Ch. 2, Corp and Municipal Debt Securities | Day 6 Flashcards
(21 cards)
What is an Original Issue Discount (OID) bond and how is it treated for tax purposes?
An OID bond is issued at a price below par. Investors must accrete the discount annually, increasing their cost basis and recognizing annual interest income.
How is the annual accretion amount for a bond bought at a discount calculated?
Annualized discount =
Total discount ÷ Number of years to maturity.
If an investor buys a bond at $900 with 10 years to maturity, what is the annual accretion?
$100 ÷ 10 years = $10 per year. The investor steps up the bond’s cost basis by $10 each year.
What happens if an OID bond is sold before maturity?
The capital gain or loss is calculated using the accreted cost basis, not the original purchase price.
What is bond premium amortization and how is it treated for municipal bonds?
For municipal bonds bought at a premium, the premium is amortized annually, reducing the bond’s cost basis. The amortized amount is not tax-deductible.
How is the annual amortization of a bond premium calculated?
Annualized premium =
Total premium ÷ Number of years to maturity.
What is the result of amortizing a municipal bond’s premium over time?
Each year, the bond’s cost basis is reduced, potentially reducing capital gains if the bond is sold before maturity.
What is a bond swap, and when might an investor use one?
A bond swap is when an investor sells a bond at a loss for tax purposes, and purchases another similar bond that differs in issuer, coupon, or maturity, to avoid a wash sale.
Why is a bond swap not considered a wash sale?
Because the replacement bond differs in material terms (issuer, maturity, or coupon), allowing the loss to be recognized for tax purposes.
What determines the quality of a municipal bond?
The financial health of the issuing municipality, including its ability to levy and collect tax revenue.
Define bond duration.
Duration measures a bond’s price sensitivity to interest rate changes, expressed in years.
What type of bonds typically have higher duration?
Long-term bonds and those with lower coupon rates generally have higher duration.
What is the formula for estimating bond price change using duration?
Bond price change (%) = Duration × (Change in yield in basis points ÷ 100)
If a bond has a duration of 7 and yields rise by 100 basis points, how much will the price fall?
Approximately 7%.
What is bond convexity?
Convexity measures how a bond’s price reacts to large interest rate changes, improving on duration by capturing nonlinear price behavior.
What is the difference between positive and negative convexity?
Positive convexity: Prices rise faster when yields fall and fall slower when yields rise.
Negative convexity: Prices rise slower and fall faster, typical of callable or mortgage-backed bonds.
When is convexity especially useful?
When comparing bonds with similar durations or in volatile or low-interest rate environments.
What are the three components of total return for a bond portfolio?
Coupon return
Reinvestment return
Price return
What is a bond ladder and its main benefit?
A bond ladder spreads investments across multiple maturities to generate steady income and reduce interest rate risk, especially useful in a rising rate environment.
How are accretion and amortization alike, and how do they differ in bond accounting?
Both adjust a bond’s cost basis annually. Accretion applies to discounted bonds and increases the cost basis over time, while amortization applies to premium bonds and reduces the cost basis over time.
How do bond duration and term compare in meaning and function?
Both are measured in years, but term is the bond’s total time to maturity, while duration measures the bond’s price sensitivity to interest rate changes, factoring in coupon payments.
