drake drake university fin 284 treasury, corporate, and municipal markets finance 284 analysis of...

DrakeDRAKE UNIVERSITY

Fin 284

Treasury, Corporate, and Municipal Markets

Finance 284Analysis of Fixed Income

Securities

DrakeDrake University

Fin 284Treasury Securities

Issues by the US Department of Treasury, represent borrowing by the Federal government. Generally are considered to be free of Credit Risk.Repayment of principal and interest is backed by the taxing power of the Federal government


Fin 284Current US public Debt

Debt Held by the Public All Fed debt held by individuals, corps, state or local

gov., foreign gov., and other entities outside of the US Gov less Fed Financing Bank securities.

$4,047,686,308,229.63 Intragovernemnt Debt Gov Account Securities: securities held by Gov trust funds, revolving funds, and special funds; and Fed Financing Bank securities

$2,954,166,299,393.72 Total

$7,001,852,607,623.35http://www.publicdebt.treas.gov/opd/opdpdodt.htm


Fin 284Interest on the Public Debt

Interest ExpenseFISCAL Year 2004

December $ 82,435,960,974.56 November 19,292,044,501.20

October 13,311,682,915.94

FISCAL Year Total $ 115,039,688,391.70

http://www.publicdebt.treas.gov/opd/opdint.htm


Fin 284Treasury Securities

Discount securities (Bills) and Coupon Securities Notes and BondsBills – 3 month, 6 month and 1 yearNotes - maturities over 1 year and less than 10 years, Bonds - maturities over 10 yearsCallable Bonds – Small number outstanding, issued prior to Nov 1984.TIPS- Treasury Inflation Protection Securities


Fin 284Auction Process

Treasury Securities are offered in the primary market via an auction process.Participants are generally financial institutions, brokers and dealers. However individuals can participate in the process via the Treasury Direct System.


Fin 284Auction History

Auction procedure instituted in 1970

Prior to 1970Subscription offerings (preset interest rate sold at a fixed price)Exchange Offerings (allowing maturing issues to be exchanged for new ones at a fixed price)Advanced Refunding (allowing exchange prior to maturity)


Fin 284Auction History

In 1970 the treasury started selling securities via a price auction, this switched to a yield based auction in 1974. Yield determined at auction determines the coupon.Prior to 1991, auction participants were limited to primary dealers, commercial banks and brokers (for their own account). Now broker / dealers can submit bids for their clients, and public can use treasury direct. Primary dealers still dominate, getting approximately 72% of all issues.


Fin 284Treasury Auction History

Uniform price auctions started in 1992 with 2 year and 5 year notesSince 1999, all treasury auctions have been single price (or “Dutch”) auctions.Other countries still use discriminatory auctions that set price based upon a demand curve determined from the bids.

www.savingsbonds.gov/of/ofauctbl.htm


Fin 284Auction Schedule

Security Purchase Min

Multiples of

Schedule

4 week bill $1,000 $1,000

Weekly13-week

bill$1,000 $1,000

26-week bill

$1,000 $1,000

2 year note

$1,000 $1,000 Monthly

5 year note

$1,000 $1,000Feb, May, Aug, Nov10 year

note$1,000 $1,000

10 year infla

indexed note

$1,000 $1,000Jan, July,

Oct


Fin 284

The US Treasury Auction Process*

Two types of bidsNoncompetitive - willing to purchase a given quantity of the security at the yield determined by the auction process Competitive – bidder reports quantity and yield (generally broker dealers, depository institutions, money management firms)

Each issue is assigned an identification code or CUSIPReceive Accrued interest on reopened issues

* Above information and rules on future slides from: http://www.publicdebt.treas.gov/gsr/gsruocam.htm


Fin 284Dates

Auction Announcement Date – announced when the auction is schedule approximately one to two weeks prior to the auctionAuction Date – The actual date of the auction, when is are due.Issue Date – 5 to 10 days after the announcement date, the actual day of issue


Fin 284

Noncompetitive Bids Position Limits

Includes individuals buying directly (limited to $5,000,000 for notes, $1,000,000 in value for bills and nonpublic purchases from Fed Res etc.)Must be received by Noon EST on the auction day


Fin 284

Competitive Bids – Auction Participation and Position Limits

No Limit on dollar amount that can be bid for, however recognized bid for a given yield or rate is limited to 35% of the offering amount. Bidders place a bid based upon yield for a given quantity.Must be expressed as a yield to three decimalsNet long position for each bidder must be reported if sum to all bids or net long amount exceeds $2 billion per note or $1 billion per bond or threshold specified for offeringNet long position determined ½ hour prior to closing.Bids must be submitted by 1:00 pm EST on Auction day


Fin 284

The US Treasury Auction Process

LimitsBidders cannot receive more than 35% of the total security offered at the initial auction. If an issued is reopened the 35% rule is lifted.

