Mortgage bonds a bond secured by a mortgage - Free Essay Example

Sample details Pages: 14 Words: 4216 Downloads: 4 Date added: 2017/06/26 Category Finance Essay Type Analytical essay Did you like this example? A mortgage bond is a bond secured by a mortgage on one or more assets.  These bonds are typically backed by real estate holdings and/or real property such as equipment. In a default situation, mortgage bondholders have a claim  to the underlying property and could sell it off to compensate for the default. Mortgage bonds offer the investor a great deal of protection in that the principal is secured by a valuable asset that could theoretically be sold off to cover the debt. Don’t waste time! Our writers will create an original "Mortgage bonds a bond secured by a mortgage" essay for you Create order However, because of this inherent safety, the average mortgage bond tends to yield a lower rate of return than traditional corporate bonds that are backed only by the corporations promise and ability to pay. Definition A  mortgage bond  is a  bond  backed by a pool of  mortgages  on a  real estate  asset such as a  house. More generally, bonds which are secured by the pledge of specific assets are called mortgage bonds. Illustrative summary An investor purchases a bond from a financial institution for a fixed amount of money. The financial institution then promises to give the money back years from that day with a small percentage of interest added to the original value. When a person purchases a house, he or she generally must borrow money from a bank or  mortgage  lending company. To borrow this money, the person must sign a  promissory note  stating he or she will pay back the value of the loan, plus a percentage of interest, which is accrued each month. Usually, a  mortgage payment  spans fifteen to thirty years and is paid back in monthly installations. To issues these loans, the mortgage lending company may need to borrow a large sum of cash from a larger financial institution. The mortgage  lender  offers a number of mortgage agreements in one lump-sum package to a financial institution, which issues a mortgage bond in return. With a mortgage bond, t he larger financial institution purchases the mortgage agreement from the mortgage lender and receives the borrowers monthly payment in exchange. The mortgage bond process helps the mortgage lender get the money it needs, while the larger financial institution earns extra money by receiving the monthly payment from the borrower. If the borrower defaults on the  mortgage loan, the loss is passed on to the financial institution that issued the mortgage bond. To regain the money lost from the mortgage bond, the financial institution that issued the mortgage bond can resell the house. This can still result in a loss of money if the mortgage bond is worth more than the home. Related concepts Consolidated Mortgage Bond A bond that consolidates the issues of multiple properties. If the properties covered by the consolidated mortgage bond are already mortgaged, the bond acts as a new mortgage. If the properties do not have outstanding mortgages then the bond is considered the first lien. It can be used as a way to refinance the mortgages on the individual properties. The bond is backed by real estate or physical capital. Consolidated mortgage bonds are used by large companies with many properties, such as railroads, looking to refinance them into one bond to market to investors. It allows companies to set a single coupon rate instead of dealing with several, and makes investors happy because they can purchase a singular bond that covers physical assets of a similar type. Mortgage Subsidy Bond One of the few types of municipal bonds ever issued that may be subject to taxation, provided that the funds raised were used for home mortgages. Mortgage subsidy bonds were issued by cities and other municipalities, and may be either taxable or tax-free. Mortgage subsidy bonds were created by the Mortgage Subsidy Act of 1980. They are issued by either state or local governments and are usually taxable. The  exceptions are a select group of mortgage bonds and veterans bonds. Conclusion In most cases, a mortgage bond is a win-win situation for both financial institutions. The recent increase in the value of homes, however, has caused some difficulty with the mortgage bond arrangement. Because homes were increasing in value, mortgage  lenders  issued loans to people who were not the ideal candidates. As such homeowners default on more loans, and the value of housing levels out, the mortgage bond may be worth more than the value of the house. Debentures Introduction Debenture is a type of fixed-interest  security, issued by companies (as borrowers) in  return  for medium and long-term investment of  funds. A debenture is evidence of the borrowers  debt  to the lender. The word derives from the Latin debeo, meaning I owe. Debentures are issued to the general public through a  prospectus  and are secured by a  trust deed  which spells out the terms and conditions of the fundraising and the rights of the debenture-holders. Typical issuers of debentures are finance companies and large industrial companies. Debenture-holders funds are invested with the borrowing  company  as secured loans, with the security