CH-7-8 Corporate Debt Instruments – Bond Markets, Analysis and Strategies : Book Guide

This Document Contains Chapters 7 to 8 CHAPTER 7 CORPORATE DEBT INSTRUMENTS CHAPTER SUMMARY Corporate debt instruments are financial obligations of a corporation that have priority over its common stock and preferred stock in the case of bankruptcy. In this chapter we discuss the seniority of debt in a firm’s capital structure, bankruptcy and creditor rights. We examine the following corporate debt instruments: corporate bonds, medium-term notes, commercial paper, and bank loans. We also look at corporate default risk, downgrade risk and credit spread risk. SENIORITY OF DEBT IN A CORPORATION’S CAPITAL STRUCTURE Issuers of corporate debt obligations are categorized into the following five sectors: public utilities, transportation, banks/finance, industrials, and Yankee and Canadian. The latter includes dollar-denominated bonds issued in the United States by sovereign governments, non-U.S. local governments, non-U.S. corporations, and foreign branches of U.S. corporations. The capital structure of the firm is the way in which the firm’s management has elected to finance itself. In broad terms, the capital structure of a firm consists of common stock, preferred stock, and debt. In capital structure decision-making, the issue is whether there is an optimal capital structure. Although optimal capital structure and the optimal debt structure is important in corporate finance and in credit risk modeling, our focus here is to merely describe the seniority structure. The different creditor classes are classified as follows: senior secured debt, senior unsecured debt, senior subordinated debt, and subordinated debt. Senior secured debt is backed by or secured by some form of collateral beyond the issuer’s general credit standing. Either real property (using a mortgage) or personal property may be pledged to offer security. A mortgage bond grants the creditor a lien against the pledged assets; that is, the creditor has a legal right to sell the mortgaged property to satisfy unpaid obligations that are owed. In practice, foreclosure and sale of mortgaged property is unusual. To satisfy the desires of bondholders for security, they will pledge stocks, notes, bonds or whatever other kind of obligations they own. Bonds secured by such assets are called collateral trust bonds. Senior unsecured debt is debt that is not secured by a specific pledge of property, but that does not mean that the creditors holding this type of debt have no claim on property of issuers or on their earnings. The bonds that are issued with priority against claims are commonly referred to as debenture bonds. Creditors holding subordinated debt rank after senior secured creditors, after senior unsecured creditors, and often after some general creditors in their claim on assets and earnings. The class of debt that has seniority within the ranks of subordinated debt is referred to as senior subordinated debt. BANKRUPTCY AND CREDITOR RIGHTS The U.S. bankruptcy law gives debtors who are unable to meet their debt obligations a mechanism for formulating a plan to resolve their debts through an allocation of their assets among their creditors. One purpose of the bankruptcy law is to set forth the rules for a corporation to be either liquidated or reorganized. The liquidation of a corporation means that all the assets will be distributed to the holders of claims of the corporation and no corporate entity will survive. A new corporate entity results in a reorganization. A company that files for protection under the bankruptcy act generally becomes a debtor in possession (DIP), and continues to operate its business under the supervision of the court. The bankruptcy act is composed of 15 chapters, each chapter covering a particular type of bankruptcy. Of particular interest to us are two of the chapters, Chapter 7 and Chapter 11. Chapter 7 deals with the liquidation of a company. Historically, liquidations have been less common than Chapter 11 filings. Chapter 11 deals with the reorganization of a company. When a company is liquidated, creditors receive distributions based on the absolute priority rule to the extent that assets are available. The absolute priority rule is the principle that senior creditors are paid in full before junior creditors are paid anything. In liquidations, the absolute priority rule generally holds. In contrast, there is a good body of literature that argues that strict absolute priority has not been upheld by the courts or the Securities and Exchange Commission (SEC). Studies of actual reorganizations under Chapter 11 have found that the violation of absolute priority is the rule rather the exception. Corporate Debt Ratings Professional money managers use various techniques to analyze information on companies and bond issues in order to estimate the ability of the issuer to live up to its future contractual obligations. This activity is known as credit analysis. Some large institutional investors and many banks have their own credit analysis departments. Other institutional investors do not do their own analysis but instead rely primarily on nationally recognized rating companies that perform credit analysis and issue their conclusions in the form of ratings. The three major rating companies are (1) Moody’s Investors Service, (2) Standard & Poor’s Corporation, and (3) Fitch Ratings. In all three systems, the term high grade means low credit risk, or conversely, high probability of future payments. Debt obligations that are assigned a rating in the top four categories are said to be investment-grade. Issues that carry a rating below the top four categories are said to be noninvestment-grade, or more popularly referred to as high-yield debt or junk debt. Thus, the corporate debt market can be divided into two sectors based on credit ratings: the investment-grade and noninvestment-grade markets. Rating agencies monitor the bonds and issuers that they have rated. CORPORATE BONDS Corporate bonds are debt obligations issued by corporations. Most corporate bonds are term bonds; that is, they run for a term of years, and then become due and payable. Generally, obligations due in under 10 years from the date of issue are called notes. Corporate borrowings due in 20 to 30 years tend to be referred to as bonds. Some corporate bond issues are arranged so that specified principal amounts become due on specified dates. Such issues are called serial bonds. Provisions for Paying Off Bonds Prior to Maturity Some corporate bond issues have call provision granting the issuer an option to buy back all or part of the issue prior to the stated maturity date. Some issues specify that the issuer must retire a predetermined amount of the issue periodically. Various types of corporate call provisions are discussed below. The call price that the price that the issuer must pay to retire the issue and may be a single call price or a call schedule that sets forth a call price based on when the issuer exercises the option to call the bond. The call price is referred to as the regular price or general redemption price because there may also be a special redemption price for debt redeemed through the sinking fund and through other provisions such as with the proceeds from the confiscation of property through the right of eminent domain. At the time of issuance, a callable bond issue may contain a restriction that prevents the issuer from exercising the call option for a specified number of years. Callable bonds with this feature are said to have a deferred call and the date at which the issue may first be called is said to be the first call date. If, instead, a callable bond does not have any protection against early call, then it is said to be a currently callable issue. Refunding a bond issue means redeeming bonds with funds obtained through the sale of a new bond issue. Bonds that are noncallable for the issue’s life are more common than bonds that are nonrefundable for life but otherwise callable. Sometimes investors are confused by the terms noncallable and nonrefundable. Call protection is much more absolute than refunding protection. The term refunding means to replace an old bond issue with a new one, often at a lower interest cost. Although there may be certain exceptions to absolute or complete call protection in some cases (such as sinking funds and the redemption of debt under certain mandatory provisions), a noncallable bond still provides greater assurance against premature and unwanted redemption than does refunding protection. A number of companies issue long-term debt with extended call protection, not refunding protection. A number are noncallable for the issue’s life. For such issues the prospectus expressly prohibits redemption prior to maturity. These noncallable-for-life issues are referred to as bullet bonds. Bonds can be called in whole (the entire issue) or in part (only a portion).When less than the entire issue is called, the specific bonds to be called are selected randomly or on a pro rata basis. With a traditional call provision, the call price is fixed and is either par or a premium over par based on the call date. With a make-whole call provision, the payment when the issuer calls a bond is determined by the present value of the remaining payments discounted at a small spread over a maturity-matched Treasury yield. The specified spread which is fixed over the bond’s life is called the make-whole premium. A corporate bond issue may require the issuer to retire a specified portion of an issue each year. This is referred to as a sinking fund requirement. This kind of provision for repayment of corporate debt may be designed to liquidate all of a bond issue by the maturity date, or it may be arranged to pay only a part of the total by the end of the term. If only a part is paid, the remainder is called a balloon maturity. The purpose of the sinking fund provision is to reduce credit risk. Some bond issues include a provision that grants the issuer the option to retire more than the amount stipulated for sinking fund retirement. This is referred to as an accelerated sinking fund provision. Usually, the sinking fund call price is the par value if the bonds were originally sold at par. When issued at a price in excess of par, the call price generally starts at the issuance price and scales down to par as the issue approaches maturity. Covenants The promises of corporate bond issuers and the rights of investors who buy them are set forth in great detail in contracts called bond indentures. The covenants or restrictions on management are important in the analysis of the credit risk of a corporate bond issue as well as for bank loans. Special Structures for High-Yield Corporate Bonds Bond issues in the high-yield corporate bonds (junk bonds) sector of the bond market may have been rated (1) noninvestment grade at the time of issuance or (2) investment grade at the time of issuance and downgraded subsequently to noninvestment grade. Bond issues in the first category are referred to as original-issue high-yield bonds. Bonds issues in the second category are either issues that have been downgraded because the issuer voluntarily significantly increased its use of debt as a result of a leveraged buyout or a recapitalization, or issues that have been downgraded for other reasons. The latter issues are commonly referred to as fallen angels. In a leverage buyout (LBO) or a recapitalization, the heavy interest payment burden that the corporation assumes places severe cash flow constraints on the firm. To reduce this burden, firms involved in LBOs and recapitalizations have issued bonds with deferred coupon structures that permit the issuer to avoid using cash to make interest payments for a period of three to seven years. There are three types of deferred coupon structures: (1) deferred-interest bonds, (2) step-up bonds, and (3) payment-in-kind bonds. Deferred-interest bonds are the most common type of deferred coupon structure. These bonds sell at a deep discount and do not pay interest for an initial period, typically from three to seven years. Step-up bonds do pay coupon interest, but the coupon rate is low for an initial period and then increases (“steps up”) to a higher coupon rate. Finally, payment-in-kind (PIK) bonds give the issuer an option to pay cash at a coupon payment date or give the bondholder a similar bond. Another structure found in the high-yield bond market is one that requires the issuer to reset the coupon rate so that the bond will trade at a predetermined price. Generally, the coupon rate at reset time will be the average of rates suggested by a third part, usually two banks. The new rate will then reflect (1) the level of interest rates at the reset date, and (2) the credit spread the market wants on the issue at the reset date. This structure is called an extendable reset. Accrued Interest In addition to the agreed-upon price, the buyer must pay the seller accrued interest. Each month in a corporate bond year is 30 days, whether it is February, April, or August. The corporate calendar is referred to as “30/360.” Secondary Market for Corporate Bonds As with all bonds, the principal secondary market for corporate bonds is the over-the-counter market. The major concern is market transparency. Efforts to increase price transparency in the U.S. corporate debt market resulted in the introduction of a mandatory reporting of over-the-counter secondary market transactions for corporate bonds that met specific criteria. Historically, corporate bond trading has been an OTC market conducted via telephone and based on broker-dealer trading desks, which take principal positions in corporate bonds in order to fulfill buy and sell orders of their customers. There has been a transition away from this traditional form of bond trading and toward electronic trading. There are the following five types of electronic corporate bond trading systems: auction systems, cross-matching systems, interdealer systems, multi-dealer systems and single-dealer systems. Auction systems allow market participants to conduct electronic auctions of securities offerings for both new issues in the primary markets and secondary market offerings. Cross-matching systems bring dealers and institutional investors together in electronic trading networks that provide real-time or periodic cross-matching sessions. Interdealer systems allow dealers to execute transactions electronically with other dealers via the anonymous services of “brokers’ brokers.” Multi-dealer systems allow customers with consolidated orders from two or more dealers that give the customers the ability to execute from among multiple quotes. Multi-dealer systems, also called client-to-dealer systems, typically display to customers the best bid or offer price of those posted by all dealers. Single-dealer systems permit investors to execute transactions directly with the specific dealer desired; this dealer acts as a principal in the transaction with access to the dealer by the investor, which increasingly has been through the Internet. Private-Placement Market for Corporate Bonds Securities privately placed are exempt from registration with the SEC because they are issued in transactions that do not involve a public offering. SEC Rule 144A allows the trading of privately placed securities among qualified institutional buyers. Not all private placements are Rule 144A private placement. Consequently, the private-placement market can be divided into two sectors. First is the traditional private-placement market, which includes non-144A securities. Second is the market for 144A securities. MEDIUM-TERM NOTES A medium-term note (MTN) is a corporate debt instrument, with the unique characteristic that notes are offered continuously to investors by an agent of the issuer. Investors can select from several maturity ranges: nine months to one year, more than one year to 18 months, more than 18 months to two years, and so on up to 30 years. Borrowers have flexibility in designing MTNs to satisfy their own needs. They can issue fixed- or floating-rate debt. The coupon payments can be denominated in U.S. dollars or in a foreign currency. When the treasurer of a corporation is contemplating an offering of either an MTN or corporate bonds, there are two factors that affect the decision. The most obvious is the cost of the funds raised after consideration of registration and distribution costs. This cost is referred to as the all-in-cost of funds. The second is the flexibility afforded to the issuer in structuring the offering. Medium-term notes differ from corporate bonds in the manner in which they are distributed to investors when they are initially sold. When they are offered, MTNs are usually sold in relatively small amounts on a continuous or an intermittent basis, whereas corporate bonds are sold in large, discrete offerings. Structured Notes MTNs created when the issuer simultaneously transacts in the derivative markets (such as a swap or an option) in order to created the security are called structured notes. By using the derivative markets in combination with an offering, borrowers are able to create investment vehicles that are more customized for institutional investors to satisfy their investment objectives, even though they are forbidden from using swaps for hedging. Because of the small