FI: Corp, Muni & Foreign Securities

Lecture Set III

Professor John P. Miller

Professor John P. Miller FI: Corp, Muni & Foreign Securities 1 / 34

Corporate Debt Instruments
General classifications of corporate bonds
Utilities
Transportation
Banks/Finance
Industrials
Features
Instruments are a promise to pay a percentage of par on specified dates,
and par at maturity
Failure to pay principal or interest when due constitutes a default
Bond indentures: Legal contract that defines the rights of the investors
and obligations of the issuer
Indenture is made out to a trustee who represents interests of bondholders
Term bond: Bonds run for a period of years then become due and payable
Notes have loan terms of 10 years or less, bonds have terms greater than
10 years
Some issues are offered as serial bonds, where a portion of the issue
becomes due at specified dates
Interest paid on a 30/360 basis
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Corporate Debt Instruments: Security

Security for Bonds

Mortgage: property is pledged as collateral
Collateral trust bonds: Bonds backed by assets other than real property
Rolling stock: Railroads pledge rail cars and locomotives as collateral
Cars and locomotives are titled to a trustee who then leases the
equipment back to the railroad
Trustee sell certificates to investor to obtain funds to purchase equipment
Originally used by railroads, this has been extended to trucking
companies, airlines and oil companies who purchase oil tankers
Debenture bonds
Not backed by specific pledge of property: behind secured debt
Subordinated debenture bonds are behind debenture bonds but ahead of
stockholders
Guaranteed Bonds: Obligations guaranteed by another entity

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Corporate Debt Call and Refund Provisions

Companies generally must pay a premium to retire debt before maturity

Usually initially amounts to par plus the annual coupon and declines to
par over time
Yield-maintenance premium: An amount that when added to the principal
amount and reinvested in a Treasury of the same maturity gives the
original yield of the issue
Refund provisions are weaker than call provisions: Only prevent
redemptions using proceeds of other debt issues sold at a lower cost
Example: A firm may not pay off bonds using proceeds from another
lower-cost debt offering, however, they could raise new funds at a higher
cost and use the proceeds to pay off the debt
Sinking fund: Indenture may require that part of the issue is paid off
before maturity to reduce credit risk
Issuer may make a cash payment to the corporate trustee who then calls
the bonds using a lottery
Issuer may present to trustee bonds purchased in open market

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Corporate Bond Ratings

Many institutional investors and investment banks do their own credit

analysis
Others depend on the ratings from (1) Moody’s, (2) Standard & Poor’s,
and (3) FitchRatings
Ratings: Investment or high grade: low credit risk, high probably of
future payments
Prime: Aaa – Moody’s, AAA – S&P and Fitch
High quality: Aa-Aa3 – Moody’s, AA-(AA-) – S&P and Fitch
Upper medium grade: A1-A3 – Moody’s, (A+)-(A-) – S&P and Fitch
Medium grade: Baa1-Baa3 – Moody’s, (BBB+)-BBB2 – S&P and Fitch
Ratings: Noninvestment grade, high-yield or junk bonds
Ba1-C – Moody’s, (BB+)-D – S&P and Fitch

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Global Rating Transition Matrix

Higher ratings more stable than lower ratings

87.09% of ‘AAA’ rated issuers were still rated ‘AAA’ a year later
Only 43.91% of ‘CCC’ rated issuers were still rated ‘CCC’ a year later

Average One-Year Transition Rates: 1981 to 2021 (%)

From/To AAA AA A BBB BB B CCC/C D NR
AAA 87.09 9.05 0.53 0.05 0.11 0.03 0.05 0.00 3.10
AA 0.48 87.32 7.72 0.46 0.05 0.06 0.02 0.02 3.88
A 0.02 1.56 88.73 4.97 0.25 0.11 0.01 0.05 4.29
BBB 0.00 0.08 3.19 86.72 3.48 0.42 0.09 0.15 5.86
BB 0.01 0.02 0.10 4.52 78.12 6.66 0.53 0.60 9.43
B 0.00 0.02 0.06 0.15 4.54 74.73 4.81 3.18 12.51
CCC/C 0.00 0.00 0.09 0.16 0.49 13.42 43.91 26.55 15.39
Source: Standard & Poor’s

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Corporate Bond Ratings: Event Risk

Factors directly affecting the issuers ability to pay timely principal and
interest payments
Natural or industrial disaster
Regulatory changes
Takeover or corporate restructuring
Spillover effects
Disaster on one nuclear plant could drive bond prices down for a
competitor
A successful leverage buyout of one firm could cause the bonds other
firms in similar situations to fall in price

