Chapter 7

1. Chapter 7 Intermediary and International Debt Securities

2. Intermediary Securities • The intermediary financial market consist of commercial banks, insurance companies, mutual funds, mortgage bankers, and other financial institutions and intermediaries. • These intermediaries sell financial claims to investors, then use the proceeds to purchase debt and equity claims. In this process, intermediate securities are created: • Types: Certificates of deposit (CDs), mutual fund shares, mortgage backed securities, payroll retirement plans, bankers acceptances, etc.

3. Certificates of Deposit • Negotiable Certificates of Deposit (CDs) are Marketable short-term bank bonds. • Features: • Minimum denomination = $100,000; average denomination = $1M • Maturity = 90 days to one year. • Zero-Coupon Notes: Technically CDs pay a principal and interest at maturity; longer-term CDs pay coupon

4. Certificates of Deposit 4. Yield: Yields on CDs > yield on T-bills. 5. Yields on CDs of large banks (prime CDs) are less than the yields on CDs of smaller banks (nonprime CDs). • Primary and secondary (OTC) markets are handled by approximately 25 dealers.

5. Certificates of Deposit 7. Special CDs: • Long-term (5-year maturity) variable rate CDs • Bull and bear CDs: rates tied to stock market indices • Eurodollar CDs • Jumbo CDs: large-denomination CDs • Yankee CDs: dollar-denominated CDs sold in US by foreign banks

6. Secondary CD Market: History • In 1961, First Bank of NY issued a CD that was accompanied by an announcement by First Boston Corporation and Salomon Brothers that they would stand ready to buy the CD before its maturity. • This announcement marked the beginning of the secondary CD market. • At the time, the maximum rates on CDs were set by the FRS (Regulation Q) with longer-term CDs usually greater than shorter-term CDs. • Because of Regulation Q, bank CDs were often not competitive with T-bills, CP, and other money market securities as a short-term investment for corporations and other investors.

7. Secondary CD Market: History • The existence of a secondary market meant that if yield curve were positively sloped and did not change, an investor could earn a rate higher than either the shorter- or longer-term CD by buying the longer‑term CD and selling it later in the secondary market at the higher price associated with the lower rate on the shorter‑term maturity.

8. Secondary CD Market: History Example • Suppose: • 6-month CDs yielded 5% (P = 100/(1.05).5 = 97.59) • 1‑year CD yielded 6% (P = 100/1.06 = 94.3396) • An investor could: • Buy the 1‑year CD for 94.3396 • Hold it for six months • Sell it for 97.59 (given the yield curve did not change) to realized an annualized yield of 7%: R = (97.59/94.3396)1/.5 – 1 = .07

9. Secondary CD Market: History • Given the Fed did not change Regulation Q very often and the rates on longer-term CDs were higher than shorter-term ones, the secondary market for CDs provided a way for banks to increase their CD yields to investors without violating Regulation Q. • Following First Bank of New York, Salomon Brothers, and First Boston's lead, other banks, brokers, and dealers quickly entered into the market for negotiable CDs, creating the secondary CD market.

10. Website • Yields on CDs and Eurodollar CDs can be found at www.federalreserve.gov/releases

11. Bankers Acceptances Bankers Acceptances (BAs) are time drafts (post-dated check) that are drawn on a bank (usually by an exporter) and are guaranteed by the bank. The guarantee improves the credit quality of the bank, making the BAs marketable. • Features: • Zero-Coupon Bonds • Maturity: 30 days - 1 year • Purchased by banks, corporations, money market funds, central banks, etc.

12. Bankers Acceptances: Example • Consider the case of a U.S. oil refinery that wants to import 80,000 barrels of crude oil at $25 per barrel ($2M) from an oil producer in South America. • Suppose the South American oil exporter wants to be paid before shipping, while the U.S. importer wants the crude oil before payment. • To facilitate the transaction, suppose they agree to finance the sale with a BA in which the U.S. importer’s banks will guarantee a $2M payment 60 days from the shipment date. • With this understanding, the U.S. oil importer would obtain a letter of credit (LOC) from his bank. • The LOC would say that the bank would pay the exporter $2M if the U.S. importer failed to do so.

13. Bankers Acceptances: Example • The LOC would then be sent by the U.S. bank to the South American bank of the exporter. • Upon receipt of the LOC, the South American bank would notify the oil exporter who would then ship the 80,000 barrels of crude oil. • The oil exporter would then present the shipping documents to the South American bank and receive the present value of $2M in local currency from the bank. • The South American bank would then present a time draft to the U.S. bank who would stamp ‘accepted’ on it, thus creating the BA. The U.S. importer would sign the note and receive the shipping documents. At this point, the South American bank is the holder of the BA. • The bank can hold the BA as an investment or sell it to the American bank at a price equal to the present value of $2M.

