3. Investment Planning. 1. Fixed Income Securities Flashcards
Module Introduction
Have you ever loaned money to a friend or family member? How long did you give the person to repay you? Did you receive your money back in payments or in one lump sum? Did you receive something extra for loaning him or her the money?
Many people experience debt through home mortgages, car loans, or student loans. These loans allow people with extra money to loan it to those who need it. For the borrower, it represents a way to obtain a large amount of money up front and pay back the loan incrementally or as a single repayment at a later date. For the lender, the benefit lies in the compensation that he or she will receive in addition to the original loan amount. This compensation is commonly known as interest or income. Because most bonds and loans have a specified amount of interest, debt instruments such as bonds are also known as fixed-income securities.
The Introduction to Fixed-income Securities module, which should take approximately five hours to complete, will explain the various types of fixed-income securities, their characteristics, listings, and the markets in which the instruments are traded.
Upon completion of this module you should be able to:
* Describe the attributes of fixed-income securities,
* Compare the various types of fixed-income securities,
* Associate unique characteristics with specific investor needs,
* Locate and read newspaper listings of the various types of fixed-income securities, and
* Associate the instruments with markets where they are traded.
Module Overview
- A fixed-income security is also known as a debt security.
- The issuer of the security is essentially taking out a loan from the investor while promising to pay the investor back at a certain time with interest.
- Interest is simply the cost of money. Interest can be paid periodically, or it can be the difference between the investment amount and the amount received at the end of the loan.
- Because the rights given to the investor can differ from one debt security to another, and because the future prospects of issuers can differ substantially, the number of different types of fixed-income securities is quite large and continues to grow.
- Debt securities that have a maturity of less than one year are also called money market instruments.
- Debt securities that mature in over one year’s time are typically called bonds.
To ensure that you have an understanding of fixed-income securities, the following lessons will be covered in this module:
* Attributes of Fixed-Income Securities
* Money Market Instruments
* U.S. Government and Agency Securities
* Municipal Bonds
* Corporate Bonds
* Foreign Bonds
Section 1 - Attributes of Fixed-Income Securities
The term fixed-income is often used interchangeably with bonds. Typically, these securities promise the investor that they will receive certain specified cash flows at certain specified times in the future. The original investment will be returned at the end of the specified time period.
Similar to a loan, the terms of a fixed-income security are stated on its certificate, which is known as the bond’s indenture. The par value is the principal amount of the loan that the purchaser of the fixed-income security is lending the issuer. This par value is to be paid back at some point in the future. The date that the loan would be repaid is known as the maturity date. The terms must also specify the amount of the interest that the borrower will pay the investor. The interest paid is known as the coupon rate (sometimes referred to as the nominal rate), which is always expressed as a percentage of the bond’s par value. Finally, the terms must specify if the loan can be paid off early.
Although the cash flows are promised, it is possible that payments may not be received. That is, in many cases there is at least some risk that a promised payment will not be made in full and on time.
To ensure that you have an understanding of fixed-income security attributes, the following topics will be covered in this lesson:
* Par Value
* Time to Maturity
* Coupon Rate
* Call and Put Provisions
* Likelihood of Default
Upon completion of this lesson, you should be able to:
* Describe the terms associated with fixed-income securities, and
* List some of the risks associated with investing in fixed-income securities.
Describe Call and Put Provisions
Issuers may want the right to pay off their bonds at par before maturity. This ability provides management with flexibility because debt could be reduced or its maturity altered by refunding. Most importantly, expensive high-coupon debt that was issued during a time of high interest rates could be replaced with cheaper lower-coupon debt if rates decline.
Despite the cost of obtaining this sort of flexibility, many issuers include call provisions in their bond indentures. This gives the corporation the option to call (essentially refinance their debt at better rates or terms) some or all of the bonds from their holders at stated prices during specified periods before maturity. In a sense, the firm sells a bond and simultaneously buys an option from the holders. Thus, the net price of the bond is the difference between the value of the bond and the option. This is similar to what homeowners do when mortgage rates drop, they will typically look to refinance.
