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Covered Bonds

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698340761 Covered Bonds

Covered bonds are securities created from public sector loans or mortgage loans, where the security is backed by a separate group of loans. Covered bonds typically carry a 2-10 year maturity rate and enjoy relatively high credit ratings, depending on the quality of the pool of loans (“cover pool”) backing the bond.

Covered bonds are often attractive to investors looking for high-quality instruments that offer attractive yields. The main advantages to the issuers of covered bonds is that the issuer can gain access to more funding at a lower cost than it could if it issued unsecured bonds. Because covered bonds often have a higher credit rating than the issuer, they can be sold to the market for more money (lower yield) than unsecured notes. Institutional investors who are limited to buying high quality instruments can buy covered bonds. Covered bonds also have greater liquidity than other asset-backed securities.

Most covered bonds are backed by mortgages. Austria, France, Germany, and Spain allow backing by public sector loans, and Denmark and Germany allow backing by ship loans.

Before 2005, only specialized banks could issue covered bonds, but laws since then have expanded the number of issuers to include any financial institution that satisfies credit quality requirements. A license is required by the issuer to issue the bonds. Some countries, however, require issuers to specialize in particular areas, such as mortgages.

Covered bonds are backed by a cover pool, consisting of specific loans, either high quality mortgages or public sector loans.

Both asset eligibility and the procedures followed in liquidation differ according to country. Covered bond laws typically specify:

- asset eligibility;
- credit quality, especially loan-to-value ratios;
- asset/outstanding covered bond ratio;
- asset pool monitoring requirements and procedures;
- procedures regarding the assets in the event of the issuer’s bankruptcy.

Typically, covered bonds cannot be based on mortgages with a loan-to-value ratio of greater than 80%, borrower income must be documented, and no more than 20% of the mortgages can be from any single metropolitan area. If the issuer becomes insolvent, then the cover pool assets are separated from the other bank assets for the benefit of the covered bondholders.

Holders of covered bonds are paid by the issuing bank, which retains the covered bonds on its balance sheet. If any of the underlying loans goes bad, the bank must replace the bad loans in the cover pool with good loans.

Hence, covered bonds offer a high yield/low risk ratio. In the event of the issuer’s bankruptcy, the bondholders would have a senior claim on the asset pool, ahead of all others. If the issuing bank does not pay the bondholders, then they would receive the payment stream from the underlying mortgages.

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Certificates of Deposit

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sunset Certificates of Deposit
Certificates of deposit (CDs) are debt instruments issued by banks and other financial institutions to investors. In exchange for lending the institution money for a predetermined length of time, the investor is paid a set rate of interest. Maturities on certificates of deposit can range from only a few weeks to several years with the interest rate earned by the investor increasing in proportion to the time his capital is tied up in the investment.

CDs can be negotiable or nonnegotiable. Nonnegotiable CDs can’t be sold before maturity, so the investor can only receive payment from the issuing bank. If the money is withdrawn before maturity, then the bank pays a lower rate of interest as an early withdrawal penalty.

Negotiable CDs, introduced in the early 1960s, can be sold before maturity in the secondary money market. However, only short-term CDs—less than 3 months—have an appreciable market.

Retail negotiable CDs, with denominations of $100,000 were introduced by Merrill Lynch in 1982. Nowadays, other security firms also offer CDs, and most stand ready to buy back their CDs before their maturity if the investor wants her money early.

Large-denomination negotiable CDs are CDs with denominations of $1,000,000 or greater, and constitute the largest part of the negotiable CD market. Most of the investors of these CDs are investment companies and money market funds, although some banks, municipalities and corporations also buy CDs.

Issuers of CDs

Issuers of CDs are grouped according to the type of bank. The main issuers are domestic banks. Eurodollar CDs (Euro CDs) are denominated on the U.S. dollar but are issued primarily in London by foreign branches of U.S. banks, and by Canadian, Japanese, and European banks. Yankee CDs are also denominated in U.S. dollars and are issued by the United States branches of foreign banks in the United States. Thrift CDs are issued by U.S. depository banks, such as thrifts and savings and loans banks, which use the deposited money for loans.

