A mortgage bond is a bond secured by a mortgage on one or more assets.A These bonds are typically backed by real estate holdings and/or real property such as equipment. In a default situation, mortgage bondholders have a claimA 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. 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 corporation’s promise and ability to pay.
AA mortgage bondA is aA bondA backed by a pool ofA mortgagesA on aA real estateA asset such as aA house. More generally, bonds which are secured by the pledge of specific assets are called mortgage bonds.
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 orA mortgageA lending company. To borrow this money, the person must sign aA promissory noteA stating he or she will pay back the value of the loan, plus a percentage of interest, which is accrued each month. Usually, aA mortgage paymentA 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 mortgageA lenderA 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, the larger financial institution “purchases” the mortgage agreement from the mortgage lender and receives the borrower’s 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 theA 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.
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.
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. TheA exceptions are a select group of mortgage bonds and veterans’ bonds.
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, mortgageA lendersA 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.
Debenture is a type of fixed-interestA security, issued by companies (as borrowers) inA returnA for medium and long-term investment ofA funds. A debenture is evidence of the borrower’sA debtA to the lender. The word derives from the Latin debeo, meaning ‘I owe’. Debentures are issued to the general public through aA prospectusA and are secured by aA trust deedA 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 borrowingA companyA as secured loans, with the security usually in the form of a fixed orA floating chargeA over theA assetsA of the borrowing company. As secured lenders, debenture-holders’A claimsA to the company’s assets rank ahead of those of ordinary shareholders, should the company be wound up; also, interest is payable on debentures whether the company makes aA profitA or not. Debentures are issued for fixed periods but if a debenture-holder wants to get his or herA moneyA back, the securitiesA can be sold.A
In theA United States, debenture refers specifically to anA unsecuredA corporate bond,A i.e. a bond that does not have a certain line of income or piece of property or equipment to guarantee repayment ofA principalA upon the bond’sA maturity. Where security is provided for loan stocks or bonds in the US, they are termed ‘mortgage bonds’. However, in theA United KingdomA a debenture is usually secured. In Asia, if repayment is secured by a charge over land, the loan document is called aA 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’. AA type of debt instrument that is not secured by physical asset or collateral.A Debentures are backed only by the generalA creditworthinessA andA reputation of the issuer.A Both corporations and governments frequently issue this type of bond in order to secure capital.A Like other types of bonds, debentures are documented in an indenture. In law, aA debentureA is a document that either creates a debt or acknowledges it. InA corporate finance, the term is used for a medium- to long-term debt instrumentA used by large companies to borrow money. In some countries the term is used interchangeably withA bond,A loan stockA orA note.
Debentures have no collateral.A Bond buyers generallyA purchase debentures based onA the belief that the bond issuer is unlikely to default on the repayment.A An example of a governmentA debenture would be any government-issuedA Treasury bond (T-bond) or Treasury bill (T-bill). T-bonds and T-billsA are generally considered riskA free because governments, at worst,A canA print off more money or raise taxes to payA these types of debts. AA Debenture is a long-term Debt Instrument issued by governments and big institutions for the purpose of raising funds. The Debenture has some similarities withA BondsA but the terms and conditions of securitization of Debentures are different from that of a Bond. A Debenture is regarded as an unsecured investmentA because there are no pledges (guarantee) or liens available on particular assets. Nonetheless, a Debenture is backed by all theA assets which have not been pledged otherwise.A 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 specificA rateA of interest is paid to the Debenture holder by the Debenture issuer similar to the case of aA 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 aA bankruptcyA occurs, Debenture holders are treated as general creditors.A A
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 financingA purposes.A
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 debentureA has a lower priority than other bonds of the issuer in case of liquidation duringA bankruptcy, below the liquidator, governmentA taxA authorities and senior debt holders in the hierarchy of creditors.
A Subordinated debtA (also known asA subordinated loan,A subordinated bond,A subordinated debentureA orA junior debt) is debt which ranks after other debts should a company fall intoA receivershipA 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.
Subordinated debt has a lower priority than other bonds of the issuer in case ofA liquidationA duringA bankruptcy, below theA liquidator, government tax authorities andA senior debt holdersA 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 higherA rate of returnA than senior debt due to the increased inherent risk. Accordingly, majorA shareholdersA andA parent companiesA 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.