14. Bankers Acceptances: Example 9. If the South American bank opts for the latter, then the U.S. bank holds the BA and can either retain it or sell it to an investor such as a money market fund or a BA dealer. 10. If all goes well, at maturity the oil importer will present the shipping documents to the shipping company to obtain his 80,000 barrels of crude oil, as well as deposit the $2M funds in his bank; whoever is holding the BA on the due date will present it to the U.S. importer's bank to be paid.

15. Bankers Acceptances: Market • The use of BAs to finance transactions is known as acceptance financing and banks that create BAs are referred to as accepting banks. • In the U.S., the major accepting banks are the money center banks such as Citicorp and Bank of America, as well as some large regional banks. Many of the large Japanese banks have also been active in creating BAs. • In the secondary market, BAs are traded as pure discount bonds, with the face value equal to the payment order and with the maturity between 30 and 270 days. With the bank guarantee, they are considered prime-quality instruments with relatively low yields.

16. Bankers Acceptances: Market • The secondary market trading of BAs takes place principally among banks and dealers. • There are approximately 20 dealers who facilitate trading in the secondary market. • The major dealers include the major investment banking firms such as Merrill Lynch (the largest dealer) and Shearson Lehman, as well as a number of money center banks. • Money market funds, banks, institutional investors, non-financial corporations, and municipal governments are the primary purchasers of BAs.

17. Bankers Acceptances: Market • The market for BAs has existed for over 70 years in the U.S., although its origin dates back to the 12th century. • In the U.S., this market grew steadily in the 60s and 70s. • From 1970 to 1985 the market accelerated from $7.6 billion in 1970 to almost $80 billion in 1985, reflecting the growth in world trade. • Due to alternative financing, though, the BA market has declined marginally since 1985.

18. Website • Historical data on BA yields can be found at www.federalreserve.gov/releases • For data on the size of the market for BAs go to www.bondmarkets.com and click on “Research Statistics” and “Money Market Instruments.”

19. Mortgage-Backed Securities Mortgage-Backed Securities: Financial claims on a portfolio of mortgages. The claims entitle the holder to the cash flows from the mortgage portfolio.

20. Mortgage-Backed Securities • Typically, a financial institution, agency, or mortgage banker buys a pool of mortgages of a certain type from mortgage originators (e.g., Federal Housing Administration-insured mortgages or mortgages with a certain minimum loan-to-value ratio or a specified payment-to-income ratios). • This mortgage portfolio is financed through the sale of the MBS, which has a claim on the portfolio. • The mortgage originators usually agree to continue to service the loans, passing the payments on to the mortgage-backed security holders.

21. Mortgage-Backed Securities • A MBS investor has a claim on the cash flows from the mortgage portfolio. This includes interest on the mortgages, scheduled payment of principal, and any prepaid principal. • Since many mortgages are prepaid early as homeowners sell their homes or refinance their current mortgages, the cash flows from a portfolio of mortgages, and therefore the return on the MBS, can be quite uncertain. • To address this type of risk, a number of derivative MBS were created in the 1980s. For example, in the late 1980s Freddie Mac introduced the collateralized mortgage obligations (CMOs). • These securities had different maturity claims and different levels of prepayment risk.

22. Asset-Backed Securities and Securitization • A MBS is an asset-backed security created through a method known as securitization. • Securitization is a process of transforming illiquid financial assets into marketable capital market instruments. Today, it is applied not only to mortgages but also home equity loans, automobile loans, lines of credit, credit card receivables, and leases. • Securitization is one of the most important financial innovations introduced in the last two decades; it is examined in detail in Chapter 11.

23. Investment Funds • Many financial institutions offer a wide variety of investment funds. • For many investors, shares in these funds are an alternative to directly buying stocks and bonds.

24. Investment Funds • In addition to the traditional stock funds, investment companies today offer shares in • Bond funds: Municipal bonds, corporate, high-yield bonds, foreign bonds, etc.) • Money market funds consisting of CDs, CP, Treasury securities, etc. • Index funds: Funds whose values are highly correlated with a stock or bond index • Funds with options and futures • Global funds: Funds with stocks and bonds from different countries • Vulture funds:Funds consisting of debt securities of companies that are in financial trouble or in Chapter 11 bankruptcy

25. Investment Funds • Currently there are over 8,000 funds in the U.S.; a number that exceeds the number of stocks listed on the NYSE. • Contributing to this large number is the increased percentage of fund investment coming from retirement investments such as individual retirement accounts (IRAs) and 401(k) accounts. • As of year 2000, mutual funds accounted for approximately 21% ($2.5 trillion) of the estimated $12 trillion dollar retirement investment market.

