Series 7 Debt Notes

Series 7 Debt Study Guide

Debt is one of the largest sections of the Series 7 exam. It comprises about 20% of the total exam, so understanding every concept is imperative to passing the Series 7 Debt section. Below are all the notes I have typed up for the debt section, along with a few practice questions along the way.

Taxing of Interest Payments

US Govt. (CMBs, T-bills, T-notes, T-bonds, STRIPS & TIPS) (3 questions)

Fed Income Tax: Subject to tax

State & Local: Exempt

High trading volume, low spreads

Minimum denominations: $100

Govt. Agency (primarily mortgages – fed home loan bank, fed farm credit) (1 question)

Fed Income Tax: Subject to tax

State & Local: Exempt

Minimum denominations: $1,000

Privatized Govt. Agency (Mortgage-backed pass throughs – fannie Freddie ginnie) (6-7 questions)

Fed Income Tax: Subject to tax

State & Local: Subject to tax

Fully Taxable!!

Minimum denominations: $25,000

Unique risks (prepayment, extension, not suitable for small investors)

Corporate Debt (3 questions)

Fed Income Tax: Subject to tax

State & Local: Subject to tax

Fully taxable!!

Minimum denominations: $1,000

Secured:

  1. Mortgage bond: (pledges assets as collateral) can be senior or junior
  2. Equipment trust cert (ETCs): pledges equipment as collateral (airlines, trucks, trains), not used by manufacturing companies
  3. Collateral Trust Cert: collateral is stock of a wholly owned subsidiary

No such thing as convertible!

Unsecured:

  1. Debenture: IOU

Backed by faith and credit – companies have usually been around a long time

Can be made convertible to lower interest cost

  1. Income Bond: adjustment bonds. Interest payment is dependent upon income targets being hit

Really means no-income bonds

No assured payment of interest or principal

Municipal (25 questions)

Fed Income Tax: Exempt

State & Local: Exempt if bond is issued in state of residency, or if it is a bond of a territory or possession (Puerto rico, guam, etc.)

Minimum denominations: $1,000

Go for the general rule, not the exception in the questions!

Low trading volume, wide bid/ask spreads. Buy & hold market

OTC dealer market, not on exchanges

MSRB is the muni regulator, makes rules for munis

Random Notes

Munis are exempt securities, so are govt, agency, private agency

Corporate securities are the only non-exempt securities, meaning they must be registered and sold with a prospectus

Exempt ones must not be registered with the SEC

FINRA enforces MSRB rules for broker-dealers.

MSRB doesn’t regulate municipality issuers, just regulates the people that trade/broker-deal Munis and the bank departments that underwrite them

Agency trade = commissions disclosed (brokered trade)

Dealer trade = doesn’t disclose commissions, but have to be reasonable (sold out of inv)

THERE IS NO EXCHANGE TRADING OF BONDS – ALL OTC

Position trading = trading out of own inventory (dealer)

Real interest rate takes out inflation

Real rates are unaffected by inflation, nominal are affected by inflation (kind of backwards)

Basis is where rates are trading now when looking at bond quotes

Bond will trade at a premium when the coupon is higher than the basis

Bond Contract vs Bond Indenture: Only in Revenue Bonds and Corp Bonds

Munis indentures are for marketability, Corp bond indentures are required by law

“book-entry” means bond is electronic, no physical certs

Bearer bonds are physical certs

Bond contract is the promise to bondholders, to revenues, and various covenants

Question asks whom the contract is between: issuer and bondholder

Trust indenture is a contract wrapped around the bond contract. Appoints a trustee to monitor the compliance of the promises and covenants of the bond contact

Contract between: trustee and the issuer (where trustee acts in interest of bondholder)

Trustee must be big deposit taking firms (commercial banks and trust companies)

Muni bonds are rarely ever sold short because they are very inactively traded (thin)

Muni Call Covenants

In whole call: Bond issued in 2017, callable in 2027-2030 at 102 step-down

Most likely to call bonds with high coupons, low call premiums

This call in an optional call

Sinking fund call: term bonds (interest only, principal in last pmt)

Call bonds at par, picked out of a random selection of bonds

Periodic call of a small % of bonds every few years – retires outstanding debt

Mandatory call!!