Put provisions give the holders an option, but this time it is to exchange their bonds for cash equal to the bond’s face value. This option generally can be exercised over a brief period of time after a stated number of years have elapsed since the bond’s issuance. Death puts, where the issuer allows the estate to exchange their bonds in the event of the death of the bond holder, are the most common puts available.
Practitioner Advice: It’s not always smart to go after a bond because of the amount of coupon that is being paid. Consider a callable bond that pays a 10% coupon versus a non-callable bond that pays an 8% coupon. If the 10% coupon bond is called, then the issuer will need to seek another fixed-income security that is likely to earn less than 10% annually. In the meantime, the person who bought the 8% coupon bond is still receiving 8% annually because the bond cannot be called. Therefore, it is important to make purchase decisions based on more than just the coupon rate.
Section 1 - Attributes of Fixed-Income Securities Summary
- Fixed-income securities can range from very conservative (money market instruments) to very aggressive (high-yield bonds).
- The distinction between the various kinds of fixed-income securities is the length of time before maturity and the quality of the issuers.
- These factors dictate the amount of coupon necessary for the issuer to pay in order to attract investors.
In this lesson, we have covered the following:
* Par Value: The principal amount of the loan that the issuer will pay back when the fixed-income security matures. The market price will change inversely with movements in interest rates (remember opposite ends of the see-saw). Bonds trade at a discount when the market price is below par and they trade at a premium when the market price above par.
- Time to Maturity: The maturity date of the issue affects the bond’s coupon rate as well as its market price movements. The greater the maturity date, the greater the risk exposure of the security.
- Coupon Rate: The stated rate on the face of the bond upon which the amount of income paid to the investor is calculated. The greater the risk of the issue, the higher the coupon rate.
- Call Provision: When interest rates decrease, issuers may want to pay off their debt early by calling their outstanding debt and reissuing debt at a lower financing cost.
- Likelihood to Default: Bonds are rated on their ability to make payments of principal and interest. The lower the rating, the higher the default risk and the higher the coupon rate.
Match the key terms to the correct description.
Par
Coupon
Maturity
Call
* Ability of the borrower to payoff loan earlier than maturity.
* Length of the loan.
* Interest payments for the loan.
* Face value of the loan.
- Par - Face value of the loan.
- Coupon - Interest payments for the loan.
- Maturity - Length of the loan.
- Call - Ability of the borrower to payoff loan earlier than maturity.
Which of the following would typical fixed-income securities investors seek?
* Par
* Call Provision
* Maturity
* Coupon
Coupon
* Most bond investors are seeking a steady income generated from the coupon payments.
* Investors of high-yield bonds may also be seeking capital appreciation from the high volatility associated with those types of bonds.
* Par is the principal amount that investors will receive at maturity.
* Call provisions are more of an advantage for issuers.
* Maturity is the length of time before a fixed-income security will come due.
Which of the following contribute to the movement in the market price of a fixed-income security?
* Inflation
* Interest rates
* Coupon rates
* Call provision
Interest rates
* The movement of interest rates can cause existing fixed-income securities to be worth more or less than their original par value.
* Inflation causes the purchasing power of the future payments to decrease and affects the real return of the investment.
* Coupon rates are set when the issue is created.
* Call provision gives issuers the right to pay off their debt before maturity.
Section 2 – Money Market Instruments
Certain types of short-term, highly marketable loans play a major role in the investment and borrowing activities of both financial and non-financial corporations. Money market instruments are short-term loans that typically mature in less than twelve months. Because of their short maturity, high liquidity, and high-quality issuers, they are considered to be very conservative or low-risk securities. Individual investors with substantial funds may invest in such money market instruments directly, but most do so indirectly via money market accounts or money market mutual funds at financial institutions.
Some money market instruments are negotiable and are traded in active secondary dealer markets; others are not. Some may be purchased by anyone with adequate funds, others only by particular types of institutions. Many are sold on a discount basis.
