt of the LOC, the South American bank
  would notify the oil exporter who would then ship
  the 80,000 barrels of crude oil.
• The oil exporter would then present the shipping
  documents to the South American bank and receive
  the present value of 2M in local currency from
  the bank.
• The South American bank would then present a time
  draft to the U.S. bank who would stamp accepted
  on it, thus creating the BA. The U.S. importer
  would sign the note and receive the shipping
  documents. At this point, the South American bank
  is the holder of the BA.
• The bank can hold the BA as an investment or sell
  it to the American bank at a price equal to the
  present value of 2M.

14
Bankers Acceptances Example

• 9. If the South American bank opts for the
  latter, then the U.S. bank holds the BA and can
  either retain it or sell it to an investor such
  as a money market fund or a BA dealer.
• 10. If all goes well, at maturity the oil
  importer will present the shipping documents to
  the shipping company to obtain his 80,000 barrels
  of crude oil, as well as deposit the 2M funds in
  his bank whoever is holding the BA on the due
  date will present it to the U.S. importer's bank
  to be paid.

15
Bankers Acceptances Market

• The use of BAs to finance transactions is known
  as acceptance financing and banks that create BAs
  are referred to as accepting banks.
• In the U.S., the major accepting banks are the
  money center banks such as Citicorp and Bank of
  America, as well as some large regional banks.
  Many of the large Japanese banks have also been
  active in creating BAs.
• In the secondary market, BAs are traded as pure
  discount bonds, with the face value equal to the
  payment order and with the maturity between 30
  and 270 days. With the bank guarantee, they are
  considered prime-quality instruments with
  relatively low yields.

16
Bankers Acceptances Market

• The secondary market trading of BAs takes place
  principally among banks and dealers.
• There are approximately 20 dealers who facilitate
  trading in the secondary market.
• The major dealers include the major investment
  banking firms such as Merrill Lynch (the largest
  dealer) and Shearson Lehman, as well as a number
  of money center banks.
• Money market funds, banks, institutional
  investors, non-financial corporations, and
  municipal governments are the primary purchasers
  of BAs.

17
Bankers Acceptances Market

• The market for BAs has existed for over 70 years
  in the U.S., although its origin dates back to
  the 12th century.
• In the U.S., this market grew steadily in the 60s
  and 70s.
• From 1970 to 1985 the market accelerated from
  7.6 billion in 1970 to almost 80 billion in
  1985, reflecting the growth in world trade.
• Due to alternative financing, though, the BA
  market has declined marginally since 1985.

18
Website

• Historical data on BA yields can be found at
  www.federalreserve.gov/releases
• For data on the size of the market for BAs go to
  www.bondmarkets.com and click on Research
  Statistics and Money Market Instruments.

19
Mortgage-Backed Securities

• Mortgage-Backed Securities Financial claims
  on a portfolio of mortgages. The claims entitle
  the holder to the cash flows from the mortgage
  portfolio.

20
Mortgage-Backed Securities

• Typically, a financial institution, agency, or
  mortgage banker buys a pool of mortgages of a
  certain type from mortgage originators (e.g.,
  Federal Housing Administration-insured mortgages
  or mortgages with a certain minimum loan-to-value
  ratio or a specified payment-to-income ratios).
• This mortgage portfolio is financed through the
  sale of the MBS, which has a claim on the
  portfolio.
• The mortgage originators usually agree to
  continue to service the loans, passing the
  payments on to the mortgage-backed security
  holders.

21
Mortgage-Backed Securities

• A MBS investor has a claim on the cash flows from
  the mortgage portfolio. This includes interest
  on the mortgages, scheduled payment of principal,
  and any prepaid principal.
• Since many mortgages are prepaid early as
  homeowners sell their homes or refinance their
  current mortgages, the cash flows from a
  portfolio of mortgages, and therefore the return
  on the MBS, can be quite uncertain.
• To address this type of risk, a number of
  derivative MBS were created in the 1980s. For
  example, in the late 1980s Freddie Mac introduced
  the collateralized mortgage obligations (CMOs).
• These securities had different maturity claims
  and different levels of prepayment risk.

22
Asset-Backed Securities and Securitization

• A MBS is an asset-backed security created through
  a method known as securitization.
• Securitization is a process of transforming
  illiquid financial assets into marketable capital
  market instruments. Today, it is applied not only
  to mortgages but also home equity loans,
  automobile loans, lines of credit, credit card
  receivables, and leases.
• Securitization is one of the most important
  financial innovations introduced in the last two
  decades it is examined in detail in Chapter 11.

23
Investment Funds

• Many financial institutions offer a wide variety
  of investment funds.
• For many investors, shares in these funds are an
  alternative to directly buying stocks and bonds.

24
Investment Funds

• In addition to the traditional stock funds,
  investment companies today offer shares in
• Bond funds Municipal bonds, corporate,
  high-yield bonds, foreign bonds, etc.)
• Money market funds consisting of CDs, CP,
  Treasury securities, etc.
• Index funds Funds whose values are highly
  correlated with a stock or bond index
• Funds with options and futures
• Global funds Funds with stocks and bonds from
  different countries
• Vulture funds Funds consisting of debt
  securities of companies that are in financial
  trouble or in Chapter 11 bankruptcy

25
Investment Funds

• Currently there are over 8,000 funds in the U.S.
  a number that exceeds the number of stocks listed
  on the NYSE.
• Contributing to this large number is the
  increased percentage of fund investment coming
  from retirement investments such as individual
  retirement accounts (IRAs) and 401(k) accounts.
• As of year 2000, mutual funds accounted for
  approximately 21 (2.5 trillion) of the
  estimated 12 trillion dollar retirement
  investment market.