Dealers can submit multiple bids at different yields


Fin 284

The Treasury Auction Process

The Treasury announces $ amount to be auctioned, date of auction and maturitiesDeduct noncompetitive bidders and nonpublic purchases the rest sent to competitive biddingStarting from the lowest yield (highest price) all bids are accepted until the total amount allocated is reached When total allocation is reached the “Stop Yield” is hit, all accepted bids pay stop yield.


Fin 284

The Treasury Auction Process

Bidders at the stop yield awarded a % of the amount desired, everyone else receives full amount


Fin 284Example of an Auction

Assume you have an issue of $20 Billion of 5 year notes. With $1 Billion in Noncompetitive bidding.

Bids: Amount Bid (Yield)$2 Billion 4.440

$3 Billion 4.450

$5 Billion 4.460$6 Billion 4.470

$12 Billion 4.480Stop Yield = 4.48 If bid at stop Yield you receive 3/12 = or 25% of the amount bid for.


Fin 284Auction Assessment Process

TailDifference between the average yield bid and the stop yield is referred to as the tail. The lower the tail the “more successful” the auction is considered.

Bid Cover RatioThe ratio of the amount of securities bided for to the amount awarded provides information about the demand for the security.

% of non competitive biddersMeasures what portion of offer went to competitive bid and what portion didn’t. Usually fairly small.


Fin 284

Example Results and offering (from Handout)

5 Year Notes Stop Yield 3.260% “low Yield” = 3.2%$15,898,848 of the $40,032,020 in competitive bids were accepted.Tenders at high yield were allotted 90.09 of their bid.Bid to Cover Ratio = 2.51Tail = 3.26% – 3.24% = .02% or 2 Bp

http://www.publicdebt.treas.gov/of/ofaucrt.htm


Fin 284

Example Results and offering (handout )

26 week Bills 1/12/04Bid to Cover Ratio = 2.05 Lower than the 5 year notesTail =.95% - .94% = .01% 1 Bp smaller than 5 year note.Bidders at stop yield received 69.08% of their bidFederal Reserve help 16B in addition to offering.

http://www.publicdebt.treas.gov/of/ofaucrt.htm


Fin 284

Rationale for Single Price Auction

Result should be more aggressive biding, resulting in a higher price (lower yield) which benefits the Treasury. (decreases possibility of “the winners curse” and bid shading)The Aggressive bidding requires more information discovery.A decrease in associated markupsBroader distribution of auction awardsResponse to uncertainty in multiple price auctions is an increase in multiple bids


Fin 284When Issued Trading

Trading between the announcement date and issue date.Basically trading a forward contract with a settlement date equal to the issue date.Prior to auction, trading is listed in yields based on the expected yield, after the auction trading is done on a price basis.Allows investors to lock in price and quantity prior to the determination in the auction.



Prior to auction the aggregate amount in the market may exceed the amount to be issued, as the auction date approaches the positions are unwound and the amount approaches the offer amount.Trading occurs throughout the auction day including between the final acceptance of bids and the announcement of results.



Dealers attempt to hedge their position in the auction, specifically they may end up with a shortfall in the auction process.

Dealers have difficulty determining the demand for an issue. They only have information on what passes through their organization, or what is shown on brokers screensDealers are not sure that they will receive the entire amount for which they bid.

Provides an opportunity for trading on private information



The WI market provides demand discovery for the dealer. By looking at quantity of activity and yield in the market, the dealer acquires information about the auction.WI market should be more active in single price auction.