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High-Yield Corporate Bonds

Quality ratings below BBB

Two types
Investment grade bonds that were downgraded
Original-issue high-yield bonds are issued as noninvestment grade
Leverage buyout (LBO) or recapitalization issues have deferred coupon
structures to ease cash flow constraints
Deferred interest bonds: Bond do not pay a coupon for 3-7 years and are
sold at a discount
Step-up bonds: low initial coupon that steps up over time
Payment-in-kind (PIK) bonds: gives issuer the option of paying cash on
the coupon date or paying with a bond that has the same coupon, and a
par equal to the payment
Extendable reset: coupon may be reset over the life to keep the price at
some level (generally $101) –this can place cash flow pressure on issuer

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 High-Yield Bond Performance

Ba credit spreads to Treasuries spreads range from 281 bps in 1978 to

around 1,750 bps in 20081
To evaluate the performance of the high-yield sector one must go
beyond the default rates
Losses from default are lower than the default rates themselves because
of recoveries, and in fact, with sufficiently high spreads, it is possible for
a portfolio of high-yield securities to outperform a Treasury portfolio of
similar duration
High-Yield bonds have outperformed investment grade corporate and
Treasuries, but have underperformed stocks

1
Frank Reilly, David Wright and James Gentry, “Historic Changes in the High Yield Bond
Market,” Journal of Applied Corporate Finance, 21, No. 3 (Summer 2009), pp. 65-79.
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Secondary Market for Corporate Bonds

Trade Reporting and Compliance Engine (TRACE)

Introduced in June 2002
FINRA (Financial Integrity Regulatory Authority) member firms are
required to report corporate bond activity to TRACE
Electronic Bond Trading - nearly 100% of corporate bond trading by
2005
Auction systems: Used for new issues
Cross-matching systems: Brings dealers and institutional investors
together
Interdealer system: Allow dealers to trade amongst themselves
Multidealer systems: Allow customers to consolidate order across several
dealers
Single-dealer system: Allow investors access to one dealer

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Other Corporate Instruments
Private-Placement
Issues not registered with the SEC
Rule 144A private placement requires the investor be a “qualified
institutional investor” (have assets exceeding $100 million)
Issuers tend to be less well known
Market is not very liquid
Medium Term Notes (MTNs)
Notes offered continuously by agent of issuer under variable maturity
ranges: 9mo-1yr, 1-1.5yrs, 1.5-2yrs, up to 30 years
Filled gap between commercial paper and long-term bonds
Registered under Rule 415: shelf registration
Issues offer flexibility between floating- and fixed-rate debt, and the
possibility of creating structure notes which include the use of interest
rate derivatives
Structured Notes:
Equity-Linked Notes (ELN): A zero-coupon bond and a call option
Commodity-Linked Notes (CLN)
Credit-Linked Notes (CLN): Credit risk linked to a reference issuer,
maturity timing and amount determined by credit event
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Commercial Paper

Commercial Paper (CP): Short-term (1-270 days) unsecured promissory

note
Provides short-term funds for seasonal, working capital and bridge
financing needs
Generally sold in lots of $100,000
Issues generally less than 270 days to maturity to avoid registering with
SEC, and less than 90 days if the paper is to be used as collateral at the
Federal Reserve’s discount window
Securities are generally paid off, or are rolled over into new CP
Issuers tend to have high credit ratings, however, those with weaker
credits can get a letter of credit (LOC) from the issuing bank for a fee,
or collateralize the issue with assets (asset-backed commercial paper)

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Commercial Paper (cont)

There have been few exceptions of default in CP, notably: Manville

Corp in August, 1982, five in 1989 and four more in 2001, and the
largest ever, Lehman’s $3.0 billion CP default on September 15, 2008.
Paper is sold on a discount basis (30/360) and can either be sold
directly by issuer, or through a dealer as an agent to sell the paper
Money market mutual funds are the largest investor in commercial paper
Money market mutual funds can only invest in CP that receives one of
the two highest ratings from at least two of the ratings agencies: Rule
2a-7 of the Investment Company Act of 1940
Tier 1 paper is rated “1” by at least two of the ratings agencies
Tier 2 paper is any other qualified paper
No more than 5% of a fund’s assets in a tier 1 company can be held
No more than 1% of a fund’s assets in a tier 2 company can be held
Tier 2 paper can represent no more than 5% of a fund’s assets