Calamity call: bonds called because the facility backing the bond has been destroyed

An extraordinary mandatory call

TIPS and STRIPS are only bought in retirement accounts!! (accretion is taxable in same year – but retirement accounts are non-taxable, aka why only they buy them)

All bonds are exempt, except Corp bonds which require a prospectus

Municipal Bonds (25 questions)

  1. General Obligation Bonds (10 questions)

    1. Characteristics and things to remember
      1. Backed by the full faith and credit, and unlimited taxing power of the issuer
      2. Only bond backed by unlimited taxing power – safest type
      3. If it’s not a GO bond, it’s a revenue bond
      4. Non-self-supporting debt – carried on the backs of taxpayers
      5. Subject to debt limit – must get public approval to issue past debt limit
      6. Refunding bonds replace an existing bond, extending the maturity of the debt
      7. Most are level debt service serial bonds: repay principal and interest. More interest early on, more principal later – similar to a mortgage
    2. Type 1: State GO Bonds
      1. Income tax
      2. Sales Tax
      3. Excise taxes (gas, tobacco, etc.)
    3. Type 2: Political Subdivision GO Bonds (county, city, etc)
      1. Property taxes (ad valorem)
        1. Not used for state!!
        2. Assessed in mills (1/1000th)
        3. Don’t use market value! Used assessed value always!!
    4. Debt Statement of a US City
      1. Bonded Debt = $100M (all bonds town has sold – total indebtedness)
      2. Less: self-supporting debt = $40M
      3. = $60M level debt service serial bonds
      4. = $60M Net Direct Debt
      5. Overlapping Debts: (for towns or counties within a city)
        1. County Debt: 20% of $100M
        2. School District: 20% of $100M
      6. Overall Net Debt: $100M
      7. Divide by: population of town: 100,000
      8. Debt per capita = $1,000 (analyze versus other towns of same size)
    5. Analyze credit rating based on:
      1. Net debt to assessed value: inconsistent from town to town
      2. Collection ratio
      3. Debt per capita: consistent from town to town
      4. Pledged revenues to debt service reqs: REVENUE BONDS!!
      5. Debt service coverage ratio: REVENUE BONDS!!
    6. Pre-refunding bond issues
      1. Characteristics:
        1. When city refunds bonds prior to their maturity date
        2. Plain refunding bonds refund at maturity date with new debt
        3. Safest muni you can buy!!
      2. Defeasance Covenant (bonds now backed by treasuries, not taxes)
        1. Escrows treasuries which turns into self-supporting
        2. Now we can take this out of our net debt and issue more debt
        3. Will pre-refund its debt when interest rates are falling
        4. Negative carry: have to pay the difference between the coupon and new T-bill rate until the debt matures
        5. Steps:
          1. Float a BAN (Bond anticipation note)
          2. Use proceeds to buy 1yr T-bills
          3. Escrow T-bills with a trustee
          4. Escrow now backs the old bond issue, self-supporting
          5. Sell new bond issue, at lower rates
          6. Use proceeds to retire the BAN
  2. Revenue Bonds (10 questions)

