Treasury Corporate and Municipal Markets Finance 284 Analysis

Treasury, Corporate, and Municipal Markets Finance 284 Analysis of Fixed Income Securities Drake Fin 284 DRAKE UNIVERSITY

Treasury Securities Drake University Fin 284 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

Current US public Debt Drake University Fin 284 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 Total $2, 954, 166, 299, 393. 72 $7, 001, 852, 607, 623. 35 http: //www. publicdebt. treas. gov/opdpdodt. htm

Interest on the Public Debt December November October Drake University Fin 284 Interest Expense FISCAL Year 2004 $ 82, 435, 960, 974. 56 19, 292, 044, 501. 20 13, 311, 682, 915. 94 FISCAL Year Total $ 115, 039, 688, 391. 70 http: //www. publicdebt. treas. gov/opdint. htm

Treasury Securities Drake University Fin 284 Discount securities (Bills) and Coupon Securities Notes and Bonds Bills – 3 month, 6 month and 1 year Notes - maturities over 1 year and less than 10 years, Bonds - maturities over 10 years Callable Bonds – Small number outstanding, issued prior to Nov 1984. TIPS- Treasury Inflation Protection Securities

Auction Process Drake University Fin 284 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.

Auction History Drake University Fin 284 Auction procedure instituted in 1970 Prior to 1970 Subscription 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)

Auction History Drake University Fin 284 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.

Treasury Auction History Drake University Fin 284 Uniform price auctions started in 1992 with 2 year and 5 year notes Since 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.

Auction Schedule Drake University Fin 284 Security Purchase Min Multiples of 4 week bill $1, 000 13 -week bill $1, 000 26 -week bill $1, 000 2 year note $1, 000 Monthly 5 year note $1, 000 10 year note $1, 000 Feb, May, Aug, Nov 10 year infla indexed note $1, 000 www. savingsbonds. gov/of/ofauctbl. htm Schedule Weekly Jan, July, Oct

The US Treasury Auction Process* Drake University Fin 284 Two types of bids Noncompetitive - 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 CUSIP Receive Accrued interest on reopened issues * Above information and rules on future slides from: http: //www. publicdebt. treas. gov/gsruocam. htm

Dates Drake University Fin 284 Auction Announcement Date – announced when the auction is schedule approximately one to two weeks prior to the auction Auction 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

Noncompetitive Bids Position Limits Drake University Fin 284 Includes individuals buying directly (limited to $5, 000 for notes, $1, 000 in value for bills and nonpublic purchases from Fed Res etc. ) Must be received by Noon EST on the auction day

Competitive Bids – Auction Participation and Position Limits Drake University Fin 284 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 decimals Net 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 offering Net long position determined ½ hour prior to closing. Bids must be submitted by 1: 00 pm EST on Auction day

The US Treasury Auction Process Drake University Fin 284 Limits Bidders 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

The Treasury Auction Process Drake University Fin 284 The Treasury announces $ amount to be auctioned, date of auction and maturities Deduct noncompetitive bidders and nonpublic purchases the rest sent to competitive bidding Starting 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.

The Treasury Auction Process Drake University Fin 284 Bidders at the stop yield awarded a % of the amount desired, everyone else receives full amount

Example of an Auction Drake University Fin 284 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. 480 Stop Yield = 4. 48 If bid at stop Yield you receive 3/12 = or 25% of the amount bid for.

Auction Assessment Process Drake University Fin 284 Tail Difference 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 Ratio The ratio of the amount of securities bided for to the amount awarded provides information about the demand for the security. % of non competitive bidders Measures what portion of offer went to competitive bid and what portion didn’t. Usually fairly small.

Example Results and offering (from Handout) Drake University Fin 284 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. 51 Tail = 3. 26% – 3. 24% =. 02% or 2 Bp http: //www. publicdebt. treas. gov/of/ofaucrt. htm

Example Results and offering (handout ) Drake University Fin 284 26 week Bills 1/12/04 Bid to Cover Ratio = 2. 05 Lower than the 5 year notes Tail =. 95% -. 94% =. 01% 1 Bp smaller than 5 year note. Bidders at stop yield received 69. 08% of their bid Federal Reserve help 16 B in addition to offering. http: //www. publicdebt. treas. gov/of/ofaucrt. htm

Rationale for Single Price Auction Drake University Fin 284 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 markups Broader distribution of auction awards Response to uncertainty in multiple price auctions is an increase in multiple bids

When Issued Trading Drake University Fin 284 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.

When Issued Trading Drake University Fin 284 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.