size of a structured note offering and the flexibility to customize the offering in the swap market, investors can approach an issuer through its agent about designing a security for their needs. This process of customers inquiring of issuers or their agents to design a security is called a reverse inquiry. Structured notes include inverse floating-rate notes, equity-linked notes, commodity-linked notes, currency-linked notes and credit-linked notes. We described inverse floating-rate notes in Chapter 1. Below we briefly describe the others. An equity-linked note (ELN) differs from a conventional bond because the principal, coupon payment, or both are linked to the performance of an established equity index, a portfolio of stocks, or an individual stock. The typical ELN is economically equivalent to a portfolio consisting of a zero-coupon bond and a call option on the equity index that is the ELN’s reference asset. The payments of a commodity-linked note are tied to the price performance of a designated commodity (such as crude oil, heating oil, natural gas, or precious metal) or a basket of commodities. At the maturity date, the investor receives the initial principal amount plus a return based the percentage change in the price of the designated commodity or basket of commodities. A credit-linked note (CLN) is a security whose credit risk is linked to a second issuer (called the reference issuer), and the return is linked to the credit performance of the reference issuer. A CLN can be quite complicated but the basic CLN is just like a standard bond as it has a coupon rate (fixed or floating), maturity date, and a maturity value. A currency-linked note pays a return linked to a global foreign-exchange index. Typically, this structured note is short-term, paying out a fixed minimum rate of interest determined by the movement in foreign exchange rates over the life of the note. On the maturity date, the note pays the initial principal amount plus return, if any. For the above structured notes, there is a negative return for the underlying reference asset or index, the investor might receive less than the initial investment. Structured notes that guarantee the return of principal (i.e., guarantees a minimum return on the reference asset or index of zero) are called principal-protected notes. COMMERCIAL PAPER Commercial paper is a short-term unsecured promissory note that is issued in the open market and that represents the obligation of the issuing corporation. The minimum round-lot transaction is $100,000, although some issuers will sell commercial paper in denominations of $25,000. In the United States, commercial paper almost always ranges in maturity from one day to 270 days. The reason that the maturity of commercial paper does not exceed 270 days because special provisions in the 1933 act exempt commercial paper from the costs of registration as long as the maturity does not exceed 270 days. To pay off holders of maturing paper, issuers generally use the proceeds obtained by selling new commercial paper. This process is often described as “rolling over” short-term paper. The risk that the investor in commercial paper faces is that the issuer will be unable to issue new paper at maturity. As a safeguard against this rollover risk, commercial paper is typically backed by unused bank credit lines. There are three types of financial companies: captive finance companies, bank-related finance companies, and independent finance companies. Captive finance companies are subsidiaries of equipment manufacturing companies. A bank holding company may have a subsidiary that is a finance company, which provides loans to enable individuals and businesses to acquire a wide range of products. Independent finance companies are those that are not subsidiaries of equipment manufacturing firms or bank holding companies. Directly Placed versus Dealer-Placed Paper Commercial paper is classified as either direct paper or dealer-placed paper. Directly placed paper is sold by the issuing firm directly to investors without the help of an agent or an intermediary. Dealer-placed commercial paper requires the services of an agent to sell an issuer’s paper. The agent distributes the paper on a best efforts underwriting basis by commercial banks and securities houses. Tier-1 and Tier-2 Paper The Investment Company Act of 1940 limits the credit risk exposure of money market mutual funds by restricting their investments to “eligible” paper. Eligibility is defined in terms of the credit ratings. Tier-1 paper is defined as eligible paper that is rated “1” by at least two of the rating agencies; tier-2 paper is defined as eligible paper that is not a tier-1 security. BANK LOANS Bank loans to corporate borrowers are divided into two categories: investment-grade loans and leveraged loans. An investment-grade loan is a bank loan made to corporate borrowers that have an investment-grade rating. A leveraged loan is a bank loan to a corporation that has a below-investment-grade rating. Syndicated Bank Loans A syndicated bank loan is one in which a group (or syndicate) of banks provides funds to the borrower. Syndicated bank loans are used by borrowers who seek to raise large amounts of funds in the loan market rather than through the issuance of securities. These bank loans are called senior bank loans because of their priority position over subordinated lenders (bondholders) with respect to repayment of interest and principal. The interest rate on a syndicated bank loan is a rate that periodically resets at the reference rate plus a spread. A syndicated loan is typically structured so that it is amortized according to a predetermined schedule, and repayment of principal begins after a specified number of years. Structures in which no repayment of the principal is made until the maturity date can be arranged and are referred to as bullet loans. A syndicated loan is arranged by either a bank or a securities house. Syndicated loans are distributed by two methods: assignment or participation. The holder of a loan who is interested in selling a portion can do so by passing the interest in the loan by the method of assignment. In this procedure, the seller transfers all rights completely to the holder of the assignment, now called the assignee. The assignee is said to have privity of contract with the borrower. A participation involves a holder of a loan “participating out” a portion of the holding in that particular loan. The holder of the participation does not become a party to the loan agreement and has a relationship not with the borrower but with the seller of the participation. Secondary Market for Syndicated Bank Loans While at one time, a bank or banks who originated loans retained them in their loan portfolio, today those loans can be traded in the secondary market or securitized to create collateralized loan obligations and therefore require periodic marking to market. The Loan Syndications and Trading Association (LSTA) has helped foster the development of a liquid and transparent secondary market for bank loans by establishing market practices and settlement and operational procedures. This association provides dealer-quote based mark-to-market prices. The LSTA in conjunction with Standard & Poor’s Leveraged Commentary & Data (LCD) has developed a leveraged loan index to gauge the performance of the different sectors of the syndicated loan market. High-Yield Bond versus Leveraged Loans Leveraged loans are bank loans in which the borrower is a non-investment-grade borrower. Leveraged loans and high-yield bonds are alternative sources of debt by noninvestment-grade borrowers. Collateralized Loan Obligations Leveraged loans have been pooled and used as collateral for the issuance of a collateralized loan obligation (CLO). A CLO is created using the securitization technology described in later chapters. A CLO is a special purpose vehicle (SPV) that issues debt and equity and from these funds raised invests in a portfolio of leveraged loans. The entity responsible for managing the portfolio of leverage loans (i.e., the collateral) is the collateral manager. In addition to the bond classes, there is a security called the equity tranche that is entitled to receive the residual cash flows as explained later. The liability structure of a CLO is referred to as its capital structure. These bond classes are commonly labeled Class A, Class B, Class C, and so forth going from top to bottom of the capital structure in terms of their priority and their credit rating. Class A in the capital structure, the one with the AAA rating, is referred to as the senior bond class. The other three bond classes are referred to as subordinate bond classes. In a typical CLO, the coupon rate floats with a reference rate (most commonly LIBOR). The cash flow credit structure is the dominant credit enhancement mechanism in most CLOs. To understand the cash flow credit structure, the rules for the distribution of collateral interest and collateral principal must be understood. These rules for the distribution of collateral interest and collateral principal, referred to as the cash flow waterfalls, specify the order in which bond classes get paid and by doing so enforce the seniority of one CLO creditor over another. Another key feature of a CLO is the coverage tests set forth in the indenture. They are important because the outcomes of these tests can result in a diversion of cash that would have gone to the subordinated bond classes and redirect it to senior bond classes. In addition, it is important to understand that there is a period of time in which collateral principal is not distributed to the bond classes or the equity tranche but instead reinvested by the collateral manager by purchasing additional loans. This time period is referred to as the reinvestment period. CORPORATE DEFAULT RISK For a corporate debt obligation, default risk is the risk that the corporation issuing the debt instrument will fail to satisfy the terms of the obligation with respect to the timely payment of interest and repayment of the amount borrowed. To assess the potential return from investing in corporate debt obligations, more than just default rates are needed. The reason is that default rates by themselves are not of paramount significance. Holders of defaulted bonds typically recover a percentage of the face amount of their investment, this is called the recovery rate. Therefore, an important measure in evaluating investments in corporate debt is the default loss rate, which is defined as: Default loss rate = Default rate × (100% – Recovery rate) As with default rates, there are different methodologies that can be employed for computing recovery rates. Moody’s defines three security classes based on the position of creditor in the issuer’s capital structure: junior, mezzanine, and senior classes. The recovery rates for those security classes are 21% for junior classes, 58% for mezzanine classes, and 93% for senior classes. The rating agencies have services that provide other information related to defaults and recoveries that are useful to investors. For example, Moody’s publishes for speculative grade bonds and loans an expected loss rating, loss-given-default assessments (LGDA), and, for corporate family ratings, probability-of-default ratings (PDRs). Fitch and Standard & Poor’s developed recovery rating systems for corporate bonds. The recovery ratings were introduced by Standard & Poor’s in December 2003. The recovery ratings were for secured debt. In July 2005, Fitch introduced a recovery rating system for corporate bonds rated single B and below. The factors considered in assigning a recovery rating to an issue by Fitch are (1) the collateral, (2) the seniority relative to other obligations in the capital structure, and (3) the expected value of the issuer in distress. CORPORATE DOWNGRADE RISK Rating agencies monitor the debt obligations and issuers that they have rated. Corporate downgrade risk is the risk that one or more of an issue’s debt obligations will be downgraded. The rating agencies accumulate statistics on how ratings change over various periods of time. A table that specifies this information is called a rating transition matrix or rating transition table. CORPORATE CREDIT SPREAD RISK Corporate credit risk is the risk that a debt obligation’s price will decline due to an increase in the credit spread sought by the market either for individual issue, the industry, or the sector. That is, it is the risk of credit spread widening. There are two unique risks that that can change corporate credit spreads: event risk and headline risk. The difference between these two risks is as follows. In the case of event risk, upon the announcement of some event there is an almost immediate credit rating downgrade for the adversely impacted corporation, sector, or industry. Hence, event risk is tied to downgrade risk. With headline risk, the announcement results in an adverse impact on the credit spread, as with event risk, but does not result in an immediate downgrade of debt. An illustration of event risk is a corporate takeover or corporate restructuring. A specific example of event risk is the 1988 takeover of RJR Nabisco for $25 billion through a financing technique known as a leveraged buyout (LBO). The new company took on a substantial amount of debt incurred to finance the acquisition of the firm. In the case of RJR Nabisco, the debt and equity after the leveraged buyout were $29.9 and $1.2 billion, respectively. Because the corporation must service a larger amount of debt, its bond quality rating was reduced; RJR Nabisco’s quality rating as assigned by Moody’s dropped from A1 to B3. The impact of the initial LBO bid announcement on the credit spreads for RJR Nabisco’s debt was an increase from 100 basis points to 350 basis points. Event risk can have spillover effects on other firms. Consider once again the RJR Nabisco LBO. An LBO of $25 billion was considered impractical prior to the RJR Nabisco LBO, but the RJR transaction showed that size was not an obstacle, and other large firms previously thought to be unlikely candidates for an LBO became fair game resulting in an increase in their credit spread. An example of headline risk is a natural or industrial accident that would be expected to have an adverse economic impact on a corporation. To illustrate, an accident at a nuclear power plant is likely to have an adverse impact on the credit spread of the debt of the corporation that owns the plant. Just as with event risk, there may be spillover effects. KEY POINTS • Corporate bonds are debts obligating a corporation to pay periodic interest with full repayment at maturity and include corporate bonds, medium-term notes, commercial paper, bank loans, convertible corporate bond, and asset-backed securities. • The issuer sectors of the corporate debt are public utilities, transportation, banks/finance, industrials, and Yankee and Canadian. • The different creditor classes in a corporation’s capital structure include senior secured creditors senior unsecured creditors, senior subordinated creditors, and subordinated creditors. The bankruptcy law governs the bankruptcy process in the United States. Chapter 7 of the bankruptcy act deals with the liquidation of a company. Chapter 11 deals with the reorganization of a company. Creditors receive distributions based on the absolute priority rule to the extent assets are available. This means that senior creditors are paid in full before junior creditors are paid anything. Generally, this rule holds in the case of liquidations. In contrast, the absolute priority rule is typically violated in a reorganization. • The credit risk of a corporate borrower can be gauged by the quality rating assigned by the three nationally recognized rating companies. Issues rated in the top ratings of both raters are referred to as investment-grade bonds; those below the top four ratings are called noninvestment-grade bonds, high-yield bonds, or junk bonds. • Provisions for payoff off a bond issue prior to maturity include traditional call and refunding provisions, make-whole call provision, and sinking fund provisions. • The high-yield sector of the corporate bond market is the market for noninvestment grade corporate bonds. Several complex bond structures are issued in the high-yield sector of the corporate bond market. These include deferred-coupon bonds (deferred-interest bonds, step-up bonds, and payment-in-kind bonds) and extendable reset bonds. • There are five types of electronic corporate bond trading systems: auction systems, cross-matching systems, interdealer systems, Multi-dealer systems, and single-dealer systems. • Medium-term notes are corporate debt obligations offered on a continuous basis. They are registered with the SEC under the shelf registration rule and are offered through agents. The rates posted are for various maturity ranges, with maturities as short as nine months to as long as 30 years. • Medium-term notes have been issued simultaneously with transactions in the derivatives market, particularly the swap market, to create structured MTNs. These products allow issuers greater flexibility in creating MTNs that are attractive to investors who seek to hedge or undertake a market play that they might otherwise be prohibited from doing. Structured notes include inverse floating-rate notes, equity-linked notes, commodity-linked notes, currency-linked notes, and credit-linked notes. • Commercial paper is a short-term unsecured promissory note issued in the open market that represents the obligation of the issuing entity. It is sold on a discount basis. Generally, commercial paper maturity is less than 30 days. Financial and nonfinancial corporations issue commercial paper, with the majority issued by the former. Direct paper is sold by the issuing firm directly to investors without using a securities dealer as an intermediary; with dealer-placed commercial paper, the issuer uses the services of a securities firm to sell its paper. There is little liquidity in the commercial paper market. • Bank loans represent an alternative to the issuance of bonds. Bank loans to corporations are classified as investment-grade loans and leveraged bank loans. It is the latter that are sold to institutional investors and traded in a secondary market. • A collateralized loan obligation is created when leveraged bank loans are pooled and used as collateral for the issuance of debt claims with different seniority. The creation of this product uses securitization technology. • The potential return from investing in a corporate debt is impacted by both the default rate and the recovery rate or default loss rate. • In addition to providing credit ratings, the rating agencies have services that provide information related to defaults and recoveries that are useful to investors. • To help gauge downgrade risk, investors can use the rating transition matrix reported by each rating agency. • Corporate credit spread can be gauged by the historical volatility of spread changes. There are two unique risks that that can change corporate credit spreads: event risk and headline risk. ANSWERS TO QUESTIONS FOR CHAPTER 7 (Questions are in bold print followed by answers.) 