    1. Characteristics and things to remember
      1. Backed by pledge of revenues from an enterprise activity
      2. If bond says “Authority” on it, it is a revenue bond
      3. Self-supporting debt – pay their own way from user fees, tolls, etc.
      4. No debt limits! But must be economic justification
      5. Bond counsel won’t look at the feasibility study!!
    2. Feasibility Study: must pass this study to be deemed economically viable
      1. Independent consultant is hired to do economic projection
        1. Expected revenue collection vs. opex
        2. Net revenues for debt service – must be adequate
      2. Double barrel: if net revenues are close but not quite there, we can back the bond by the revenues AND the ad valorem tax power to get deal done. Must be room in the debt limit for this to be done
      3. Bond Counsels/Bond Attorneys
        1. Write the bond contract
        2. Write the trust indenture
        3. Opine on the new issue of bonds (**legal opinion on: validity, legality, tax exempt status** – there is a question on this)
          1. Unqualified – clean no problems
          2. Qualified – problems, something needs to be fixed
      4. Flow of Funds: always first deposited to revenue fund!
        1. Gross Revenue Pledge
          1. Dollars go into revenue fund
          2. Sinking fund
          3. Operation and maintenance fund
        2. Net Revenue Pledge (usually includes a rate covenant)
          1. Revenue fund
          2. Operation and maintenance fund
          3. Sinking fund
          4. Rate covenant: set toll at 150% opex
  3. Industrial Revenue Bonds

    1. Characteristics and things to remember
      1. State industrial development authority signs a lease with a corporation so that Corp is lessee and authority is lessor. Lease payments is the revenue source that backs the bonds
      2. Bond is also guaranteed by the corporate lessee
      3. Credit rating is the rating of the corporation cause they guarantee
      4. Non-essential use private purpose bond issue
        1. Now taxable at federal level!
        2. Question asks which bond issue would be fed taxable?
  4. Special Tax Bonds

    1. Characteristics and things to remember
      1. Political subdivision issue
      2. Typically supported by excise tax
      3. Used to fund improvements, but require voter approval
    2. Special Assessment Bond Issue
      1. Funds improvements
      2. Only those who get the improvement pay for it through taxes
  5. Moral Obligation Bonds

    1. Characteristics and things to remember
      1. Backed by cities taxes
      2. State has the moral obligation to pay, but not the legal obligation if the municipality defaults
      3. Apportions funds to service the debt
      4. A bond issue where the state legislature has the authority but not the obligation to apportion funds to service the debt: moral obligation
      5. Ultimate payment will be made by: legislative apportionment
  6. Build America Bonds

    1. Characteristics and things to know
      1. Used for infrastructure projects
      2. Taxable bonds – sold at higher rates
      3. Muni gets 35% tax kick for the interest
  7. COP (Certificate of Participation) – pure definition question if it shows up

    1. Issued by muni’s that are capped at their debt limit (technically a revenue bond)
    2. A way to get around raising more debt without upping the debt limit
    3. Governing body authorizes an appropriation from tax collections to pay debt service on bonds
    4. Similar to GO bond but does not have the backing

Short-Term Municipal Debt

These are rated on the MIG scale! MIG 1-3 and then SG for speculative

  1. BANs (Bond Anticipation Note)
    1. Bridge loan in a defeasance situation
    2. Not a cash flow smoother!!
  2. TANs (Tax Anticipation Note)
    1. Gets paid off in the future with tax revenues
    2. Smooths cash flows
  3. RANs (Revenue Anticipation Note)
    1. Gets paid off with future revenues
    2. Smooths cash flows
  4. TRANS (Tax and Revenue Anticipation Note)
    1. Combo of TAN and RAN
    2. Smooths cash flows
  5. GANs (Grant Anticipation Note)
    1. Paid off by future receival of federal grants
    2. Smooth cash flow
  6. CLNs (Construction Loan Notes)
    1. 2-3 years
    2. For big construction projects
    3. They are taken out by a later long-term bond sale (paid off)
  7. VRDOs (Variable Rate Demand Obligation)
    1. Long-term financing at short-term rates
    2. Weekly renewable notes
    3. Includes an embedded put option – can put bond at par at each adjustment
    4. Almost no market risk! Because of weekly adjusted rate
  8. ARS (Auction/Adjustable Rate Securities)
    1. Long term financing at short-term rates
    2. Weekly renewable note
    3. No embedded put option!! Can’t be put to par
    4. Auction held every week – holder can either hold or sell to someone else at auction
    5. Issuer essentially never has to pay it back
    6. Failed because:
      1. No buyers
      2. Clearing rate: if interest rates were bid above the clearing rate, the rates stayed until the next week
      3. If interest rates bid were above the clearing rate, the auctions fail