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 company’sA financialA 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 borrowedA moneyA is returned. In other words, the investors gain interest as income from the debentures.A
Subordinated debenture and bonds are similar, butA bondsA 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,A high interest ratesA are paid to the subordinated debenture holders.A
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 especiallyA 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 ofA 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 the so-called “canary in the mine,” and also an incentive for bank management to act prudently, thus helping to offset theA moral hazardA 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 inA tranches. The senior tranches get paid back first, the subordinated tranches later. Finally,A mezzanine debtA is another example of subordinated debt.
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 sameA asset. Subordinated bonds are regularly issued (as mentioned earlier) as part of the securitization of debt, such asA asset-backed securities,A collateralized mortgage obligationsA orA 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 withA preferred stockA to create so calledA monthly income preferred stock, aA hybrid securityA paying dividends for the lender and funded as interest expense by the issuer.
AA bondA is consideredA investment gradeA orA IGA if its credit rating is BBB- or higher byA Standard HYPERLINK “https://en.wikipedia.org/wiki/Standard_&_Poor’s”&HYPERLINK “https://en.wikipedia.org/wiki/Standard_&_Poor’s” Poor’sA or Baa3 or higher byA Moody’sA or BBB (low) or higher byA 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-gradeA 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 market’s belief in the stability of the economy. The higher these investment-grade spreads (orA 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 (S&P, Moody’s, 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 agencies, 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 theA subprime mortgage crisisA (which began in 2007), when some securities, particularlyA mortgage backed securitiesA (MBSs) and collateralizedA (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.
Investment grade bondsA are bonds which are rated BBB- or higher by S&P and Fitch or Baa3 or higher by Moody’s. These ratings are indicators ofA default riskA on a particular bond issue — with higher rating suggesting lower risk. Bonds which fall below the investment grade threshold are known asA speculative bondsA (also known asA high yield bonds,A non-investment gradeA bonds orA junk bonds) The following table lists the ratings which would qualify an issue asA investment grade. Description Moody’s S&P 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- Investment grade bondsA 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.
Bonds are rated as to their creditworthiness by the investment ratings agencies, the two primaries of which are Standard & Poor’s and Moody’s. 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 & Poor’s and Aaa by Moody’s. 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 economy’s general stability. The lower the spread, the more stable the market views the economy.
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.
High Yield Bonds,A 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 aA credit ratingA of BB+ or lower, while bonds with rating of BBB or higher are known as investment grade.A DebtA instruments are the converse ofA equity instruments, or stocks, and generally perform better than equities duringA economic downturns. This generality holds because debt holders have the first claim on a company’s 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 aren’t 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 interest rate reflects the higher chance of default by the company. Bonds rated BBBA and higher are calledA investment gradeA 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 ofA financial portfoliosA and strategies. ManyA pension fundsA and other investors (banks, insurance companies), however, are prohibited in theirA by-lawsA 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 thanA investment grade bondsA by the possibility ofA default. For example, in aA recessionA 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.
A high-risk, high-yield debt security that, if rated at all, is graded less than BBB by Standard & Poor’s or BBB3 by Moody’s. These securities are most appropriate for risk-oriented investors. Also calledA high-yield bond.
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 reducesA risk. This is because the risk is spread over a larger number of contracts, which is known asA diversifyingA 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 ofA defaultA 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.A Therefore, even when high yield bonds default, the investor often does not lose the entireA principal. There are other considerations to take into account besides simply the yield and credit risk. There are two ways 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 X’s 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, yourA holding period returnA will suffer with drops in credit ratings. Conversely, if you purchase a high yield bond, and the company’s credit rating improves to investment grade, the value of your bond will increase significantly. An investor can view the interest payments as analogous toA dividendA payments made by stocks while changes in credit ratings are somewhat analogous to changes in the bond price.
The holder of any debt is subject toA interest rate riskA andA credit risk, inflationary risk, currency risk, duration risk,A convexity risk, repayment of principal risk, streaming income risk,A 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, Moody’s, or Standard & Poors. AA credit rating agencyA attempts to describe the risk with aA credit ratingA such as AAA. InA North America, the five major agencies areA Standard and Poor’s,Moody’s,A Fitch Ratings,A Dominion Bond Rating ServiceA andA 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 inA arrears.A Government bondsA and bonds issued byA government HYPERLINK “https://en.wikipedia.org/wiki/Government_sponsored_enterprise”sponsored enterprisesA (GSE’s) 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 “AAA” or “AA+”.
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