They can cover short positions by aggressively bidding in WI market (everyone pays the same price if bid too high). In discriminatory auction – may be subject to “winner curse”


Fin 284WI Trading

ExampleDealer has sold $700 million in the WI market for a weighted average yield of 6%. To make a profit the dealer must be bidding at a yield above 6%.Downside is that dealer may win less at auction than what was sold in the WI market (the dealer may be squeezed)


Fin 284

Evidence on Single Price Auctions

from the WI Market

Nyborg and Sundaresan, 1996In single price auction market the volatility of WI rates is higher prior to announcement of auction results then decreases. Opposite is true for for discriminatory auction.

Sundaresan, 2002 & Treasury Dept 1998


Fin 284Evidence part 2 – Treasury Studies

Average Spread between Auction Result &

1:00 pm WI Bid Yield

Security

Mut Price 6/91-8/92

Total 9/92-5/98

9/92-9/95

9/95-5/98

2 year 0.41 0.20 0.22 0.17

5 year 0.33 0.22 0.20 0.24

2 & 5 year

0.37 0.21 0.21 0.21

3 year 0.50 0.49 0.58 0.39

10 year 0.56 0.66 0.79 0.53


Fin 284Short Squeeze

Squeeze refers to a shortage of supply of an issue in comparison to demand. Evidence of this is observed when the price increases above what is being traded by comparable securities.With a short position in the WI market a dealer assumes it will be possible to either acquire or borrow the security in time for delivery.If they do not get enough of the issue at auction they must cover the position via the WI market prior to the issue date.


Fin 284Short Squeeze continued

One aggressive dealer could create a significant imbalance in the market (the average short position is 28% of auction awards according to the treasury)


Fin 284

Squeezes and the Repo Market

Bond dealers often finance a position of their holdings via the repo market. In the event of a squeeze it is possible that different securities with the same cash flow patterns will demand different returns in the repo market.The squeeze creates a shortage of the security which could be covered in the repo market


Fin 284

Squeeze and the Repo Market

When will the owner of a security be willing to lend the security in the repo market?

The owner is willing to agree to sell the security for cash then buy it back in the future. In essence borrowing cash. If the rate is low (less then the rate on similar securities or on cash) the owner can earn a return with the cash then buy back the original security and make a profit. This lower rate is called the “Special Repo Rate”


Fin 284Squeeze and the Repo Rate

This implies that the repo rate for the on the run treasury may be lower than the repo rate n similar securities. This occurs because there is no substitution of the security in the event of squeeze (the other party needs it to cover their short position). Approximately 90-95% of treasuries will trade at the general collateral rate (for that maturity), the rest trade at the special rate.

Sundaresan, 1994, J of FI


Fin 284Empirical Evidence

Repo Rates: General Collateral–Special Rate 1987-1991

Period 2 yr 3 yr 5 yr 7 yr 10 yr 30 yr

# of Auctions

57 19 23 18 29 16

Mean 56.5747.2

067.39

56.22

96.94 69.47

Standard Dev

107.42

82.90

110.31

87.13

130.68

105.82

T-Stat 18.2519.5

121.03

21.90

25.42 22.22

Sundaresan 2002, FRBNY EPR 4/2000


Fin 284Empirical Evidence

Repo Special Rate – Collateral Rate during Russian Currency Crisis (in basis points)

2 yr 5 yr 10 yr 30 yr

Precrisis7/97-8/98

21.0 76.9 165.8 120.6

Crisis8/98 – 11/98

52.8 126.1 115.6 211.1

Post crisis11/98-10/99

35.3 75.0 200.3 120.1

Full Sample 30.4 81.8 173.9 130.8


Fin 284Some Pricing Issues

Day Count ConventionsUsed to determine the interest earned between two points in timeUseful in calculating accrued interestSpecified as X/Y

X = the number of days between the two datesY = The total number of days in the reference period


Fin 284Day Count Conventions

Day Count Convention

Market Used

US Treasury Bonds

Corporate and Municipal

Bonds

US T-Bills & money Market Instruments

period)(in ActualActual

36030

360Actual


Fin 284

Price Quotes – Notes and Bonds

Prices are given as a % of par value (assuming 100 par) and given in 1/32For example the price of 94-14 would imply a price of $94 14/32 per $100If a + follows the quote 1/64 is added. A price of 94-14+ would imply $94 29/64 per $100


Fin 284

Price Quotes for Treasury Bills

Let Yd = annualized yield, D = Dollar Discount F= Face Value, t = number of days until maturityPrice = F -D