When Issued Trading Drake University Fin 284 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 screens Dealers are not sure that they will receive the entire amount for which they bid. Provides an opportunity for trading on private information

When Issued Trading Drake University Fin 284 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”

WI Trading Drake University Fin 284 Example Dealer 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)

Evidence on Single Price Auctions from the WI Market Drake University Fin 284 Nyborg and Sundaresan, 1996 In single price auction market the volatility of WI rates is higher prior to announcement of auction results then decreases. Opposite is true for discriminatory auction.

Evidence part 2 – Treasury Studies Drake University Fin 284 Average Spread between Auction Result & 1: 00 pm WI Bid Yield Security Mut Price 6/918/92 Total 9/925/98 9/92 -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 3 year 0. 50 0. 49 0. 58 0. 39 10 year 0. 56 0. 66 0. 79 0. 53 Sundaresan, 2002 & Treasury Dept 1998

Short Squeeze Drake University Fin 284 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.

Short 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) Drake University Fin 284

Squeezes and the Repo Market Drake University Fin 284 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

Squeeze and the Repo Market Drake University Fin 284 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”

Squeeze and the Repo Rate Drake University Fin 284 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.

Drake Empirical Evidence Drake University Fin 284 Repo Rates: General Collateral–Special Rate 19871991 Period 2 yr 3 yr 5 yr 7 yr 10 yr 30 yr # of Auctions 57 19 23 18 29 16 Mean 56. 57 47. 20 67. 39 56. 22 96. 94 69. 47 107. 4 110. 3 130. 6 105. 8 Standard Dev 82. 90 87. 13 2 1 8 2 T-Stat 18. 25 19. 51 21. 03 21. 90 25. 42 22. 22 Sundaresan, 1994, J of FI

Drake Empirical Evidence Drake University Fin 284 Repo Special Rate – Collateral Rate during Russian Currency Crisis (in basis points) 2 yr Precrisis 7/97 -8/98 Crisis 8/98 – 11/98 Post crisis 11/98 -10/99 Full Sample 5 yr 10 yr 30 yr 21. 0 76. 9 165. 8 120. 6 52. 8 126. 1 115. 6 211. 1 35. 3 75. 0 200. 3 120. 1 30. 4 81. 8 173. 9 130. 8 Sundaresan 2002, FRBNY EPR 4/2000

Some Pricing Issues Drake University Fin 284 Day Count Conventions Used to determine the interest earned between two points in time Useful in calculating accrued interest Specified as X/Y X = the number of days between the two dates Y = The total number of days in the reference period

Day Count Conventions Day Count Convention Market Used US Treasury Bonds Corporate and Municipal Bonds US T-Bills & money Market Instruments Drake University Fin 284

Price Quotes – Notes and Bonds Drake University Fin 284 Prices are given as a % of par value (assuming 100 par) and given in 1/32 For example the price of 94 -14 would imply a price of $94 14/32 per $100 If a + follows the quote 1/64 is added. A price of 94 -14+ would imply $94 29/64 per $100

Price Quotes for Treasury Bills Drake University Fin 284 Let Yd = annualized yield, D = Dollar Discount F= Face Value, t = number of days until maturity Price = F -D

Price 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 Drake University Fin 284

Accrued Interest Drake University Fin 284 When purchasing a bond between coupon payments the purchaser must compensate the owner for interest earned, but not received, since the last coupon payment

STRIPS Drake University Fin 284 Separate Trading of Registered Interest and Principle Securities (1985). Available on all bonds In 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.

STRIPS Drake University Fin 284 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

STRIPS example Drake University Fin 284 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.

Tax Treatment of Strips Drake University Fin 284 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.

Federal Agency Securities Drake University Fin 284 Federally related Institutions Arms 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

Government Sponsored Agencies Drake University Fin 284 Privately owned, government sponsored entities. Created to lower the cost of capital for a specific sector Generally issue two types of notes and debt

GSE’s Drake University Fin 284 Debt and mortgage backed securities are exempt from SEC registration Agencies are exempt from state and local taxes Treasury can purchase up to $2. 2 B of FNMA and $4 B of FHLB via line of credit Banks can make unlimited investment in debt issued by GSE’s GSE securities are eligible as collateral for public deposits and for loans from the Fed

GSE’s continued Drake University Fin 284 GSE securities are lawful investments for federal fiduciary and public funds GSE’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

GSE – Federal Farm Credit Bank Responsible for the credit market in the agricultural sector. Three entities: Federal Land Bank Federal Intermediate Credit Bank for Cooperatives Issues “joint and several obligations” Issues short term notes and debt Drake University Fin 284

GSE- Federal Home Loan Bank Drake University Fin 284 FHLB originally established to regulate savings and loans. No longer the primary regulator Largest issuer of agency debt

Federal National Mortgage Association Drake University Fin 284 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.