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Bank Loans
Investment Grade Loans
Borrower holds an investment-grade rating
Loans are generally revolving credit lines
Loans are retained by lender
Leveraged Loans
Borrower holds a sub-investment grade rating
Rates are generally floating and based on LIBOR
Syndicated Bank Loans: Lending is provided by a group, or syndicate, of
banks
Senior bank loans in they have priority over bondholders
Floating rates
Fixed loan terms
Amortizing provisions
Collateralized Loan Obligations (CLOs)
Loans are pooled and placed in a special purpose vechicle (SPV), and the
SPV issues new bonds
CLO bonds are tranched according to priority of the cash flows with the
highest-rated bonds given first access
Banks use CLOs to release risk-based capital
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Bankruptcy

Holders of corporate debt instruments have priority over equity holders

in the event of a bankruptcy
Bankruptcy can be of two types
Liquidation:
Chapter 7 of the Bankruptcy Reform Act of 1978
Enron (2001), Worldcom (2002), Lehman Brothers (2008)
Reorganization
Chapter 11 of the Bankruptcy Reform Act of 1978
United Airlines (entered Dec. 2002, exited Feb. 2006)
CIT Group (entered Nov. 2009, exited Dec. 2009)
GM (entered Jun. 2009, exited Jul. 2009)
Investors may receive cash or in some cases new securities
Bankruptcy allows firms protection from creditors while they determine
whether to liquidate or reorganize

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Creditor Rights

In the case of liquidation, distributions are based on absolute priority

rule: Senior creditors are paid in full before junior creditors receive
anything, and all creditors are senior to equity holders
Reasons why courts have deviated from absolute priority rule
Incentive hypothesis: The longer the negotiating proceeds, the higher the
cost and the less to distribute
Plan must be accepted by 2/3 of the amount voting shares and majority
of claims
Creditors will offer concessions to get the votes needed to accept the plan
Recontracting process hypothesis: Managers will possess better
information than either the creditors or stockholders, and use the
information to reinforce its position
Strategic bargaining process hypothesis: Because of the complexity of the
bankruptcy process, creditor have more to gain through a merger or
reorganization

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Municipal Securities

Exempt from federal taxes, and some state and local taxes
Municipal Bond Security Structures
General Obligation Debt (GO)
Unlimited tax GO: Secured by issuer’s unlimited taxing power (income,
property and sales taxes), and also the full faith and credit of the issuer
Double-barreled securities are backed not only by the taxing authority but
also fees, grants, and special charges
Appropriation-Backed Obligations
State has the obligation to cover short-falls
Moral obligation bonds are backed by non-binding obligation
Public Credit Enhancements
Moral obligation bonds are not binding, public credit enhancements are
Are generally issued to support GOs for schools

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Revenue Bonds

Revenue Streams from projects built with funds of debt offerings are
used to service the bonds
Indentures determine priority of proceeds from a revenue fund for the
following uses
Operation and maintenance fund
Sinking fund
Debt service reserve fund
Renewal and replacement fund
Reserve maintenance fund
Surplus fund
Some examples of revenue bonds
Airport revenue bonds use the landing, concession and fueling fees to
service bonds
Public power revenue bonds use the revenues from electrical service to
service bonds
Toll road and gas revenue bonds use the proceeds from tolls and gas taxes
to pay for the bonds issued to build highway infrastructure

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Hybrid and Special Bond Securities

Insured bonds – In addition to issuer’s revenue, these bonds are backed

by commercial bond insurance companies
Bank-backed bonds – Backed by credit facilities of commercial banks
Letter-of-credit agreement: Bank is required to advance funds to the
trustee in the event of a default
Irrevocable line of credit: Not a guarantee, but provides security if the
issuer complies with the terms set by the line of credit
Revolving line of credit: A funding facility that provides funds for paying
maturing debt in the event there are no other funds available

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Hybrid and Special Securities: Refunded Bonds

New bonds are issued, then used to purchase government securities that
match the original issue cash flows
These securities are placed in a trust and then replace the revenue
streams to service the original muni issue
Example: Suppose a non-callable $100 million muni bond is issued at
par with a 4.2% coupon. Now suppose that yields fall to 3.6% when
there is 5 years remaining to maturity
The 4.2% bond is priced at $102.7232 when the YTM falls to 3.6% and
suppose 5-year Treasuries with a 4.2% coupon are priced at par
How does the municipality reduce is interest expense?
Issue $100 million new 5-year bonds at par with a 3.6% coupon, and use
proceeds to purchases 5-year Treasuries with a 4.2% coupon
The Treasuries now pay the cash flows for the original issue and the
municipality now pays a semiannual coupon of 1.8% (3.6%/year)

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Hybrid and Special Securities (cont)