To ensure that you have an understanding of money market instruments, the following topics will be covered in this lesson:
* Money Market Mutual Funds
* Certificate of Deposit (CD)
* Commercial Paper
* Bankers’ Acceptance (BA)
* Eurodollar
* Repurchase Agreement (Repo)
* Money Rates Listing
Upon completion of this lesson, you should be able to:
* Describe the types of money market instruments, and
* Compare and contrast various types of money market instruments.
Assume an investor is considering purchasing a money market instrument with a $1,000,000 denomination quoted with a discount rate of 1.5%. Identify the investor’s real interest rate.
* 1.50%
* 1.52%
* 9.85%
* 0.15%
1.52%
* The investor will purchase the security for $985,000 ($1,000,000 x 0.985).
* The bank discount bases which is the investor’s real interest rate = $15,000 (discount rate x denomination)/$985,000 (purchase price) = 1.52%.
Section 2 – Money Market Instruments Summary
Money market instruments are short-term investments that are low risk and generate modest interest income for investors. They are typically used to fulfill short-term financing needs or to facilitate business transactions. Individual investors will likely experience these short-term instruments by investing in mutual funds that have money market securities within their holdings. Because of their short-term maturities, the interest paid on these instruments is typically a one-time payment at maturity, or the difference between what was paid to buy the instrument at discount versus the face value of the loan. There are various types of money market instruments that serve as fixed-income securities.
In this lesson, we have covered the following:
* A Certificate of Deposit (CD) represents a time deposit at a commercial bank or savings and loan associations. The FDIC or NCUA insures CDs.
* Commercial Paper is an unsecured short-term promissory note.
- Bankers’ Acceptance (BA) is used to finance foreign trade.
- Eurodollar CD or Euro CD is a large short-term CD denominated in U.S. dollars and issued by banks outside the United States. Eurodollar deposits are investments in dollar-denominated time deposits in banks outside the United States.
- Repurchase Agreement (Repo) is an agreement signed between two investors where one sells securities to the other and promises to purchase them back in the near future at a predetermined higher price.
- Money Rates Listing: Interest rates on money market instruments are often reported on what is known as a bank discount basis.
- Practitioner Advice: CFP Board recommends that investors hold 3 to 6 months’ worth of living expenses as emergency funding. The money should be held in cash or funds comprised of money market securities.
What does an investor seek when they purchase money market instruments? (Select all that apply)
* Potentially high returns from aggressive growth.
* A liquid investment that can be sold quickly at fair value.
* High quality investments with low risk.
* A long-term investment.
A liquid investment that can be sold quickly at fair value.
High quality investments with low risk.
* Money market instruments are fixed-income securities that are highly liquid. Since many businesses use them for business transactions, they are constantly traded in the secondary market as cash equivalents. Since they are issued in high denominations, the issuers typically have low credit risk. Their shorter-term maturity also partially shields them from interest rate risk. Since there is less risk associated with them, they would not provide a high return. The relatively lower return makes them less likely to overcome inflation risk than other securities for long-term investing.
Match the money market instrument to the correct description.
Commercial Paper
Bankers’ Acceptance
Certificate of Deposit
Repo
* Agreement to sell and repurchase assets
* Used for facilitating international trade
* Short-term promissory notes
* Large deposits with banks
- Commercial Paper - Short-term promissory notes
- Bankers’ Acceptance - Used for facilitating international trade
- Certificate of Deposit - Large deposits with banks
- Repo - Agreement to sell and repurchase assets
Section 3 – U.S. Government and Agency Securities
It should come as no surprise that the U.S. government relies heavily on debt financing. Since the 1960s, revenues have seldom covered expenses and the differences have been financed primarily by issuing debt instruments. New debt is issued in order to get the necessary funds to pay off old debt that comes due. Debt refunding sometimes allows the holders of the maturing debt to exchange it directly for new debt, and in the process receive beneficial treatment for tax purposes. Depending on the state of residency, investors in U.S. government or Federal agency issued fixed-income securities may enjoy state and city tax breaks on interest earned.