GSE – Government National Mortgage Association Drake University Fin 284 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.

Federal Home Loan Mortgage Corporation Drake University Fin 284 Founded in 1970 Freddie Mac is responsible for providing support for conventional (not guaranteed by US gov’t ) mortgages.

GSEStudent Loan Marketing Association Drake University Fin 284 Provides liquidity for the participants in the student loan programs. Started issuing notes backed by student loans 1995.

Resolutions Trust Corporation Drake University Fin 284 Responsible for liquidating or bailing out troubled savings and loan associations. Obtained funding by issuing securities backed by treasury securities.

GSE Credit Risk Drake University Fin 284 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.

Agency Usage Drake University Fin 284

Federal Agency Debt Issuance (total in $ billions) Drake University Fin 284 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

Growth in Agency Securities Drake University Fin 284 One concern is that the recent growth has started to “crowd out” corporate debt. Forces corporate debt to pay a higher rate Public policy perspective.

Types of Agency Securities Drake University Fin 284 Mortgage Passthrough Mortgages 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 Obligation The investor above is exposed to prepayment risk, the CMO structures the timing of the prepayments into tranches

Municipal Securities Drake University Fin 284 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 revenue Revenue Bonds – repayment of principal and interest payments are made by revenue earned by the project financed by the project

Long Term vs. Short term uses Drake University Fin 284 Short term Used in anticipation of the receipt of funds from taxes or bond issues Allow the coverage of seasonal or temporary imbalances Long Term Main means of financing capital improvement and LT budget deficits.

Types and Features of Municipal Securities Drake University Fin 284 Tax Backed Debt Issued by cities, counties etc… and secured by tax revenue Differences in bonds result from difference in taxing power and the revenue pledged to pay the commitments of the debt.

General Obligation Debt Drake University Fin 284 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)

Appropriations Backed Obligations Drake University Fin 284 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)

Credit Enhancement Programs Drake University Fin 284 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.

Revenue Bonds Drake University Fin 284 The revenue produced from a project are pledged to the bondholder. Often used to finance airports, colleges and universities, sports complexes, toll roads etc…

Hybrid and Special Bond Structures. Drake University Fin 284 Insured bonds Backed by the issuers revenues and also by insurance polices written by commercial insurance companies.

Hybrids continued Drake University Fin 284 Prerefunded Bonds The 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

Asset backed bonds Drake University Fin 284 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…

Municipal Notes Drake University Fin 284 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.

Redemption Features Drake University Fin 284 Serial Maturity Structure A portion of the debt is retired each year. Term maturity structure Principle 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.

Municipal Bond Ratings Drake University Fin 284 Credit risk Often 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.

Muni Bond Ratings Drake University Fin 284 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.

Rating Criteria The ratings process is very similar to corporate ratings Debt burden Political discipline Taxes and other revenues available Socioeconomic environment Drake University Fin 284

Tax risks Drake University Fin 284 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.

The Primary Market Drake University Fin 284 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.

The secondary market Drake University Fin 284 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 lots Usually the price is quoted as a % of par value (based on 100)

Yields on Munis Drake University Fin 284 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.

Regulation Drake University Fin 284 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.

Reasons for the exemption 1. 2. 3. 4. Drake University Fin 284 To promote harmonious relations between different levels of gov’t Absence of major struggles. Sophistication of investors Lack of defaults The market functioned well until the 1970’s when individuals started to participate in the market.

The Securiteis Act Amendment 1975 Drake University Fin 284 Broadened federal regulation Muni Securities Rulemaking Board was also established Still do not have to report but regulation is increasing.

Types of Commercial Borrowing Corporate Senior Instruments Commercial Paper Medium Term Notes Drake University Fin 284

Commercial Paper Drake University Fin 284 Unsecured short term borrowing – An alternative to bank borrowing March 92 March 97 March 02 millions of $ total outstanding non financial 137, 857. 40 389, 559. 30 187, 705. 30 642, 717. 70 188, 752. 80 1, 169, 361. 00

History of Commercial paper Drake University Fin 284 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.

CP – Market Facts Drake University Fin 284 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.

Issuers of Commercial Paper Drake University Fin 284 Financial firms offer 78% of all commercial paper Captive Finance Companies Financing arms of industrial firms (GMAC for example) Bank-related finance companies Subsidiary of a bank that provides loans that enables business and individuals to borrow Independent finance companies Smaller portion of the market (non financial related firms)

Hybrids of Commercial paper Drake University Fin 284 Small firms have also been active in the market LOC 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 outstanding.

