Guide to the Debt Market
The debt capital market is divided into short-term financial instruments (Money Market) and long-term financial instruments (Capital Market bonds). Please see the Money Market Section for an explanation of short-term debt instruments (CDs, Banker's Acceptances, etc.).
The purchasers of debt include foreign nations, bank, financial institution and non-bank financial institution trading desks, corporate treasury operations, individual investors, and pension and investment funds.
Debt capital is money loaned to an entity (government, organization or corporation) by investors. A Bond is a security that is issued by the entity that borrows the capital and represents the formal written obligation from the issuer to repay the borrowed amount of the issued bond. On the accounting statements of the entity that the issued bond it is termed as debt or liability. This is a key difference between a bond and stock. Stock represents an ownership interest in the entity / company. If you accumulate enough stock, you will own the company. Whereas, a bond is a loan. You don't own any part of the company by lending it capital although you may be given a claim on specific assets as collateral for the loan.
A government, agency, municipality or corporation must decide whether borrowing money is an appropriate addition to its capital structure, how much of an amount is an appropriate issue, whether the interest cost is the lowest possible, what maturity, redmption features and covenants should be offered
The terms Debt, Bond, Debt Security, Debenture and Loan all tend to be substituted for one another and what they do have in common is that they all mean that an entity has borrowed funds (principal) for a specific period and has an obligation that they must eventually pay the funds back to the lender. What distinguishes a Debenture is that is is usually an unsecured loan (not collateralized by specific pledged assets) and is offered based on the financial strength of the issuer and its ability to repay.
As per the Investment Company Act of 1940, a "Security means any note, stock, treasury stock, security future, bond, debenture, evidence of indebtedness, certificate of interest or participation in any profit-sharing agreement, collateral-trust certificate, preorganization certificate or subscription, transferable share, investment contract, voting-trust certificate, certificate of deposit for a security, fractional undivided interest in oil, gas, or other mineral rights, any put, call, straddle, option, or privilege on any security (including a certificate of deposit) or on any group or index of securities (including any interest therein or based on the value thereof), or any put, call, straddle, option, or privilege entered into on a national securities exchange relating to foreign currency, or, in general, any interest or instrument commonly known as a "security", or any certificate of interest or participation in, temporary or interim certificate for, receipt for, guarantee of, or warrant or right to subscribe to or purchase, any of the foregoing."
- The Issuer must either on its own or with the assistance of a financial advisor prepare the Offering Memorandum and Prospectus documentation for the marketing and sale of the debt issue (amount of issue, features of the debt securities, financial condition of the issuer, collateral or revenue stream, etc.). The Issuer then approaches an Underwriter to either purchase the bond issue in full or arrange for a group of underwriters to purchase the issue, which is then offered to investors and general the public for sale. There are two ways that bonds are offered by the Issuer to an Underwriter:
- Negotiated Sale: the Issuer works directly with a single Underwrtirer (broker / dealer) or a group of underwriters lead by the primary Underwriter to offer the bond issue at a negotiated interest rate that would insure the issue would be purchased by retail investors and also reflects the credit standing of the Issuer. A negotiated sale is used during periods of market volatility, if the Issuer is new or not welll known (issuers that are not rated) or has a low credit rating, if the bond issue has unusual terms or if the amount of the issue is rather large.
- Competitive Auction: the bond issue is offered to the market of established broker / dealers and banks who bid either individually or in groups (bidding syndicate) on the issue by offering to take the bond issue or a portion of the bond issue at a proposed interest rate that they believe would be attractive to retail investors and also reflects the credit standing of the Issuer. The bidder that proposes to purchase the issue at the lowest coupon interest rate cost offered to the Issuer wins the issue.
- Dutch Auction: or uniform price auction, successful bidders pay only the price of the lowest accepted bid rather than the actual price as in a conventional multiple-price auction.
One of the keys to an issue being brought efficiently to the market at favorable pricing is whether the entity has a public rating from of the Credit Rating Agencies.
Every public bond issue receives a CUSIP (Committee on Uniform Security Identification Procedures) indentification number, which follows the specific bond through the lifetime of its existence and is always referred to with regard to transactions related to the bond (sale, call redemption, maturity, etc.).