Structured/Asset-backed bonds
Revenue streams from sales taxes, tobacco settlement payments, fees and
penalty payments can be realized today by issuing bonds backed by these
revenue streams
Bonds have credit risk that the dedicated revenue streams become
impaired
For example, tobacco companies may default on settlement payments if
they face additional legal liabilities and file for bankruptcy protection
Troubled City Bailout bonds
Bonds structured to appear as revenue bonds, but are really a claim on
revenues that would have otherwise gone to a state or city general fund
Examples
New York State Municipal Assistance Corp of New York City Bonds
State of Illinois Chicago Finance Authority Bonds

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Redemption and Special Investment Features

Bonds may have either a term maturity structure or a serial maturity

structure
A serial maturity structure requires a portion of the offering be retired
each years, usually 5-10 years before the final term maturity
Bond also have a catastrophe provision that requires the deal be called
if the facility is destroyed
Special Investment Features: Zero-coupon bonds
Example: 5-year $1,000 bond with a 4% coupon
1,000
P V = 1.02 10 = $820.35
F V = $1, 000
Municipal multiplier bond
Bond is issued at par and pays a semiannual coupon
Example: 5-year $1,000 bond with a 4% coupon
P V = $1, 000 F V = 1, 000 × 1.0210 = $1, 218.99

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Municipal Money Market Products

Municipal Notes
Have maturities of 3 months to 3 years
Used as temporary borrowings to even out irregular expected cash flows
Auction rate securities (ARS)
Long-term maturity with coupon that is reset every seven or 28 days
Interest is determined in a Dutch auction in which all securities receive
the “clearing rate”
Commercial Paper/VRDO Hybrid
Long-term maturity with put provision from 1 day to more than 360 days
On put date, investor elects to extend maturity at new rate until next put
date
Interest is paid on put if put date is less than 180 days, or is paid on a
semiannual coupon basis if put date is longer

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Municipal Derivative Securities

Demand for municipal bonds issues has increased by the development of

the structured muni products markets
The cash flows from a fixed rate bond is split into two or more bonds
classes called tranches
The risk/return profile for each tranche can be different than the profile
of the security off which they are structured
Most common structure is the floater/inverse floater bond combinations
Municipal-strip obligations are similar to Treasury STRIPS
Another structure is to create a discount bond with a portion of the
fixed-coupon issue, then carve out a floater and an inverse floater off the
remaining amount
The Kenny Index is used to determine the coupons for the floater/inverse
floater bonds
The Kenny Index is published by the J.J. Kenny Company, and is
considered as the most accurate measure of long-term tax-exempt yields

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Credit and Tax Risk

Until the $100 million default of a New York City bond obligation in
1975, investors considered municipal issues to nearly as safe as
Treasuries
The interests of tax payers, employee unions and community groups
limits the ability of a municipality to cut expenses or raise taxes and fees
to insure timely payment of interest and principal
Another issue is that some of the new credit structures such as “moral
obligation” and letter/line of credit structure have not been legally
tested
Tax risk
Risk that the marginal federal tax rates will be reduced, reducing the
value of the tax exemption
Risk that the issue will be declared as taxable by the Internal Revenue
Service

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Municipal Bond Market
Bonds are issued on a weekly basis to the investor community, or
placement with a small group of investors
Information about the bonds can be found at
http://emma.msrb.org/Home/Index
Issues can be priced competitively, with issue being awarded to the
highest bidders, or issues can be priced through negotiations with an
underwriter
Issuing governments generally require public notice of the offering in
advance of the auction
The official statement is a two-fold legal statement
Is issuer able to legally issue the bonds
Has the issuer prepared for the sale by enacting required ordinances,
resolutions and trust indentures without violating existing laws and
regulations
Secondary trading of issues through dealers is active with price spreads
of 1/4 to 1/2 point
Bonds are quoted on a yield basis except long-term issues which are
quoted on a price basis
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Taxable Municipal Bond Market

The Tax Reform of 1986 imposed restrictions on activities that can be

finance with tax-exempt bonds
If the bonds are used for a private development, then the maximum
amount of issue that can be tax exempt is $150 million or $50 per state
resident per year
Restrictions limit the tax arbitrage for governments
Some municipalities issue bonds to investors outside the U.S. where
there is no value to the tax exemption
Example of projects funded with taxable municipal issues
Sport facilities
Investor-led housing projects
Underfunded pension plan obligations

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Non-U.S. Bond Classification