1. What is the significance of a secured position if the absolute priority rule is typically not followed in a reorganization? A corporate debt obligation can be secured or unsecured. In the case of a liquidation, proceeds from a bankruptcy are distributed to creditors based on the absolute priority rule where senior claimants are paid first. For example, debtholders are paid before stockholders. However, in the case of a reorganization, the absolute priority rule rarely holds. That is, an unsecured creditor may receive distributions for the entire amount of his or her claim and common stockholders may receive something, while a secured creditor may receive only a portion of its claim. The reason is that a reorganization requires approval of all the parties. Consequently, secured creditors are willing to negotiate with both unsecured creditors and stockholders in order to obtain approval of the plan of reorganization. Even though the absolute priority rule is not typically followed, it is still significant because senior claimants can use it to exercise clout in the reorganization process to insure they get the best possible deal. Even though the amount of cash owed may not be received immediately, the bargaining process can allow for future claims on assets that might make the senior claimants better off than if the assets were just liquidated. 2. Answer the below questions. (a) What is the difference between a liquidation and a reorganization? First, there is a difference in how the absolute priority rule holds. A corporate debt obligation can be secured or unsecured. In the case of a liquidation, proceeds from a bankruptcy are distributed to creditors based on the absolute priority rule. However, in the case of a reorganization, the absolute priority rule rarely holds. That is, an unsecured creditor may receive distributions for the entire amount of his or her claim and common stockholders may receive something, while a secured creditor may receive only a portion of its claim. The reason is that a reorganization requires approval of all the parties. Consequently, secured creditors are willing to negotiate with both unsecured creditors and stockholders in order to obtain approval of the plan of reorganization. Second, there is a difference in outcome as to what happens to the company being liquidated versus the company being reorganized. The liquidation of a corporation means that all the assets will be distributed to the holders of claims of the corporation and no corporate entity will survive. In a reorganization, a new corporate entity will result. Some holders of the claim of the bankrupt corporation will receive cash in exchange for their claims; others may receive new securities in the corporation that results from the reorganization; and still others may receive a combination of both cash and new securities in the resulting corporation. (b) What is the difference between a Chapter 7 and Chapter 11 bankruptcy filing? The law governing bankruptcy in the United States is the Bankruptcy Reform Act of 1978. The bankruptcy act is composed of 15 chapters, each chapter covering a particular type of bankruptcy. Of particular interest are two chapters, Chapter 7 and Chapter 11. Chapter 7 deals with the liquidation of a company; Chapter 11 deals with the reorganization of a company. Thus, for a Chapter 7 bankruptcy filing, the spotlight is on rules governing liquidations; for a Chapter 11 bankruptcy filing, the focus is on rules governing reorganizations. 3. What is a debtor in possession? The term “a debtor in possession” refers to the company filing for protection while continuing to carry on business. One purpose of the Bankruptcy Reform Act of 1978 is to give a corporation time to decide whether to reorganize or liquidate and then the necessary time to formulate a plan to accomplish either a reorganization or liquidation. This is achieved because when a corporation files for bankruptcy, the act grants the corporation protection from creditors who seek to collect their claims. A company that files for protection under the bankruptcy act generally becomes a debtor in possession, and continues to operate its business under the supervision of the court. 4. What is the principle of absolute priority? When a company is liquidated, creditors receive distributions based on the absolute priority rule to the extent that assets are available. The absolute priority rule is the principle that senior creditors are paid in full before junior creditors are paid anything. For secured creditors and unsecured creditors, the absolute priority rule guarantees their seniority to equity holders. In liquidations, the absolute priority rule generally holds. In contrast, there is a good body of literature that argues that strict absolute priority has not been upheld by the courts or the SEC. Studies of actual reorganizations under Chapter 11 have found that the violation of absolute priority is the rule rather the exception. 5. Comment of the following statement: “A senior secured creditor has little risk of realizing a loss if the issuer goes into bankruptcy.” When a company goes bankrupt there are varying degrees of risk for all creditors. Even though the risk can be “little” or small relatively speaking compared to junior unsecured claimants, there is still some risk for senior secured creditors. This is because seniority does not always insure that payments owed will be made for the following reasons. First, the assets of the bankrupt firm may not provide sufficient payments even for senior secured creditors who must compete with other entities including the IRS and unpaid employees. Second, the seniority ranking can be at least partially overturned so that junior claimants receive some payments at the expense of more senior claimants. In conclusion, it is important to recognize that the superior legal status of any debt obligation will not prevent creditors from suffering financial loss when the issuer’s ability to generate cash flow adequate to pay its obligations is seriously eroded. 6. What is meant by an issue or issuer being placed on a credit watch? Being placed on a credit watch means the issue or issuer is under review for a possible change in rating. Rating agencies monitor the bonds and issuers that they have rated and can at any time it is reviewing a particular credit rating. It may go even further and state that the outcome of the review may result in a downgrade (i.e., a lower credit rating being assigned) or upgrade (i.e., a higher credit rating being assigned). 7. Comment on the following statement: “An investor who purchases the mortgage bonds of a corporation knows that should the corporation become bankrupt, mortgage bondholders will be paid in full before the common stockholders receive any proceeds.” When a company is liquidated, creditors receive distributions based on the absolute priority rule to the extent that assets are available. The absolute priority rule is the principle that senior creditors are paid in full before junior creditors are paid anything. For secured creditors and unsecured creditors, the absolute priority rule guarantees their seniority to equity holders. In liquidations, the absolute priority rule generally holds. In contrast, there is a good body of literature that argues that strict absolute priority has not been upheld by the courts or the Securities and Exchange Commission (SEC). Studies of actual reorganizations under Chapter 11 have found that the violation of absolute priority is the rule rather the exception. Consequently, although investors in the debt of a corporation may feel that they have priority over the equity owners and priority over other classes of debtors, the actual outcome of a bankruptcy may be far different from what the terms of the debt agreement state. 8. Answer the below questions. (a) What is the difference between refunding protection and call protection? Unlike call protection, refunding protection prevents redemption only from certain sources, namely the proceeds of other debt issues sold at a lower cost of money. The holder is protected only if interest rates decline and the borrower can obtain lower-cost money to pay off the debt. (b) Which protection provides the investor with greater protection that the bonds will be acquired by the issuer prior to the stated maturity date? Call protection is much more absolute than refunding protection. Although there may be certain exceptions to absolute or complete call protection in some cases (such as sinking funds and the redemption of debt under certain mandatory provisions), it still provides greater assurance against premature and unwanted redemption than does refunding protection. 9. Answer the below questions. (a) What is a bullet bond? Beginning in early 1986 a number of industrial companies issued long-term debt with extended call protection, not refunding protection. In Wall Street, these noncallable-for-life issues are referred to as bullet bonds. (b) Can a bullet bond be redeemed prior to the stated maturity date? Some bullet bonds are noncallable for the issue’s life as the prospectus expressly prohibits redemption prior to maturity. Other issues carry limited call protection and can be called after a period of time. 10. Answer the below questions. (a) What is meant by a make-whole call provision? With a make-whole call provision, the payment when the issuer calls a bond is determined by the present value of the remaining payments discounted at a small spread over a maturity-matched Treasury yield. The specified spread which is fixed over the bond’s life is called the make-whole premium. Because the spread is small relative to the market spread at issuance, the bondholder is highly likely to benefit when the issuer invokes this option. (b) What is the make-whole premium? As seen in part a, the specified spread which is fixed over the bond’s life is called the make-whole premium. Because the spread is small relative to the market spread at issuance, the bondholder is highly likely to benefit when the issuer invokes this option. (c) How does a make-whole call provision differ from a traditional call provision? With a traditional call provision, the call price is fixed and is either par or a premium over par based on the call date. With a make-whole call provision, the payment when the issuer calls a bond is determined by the present value of the remaining payments discounted at a small spread over a maturity-matched Treasury yield. (d) Why is a make-whole call provision probably a misnomer? With a make-whole call provision, the payment when the issuer calls a bond is determined by the present value of the remaining payments discounted at a small spread over a maturity-matched Treasury yield. The specified spread which is fixed over the bond’s life is called the make-whole premium. Because the spread is small relative to the market spread at issuance, the bondholder is highly likely to benefit when the issuer invokes this option. Thus, the term “make-whole” misrepresents this provision and is probably a misnomer. It is highly likely that when the issuer invokes the option the bondholder will be made more than whole to compensate for the issuer’s action. As of mid 2010, about 7% of the 50,000 corporate bonds have a make-whole call provision. 11. Answer the below questions. (a) What is a sinking fund requirement in a bond issue? Corporate bond indentures may require the issuer to retire a specified portion of an issue each year. This is referred to as a sinking fund requirement. This kind of provision for repayment of corporate debt may be designed to liquidate all of a bond issue by the maturity date, or it may be arranged to pay only a part of the total by the end of the term. If only a part is paid, the remainder is called a balloon maturity. Generally, the issuer may satisfy the sinking fund requirement by either (i) making a cash payment of the face amount of the bonds to be retired to the corporate trustee, who then calls the bonds for redemption using a lottery, or (ii) delivering to the trustee bonds purchased in the open market that have a total face value equal to the amount that must be retired. (b) “A sinking fund provision in a bond issue benefits the investor.” Do you agree with this statement? The sinking fund provision does not give investors complete call protection because debt is being retired periodically. This could be disadvantageous if interest rates fall. However, the purpose of the sinking fund provision is to reduce credit risk. This is advantageous to investors because it lowers the probability of investors not eventually receiving their interest and principal payments. Thus, it boils down to the investor’s preference. Would one prefer to lock in the current rate for a long period of time and risk a higher default probability or would one prefer a safer course of action which calls for a shorter term investment horizon but eliminates a longer term bankruptcy possibility? 12. What is the difference between a fallen angel and an original-issue high-yield bond? In brief, a fallen angel is a bond with the same low rating as an original-issue high-yield bond. However, unlike the original-issue high-yield bond, the fallen angel once had a higher bond rating before it was downgraded. More details are given below. High-yield bonds, commonly called junk bonds, are issues with quality ratings below triple B. Bond issues in this sector of the market may have been rated investment grade at the time of issuance and have been downgraded subsequently to noninvestment-grade, or they may have been rated noninvestment-grade at the time of issuance, called original-issue high-yield bonds. Bonds that have been downgraded fall into two groups: (i) issues that have been downgraded because the issuer voluntarily significantly increased their debt as a result of a leveraged buyout or a recapitalization, and (ii) issues that have been downgraded for other reasons most likely financial distress problems. The latter issues are commonly referred to as “fallen angels.” 13. “A floating-rate note and an extendable reset bond both have coupon rates readjusted periodically. Therefore, they are basically the same instrument.” Do you agree with this statement? As discussed below, there are differences between a floating-rate note and an extendable reset bond due to the manner in which they are adjusted. In late 1987, a junk bond came to market with a structure allowing the issuer to reset the coupon rate so that the bond will trade at a predetermined price. The coupon rate may reset annually or even more frequently, or reset only one time over the life of the bond. Generally, the coupon rate at reset time will be the average of rates suggested by two investment banking firms. The new rate will then reflect both the level of interest rates at the reset date, and the credit spread the market wants on the issue at the reset date. This structure is called an extendable reset. In a floating-rate issue, the coupon rate resets according to a fixed spread over some benchmark, with the spread specified in the indenture. The amount of the spread reflects market conditions at the time the issue is offered. The coupon rate on an extendable reset bond by contrast is reset based on market conditions (as suggested by several investment banking firms) at the time of the reset date. Moreover, the new coupon rate reflects the new level of interest rates and the new spread that investors seek. The advantage to issuers of extendable reset bonds is again that they can be assured of a long-term source of funds based on short-term rates. For investors, the advantage of these bonds is that the coupon rate will reset to the market rate—both the level of interest rates and the credit spread, in principle keeping the issue at par. 14. What is a payment-in-kind bond? In an LBO or a recapitalization, the heavy interest payment burden that the corporation assumes places severe cash flow constraints on the firm. To reduce this burden, firms involved in LBOs and recapitalizations have issued bonds with deferred coupon structures that permit the issuer to avoid using cash to make interest payments for a period of three to seven years. There are three types of deferred coupon structures: deferred-interest bonds, step-up bonds, and payment-in-kind bonds. Payment-in-kind (PIK) bonds give the issuer an option to pay cash at a coupon payment date or give the bondholder a similar bond (i.e., a bond with the same coupon rate and a par value equal to the amount of the coupon payment that would have been paid). The period during which the issuer can make this choice varies from 5 to 10 years. 