26
Structure of Funds

• There are three types of investment fund
  structures
• Open-end funds (or mutual funds)
• Closed-end funds
• Unit investment trusts
• The first two can be defined as managed funds,
  while the third is an unmanaged one.

27
Open-End Fund

• Open-end funds (mutual funds) stand ready to buy
  back shares of the fund at any time the fund's
  shareholders want to sell, and they stand ready
  to sell new shares any time an investor wants to
  buy into the fund.
• Technically, a mutual fund is an open-end fund.
  The term mutual fund, though, is often used to
  refer to both open- and closed-end funds.
• With an open-end fund the number of shares can
  change frequently. The price an investor pays
  for a share of an open-end fund is equal to the
  fund's net asset values (NAV).

28
Open-End Fund

• At a given point in time, the NAV of the fund is
  equal to the difference between the value of the
  fund's assets (VAt) and its liabilities (VLt)
  divided by the number of shares outstanding (Nt)

29
Open-End Fund

• Example Suppose a balanced stock and bond fund
  consist of
• A stock portfolio with a current market value
  100M
• A corporate bond portfolio with current market
  value of 100M,
• Liquid securities of 8M
• Liabilities of 8 million
• The current net worth of this fund would be
  200M. If the fund, in turn, has 4 million shares
  outstanding, its current NAV would be 50 per
  share
• Note This value can change if the number of
  shares, the asset values, or the liability values
  change.

30
Closed-End Fund

• A Closed-end fund has a fixed number of
  non-redeemable shares sold at its initial
  offering.
• Unlike an open-end fund, the closed-end fund does
  not stand ready to buy existing shares or sell
  new shares.
• The number of shares of a closed-end fund is
  therefore fixed.

31
Closed-End Fund

• An investor who wants to buy shares in an
  existing closed-end fund can do so only by buying
  them in the secondary market from an existing
  holder.
• Shares in existing funds are traded on the
  over-the counter market.
• Interestingly, the prices of many closed-end
  funds often sell at a discount from their NAVs.

32
Unit Investment Trust

• A unit investment trust has a specified number of
  fixed-income securities that are rarely changed,
  and the fund usually has a fixed life.
• A unit investment trust is formed
• by a sponsor (investment company) who buys a
  specified number of securities,
• deposits them with a trustee, and
• sells claims on the security, known as redeemable
  trust certificates, at their NAV plus a
  commission fee.
• These trust certificates entitle the holder to
  proportional shares in the income from the
  deposited securities.

33
Unit Investment Trust

• Example
• An investment company purchases 20 million worth
  of Treasury bonds
• Places them in a trust
• Issue 20,000 redeemable trust certificates at
  1,025 per share
• If the investment company can sell all of the
  shares, it will be able to finance the 20
  million bond purchase and earn a 2.5 commission
  of 500,000

NAV Commission (20 million/20,000) 25
1,025
34
Unit Investment Trust

• Most unit investment trusts are formed with
  fixed-income securities government securities,
  corporate bonds, municipal bonds, and preferred
  stock.
• Unlike open- and closed-end funds, when the
  securities in the pool mature, the investment
  trust ceases.
• Depending on the types of bonds, the maturity on
  a unit investment trust can vary from six months
  to 20 years.
• The holders of the securities usually can sell
  their shares back to the trustee prior to
  maturity at their NAV plus a load. To finance
  the purchase of the trust certificate, the
  trustee often sells a requisite amount of
  securities making up the trust.

35
Types of Investment Funds

• One way of grouping the many types of funds is
  according to the classifications defined by
  Weisenberger's Annual Investment Companies
  Manual
• Growth Funds
• Income Funds
• Balanced Funds

36
Types of Investment Funds

• Growth funds are those whose primary goal is in
  long-term capital gains. Such funds tend to
  consist primarily of those common stocks offering
  growth potential. Many of these are diversified
  stock funds, although there are some that
  specialize in certain sectors.
• Income funds are those whose primary goal is
  providing income. These funds are made up mainly
  of stocks paying relatively high dividends or
  bonds with high coupon yields.
• Balanced funds are those with goals somewhere
  between those of growth and income funds.
  Balance funds are constructed with bonds, common
  stocks, and preferred stocks that are expected to
  generate moderate income with the potential for
  some capital gains.

37
Types of Investment Funds

• A second way of classifying funds is in terms of
  their specialization. There are four general
  classifications
• Equity Funds
• Bond Funds
• Hybrid Funds (Stocks and Bonds)
• Money-Market Funds
• Each of these fund types can be broken down
  further by their specified investment objectives.

38
Types of Investment Funds

• Equity Funds
• Value Funds
• Growth Funds
• Sector Funds
• World Equity Funds
• Emerging Market Funds
• Regional Equity Funds
• Taxable Bond Funds
• Corporate bond funds
• High Yield Funds
• Global Bond Funds
• Government Bond Funds
• Mortgage-Backed Securities 

• Tax-Free Bond Funds
• State Municipal Bond Funds
• National Municipal Bond Funds
• Hybrid Funds
• Asset allocation Funds
• Balanced Funds
• Income-Mixed Funds
• Money Market Funds
• Taxable Money Market Funds
• Tax-Exempt Money Market Funds

39
Types of Bond Funds

• Bond funds can be classified as corporate,
  municipal, government, high-yield, global,
  mortgage-backed securities, and tax-free. For
  example
• Municipal bond funds specialize in providing
  investors with tax-exempt municipal securities.
• Corporate bond funds are constructed to replicate
  the overall performance of a certain type of
  corporate bond, with a number of them formed to
  be highly correlated with a specific index such
  as the Shearson-Lehman index.
• Money market funds are constructed with money
  market securities in order to provide investors
  with liquid investments.