360

tFxYD

t

360

F

DY

d

d


Fin 284Price Quotes on T- Bills

Note: Return was based on face value invested, no the actual amount invested.360 day convention makes it difficult to compare to notes and bonds.CD equivalent yield makes the measure comparable to other money market instruments

d

d

tY- 360

360Y yieldeqivalent CD


Fin 284Accrued Interest

When purchasing a bond between coupon payments the purchaser must compensate the owner for for interest earned, but not received, since the last coupon payment

PeriodCoupon in Days

period AIin Days

2

Coupon $ Annual AI


Fin 284STRIPS

Separate Trading of Registered Interest and Principle Securities (1985).Available on all bondsIn 1982 Merrill offered TIGRS and Salomon offered CATS – treasury receipts effectively stripping the treasury.Cash flow is designated as coming from the principle, or coupon.


Fin 284STRIPS

Basically allows the security to be maintained in the Fed Res book entry system in such a way that it is possible to trade the components (principle and interest).Duration will always be the maturity of the component – this makes it easier to match duration.NOTE: STRIPS are not implied zero coupon bonds


Fin 284STRIPS example

Assume $100 Million of 10 year Treasury notes with a 5% coupon rate.The cash flow from this would be $2.5 Million each 6 months in coupon and $100 Million at the end of 10 years. Each cash flow could be sold as a separate zero coupon security.


Fin 284Tax Treatment of Strips

Accrued interest is taxed each year even though interest is not paid. This decreases the attractiveness of them to many investors. This effectively makes them negative cash flow instruments since tax payments are made, but no interest is received.


Fin 284Federal Agency Securities

Federally related InstitutionsArms of the government that operate in the marketplace.Export –Import Bank, TVA, SBA etc.. Are exempt from SEC regulation except for TVA and private export funding corp. Backed by full faith and credit of US government


Fin 284

Government Sponsored Agencies

Privately owned, government sponsored entities.Created to lower the cost of capital for a specific sectorGenerally issue two types of notes and debt


Fin 284GSE’s

Debt and mortgage backed securities are exempt from SEC registrationAgencies are exempt from state and local taxesTreasury can purchase up to $2.2 B of FNMA and $4B of FHLB via line of creditBanks can make unlimited investment in debt issued by GSE’sGSE securities are eligible as collateral for public deposits and for loans from the Fed


Fin 284GSE’s continued

GSE securities are lawful investments for federal fiduciary and public fundsGSE’s are authorized to use Federal Reserve Banks as their fiscal agents including issuing and transferring funds via the book entry system maintained by the Fed


Fin 284

GSE – Federal Farm Credit Bank

Responsible for the credit market in the agricultural sector.Three entities:

Federal Land BankFederal Intermediate Credit BankBank for Cooperatives

Issues “joint and several obligations”Issues short term notes and debt


Fin 284

GSE- Federal Home Loan Bank

FHLB originally established to regulate savings and loans. No longer the primary regulatorLargest issuer of agency debt


Fin 284

Federal National Mortgage Association

Saving and loans previously were the primary supplier of cash in the residential loan market.Goal of Fannie Mae is to create a liquid secondary market for mortgages.Funds its purchases of mortgages through the sale of its securities.


Fin 284

GSE – Government National Mortgage Association

Ginnie Mae split off of Fannie Mae in 1968.Ginnie Mae has the responsibility of providing a liquid market for government insured mortgages (VA, FHA etc) Has the ability to use the “full faith and credit of US government” to back its securities.


Fin 284

Federal Home Loan Mortgage Corporation

Founded in 1970 Freddie Mac is responsible for providing support for conventional (not guaranteed by US gov’t ) mortgages.


Fin 284

GSE-Student Loan Marketing

Association

Provides liquidity for the participants in the student loan programs.Started issuing notes backed by student loans 1995.


Fin 284

Resolutions Trust Corporation

Responsible for liquidating or bailing out troubled savings and loan associations.Obtained funding by issuing securities backed by treasury securities.


Fin 284GSE Credit Risk

With the exception of the Farm Credit Corporation the securities offered by the GSE’s are not backed by the full faith of the Us government.


