Debt Securities [Basic Investing I Studied #14]

Chapter 10 time. Debt Securities.

This post is the grand tour — all the types of bonds. So just settle in and think of it as a tasting menu, heh.

Aaaaaaaaa.

OK so. If the Money Market was the short-term joint — maturities of a year or less — what we’re stepping into now is the Bond Market. This is where the stuff with maturities of 1 year or more lives. In Korean it’s literally called the “long-term financial market,” which… yeah, fits.

(Side note: money market + bond market together = the Capital Market. heh.)

Alright. In we go.

(From here on I’m working off the original textbook, and I’m bracing myself — there are gonna be way more English terms than Korean ones. I’ll do my best to look stuff up and find Korean equivalents where I can.)

A bond is a long-term security — a long-term debt instrument — issued by a government or a company. The issuer pays interest, aka a coupon!!! So the investor buys this piece of paper that says “the issuer is on the hook to pay me this interest periodically,” and the investor has the right to collect. Make sense???

And of course that paper also says the par value gets paid back at maturity.

These can be way more precarious than short-term debt instruments. (Look long-term, see it collapse, cry.)

So to issue these, the issuer has to demonstrate that future cash flows can cover the coupons plus the par value at the end.

(Side note: why is interest from a bond called a “coupon”? Because back before computers were everywhere, bonds literally had little coupons attached. You’d tear one off, present it to the issuer, and they’d pay you the interest. Wow. Wild.)

Bonds get classified by who’s issuing them.

Treasury Bond, Federal Agency Bond, Municipal Bond, Corporate Bond.

Four big buckets. Maturities are usually somewhere between 10 and 30 years. (Usually usually.)

That’s not the only way to slice them, though. By ownership structure, you can also split them into bearer bonds and registered bonds, and the difference matters in ways we’ll see later. The fun thing about bearer bonds: no transfer procedure, super convenient — which is exactly why apparently they’re great for bribes. lol. You know that drama trope where someone stuffs a duffel bag full of bearer bonds and slides it across the table? Yeah. Back then I had no clue what was going on. Now I do.

From the issuer’s perspective, yield is usually measured as YTM — Yield to Maturity. This represents the annualized return the issuer is paying out over the life of the bond.

(Textbook phrasing: the issuer’s cost of financing with a bond is commonly measured by the yield to maturity, which reflects the annualized yield paid by the issuer over the life of the bond.)

Later on you’ll see things like “market yield,” “interest rate,” and a bunch of other terms that all mean basically the same thing as YTM. (Don’t get tripped up.) Same way Korean textbooks dress up the same concept in five different words — English does the same thing here.

OK so that’s the issuer’s side. What about the investor’s side?

If an investor holds the bond all the way to maturity, sure — the yield they get is exactly the YTM. But most people don’t hold to maturity; selling along the way is the norm. So really we should focus on the holding period. Their return is measured from purchase price (pp), sale price (sp), and whatever coupons they collected in between.

Catch is, while they’re holding it, they don’t know sp yet. So (naturally) the yield isn’t fixed during the holding period. Can’t unpack all of that here — we’ll get into it through the chapter. Just get the rough shape and move on.

Alright. Just like before, let’s now actually walk through the four bond types, heh.

Treasury Bonds

First up: Treasury Bond. Wait — actually, it’s Note AND Bond.

The Treasury issues both Treasury Notes and Treasury Bonds in parallel to raise funds. Notes = maturity of 10 years or less. Bonds = maturity of 10 years or more.

Minimum unit is $100, so small investors (retail investors?) aren’t shut out either. There’s also a (non-listed) secondary market (SM), so it’s easy to dump them before maturity. Oh — and these pay coupons semiannually (twice a year).

Also also also also — big feature: interest income is normally taxed as ordinary income, BUT! these are exempt from state and local taxes!!!

Where do they trade?~~~~~

Like T-bills, T-notes/bonds also trade at the Treasury Auction. (Auction held in the middle of every quarter.) Same process as T-bills.

How about the secondary market?!?!?!

Dealers. Sprinkled all over the place. There are about 2,000 registered dealers total, but ~20 primary dealers are said to dominate. The dealer’s job is simple: take the seller’s bid price to the buyers, take the buyer’s ask price to the sellers. The spread between bid and ask is their cut. All of this happens over a telecom network.

One more cool thing — most government securities trade only inside the U.S., but T-bonds are uniquely worldwide. They get traded across time zones simultaneously. Tokyo (PM 7:30 ~ AM 3:30, NY time), and so on.

We’re not done with Treasuries!!

Still on Treasuries!!

Next up — stripped Treasuries!!!

This is where the interest and the principal get split apart and traded separately!!

STRIPS = Separate Trading of Registered Interest and Principal of Securities.

Whew that’s a mouthful.

Because STRIPS exist, investors can buy just the interest piece, or just the principal piece, depending on what they actually need. STRIPS aren’t issued by the Treasury directly — they’re sold by various FIs (financial institutions). So if you want one, you go to an FI. The underlying is still U.S. Treasury bonds, of course, heh.