CD Yields

Unlike other short-term money market instruments, CDs are not sold at a discount, but pay interest on the money deposited. For CD maturities of less than 1 year, interest is paid at maturity. For term CDs, interest is paid semiannually. A banker’s year of 360 days is used to compute interest.

Market yields on CDs are determined by the usual factors that affect rates for fixed-income securities: the credit rating of the issuer and the term of the CD. The length of the term on the yield is dependent on the shape of the yield curve.

A major determinant of CD yields is the bank’s demand for money for loans and the cost of alternative sources of funding, such as commercial paper. The greater the demand or the higher the cost of alternative funding sources, the greater the yields paid on CDs.

CDs can also be grouped as prime CDs or nonprime CDs, depending on the credit rating of the issuer. Prime CDs are issued by highly rated domestic banks; nonprime CDs are issued by smaller, less well-known banks.

Yankee CDs generally yield more than issues by domestic banks, because investors are not as familiar with foreign banks, and, hence, a lack of information increases the perception of credit risk.

The issuers of Euro CDs have several advantages that allow them to pay a higher interest rate. Because the issuer is not subject to United States laws and regulations, the issuer of a Euro CD does not have to pay insurance to the FDIC for the deposited money, nor is there any reserve requirement for the money. In the United States, the Federal Reserve imposes a reserve requirement on money deposited in U.S. banks. Domestic banks must, therefore, deposit some of the money in its Federal Reserve account, which does not earn any interest, so the bank is not able to use all of the money for its business—hence, it pays a lower rate.

The other factor increasing the yields on Euro CDs is the lack of information regarding the issuer and its government and laws, which creates some uncertainty as to repayment, and in some cases, there is the perception of sovereign risk, which is the risk that if the issuer does not repay the CD, it will be difficult to collect because the issuer is located in another country with different laws and regulations, or the government may not enforce its laws. However, this sovereign risk premium is small for most modern nations.

Example:

What is the actual cost to a bank with a 5% Federal Reserve requirement of a 1-year $100,000 CD paying 6% interest?

Because the bank must keep 5%, or $5,000, of the money in a Federal Reserve account that pays no interest, the $6,000 interest that the bank is paying is on $95,000, yielding an actual interest rate of 6,000/95,000 ≈ 6.32%. A simpler way to calculate the bank’s cost is to multiply the interest rate on the CD by 1 plus the Federal Reserve requirement percentage.

Actual Cost to Bank = CD Interest Rate x (1 + Federal Reserve Requirement Percentage)

In this case, the equation would be:

6% x 1.05 = 6.3%

Adding a typical 8 basis points (0.08%) to the interest rate for FDIC insurance increases the bank’s actual cost to 6.4%.

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Fixed-Rate Capital Securities

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344910main SABER aurora full Fixed Rate Capital Securities
In the early 1990s, a product called fixed-rate capital securities was introduced to meet the needs of income-oriented investors and provide a cost efficient source of capital for issuers.

These securities combine the features of corporate debt securities and preferred stock: generous yields compared with other investment vehicles, regular income disbursement, predictable investment time frames, liquidity and investment grade quality (in almost every case).

Fixed-rate capital securities (aka hybrids) are like preferred stock, but with a few peculiarities. There is no DRD tax advantage; thus, they pay a higher yield than preferred stocks or bonds from the same issuer. The have a lien status that is higher than preferreds but below creditors, and they carry the credit rating of the issuer. They are traded in the OTC market and most are also listed on the NYSE and AMEX stock exchanges. Most are priced at $25 per share, they have a stated maturity, and are callable after 5 to 10 years. Most issuers are utilities, industrial companies, and financial institutions.

FRCS are also classified based on how they are issued:
1.Junior subordinated debentures are issued directly by the parent company.
2.Trust preferred FRCS are issued by a trust.
3.Partnership preferred FRCS are issued by a partnership.