usually in the form of a fixed or  floating charge  over the  assets  of the borrowing company. As secured lenders, debenture-holders  claims  to the companys assets rank ahead of those of ordinary shareholders, should th e company be wound up; also, interest is payable on debentures whether the company makes a  profit  or not. Debentures are issued for fixed periods but if a debenture-holder wants to get his or her  money  back, the securities  can be sold. Definition In the  United States, debenture refers specifically to an  unsecured  corporate bond,  i.e. a bond that does not have a certain line of income or piece of property or equipment to guarantee repayment of  principal  upon the bonds  maturity. Where security is provided for loan stocks or bonds in the US, they are termed mortgage bonds. However, in the  United Kingdom  a debenture is usually secured. In Asia, if repayment is secured by a charge over land, the loan document is called a  mortgage; where repayment is secured by a charge against other assets of the company, the document is called a debenture; and where no security is involved, the document is called a note or unsecured deposit note. A  type of debt instrument that is not secured by physical asset or collateral.  Debentures are backed only by the general  creditworthiness  and  reputation of the issuer.  Both corporations and governments frequently issue this type of bond in order to secure capital.  Like other types of bonds, debentures are documented in an indenture. In law, a  debenture  is a document that either creates a debt or acknowledges it. In  corporate finance, the term is used for a medium- to long-term debt instrument  used by large companies to borrow money. In some countries the term is used interchangeably with  bond,  loan stock  or  note. Illustrative summary Debentures have no collateral.  Bond buyers generally  purchase debentures based on  the belief that the bond issuer is unlikely to default on the repayment.  An example of a government  debenture would be any government-issued  Treasury bond (T-bond) or Treasury bill (T-bill). T-bonds and T-bills  are generally considered risk  free because governments, at worst,  can  print off more money or raise taxes to pay  these types of debts. A  Debenture is a long-term Debt Instrument issued by governments and big institutions for the purpose of raising funds. The Debenture has some similarities with  Bonds  but the terms and conditions of securitization of Debentures are different from that of a Bond. A Debenture is regarded as an unsecured investment  because there are no pledges (guarantee) or liens available on particular assets. Nonetheless, a Debenture is backed by all theƚ  assets which have not been pledged otherwise. Normally, Debentures are referred to as freely negotiable Debt Instruments. The Debenture holder functions as a lender to the issuer of the Debenture. In return, a specific  rate  of interest is paid to the Debenture holder by the Debenture issuer similar to the case of a  loan. In practice, the differentiation between a Debenture and a Bond is not observed every time. In some cases, Bonds are also termed as Debentures and vice-versa. If a  bankruptcy  occurs, Debenture holders are treated as general creditors.  Ãƒâ€š Conclusion The English term debenture has two meanings: 1: a certificate or voucher acknowledging a debt; 2: the ability of a customer to obtain goods or services before payment, based on the trust that payment will be made in the future. The Debenture issuer has a substantial advantage from issuing a Debenture because the particular assets are kept without any encumbrances so that the option is open for issuing them in future for financing  purposes. Subordinated debentures Introduction An unsecured bond with a claim to assets that is subordinate to all existing and future debt. Thus, in the event that the issuer encounters financial difficulties and must be liquidated, all other claims must be satisfied before holders of subordinated debentures can receive a settlement. Frequently, this settlement amounts to relatively little. Because of the risk involved, the issuers have to pay relatively high interest rates in order to sell these securities to investors. Many issues of these debentures include a sweetener such as the right to exchange the securities for shares of common stock. The sweeteners are included so that interest rates on the subordinated debentures can be reduced below the level that would be required without them. Subordinated debentures without the conversion option appeal to risk-oriented investors seeking high current yields. Subordinated debenture  has a lower priority than other bonds of the issuer in case of liquidation during  bankruptcy, below the liquidator, government  tax  authorities and senior debt holders in the hierarchy of creditors. Definition   Subordinated debt  (also known as  subordinated loan,  subordinated bond,  subordinated debenture  or  junior debt) is debt which ranks after other debts should a company fall into  receivership  or be closed. Such debt is referred to as subordinate, because the debt providers (the lenders) have subordinate status in relationship to the normal debt. A typical example for this would be when a promoter of a company invests money in the form of