Bonds use to be sold to investors in the form of a Bearer Bond, also known as coupon bonds. With bearer bonds, the purchaser's name was not recorded nor did it appear on the purchased bond or the coupon. The purchaser or their trustee submit the coupon(s) twice a year and the authorized bank pays the interest. For instance, a twenty year $1,000 bond paying 8% interest would have 40 coupons for $40 each. Bearer bonds can be used like cash and they are highly negotiable. There are still many in circulation however, due to loss or stolen bonds being difficult to trace the Tax Reform Act of 1982 ended the issuance of new bearer bonds.
Today, bonds are sold either in a fully registered form (Registered Bond) or book-entry. A registered bond comes with the purchaser's name already on them. Twice a year, the purchaser automatically receives a check for the interest. At maturity, the registered owner receives a check for the principal amount. A partially registered bond is a cross between a registered bond and a coupon bond. The bond comes registered to the purchaser however, it has coupons attached which must be sent in for payment. When a registered bond is sold prior to maturity, the registered owner has to endorse the bond over to the new owner. When a bond is sold in book-entry form, the purchasers name is submitted to an stored in the database server of the clearing house. The sales confirmation from the broker / dealer is the only written record of the the transaction, no bond certificate is actually issued. The advantage of this format is the cost savings for not having to design, print and distribute certificates or having to pay for custody / security services. The advantage to the investor is that there is no certificate to misplace or be stolen, it is very easy to transfer ownership if the bond is sold, and the bond holder receives automatic interest payment by electronic funds transfer and automatic notification of calls.
Bonds typically have a fixed maturity of when the full or partial repayment of the bond is due. The maturity can be from overnight to in excess of 30 years, depending on the type and purpose of the bond. There may also be a schedule of partial repayment of a portion of the principal prior to the final maturity date. The bond also usually has an indicated interest rate, which is the cost to the issuer for borrowing the funds and the fee to the bond holder for lending the funds. Interest rates in the marketplace are always fluctuating and will move in terms of basis points and percentage points. A basis point is one hundredth of a percent (0.01%). A percentage point is one hundred basis points or one full percent (1.00%).
The bond is issued at Face Value, which is the Principal amount of the bond itself. Depending on the Issuer and the characteristics of the issue there could be a single bond or a series of related (and sequential) bonds, each in the face value principal amount of $1,000 to $1,000,000 (or some round amount in between), with as many bonds issued as is necessary to add up to the total amount of funds required by the borrower.
- There are several types of possible interest charge structures:
- None or Zero Coupon.
- Fixed, flat rate of interest during the lifetime of the bond.
- Floating rate in which the interest rate is actually a margin added to a publicly available base interest rate for certain issues of government debt or loans between financial institutions, and is periodically reset based on the present prevailing rate of that same publicly available base rate index at the date of reset.
The amount of the interest rate reflects the perceived credit worthiness of the Issuer and the prevailing interest rate environment at the given point of time of the date of the new bond issue. The interest rate charge is computed as a percentage of the face value of the bond. The Frequency of interest payments (when a payment is made by the bond issuer to the bond holder) can be structured to be either monthly, quarterly, semiannually or annually.
Interest payments on a fixed rate bond do not fluctuate over the lifetime of the bond. Floating rate interest payments fluctuate as interest rate market conditions change over the lifetime of the bond. The decision by the Issuer to structure the bond as a fixed rate or floating rate issue reflects the matching of revenue sources to repay the bond(s) and / or the perception by the Issuer of what the interest rate market conditions may be in the future.
- Base Interest / Reference Rates
- Federal Reserve Bank of NY Discount Rate
- U.S. Prime Rate
- Federal Funds Rate
- Commercial Paper (30-day, 60-day, 90-day)
- LIBOR (London Interbank Offered Rate)
- Euro-US Dollar Deposits in London (3 month)
- 90-Day Treasury Bills
- 2-Year Treasury Notes
- 10-Year Treasury Notes
- 30-Year Treasury Bonds
- There are several different assumptions / approaches to calculate accrued interest:
- Every month has 30 days and every year has 360 days (30 / 360)
- Every month has 30 days and every year has 365 days (30 / 365)
- Actual number of days divided by 365 (Actual / 365)
- Actual number of days in a given year (Actual / Actual)
An example of computing accrued interest would be a USD $10 million bond, paying 4.75%, 360 day annual calendar assumption and 19 days elapsed; Accrued interest: $10,000,000 multiplied by 4.75% = $475,000, divided by 360 = $1,319.44, multiplied by 19 = $25,069.44 accured interest.
