Investments & Securities Chapter 7 What Meant Issue Issuer Being Placed Credit Watch Being Placed Credit Watch

6. What is meant by an issue or issuer being placed on a credit watch?

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

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,

(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

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

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referred to as bullet bonds.

(b) When a bullet bond is redeemed prior to the stated maturity date, could it be called in

part (only a portion)?

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

(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

(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

(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

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

(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

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

13. What are the similarities and differences between a floating-rate note and an

extendable reset bond?

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

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

14. What is a payment-in-kind bond?

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.

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.

(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.

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

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share of MTN transactions.

16. Indicate why you agree or disagree with the following statements:

(a) “Most MTN issues are rated investment-grade at the time of offering.”

One would tend to agree 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

(b) “An investment–grade bond must be sold at a price higher than a junk bond.”

One would disagree about the statement. Despite the fact that the credit risk for the junk bond is

higher than that of an investment-grade bond, the bond price does not solely depend on the credit

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.

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

(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

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.

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) (BloombergTicker: 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

Term:

Approximately five (5) years

(a) What type of structured note is this?

(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.

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.

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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

(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.

(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

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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

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

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

(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

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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

(b)What is the reference rate typically used for a syndicated bank loan?

(c)What is the difference between an amortized bank loan and a bullet bank loan?

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

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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.

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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

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

27. What is a rating transition matrix?

The rating agencies accumulate statistics on how ratings change over various periods of time. A

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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,

29. What would be the possible credit ratings for a corporate bond in which it is sold in the

investment-grade market?

The bond would be assigned a rating in the top four categories as it is in the investment-grade

market. Issues that carry a rating below the top four categories are referred to as noninvestment-

30. What is meant by collateral trust bonds?