There’s a secondary market for these too, so you don’t need to hold to maturity. Apparently quite popular over there. (In the U.S.) In Korea, STRIPS don’t exist yet, and the professor said he doesn’t know whether they ever will.

IO: interest only. PO: principal only.

There’s also a thing called TIPS.

TIPS = Treasury Inflation-Protected Securities. Coupon rate is lower than a regular T-bond, BUT — the principal value rises with U.S. inflation. And the inflation rate they use isn’t the GDP deflator — it’s pegged to CPI (Consumer Price Index), measured every 6 months.

Oh!!! And this one is issued by the Treasury!

There’s also Saving Bonds.

Saving Bonds are issued by the Treasury, but you can also buy them at lots of FIs. These have to be irresistible for small investors, lol — minimum face value is $25!!!!

Three flavors:

Series EE bond
Series I bond
Interest income on saving bond

Quick version of what each one does:

Series EE pays interest based on a market interest rate it offers.
Series I pays interest pegged to inflation.
Interest is exempt from state and local taxes; only Federal tax applies.

Oh — and there’s no secondary market for these. So you have to keep holding them. BUT, after 12 months you can just redeem them straight up. (Penalty: you forfeit the last three months of interest.)

Federal Agency Bonds

Federal agencies — like the Federal National Mortgage Association (Fannie Mae), the Federal Home Loan Mortgage Association (Freddie Mac), and friends — also issue bonds. The proceeds go to buying mortgages, so these bonds basically inherit the characteristics of the mortgage market.

In 2008, these blew up because they’d been buying way too much risky subprime mortgage stuff. Yeah. That problem.

Municipal Bonds

So — federal government, state, local government — all of them have moments where they spend more than they take in. Bonds get issued to plug that gap, and those are Municipal Bonds.

(Don’t sleep on these as just “local government debt.” Some U.S. states are bigger than the entire Korean Peninsula. lol scary.)

Munis come in two flavors: general obligation bonds and revenue bonds. The first kind is paid back from the municipal government’s tax revenue. The second is tied to revenue from a specific project (tollway, toll bridge, state college dorm, etc.). Yeah, you get the vibe, heh.

Both flavors pay interest semiannually. There’s a secondary market, but it’s said to be less active than the T-bond SM.

We’ll see this later, but most muni bonds also include a Call provision. What’s that? — a clause where the issuer reserves the right to buy the bond back at a specific price before maturity. (More on this later.) If market interest rates crater, the issuer activates the call, takes the bonds back, and reissues at the lower rate, right?!?!?!

This isn’t muni-only. A call provision can be tucked into pretty much anything. So yeah — you can have a corporate bond with a call provision too, negotiated in. Sure.

Also — munis don’t have zero default risk like Treasuries do… So investors really have to keep an eye on the rating. But the muni rating system is also kinda criticized for not being super trustworthy. In Korea’s case, apparently the city of Incheon and Samsung get rated at the same level… which honestly. Doesn’t make sense.

Corporate Bonds

And now corporate bonds!!!! Also long-term securities. Also pay coupons semiannually. Minimum unit is $1,000, maturity is around 10–30 years…

(Compared to other bonds, these are a little harder for small investors to get into.)

Corporate bonds are set up so that investors can get a tax deduction on the interest income from them!!!! Why the tax break? Because a lot of companies lean heavily on bond financing, so the government supports it from the top down. HOWEVER!!! No such tax exemption exists for equity (stocks) and the like!!!

Even so, a company can’t just spew bonds into the wild — there are restrictions on bond issuance based on each company’s repayment ability!!!

So how do companies actually sell these? Auction like the Treasury?!?!?!? Nope nope.

Companies issue via Public offering or Private Placement.

We covered the public/private placement procedures before!!! Wanna skip? Ehh, let me jot it down briefly again…

An underwriter goes out to the market, sniffs around at conditions, and figures out the desired quantity and price. (A price the issuer is happy with AND a price low enough to actually move all the bonds?!?!?! Some kind of convergence point I guess… (sigh)) Once that’s locked in, the issuer has to register with the SEC (Securities and Exchange Commission). Register what? — they submit a prospectus (business plan) and the offering plan (amount). Once registration goes through, it gets reflected in the Financial Condition.

In the meantime, the underwriter is handing out copies of the prospectus to the syndicate doing the co-underwriting. Once the SEC gives the green light, the syndicate gets the bonds.

(After that, you can actually buy with up to about a 2-year delay. The “buy with a delay” thing is a U.S. feature — in Korea, if it’s delayed you have to redo basically all of those steps from scratch… The textbook term for this is batch processing possible in the U.S., batch processing not possible in Korea.)

Oh, and the underwriter — in the U.S., it’s IBs (investment banks). Korea doesn’t have IBs, so securities firms play that role.

Some companies skip the IPO and go through private placement. The cool thing here is that, unlike a public offering, you don’t have to register with the SEC, get approval, all that. So companies trying to raise funds at relatively lower cost have to offer a noticeably better price than they’d offer in a public offering. And the borrower probably has to, like, take the lender out for drinks or something…

There’s a key difference between Public offering and Private Placement: public offerings have a secondary market, so if the investor’s plans change they can sell. Private placement bonds have no SM. But honestly, either way, the typical investor here is someone willing to hold for a loooooong time.