40
Bond Market Indices

• The managers of these various bond funds, as well
  as the managers of pension, insurance, and other
  fixed-income funds, often evaluate the
  performance of their funds by comparing their
  funds return with those of an appropriate bond
  index.
• In addition, many funds are constructed so that
  their returns replicate those of a specified
  index.

41
Bond Market Indices

• A number of bond indexes have been developed in
  recent years on which bond funds can be
  constructed or benchmarked.
• The most well known indexes are those constructed
  by Dow Jones that are published daily in the Wall
  Street Journal.
• A number of investment companies also publish a
  variety of indexes theses include Lehman
  Brothers, Merrill Lynch, Salomon Smith Barney,
  First Boston, and J.P. Morgan.
• The indexes can be grouped into three categories
  U.S. investment grade bonds indexes (including
  Treasuries), U.S. high-yield bond indexes, and
  global government bond indexes. Within each
  category, subindexes are constructed based on
  sector, quality ratings, or country.

42
Bond Market Indexes
The Handbook of Fixed-Income Securities, editor
F. Fabozzi, 6th edition, p. 158.
43
Other Investment Funds

• In addition to open-end and closed-end investment
  funds and unit investment trusts, three other
  investment funds of note are
• Hedge Funds
• Real Estate Investment Trusts
• Dual Purpose Funds

44
Hedge Funds

• Hedged Funds can be defined as special types of
  mutual funds. There are estimated to be as many
  as 4,000 such funds.
• They are structured so that they can be largely
  unregulated. To achieve this, they are often set
  up as limited partnerships. By federal law, as
  limited partnerships, hedge funds are limited to
  no more than 99 limited partners each with annual
  incomes of at least 200,000 or a net worth of at
  least 1M (excluding home), or to no more than
  499 limited partners each with a net worth of at
  least 5M.
• Many funds or partners are also domiciled
  offshore to circumvent regulations.

45
Hedge Funds

• Hedge funds acquire funds from many different
  individual and institutional sources the
  investments range from 100,000 to 20M, with the
  average investment being 1M.
• They use the funds to invest or set up investment
  strategies reflecting pricing aberrations.
• Many of the strategies of hedge funds involve
  bond positions.
• One of the most famous is that of Long-Term
  Capital who set up positions in T-bonds and
  long-term corporate bonds to profit from an
  expected narrowing of the default spread that
  instead widened.

46
Real Estate Investment Trust

• Real Estate Investment Trust (REIT) A REIT is a
  fund that specializes in investing in real estate
  or real estate mortgages.
• The trust acts as an intermediary, selling stocks
  and warrants and issuing debt instruments (bonds,
  commercial paper, or loans from banks), then
  using the funds to invest in commercial and
  residential mortgage loans and other real estate
  securities.

47
Real Estate Investment Trust

• REITs can take the following forms
• Equity Trust that invests directly in real estate
  
• Mortgage Trust that invests in mortgage loans or
  mortgage-backed securities
• Hybrid Trust that invests in both

48
Real Estate Investment Trust

• Many REITs are highly leveraged, making them more
  subject to default risks.
• REITs are tax-exempt corporations, often formed
  by banks, insurance companies, and investment
  companies.
• To qualify for tax exemptions, the company must
  receive approximately 75 of its income from real
  estate, rents, mortgage interest, and property
  sales, and distribute 95 of its income to its
  shareholders.
• The stocks of many existing shares in REITs are
  listed on the organized exchanges and the OTC
  market.

49
Dual Purpose Fund

• Dual Purpose Funds A fund that sells different
  types of claims on the funds cash flows. For
  example
• Claim on dividends
• Claim on capital gains

50
Websites

• Information on investment funds www.ici.org.
• Information on investment fund and ratings
  www.quicken.com/investments/mutualfunds/finder/ ,
• www.morningstar.com, and www.lipperweb.com.
• Information on money market funds
  www.imoneynet.com.
• Information on Real Estate Investment Trusts
  www.nareit.com.
• Information on hedge funds www.thehfa.org,
  www.hedgefundcenter.com,
• and www.hedgefund.net.

51
Insurance Companies

• Insurance companies use the premiums paid on
  various insurance policies and retirement and
  savings plans to invest in bonds, stocks,
  mortgages, and other assets.
• As such, they are important financial
  intermediaries.
• Insurance companies can be classified as either
  property and casualty companies or life insurance
  companies.

52
Property and Casualty

• Property and casualty companies provide property
  insurance to businesses and households against
  losses to their properties resulting from fire,
  accidents, natural disasters, and other
  calamities, and casualty (or liability) insurance
  to businesses and households against losses the
  insurer may cause to others as a result of
  accidents, product failures, and negligence.
• Property and casualty insurance policies are
  short term, often renewed on an annual basis.
  Since the events being insured by the policies
  are difficult to predict, insurance companies
  tend to invest the premiums from property and
  casualty policies into more liquid assets.
• Approximately 10 of property and casualty
  insurance policies are reinsured. Reinsurance
  refers to the allocation of the policy to other
  insurers

53
Life Insurance

• Life Insurance companies provide basic life
  insurance protection in the form of income to
  benefactors in the event of the death of the
  insurer.
• They also provide disability insurance, health
  insurance, annuities, and guaranteed investment
  contracts.