Internal Market
Domestic Market: Issuers domiciled in the issuing country
Foreign Market: Issuers not domiciled in the issuing country
Restrictions placed on structure, size of offering, frequency of offerings,
credit quality, reporting and types of issuing institutions
Yankee bonds: Non-US issuer bonds traded in US market
Samurai bonds: Non-Japanese bonds traded in the Japanese market
Bulldog bonds: Non-UK bonds traded in UK market
External Market
Underwritten by international syndicate, simultaneously, outside the
jurisdiction of a single country and in unregistered form
Example: July 2005, Asian Development Bank (ADB) issued $1 billion
5-year bond with 65%, 15% and 20% offered in Asia, the US and Europe,
respectively

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Exchange Rate Risk and Bond Returns

Because most currencies are floating, investors risk the impact of

changes in exchange rate when the funds are converted back to the
domestic currency
Example: Suppose in 2001 a French investor purchases a $100 million
6-year zero-coupon Treasury bond yielding 5%. How does the
dollar/Euro exchange rate impact the return?
Suppose the initial exchange rate is e1.25 = $1 US in 2001
When the bond matures, the investor converts back to Euros when the
exchange rate is e0.73 = $1 US
Purchase price = $100 × 1.025−12 × 1.25 = $74.35559 × 1.25 =
e92.94449 million
Future value = h$100 million × 0.73 = ie73 million
1
Total return = (73/92.94449) 12 − 1 × 2 = −3.3985%

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Eurobond Market

Market is divided into sectors depending on the currency the issue is

denominated such as the Eurodollar (for US dollar) and Euroyen
(Japanese yen) bonds
Eurobond markets are determined by the characteristics of the
underwriters and the interest in which the currency is paid
Bond issued and underwritten by participants outside the market where
the bond is issued are not consider Eurobonds
Eurobonds are not regulated by the country whose currency pays the
interest
Eurobonds are registered on national stock exchanges such as London,
Luxembourg and Zurich but typically trade over-the-counter
Issuers include national governments, their subdivisions, corporations
and supranationals (entity formed by two or more central governments,
example is the World Bank)
Bonds trade on a spread to a benchmark

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Characteristics of Corporate Eurobonds

Most transactions are governed by U.K. law, with a few using New York
state law
Issues are not secured by company assets
Negative pledges: Issuer cannot create security interest in assets unless
all bondholders receive the same level of security
Bonds are sold on a senior basis
Cross-default clauses: Bonds become payable if the issuer defaults in
excess of some minimum amount on another issue
Issuers are prohibited from selling material assets or subsidiaries

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Types of Eurobond Securities

Euro straights or regular fixed-term bonds

Floating-rate notes: Coupons are paid according to some index
(typically LIBOR) plus a spread
Rates can be subject to a cap or floor, or collared if subject to both
Drop-lock bonds gives the borrower the right to convert the floating
security into a fixed-rate bond under certain circumstances
Bonds may have a stated maturity or be perpetual
Dual-Currency bonds pay the interest and principal in different
currencies, and the exchange rate can be fixed at issue or floating
Bonds with warrants come with detachable coupons that allow investors
to either purchase common stock, purchase additional debt at the same
price and yield of the original issue, or exchange one currency for another
Step-up and step-down bonds allow the coupon to change depending on
some event such as a change in the issuer’s credit rating

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Non-US Government Bond Markets

Japanese government securities (JGBs) offered in 2-, 3- and 4-year

coupon issues, 5-year zero-coupon and long-dated coupon issues
Germany issues Bunds with 8-30 year maturities and Bobls with a 5-year
maturity
Since the 1990s, the start of the European Monetary Union has resulted
in a government bond market that exceeds the size of the U.S. treasury
market
Methods of distribution
Regular calendar/Dutch auction where the yield (price) is allocated
starting from the lowest yield (highest price) to the highest (lowest price)
Regular calendar/minimum-price offering - US Treasury system
Ad hoc system happens when the funding needs and market conditions
are appropriate – UK offers its gilts this way
Tap system is where previous outstanding issues are reopened with an
additional offering

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Sovereign Bond Ratings and Emerging Market Bonds
Unlike the US Treasury market which is not rated, issues of other
national governments are
Rating incorporate economic and political risk
Economic risk
Includes economic growth, inflation and unemployment
Includes monetary and fiscal policies
Because interest is paid in US dollars, rating agencies need to consider the
impact of a currency devaluation on the issuing country’s ability to service
debt
Political risk
Stability and legitimacy of political institutions
Transparency in economic policy decisions
Public security and geopolitical risk
Emerging market bonds
Includes Latin America, Eastern European and Asia (excluding Japan)
Government issue Eurobonds, global bonds, and to a much lesser extent
Brady bonds (bonds that represent a restructuring of nonperforming bank
loans of governments to marketable securities)

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