15. Answer the below questions. (a) In what ways does an MTN differ from a corporate bond? There are four ways that MTN differ from a corporate bond. First, corporate bonds generally have a longer maturity than a medium term note (MTN). With shorter maturities and an upward sloping yield curve, MTNs tend to have lower coupon rates if everything else is equal. Second, medium-term notes differ from corporate bonds in the manner in which they are distributed to investors when they are initially sold. Although some investment-grade corporate bond issues are sold on a best-efforts basis, typically they are underwritten by investment bankers. Traditionally, MTNs have been distributed on a best-efforts basis by either an investment banking firm or other broker/dealers acting as agents. Third, MTNs are usually sold in relatively small amounts on a continuous or an intermittent basis, whereas corporate bonds are sold in large, discrete offerings. MTNs are offered continuously to investors by an agent of the issuer. Investors can select from several maturity ranges: 9 months to 1 year, more than 1 year to 18 months, more than 18 months to 2 years, and, on rare occasions, up to 30 years and even longer. Fourth, on occasion, MTNs can offer advantages in terms of cost and flexibility. When the treasurer of a corporation is contemplating an offering of either an MTN or corporate bonds, there are two factors that affect the decision. The most obvious is the cost of the funds raised after consideration of registration and distribution costs. This cost is referred to as the all-in-cost of funds. The second is the flexibility afforded to the issuer in structuring the offering. The tremendous growth in the MTN market is evidence of the relative advantage of MTNs with respect to cost and flexibility for some offerings. However, the fact that there are corporations that raise funds by issuing both bonds and MTNs is evidence that there is no absolute advantage in all instances and market environments. (b) What derivative instrument is commonly used in creating a structured MTN? The most common derivative instrument used in creating structured notes is a swap. More details on MTNs and their relationship with the derivative markets are given below. At one time the typical MTN was a fixed-rate debenture that was noncallable. It is common today for issuers of MTNs to couple their offerings with transactions in the derivative markets (options, futures/forwards, swaps, caps, and floors) so as to create debt obligations with more interesting risk-return features than are available in the corporate bond market. Specifically, an issue can be floating-rate over all or part of the life of the security, and the coupon reset formula can be based on a benchmark interest rate, equity index or individual stock price, a foreign exchange rate, or a commodity index. Inverse floaters are created in the structured MTN market. MTNs can have various embedded options included. MTNs created when the issuer simultaneously transacts in the derivative markets are called structured notes. As stated above, the most common derivative instrument used in creating structured notes is a swap. The development of the MTN market has been fostered by commercial banks involved in the swap market. By using the derivative markets in combination with an offering, borrowers are able to create investment vehicles that are more customized for institutional investors to satisfy their investment objectives, even though they are forbidden from using swaps for hedging. Moreover, it allows institutional investors who are restricted to investing in investment-grade debt issues the opportunity to participate in other asset classes to make a market play. For example, an investor who buys an MTN whose coupon rate tied to the performance of the S&P 500 is participating in the equity market without owning common stock. If the coupon rate is tied to a foreign stock index, the investor is participating in the equity market of a foreign country without owning foreign common stock. In exchange for creating a structured note product, borrowers can reduce their funding costs. Because of the small size of an offering and the flexibility to customize the offering in the swap market, investors can approach an issuer through its agent about designing a security for their needs. This process of customers inquiring of issuers or their agents to design a security is called a reverse inquiry. Transactions that originate from reverse inquiries account for a significant share of MTN transactions. 16. Answer the below questions. (a) Do you agree or disagree with the following statement? “Most MTN issues are rated non-investment grade at the time of offering.” One would tend to disagree given the nature of most MTNs. Because MTNs are issued with shorter maturity, ceteris paribus, they have less credit risk than long term bonds, which regularly achieve investment grade ratings. Thus, there is no inherent reason that MTN issues should be rated non-investment grade at the time of the offering. Furthermore, borrowers have flexibility in designing MTNs to satisfy their own needs including need for a lower credit risk. For example, investors can request that firms issue floating-rate debt or that coupon payments be denominated in a foreign currency. In addition, MTNs can have the same features as corporate bonds. For example, there are MTNs backed by equipment trust certificates issued by railways and subordinated notes issued by bank holding companies. Also, there are asset-backed MTNs. (b) Do you agree or disagree with the following statement? “Typically, a corporate issuer with an MTN program will post rates for every maturity range.” The company issuing MTNs may not desire to sell MTNs for various maturities. Thus, in their offering schedule, the company will not post rates for every maturity range. Because the maturity range in the offering rate schedule does not specify a specific maturity date, the investor can choose the final maturity subject to approval by the issuer. The rate offering schedule can be changed at any time by the issuer either in response to changing market conditions or because the issuer has raised the desired amount of funds at a given maturity. In the latter case, the issuer can either not post a rate for that maturity range or lower the rate. More details are supplies below on the MTN program and posting of rates. A corporation that wants an MTN program will file a shelf registration with the SEC for the offering of securities. After the MTN offering is sold, the issuer can file another shelf registration. The registration will include a list of the investment banking firms, usually two to four that the corporation has arranged to act as agents to distribute the MTNs. The large New York-based investment banking firms dominate the distribution market for MTNs. The issuer then posts rates over a range of maturities: for example, 9 months to 1 year, 1 year to 18 months, 18 months to 2 years, and annually thereafter. Usually, an issuer will post rates as a spread over a Treasury security of comparable maturity. For example, in a two-to three-year maturity range, the offering rate might be posted as 35 basis points over the two-year Treasury. If the two-year Treasury is at 4%, then the MTN offering rate is 4.35%. Rates will not be posted for maturity ranges that the issuer does not desire to sell. The agents will then make the offering rate schedule available to their investor base interested in MTNs. An investor who is interested in the offering will contact the agent. In turn, the agent contacts the issuer to confirm the terms of the transaction. The minimum size that an investor can purchase of an MTN offering typically ranges from $1 million to $25 million. 17. What is meant by reverse inquiry? Reverse inquiry is the process whereby customers inquire of issuers or their agents about designing a security with desired features. More details are given below. Investors often play an active role in the MTN market through the “reverse inquiry” process. An investor may seek an investment in a specified principal amount, with a specified credit rating, and a specified maturity. If a security with the desired terms is not available in the corporate bond market, the investor may be able to obtain it in the MTN market through reverse inquiry. In this case, the investor will communicate the terms of the investment it is seeking to an issuer of MTNs through the issuer’s selling agent. If the issuer finds the terms of the reverse inquiry acceptable, it may agree to the transaction even if it was not posting rates at the desired maturity. Reverse inquiry transactions play an important role in both “plain vanilla” debt issued in MTN programs and more exotic structured securities. 18. Answer the below questions pertaining to the private-placement corporate debt market. (a) Do you agree or disagree with the following statement? “Since Rule 144A became effective, all privately placed issues can be bought and sold in the market.” As seen in the discussion that follows, one would disagree with the statement because not all privately placed issues are Rule 144A private placements (which are the only private placements eligible for trading). Securities privately placed are exempt from the registration with the SEC because they are issued in transactions that do not involve a public offering. The private-placement market has undergone a major change since the adoption of SEC Rule 144A in 1990, which allows the trading of privately placed securities among qualified institutional buyers. However, not all private placements are Rule 144A private placement. Consequently, the private-placement market can be divided into two sectors. First is the traditional private-placement market, which includes non-144A securities. For this market privately placed issues cannot be bought and sold in the market among qualified institutional buyers. Second is the market for 144A securities. For this market privately placed issues can be bought and sold in the market among qualified institutional buyers. (b) Do you agree or disagree with the following statement? “Traditionally privately placed issues are now similar to publicly offered securities.” The private-placement market includes the Rule 144A private placements and the traditional private-placement market (which includes non-144A securities). Thus, any changes in the differences and similarities between the private-placement and the publicly offered securities market largely concern the Rule 144A private placement. While there are now more similarities, significant differences still exist today between the Rule 144A privately placed issues and publicly offered securities. The similarities and differences are described below. Rule 144A private placements are now underwritten by investment bankers on a firm commitment basis, just as with publicly issued bonds. The features in these issues are similar to those of publicly issued bonds. For example, the restrictions imposed on the borrower are less onerous than for traditional private-placement issues. For underwritten issues, the size of the offering is comparable to that of publicly offered bonds. However, unlike publicly issued bonds, the issuers of privately placed issues tend to be less well known. In this way, the private-placement market shares a common characteristic with the bank loan market. Borrowers in the publicly issued bond market are typically large corporations. Issuers of privately placed bonds tend to be medium-sized corporations. Those corporations that borrow from banks tend to be small corporations. Although the liquidity of privately placed issues has increased since Rule 144A became effective, it is still not comparable to that of publicly offered issues. Yields on privately placed debt issues are still higher than those on publicly offered bonds. However, one market observer reports that the premium that must be paid by borrowers in the private placement market has decreased as investment banking firms have committed capital and trading personnel to making markets for securities issued under Rule 144A.10. 19. The supplemental prospectus of an actual offering by Royal Bank of Canada states the following: “Reference Asset: SGI Smart Market Neutral Commodity Index (USD – Excess Return) (Bloomberg Ticker: SGICVMX). For a description of the Reference Asset, please see the section below, “The Reference Asset.” Specified Currency: U.S. Dollars Minimum Investment: $1,000 Denomination: $1,000 Pricing Date: January 26, 2010 Issue Date: January 29, 2010 CUSIP: 78008HTY6 Interest Payable: None Payment at Maturity (if held to maturity): The Payment at Maturity will be calculated as follows: 1. If the Reference Asset Performance is greater than 0%, then you will receive an amount equal to: Principal Amount + [(Principal Amount × Reference Asset Performance)] × Participation Rate 2. If the Reference Asset Performance is less than or equal to 0%, then you will receive an amount equal the principal amount of your notes. Reference Asset Performance: The Reference Asset Performance, expressed as a percentage and rounded to four decimal places, will be calculated using the following formula: Final Level – Initial Level Initial Level Participation Rate: 100% Initial Level: 109.0694 Term: Approximately five (5) years (a) What type of structured note is this? This is a commodity-linked note. The payments of a commodity-linked note are tied to the price performance of a designated commodity (such as crude oil, heating oil, natural gas, or precious metal) or a basket of commodities as represented by an index (in our problem the commodity index is SGI Smart Market Neutral Commodity Index). At the maturity date, the investor receives the initial principal amount plus a return based on the percentage change in the price of the designated commodity or basket of commodities. (b) What are the risks associated with investing in this structured note? In addition to credit risk and the risk associated with the play that the investor is seeking to make, structured notes expose investors to liquidity risk because structured notes rarely trade in the secondary market. More details are given below. The risks associated with many structured products, especially those products that present risks of loss of principal due to market movements, are similar to those risks involved with options. The potential for serious risks involved with options trading are well-established, and as a result of those risks customers must be explicitly approved for options trading. In the same vein, the U.S. Financial Industry Regulatory Authority (FINRA) suggests that firms “consider” whether purchasers of some or all structured products be required to go through a similar approval process, so that only accounts approved for options trading would also be approved for some or all structured products. In the case of a “principal protected” product, these products are not always insured in the United States by the Federal Deposit Insurance Corporation; they may only be insured by the issuer, and thus have the potential for loss of principal in the case of a liquidity crisis, or other solvency problems with the issuing company. Some firms have attempted to create a new market for structured products that are no longer trading. These securities may not be trading due to issuer bankruptcy or a lack of liquidity to insure them. Some structured products of a once solvent company have been known to trade in a secondary market for as low as pennies on the dollar. 