debt, rather than in the form of stock. In the case of liquidation (e.g. the company winds up its affairs and dissolves) the promoter would be paid just before stockholders assuming there are assets to distribute after all other liabilities and debts have been paid. Explanation Subordinated debt has a lower priority than other bonds of the issuer in case of  liquidation  during  bankruptcy, below the  liquidator, government tax authorities and  senior debt holders  in the hierarchy of creditors. Because subordinated debt is repayable after other debts have been paid, they are more risky for the lender of the money. It is unsecured and has lesser priority than that of an additional debt claim on the same asset. Subordinated loans typically have a higher  rate of return  than senior debt due to the increased inherent risk. Accordingly, major  shareholders  and  parent companies  are most likely to provide subordinated loans, as an outside party providing such a loan would normally want compensation for the extra risk. Subordinated bonds usually have a lower credit rating than senior bonds. Subordinate debenture and stocks. When somebody decides to invest in stocks, he or she becomes one of the owners and thus, becomes a shareholder of the good and bad times of the company. The investor faces uncertain fortunes related to the companys  financial  graph. So this explains the amount of risk related to stock-investments. But debentures are more secured investment, as payments with high interest rates are guaranteed. The company is bound to pay interest on the borrowed money, and once the debenture matures, all the borrowed  money  is returned. In other words, the investors gain interest as income from the debentures. Subordinated debenture and bonds. Subordinated debenture and bonds are similar, but  bonds  carry more security than debentures. In both of these investment forms, interest and value is guaranteed, but in case of liquidation, bond holders receive the payment first, followed by the senior bonds, and only after that comes the subordinated debenture holders, who have no collateral which they can claim from the company in case bankruptcy takes place. To compensate for the possibility of such losses,  high interest rates  are paid to the subordinated debenture holders. Examples A particularly important example of subordinated bonds can be found in bonds issued by banks. Subordinated debt is issued periodically by most large banking corporations in the U.S. Subordinated debt can be expected to be especially  risk-sensitive, because subordinated debt holders have claims on bank assets after senior debt holders and they lack the upside gain enjoyed by shareholders. This status of subordinated debt makes it perfect for experimenting with the significance of  market discipline, via the signaling effect of secondary market prices of subordinated debt (and, where relevant, the issue price of these bonds initially in the primary markets). From the perspective of policy-makers and regulators, the potential benefit from having banks issue subordinated debt is that the markets and their information-generating capabilities are enrolled in the supervision of the financial condition of the banks. This hopefully creates both an early-warning system, like t he so-called canary in the mine, and also an incentive for bank management to act prudently, thus helping to offset the  moral hazard  that can otherwise exist, especially if banks have limited equity and deposits are insured. This role of subordinated debt has attracted increasing attention from policy analysts in recent years. For a second example of subordinated debt, consider asset-backed securities. These are often issued in  tranches. The senior tranches get paid back first, the subordinated tranches later. Finally,  mezzanine debt  is another example of subordinated debt. Conclusion Because subordinated debenture is repayable after other debts have been paid, they are more risky for the lender of the money. It is unsecured and has lesser priority than that of an additional debt claim on the same  asset. Subordinated bonds are regularly issued (as mentioned earlier) as part of the securitization of debt, such as  asset-backed securities,  collateralized mortgage obligations  or  collateralized debt obligations. Corporate issuers tend to prefer not to issue subordinated bonds because of the higher interest rate required to compensate for the higher risk, but may be forced to do so if indentures on earlier issues mandate their status as senior bonds. Also, subordinated debt may be combined with  preferred stock  to create so called  monthly income preferred stock, a  hybrid security  paying dividends for the lender and funded as interest expense by the issuer. Investment-grade bonds Introduction A  bond  is considered  investment grade  or  IG  if its credit rating is BBB- or higher by  Standard HYPERLINK https://en.wikipedia.org/wiki/Standard__PoorsHYPERLINK https://en.wikipedia.org/wiki/Standard__Poors Poors  or Baa3 or higher by  Moodys  or BBB (low) or higher by  DBRS. Generally they are bonds that are judged by the rating agency as likely enough to meet payment obligations that banks are allowed to invest in them. Ratings play a critical role in determining how many companies and other