In Zero Coupon bonds the interest "coupon" (rate) is stripped from the note/bond and no periodic interest payments are made. Rather, a Zero Coupon Bond is sold at a discount to its face value. By paying the investor the face value at maturity there is an implied interest rate that makes the bond grow to its face value from the discount value. All "interest" is paid upon maturity although accrued interest is subject to taxes annually. The value of this bond can be volatile if the inflation rate or interest rates increase and the implied lock-in rate is below inflation / present interest rate.
The Indenture Agreement is the terms of the legal agreement between the Borrower and the one loaning them the money. The Indenture, which is printed on the bond certificate, contains the following information: The duties and obligations of the trustee (usually a bank or trust company hired by the corporation), all the rights of the lender (the bondholder), how and when the principal will be repaid, the rate of interest, the description of any property to be pledged as collateral if applicable, steps the bondholder can take in the event of default, and callable features.
The Trust Indenture Act of 1939 stipulates that bonds, debentures, and notes that are registered under the Securities Act of 1933 may not be offered for sale to the public unless the Trust Indenture (again, the formal agreement between the issuer of bonds and the bondholder as indicated previously) conforms to the standards specified by this Act.
There is a very active secondary market for bonds, especially government (federal and municipal), government agency, GSE, supranational, highly rated corporate debt securities and high yield bonds. High grade corporate debt use to be listed on the NYSE Automated Bond Trading System, however the actual volume of listings has declined substantially in the past decade. There has recently been the development of an electronic secondary market exchange for debt securities, however most bebt securities still tend to marketed and sold through a over-the-counter network of investment banks, broker / dealers and banks that communicate electronically and telephonically.
The yield to maturity of a bond always moves in the opposite direction of its price. For instance, if a bond is paying 6% per annum, and interest rates on similar debt decline to 5%, then the bond paying 6% is more desirable to own as it is paying a higher interest rate compared to similar bonds. However, many investors want to hold the 6% bond, thus the market price to purchase the bond increases due to competitive demand. A potential owner will have to pay a Premium to own the bond. This Premium means that the potential owner is paying more than par or more than 100% of the face value of the bond. However, the potential owner will still only receive the 6%, thus the yield to maturity has declined as now the 6% received per annum is measured on a higher purchased value (perhaps 101.5% over face value) as opposed to the original face value of the bond. Conversely, if one pays a Discounted price for the bond, say 99.5% of the original face value of the bond, then the yield has increased to the bondholder as the per annum payment is measured against a new value less than the issued face value. Yields move inversely to prices.
The Yield Curve is the difference between short and long-term rates.
In the United States, changes in the value of a bond are quoted in fractions.
Issuers of Bonds
An issuer does not bring a debt offering to the market on their own. Rather, the bond offering is usually underwritten by a syndicate of investment banks and financial institutions that have departments and personnel with the experience of presenting and selling a debt issue to potential investors. The offering will include a legal opinion setting out the tax-exempt status of the debt offering to investors or a certain class of investors.
All governments need to finance their operations, which consists of departmental and agency programs and payroll for all levels of employees. If tax and revenue is insufficient to cover the costs of operating a government then the government must issue bonds (debt) to raise funds. This debt is purchased and held by foreign governments, institutional investors, financial institutions, corporate treasury operations, investment funds and individual investors.
U.S. Government Debt
U.S. Treasury issues are considered the world's risk-free investment, hence the interest rate is closely monitored and functions as an index rate (what other lower quality debt interest rates are based on, for instance some margin measured in basis points is added to the U.S. Treasury rate to compensate for the higher risk). Treasuries are sold by competitive auction in which the response and bidding by investors determines the pricing of the bond offer. The U.S. Treasury also sells individual Savings Bonds. Interest on U.S. Treasuries are taxed at the Federal level for investors required to file with the IRS in the United Staes but not at the state or local level.