54
Life Insurance Role in the Financial Market

• Life insurance companies are a major player in
  the financial markets, investing billions of
  dollars of inflows received each year from the
  premiums from their insurance policies and from
  their savings and investment products into the
  financial markets.
• In 2001, about 41 of the investments of life
  insurance companies were in corporate bonds,
  followed by stock (29), government securities
  (9.5), mortgages (7.7), and direct loans
  (5.6).
• In addition to insurance policies, life insurance
  companies also provide two investment-type
  products annuities and guaranteed investment
  contracts.

55
Annuities

• Annuities A life insurance company annuity pays
  the holder a periodic fixed income for as long as
  the policyholder lives in return for an initial
  lump-sum investment (coming for example from a
  retirement benefit or insurance cash value).
• Annuities provide policyholders protection
  against the risk of outliving their retirement
  income.
• Thus, in contrast to life insurance policies that
  provide insurance against dying too soon,
  annuities provide insurance against living too
  long.

56
Types of Annuities

• Types
• Life annuity Pays a fixed amount regularly
  (e.g., monthly) until the investor's death.
• Last survivor's annuity Pays regular fixed
  amounts until both the investor and spouse die.
• Fixed-period annuity Makes regular fixed
  payments for a specified period (5, 10, 20
  years), with payments made to a beneficiary if
  the investor dies. These annuities are referred
  to as fixed annuities.

57
Types of Annuities

• Variable annuity has regular payments that are
  not fixed, but rather depend on the returns from
  the investments made by the insurance company
  (the insurance company sometimes invests in a
  mutual fund that they also manage).
• Deferred annuities (variable or fixed) allow an
  investor to make a series of payments instead of
  a single payment.

58
Guaranteed Investment Contract

• A guaranteed investment contract (GIC) is an
  obligation of an insurance company to pay a
  guaranteed principal and rate on an invested
  premium.
• For a lump-sum payment, an insurance company
  guarantees a specified dollar amount will be paid
  to the policyholder at a specified future date.

59
Guaranteed Investment Contract

• Example
• A life insurance company for a premium of 1M,
  guarantees the holder a five-year GIC paying 8
  interest compounded annually.
• The GIC, in turn, obligates the insurance company
  to pay the GIC holder 1,469,328 in five years

60
Features of Guaranteed Investment Contract

• Features
• The generic GIC, also called a bullet contract,
  is characterized by
• Lump-sum premium
• Specified rate
• Compounding frequency
• Lump-sum payment at maturity
• The generic GIC contract is similar to a zero
  coupon debenture issued by a corporation.

61
Features of Guaranteed Investment Contract

• Features
• A GIC holder is a policyholder who has a senior
  claim over general creditors on the insurance
  company. This contrast to a debenture holder who
  is a general creditor.
• Maturities can range from one year to 20 years,
  with the short-term GICs often set up like money
  market securities.

62
Management of Guaranteed Investment Contracts

• In managing the funds from GICs, insurance
  companies may either pool the contracts into
• a general account (no separate identification of
  assets for a particular policy), or
• as a separate account (separate account for the
  GIC holder or group). GIC pooled into separate
  accounts are known as a Separate Account Contract
  (SAC).
• When securities are separated from other
  liabilities of the insurer and managed separately
  in a SAC, they are considered legally protected
  against the liabilities arising from other
  businesses of the insurance company.

63
Different GICs

• Variations of the Bullet Contract
• A window GIC allows for premium deposits to be
  made over a specified period, such as a year
  they are designed to attract the annual cash flow
  from a pension or 401(k) plan.
• A GIC may consist of a single type of security,
  such as a mortgage-backed or other asset-backed
  security or a portfolio of securities that are
  managed and immunized to the specified maturity
  date of the contract.

64
Different GICs

• Variations of the Bullet Contract
• Some GICs may be secured by letters of credit or
  other credit enhancements.
• Instead of a specified maturity date, the
  contract may specify that it will maintain a
  portfolio with a constant duration.
• There are floating-rate GIC contracts in which
  the rate is tied to a benchmark rate.
• A GIC may have a wrapped contract with clauses
  that give the holders the right to sell the
  contract and receive the book value or to change
  the rate under certain conditions.

65
Market for Guaranteed Investment Contracts

• Pension funds are one of the primary investors in
  GICs.
• GICs provide pensions not only an investment with
  a known payment but also an investment that
  always has a positive value to report this
  contrast with bond investments whose values may
  decrease if interest rate increase.
• The growth in GICs started in the 1980s with the
  increased investment in 401(k) plans.

66
Bank Guaranteed Investment Contracts

• In addition to insurance companies, banks have
  also become an active participant in this market
  offering bank investment contracts (BIC).
• BICs are deposit obligations with a guaranteed
  rate and fixed maturity.
• BICs and GICs are sometimes referred to as
  stable value investments.

67
Websites

• Web Information on Insurance Industry
• For industry trends
• www.activemediaguide.com
• www.riskandinsurance.com
• For healthcare insurers
• www.plunkettresearch.com
• For quality rating of insurers
• www.bestweek.com
•  

68
Pension Funds

• Pension funds are financial intermediaries that
  invest the savings of employees in financial
  assets over their working years, providing them
  with a large pool of funds at their retirements.
  
• Pension funds are one of the fastest growing
  intermediaries in the United States.
• The total assets of pension funds (private and
  state and local government) have grown from 700
  billion in 1980 to approximately 8 trillion in
  2000.

