Topic 7: Fixed Income Securities and Managing Bond Portfolios

Question 1

Who are the different issuers of bonds?

Answer 1

• U.S. treasury

- Corporate bonds

Question 2

What type of bonds do U.S. treasury issue?

Answer 2

• Notes (up to 10 years)

- Bonds (10 to 30 years)

Question 3

What type of corporate bonds can be issued?

Answer 3

• Callable bonds
  
  • Allowing issuers to repurchase bonds at a specified call price before maturity
• Convertible bonds: Giving bondholders an option to exchange each bond for a specified number of shares of common stock of the firm
• Puttable bonds: Allowing bondholders to
  extend or retire bonds

Question 4

Realized compound yield equals to YTM when?

Answer 4

• The reinvestment rate is YTM

Question 5

Whats the difference between YTM and HPR?

Answer 5

• YTM depends on coupon, current price and par value, and is a measure of the average rate of return if the investment in the bond is held to maturity
• HPR is the rate of return over a particular investment period and depends on the market price of the bond at the end of the holding period

Question 6

If short term interest rates are known with certainty then?

Answer 6

• We can know the zero coupon bond prices, YTM (spot rates) and coupon prices.

Question 7

What some features of liquidity preference?

Answer 7

• Investors will demand a premium for the risk associated with long-term bonds
• The yield curve has an upward bias built into the long-term rates because of the risk premium
• Forward rates contain both a liquidity premium and expected future short-term rates

Question 8

Features of a passive bond strategy?

Answer 8

• Take market prices as fairly set
• Control risk, balance risk and return
• Immunization strategy to immunize interest rate risk

Question 9

Features of an active strategy?

Answer 9

• Trade on interest rate predictions

- Trade on market inefficiencies (mis-priced bonds)

Question 10

What does an increase in a bonds YTM cause the price of the bond to do?

Answer 10

• an increase in a bond’s
  yield to maturity results in a smaller price decline than
  a decrease in yield of equal magnitude

Question 11

Are short or long term bonds more sensitive? Why?

Answer 11

• Long-term bonds tend to be more price sensitive than
  short-term bonds, since the impact of the higher
  discount rate will be greater as that rate is applied to
  more-distant cash flows

Question 12

What does higher coupon rate mean for interest rate sensitivity?

Answer 12

• High coupon shortens the maturity of total cash flows–“effective maturity”. So higher coupon rates, lower interest rate sensitivity

Question 13

What does higher yield mean for interest rate sensitivity?

Answer 13

• A higher yield reduces PV of all of the bond’s payment, but more so for more distant payments, which leads a lower effective maturity and interest rate sensitivity

Question 14

What is duration

Answer 14

• A measure of the effective maturity of a bond

Question 15

reasons duration is important?

Answer 15

• It is a simple summary statistic of the effective average maturity of the portfolio
• It turns out to be an essential tool in immunizing portfolios from interest rate risk
• Duration is a measure of the interest rate sensitivity of a portfolio

Question 16

Go over rules of Duration

Answer 16

Go over rules of duration

Question 17

What are the two types of interest rate risk fixed income investors face?

Answer 17

• price risk and
• reinvestment rate risk, (increases in interest rates cause capital losses but increase the rate at which reinvested income will grow)

Question 18

What is a substitution swap?

Answer 18

• An exchange of one bond for a nearly identical
  substitute with essentially equal coupon, maturity,
  quality call features and so on
• Example: a sale of a 20-year maturity, 9% coupon Ford bond callable after 5 years at $1050 with a YTM of 9.05%; a purchase of a 9% coupon GM bond with the same call provisions, time to maturity and credit rating that yields at 9.15%

Question 19

What is a inter-market swap?

Answer 19

• When investors believe the yield spread between two sectors of the bond market is temporarily out of line
• For example, if the yield spread between 10-year Treasury bonds and 10-year Baa-rated corporate bonds is now 3%, and the historical spread has been only 2%; an investor will consider buying corporates and selling Treasury bonds

Question 20

What is a rate anticipation swap?

Answer 20

• If investors believe interest rate will fall, they
  will buy bonds of longer duration
• If investors believe interest rate will rise, they
  will buy bonds of shorter duration

Question 21

What is a pure yield pickup swap?

Answer 21

• When yield curve is upward sloping, investors will buy longer-term bonds and sell shorter term bonds to earn an expected term premium in higher-yield bonds

Question 22

For passive management what is cash flow matching and dedication?

Answer 22

• Manager selects either zero-coupon or coupon bonds that provide total cash flows in each period that match a series of obligations

Question 23

What is contingent Immunization?

Answer 23

• A combination of active and passive management
• The strategy involves active management with a floor rate of return
• As long as the rate earned exceeds the floor, the
  portfolio is actively managed
• Once the floor rate or trigger rate is reached, the
  portfolio is immunized