20. Answer the below questions. (a) Why is commercial paper an alternative to short-term bank borrowing for a corporation? Commercial paper is an alternative to short-term bank borrowing for a corporation because it gives them another way of borrowing or acquiring funds needed in the immediate future. For companies able to issue commercial paper, the rate is often below the rate that banks require. More details are given below. Commercial paper is a short-term unsecured promissory note that is issued in the open market and that represents the obligation of the issuing corporation. The primary purpose of commercial paper was to provide short-term funds for seasonal and working capital needs. However, corporations now use commercial paper for other purposes such as bridge financing. For example, suppose that a corporation needs long-term funds to build a plant or acquire equipment. Rather than raising long-term funds immediately, the corporation may elect to postpone the offering until more favorable capital market conditions prevail. The funds raised by issuing commercial paper are used until longer-term securities are sold. (b) What is the difference between directly placed paper and dealer-placed paper? Commercial paper is classified as either direct paper or dealer-placed paper. Directly placed paper is sold by the issuing firm directly to investors without the help of an agent or an intermediary. (An issuer may set up its own dealer firm to handle sales.) A large majority of the issuers of direct paper are financial companies. These entities require continuous funds in order to provide loans to customers. As a result, they find it cost-effective to establish a sales force to sell their commercial paper directly to investors. Dealer-placed paper requires the services of an agent to sell an issuer’s paper. The agent distributes the paper on a best efforts underwriting basis by commercial banks and securities houses. (c) What does the yield spread between commercial paper and Treasury bills of the same maturity reflect? In brief, the yield spread between commercial paper and Treasury bills of the same maturity reflects differences in credit risk, taxability, and liquidity. More details are included below. Like Treasury bills, commercial paper is a discount instrument. That is, it is sold at a price that is less than its maturity value. The difference between the maturity value and the price paid is the interest earned by the investor, although there is some commercial paper that is issued as an interest-bearing instrument. For commercial paper, a year is treated as having 360 days. The yield offered on commercial paper tracks that of other money market instruments. The commercial paper rate is higher than that on Treasury bills for the same maturity. There are three reasons for this. First, the investor in commercial paper is exposed to credit risk. Second, interest earned from investing in Treasury bills is exempt from state and local income taxes. As a result, commercial paper has to offer a higher yield to offset this tax advantage. Finally, commercial paper is less liquid than Treasury bills. The liquidity premium demanded is probably small, however, because investors typically follow a buy-and-hold strategy with commercial paper and so are less concerned with liquidity. (d) Why does commercial paper have a maturity of less than 270 days? In the United States, commercial paper ranges in maturity from 1 day to 270 days. The reason that the maturity of commercial paper does not exceed 270 days is as follows. The Securities Act of 1933 requires that securities be registered with the SEC. Special provisions in the 1933 act exempt commercial paper from registration as long as the maturity does not exceed 270 days. Hence, to avoid the costs associated with registering issues with the SEC, firms rarely issue commercial paper with maturities exceeding 270 days. Another consideration in determining the maturity is whether the commercial paper would be eligible collateral for a bank that wanted to borrow from the Federal Reserve Bank’s discount window. To be eligible, the maturity of the paper may not exceed 90 days. Because eligible paper trades at lower cost than paper that is not eligible, issuers prefer to issue paper whose maturity does not exceed 90 days. (e) What is meant by tier-1 and tier-2 commercial paper? A major investor in commercial paper is money market mutual funds. However, there are restrictions imposed on money market mutual funds by the SEC. Specifically, Rule 2a-7 of the Investment Company Act of 1940 limits the credit risk exposure of money market mutual funds by restricting their investments to “eligible” paper. To be eligible paper, the issue must carry one of the two highest ratings (“1” or “2”) from at least two of the nationally recognized statistical ratings agencies. Tier-1 paper is defined as eligible paper that is rated “1” by at least two of the rating agencies; tier-2 paper security is defined as eligible paper that is not a tier-1 security. Money market funds may hold no more than 5% of their assets in tier-1 paper of any individual issuer and no more than 1% of their assets in the tier-2 paper of any individual issuer. Furthermore, the holding of tier 2 paper may not represent more than 5% of the fund’s assets. 21. Answer the below questions. (a) Bank loans are classified as investment-grade and leveraged bank loans. Explain the difference between these two types of loans. While both investment-grade loans and leveraged loans are bank loans, the major difference relates to the rating. An investment-grade loan is a bank loan made to corporate borrowers that have an investment-grade rating. In contrast, a leveraged loan is a bank loan to a corporation that has a below-investment-grade rating. More details are given below. Investment-grade loans are typically originated by and held in the originating bank in its portfolio. The reason is that the loans are revolving lines of credit. In such a loan arrangement, a bank sets a maximum amount that can be borrowed by a corporation, and the corporation can take down any part of that amount and repay it at any time. Because of the ability of the corporate borrower to repay at any time and the absence of a maturity date for the loan, an investment-grade bank loan is not sold by the originating bank to institutional investors. In contrast to an investment-grade loan, a leveraged loan is a bank loan to a corporation that has a below-investment-grade rating. A leverage loan has a maturity, and the interest rate is a floating rate with the reference rate being LIBOR. In fact, when market participants refer to corporate bank loans, they typically mean a leveraged loan. These loans can be sold to institutional investors. A corporation may have as its debt obligations both leveraged loans and high-yield bonds. (b) Which of the two types of bank loans is typically sold and traded in the secondary market? A leveraged loan can be typically sold and traded in the secondary market. In particular, leverage loans are sold to institutional investors. In spite of many advantages, leveraged loans drop significantly in price during credit liquidity crunches. Open end mutual funds that invest in leveraged loans then experience fund redemptions which means forced selling. A good way for retail investors to buy leveraged loans is to use closed end funds selling at a discount to NAV. That way an investor gets a discount on assets that are already heavily discounted by forced selling. 22. Answer the below questions. (a) What is a syndicated bank loan? A syndicated bank loan is one in which a group (or syndicate) of banks provides funds to the borrower. A syndicated bank loan is used by borrowers who seek to raise a large amount of funds in the loan market rather than through the issuance of securities. These bank loans are called senior bank loans because of their priority position over subordinated lenders (bondholders) with respect to repayment of interest and principal. Structures in which no repayment of the principal is made until the maturity date can be arranged and are referred to as bullet loans. Syndicated loans are distributed by two methods: assignment or participation. Each method has its relative advantages and disadvantages, with the method of assignment being the more desirable of the two. The holder of a loan who is interested in selling a portion can do so by passing the interest in the loan by the method of assignment. In this procedure, the seller transfers all rights completely to the holder of the assignment, now called the assignee. The assignee is said to have privity of contract with the borrower. Because of the clear path between the borrower and assignee, assignment is the more desirable choice of transfer and ownership. (b) What is the reference rate typically used for a syndicated bank loan? The interest rate on a syndicated bank loan is a rate that periodically resets at the reference rate plus a spread. The reference rate is typically LIBOR, although it could be the prime rate (that is, the rate that a bank charges its most creditworthy customers) or the rate on certificates of deposits. (c) What is the difference between an amortized bank loan and a bullet bank loan? The main difference between an amortized bank loan and a bullet bank loan involves the repayment of principle. Typically, a syndicated bank loan has a fixed term that is amortized according to a predetermined schedule with the repayment of principal beginning after a specified number of years (typically not longer than 5 or 6 years). Structures in which no repayment of the principal is made until the maturity date can be arranged and are referred to as bullet loans. 23. Explain the two ways in which a bank can sell its position in a syndicated loan. A syndicated loan is arranged by either a bank or a securities house. The arranger then lines up the syndicate of banks with each bank providing the funds for which it has committed. The banks in the syndicate have the subsequent right to sell or distribute its position in the loan to other banks. The two methods of distribution are assignment or participation. These methods are described below. For the method of assignment, the holder of a loan who wants to sell its position can do so by passing on or assigning its interest in the loan. In this procedure, the seller transfers all rights completely to the holder of the assignment, now called the assignee. The assignee is said to have privity of contract with the borrower. Because of the clear path between the borrower and assignee, assignment is the more desirable choice of transfer and ownership. For the method of participation, the owner of a loan “participates out” a portion of its holdings. The holder of the participation does not become a party to the loan agreement and has a relationship not with the borrower but with the seller of the participation. Unlike an assignment, a participation does not confer privity of contract on the holder of the participation, although the holder of the participation has the right to vote on certain legal matters concerning amendments to the loan agreement. These matters include changes regarding maturity, interest rate, and issues concerning the loan collateral. Because syndicated loans can be sold in this manner, they are marketable. 24. In a collateralized loan obligation, how is protection afforded to the most senior bond class? A collateralized loan obligation (CLO) is a special purpose vehicle (SPV) that issues debt and equity and from the funds raised invests in a portfolio of leveraged loans. The entity responsible for managing the portfolio of leverage loans (i.e., the collateral) is the collateral manager. Protection is provided to the most senior bond class in a collateralized loan obligation because this class has senior claims enforced by the rules for the distribution of collateral interest and collateral principal. These rules for the distribution of collateral interest and collateral principal, referred to as the cash flow waterfalls, specify the order in which bond classes get paid and by doing so enforce the seniority of one CLO creditor over another. Another key feature of a CLO is the coverage tests set forth in the indenture. They are important because the outcomes of these tests can result in a diversion of cash that would have gone to the subordinated bond classes and redirect it to senior bond classes. In addition, it is important to understand that there is a period of time in which collateral principal is not distributed to the bond classes or the equity tranche but instead reinvested by the collateral manager by purchasing additional loans. This time period is referred to as the reinvestment period. More details are provided below about the classes or tranches. Investors in the debt securities that the SPV issues — referred to as bond classes or tranches — are entitled to the cash flows from the portfolio of loans. The cash flow is distributed to the bond classes in prescribed ways that take into account the seniority of those liabilities. The rules described for the distribution of the cash flow are set forth in the CLO’s indenture. In addition to the bond classes, there is a security called the equity tranche that is entitled to receive the residual cash flows. The liability structure of a CLO is referred to as its capital structure. These bond classes are commonly labeled Class A, Class B, Class C, and so forth going from top to bottom of the capital structure in terms of their priority and their credit rating. They run the gamut from the most secured AAA rated bond class to the lowest rated bond class in the capital structure. Class A in the capital structure, the one with the AAA rating, is referred to as the senior bond class. The other three bond classes are referred to as subordinate bond classes. Notice that in a typical CLO, the coupon rate floats with a reference rate (most commonly LIBOR). 25. Why is a default rate not a good sole indicator of the potential performance of a portfolio of high-yield corporate bond? To assess the potential return from investing in corporate debt obligations, more than just default rates are needed. The reason is that default rates by themselves are not of paramount significance. It is perfectly possible for a portfolio of corporate debt obligations to suffer defaults and to outperform a portfolio of U.S. Treasuries at the same time, provided the yield spread of the portfolio is sufficiently high to offset the losses from default. Furthermore, holders of defaulted bonds typically recover a percentage of the face amount of their investments. This is called the recovery rate. Therefore, an important measure in evaluating investments in corporate debt is the default loss rate, which is defined as follows: Default loss rate = Default rate × (100% − Recovery rate). 26. What is the difference between a credit rating and recovery rating? Recovery ratings were developed in response for the market’s need for more information for particular bond issues than could be supplied by a credit rating. While a credit rating can provide guidance on recovery if a firm is in default, a recovery rating corresponds to a specific range of recovery values. More details are given below. While credit ratings provide guidance for the likelihood of default and recovery given default, the market needed better recovery information for specific bond issues. In response to this need, two ratings agencies, Standard & Poor’s and Fitch, developed recovery rating systems for corporate bonds. Standard & Poor’s introduced recovery ratings in December 2003 for secured debt using an ordinal scale of 1+ through 5. In July 2005, Fitch introduced a recovery rating system for corporate bonds rated single B and below. The factors considered in assigning a recovery rating to an issue by Fitch are (1) the collateral, (2) the seniority relative to other obligations in the capital structure, and (3) the expected value of the issuer in distress. The recovery rating system does not attempt to precisely predict a given level of recovery. Rather, the ratings are in the form of an ordinal scale and referred to accordingly as a Recovery Ratings Scale. Despite the recovery ratings being in relative terms, Fitch also provides recovery bands in terms of securities that have characteristics in line with securities historically recovering current principal and related interest. 27. What is a rating transition matrix? The rating agencies accumulate statistics on how ratings change over various periods of time. A table that specifies this information is called a rating transition matrix. It shows the number of downgrades, upgrades, and the ratio of upgrades to downgrades for a period of time as given by a commercial rating company such as Moody’s Investors Service, Standard & Poor’s Corporation, or Fitch Ratings. 