Treasury Bill (T-Bill) short-term of one week to 12 months (maturity may not exceed one year); issued and purchased by investors at a discount and pay / redeemed at par (face value) at maturity.
Treasury Note (T-Note) is a medium-term obligation of one to ten years (maturity may not exceed ten years); Purchaser locks in a fixed interest rate and receives interest payments on a semi-annual basis (every six months) until maturity; Marketed / sold by auction at a discount, at par, or at a premium according to the results of the auction and are redeemed at par at maturity.
Treasury Bond (T-Bond) is a long-term obligation of ten to thirty years, and pay interest on a semi-annual basis. The thirty year bond is also known as the long bond and makes interest payments on a semi-annual basis (every six months until maturity. As of Fall 2001, the United States has not been issuing 30-year Treasury bonds.
TIPS: Treasury Inflation Protected Securities (Notes and Bonds), inflation indexed bonds that adjust the underlying principal twice a year in response to the CPI-U (Consumer Price Index - Urban Consumers) report and make semi-annual payments. Not only is the accrued interest taxable but the increase in principal is also taxable as it is considered an increase in income (known as a "phantom tax" as it is not payable until the bond is sold or redeemed at maturity). The TIPS bond must be compared to the similar term, fixed-rate Treasury bond to determine if its a better investment in an inflation environment. TIPS were first first introduced in May 1996, had its structure finalized in September 1996 (patterned after the Canadian Real Return Bonds), and the first auction was January 1997 based on the single price Dutch-style auction procedure. There is also a repo market in TIPS.
STRIPS (Separate Trading of Registered Interest and Principal of Securities), which are Zero-coupon securities backed by the U.S. Government that have been separated into interest and principal components.
- Inflation-linked / Stripped interest components from non-government / broker-dealers:
- TINTS (Treasury Inflation-Indexed Securities)
- TIGRs (Treasury Investment Growth Receipt)
- CATS (Certificates of Accrual on Treasury Securities)
- LIONs (Lehman Investment Opportunity Notes)
- A U.S. Savings Bond is issued (registered) to a specific individual and only that individual can collect the interest and principal payment (there is no secondary market on U.S. Savings Bonds, thus they are non-marketable). The maturity on U.S. Savings Bonds is up to 30 years, however the owner may cash in the bond prior to maturity (within 12 months from purchase on bonds purchased after February 1, 2003).
- One series of savings bond is known as the EE Series and it is an accrual-type security, such that it does not pay interest periodicaly. Rather, the EE Savings Bond is sold at a discount from its face value and the accrued interest (bond appreciation as the bond approaches maturity) is added to the bond monthly and only paid when the bond is cashed (redeemed).When the bond is redeemed, the owner must pay taxes on all of the interest that has accrued over the life of the bond, which could be many years (up to 30 years). The accrued interest payment in a lump sum can be substantial and may actually move the recipient into a higher tax bracket.
- The other series of savings bond is known as the HH Series are sold to the investor at face value and pay interest monthly. As of September 1, 2004, HH Bonds are no longer offered by the U.S. Government and holders of E or EE savings bonds may no longer convert them to HH bonds..
The Series I U.S. Savings Bond (I Bonds) is an inflation-adjusted savings bond. It is an accrual-types security such that interest is added to the bond monthly and only paid when the bond is cashed. The cost of the bond is face value and the interest rate has 2 components: a fixed rate (set every May and November bt the U.S. Treasury Department) and an iflation-linked index (CPI-U) that is adjusted every six months. Earnings from I Bonds are exempt from state and local taxes and is deferred of federal taxes until the bond is redeemed. These bonds are denominated in (United States dollars) $50, $75, $100, $200, $500, $1,000, $5,000, $10,000. Any investor is limited to total investments in I Bonds of a maximum $30,000 per annum. I Bonds are redeemable after 12 months from date of purchase.
The World Bank, African Development Bank (Located in Abidjan, Côte d'Ivoire, members are 53 independent African states and 24 non-African states; capital stock is owned by its member countries), Asian Development Bank, Inter-American Development Bank, European Investment Bank, Caribbean Development Bank, European Bank for Reconstruction and Development all issue debt in the global markets to fund projects.
