Chapter 10/11- Fixed Income Securities

Question 1

Bonds vs. Stocks:

Answer 1

• generally speaking, bonds offer lower returns (over the next decade, bonds will most likely not outperform stocks)
• Main benefits of bonds in a portfolio:
  - lower risk/less volatility
  - higher levels of current income
  - diversification
• Bonds add an element of stability to the portfolio

Question 2

What are Bonds?

Answer 2

• Debt, liabilities, or “publicly traded IOU”
• referred to as “fixed income securities” since payments are fixed amounts, an assurance that interest will be payed

Question 3

Why Invest in Bonds?

Answer 3

• provide a current income for conservative investors
• primary investment goal- preservation and long term accumulation of capital

Question 4

Interest rates and bonds:

Answer 4

• the behavior of interest rates is the single most important factor in evaluating a bond
• interest rates and bond prices move in opposite directions
• when interest rates rise, bond prices fall
• when interest rates drop, bond prices move up
• when interest rates are really low (as they are now) bonds can be dangerous because history tells us interest rates will rise and fluctuate
• high rate of inflation increases interest rates

Question 5

Bonds and Risk:

Answer 5

• interest rate risk; interest rates will turn in the opposite direction
• purchasing power risk- bonds lag behind inflation rates
• business/financial risk- prospect of company defaulting ( if company gets in trouble value of bond can drop, due to uncertainty of company being able to pay back debts)
• liquidity risk- difficult to sell
• call risk- “called” (retired) before its scheduled maturity date, must be “callable “ generally will only call a bond when interest rates decline, callability must be determined when the bond issued (company must tell you), company must pay a higher interest rate when it is issued in order for it to be callable
• always remember the risk/return trade-off
• must keep up on the rate of inflation

Question 6

Required Return:

Answer 6

• the rate of return an investor must earn on an investment to be fully compensated for its risk

Required Return on Investment= Real Rate of Return + Expected Inflation Premium + Risk Premium for investment

Question 7

Coupon

Answer 7

• the amount of annual interest income (rate of return for the bond)

Question 8

Principal (par value)-

Answer 8

• generally 1000 dollars, the amount of capital that must be repaid at maturity

Question 9

Maturity Date

Answer 9

• the date when a bond matures and the principal must be re-paid

Question 10

Term Bond

Answer 10

• a bond that has a single maturity date

Question 11

Serial Bond

Answer 11

• a bond that has a series of different maturity rates

Question 12

Call feature

Answer 12

• allows the issuer to repurchase the bonds before the maturity date, will pay a call premium

Question 13

Call Premium

Answer 13

• the amount added to bond’s par value and paid upon call to compensate bondholders

Question 14

Sinking Fund

Answer 14

• stipulates how a bond will be paid off over time, applies to only term bonds, issuer is obligated to pay off the bond systematically over time

Question 15

Secured Debt

Answer 15

• Debt backed or secured by collateral to reduce the risk associated with lending. An example would be a mortgage, your house is considered collateral towards the debt. If you default on repayment, the bank seizes your house, sells it and uses the proceeds to pay back the debt.

Question 16

Unsecured Debt

Answer 16

loan not secured by an underlying asset or collateral. Unsecured debt is the opposite of secured debt.

Question 17

subordinated debentures

Answer 17

claim is secondary to other claims

Question 18

income bond

Answer 18

• requires interest to be paid only after a specific amount of income has been earned, only required to pay income if you have enough money to pay the interest, not in default

Question 19

The Price Behavior of a bond

Answer 19

• the price change will be greater the farther the way it is from maturity, risk is with long term bond

Question 20

U.S. Treasury Bonds

Answer 20

• considered risk free- no risk of default
• interest is exempt form state and local taxes
• sold in $1000 denominations and generally sold on a discount, which is how you get your interest back
• types of treasuries:
  - Bills: matures in 1 yr. or less
  - Notes: mature in 2 to 10 yrs.
  - Bonds- mature in 20 to 30 yrs.
• Treasury Inflation- Index Obligations (TIPS)
  - protect against inflation by adjusting investor returns
  - interest rates are very low

Question 21

Agency Bonds:

Answer 21

• Issued by U.S. government agencies
  - Federal Home Loan Bank
  - Federal National Mortgage Association
  - Small Business Administration
• high quality securities with low risk of default

Question 22

Municipal Bonds:

Answer 22

• issued by states, counties, cities and any other political subdivision to fund projects
• not risk free
• exempt from federal taxes and sometimes local and state taxes

Question 23

Corporate Bonds:

Answer 23

• Issued by corporations
• Provide higher returns due to their higher risk of default
• Wide variety of bond quality and bond types available

Question 24

Zero-Coupon Bonds:

Answer 24

• do not pay interest
• sold at a deep discount from par value
• will still have face value (1000) but may buy it at very reduced cost
• subject to tremendous price volatility as interest rates fluctuate
• interest must be reported as it is accrued for tax purposes, even though no interest is actually recieved
• treasury strips are zero coupon bonds created from U.S. Treasury securities

Question 25

Mortgage-Backed Securities:

Answer 25

• Bond backed by pool of residential mortgages
• Governmental agencies are major issuers
• self-liquidating investment since portion of principal is received each month