28. What is the difference between event risk and headline risk? There are two unique risks that that can change corporate credit spreads: event risk and headline risk. The difference between these two risks is as follows. In the case of event risk, upon the announcement of some event there is an almost immediate credit rating downgrade for the adversely impacted corporation, sector, or industry. Hence, event risk is tied to downgrade risk. With headline risk, on the other hand, the announcement results in an adverse impact on the credit spread, as with event risk, but does not result in an immediate downgrade of debt. More details are given below. An example of event risk is a corporate takeover or corporate restructuring. A specific example of event risk is the 1988 takeover of RJR Nabisco for $25 billion through a financing technique known as a leveraged buyout (LBO). The new company took on a substantial amount of debt incurred to finance the acquisition of the firm. In the case of RJR Nabisco, the debt and equity after the leveraged buyout were $29.9 and $1.2 billion, respectively. Because the corporation must service a larger amount of debt, its bond quality rating was reduced; RJR Nabisco’s quality rating as assigned by Moody’s dropped from A1 to B3. The impact of the initial LBO bid announcement on the credit spreads for RJR Nabisco’s debt was an increase from 100 basis points to 350 basis points. Event risk can have spillover effects on other firms. Consider once again the RJR Nabisco LBO. An LBO of $25 billion was considered impractical prior to the RJR Nabisco LBO, but the RJR transaction showed that size was not an obstacle, and other large firms previously thought to be unlikely candidates for an LBO became fair game resulting in an increase in their credit spread. An example of headline risk is a natural or industrial accident that would be expected to have an adverse economic impact on a corporation. For example, an accident at a nuclear power plant is likely to have an adverse impact on the credit spread of the debt of the corporation that owns the plant. Just as with event risk, there may be spillover effects. CHAPTER 8 MUNICIPAL SECURITIES CHAPTER SUMMARY Municipal securities are issued by state and local governments and by entities that they establish. All states issue municipal securities. Local governments include cities and counties. Political subdivisions of municipalities that issue securities include school districts and special districts for fire prevention, water, sewer, and other purposes. Municipalities issue long-term bonds as the principal means for financing both (1) long-term capital projects such as the construction of schools, bridges, roads, and airports; and (2) long-term budget deficits that arise from current operations. The tax treatment of interest at the state and local level varies. Historically, the investors in municipal bonds have included mutual funds, bank trust departments, property and casualty insurance companies, and high net worth individuals. Hedge funds, arbitrageurs, life insurance companies, and foreign banks have become important participants. These investors are not interested in the tax-exempt feature. Instead, their primary interest is in opportunities to benefit from leveraged strategies that seek to generate capital gains. TYPES AND FEATURES OF MUNICIPAL SECURITIES There are basically two different types of municipal bond security structures: tax-backed bonds and revenue bonds. There are also securities that share characteristics of both tax-backed and revenue bonds. Tax-Backed Debt Tax-backed debt obligations are instruments issued by states, counties, special districts, cities, towns, and school districts that are secured by some form of tax revenue. Tax-backed debt includes general obligation debt, appropriation-backed obligations, and debt obligations supported by public credit enhancement programs. General Obligation Debt The broadest type of tax-backed debt is general obligation debt. An unlimited tax general obligation debt is the stronger form of general obligation pledge as it is secured by the issuer’s unlimited taxing power. A limited tax general obligation debt is a limited tax pledge because for such debt there is a statutory limit on tax rates that the issuer may levy to service the debt. Agencies or authorities of several states have issued bonds that carry a potential state liability for making up shortfalls in the issuing entity’s obligation. However, the state’s pledge is not binding. Debt obligations with this nonbinding pledge of tax revenue are called moral obligation bonds. Revenue Bonds The second basic type of security structure is found in a revenue bond. Such bonds are issued for either project or enterprise financings in which the bond issuers pledge to the bondholders the revenues generated by the operating projects financed. For a revenue bond, the revenue of the enterprise is pledged to service the debt of the issue. The details of how revenue received by the enterprise will be disbursed are set forth in the trust indenture. There are various restrictive covenants included in the trust indenture for a revenue bond to protect the bondholders. A rate, or user charge, covenant dictates how charges will be set on the product or service sold by the enterprise. An additional bonds’ covenant indicates whether additional bonds with the same lien may be issued. Other covenants specify that the facility may not be sold, the amount of insurance to be maintained, requirements for recordkeeping and for the auditing of the enterprise’s financial statements by an independent accounting firm, and requirements for maintaining the facilities in good order. Hybrid and Special Bond Securities Some municipal bonds that have the basic characteristics of general obligation bonds and revenue bonds have more issue-specific structures as well. Some examples are insured bonds, bank-backed municipal bonds, refunded bonds structured/asset-backed securities and “troubled city” bailout bonds. Insured bonds, in addition to being secured by the issuer’s revenue, are also backed by insurance policies written by commercial insurance companies. Because municipal bond insurance reduces credit risk for the investor, the marketability of certain municipal bonds can be greatly expanded. Municipal obligations have been increasingly supported by various types of credit facilities provided by commercial banks. There are three basic types of bank support: letter of credit, irrevocable line of credit, and revolving line of credit. A letter-of-credit agreement is the strongest type of support available from a commercial bank. Under this arrangement, the bank is required to advance funds to the trustee if a default has occurred. An irrevocable line of credit is not a guarantee of the bond issue, although it does provide a level of security. A revolving line of credit is a liquidity-type credit facility that provides a source of liquidity for payment of maturing debt in the event that no other funds of the issuer are currently available. Although originally issued as either revenue or general obligation bonds, municipals are sometimes refunded. A refunding usually occurs when the original bonds are escrowed or collateralized by direct obligations guaranteed by the U.S. government. The escrow fund for a refunded municipal bond can be structured so that the refunded bonds are to be called at the first possible call date or a subsequent call date established in the original bond indenture. Such bonds are known as pre-refunded municipal bonds. Although refunded bonds are usually retired at their first or subsequent call date, some are structured to match the debt obligation to the retirement date. Such bonds are known as escrowed-to-maturity bonds. There are three reasons why a municipal issuer may refund an issue by creating an escrow fund. First, many refunded issues were originally issued as revenue bonds. Second, some issues are refunded in order to alter the maturity schedule of the obligation. Third, when interest rates have declined after a municipal security has been issued, there is a tax arbitrage opportunity available to the issuer by paying existing bondholders a lower interest rate and using the proceeds to create a portfolio of U.S. government securities paying a higher interest rate. MUNICIPAL MONEY MARKET PRODUCTS Tax-exempt money market products include notes, commercial paper, variable-rate demand obligations, and a hybrid of the last two products. Municipal notes include tax anticipation notes (TANs), revenue anticipation notes (RANs), grant anticipation notes (GANs), and bond anticipation notes (BANs). These are temporary borrowings by states, local governments, and special jurisdictions. Usually, notes are issued for a period of 12 months, although it is not uncommon for notes to be issued for periods as short as three months and for as long as three years. TANs and RANs (also known as TRANs) are issued in anticipation of the collection of taxes or other expected revenues. These are borrowings to even out irregular flows into the treasuries of the issuing entity. BANs are issued in anticipation of the sale of long-term bonds. Variable-rate demand obligations (VRDOs) are floating-rate obligations that have a nominal long-term maturity but have a coupon rate that is reset either daily or every seven days. The investor has an option to put the issue back to the trustee at any time with seven days’ notice. The put price is par plus accrued interest. Floaters / Inverse Floaters A common type of derivative security in the municipal bond market is one in which two classes of securities, a floating-rate security and an inverse-floating-rate bond, are created from a fixed-rate bond. The coupon rate on the floating-rate security is reset based on the results of a Dutch auction. Inverse floaters can be created in one of three ways. First, a municipal dealer can buy in the secondary market a fixed-rate municipal bond and place it in a trust. The trust then issues a floater and an inverse floater. The second method is similar to the first except that the municipal dealer uses a newly issued municipal bond to create a floater and an inverse floater. The third method is to create an inverse floater without the need to create a floater. This is done using the municipal swaps market. The third method is to create an inverse floater without the need to create a floater. The structure used to create the inverse floater is called a tender option bond structure. CREDIT RISK Municipal bonds are viewed as having little default risk. The default record as reported by Moody’s indicates that for the issues it rated between 1970 and 2006, there were only 41 defaults. This was not always the case. Between 1939 and 1969, 6,195 municipal defaults were recorded. As with corporate bonds, some institutional investors in the municipal bond market rely on their own in-house municipal credit analysts for determining the credit worthiness of a municipal issue; other investors rely on the nationally recognized rating companies. The two leading rating companies are Moody’s and Standard & Poor’s, and the assigned rating system is essentially the same as that used for corporate bonds. RISKS ASSOCIATED WITH INVESTING IN MUNICIPAL SECURITIES The investor in municipal securities is exposed to the same risks affecting corporate bonds plus an additional one that may be labeled tax risk. There are two types of tax risk to which tax-exempt municipal securities buyers are exposed. The first is the risk that the federal income tax rate will be reduced. The second type of tax risk is that a municipal bond issued as a tax-exempt issue may eventually be declared to be taxable by the Internal Revenue Service. YIELDS ON MUNICIPAL BONDS A common yield measure used to compare the yield on a tax-exempt municipal bond with a comparable taxable bond is the equivalent taxable yield. The equivalent taxable yield is computed as follows: equivalent taxable yield = . Yield Spreads Because of the tax-exempt feature of municipal bonds, the yield on municipal bonds is less than that on Treasuries with the same maturity. The yield on municipal bonds is compared to the yield on Treasury bonds with the same maturity by computing the following ratio: yield ratio = . Yield spreads within the municipal bond market are attributable to differences between credit ratings (i.e., quality spreads), sectors within markets (intra-market spreads), and differences between maturities (maturity spreads). MUNICIPAL BOND MARKET Primary Market A substantial number of municipal obligations are brought to market each week. A state or local government can market its new issue by offering bonds publicly to the investing community or by placing them privately with a small group of investors. When a public offering is selected, the issue usually is underwritten by investment bankers and/or municipal bond departments of commercial banks. Most states mandate that general obligation issues be marketed through competitive bidding, but generally this is not required for revenue bonds. An official statement describing the issue and the issuer is prepared for new offerings. Municipal bonds have legal opinions that are summarized in the official statement. Secondary Market Municipal bonds are traded in the over-the-counter market supported by municipal bond dealers across the country. Markets are maintained on smaller issuers (referred to as local general credits) by regional brokerage firms, local banks, and by some of the larger Wall Street firms. Larger issuers (referred to as general names) are supported by the larger brokerage firms and banks, many of whom have investment banking relationships with these issuers. The convention for both corporate and Treasury bonds is to quote prices as a percentage of par value with 100 equal to par. Municipal bonds, however, generally are traded and quoted in terms of yield (yield to maturity or yield to call). The price of the bond in this case is called a basis price. The exception is certain long-maturity revenue bonds. A bond traded and quoted in dollar prices (actually, as a percentage of par value) is called a dollar bond. There are municipal bond indexes for gauging portfolio performance and the market’s performance. These indexes are primarily used by portfolio managers of regulated investment companies (mutual funds and closed-end funds) for performance evaluation purposes as well as the benchmark for exchange-traded funds. The municipal bond indexes most commonly used by institutional investors are those produced Barclays (which it inherited from its acquisition of Lehman Brothers). The broad-based index is the Barclays Capital National Municipal Bond Index. This index covers long-term tax-exempt bonds that are investment grade. Barclays also publishes a High-Yield Municipal Index and enhanced state-specific indexes. THE TAXABLE MUNICIPAL BOND MARKET Taxable municipal bonds are bonds whose interested is taxed at the federal income tax level. Because there is no tax advantage, an issuer must offer a higher yield than for another tax-exempt municipal bond. The most common types of activities for taxable municipal bonds used for financing are (i) local sports facilities, (ii) investor-led housing projects, (iii) advanced refunding of issues that are not permitted to be refunded because the tax law prohibits such activity, and (iv) underfunded pension plan obligations of the municipality. Despite the excellent performance of the municipal bond sector in terms of credit risk, in 2008 state and local governments and their agencies faced financial difficulties. To provide assistance to these municipal entities, the American Recovery and Investment Act of 2009 authorized the issuance of a new type of taxable municipal bond, Build America Bonds (dubbed BABs). A BAB is a taxable municipal bond wherein the issuer is subsidized for the higher cost of issuing a taxable bond rather than a tax-exempt bond in the form of a payment from the U.S. Department of the Treasury. KEY POINTS • Municipal securities are issued by state and local governments and their authorities, with the interest on most issues exempt from federal income taxes. Tax-exempt and taxable municipal securities are available. “Tax exempt” means that interest on a municipal security is exempt from federal income taxation. • The two basic types of municipal security structures are tax-backed debt and revenue bonds. • Tax-backed debt obligations are instruments issued by states, counties, special districts, cities, towns, and school districts that are secured by some form of tax revenue. Tax-backed debt includes general obligation debt (the broadest type of tax-backed debt), appropriation-backed obligations, and debt obligations supported by public credit enhancement programs. • A general obligation bond is said to be double-barreled when it is secured not only by the issuer’s general taxing powers to create revenues accumulated in a general fund but also by certain identified fees, grants, and special charges, which provide additional revenues from outside the general fund. • Revenue bonds are issued for enterprise financings secured by the revenues generated by the completed projects themselves or for general public-purpose financings in which the issuers pledge to the bondholders the tax and revenue resources that were previously part of the general fund. • Credit-enhanced municipal bonds include insured bonds and letter-of-credit–backed municipal bonds. Insured bonds, in addition to being secured by the issuer’s revenue, are backed by an insurance policy written by commercial insurance companies; letter-of-credit–backed municipal bonds are supported by various types of credit facilities provided by commercial banks. Because of the difficulties faced by monoline insurers, the number of such insured municipal bonds issued today is minimal. • Pre-refunded bonds are no longer secured as either general obligation or revenue bonds when originally issued but are supported by a portfolio of securities held in an escrow fund. If escrowed with securities guaranteed by the U.S. government, refunded bonds are the safest municipal bonds available. A pre-refunded municipal bond is one in which the escrow fund is structured so that the bonds are to be called at the first possible call date or a subsequent call date established in the original bond indenture. • Municipal securities structured as asset-backed securities are backed by “dedicated” revenues such as sales taxes and tobacco settlement payments. • Municipal notes and variable-rate demand obligations are tax-exempt money market products issued by municipalities. • Investing in municipal securities exposes investors to credit risk and tax risk. Because of the low historical default rates for municipal bonds, until recently credit risk has been viewed as small. Rating agencies evaluate the credit risk associated with municipal securities just as they do for corporate bonds. • A tax risk associated with investing in municipal bonds is that the highest marginal tax rate will be reduced, resulting in a decline in the value of municipal bonds. Another tax risk associated with investing in municipal bonds is that a tax-exempt issue may be eventually declared by the Internal Revenue Service to be taxable. • Because of the tax-exempt feature, yields on municipal securities are lower than those on comparably rated taxable securities. Within the municipal bond market, there are credit spreads and maturity spreads. Typically, the municipal yield curve is upward sloping. Moreover, there are yield spreads related to differences between in-state issues and general market issues. • While the municipal bond market is dominated by tax-exempt municipal bonds, there are taxable municipal bonds. Most recently, the issuance of Build America Bonds has dramatically increased the municipal taxable bond market. Bonds issued under this federal subsidized program has ceased because the program was terminated at the end of 2010. ANSWERS TO QUESTIONS FOR CHAPTER 8 (Questions are in bold print followed by answers.) 