Sinking fund provision: clause in the bond contract where the borrower commits to retiring a certain chunk of debt each year (the mechanism being a Call).

A bond comes with something called a Bond indenture — a legal document spelling out the collateral, payment due date, default provisions, call provisions, all that.

Sometimes inside the indenture there’s a sinking fund provision, which is what?~~~~~

A sinking fund provision is a requirement that forces the company to retire a certain amount of bonds. So if it doesn’t look like you can repay, you literally can’t issue them!!! The point is to protect the remaining bondholders, right?!?!?!~~

Protective Covenant

Bonds might come with this thing too, and what is it…

It’s basically just: bondholders get priority over stockholders. That’s the whole vibe.

Even during the bond’s life, to make sure bondholders aren’t hung out to dry, the company pays interest to them first, and then dividends to stockholders. So this provision sometimes restricts dividends, sometimes restricts further bond issues.

Why is a Protective Covenant necessary? Because bondholders and stockholders want fundamentally different things from the company they invested in. Bondholders just want their interest and principal back, period — so they want stable, conservative management. Stockholders want the company to have more debt, because more leverage = bigger profits flowing to them — meaning stockholders want the company to swing for the fences with riskier management!!!

So this provision is non-negotiable. The “creditors come first” principle keeps the company from going on adventure mode!

Call Provision

The call provision — the thing that’s tucked into almoooooost every muni bond, as we mentioned!!

Roughly, it’s about the issuer retiring the bond by paying a call premium — essentially demanding to pay the investor more than par value to take it back. That difference — the gap between what’s paid and par — is called the Call premium.

When would you actually use a Call? Like I said earlier — if market interest rates drop way too much, the issuer activates the Call, kills the contract, and reissues at the lower rate, right?!?! Or they might just want to shrink the amount of outstanding bonds.

Either way, the takeaway: this is bad news for bondholders.~~~

Bond Collateral

If you crack open a dictionary, collateral comes back as “security/pledge.” So… yeah, just collateral. Collateral. Real estate (a house), movable property — the totally normal kind of collateral anyone would put up.

Not all bonds have collateral. The unsecured ones are called debentures! But unsecured bonds are only something that absurdly biiiiiig, absurdly heaaaalthy companies — companies whose ability to repay is basically beyond doubt — can pull off, riiiight~?

There are also bonds with all kinds of provisions bolted on.

First, there’s subordinated debenture (junior bond) — basically a hybrid between a bond and a stock. Why? Because while it ranks higher than stock for repayment, it’s at the bottom of the bond pecking order!!!! lol.

Zero coupon bond, low coupon bond. As the names imply — bonds with little or no coupon rate. No periodic interest, but they’re sold at a deep discount! (Yeah… these exist too, heh.)

Variable-Rate Bond (floating rate bond). Among long-term securities, there are bonds whose coupon rate gets readjusted periodically. The readjustment is pegged to LIBOR and happens every 3 months.

Convertible bond. In Korean: 전환사채. Convert into what?~~~ A bond where the investor can convert the bond they’re holding into stock!!! By converting, the investor can chase a higher return, so it’s a plus for them.

But what about from the company’s side????

The company is very into the conversion too. Why?

Because if the bond converts into stock, the numerator drops and the denominator rises, so the overall leverage ratio improves. Translation: the company’s financial health looks better on paper, so the company welcomes the conversion too!!~~

Junk Bond. Corporate bonds seen as high-risk get lumped together as junk bonds. (Officially, bonds issued by below-investment-grade companies are junk.) As compensation for stomaching the higher risk along with the higher yield, there’s also a risk premium tacked on. The risk premium adds something like 3%–7% on top of a T-bond of the same maturity.

Junk bonds are commonly used for LBOs (Leveraged Buyouts) — and the Homeplus acquisition that went down in September 2015 was also pulled off using JBs!!!! lol.

Preferred Stock. It’s stock, but stock that promises a fixed dividend payment, like a bond. So since it’s almoooost the same as a bond, it gets introduced here.

The thing is — if a company misses bond payments, it’s bankruptcy. But if a company delays a preferred stock dividend, that does not trigger bankruptcy. Bondholders’ claims still come first, but preferred stock takes priority over common stock in claims, heh.

Asset-backed bond. Hmm… The Walt Disney Company once issued a bond where the interest source was tied to revenue from the films they made. And one singer once linked album royalties to a bond’s interest payments. The point: assets like these can be packaged into bonds and given liquidity.

Oh — those are the slightly oddball cases. The mainstream examples of asset-backed securities are mortgage-backed securities, auto loan-backed securities… that kind of thing.

Catastrophe bond. A Swedish(?) company called Electrolux once issued a bond where the payout was determined by whether an earthquake hit Japan. A Swiss(?) company called Winterthur once issued a bond where the payout depended on whether serious hail fell in Switzerland. Yeah… bonds like that exist too… heh. heh.

The more I learn about finance, the more it looks like a casino floor.

It wasn’t science. (sigh)

Originally written in Korean on my Naver blog (2016-05). Translated to English for gdpark.blog.