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10 -- Part 3: Fixed-Income Securities
Caterpillar's bonds were set to be examined later in this chapter, but other types of debt include first-mortgage obligations, convertible bonds, and capital notes.
The company's longest was not even that maturity.
1997 Caterpillar issued bonds that interest on corporate bonds semiannually, and sinking funds were not planned to retire until 2097, common.
The bonds are usually issued in $1,000 denominations.
Prepayment for the first 5 to 10 years is not allowed on long term bonds with call deferment provisions.
The equipment trust certificates' proceeds are used to purchase equipment that is used in the issue.
The bonds are usually issued in serial form.
They normally have maturities of up to 15 years, with the maturity reflecting the useful life of the equip ment.
Despite a near perfect payment record that dates back to pre-Depression days, these issues offer above-average yields to investors.
There are a number of specialty bonds that investors can choose from.
These bonds have unusual coupon or repayment provisions.
Most of them are issued by corporations, although they are being used by other issuers as well.
Zero-coupon bonds, mortgage-backed securities, asset-backed securities, and high-yield junk bonds are some of the most actively traded specialty issues.
Rather, these securities are sold at a discount from their par values and then increase in value over time at a compound rate of return.
They are worth more than their initial cost at maturity.
The cheaper the zero-coupon bond, the greater the return an investor can earn.
These bonds don't pay interest semiannually because they don't have coupons.
They pay nothing until the issue matures.
This feature is the main attraction of zero-coupon bonds.
There is no need to worry about reinvesting interest income twice a year because there is no coupon pay ments.
The rate of return on a zero-coupon bond is almost certain to be the yield that existed at the time of purchase as long as the investor holds the bond to maturity.
The U.S. Treasury had zero-coupon bonds with 10-year maturities.
For around $780, investors could buy a bond that would be worth $1,000 in 10 years.
The 2.5% yield is locked in for the life of the issue.
Zeros have some serious disadvan tags.
If market interest rates go up, investors won't be able to participate in the higher return.
Zero-coupon bonds are subject to tremendous price fluctuations.
As the prices of zero-coupons plunge, investors will experience a sizable capital loss.
The IRS has ruled that zero-coupon bond holders have to pay tax on interest as it accrues, even if they don't actually receive interest payments.
Corporations, municipalities, and federal agencies issue zeros.
Zero-coupon bonds are not issued by the Treasury.
The interest and principal payments are stripped from a Treasury bond and sold separately as zero-coupon bonds.
A 10-year Treasury note has 20 semiannual interest payments.
There are 21 different zero-coupon securities with maturities ranging from 6 months to 10 years.
To strip a Treasury note or bond of its par value, you need a minimum of $100 and a multiple of $100.
Treasury strips with the same maturity are often sold in minimum denominations of $10,000.
Because there's an active secondary market for Treasury strips, investors can get in and out of these securities with ease.
Strips offer a wide array of maturities and are popular because of their high quality, active secondary market and wide array of maturities.
An issuer, such as the Government National Mortgage Association (GNMA), puts together a pool of home mortgages and then issues securities in the amount of the total mortgage pool.
Although their maturities can last as long as 30 years, the average life is shorter because many of the mortgages are paid off early.
You hold an interest in the pool of mortgages as an investor in one of these securities.
When a homeowner makes a monthly mortgage payment, it is passed on to the bondholder to pay off the mortgage-backed bond.
The securities come with normal coupons, but the interest is paid monthly.
Bondholders receive monthly payments made up of both principal and interest.
The principal portion of the payment is tax-free because it represents return of capital.
The interest portion is subject to state and federal income taxes.
Three federal agencies issue the majority of mortgage-backed securities.
The market is dominated by agency issues and they account for most of the activity.
It is the oldest and largest issuer of mortgage-backed securities.
Freddie Mac was the first to issue pools of conventional mortgages.
Fannie Mae is the leader in marketing seasoned/older mortgages.
At maturity, there is no big principal payment because investors always receive back part of the original investment capital.
A number of mutual funds invest in mortgage-backed securities in order to counter this effect.
The interest that mutual fund investors receive is the only thing that matters.
Prepayment of a loan is a problem with mortgage-backed securities.
All bondholders receive a portion of the prepayments.
The net effect is to shorten the life of the bond.
All principal payments go first to the shortest portion until fully retired, because interest is paid to all bondholders.
The next class in the sequence becomes the sole recipient of principal until the last one is retired.
The trust is sold to the investing public in the form of CMOs.
The net effect of this transformation is that CMOs are very much like any other bond.
They have predictable maturities and predictable interest payments.
Although they carry the sameAAA ratings and implicit U.S. government backing as the mortgage-backed bonds that underlie them, CMOs are a quantum leap in complexity.
CMOs can be as safe as Treasury bonds.
Others can be riskier than the standard ones.
Wall Street does the financial equivalent of gene splicing when putting CMOs together.
Investment bankers channel the interest and principal payments from the underlying MBSs to different tranches.