26. Structure of Funds • There are three types of investment fund structures: • Open-end funds (or mutual funds) • Closed-end funds • Unit investment trusts • The first two can be defined as managed funds, while the third is an unmanaged one.

27. Open-End Fund • Open-end funds (mutual funds) stand ready to buy back shares of the fund at any time the fund's shareholders want to sell, and they stand ready to sell new shares any time an investor wants to buy into the fund. • Technically, a mutual fund is an open-end fund. The term mutual fund, though, is often used to refer to both open- and closed-end funds. • With an open-end fund the number of shares can change frequently. The price an investor pays for a share of an open-end fund is equal to the fund's net asset values (NAV).

28. Open-End Fund • At a given point in time, the NAV of the fund is equal to the difference between the value of the fund's assets (VAt) and its liabilities (VLt) divided by the number of shares outstanding (Nt):

29. Open-End Fund • Example: Suppose a balanced stock and bond fund consist of: • A stock portfolio with a current market value $100M • A corporate bond portfolio with current market value of $100M, • Liquid securities of $8M • Liabilities of $8 million • The current net worth of this fund would be $200M. If the fund, in turn, has 4 million shares outstanding, its current NAV would be $50 per share: • Note: This value can change if the number of shares, the asset values, or the liability values change.

30. Closed-End Fund • A Closed-end fund has a fixed number of non-redeemable shares sold at its initial offering. • Unlike an open-end fund, the closed-end fund does not stand ready to buyexisting shares or sell new shares. • The number of shares of a closed-end fund is therefore fixed.

31. Closed-End Fund • An investor who wants to buy shares in an existing closed-end fund can do so only by buying them in the secondary market from an existing holder. • Shares in existing funds are traded on the over-the counter market. • Interestingly, the prices of many closed-end funds often sell at a discount from their NAVs.

32. Unit Investment Trust • A unit investment trust has a specified number of fixed-income securities that are rarely changed, and the fund usually has a fixed life. • A unit investment trust is formed • by a sponsor (investment company) who buys a specified number of securities, • deposits them with a trustee, and • sells claims on the security, known as redeemable trust certificates, at their NAV plus a commission fee. • These trust certificates entitle the holder to proportional shares in the income from the deposited securities.

33. Unit Investment Trust Example: • An investment company purchases $20 million worth of Treasury bonds • Places them in a trust • Issue 20,000 redeemable trust certificates at $1,025 per share: • If the investment company can sell all of the shares, it will be able to finance the $20 million bond purchase and earn a 2.5% commission of $500,000 NAV + Commission = ($20 million/20,000) + $25 = $1,025

34. Unit Investment Trust • Most unit investment trusts are formed with fixed-income securities: government securities, corporate bonds, municipal bonds, and preferred stock. • Unlike open- and closed-end funds, when the securities in the pool mature, the investment trust ceases. • Depending on the types of bonds, the maturity on a unit investment trust can vary from six months to 20 years. • The holders of the securities usually can sell their shares back to the trustee prior to maturity at their NAV plus a load. To finance the purchase of the trust certificate, the trustee often sells a requisite amount of securities making up the trust.

35. Types of Investment Funds • One way of grouping the many types of funds is according to the classifications defined by Weisenberger's Annual Investment Companies Manual: • Growth Funds • Income Funds • Balanced Funds

36. Types of Investment Funds • Growth funds are those whose primary goal is in long-term capital gains. Such funds tend to consist primarily of those common stocks offering growth potential. Many of these are diversified stock funds, although there are some that specialize in certain sectors. • Income funds are those whose primary goal is providing income. These funds are made up mainly of stocks paying relatively high dividends or bonds with high coupon yields. • Balanced funds are those with goals somewhere between those of growth and income funds. Balance funds are constructed with bonds, common stocks, and preferred stocks that are expected to generate moderate income with the potential for some capital gains.

37. Types of Investment Funds • A second way of classifying funds is in terms of their specialization. There are four general classifications: • Equity Funds • Bond Funds • Hybrid Funds (Stocks and Bonds) • Money-Market Funds • Each of these fund types can be broken down further by their specified investment objectives.