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Pension Funds

• There are two general types of pension plans
• Defined-Benefit Plan
• Defined-Contribution Plan

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Defined-Benefit Plan

• A defined-benefit plan promises the employee a
  specified benefit when they retire. The benefit
  is usually determined by a formula.
• Example The employees annual benefit during her
  retirement might be based on a specified
  percentage (for example, 2 ) times the average
  salary over her last five years (75,000) times
  her years of service (30 years)
  (.02)(75,000)(30) 45,000.
• The funding of defined-benefit plans is the
  responsibility of the employer. Financial
  problems can arise when pension funds are under
  funded and the company goes bankrupt.

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Defined-Contribution Plan

• A defined-contribution plan specify what the
  employee will contribute to the plan, instead of
  what the plan will pay.
• At retirement, the benefits are equal to the
  contributions the employee has made and the
  returns earned from investing them.
• The employees contributions to the fund are
  usually a percentage of his income, often with
  the contribution, or a proportion of it, made by
  the employer.

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Defined-Contribution Plan

• An insurance company, bank trust department, or
  investment company often acts as the trustee and
  investment manager of the funds assets.
• In many defined-benefit plans, the employee is
  allowed to determine the general allocation
  between equity, bonds, and money market
  securities in his individual accounts.

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Defined-Contribution Plan

• Note
• Some companies have pension plans that encourage
  employees to invest exclusively in their own
  stock.
• As the collapse of some recent corporations
  painfully showed, the lack of diversification can
  lead to employees not only losing their jobs but
  also their pension investments if the company
  goes bankrupt.

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Pension Fund Investments

• To pension contributors, pension funds represent
  long-term investments through intermediaries.
• As of 2000, private funds sponsored by employers,
  groups, and individuals private pensions were one
  of the largest institutional investor in equity,
  with about 48 of their total investments of
  5.129 trillion going to equity and another 18
  in mutual fund shares, 9 in government
  securities, and 6 in corporate and foreign
  bonds.
• In 2000, public funds sponsored by state and
  local governments invested 3.034 trillion with
  64 in equity, 12 in federal agency and Treasury
  securities, and 11 in corporate and foreign
  bonds.

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IRAs

• In addition to employee and institutional pension
  plans, retirement plans for U.S. individuals can
  also be set up through Keough plans and
  individual retirement accounts (IRAs).
• By tax laws established in 1962, self-employed
  people can contribute up to 20 of their net
  earnings to a Keough plan (retirement account)
  with the contribution being tax deductible from
  gross income.
• Since the passage of the Economic Recovery Tax
  Act, any individual can also contribute up to
  2,000 of their earned income to an IRA with no
  taxes paid on the account until they are
  withdrawn.

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Management of Pension Funds and IRAs

• In addition to company-sponsored and
  group-sponsored pensions, bank trust departments,
  insurance companies, and investment companies
  offer and manage company pensions, individual
  retirement accounts, and Keough plans.
• These institutions often combine the accounts in
  a commingled fund, instead of managing each
  account separately.

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Commingled Fund

• A commingled fund is similar to a mutual fund.
• For accounting purposes, individuals and
  companies setting up accounts are essentially
  buying shares in the fund at their NAV and when
  they withdraw funds they are selling essentially
  shares at their NAV.
• Like mutual funds, insurance companies and banks
  offer a number of commingled funds, such as money
  market funds, stock funds, and bond funds.

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Websites

• For information and updates on pension funds
• www.ifebp.org

79
Foreign Security Market - Overview

• Before the 1980s, the U.S. financial markets were
  larger than the markets outside the U.S.
• With the growth of world business and
  deregulations, this is no longer the case.
• Today, American corporations, banks, and
  institutional investors have increasing tapped
  the international money and capital markets to
  raise or invest short-term and long-term funds,
  just as non-U.S. borrowers and investors have
  historically tapped the U.S. market to raise and
  invest funds.

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Investing in Foreign Bonds

• A U.S. investor looking to buy foreign bonds has
  several options
• Purchase a bond of a foreign government or
  corporation that is issued in the U.S. or traded
  on a U.S. exchange -- foreign bonds.
• Purchase a bond issued in a number of countries
  through a syndicate -- Eurobonds.
• Purchase a bond issued by a foreign government or
  foreign corporation that is issued in the foreign
  country or traded on that countrys exchange --
  domestic bond.

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Foreign Debt Securities

• Foreign Bond
• Eurobond
• Global Bonds
• Non-U.S. Domestic
• Emerging Market Debt
• Eurocurrency Deposits

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Foreign Bonds

• The Foreign Bond Market
• A country's foreign bond market is that market in
  which the bonds of issuers not domiciled in that
  country are sold and traded.
• For example, the bonds of a German company issued
  in the U.S. or traded on the U.S. secondary
  markets would be part of the U.S. foreign bond
  market.

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Foreign Bonds

• Features of the Foreign Bonds
• Foreign bonds are sold in the currency of the
  local economy.
• Foreign bonds are subject to the regulations
  governing all securities traded in the national
  market and sometimes special regulations
  governing foreign borrowers (e.g., additional
  registration).
• Foreign bonds have been issued and traded on
  national market for many years.
• Foreign bonds provide foreign companies access to
  funds they often use to finance their operations
  in the country where they sell the bonds.