entities that issue debt, including sovereign governments; have to pay to access credit markets, i.e., the amount of interest they pay on their issued debt. The threshold between investment-grade and speculative-grade ratings has important market implications for issuers borrowing costs. The risks associated with investment-grade bonds (or investment-grade  corporate debt) are considered noticeably higher than in the case of first-class government bonds. The difference between rates for first-class government bonds and investment-grade bonds is called investment-grade spread. It is an indicator for the markets belief in the stability of the economy. The higher these investment-grade spreads (or  risk premiums) are, the weaker the economy is considered. Until the early 1970s, bond credit ratings agencies were paid for their work by investors who wanted impartial information on the credit worthiness of securities issuers and their particular offerings. Starting in the early 1970s, the Big Three ratings agencies (SP, Moodys, and Fitch) began to receive payment for their work by the securities issuers for whom they issue those ratings, which has led to charges that these ratings agencies can no longer always be impartial when issuing ratings for those securities issuers. Securities issuers have been accused of shopping for the best ratings from these three ratings agenc ies, in order to attract investors, until at least one of the agencies delivers favorable ratings. This arrangement has been cited as one of the primary causes of the  subprime mortgage crisis  (which began in 2007), when some securities, particularly  mortgage backed securities  (MBSs) and collateralized  (CDOs) rated highly by the credit ratings agencies, and thus heavily invested in by many organizations and individuals, were rapidly and vastly devalued due to defaults, and fear of defaults, on some of the individual components of those securities, such as home loans and credit card accounts. Definition Investment grade bonds  are bonds which are rated BBB- or higher by SP and Fitch or Baa3 or higher by Moodys. These ratings are indicators of  default risk  on a particular bond issue with higher rating suggesting lower risk. Bonds which fall below the investment grade threshold are known as  speculative bonds  (also known as  high yield bonds,  non-investment grade  bonds or  junk bonds) The following table lists the ratings which would qualify an issue as  investment grade. Description Moodys SP Fitch Maximum Safety Aaa AAA AAA High grade Aa1 AA+ AA+ High grade Aa2 AA AA High grade Aa3 AA- AA- Higher medium Grade A1 A+ A+ Higher medium Grade A2 A A Higher medium Grade A3 A- A- Lower medium Grade Baa1 BBB+ BBB+ Lower medium Grade Baa2 BBB BBB Lower medium Grade Baa3 BBB- BBB- In vestment grade bonds  are the investment vehicle of choice for many individual and institutional investors. Understanding what an investment grade bond is and what its benefits and risks are will help you make smart choices. Explanation Bonds are rated as to their creditworthiness by the investment ratings agencies, the two primaries of which are Standard Poors and Moodys. Investment grade bonds must be rated BBB- or Baa3, respectively, or higher by these rating agencies. The highest ratings for investment grade bonds are AAA by Standard Poors and Aaa by Moodys. Even the highest-rated investment grade bonds are considered riskier than government-issued bonds. If you take the rate on an investment grade bond and on a government bond, the difference or spread between them is considered a measure of the economys general stability. The lower the spread, the more stable the market views the economy. Conclusion These ratings are important because corporations use bonds as one method of raising funds. Investment grade bonds are considered reliably certain enough to be repaid that banks can invest in them. For this reason, a bond issuer will strive for the highest rating it can get. And, clearly, for the same reason the objectivity and trustworthiness of the ratings agencies is paramount. Junk bonds Introduction High Yield Bonds,  often referred to as junk bonds, are bonds that carry a high risk of default and, as a result, offer a higher yield than investment grade bonds. A high yield bond is classified as having a  credit rating  of BB+ or lower, while bonds with rating of BBB or higher are known as investment grade.  Debt  instruments are the converse of  equity instruments, or stocks, and generally perform better than equities during  economic downturns. This generality holds because debt holders have the first claim on a companys assets. In recessionary periods when cash flows are tight, the companies are required to pay their bond holders before their shareholders receive anything. Junk bonds are the ones that usually pay a high yield because their credit ratings arent stellar. Therefore, in order to borrow money from outside investors, they must pay a higher interest rate in order to attract people to lend them money. This higher i nterest rate reflects the higher chance of default by the company. Bonds rated BBBÃÆ' ¢Ãƒâ€¹Ã¢â‚¬  Ãƒ ¢Ã¢â€š ¬Ã¢â€ž ¢ and higher are called  investment grade  bonds. Bonds rated lower than investment grade on their date of issue are called speculative grade bonds, derisively