Debt Instruments

This page of our free SIE Study Guide covers debt instruments that are issued by governments, agencies, and corporations.

Debt issuers borrow money from investors, pay interest for the use of that money, and then finally pay back the loan principal at the end of the loan term (which is known as the maturity date).

Treasury Securities

United States Government & Agencies: The United States borrows money in many different forms:

  • Treasury Bills (T-Bills): Short-term borrowings (1 year or less). Interest is paid at maturity and it is determined as the excess of the face amount over the discounted-by-interest purchase price.
  • Treasury Notes: Intermediate-term borrowings (2 to 10 years). Interest is paid semi-annually and is exempt from state tax.
  • Treasury Bonds: Long-term borrowings (up to 30 years). Interest is paid semi-annually and is exempt from state tax.

Bill Auctions: On a weekly basis, the U.S. Treasury holds public auctions of T-Bills by which investors place (a) competitive bids or (b) non-competitive tenders on the offerings. The price of the offering is set once all the bids are in; investors who bid at or above the winning yield (the lowest discount rate) receive the bills.

Ginnie Mae/Fannie Mae/Freddie Mac: These entities facilitate the mortgage market for primarily residential housing and may issue short-term or long-term debt securities for funding purposes.


Municipal Securities

A unicipality is a city or town that has corporate status and local government. Local governments borrow money in a number of different ways in order to fund capital asset projects and day-to-day obligations, or to cover cash flow deficits.

General Obligation Bonds: The traditional financing method for capital asset projects related to infrastructure, buildings, utility lines, and others. These bonds are not backed by collateral; rather, they are backed by the municipality’s total tax and operating revenue.

Revenue Bonds: Like general obligation bonds, revenue bonds are issued to fund public projects. However, purchasers of these bonds are repaid from the income generated by the specific project the bond was funding rather than by the issuer’s total revenue.

Special Tax Bonds: Combination of general obligation bonds and revenue bonds. Municipalities issue these in order to fund public projects and will increase a specific tax, either an excise or a special assessment tax, to repay the bondholders. For example, a municipality might decide to implement an excise tax on fuel or tobacco.

Authority Bonds: These bonds are issued to enable the construction of an income-producing facility, such as a toll bridge or an airport, where the revenue from business operations pays the interest and repays the principal at maturity.

Taxable Bonds: Fixed-income municipal securities issued to fund projects not subsidized by the federal government because they do not provide a meaningful benefit to the general public. Projects might include sports facilities, public pension funding, or refinancing of existing debt. These bonds are not tax-exempt like others.

Municipal Notes: Short-term debt securities that typically mature in one year or less. Interest and principal are paid in one payment at the time of maturity and are exempt from federal income tax.


Corporate Bonds

In addition to stock offerings, corporations can raise money by issuing bonds to investors. The company pays interest on the bonds, typically semi-annually, and then repays the principal to the bondholders at maturity.

For example, let’s say you purchase a 10-year bond with 4% fixed interest for $1,000 (known as a fixed-rate bond). The company will pay you $40 per year in interest and will then repay the $1,000 in 10 years. Other types of corporate bonds include zero-coupon bonds and convertible bonds which are described later on in this section.

Zero-Coupon Bonds: Don’t pay any interest. Rather, the investor pays below the face value of the bond and then receives the full value at maturity.

Convertible Bonds: Companies have the option to repay the loan with common stock rather than cash.


Money Market Instruments

Money market securities are short-term fixed-income debt instruments that mature in up to 270 days. These investments are typically considered to be safe and liquid.

  • Certificates of Deposit (CD): CDs are essentially savings accounts issued by a bank or credit union that generate fixed interest on a fixed amount of money for a fixed length of time. The length of time can vary but is typically six months, one year, or five years. Though most will penalize investors for withdrawing funds early, CDs are considered to be one of the safest investments and those held at federally insured banks are insured up to $250,000. CDs purchased from brokerage firms or independent salespersons are known as brokered CDs and carry more risk than traditional CDs.
  • Banker’s Acceptances: Banker’s acceptances are financial instruments that trade on the secondary money market prior to maturity. They represent future guaranteed payments from banks with maturities of between 30 and 180 days and are most commonly used in international transactions. When traded on the secondary market, banker’s acceptances are sold at a discount to face value dependent upon their length to maturity.
  • Commercial Papers: Commercial papers are unsecured interest-paying securities, often referred to as promissory notes, issued by large corporations with high credit ratings as a way to cover short-term obligations. They are essentially written promises to pay back a certain amount of money within a certain amount of time and are typically sold at a discount to face value.

Par Value

The initial loan amount of a bond is referred to as the par value, face value, nominal value, or principal, and indicates how much the bond will be worth at maturity. Par value is typically $100 or $1,000.


Interest Rate

Most bonds carry interest which is also referred to as the nominal yield or the coupon rate. Expressed as a percentage, interest is paid to investors by the bond issuer on a regular basis, typically twice a year. The interest rate can be determined by dividing the sum of the annual coupon payments by the bond’s face value.

  • As an example, a bond with a face value of $1,000 and $20 semiannual interest payments has a coupon rate of 4%.