1. Answer the below questions. (a) Explain why you agree or disagree with the following statement: “All municipal bonds are exempt from federal income taxes.” One would disagree with the statement: “All municipal bonds are exempt from federal income taxes.” The argument and clarification are given below. Municipal securities are issued by state and local governments and by governmental entities such as “authorities” or special districts. There are both tax-exempt and taxable municipal bonds. “Tax-exempt” means that interest on municipal bonds is exempt from federal income taxation, and it may or may not be taxable at the state and local levels. Most municipal bonds outstanding are tax-exempt. Taxable municipal bonds are bonds whose interested is taxed at the federal income tax level. Because there is no tax advantage, an issuer must offer a higher yield than for another tax-exempt municipal bond. The yield must be higher than the yield on U.S. government bonds because an investor faces credit risk by investing in a taxable municipal bond. The investors in taxable municipal bonds are investors who view them as alternatives to corporate bonds. (b) Explain why you agree or disagree with the following statement: “All municipal bonds are exempt from state and local taxes.” One would disagree with the statement that all municipal bonds are exempt from state and local taxes. “Tax-exempt” means that interest on municipal bonds is exempt from federal income taxation, and it may or may not be taxable at the state and local levels. Thus, not all municipal bonds are exempt from state and local taxes. 2. If Congress changes the tax law so as to increase marginal tax rates, what will happen to the price of municipal bonds? An increase in the maximum marginal tax rate for individuals will increase the attractiveness of municipal securities. This was seen with the Tax Act of 1990 which raised the maximum marginal tax rate to 33%. Ceteris paribus, an increase in tax rates have a positive effect on the price of municipal securities as demand will increase. An increase in price is needed to restore the desired returns. On the other hand, a decrease in the maximum marginal tax rate for individuals will decrease the attractiveness of municipal securities. This was seen with the Tax Reform Act of 1986 where the maximum marginal tax rate for individuals was reduced from 50% to 28%. Ceteris paribus, a decrease in tax rates have a negative effect on the price of municipal bonds as demand will decrease. The effect of a lower tax rate was once again seen in 1995 with Congressional proposals regarding the introduction of a flat tax when tax-exempt municipal bonds began trading at lower prices. The higher the marginal tax rate, the greater the value of the tax exemption features. As the marginal tax rate declines, the price of a tax-exempt municipal security also declines. 3. What is the difference between a tax-backed bond and a revenue bond? The two basic security structures are tax-backed debt and revenue bonds. The former are secured by the issuer’s generally taxing power. Revenue bonds are used to finance specific projects and are dependent on revenues from those projects to satisfy the obligations. Thus, the difference between tax-backed bonds and revenue bonds involve how the bonds are secured. More details are supplied below. There are basically two different types of municipal bond security structures: tax-backed bonds and revenue bonds. Tax-backed debt obligations are instruments issued by states, counties, special districts, cities, towns, and school districts that are secured by some form of tax revenue. Tax-backed debt includes general obligation debt, appropriation-backed obligations, and debt obligations supported by public credit enhancement programs. The broadest type of tax-backed debt is general obligation debt. There are two types of general obligation pledges: unlimited and limited. An unlimited tax general obligation debt is the stronger form of general obligation pledge because it is secured by the issuer’s unlimited taxing power. The tax revenue sources include corporate and individual income taxes, sales taxes, and property taxes. Unlimited tax general obligation debt is said to be secured by the full faith and credit of the issuer. The second basic type of security structure is found in a revenue bond. Such bonds are issued for either project or enterprise financings in which the bond issuers pledge to the bondholders the revenues generated by the operating projects financed. For a revenue bond, the revenue of the enterprise is pledged to service the debt of the issue. There are various restrictive covenants included in the trust indenture for a revenue bond to protect the bondholders. A rate, or user charge, covenant dictates how charges will be set on the product or service sold by the enterprise. 4. Which type of municipal bond would an investor analyze using an approach similar to that for analyzing a corporate bond? Investors use a similar approach to analyze both municipal bonds and corporate bonds. As with corporate bonds, some institutional investors in the municipal bond market rely on their own in-house municipal credit analysts for determining the credit worthiness of a municipal issue; other investors rely on the nationally recognized rating companies. The two leading rating companies are Moody’s and Standard & Poor’s, and the assigned rating system is essentially the same as that used for corporate bonds. More details on the actual procedure are given below. In evaluating general obligation bonds, the commercial rating companies assess information in four basic categories. The first category includes information on the issuer’s debt structure to determine the overall debt burden. The second category relates to the issuer’s ability and political discipline to maintain sound budgetary policy. The focus of attention here usually is on the issuer’s general operating funds and whether it has maintained at least balanced budgets over three to five years. The third category involves determining the specific local taxes and intergovernmental revenues available to the issuer as well as obtaining historical information both on tax collection rates, which are important when looking at property tax levies, and on the dependence of local budgets on specific revenue sources. The fourth and last category of information necessary to the credit analysis is an assessment of the issuer’s overall socioeconomic environment. The determinations that have to be made here include trends of local employment distribution and composition, population growth, real estate property valuation, and personal income, among other economic factors. 5. In a revenue bond, which fund has priority when funds are disbursed from the reserve fund, the operation and maintenance fund or the debt service reserve fund? For a revenue bond, the revenue of the enterprise is pledged to service the debt of the issue. The details of how revenue received by the enterprise will be disbursed are set forth in the trust indenture. Typically, the flow of funds for a revenue bond is as follows. First, all revenues from the enterprise are put into a revenue fund. It is from the revenue fund that disbursements for expenses are made to the following funds with priority given to those listed first: operation and maintenance fund, sinking fund, debt service reserve fund, renewal and replacement fund, reserve maintenance fund, and surplus fund. Thus, the operation and maintenance fund has priority over the debt service reserve fund. More details are supplied below. Operations of the enterprise have priority over the servicing of the issue’s debt, and cash needed to operate the enterprise is deposited from the revenue fund into the operation and maintenance fund. The pledge of revenue to the bondholders is a net revenue pledge; net meaning after operation expenses, so cash required servicing the debt is deposited next in the sinking fund. Disbursements are then made to bondholders as specified in the trust indenture. Any remaining cash is then distributed to the reserve funds. The purpose of the debt service reserve fund is to accumulate cash to cover any shortfall of future revenue to service the issue’s debt. The specific amount that must be deposited is stated in the trust indenture. The function of the renewal and replacement fund is to accumulate cash for regularly scheduled major repairs and equipment replacement. The function of the reserve maintenance fund is to accumulate cash for extraordinary maintenance or replacement costs that might arise. Finally, if any cash remains after disbursement for operations, debt servicing, and reserves, it is deposited in the surplus fund. The issuer can use the cash in this fund in any way it deems appropriate. 6. “An insured municipal bond is safer than an uninsured municipal bond.” Indicate whether you agree or disagree with this statement. Everything else being equal, an insured municipal bond is safer. However, generally speaking, municipal bonds that are insured are riskier than those not insured especially if they are of inferior quality. Thus, the insurance does not guarantee they are safer than an uninsured municipal bond. More details are supplied below. Insured bonds, in addition to being secured by the issuer’s revenue, are also backed by insurance policies written by commercial insurance companies. Insurance on a municipal bond is an agreement by an insurance company to pay the bondholder any bond principal and/or coupon interest that is due on a stated maturity date but that has not been paid by the bond issuer. When issued, this municipal bond insurance usually extends for the term of the bond issue, and it cannot be canceled by the insurance company. Because municipal bond insurance reduces credit risk for the investor, the marketability of certain municipal bonds can be greatly expanded. Municipal bonds that benefit most from the insurance would include lower-quality bonds, bonds issued by smaller governmental units not widely known in the financial community, bonds that have a sound though complex and difficult-to-understand security structure, and bonds issued by infrequent local-government borrowers who do not have a general market following among investors. 7. Who are the parties to a letter-of-credit–backed municipal bond, and what are their responsibilities? A letter-of-credit (LOC) agreement is the strongest type of support available from a commercial bank. There are three parties to an LOC: (1) LOC provider, (2) municipal issuer, and (3) bond trustee. The duties of these three parties are discussed below. The LOC provider `is the bank that issues the LOC and is required to advance funds to the trustee if one of any specified events occurs. The municipal issuer is the municipality that is requesting the LOC in connection with the offering of the bond. The municipal issuer agrees to two things: (1) to reimburse the LOC provider for any payments that the LOC provider had to make under the agreement, and (2) to make an LOC fee payment periodically to the LOC provider. The LOC fee is typically from 50 basis points to 200 basis points of the outstanding principal amount of the bond issue. A direct-pay LOC grants the trustee the right to request that the LOC provider provide principal and/or interest for the LOC-backed municipal bond if there is a specified event or default or an inability of the municipal issuer to meet a contractual interest payment or principal at the maturity date. The trustee can make this demand for funds on the LOC provider without requesting that the municipal issuer make the payment first. In contrast to a direct-pay LOC, the other two types of LOC arrangements (standby LOC and confirming LOC) require that the trustee must first request any contractual payment from the municipal issuer before drawing down on the LOC. 8. Answer the below questions. a. What are the three different types of letter-of-credit in a municipal bond, and how do they differ? There are three types of letter-of-credit (LOC) arrangements: (1) direct-pay LOC, (2) standby LOC, and (3) confirming LOC. Below we describe these types and their differences. A direct-pay LOC grants the trustee the right to request that the LOC provider provide principal and/or interest for the LOC-backed municipal bond if there is a specified event or default or an inability of the municipal issuer to meet a contractual interest payment or principal at the maturity date. The trustee can make this demand for funds on the LOC provider without requesting that the municipal issuer make the payment first. From a credit perspective, the direct-pay LOC provides the trustee and therefore the bondholders with the most comfort. This is because in contrast to a direct-pay LOC, the other two types of LOC arrangements (standby LOC and confirming LOC) require that the trustee must first request any contractual payment from the municipal issuer before drawing down on the LOC. The distinction between a standby LOC and a confirming LOC (also called a LOC wrap) is that there are small community banks that are unrated by any of the rating agencies but nevertheless can issue an LOC. As a result, these small banks look to a correspondent bank that is a larger rated bank to confirm their LOC. If the correspondent bank fails to honor its LOC, the smaller bank must do so. That is, the LOC provider is the small bank but the underlying credit is the larger bank. In fact, a confirming LOC can also be provided so that an entity other than a bank can be an LOC provider. b. Which of letter-of-credit bond provides the greatest protection for investors? From a credit perspective, the direct-pay LOC provides the trustee and therefore the bondholders with the greatest protection compared to either the standby LOC or the confirming LOC. This is because the latter two types of LOC arrangements (in contrast to direct-pay LOC) require that the trustee must first request any contractual payment from the municipal issuer before drawing down on the LOC. 9. Answer the below questions. a. What is a pre-refunded bond? The escrow fund for a refunded municipal bond can be structured so that the refunded bonds are to be called at the first possible call date or a subsequent call date established in the original bond indenture. Such bonds are known as pre-refunded municipal bonds. b. Why does a properly structured pre-refunded municipal bond have no credit risk? When this portfolio of securities whose cash flow matches that of the municipality’s obligation is in place, the refunded bonds are no longer secured as either general obligation or revenue bonds. The bonds are now supported by the portfolio of securities held in an escrow fund. Such bonds, if escrowed with securities guaranteed by the U.S. government, have little if any credit risk. They are the safest municipal bond investments available. 10. Give two reasons why an issuing municipality would want to refund an outstanding bond issue. There are three reasons why a municipal issuer may refund an issue by creating an escrow fund. First, many refunded issues were originally issued as revenue bonds. Included in revenue issues are restrictive-bond covenants. The municipality may wish to eliminate these restrictions. The creation of an escrow fund to pay the bondholders legally eliminates any restrictive-bond covenants. This is the motivation for the escrowed-to-maturity bonds. Second, some issues are refunded in order to alter the maturity schedule of the obligation. Third, when interest rates have declined after a municipal security has been issued, there is a tax arbitrage opportunity available to the issuer by paying existing bondholders a lower interest rate and using the proceeds to create a portfolio of U.S. government securities paying a higher interest rate. This is the motivation for the pre-refunded bonds. 