Specific FRCS are known by acronyms and names which describe the frequency of the payments, or how they are issued, such as:
•MIDS – Monthly Income Debt Securities
•QUICS – Quarterly Income Capital Securities
•QUIDS – Quarterly Income Debt Securities
•QUIPS – Quarterly Income Preferred Securities
•SKIS – Subordinated Capital Income Securities
•TOPrS – Trust Originated Preferred Securities
•TruPS – Capital Trust Pass-through Securities

The main difference between preferreds and FRCS is that FRCS pay interest—not dividends—monthly, quarterly, or semi-annually, but can be deferred if the company is in financial trouble. However, payments can be deferred only if no dividends are being paid for the issuer’s common or preferred stock, and if the interest payments are deferred, then interest continues to accumulate until it is paid. Sometimes FRCS are issued as zero coupon bonds, which are original issue discount (OID) instruments.

However, these securities can have tax complications, either because of interest payment deferral or because they are OIDs. In these cases, interest accrues, and if it is not paid in the year earned, then the investor in these securities must pay taxes on the accrued interest, which is calculated according to complex laws and formulas.

Besides the deferral risk mentioned above, there is also a special event risk, which allows the issuer to redeem the FRCS, at any time, for face value, if the tax law changes that disallows the tax deduction for the interest payments for the issuer’s parent company.

Features and Benefits

Priority of Claims
• FRCS typically offer a higher security claim than preferred and common stock, but rank junior and are subordinate in right of payment to all senior debt of the issuer.

Potential for Attractive Yields
• FRCS typically provide yield advantages relative to preferred stock and corporate bonds of the same issuer, partly to compensate investors for claims with a lower priority in addition to payment deferral risk.

Liquidity
• Certain FRCS trade on the OTC and listed markets, and generally have easily attainable quotes. Many FRCS are also listed on the NYSE®.

Credit Ratings
• FRCS may be rated by investment rating agencies such as Moody’s® and Standard & Poor’s® to assist investors in their evaluations of the securities.

Low Investment Minimum
• Many FRCS are issued at $25 a share (although some are issued with a $1000 par value). This feature enables investors to buy and sell in smaller increments. The actual price paid by the investor may be more or less than $25, particularly when the security is purchased in the secondary market.

Risks

While it may seem appealing to look at securities that offer higher yields, investors should consider those higher yields to be a sign of potentially greater risk.

Market Risk
• FRCS are subject to price fluctuation due to material events affecting the issuer or the market. Additionally, FRCS prices typically decline on ex-dividend days (the dates that buyers of FRCS are not entitled to receive the dividend).

Interest Rate Risk
• FRCS tend to rise in value when interest rates fall, and decline in value when interest rates rise.

Credit and Default Risk
• Investors should consider the possibility of risk that a corporation might default on its payments of interest or principal. Purchasing top–rated securities from companies with a stable or good credit history may help reduce credit risk.

Call Risk
• FRCS generally have a call provision which entitles the issuer to redeem the shares prior to maturity. Typically an issuing corporation will call its securities when interest rates fall, leaving the investor with potentially less favorable reinvestment possibilities. When evaluating FRCS, an investor should know whether call options exist and when these options may be exercised by the issuer.

Special Event Risk
• Many FRCS include a “special event” redemption option, allowing the issuer to redeem the securities at the liquidation value if a tax law change disallows the deductibility of payments by the issuer’s parent company, or subjects the issue to taxation separate from the parent company.

Deferral Risk
• FRCS permit the deferral of payments without declaring default, if the issuer experiences financial difficulties. Payments may be deferred or suspended for some stipulated period. If the issuer defers payments on a cumulative FRCS issue, the deferred income typically continues to accrue for tax purposes, even though the investor does not receive cash payments. Investors should consult with a tax professional regarding the tax treatment of investment income.

Inflation Risk
• FRCS are subject to the risk that the rate of the yield to call or maturity of the investment may not provide a positive return over the rate of inflation for the period of the investment.

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