Notes and bonds issued by a supranational organization do not represent the obligation of any government. The notes are issued at a discount or may bear fixed or floating rate interest or a coupon calculated by reference to an index or formula. In the United states, supranational debt are somtetimes referred to as exempted securities within the meaning of Section 3(a)(2) of the Securities Act and Section 3(a)(12) of the United States Securities Exchange Act of 1934.
U.S. Federal Agencies
Government agencies are actual divisions of the U.S. Federal government and the debt issued by these entities are backed by the full faith of the goverment (issued under the authority of an Act of Congress and are exempt from registration with the Securities and Exchange Commission). The most active issuer is the Government National Mortgage Association (GNMA / "Ginnie Mae"), Tennessee Valley Authority (TVA) and the U.S. Agency for International Development (U.S. AID).
Government Sponsored Enterprises (GSE)
Government Sponsored Enterprise (GSE) sometimes are also defined as federal agencies. However, GSEs are organizations that were sponsored by the U.S. Federal government to provide credit and financing to specific borrowers within the nation as a part of social policy. These entities are private corporations and not a division of the U.S. Federal government nor does the government guarantee their debt securities. Federal Home Loan Bank Board (FHLB), Federal National Mortgage Association (FNMA / "Fannie Mae"), Federal Home Loan Mortgage Corporation (FHLMC / "Freddie Mac"), Federal Farm Credit Banks, Student Loan Marketing Association (SLMA / "Sallie Mae"), Federal Farm Credit Bank (FFCB), Federal Agricultural Mortgage Corporation (FAMC) or Farmer Mac, Resolution Funding Corporation (REFCORPS; no longer issued, but are available on the secondary market in maturities of 1- to 30-years), Financing Corporation (FICOs; no longer issued, but are available on the secondary market in maturities of 1- to 20-years).
Fannie Mae and Freddie Mac
Both FNMA and FHLMC assemble and package mortgage-backed securities, however they both issue debt under their own names (unsecured obligations) to fund their purchases of mortgage loans prior to securitization or for purchasing mortgage loans to hold in their own portfolio. For instance, FNMA (one of the largest debt issuers in the world) issues Benchmark securities: Benchmark Bills (1-month, 3-month and 1-year maturities) issued through a Dutch Auction mechanism, Benchmark Notes and Callable Benchmark Notes issued through a traditional underwriting syndicate.
FNMA debt receives a favorable treatment in the marketplace as although it is not a subdivision of a U.S. Federal government agency and the U.S. Federal government does not guarantee its debt, there is a perception in the marketplace that there is an implicit commitment that the U.S. Federal government would support the FNMA (and FHLMC) sufficiently that they would be in a position to honor their obligations. Thus, FNMA has a credit rating of AAA / A1+ (Standard & Poor's), Aaa / P-1 (Moody's) and AAA / F1+ (Fitch), and pricing on its debt is somewhere between U.S. Treasuries and AAA corporate debt. In addition, depository financial institutions and commercial banks subject to risk-weighted assets capital regulations have a lower capital reserve requirement for FNMA and FHLMC debt (similar to U.S. Government debt of 0%) than they would have for corporate debt (50% / 100%).
Federal Home Loan Banks
- CO (Consolidated Obligations) are debt securities issued by the Federal Home Loan Banking System (FHLB), Office of Finance (central issuer for all 12 district banks in the FHLB system).
- The FHLB is a Government Sponsored Enterprise (GSE): rated Aaa / P-1 by Moody's and AAA/ A1+ by Standard and Poor's (Each District Bank of the FHLB system also has their own respective rating); While there is no explicit support, there is an implicit understanding that the U.S. Federal Government will insure that the FHLB will always be in a position to honor its obligations.
- The FHLB System is one of the largest debt issuers in the world and is the second largest GSE borrower.
- Interest on FHLB debt securities are exempt from state and local income tax.
- FHLB debt securities are eligible for collateral for certain public deposits and eligible for investment by national banks and thrifts.
- Loans made by FHLB District Banks to member institutions (advances) are generally short-term, and are over-collateralized with residential mortgages. FHLB maintains its own collateral delivery system with its members.
- All FHLB, Office of Finance issued CO debt is the joint and several liability for debt among the 12 FHLB District Banks.