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Names of Foreign Bonds

• Foreign bonds in the U.S. are called Yankee
  bonds.
• Foreign bonds in Japan are called Samurai bonds.
• Foreign bonds in Spain are called Matador bonds.
• Foreign bonds in the United Kingdom are called
  Bulldog bonds.
• Foreign bonds in the Netherlands are called
  Rembrandt bonds.

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Eurobonds

• A Eurobond is a bond issued outside the country
  in whose currency it is denominated.
• They are usually sold in a number of countries.
• For example, to raise funds to finance its
  European operations, a U.S. company might sell a
  bond denominated in British pounds throughout
  Europe.

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Eurobonds

• Eurobonds are a very popular debt instruments.
• Guinness, Volvo, Walt Disney, Nestle, and other
  multinational corporations finance many of their
  global operations by selling Eurobonds.

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Eurobonds

• Eurobonds are also a source of intermediate and
  long-term financing of sovereign governments and
  supranationals (e.g., World Bank and European
  Investment Bank).
• Russia, for example, raised 4B in 1997 through
  the sale of Eurobonds.

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Eurobonds

• Currently, about 80 of new issues in the
  international bond market are Eurobonds.
• The Eurobond market currently exceeds in size the
  U.S. bond market as a source of new funds.

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Origin of the Eurobond Market

• Interest Equalization Tax
• In the 1950s and early 1960s, New York was the
  most accessible market for corporations to raise
  capital. As a result, many foreign companies
  issued dollar-denominated bonds in the U.S..
• The popularity of the Yankee bond market began to
  decline stating in 1963 when the U.S. government
  imposed the Interest Equalization Tax (IET) on
  the price of foreign securities purchased by U.S.
  investors.

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Origin of the Eurobond Market

• Interest Equalization Tax
• The interest-equalization tax was aimed at
  reducing the interest-rate difference between
  higher-yielding foreign bonds and lower-yielding
  U.S. bonds.
• Predictably, it led to a decline in the Yankee
  bond market.
• It also contributed, though, to the development
  of the Eurobond market as more foreign borrowers
  began selling dollar-denominated bonds outside
  the U.S..
• The IET was repealed in 1974.

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Origin of the Eurobond Market

• Foreign Withholding Tax
• The Eurobond market also benefited in the 1970s
  from a U.S. foreign withholding tax that imposed
  a 30 tax on interest payments made by domestic
  U.S. firms to foreign investors.
• There was a tax treaty, though, that exempted the
  withholding tax on interest payments from any
  Netherlands Antilles subsidiary of a U.S.
  incorporated company to non-U.S. investors.

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Origin of the Eurobond Market

• Foreign Withholding Tax
• This tax-treaty led to many U.S. firms issuing
  dollar-denominated bonds in the Eurobond market
  through financing subsidiaries in the Netherlands
  Antilles.
• During this time, Germany also imposed a
  withholding tax on German DM-denominated bonds
  held by nonresidents.

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Origin of the Eurobond Market

• Foreign Withholding Tax
• Even though the U.S and other countries with
  withholding taxes granted tax credits to their
  residents when they paid foreign taxes on the
  incomes from foreign security holdings, the tax
  treatments were not always equivalent.
• In addition, many tax-free investors, such as
  pension funds, could not take advantage of the
  credit (or could, but only after complying with
  costly filing regulations).

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Growth of the Eurobond Market

• During the 1970s and early 1980s, Eurobonds were
  often more attractive to foreign investors and
  borrowers than foreign bonds.
• The Eurobond market was also aided in the late
  1970s by the investments of oil-exporting
  countries that had large dollar surpluses.

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Growth of the Eurobond Market

• From 1963 to 1984, the Eurobond market grew from
  a 7.5M market with a total of seven Eurobonds
  issues to an 80 billion market with issuers that
  included major corporations, supranationals, and
  governments.

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Growth of the Eurobond Market

• In 1984, the U.S. and Germany rescinded their
  withholding tax laws on foreign investments and a
  number of other countries followed their lead by
  eliminating or relaxing their tax codes.
• Even with this trend, though, the Eurobond market
  had already been established and would continue
  to remain a very active market, growing from an
  80 billion market in new issue in 1984 to a 525
  billion market by 1990 and to a 1.4 trillion
  market in 1998.

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Eurobond Market

• The Eurobond market is handled through an
  international syndicate consisting of
  multinational banks, brokers, and dealers.
• A corporation or government wanting to issue a
  Eurobond will usually contact a multinational
  bank who will form a syndicate of other banks,
  dealers, and brokers from different countries.
• The members of the syndicate usually agree to
  underwrite a portion of the issue, which they
  usually sell to other banks, brokers, and dealers.

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Eurobond Market

• Market makers handle the secondary market for
  Eurobonds.
• Many of market makers are the same dealers that
  are part of syndicate that helped underwrite the
  issue, and many belong to the Association of
  International Bond Dealers (AIBD).
• The AIBD oversees an international OTC market
  consisting of Eurobond dealers it is similar to
  the National Association of Securities Dealers,
  except that there is less government involvement.
  
• An investor who wants to buy or sell an existing
  Eurobond can usually contact several market
  makers in the international OTC market to get
  several bid-ask quotes, before selecting the best
  one.

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Eurobond Market

• While most secondary trading of Eurobonds occurs
  in the OTC market, many Eurobonds are listed on
  organized exchanges in Luxembourg, London, and
  Zurich.
• These listings are done primarily to accommodate
  investors from countries that prohibit (or once
  prohibited) institutional investors from
  acquiring securities that are not listed.