referred to as junk bonds. The lower-rated debt typically offers a higher yield, making speculative bonds attractive investment vehicles for certain types of  financial portfolios  and strategies. Many  pension funds  and other investors (banks, insurance companies), however, are prohibited in their  by-laws  from investing in bonds which have ratings below a particular level. As a result, the lower-rated securities have a different investor base than investment-grade bonds. The value of speculative bonds is affected to a higher degree than  investment grade bonds  by the possibility of  default. For example, in a  re cession  interest rates may drop, and the drop in interest rates tends to increase the value of investment grade bonds; however, a recession tends to increase the possibility of default in speculative-grade bonds. Definition A high-risk, high-yield debt security that, if rated at all, is graded less than BBB by Standard Poors or BBB3 by Moodys. These securities are most appropriate for risk-oriented investors. Also called  high-yield bond. Explanation High yield bonds can be bought individually through a broker or in bulk through mutual funds. A high yield mutual fund is a better choice for individual investors because it reduces  risk. This is because the risk is spread over a larger number of contracts, which is known as  diversifying  your credit risk of high yield bonds. That is, while any single bond within the fund may have a relatively high probability of default, when many are grouped together the risk that all, or even most, of the bonds defaulting is much lower. In fact, historically the average rate of  default  between 1971 and 2008 was 3.18%, and even when a high yield bond defaults, bond holders are able to recover on average 44 cents on the dollar.[1]  Therefore, even when high yield bonds default, the investor often does not lose the entire  principal. There are other considerations to take into account besides simply the yield and credit risk. There are two way s high yield bonds enter the market. The first are high yield bonds that are issued by corporations whose credit rating is below investment grade at the time of issue. Because the debt that is being issued is backed by corporations that may a higher chance of being unable to repay, their debt is considered below investment grade and therefore they must pay a higher interest rate. The second way are bonds issued by corporations that were investment grade at the time of issue, but whose credit rating fell below investment grade. For example, suppose Company X currently has a credit rating of AA (investment grade), and issues bonds that expire in 10 years. Two years later, Company Xs performance has fallen off considerably, and its credit rating is now BB+, meaning it is now below investment grade. Therefore, even though the bonds were initially investment grade bonds, it can still fall below investment grade and turn into a high yield bond. These are often referred to as fallen stars. When investment grade companies credit ratings drop to below investment grade, the bond now not only has a higher risk of default, but the price of the bond will fall as well. Therefore, if you plan to sell the bond before maturity, your  holding period return  will suffer with drops in credit ratings. Conversely, if you purchase a high yield bond, and the companys credit rating improves to investment grade, the value of your bond will increase significantly. An investor can view the interest payments as analogous to  dividend  payments made by stocks while changes in credit ratings are somewhat analogous to changes in the bond price. Conclusion The holder of any debt is subject to  interest rate risk  and  credit risk, inflationary risk, currency risk, duration risk,  convexity risk, repayment of principal risk, streaming income risk,  liquidity risk, default risk, maturity risk, reinvestment risk, market risk, political risk, and taxation adjustment risk. Interest rate risk refers to the risk of the market value of a bond changing in value due to changes in the structure or level of interest rates or credit spreads or risk premiums. The credit risk of a high-yield bond refers to the probability and probable loss upon a credit event (i.e., the obligor defaults on scheduled payments or files for bankruptcy, or the bond is restructured), or a credit quality change is issued by a rating agency including Fitch, Moodys, or Standard Poors. A  credit rating agency  attempts to describe the risk with a  credit rating  such as AAA. In  North America, the fiv e major agencies are  Standard and Poors,Moodys,  Fitch Ratings,  Dominion Bond Rating Service  and  A.M. Best. Bonds in other countries may be rated by US rating agencies or by local credit rating agencies. Rating scales vary; the most popular scale uses (in order of increasing risk) ratings of AAA, AA, A, BBB, BB, B, CCC, CC, C, with the additional rating D for debt already in  arrears.  Government bonds  and bonds issued by  government HYPERLINK https://en.wikipedia.org/wiki/Government_sponsored_enterprisesponsored enterprises  (GSEs) are often considered to be in a zero-risk category above AAA; and categories like AA and A may sometimes be split into finer subdivisions like AAÃÆ' ¢Ãƒâ€¹Ã¢â‚¬  Ãƒ ¢Ã¢â€š ¬Ã¢â€ž ¢ or AA+.