Fin 284Agency Usage

0

5

10

15

20

25

30

35

%

FHLB FannieMae

FreddieMac

FarmCredit

TVA SallieMae

1985

1999


Fin 284

Federal Agency Debt Issuance (total in $ billions)

Short Term Long Term Total

1991 581.7 55.2 636.9

1993 817.1 109.7 926.9

1995 3,302.6 228.1 3,530.7

1997 5,428.0 323.1 5,751.2

1999 6,538.2 536.3 7,074.4


Fin 284Growth in Agency Securities

One concern is that the recent growth has started to “crowd out” corporate debt.

Forces corporate debt to pay a higher ratePublic policy perspective.


Fin 284Types of Agency Securities

Mortgage PassthroughMortgages are pooled and the cash payments on the mortgages are used to make payments to the newly issued passthrough security based upon a set of rules for the security

Collateralized Mortgage ObligationThe investor above is exposed to prepayment risk, the CMO structures the timing of the prepayments into tranches


Fin 284Municipal Securities

Issued by state and local governments are often tax free.Tax Backed Debt – repayment of principal and payment of interest is from cash flows generated by tax revenueRevenue Bonds – repayment of principal and interest payments are made by revenue earned by the project financed by the project


Fin 284Long Term vs. Short term uses

Short term Used in anticipation of the receipt of funds from taxes or bond issues Allow the coverage of seasonal or temporary imbalancesLong Term Main means of financing capital improvement and LT budget deficits.


Fin 284

Types and Features of Municipal Securities

Tax Backed DebtIssued by cities, counties etc… and secured by tax revenueDifferences in bonds result from difference in taxing power and the revenue pledged to pay the commitments of the debt.


Fin 284General Obligation Debt

Unlimited: secured by the issuers taxing power. (corporate, individual, sales etc…)Limited: Statutory limit on the tax rates and type of taxes used to service the debt.Some also include a second source of revenue from fees and other administrative sources of revenue (termed double barreled obligations)


Fin 284

Appropriations Backed Obligations

The creditworthiness of the issue is increased by having state tax revenue as a possible source of repayments. The revenue must be approved by the legislature – therefore these are often termed appropriations- backed obligation. Also termed moral obligation bonds because the states pledge is not binding (they have a moral obligation to follow through on the pledge)


Fin 284Credit Enhancement Programs

Similar to appropriations however, in the case of credit enhancement programs the backing is usually legally binding. An example is school bonds. The legally binding obligation may be for the state to pay any defaulted debt. Generally the funds are diverted from state aid the issuing agency was going to receive.


Fin 284Revenue Bonds

The revenue produced from a project are pledged to the bondholder. Often used to finance airports, colleges and universities, sports complexes, toll roads etc…


Fin 284

Hybrid and Special Bond Structures.

Insured bondsBacked by the issuers revenues and also by insurance polices written by commercial insurance companies.


Fin 284Hybrids continued

Prerefunded BondsThe original bonds are escrowed or collateralized by direct obligations guaranteed by the US government. A portfolio of securities guaranteed by the US government is placed in a trust and the cash flows from the US securities match those needed to pay the interest and principal. The bond (originally tax backed or revenue backed) is not funded by the US government


Fin 284Asset backed bonds

Also Called dedicated revenue backed bonds and structured notes.The debt service is to be paid by dedicated revenues such as sales taxes, tobacco settlement, fees etc…


Fin 284Municipal Notes

Up to three years in maturity. TANS (Tax anticipation notes), RANS (revenue anticipation notes), GANS (grant anticipation notes) and BANS (bond anticipation notes). Main purpose is to even out funding when there is a short term shortfall prior to an expected revenue source.


Fin 284Redemption Features

Serial Maturity StructureA portion of the debt is retired each year.Term maturity structurePrinciple is repaid at the end of the bond often there is a sinking fund present. Usually issued for a period of 20 to 40 years.


Fin 284Municipal Bond Ratings

Credit riskOften considered second only to US government securities there has been some defaults. Because of this the investor is exposed to a small amount of credit risk. Example: NY Urban development Corp defaulted on a $100 million notes in 1975. Eventually the city obtained $140 million in revolving bank credit to “cure” the default.


Fin 284Muni Bond Ratings

Another concern has been developed because of new types of bonds. General obligation and revenue bonds generally required voter approval. Many of the new financing structures avoid that. In these cases there is no legal precedent that assures the bond will be backed by the revenue source. Ratings are generally conducted by the standard rating agencies.