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Eurobond Features

• 1. Currency Denomination
• The generic, plain vanilla Eurobond pays an
  annual fixed interest and has a long-term
  maturity. There are a number of different
  currencies in which Eurobonds are sold. The
  major currency denominations are the U.S. dollar,
  yen, and euro.
• Some Eurobonds are also valued in terms of a
  portfolio of currencies, such as the European
  currency unit (ECU).
• The central bank of a country can protect its
  currency from being used. Japan, for example,
  prohibited the yen from being used for Eurobond
  issues of its corporations until 1984.

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Eurobond Features

• 2. Non-Registered
• Eurobonds are usually issued from countries in
  which there is little regulation. As a result,
  many Eurobonds are unregistered, issued as bearer
  bonds.
• While this feature provides confidentiality, it
  has created some problems in countries such as
  the U.S., where regulations require that security
  owners be registered on the books of issuer.

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Eurobond Features

• 2. Non-Registered
• To accommodate U.S. investors, the SEC allows
  them to purchase these bonds after they are
  "seasoned," that is, sold for a period of time
  (e.g., 2 months).
• The fact that U.S. investors are locked out of
  the primary market does not affect U.S. borrowers
  from issuing Eurobonds.
• In 1984, U.S. corporations were allowed to issue
  bearer bonds directly to non-U.S. investors
  another factor that contributed to the growth of
  this market.

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Eurobond Features

• 3. Credit Risk
• Compared to U.S. corporate bonds, Eurobonds have
  fewer protective covenants, making them an
  attractive financing instrument to corporations,
  but riskier to bond investors.
• Eurobonds differ in term of their default risk
  and are rated in terms of quality ratings.

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Eurobond Features

• 4. Maturities
• The maturities on Eurobonds vary. Many have
  intermediate terms (2 to 10 years), referred to
  as Euronotes, and long terms (10-30 years),
  called Eurobonds.
• There is also short-term Europaper and Euro
  Medium-term notes.

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Europaper

• Europaper or Euro CP
• Like some CP issues, Europaper issues, as well as
  some Euronotes, are often secured by lines of
  credit.
• The credit lines are sometimes set up through
  note issuance facilities (NIF) of international
  banks, also called revolving underwriting
  facilities (RUFS).
• These facilities provide credit lines in which
  borrowers can obtain funds up to a maximum amount
  by issuing short-term and intermediate-term paper
  over the term of the line.

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Euro Medium-Term Notes

• There is a growing market for Euro medium-term
  notes (Euro-MTN).
• Like regular MTN, Euro MTNs are offered to
  investors as a series of notes with different
  maturities.
• In addition, Euro-MTN programs also offer
  different currencies and are not subject to
  national regulations.
• They are sold though international syndicates and
  also through offshore trusts set up by commercial
  banks, investment banks, and banking groups.

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Eurobond Features

• 5. Other Features
• Like many securities issued today, Eurobonds
  often are sold with many innovative features. For
  example
• Dual-currency Eurobonds pay coupon interest in
  one currency and principal in another.
• Option currency Eurobond offers investors a
  choice of currency. For instance, a
  sterling/Canadian dollar bond gives the holder
  the right to receive interest and principal in
  either currency.
• A number of Eurobonds have special conversion
  features One type of convertible is a
  dual-currency bond that allows the holder to
  convert the bond into stock or another bond that
  is denominated in another currency.

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Eurobond Features

• 5. Other Features
• A number of Eurobonds have special warrants
  attached to them. Some of the warrants sold with
  Eurobonds include those giving the holder the
  right to buy stock, additional bonds, currency,
  or gold.
• There are also floating-rate Eurobonds with the
  rates often tied to the LIBOR and floaters with
  the rate capped.
• The Eurobond market has also issued zero discount
  bonds, and at one time, perpetual Eurobonds with
  no maturities were issued they, however, were
  not very popular and were discontinued in 1988.

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Global bonds

• A Global Bonds is both a foreign bond and a
  Eurobond.
• It is issued and traded as a foreign bond (being
  registered in a country) and also it is sold
  through a Eurobond syndicate as a Eurobond.

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Global bonds

• The first global bond issued was a 10-year, 1.5
  billion bond sold by the World Bank in 1989.
  This bond was registered and sold in the U.S.
  (Yankee bond) and also in the Eurobond market.
• Currently, U.S. borrowers dominate the global
  bond market, with an increasing number of these
  borrowers being U.S. federal agencies.
• The market has grown from a 30 billion market
  in the early 1990s to a 100 billion one in the
  late 1990s.

111
Non-U.S. Domestic Bonds

• Foreign investors who buy domestic bonds will
  find many differences from country to country in
  how the bonds are issued and regulated.

112
Different Features of Foreign Markets

• In a number of countries, new bonds are
  underwritten by banks instead of investment
  bankers.
• In the secondary market, some countries trade
  bonds exclusively on exchanges, while others,
  such as the U.S., Japan, and the United Kingdom,
  trade bonds on both the exchanges and through
  market makers on an OTC market.

113
Different Features of Foreign Markets

• Types of Foreign Security Exchanges
• Public Bourse is a government security exchange
  in which listed securities (usually both stocks
  and bonds) are bought and sold through brokers
  who are appointed by the government.
• Private Bourse is security exchange owned by its
  members.
• Banker Bourse is a market in which securities
  are traded through bankers.

114
Different Features of Foreign Markets

• Types of Trading
• A number of exchanges, including those in the
  U.S., use specialists or market makers to ensure
  a continuous trading.
• On the exchanges in other countries, though,
  securities are sometimes traded only once or just
  a few times during a day. These so-called call
  markets use an open-auction or crieé system, in
  which interested traders gather in a designated
  trading area when the security is called. An
  exchange clerk then calls out prices until one is
  determined that clears all trades.