Bond Risks

Generic Bond Risks

  1. Market Risk: Interest rate risk
    1. If interest rates go up, bond prices go down (fixed rate bonds only)
    2. Variable rate bonds do not have interest rate/market risk
    3. Volatility of prices:
      1. Long term bonds drop price faster
      2. Low coupon rates drop price faster
  2. Marketability Risk
    1. Essentially liquidity risk – can you sell the bond
    2. Govt and agency bond market has plenty of marketability
    3. Corp bonds have a little bit of marketability risk
    4. Muni market has a ton of marketability risk!!
  3. Credit Risk / Default Risk
    1. Risk of not being paid back – this is what is rated by credit agencies
    2. Baa and BBB are lowest rated investment grade! Below is speculative
    3. Ba and BB are highest rated speculative grade
  4. Legislative Risk
    1. Essentially tax change risk
    2. Big for Municipal debt but none others
  5. Purchasing Power Risk
    1. Inflation risk
    2. Avoid with: variable rate securities and TIPS
  6. Call Risk
    1. Risk bond is going to be called prior to maturity
    2. Likely to be called when rates drop and premiums are low
  7. Re-Investment Risk
    1. Risk that coupon payments can’t be reinvested at the same rate (lower rates)
    2. Not an issue for zeros!!
    3. Risk for long-term investments that pay coupons
    4. STRIPS avoid reinvestment risk! Zero coupon treasury bond
  8. Political Risk (unique to foreign investing)
    1. Issue investing outside of US with weak political systems
  9. Exchange Rate Risk (unique to foreign investing)
    1. Risk of US dollar strengthening, foreign currency buys less US dollars

Bond Math

Corp bonds are in 8ths

Government bonds are quoted in 32nds

Muni’s are quoted in 8ths

Nominal yield = stated coupon yield

Current yield = Annual income / purchase price

Yield to maturity (aka the basis) = annual income + annual gain / avg bond price (adds in accretion value)

Or income – annual loss / avg bond price if its trading at a premium

For discount bond low to high: nominal, current, basis (YTM)

For premium bond low to high: basis (YTM), current, nominal

Worst case for discount bond: held to maturity

Worst case for premium bond: called at earliest possible date

Must amortize a premium bond but are not allowed to deduct the premium amortized – negative tax benefit

Annual accretion on a discount bond is taxable at the federal ordinary income tax rate!!

US Government Bonds

  1. CMBs (Cash Management Bills)
    1. Shortest maturity treasury security
  2. T-Bills
    1. Issued 1,3,6,12-month maturities
    2. Not available in 9 month!!
    3. Original Issue Discount
    4. Quoted on a yield basis!! This is why the ask is a lower # than the bid
    5. Auctioned weekly, primary government dealers must bid at this auction (obligated)
      1. US and Foreign banks and broker-dealers can all be primary dealers
      2. New issues, settles Thursday of the auction week
  3. T-Notes / T-Bonds
    1. 2-10 year maturities, 10+ year maturities
    2. Sold at par, pay interest semi-annually
    3. Quoted in 32nds (100-16 or 100-24 for example) (price quote)
    4. No treasury securities are callable!!
  4. STRIPS (Treasury Receipts – broker created zero coupon)
    1. Sold directly from US Gov
    2. Stripped of interest payments – zero coupon
    3. Avoid reinvestment risk!
  5. TIPS
    1. Inflation protected
    2. Makes adjustments on principal either up or down based on inflation
    3. Real interest rate will stay constant
    4. Dollar amount of interest adjusts up with inflation
  6. Trades of treasuries settle regular way – next business day!!
    1. Only ones to do so (along with options)
    2. Rest settle T + 3

Privatized Govt Agencies (Fannie, Freddie, Ginnie)