Fin 284Rating Criteria

The ratings process is very similar to corporate ratings

Debt burdenPolitical disciplineTaxes and other revenues availableSocioeconomic environment


Fin 284Tax risks

Most munis are tax free for the investor. If the Federal government reduces marginal tax rates, the tax exemption feature is less valuable so the price of the bond will decline. Also the IRS can change the tax status of the issue and make the debt service taxable.


Fin 284The Primary Market

Most general obligation bonds are marketed through competitive bidding. In this case the highest bidder receives the right to market the security to the public. The bonds are generally placed either publicly to the entire investing community, or to a small group of investors.


Fin 284The secondary market

Traded OTC by bond traders. An odd lot is considered anything less than 25,000 (100,000 for the corporate bond market) The dealer spread usually ranges from ¼ of a point to 4 points on odd lotsUsually the price is quoted as a % of par value (based on 100)


Fin 284Yields on Munis

The tax advantage decreases the yield paid on municipal securities. As the length of time increases the yield is closer to that of government bonds. The municipal yield curve is generally positively sloped and may differ from the US government curve. There has been many times when the YC was steeper than the US government YC.


Fin 284Regulation

Congress has exempted munis from the registration process required by the SEC under the securities act of 1933 and the periodic reporting required by the SEC Act in 1934.


Fin 284Reasons for the exemption

1. To promote harmonious relations between different levels of gov’t

2. Absence of major struggles.3. Sophistication of investors4. Lack of defaults

The market functioned well until the 1970’s when individuals started to participate in the market.


Fin 284

The Securiteis Act Amendment 1975

Broadened federal regulation Muni Securities Rulemaking Board was also established Still do not have to report but regulation is increasing.


Fin 284

Types of Commercial Borrowing

Corporate Senior InstrumentsCommercial PaperMedium Term Notes


Fin 284Commercial Paper

Unsecured short term borrowing – An alternative to bank borrowing

millions of $ total outstandingnon financial financial

March 92 137,857.40 389,559.30March 97 187,705.30 642,717.70March 02 188,752.80 1,169,361.00


Fin 284History of Commercial paper

One of the oldest money market instruments, use can be traced back to the early 1800’s

Originally issued by textile mills, railroads etc as a sources of seasonal funds.

Often it is used as bridge financing.


Fin 284CP – Market Facts

Usually sold in denominations of $100,000.Less than 270 days in maturity most common is 30 to 60 days. Less than 270 days does not have to be registered with the SEC (Securities Act of 1933)Also commercial paper with a less than 90 day maturity is eligible to be collateral for a bank borrowing from the Fed. Therefore the cost of borrowing is less if the maturity is less than 90 days.A common practice is to roll over the commercial paper, paying off old borrowing with new.


Fin 284Issuers of Commercial Paper

Financial firms offer 78% of all commercial paper

Captive Finance CompaniesFinancing arms of industrial firms (GMAC for example)

Bank-related finance companiesSubsidiary of a bank that provides loans that enables business and individuals to borrow

Independent finance companiesSmaller portion of the market (non financial related firms)


Fin 284

Hybrids of Commercial paper

Small firms have also been active in the marketLOC paper (Credit supported cp) – have letter of credit from bank or other institution promising to pay off the paper if the issuer fails to do so. Usually there is a fee charged by the bank or institution. $ outstanding has been decreasing current there is $1,541,000,000 outstanding.


Fin 284

Placement of Commercial Paper

Direct placement – Sold directly by issuing firm to investors saves approximately 1/8 of a percent

Dealer Placed commercial paper.Glass Steagall originally prohibited banks from underwriting commercial paper, but that changed in June of 1987 Banks now are active in underwriting in an attempt to recoup lost revenue from short term borrowing.


Fin 284Medium Term Notes

Offered on a continuous basis with the investor having the ability to select maturity.

Allowed under the self registration rule (Rule 415). Register with the SEC to sell a certain amount of a certain class of securities one or more times within the next two years. Vast majority of MTN rated as investment grade.MTN accounted for 13% of outstanding debt in 2000 with a total of $71 billion dollars filed for. This was down from 150 billion in 98 and 135 billion in 99.