115
Different Features of Foreign Markets

• Other Differences
• Bonds sold in different countries also differ in
  terms of whether they are sold as either
  registered bonds or bearer bonds.
• A foreign investor buying a domestic bond may
  also be subject to special restrictions. These
  can include special registrations, exchange
  controls, and foreign withholding taxes.

116
Different Features of Foreign Markets

• Other Differences
• Domestic bonds in other countries differ in their
  innovations.
• For example, the British government issues a
  bond, also referred to as a gilt, which has a
  short-term maturity that can be converted to a
  bond with a longer maturity.
• They also issue an irredeemable gilt
  (perpetuities) which does not have a maturity,
  although it can be redeemed after a specified
  date. 

117
Emerging Market Debt

• Over the last two decades, emerging market debt
  has become a popular addition to global bond
  portfolios.
• Emerging markets include Latin America, Eastern
  Europe, Russia, and a number of Asian countries.
• Their sovereign debt includes
• Eurobonds
• Bonds they offer and trade domestically
• Performing loans that are tradable
• Brady bonds sovereign bonds issued in exchange
  for rescheduled banks loans

118
Emerging Market Debt

• Return
• The openings of markets and the privatization of
  companies in Russia and Eastern Europe along with
  the economic reforms in Latin America have
  enhanced the profit potential of many emerging
  economies and with that the expected rates of
  return on their securities.

119
Emerging Market Debt

• Risk
• Emerging market debt is also subject to
  considerable risk.
• Much of the risk germane to emerging market
  securities comes from concerns over changes in
  political, social, and economic conditions
  (refereed to as cross-border risk) and sovereign
  risk in which the government is unable, or in
  some cases unwilling, to service its debt.

120
Emerging Market Debt

• Risk
• Some of the more recent sovereign debt crises of
  note occurred in
• Latin America in the 1980s
• Venezuela in 1994
• East Asia in 1994
• Mexico in 1995
• Russia in 1998

121
Brady Bonds

• One of the more popular emerging debt securities
  is the Brady Bond.
• Named after U.S. Treasury Secretary Nicholas
  Brady, these bonds were issued by a number of
  emerging countries in exchange for rescheduled
  bank loans.
• The bonds were part of a U.S. government program
  started in 1989 to address the Latin American
  debt crisis of the 1980s.

122
Brady Bonds

• The Brady plan allowed debtor countries to
  exchange their defaulted bank debt for Brady
  bonds or restructured loans at lower rates.
• In return for this debt relief, the countries
  agreed to accept economic reforms proposed by the
  International Monetary Funds.

123
Brady Bonds

• While there is some variations in plans, the
  basic Brady plan offered creditor banks two
  choices for the nonperforming loans of emerging
  countries they were carrying
• A discount bond issued below par (e.g., 50 or
  65 of par) in exchange for the original loan or
  a discount bond paying a floating rate tied to
  the LIBOR plus13/16 in exchange for fewer bonds
  than the original loan.
• A bond issued at par and paying a below market
  coupon in exchange for the original face value of
  the loan.

124
Brady Bonds

• Other Features of Brady Bonds
• The principal on a Brady bond was secured by a
  U.S. Treasury security and the interest was
  backed by investment grade bonds, with the
  guarantee rolled forward from one interest
  payment to the next if the collateral was not
  used.
• All Brady bonds were callable and some gave
  bondholders a value recovery option giving them
  the right to recover some of the debt if certain
  events occurred such as an increase in gross
  domestic product or energy prices.

125
Brady Bonds

• The first country to accept a Brady plan was
  Mexico who used it in 1989 to restructure its
  approximate 50 billion in foreign debt to
  commercial banks.
• As of 1999, the total Brady debt was
  approximately 114 billion, with Brazil, Mexico,
  Venezuela, and Argentina accounting for
  approximately 73 of the debt.

126
Brady Debt, 1999

• Russia restructured it debt in 1998. the
  restructure package is sometimes include as Brady
  debt,
• even though it is not officially considered as
  following under the Brady plan.
• Source Merrill Lynch. Reprinted in Handbook of
  Fixed-Income Securities, p.389.

127
Brady Bonds

• When they were introduced, the initial holders of
  Brady bonds were the creditor banks. With the
  principal and interest guarantees and the
  potentially high returns, the bonds were
  attractive investments to hedge funds, global
  bond funds, growth funds, and emerging market
  funds.
• Many banks sold their Brady bonds to non-bank
  institutional investors who are now one of the
  primary holders.

128
Eurocurrency Market

• The Eurocurrency market is the money market
  equivalent of the Eurobond market.
• It is a market in which funds are intermediated
  (deposited or loaned) outside the country of the
  currency in which the funds are denominated.

129
Eurocurrency Market

• For example
• A certificate of deposit denominated in dollars
  offered by a subsidiary of a U.S. bank
  incorporated in the Bahamas is a Eurodollar CD.
• A loan made in yens from a bank located in the
  U.S. would be an American-yen loan.

130
Eurocurrency Market

• Eurocurrency deposits and loans represent
  intermediation occurring in the Eurocurrency
  market.
• Even though the intermediation occurs in many
  cases outside Europe, the Euro prefix usually
  remains.
• An exception is the Asiandollar market. This
  market includes banks in Asia that accept
  deposits and make loans in foreign currency this
  market is sometimes referred to separately as the
  Asiandollar market.

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