Length to Maturity

Also known as term to maturity. For treasuries and corporate bonds, length to maturity is simply the length of time between the issue date and the maturity date, when interest payments are made. The bonds are traded on such basis.

However, asset-backed securities and mortgage-backed securities are traded based on average life, also known as weighted average life. This is the average length of time that each dollar of principal is expected to be outstanding. Therefore, because periodic payments include partial repayment of principal as well as interest, the average life will be considerably shorter than the length to maturity.


Accrued Interest

Accrued interest is interest earned that has not yet been paid. It is calculated as the number of days since the last coupon payment plus the assumed number of business settlement days, divided by the number of days in the year, then multiplied by the coupon interest rate.

For corporate and municipal bonds, the number of business settlement days is three and the number of days in the year is 360.

For U.S. Government bonds, the number of business settlement days is one and the number of days in the year is 365.


Yields

The term yield in the securities industry means the rate of return of an investment. In stocks, this is typically measured by dividends, whereas in bonds the yield is measured by interest. There are several different formulas for measuring the yield of a bond investment. Include math examples below?

Current Yield: The expected annual rate of return of the bond, calculated by dividing the annual interest by the current market price.

Yield to Maturity (YTM): Also called book yield or redemption yield, the YTM is the overall expected yield of the bond if held until the maturity date.

Yield to Call (YTC): For callable bonds, the YTC is the bondholder’s overall yield if the bond were called by the issuer, which occurs prior to the maturity date.


Other Bond Features

Issuers will at times add certain provisions to their bond offerings in order to attract investors. Such features are described below. It’s important to note that none of these provisions are ever required.

Callable: Gives the issuer to right to pay off the bonds at a date earlier than the maturity date. Callable bonds tend to offer higher interest rates due to higher risk.

Puttable: Allows a bondholder to redeem the principal amount of their bond on or after a specific date(s), well before the maturity date. Puttable bonds tend to offer lower interest rates due to lower risk.

Zero-Coupon: These bonds don’t pay any interest. Rather, the investor pays below the face value of the bond and then receives the full value at maturity.

  • For example, let’s say you purchase a 10-year zero-coupon bond for $600, and at maturity you receive $1,000. Your yield in this case is based on the $400 of appreciation in value over the 10-year holding period rather than regular interest payments.

Convertible: Gives the issuer the option to repay the loan with common stock rather than cash.

Insured (Municipals Only): When a municipality has a somewhat unfavorable credit rating, they may elect to purchase bond insurance which guarantees the timely payment of interest and principal, in order to give prospective investors confidence that they won’t default on the loan. The guarantee comes from a municipal bond insurance corporation, generally a multi-billion-dollar insurance company that is prepared and equipped to make such guarantees.


Bond Rating Agencies

There are three primary rating agencies that account for 95% of the international bond ratings industry: Moody’s Investor Services, Standard & Poor’s (S&P), and Fitch Group. These organizations evaluate the credit risk of debt securities and their issuers and then assigns them a rating. The ratings range from AAA, which indicates the highest quality and lowest risk, down into the Bs and Cs, which indicate lower quality and higher risk.


Priority in Liquidation

Many issuers have more than one bond issue outstanding at a time. Different types of bonds are ranked by their priority of payment, with senior secured debt being the top priority followed by senior debt and then subordinated debt. Senior debt is typically secured, meaning it is collateralized by assets, while subordinated debt is typically unsecured. All types of debt have priority over equity.


Relationship between Price and Interest Rate

There is an inverse relationship between interest rates and bond market prices. As interest rates rise, bond market prices fall, and vice versa.

Impact of length to maturity: A bond with a longer length to maturity will react to a greater degree when interest rates change than will a bond that has a shorter length to maturity.

Impact of credit rating (AAA, AA, etc.): The highest quality bonds will tend to react to a lesser degree when rates change than will bonds of lower quality.


Risks of Debt Securities

Although bonds are generally considered safe, they can still carry a number of risks.

Interest Rate Risk: Risk that the value of the bond will decrease due to unexpected fluctuations in interest rates.

Inflation Risk: Risk that inflation will decrease the purchasing power of money which will lead to a decline in the expected return of a bond.

Credit Risk: Risk that the issuer will default on loan payments.

Liquidity Risk: Risk that few buyers are available when the security needs to be sold quickly.

Political Risk: Risk of default, or debt downgrade, due to political challenges impacting the issuer.


Municipal Bond Offerings: Negotiated vs. Competitive

There are two methods by which underwriters can purchase municipal bonds from issuers for public resale: competitive or negotiated sales. Bonds sold in competitive sales typically have lower interest rates.

Competitive: Issuers advertise that their bonds are for sale by releasing a notice of sale to the public. This advertisement contains terms of both the sale and the bond issue. From there, broker-dealers and/or banks (underwriters) place bids on the bonds at a specified time on a specified date and the bidder offering the lowest interest rate wins.

Negotiated: Issuers are allowed to select the underwriter(s), with whom they directly negotiate the terms of the bonds and the terms of the sale in a “two-party” process. Additionally, investors are able to submit indications of interest (IOIs) in negotiated sales which then help the underwriter(s) finalize the offering price and sell the bonds.

 
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