Fin 284The Primary Market

Rates often posted as a spread to Treasury markets.

maturity yield Spread Treas Mat Yield

9 to 12mos -

12 to 18 mos

-

18 mos to 2 y

2.05 25 1 yr 1.8

2y to 5 y 2.39 35 2 yr 2.04

5 y to 7 yr 3.56 60 5 yr 2.96

7 yr to 10 yr

4.29 40 10 yr 3.89

10 yr 4.29 40 10yr 3.89


Fin 284Structured MTN’s

Coupling of the MTN with derivative markets to offer different return characteristics. (Partially floating over the life of the note, or resetting based on different indexes or even inversely related rates.


Fin 284The High Yield Debt Market

The high yield market consists of bonds issued or ranked at below investment grade (BBB rating)Linked to this market is the market for firm in financial distress (they have defaulted on their debt)


Fin 284

Rating Migration Corporate Debt

Aaa Aa A Baa Ba Bb

C or D

total

Aaa 91.9 7.38 0.72 0 0 0 0 100

Aa 1.13 91.26 7.09 0.31 0.21 0 0 100

A 0.10 2.56 91.2 5.33 0.61 0.2 0 100

Baa 0.00 0.21 .36 87.94 5.46 0.82 0.21 100


Fin 284Financial Distress

Implies that the firm has stopped making payments on its debt.

It has either formally or informally declared bankruptcy


Fin 284Federal bankruptcy law

Chapter 1, 2, 3 general provisions dealing with the other chapters.Chapter 9 Financially distressed municipalitiesChapter 12 Family owned firmsChapter 15 Appointment of trustees.Chapter 7 and Chapter 11 of the bankruptcy code are the most important to businessChapter 11 -- When a firm attempts to reorganize with the supervision of a bankruptcy court.Chapter 7 -- Instigates formal proceedings to liquidate the firm


Fin 284Formal Reorganization

Formal proceedings (either reorganization or liquidation) are designed to protect both the debtor and creditor during the proceedings.

The primary purpose of the court is to determine the fairness and feasibility of the plan. Fairness --the claims must be in the order of their legal and contractual priority. Feasibility asks whether the firm can manage the settlement after the process is complete.


Fin 284Common Pool Problem

Common Pool problem -- individual creditors have an incentive to force foreclosure on a firm even if it is possible that the firm is worth more if it continues to operate.


Fin 284Holdout Problem

Under informal reorganization, a second problem arises, the holdout problem. Use the same situation as above but now lets say that seven creditors agree to receive 850,000 each in the reorganization, that leaves a little over three million for the remaining three creditors. They each benefited by not agreeing to reduce their claim or holding out.


Fin 284

Chapter 11 has other Advantages:

Interest and principal payments are delayed without penalty (including interest on delayed payments) until the plan is approved.The firm is permitted to issue debtor in possession financing, which has priority over other financing.The debtors are given exclusive rights to submit the reorganization plan for 120 days after filing then another 60 days to obtain agreement on the plan. After this time any party may propose alternative reorganization plans.


Fin 284

Liquidation in Bankruptcy (Chapter 7)

The primary advantages of filing for Chapter 7 bankruptcy are:

1) It provides a safeguard against debtor fraud

2) It provides for an equitable distribution of assets

3) It allows insolvent debtors to discharge all of their debt obligations and start over.


Fin 284

The priority of claims under Chapter 7

1) Past due Property taxes2) Secured Creditors --creditors entitled to the

proceeds of the sale of specific property pledged for a lien or a mortgage

3) Legal Fees and other expenses to administer and operate the bankrupt firm.

4) Expenses incurred after an involuntary case has begun but before a trustee is appointed

5) Wages due workers if earned within three months prior to the filing of the petition in bankruptcy (limited to $2,000 per employee)


Fin 284

6) Claims for unpaid contributions to employee pension plans that should have been paid within six months of filing

7) Unsecured claims for customer deposits. not to exceed $900 per individual

8) Taxes due to federal, state, county and other government agencies

9) Unfunded pension plan liabilities. these liabilities have a claim above that of the general creditors


Fin 284

10) General or Unsecured creditors (holders of trade credit, unsecured loans, the unsatisfied portion of secured loans, and debenture bonds (or general creditors)

11) Preferred stockholders. Receive an amount up to the par value of their stocks

12) common stockholders -- any remaining funds.


Fin 284

Bonds in default -- Is patience a virtue?

What happens to the creditor during a default?Should they hold on to the bond or sell it?