Placement of Commercial Paper Drake University Fin 284 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.

Medium Term Notes Drake University Fin 284 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.

Drake The Primary Market Drake University Fin 284 Rates often posted as a spread to Treasury markets. maturity yield 9 to 12 mos 12 to 18 mos to 2 2. 05 y 2 y to 5 y 2. 39 5 y to 7 yr 3. 56 Spread Treas Mat - Yield 25 1 yr 1. 8 35 60 2 yr 5 yr 2. 04 2. 96

Structured MTN’s Drake University Fin 284 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.

The High Yield Debt Market Drake University Fin 284 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)

Rating Migration Corporate Debt Drake University Fin 284

Financial Distress Drake University Fin 284 Implies that the firm has stopped making payments on its debt. It has either formally or informally declared bankruptcy

Federal bankruptcy law Drake University Fin 284 Chapter 1, 2, 3 general provisions dealing with the other chapters. Chapter 9 Financially distressed municipalities Chapter 12 Family owned firms Chapter 15 Appointment of trustees. Chapter 7 and Chapter 11 of the bankruptcy code are the most important to business Chapter 11 -- When a firm attempts to reorganize with the supervision of a bankruptcy court. Chapter 7 -- Instigates formal proceedings to liquidate the firm

Formal Reorganization Drake University Fin 284 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.

Common Pool Problem Drake University Fin 284 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.

Holdout Problem Drake University Fin 284 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.

Chapter 11 has other Advantages: Drake University Fin 284 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.

Liquidation in Bankruptcy (Chapter 7) 1) 2) 3) Drake University Fin 284 The primary advantages of filing for Chapter 7 bankruptcy are: It provides a safeguard against debtor fraud It provides for an equitable distribution of assets It allows insolvent debtors to discharge all of their debt obligations and start over.

The priority of claims under Chapter 7 Drake University Fin 284 1) Past due Property taxes 2) 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)

Drake University 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

Drake University 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.

Bonds in default -- Is patience a virtue? Drake University Fin 284 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.

56 defaulted bonds for 36 companies between 1982 and 1994 Drake University Fin 284

Returns from holding the bonds : Drake University Fin 284

Compare the returns to what return would have earned elsewhere. Drake University Fin 284

There was a large amount of variation among the firms: Drake University Fin 284

Characteristics of the winners Drake University Fin 284 Firm Size Top 10 Average $2 Billion in Assets and $2. 5 Billion in Sales Bottom 7 Average $0. 7 Billion in Assets and $0. 4 Bil in Sales Brand Names Interco (Converse, Floresheim, Broyhill and Lane) Federated Department Stores (Bloomingdale’s) Charter Medical Public Service of New Hampshire Independent of Industry

Asset Backed Securities Drake University Fin 284 Creating a special purpose vehicle or corporation and issuing a security under the name of the SPV Allows Corporation to borrow at a lower cost than the entire firm by increasing the credit rating of the issue.

Other Credit Enhancement Drake University Fin 284 External Credit Enhancement – third party guarantees of payment – subject to credit risk of the third party Corporate guarantee Letter of Credit Bond Insurance Internal Credit Enhancement Reserve Funds Overcollateralization Senior/ subordinate structures

International Bonds Drake University Fin 284 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 – Japan Bulldog Bond – United Kingdom Rembrandt Bond – Netherlands Matador Bond – Spain

Foreign Bonds Drake University Fin 284 The regulations of the country where the bonds are issued govern the structure and trading of the bonds and can include: Restrictions on bond structures Size of issue Waiting periods prior to issue being brought to market Disclosure and reporting requirements Underwriting restrictions

Eurobond Characteristics Drake University Fin 284 Underwritten by an international syndicate Offered to investors in multiple countries at the same time Not under the jurisdiction of a single country Unregistered US and Canada less restrictive on issues denominated in their currency compared to most other countries (Eurodollar bonds)

Global Bonds Drake University Fin 284 Issued and traded in both the US Yankee market and Eurobond market Commonly held beliefs about issuer characteristics Consistent demand for funds Total amount raised needs to be large (excess of $3 Billion) High credit rating of issuer

Sovereign Debt Drake University Fin 284 Debt issued by federal governments (US debt is sovereign debt for the US). Backed by the individual governments taxing authority May be sold either single price or multiple price auctions, or other methods Two credit ratings Local currency rating Foreign currency debt rating