38. Equity Funds Value Funds Growth Funds Sector Funds World Equity Funds Emerging Market Funds Regional Equity Funds Taxable Bond Funds Corporate bond funds High Yield Funds Global Bond Funds Government Bond Funds Mortgage-Backed Securities Tax-Free Bond Funds State Municipal Bond Funds National Municipal Bond Funds Hybrid Funds Asset allocation Funds Balanced Funds Income-Mixed Funds Money Market Funds Taxable Money Market Funds Tax-Exempt Money Market Funds Types of Investment Funds

39. Types of Bond Funds • Bond funds can be classified as corporate, municipal, government, high-yield, global, mortgage-backed securities, and tax-free. For example: • Municipal bond funds specialize in providing investors with tax-exempt municipal securities. • Corporate bond funds are constructed to replicate the overall performance of a certain type of corporate bond, with a number of them formed to be highly correlated with a specific index such as the Shearson-Lehman index. • Money market funds are constructed with money market securities in order to provide investors with liquid investments.

40. Bond Market Indices • The managers of these various bond funds, as well as the managers of pension, insurance, and other fixed-income funds, often evaluate the performance of their funds by comparing their fund’s return with those of an appropriate bond index. • In addition, many funds are constructed so that their returns replicate those of a specified index.

41. Bond Market Indices • A number of bond indexes have been developed in recent years on which bond funds can be constructed or benchmarked. • The most well known indexes are those constructed by Dow Jones that are published daily in the Wall Street Journal. • A number of investment companies also publish a variety of indexes; theses include Lehman Brothers, Merrill Lynch, Salomon Smith Barney, First Boston, and J.P. Morgan. • The indexes can be grouped into three categories: U.S. investment grade bonds indexes (including Treasuries), U.S. high-yield bond indexes, and global government bond indexes. Within each category, subindexes are constructed based on sector, quality ratings, or country.

42. Bond Market Indexes The Handbook of Fixed-Income Securities, editor F. Fabozzi, 6th edition, p. 158.

43. Other Investment Funds • In addition to open-end and closed-end investment funds and unit investment trusts, three other investment funds of note are: • Hedge Funds • Real Estate Investment Trusts • Dual Purpose Funds

44. Hedge Funds • Hedged Funds can be defined as special types of mutual funds. There are estimated to be as many as 4,000 such funds. • They are structured so that they can be largely unregulated. To achieve this, they are often set up as limited partnerships. By federal law, as limited partnerships, hedge funds are limited to no more than 99 limited partners each with annual incomes of at least $200,000 or a net worth of at least $1M (excluding home), or to no more than 499 limited partners each with a net worth of at least $5M. • Many funds or partners are also domiciled offshore to circumvent regulations.

45. Hedge Funds • Hedge funds acquire funds from many different individual and institutional sources; the investments range from $100,000 to $20M, with the average investment being $1M. • They use the funds to invest or set up investment strategies reflecting pricing aberrations. • Many of the strategies of hedge funds involve bond positions. • One of the most famous is that of Long-Term Capital who set up positions in T-bonds and long-term corporate bonds to profit from an expected narrowing of the default spread that instead widened.

46. Real Estate Investment Trust • Real Estate Investment Trust (REIT): A REIT is a fund that specializes in investing in real estate or real estate mortgages. • The trust acts as an intermediary, selling stocks and warrants and issuing debt instruments (bonds, commercial paper, or loans from banks), then using the funds to invest in commercial and residential mortgage loans and other real estate securities.

47. Real Estate Investment Trust • REITs can take the following forms • Equity Trust that invests directly in real estate • Mortgage Trust that invests in mortgage loans or mortgage-backed securities • Hybrid Trust that invests in both

48. Real Estate Investment Trust • Many REITs are highly leveraged, making them more subject to default risks. • REITs are tax-exempt corporations, often formed by banks, insurance companies, and investment companies. • To qualify for tax exemptions, the company must receive approximately 75% of its income from real estate, rents, mortgage interest, and property sales, and distribute 95% of its income to its shareholders. • The stocks of many existing shares in REITs are listed on the organized exchanges and the OTC market.

49. Dual Purpose Fund • Dual Purpose Funds: A fund that sells different types of claims on the fund’s cash flows. For example: • Claim on dividends • Claim on capital gains

50. Websites • Information on investment funds: www.ici.org. • Information on investment fund and ratings: www.quicken.com/investments/mutualfunds/finder/ , www.morningstar.com, and www.lipperweb.com. • Information on money market funds: www.imoneynet.com. • Information on Real Estate Investment Trusts: www.nareit.com. • Information on hedge funds: www.thehfa.org, www.hedgefundcenter.com, and www.hedgefund.net.