Studies have shown that there are excess returns from holding the bond from about 6 months past default to 18 months past default.We wanted to know what to do if you were caught holding a bond when it went into default.


Fin 284

56 defaulted bonds for 36 companies between 1982

and 1994

Average Standard MedianPrice Deviation Price

Default Date 52.80 28.77 50.38Confirmation Date 52.71 39.13 45.19Value 12 Months After Confirmaiton

Sample Top 10 Bottom 7Average MonthsIn Bankruptcy

57.34 42.38 50.88

25.8 20.6 32.5


Fin 284

Returns from holding the bonds

: Average MedianTotal Standard TotalReturn Deviation Return

Default Date to 12 Months After

12 Months Prior to Default Date

6 Months Prior to Default Date

Default Date to Confirmation Date

Confirmation Date to 12 Months After

49.09 141.42 10.10Confirmation

29.42 100.08 12.69

23.08 96.43 0.98

-24.86 55.8 -31.06

-7.61 72.7 -10.54


Fin 284

Compare the returns to what return would have

earned elsewhere.

Average MedianTotal Standard TotalReturn Deviation Return



3.84 50.05 -9.94

-0.77 141.30 -37.37Confirmation


S&P 500

Merrill Lynch High Yield Index

Confirmation

Defualt Date to Confirmation Date


-5.27 104.00 -25.34

Defualt Date to Confirmation Date

7.13 144.00 -21.09

6.37 46.27 -5.51

-2.55 103.02 -19.07


Fin 284

There was a large amount of variation among the firms:

Top 10 Sample Bottom 7


Average Total Returns

188.62 49.09 -80.02Confirmation

-81.39

Confirmation Date to 12 Months After 40.95 23.08 -20.18

Defualt Date to Confirmation Date 142.80 29.42


Fin 284

Characteristics of the winners

Firm SizeTop 10 Average $2 Billion in Assets and $2.5 Billion in SalesBottom 7 Average $0.7 Billion in Assets and $0.4 Bil in Sales

Brand NamesInterco (Converse, Floresheim, Broyhill and Lane)Federated Department Stores (Bloomingdale’s) Charter MedicalPublic Service of New Hampshire

Independent of Industry


Fin 284Asset Backed Securities

Creating a special purpose vehicle or corporation and issuing a security under the name of the SPVAllows Corporation to borrow at a lower cost than the entire firm by increasing the credit rating of the issue.


Fin 284Other Credit Enhancement

External Credit Enhancement – third party guarantees of payment – subject to credit risk of the third party

Corporate guaranteeLetter of CreditBond Insurance

Internal Credit EnhancementReserve FundsOvercollateralizationSenior/ subordinate structures


Fin 284International Bonds

Foreign bonds issued and traded in a foreign countries bond market ( a market other than the domestic home of the firm).

Yankee Bonds – Bonds issued by non US corporations, but traded in the US bon market

Other markets and nicknames:Samurai Bond – JapanBulldog Bond – United KingdomRembrandt Bond – NetherlandsMatador Bond – Spain


Fin 284Foreign Bonds

The regulations of the country where the bonds are issued govern the structure and trading of the bonds and can include:

Restrictions on bond structuresSize of issueWaiting periods prior to issue being brought to marketDisclosure and reporting requirementsUnderwriting restrictions


Fin 284Eurobond Characteristics

Underwritten by an international syndicateOffered to investors in multiple countries at the same timeNot under the jurisdiction of a single countryUnregisteredUS and Canada less restrictive on issues denominated in their currency compared to most other countries (Eurodollar bonds)


Fin 284Global Bonds

Issued and traded in both the US Yankee market and Eurobond marketCommonly held beliefs about issuer characteristics

Consistent demand for fundsTotal amount raised needs to be large (excess of $3 Billion)High credit rating of issuer


Fin 284Sovereign Debt

Debt issued by federal governments (US debt is sovereign debt for the US).Backed by the individual governments taxing authorityMay be sold either single price or multiple price auctions, or other methodsTwo credit ratings

Local currency ratingForeign currency debt rating

drake drake university fin 284 treasury, corporate, and municipal markets finance 284 analysis of...

Documents

drake drake university

treasury securities

treasury auctions

auction participants

coupon securities notes

maturity slide

us department of treasury

fed financing bank securities