11. The following statement appeared in a publication by the Idaho State Treasurer’s Office: “Each year since 1982 the Idaho State Treasurer has issued a State of Idaho Tax Anticipation Note ‘TAN’. These notes are municipal securities that are one-year, interest-bearing debt obligations of the State of Idaho. The distinguishing characteristic of a municipal security is that the interest earned on them is exempt from federal income tax. Idaho municipal securities are further exempt from state income taxes. Idaho’s TANs are issued in multiples of $5,000 which is the amount paid when the bond matures. Idaho TANs are issued with a fixed interest rate.” Why is a TAN issued by a municipality? A TAN is a tax anticipation note that is a short-term obligation issued by a state or municipal government in anticipation of future tax collections. Because municipalities need to cover seasonal and temporary imbalances and also need immediate funding for a project (such as a highway construction), a TAN is an ideal means of raising the money now and paying off the expenditures at a later date through taxes that will be collected. 12. What are the revenues supporting an asset-backed security issued by a municipality? Municipal securities structured as asset-backed securities are backed by “dedicated” revenues such as sales taxes and tobacco settlement payments. Municipal notes are issued for shorter periods (1–3 years) than municipal bonds. 13. The four largest tobacco companies in the United States reached a settlement with 46 state attorneys general to pay a total of $206 billion over the following 25 years. Answer the below questions. a. States and municipalities, New York City being the first, sold bonds backed by the future payments of the tobacco companies. What are these bonds called? In recent years, state and local governments began issuing bonds where the debt service is to be paid from so-called dedicated revenues such as sales taxes, tobacco settlement payments, fees, and penalty payments. Asset-backed bonds are also referred to as dedication revenue bonds and structured bonds. These bonds have unique risks compared to other types of revenue bonds. Below we describe examples of these bonds. One example is the bonds backed by tobacco settlement payments. In 1998, the four largest tobacco companies (Philip Morris, R. J. Reynolds, Brown & Williamson, and Lorillard) reached a settlement with 46 state attorneys general to pay over the following 25 years a total of $206 billion. States and municipalities began to sell bonds backed by the future payments of the tobacco companies, commonly referred to as Tobacco Settlement Bonds. New York City was the first to do so in November 1999 with a bond offering of $709 million. The second example is the New Jersey Economic Development Authority series of cigarette tax revenue bonds issued in 2004. A concern that arose here after the bonds were issued was that the New Jersey 2007 state budget increased the cigarette tax but, at the same time, increased the amount of the cigarette tax revenue that had to be distributed into the State’s health care subsidy fund. Hence, there was concern that there would not be a sufficient amount after the allocation to that fund to pay the bondholders. b. What is the credit risk associated with these bonds? The credit risk (associated with the dedication revenue bonds just described) is that they depend on the ability of the tobacco companies to make the payments or the concern that the state would sufficiently allocate cigarette tax revenue. 14. Answer the below questions. (a) Explain how an inverse-floating-rate municipal bond can be created. A common type of derivative security in the municipal bond market is one in which two classes of securities, a floating-rate security and an inverse-floating-rate bond, are created from a fixed-rate bond. The sum of the interest paid on the floater and inverse floater (plus fees associated with the auction) must always equal the sum of the fixed-rate bond from which they were created. Inverse floaters can be created in one of three ways. First, a municipal dealer can buy in the secondary market a fixed-rate municipal bond and place it in a trust. The trust then issues a floater and an inverse floater. The second method is similar to the first except that the municipal dealer uses a newly issued municipal bond to create a floater and an inverse floater. The third method is to create an inverse floater without the need to create a floater. This is done using the municipal swaps. (b) Who determines the leverage of an inverse floater? The dealer determines the leverage of an inverse floater by choosing the ratio of floaters to inverse floaters. For example, an investment banking firm may purchase $100 million of the underlying bond in the secondary market and issue $50 million of floaters and $50 million of inverse floaters. The dealer may opt for a 60/40 or any other split. The split of floaters/inverse floaters determines the leverage of the inverse floaters and thus affects its price volatility when interest rates change. (c) What is the duration of an inverse floater? The duration of an inverse floater is a multiple of the underlying fixed-rate issue from which it was created. The multiple is determined by the leverage. To date, the most popular split of floaters and inverse floaters has been 50/50. In such instances, the inverse floater will have double the duration of the fixed-rate bond from which it is created. Determination of the leverage will be set based on the desires of investors at the time of the transaction. 15. Historically, what have been the causes of municipal bankruptcies? Municipal bonds are viewed as having little default risk. Moreover, cumulative default rates and recovery rates for investment-grade municipal bonds are better than for comparably rated corporate bonds. For example, according to Moody’s, over the period of 1970 to 2005, the 10-year cumulative default rate was 2.23% for corporate bonds compared to 0.06% for comparably rated municipal bonds. Moreover, Moody’s also reports that the average recovery rate was only 42% of par for corporate bonds that defaulted compared to 66% for defaulted municipal bonds. Spiotto provides a history of municipal bond defaults as well as the causes and nature of defaults. These include: Economic conditions: Defaults caused by downturns in the economy and high interest rates. Nonessential services: Revenue bonds issued for services whose service was no longer needed. Feasibility of projects and industries: Revenue bonds are issued after a feasibility study for a project is completed. The feasibility study may have been too optimistic with respect to the demand for the project or the cost of completing the project. Fraud: Municipal officials fail to comply with the terms of the relevant documents. Mismanagement: Inability to successfully manage a project. Unwillingness to pay: A municipality may simply be unwilling to pay (i.e., repudiation of the debt obligation). Natural disasters: The impairment of a municipality’s budget (reduction in revenue and increase in costs) may be the result of a natural disaster such as a hurricane. 16. Credit default swaps, a derivative instrument described in Chapter 30, allow investors to buy and sell protection against the default of a municipal issuer. Why do you think it is difficult to find investors who are willing to buy protection against default of a municipal issuer but a large number of investors are willing to sell such protection? Municipal bonds are viewed as having little default risk thus indicating no need to buy default protection. For example, according to Moody’s, over the period of 1970 to 2005, the 10-year cumulative default rate was 2.23% for corporate bonds compared to 0.06% for comparably rated municipal bonds. Moreover, Moody’s also reports that the average recovery rate was only 42% of par for corporate bonds that defaulted compared to 66% for defaulted municipal bonds. In conclusion, because the default rate is very low and the recovery rate is relatively high, many more would want to sell protection on a low risk municipal issuer as opposed to buying protection. 17. In a revenue bond, what is a catastrophe call provision? In revenue bonds there is a catastrophe call provision that requires the issuer to call the entire issue if the facility is destroyed. More information on the retirement structure of municipal bonds including call provisions are given below. Municipal bonds are issued with one of two debt retirement structures, or a combination. Either a bond has a serial maturity structure or it has a term maturity structure. A serial maturity structure requires a portion of the debt obligation to be retired each year. A term maturity structure provides for the debt obligation to be repaid on a final date. Usually, term bonds have maturities ranging from 20 to 40 years and retirement schedules (sinking fund provisions) that begin 5 to 10 years before the final term maturity. Municipal bonds may be called prior to the stated maturity date, either according to a mandatory sinking fund or at the option of the issuer. In revenue bonds there is a catastrophe call provision that requires the issuer to call the entire issue if the facility is destroyed. 18. What is the tax risk associated with investing in a municipal bond? The investor in municipal securities is exposed to the same risks affecting corporate bonds plus an additional one that may be labeled tax risk. There are two types of tax risk to which tax-exempt municipal securities buyers are exposed. The first is the risk that the federal income tax rate will be reduced. The higher the marginal tax rate, then the greater the value of the tax exemption feature. As the marginal tax rate declines, the price of a tax-exempt municipal security will decline. The second type of tax risk is that a municipal bond issued as a tax-exempt issue may eventually be declared to be taxable by the Internal Revenue Service. This may occur because many municipal revenue bonds have elaborate security structures that could be subject to future adverse congressional action and IRS interpretation. A loss of the tax exemption feature will cause the municipal bond to decline in value in order to provide a yield comparable to similar taxable bonds. 19. Answer the below questions. (a) What is the equivalent taxable yield for an investor facing a 40% marginal tax rate, and who can purchase a tax-exempt municipal bond with a yield of 7.2? A common yield measure used to compare the yield on a tax-exempt municipal bond with a comparable taxable bond is the equivalent taxable yield. The equivalent taxable yield is computed as follows: equivalent taxable yield = . In our problem, we assume that an investor in the 40% marginal tax bracket is considering the acquisition of a tax-exempt municipal bond that offers a yield of 7.2%. Inserting our values into our equation gives: equivalent taxable yield = = 0.1200 = 12.00%. (b) What are the limitations of using the equivalent taxable yield as a measure of relative value of a tax-exempt bond versus a taxable bond? When computing the equivalent taxable yield, the traditionally computed yield to maturity is not the tax-exempt yield if the issue is selling at a discount because only the coupon interest is exempt from federal income taxes. Instead, the yield to maturity after an assumed tax rate on the capital gain is computed and used in the numerator of the formula that computes the equivalent taxable yield. Also, as described below, one must realize that the effects of other taxes can also pose problems when comparing tax-exempt bonds versus taxable bonds. Because of the tax-exempt feature of municipal bonds, the yield on municipal bonds is less than that on Treasuries with the same maturity. Bonds of municipal issuers located in certain states yield considerably less than issues of identical credit quality that come from other states that trade in the general market. One reason for this is that states often exempt interest from in-state issues from state and local personal income taxes, whereas interest from out-of-state issues is generally not exempt. Consequently, in states with high income taxes, such as New York and California, strong investor demand for in-state issues will reduce their yields relative to bonds of issuers located in states where state and local income taxes are not important considerations (e.g., Florida). 20. What can you say about the typical relationship between the yield on short-term and long-term municipal bonds? In the Treasury and corporate bond markets, it is not unusual to find at different times either upward, downward or flat shapes for the yield curve. In general, the municipal yield curve is positively sloped indicating that short-term bonds have lower yields than long-term bonds. The most likely explanation is a maturity premium although other reasons could be present including expectations about inflation and supply versus demand considerations. 21. How does the steepness of the Treasury yield curve compare with that of the municipal yield curve? Assume slopes for both Treasury bonds and municipal bonds are upward sloping. If so, then a steeper municipal yield curve implies that yields for longer term municipal bonds increase more rapidly than for Treasury bonds. This could be caused if certain factors are more prominent in the municipal bond market. For example, if longer term municipal bonds are in shorter supply compared to Treasury bonds, then this factor could lead to greater yields for longer term maturities for municipal bonds. Consequently, a steeper upward sloping yield curve for municipal bonds would result. Similarly, if longer term municipal bonds are seen as increasing more rapidly in terms of credit risk with longer maturities, then the upward slope for yield curves for municipal bonds would be steeper. Finally, investing in municipal securities exposes investors to the same qualitative risks as investing in corporate bonds, with the additional risk that a change in the tax law may affect the price of municipal securities adversely. Since the impact can be greater for longer term maturities, this could cause yield curve for municipal bonds to be steeper. 22. Explain why the market for taxable municipal bonds competes for investors with the corporate bond market. Like the corporate bond market, taxable municipal bonds are bonds whose interested is taxed at the federal income tax level. Thus, investors are going to look at the risk and return trade-off to determine which bond they prefer. Because there is no tax advantage, investors will expect a higher return for a lower rated bond regardless of whether it is a municipal or corporate bond. For either a municipal or corporate bond, their yields must be higher than for another tax-exempt municipal bond. Also, their yields must be higher than the yield on U.S. government bonds because an investor faces credit risk by investing in either bond. 23. What is the yield ratio and why is it typically less than 1? Because of the tax-exempt feature of municipal bonds, the yield on municipal bonds should be less than that on Treasuries with the same maturity. Thus, we should typically get a number less than one when comparing the yield on municipal bonds to the yield on Treasury bonds with the same maturity. This can be seen by examining the below equation for the yield ratio: yield ratio = . We can add that the yield ratio varies over time. For example, according to Bloomberg, from April 28, 2001, to August 31, 2006, the yield ratio for AAA 20-year general obligation bonds ranged from 82.5% on May 31, 2005, to a high of 101% on June 30, 2003, with an average yield ratio of 90.6%. This, while not the typical occurrence, the yield ratio can sometimes exceed 1. 24. Answer the below questions. (a) What is a Build America Bond? Despite the excellent performance of the municipal bond sector in terms of credit risk, in 2008 state and local governments and their agencies faced financial difficulties. To provide assistance to these municipal entities, the American Recovery and Investment Act of 2009 authorized the issuance of a new type of taxable municipal bond, Build America Bonds (dubbed BABs). A BAB is a taxable municipal bond wherein the issuer is subsidized for the higher cost of issuing a taxable bond rather than a tax-exempt bond in the form of a payment from the U.S. Department of the Treasury. (b) What is the current status of the federal government program authorizing the issuance of such bonds? From the time of the program's inception in April 2009, through the end of the program at the end of 2010, a total of $181 billion of Build America Bonds were issued. Under this program, the payment made by the federal government to the issuer is equal to 35% of the interest payments. Issuance of BABs significantly increased the size of the taxable sector of the municipal bond market during its operations in 2009 and 2010. Although the program has been terminated, there is considerable supply of BABs outstanding. There have been various proposals in Congress to reinstitute this program. Solution Manual for Bond Markets, Analysis and Strategies Frank J. Fabozzi 9780132743549, 9780133796773