The FHLB Chicago is in the process of developing a program to securitize the mortgages it purchases from its member banks and then resell the securities to its members. It is anticipated that the next step would be to begin to offer MBS to the public.
MBS securities are purchased by banks, pension funds, endowment funds and mutual funds. During 2002 and 2003, a record amount of MBS were created and purchased. The surge in MBS volume reflected the record amount of new home purchases and refinances spurred by the record low interest rate environment prevalent during those 2 years. However, investors who hold these securities are subject to interest rate shock. In a continued low rate environment these securities may have a 4 year maturity. However, if rates rise and the individual homeowners whose mortgages make up these securities remain with their low rate mortgages then the MBS maturity increases substantially out to seven years or longer. These longer term assets are more subject to interest rate moves and if rates move higher then their value moves inversely.
Federal Farm Credit Banks
The Federal Farm Credit Banks (?FFCB?) are a government sponsored enterprise (GSE, created 1916) and is a nationwide network of lending institutions and affiliated services and other entities. Through its non-deposit taking Banks and related associations, the System lends money and provides related credit and other services to farmers, ranchers, producers and harvesters of aquatic products, rural homeowners, certain farm-related businesses, agricultural and aquatic cooperatives (or to other entities for the benefit of such cooperatives), rural utilities, and to certain foreign or domestic entities in connection with international agricultural credit transactions. The Banks and related associations are not commonly owned or controlled. They are cooperatively owned, directly or indirectly, by their respective borrowers. System institutions are federally chartered under the Act and are subject to supervision, examination and regulation by an independent Federal agency, the Farm Credit Administration (FCA).
The Farm Credit System is composed of four regional Farm Credit Banks (FCB), one regional Agricultural Credit Bank (ACB) and numerous associations (approximately 99 related Production Credit Associations / PCAs, Federal Land Credit Associations / FCLAs and Agricultural Credit Associations /ACAs. The PCAs, FLCAs, and ACAs are collectively referred to as Associations) across the nation. The System Banks and Associations are cooperatively owned, directly or indirectly, by their borrowers, which are the smaller, local banks that lend directly to the agricultural sector in all 50 states of the United states and in Puerto Rico. These entities have specific lending authorities within their chartered territories.
As none of the banks within the system are deposit taking institutions, funds are raised through the issuance of Farm Credit Debt Securities in the U.S. domestic and global capital markets by the Federal Farm Credit Banks Funding Corporation (FFCBFC).
- AgriBank, FCB
- Serves Arkansas, Illinois, Iowa, Indiana, Kentucky, Michigan, Minnesota, Missouri, Nebraska, North Dakota, Ohio, South Dakota, Tennessee, Wisconsin and Wyoming.
- CoBank, ACB (Agricultural Credit Bank)
- Agricultural Credit Bank with a national charter to finance agricultural cooperatives and rural utility systems, CoBank has 11 regional banking centers. Its regional office in the Northeast lends to Farm Credit associations in Connecticut, Maine, Massachusetts, New Hampshire, New Jersey, New York, Rhode Island and Vermont. International banking services are provided through its headquarters in Denver.
- Farm Credit Bank of Texas
- Providing short-term financing to New Mexico, Northwest Louisiana and Texas. Long-term financing to Alabama, Louisiana, Mississippi and Texas.
- AgFirst, FCB
- U.S. AgBank, FCB
- U.S. AgBank, FCB serves Farm Credit Associations in Arizona, California, Hawaii, Nevada, Utah, Idaho, Kansas, Colorado, Oklahoma, and New Mexico.
- The Federal Farm Credit Bank Funding corporation (?FFCBFC?) is the fiscal agent for the banks of the Federal Farm Credit system and is authorized to sell:
- Federal Farm Credit Banks Consolidated Systemwide Bonds
- Federal Farm Credit Banks Consolidated Systemwide Discount Notes
- Federal Farm Credit Banks Consolidated Systemwide Master Notes
- Federal Farm Credit Banks Global Securities
- Federal Farm Credit Banks Consolidated Systemwide Medium-Term Notes
The securities are Triple-A rated by both Moody's and standard & Poor's and are sold to a client base that includes banks, state and local governments, pension funds, insurance companies, investment managers, credit unions, corporations, central banks and individuals.