Prepayment, or call, risk is the problem here, not issue quality or risk of default.
Even if all of the bonds are paid off, investors don't know when the next payments will be.
There are different levels of prepayment risk for different types of CMOs.
The overall risk in a CMO cannot exceed that of the underlying mortgage backed bonds, so in order for there to be some tranches with very little prepayment risk, others have to endure a lot more.
Some CMOs are low in risk, but others are loaded with it.
As the financial crisis unfolded, investors discovered how complex and risky these securities could be.
The values of CMOs plummeted as homeowner defaults rose.
It was difficult to know what the underlying values of some CMOs were because trading in the secondary market dried up.
Investment and commercial banks that had invested heavily in these M11_SMAR3988_13_GE_C10.indd 434 came under intense pressure as doubts about their solvency grew into a near panic.
Everyone wanted to know which institutions had the most toxic assets on their balance sheets.
The federal government poured hundreds of billions of dollars into the banking system to try to prevent the collapse of Lehman Brothers and other financial institutions.
These securities are created when an investment bank bundles some type of debt-linked asset and then sells it to investors, who have the right to receive all or part of the future payments.
GMAC is a regular issuer of auto loan securities.
GMAC takes the monthly cash flow from a pool of auto loans and pledges them to a new issue of bonds, which are then sold to investors.
Credit card receivables are the biggest segment of the market, as are home equity loans, which are the second biggest.
There are a number of reasons why investors are drawn to the bonds.
These securities have rela tively high yields, and they typically have short maturities of no more than five years.
The monthly principal and interest payments that accompany many of the securities are a third reason investors like them.
High credit quality is important to investors.
Most of these deals are backed by generous credit protection.
The pool of assets backing the bonds may be 25% to 50% larger than the bond issue itself.
The leading rating agencies give the highest credit rating possible to a large portion of the bonds.
Junk bonds are highly specula tive securities that have received low, sub-investment-grade ratings.
Corporations and municipalities issue these bonds.
Junk bonds have a high risk of default.
The companies that issue them have excessive amounts of debt in their capital structures and their ability to service that debt is questionable.
The issuer is supposed to start making interest payments in real money after five or six years of this financial printing press.
They have high yields.
In a typical market, investors can expect to pick up anywhere from two to five percentage points in added yield.
Junk bonds are more likely to be invested in FIXED- INCOME SECURITIES than investment-GRADE corporates.
The yield is only available because of the higher exposure to risk.
Junk bonds are subject to a lot of risk.
Junk bonds tend to behave more like stocks when compared to investment-grade bonds.
The returns are very unpredictable.
Only investors who are familiar with the risks involved should purchase these securities.
Just as the stock market has Globalization hit the bond market.
Foreign bonds are popular with U.S. investors because of their high yields and attractive returns.
High risk of default is not always one of the risks with foreign bonds.
The big risk with foreign bonds has to do with the impact thatncy fluctuations have on returns in U.S. dollars.
The United States has the world's biggest bond market, accounting for less than half of the global market.
Japan, China, and several countries in the European Union follow the United States.
These countries make up more than 90 percent of the world bond market.
Various forms of government bonds dominate the market.
There are many ways to invest in foreign bonds.
The cash flows from foreign bonds are in U.S. dollars.
The cash flows from non-dollar bonds are in a foreign currency.
Yankee bonds and Eurodollar bonds are Dollar denominated foreign bonds.
The bonds are registered with the SEC and traded in U.S. dollars.
The Yankee-bond market is dominated by Canadian issuers.
Buying a Yankee bond is the same as buying any other U.S. bond.
The bonds are traded on U.S. exchanges and the OTC market and there is no currency exchange risk.
The bonds are very high quality and offer very competitive yields, which is not surprising given the quality of the issuers.
Because they are not registered with the SEC, they are not allowed to be sold to the public.
The Eurodollar market is dominated by foreign investors and is aimed at institutional investors.
Foreign-pay international bonds encompass all the issues that are denominated in a currency other than dollars.
These bonds are not registered with the SEC.
German government bonds are paid in euros, while Japanese bonds are paid in yen.
The segment of the market that most investors have in mind is foreign bonds.
Changes in currency exchange rates can affect total returns to U.S. investors.
The returns on foreign-pay bonds are dependent on three things: the level of coupon income earned on the bonds, the change in market interest rates, and the behavior of currency exchange rates.
The variables that drive U.S. bond returns are the same as the first two.
They are just as important to foreign bonds as they are to domestic bonds.
If individuals are investing over seas, they want to know what the yields are today and where they're going.
The return behavior of dollar-denominated bonds is different from foreign-pay bonds.
An example would be a U.S. investor buying a Swedish government bond with a 7.5% coupon.
If the bond was bought at par and market rates fell over the course of the year, the security would provide a return in excess of 7.5%.
If the Swedish krona fell relative to the dollar, the total return would be different.
The equation above can be used to find out how this investment is formed.
Foreign-pay bonds can pay off from both the behavior of the security and the currency.