  1. Mortgage Backed Pass-Throughs
    1. Ginnie is directly government backed, Fannie & Freddie is only implied backing (gov does not have to back them)
    2. Prepayment risk (call risk equivalent) – risk of people paying their mortgages earlier than expected – results in a lower rate of return
      1. Happens when rates are dropping, pay off faster so they can refinance at a lower rate
    3. Extension risk – risk when people extend the amount of time they take to pay their mortgage
      1. Happens when rates are rising, people take longer to pay so they don’t have to finance at a higher rate
  2. CMOs (Collateralized Mortgage Obligations)
    1. Takes the cash flows of pass-through certs and divides the flows into tranches
      1. Then sold in denominations of $1,000
      2. Tranches have various maturity dates, usually from one year to 30 years
      3. Creates more certainty in maturity dates
      4. Not guaranteed by the US government!!
      5. Taxes = subject to state federal local
  3. Plain Vanilla
    1. Principal payments are paid off sequentially (first tranche to last), but interest payments are pro-rata or proportionately
  4. PAC Tranches (Planned Amortization Class)
    1. Safest tranche – less prepayment risk and extension risk than companions
    2. Most certain repayment date!!
    3. Lower rates
  5. Companion Tranches
    1. “Shock-absorbers” – take prepayment risk and extension risk away from PAC tranche
    2. Least certain repayment date!!
    3. Higher rates
  6. TAC Tranche (Targeted Amortization Class)
    1. Buffered against prepayment risk
    2. Not safe from extension risk!!
  7. PAC > TAC > Plain Vanilla > Companion (least to most risk)
  8. Banks do make their own Private Label CMOs
  9. IO Tranches
    1. Interest only tranches
    2. More payment earlier on, less later on
    3. Not getting all your payments if prepaid – get much less interest
    4. When rates go down, value of IO goes down = moves direct with interest rates
  10. PO Tranches
    1. Principal only tranches
    2. Smaller payments in earlier years, bigger in later
    3. Work like conventional bonds
  11. Z-Tranches
    1. Zero tranche – gamble
    2. If there is anything left after all other tranches get paid, this tranche gets paid
    3. Might or might not get paid – depends on default

Accrued Interest

Corp / Muni bonds: Interest accrues up to, but not including settlement

Settle regular way Trade date + 3 days

Accrues on a 30/360

Tues, Aug. 8 (Jan 1 + Jul 1 interest) = 30 days for July, 10 days for July = 40 days

Mon/tues will trade that week (+2), Wed-Fri trades over weekend (+4)

US Gov bonds: accrues up to but not including settlement

Regular way Trade date + 1 days

Accrues on an actual/actual basis

Trading flat means no accrued interest is added: zero coupon bonds, defaulted bonds, income bonds

No accrued interest if bond trades on the 6 month date

Muni term bonds are quoted; percentage of par in 8ths (same as corp) (aka dollar bonds)

Muni serial bonds (GO bonds) are quoted: on basis (yield)

Money Market Instruments

Less than one year maturity

All OID – original issue discounts

Quoted on a yield basis

  1. T-Bills
  2. Commercial Paper
    1. Most common maturity is 30 days
    2. 30-day is also shortest, max is 270 days
    3. Max is 270 because its exempt under act of 33 if maturity is less than 270
  3. Bankers Acceptances
    1. P1-3, NP
    2. Time-draft – similar to a post-dated check
    3. Used to finance imports and exports
  4. Negotiable CD
    1. Negotiable meaning it can be traded in the market
    2. Different than above because they are issued at par and accrue up!!
  5. Long-Term Negotiable CD (Not MM)
    1. Not a money market instrument because of maturity
    2. Disclosures must be given:
      1. Market value can vary
      2. Step-up or step-down = interest rate can vary
      3. Negotiable (tradable)
      4. Can’t be redeemed at par prior to maturity
      5. No prepayment penalty – cause there are no prepayments
      6. Can only sell in market until it matures
      7. Has FDIC protection up to $250k – if its titled in customer name!! (it does not if its in street name)

Structured Products

“market index linked CD” – what they’re called on test

It is “bond-like” but technically not a bond

Maturity of 5-7 years (not MM)

Interest rate is based on a stock index (S&P500)

If index is up, interest rate goes up – but is capped at a max

If index is down, interest rate goes down – but there is a floor too

Backed by guarantee of the issuing bank (credit risk is biggest risk with these!!)