To ensure that you have an understanding of U.S. government and agency securities, the following topics will be covered in this lesson:
* U.S. Treasury Securities
* Federal Agency Securities
Upon completion of this lesson, you should be able to:
* List and explain U.S. Treasury securities,
* Enumerate the types of Federal agency securities, and
* Describe Federal agency securities.
You own a 9-month T-Bill ($1,000 face value) with a discount rate of 3% that matures in 180 days. If you were to sell this T-Bill today, how much would you receive?
* $977.50
* $1,000
* $992.50
* $985
$985
* If your T-Bill were sold today, you would receive $985, calculated as follows:
$1,000 × [1 – ((180 ÷ 360) × 0.03)] = $985
Example (T-Bond/TIPS Side-by-side)
Let us compare the yield available on 10-year Treasury Bond to a TIPS equivalent. If the CPI is 3%, a 10-year Treasury Bond yielding 6.5% would have an approximate real yield (nominal yield minus inflation, or 6.5% - 3.0%) of 3.5%.
This means a 10-year TIPS should be paying __ ____??____ __%.
This means a 10-year TIPS should be paying 3.5%.
Example (The Logistics of TIPS)
An investor buys $100,000 of TIPS bearing a 3.5% coupon. For the next 6 months, the inflation rate averages 3% per year.
What will be the coupon payment made to the investor?
The coupon rate (3.5% in this case) is fixed.
The principal is adjusted every six months to reflect the inflation rate.
In this case the principal would be increased to $101,500 ($100,000 X 0.03 ÷ 2), and, therefore, the payment of the first coupon would be $1,776.25 ($101,500 X 0.035 ÷ 2).
Section 3 – U.S. Government and Agency Securities Summary
The U.S. government offers two types of fixed-income securities that vary depending on the issuing authority. The securities are issued by the U.S. Treasury, Federal Agencies, or Federally Sponsored Agencies. Because of the U.S. government’s stability and power in taxation, these securities are considered the highest credit quality.
In this lesson, we have covered the following:
- The U.S. Treasury marketable securities include: T-Bills, T-Notes, and T-Bonds. They differ in time to maturity and interest. Newer iterations of Treasury securities include Treasury Inflation-Protected Securities (TIPS), Zero-Coupon Bonds, and STRIPS.
- Other fixed-income securities that fund the U.S. government’s operations such as Mortgage-Backed Securities (MBS) are issued by Federal Agencies or Federally Sponsored Agencies. Federal Agencies provide funds to support activities such as housing through either direct loans or the purchase of existing mortgages, export and import activities, and the activities of the Tennessee Valley Authority. Federally sponsored agencies are privately owned agencies that issue securities and use the proceeds to support the granting of certain types of loans to farmers, students, homeowners and others.
- Mortgage pass-through securities (GNMA, FNMA, FHLMC) are pools of mortgages in which investors purchase certificates in order to receive on a monthly basis an amount of money that represents both a pro rata return of principal and interest on the underlying mortgages.
- Collateralized Mortgage Obligations (CMOs) are a means to allocate a mortgage pool’s principal and interest payments among investors in accordance with their preferences for prepayment risk.
- Stripped Mortgage-Backed Securities such as interest-only (IO) and principal-only (PO) offer investors a significantly different price/yield relationship as compared to the traditional mortgage pass-through securities.
What makes U.S. Government issued fixed-income securities safe relative to other issuers? (Select all that apply)
Inflation Protection
Stability of Government
Interest Rate Risk Protection
Power of Taxation
Prepayment Protection
Stability of Government
Power of Taxation
* U.S. Government Securities are either direct obligations that are required to be paid by either tax collecting or refunding, or they are backed by the full faith of the government. The government’s stability makes it less likely to default than less stable governments or borrowers of the private sector. Not all U.S. government issued securities are protected against inflation risk. All fixed-income securities are subject to interest rate risk, some more than others. And Government backed mortgage pass-throughs such as GNMAs and CMOs are susceptible to prepayment risks.