It means superior returns to U.S. investors.
Knowledgeable investors find these bonds attractive because of their competitive returns and also because of the positive effects they have on bond portfolios.
Explain the types of bonds: Treasury bonds, agency issues, municipal securities, and corporate bonds.
Mention the two major types of bonds.
Even though convertibles may start out as bonds, they usually end up as shares of common stock because they are only issued by corporations.
These securities have an option to convert their bonds into shares of the issuing firm's stock.
Even though they have features and performance characteristics of both fixed-income and equity securities, convertibles should be viewed as a form of equity.
Most investors commit their capital to such obligations not for the yields they provide but for the potential price performance of the stock side of the issue.
If you are considering a common stock investment, it is always a good idea to know if a corporation has outstanding convertible issues.
The firm's common stock may be a better investment than the convertible.
The company's common stock can be converted into these bonds.
The market price of a convertible has a tendency to be similar to the price of its underlying common stock.
Firms can raise equity capital through convertibles.
When a company issues stock in the normal way, by selling more shares in the company, it does so by setting a price on the stock that's slightly below prevailing market prices.
It can get $25 for a stock that's priced in the market at $27 a share.
When it issues the stock indirectly through a convertible issue, the firm can set a price that's above the prevailing market--for example, it might be able to get $35 for the same stock.
If the market price of the shares increases above $35, convertible bond investors will convert their bonds into shares.
The com pany can raise the same amount of money by issuing less stock.
Companies issue convertibles to raise equity rather than debt capital.
Both convertible bonds and convertible preferreds are linked to the equity position of the firm, so they are interchangeable for investment purposes.
Unlike preferreds, convertible bonds and convertible preferreds pay dividends rather than interest and do so quarterly.
The information and implications apply equally well to convertible preferreds because of their similarities.
The issuing company's common stock may be converted into a certain number of shares.
The debt portion of the security is usually 5 to 10 years shorter than the convertible notes.
There is no difference between the convertible notes and bonds.
They're both debt obligations, and they're usually subordinated to other forms of debt.
At the time of conversion, little or no cash is exchanged between investors and issuing firms.
There is a stipulated number of shares of common stock for convertible bondholders to trade in.
If a certain convertible security came to the market recently, it had a provision that each $1,000 note could be converted into shares of the issuing company's stock at $50 a share.
Regardless of what happens to the stock price, investors can redeem each note for 20 shares of the company's stock.
If the company's stock is trading at $65 a share at the time of conversion, an investor could convert a $1,000 debt obligation into $1,300 worth of stock.
The low coupon that convertibles usually carry comes at a price.
When new convertible issues come to the market, their coupons are usually less than those on comparable straight bonds.
To give the corporation flexibility to retire the debt and force conversion, most convertibles come out as freely callable issues, or they carry very short call periods.
You can either convert the bond into common stock or redeem it for cash at the stipulated call price.
If the market value of the stock exceeds the call price of the bond, seasoned investors will never choose the second option.
The firm wants them to convert the bond.
They can either hold the stocks or sell them in the market and get more cash than they would have gotten if they had taken the call price.
The bonds no longer exist after the conversion; instead, there are more common stock in their place.
It states when the debenture can be converted.
There may be an initial waiting period of six months to two years after the date of issue, during which time the security cannot be converted.
The conversion period usually lasts for the remaining life of the debenture, but in some cases it may only last for a few years.
The issuing firm will have more control over its capital structure.
If the issue has not been converted by the end of the conversion period, it becomes a straight-debt issue with no conversion privileges.
The most important piece of information for the investor is the conversion ratio.
The number of shares of stock into which the bond can be converted is either directly or indirectly specified by these terms.
The common stock will be delivered to the investor in exchange for the bond.
It's clear that a given conversion ratio implies a certain conversion price when you stop to think about it.
If a $1,000 convertible bond has a conversion ratio of 40, it can be converted into 40 shares of common stock.
If you give up your $1,000 bond in exchange for 40 shares of stock, you will end up buying 40 shares of stock for $25 per share.
The conversation ratio is equivalent to a conversion price.
The conversion ratio is adjusted for stock splits and significant stock dividends.
If a firm declares a 2-for-1 stock split, the conversion ratio of any outstanding convertible issues also doubles.
When the conver sion ratio includes a fraction, such as 33.5 shares of common, the conversion specifies how any fractional shares are to be handled.
The investor can either put up the additional funds necessary to purchase another full share of stock at the conversion price or receive the cash equivalent of the fractional share.
Wall Street can take a basic investment product and turn it into a sophisticated investment vehicle.
Zero-coupon convertible bonds are convertible at a fixed version ratio for the life of the issue.
They offer the built-in increase in value over time that accompanies any zero-coupon bond, plus full participation in the equity side of the issue via the equity kicker.
LYON is a zero coupon bond and there is no current income.
It has an option feature that allows investors to put or sell bonds back to the issuer.
The put option gives investors the right to redeem their bonds periodically.
If investors want to, they can get out of these securities at set prices.
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