The Farm Credit Debt Securities are the joint and several obligations of the System Banks.
Federal Agricultural Mortgage Corporation (Farmer Mac)
Farmer Mac provides a secondary market for agricultural real estate and rural housing mortgages. Farmer Mac is excluded from the joint and several guaranty of the other institutions debt and they do guarantee Farmer Mac?s debt.
Farmer Mac purchases agricultural mortgage loans from mortgage lenders such as mortgage companies, savings institutions, credit unions and commercial banks, thereby replenishing those institutions' supply of mortgage funds. Farmer Mac either packages these loans into Agricultural Mortgage-Backed Securities (AMBS), which it guarantees for full and timely payment of principal and interest, or purchases these loans for cash and retains the mortgages in its portfolio. Farmer Mac obtains the funds to finance its mortgage purchases and other business activities by selling debt securities in the capital markets. Farmer Mac obtains most of its funding through two types of funding vehicles: discount notes and medium-term notes.
Farmer Mac is regulated, examined, and supervised by the Farm Credit Administration through its Office of Secondary Market Oversight (OSMO).
State / Provincial / Municipal Governments
- Oversight for municipal bond issues in the United States falls under the jurisdiction of the Municipal Securities Rule Making Board (most municipal securities offerings are exempt from the registration provisions of the federal securities laws, which means that municipal issuers do not have to file a registration statement with the SEC). There are also four Nationally Recognized Municipal Securities Information Repositories (NRMSIRs), which collect annual operating / disclosure data from municipal bond issuers:
- Bloomberg Municipal Repository
- DPC Data Inc.
- Interactive Data Pricing and Reference Data, Inc.
- Standard & Poor's Securities Evaluations, Inc.
Municipal bonds are issued by states, provinces, counties and cities (and affiliated agencies) for funding the construction of public facilities such as schools (all grades), courthouses, housing (single-family and multi-family), sports facilities, hospital and health care, adult assisted living and libraries, or to finance infrastructure improvements, such as bridges, airports, marine facilities, pollution control, roads, railways, tunnels, telephone utilities, electric utilities, gas utilities and water and sewer systems. Repayment can come from general obligation, toll revenue, parking fee revenue, sales tax revenue, special assessment, special tax or sports facility revenue. The key attraction for investors is that the interest income earned from a municipal bond issue may be exempt from some combination of Federal, State or local taxation, which usually requires that the investor reside within the territorial jurisdiction of the issuer to obtain the full tax benefit. Not all municipal bond issues are exempt from taxation. Secondly, the exemption is on the interest income. If the bond is sold prior to maturity at a price above par, the sale may be separately taxable as a long-term capital gain (15% marginal tax).
A key measurement of whether to invest in a municipal bond that is exempt from taxation at the federal level is to determine what the tax rate is and then compare it with a taxable issue that is also available in the market:
|4.5% Tax-exempt Bond||6.0% Taxable Investment|
|Investment||$ 50,000||$ 50,000|
|Interest Income||$ 2,250||$ 3,000|
|Federal income tax in the 36% marginal tax bracket||0||$ 1,080|
|Net return||$ 2,250||$ 1,920|
|Yield on investment after taxes||4.5%||3.84%|
Taxable Equivalent Yield: The calculation to determine the taxable equivalent yield (the interest rate that a taxable bond would have to pay to be equal with a tax-tree bond given the investor's marginal tax bracket) is equal to the tax free yield divided by the sum of 100 minus the current tax bracket. For example the taxable equivalent yield of a 4.50% tax free bond for an investor in the 36% marginal tax bracket would be: 4.5/(100-36) = 0.07031313, or 7.03%.
|4.5% Tax-exempt Bond||7.03% Taxable Investment|
|Investment||$ 50,000||$ 50,000|
|Interest Income||$ 2,250||$ 3,515|
|Federal income tax in the 36% marginal tax bracket||0||$ 1,265|
|Net return||$ 2,250||$ 2,250|
|Yield on investment after taxes||4.5%||4.5%|
Tax Exempt / Taxable Yield Equivalents:
|Tax Exempt Yields (%)||Taxable Yield Equivalents (%)|