Also have liquidity risk – hard to get out of

Have large prepayment penalties

Exchange Traded Notes (ETNs)

Structured products that are traded on an exchange

Have maturities

Backed by guarantee of issuing bank

Eliminates liquidity risk and prepayment penalties!

Still have credit risk

Reverse Convertible Notes

Structured product created by an IB

Tied to an underlying stock

Has a “knock-in” price – if at maturity, stock price is above the knock-in price, you get your principal back

If stock price is below the knock-in price, you get the shares and not the principle

Can lose everything, if stock price goes to 0

Random Question Notes

When evaluating the credit of a GO bond, the following are considered: population trend, demographics, assessed value trend, attitude of community towards its debt

Answer: all

All of the following are overlapping debts except: state debt, county debt, road district debt, school district debt

Answer: State, the rest are overlapping – any district debt is overlapping

A town and a school district are coterminous (share same geo boundaries). School district debt is:

  1. A direct debt
  2. A self-supporting debt
  3. A 100% overlapping debt
  4. A 100% underlying debt
    1. Answer: C, a 100% overlapping debt

Overall net debt is:

  1. Direct plus indirect debt
  2. Overlapping and underlying debt
  3. Net direct plus overlapping debt
  4. Self-supporting plus non-self-supporting
    1. Answer: C, net direct plus overlapping

A municipality will pre-refund its debt with:

  1. US Govts
  2. Agency Debt
  3. Triple AAA Muni’s
  4. Bank CD’s
    1. Answer: A, B, D
    2. Will not pre-refund with muni debt!! (cause bad yield curve)
    3. MSRB says only allowed to use US gov, agencies, and bank CD’s (sometimes)

You have a customer in the 40% tax bracket. You recommend a 6% muni bond. What is the equivalent taxable yield? Equivalent taxable yield = tax free yield / 100% – Tax bracket. Equiv yield is 10%.

Annual accretion on muni bonds is annual adjustment to the bonds:

  1. Cost basis
  2. Sale proceeds
  3. Market value
  4. Book value
    1. Answer is: Book Value

What is the term for the excess of par value over the purchase price of a muni bond?

Answer: this is the discount!! (backwards but think about it)

Only two types of securities calculated on a yield basis: money market, GO bonds

MSRB rules: for serial bonds quoted on a yield basis

If discount: price it to maturity

If premium: price to near term in whole call date

A Market discount muni bond is a 6% coupon quoted on an 8% basis, after considering all taxes, the yield will be: (muni)

  1. Less than 6%
  2. 6%
  3. 6-8%
  4. 8%
    1. Answer: more than 6, less than 8 because of the tax effect on the accretion of the discount bond

A market premium discount bond is an 8% coupon quoted on a 6% basis, after considering all taxes, the yield will be: (muni)

  1. Less than 6%
  2. 6%
  3. 6-8%
  4. 8%
    1. Answer: 6% because the amortization of the premium is not tax deductible

When pricing premium muni bonds quoted on a yield basis, what calls are considered?

  1. In whole calls
  2. Sinking fund calls
  3. Calamity calls
    1. 1 only
    2. 1 + 2 only
    3. 2 + 3 only
    4. 1 + 2 + 3
      1. Answer: A, in whole calls only!

Market segmentation theory of the yield curve does explain irregular movements of the yield curve

PSA stands for Prepayment Speed Assumption!!

The Amount of accrued interest is:

Added to the buyer’s confirmation

Added to the seller’s confirmation

Subtracted from buyer’s confirmation

Subtracted from seller’s confirmation

Answer: added to buyer’s and seller’s confirmation!! (no subtraction)