Debt-CM Flashcards
Which of the following statements are TRUE regarding convertible bond issues?
I At the time of issuance, the conversion price is set at a premium to the stock’s current market price
II When the stock price is at a premium to the conversion price, the conversion feature has intrinsic value.
III For the conversion feature to have value, the stock’s price must move up in the market after issuance
IV Convertible bonds usually have lower yields than bonds without the conversion feature
D. ALL
When convertible bonds are issued, it is normal for the conversion price to be set at a premium to the current market price. Assume that a convertible bond is issued with a conversion price of $40 when the market price of the common is $30. Thus, the market price must rise to the conversion price before the conversion feature has any value. If the market price rises above the conversion price, then the conversion feature has “intrinsic value.” For example, if the conversion price is set at $40 and the market price rises to $50 per share, there is $10 per share of “intrinsic value.” Once the stock’s market price moves above the conversion price, for every dollar that the stock price now moves, the bond will move by an equivalent amount as well. The securities are termed “equivalent.” For the conversion feature to be worth something, the stock’s price must move up in the market after issuance. Due to the value of the conversion feature (or rather, the potential value if the stock price goes up), convertible bonds are saleable at lower yields than bonds without the conversion feature.
Which of the following statements describe Freddie Mac?
I. Freddie Mac buys conventional mortgages from financial institutions
II.Freddie Mac is an issuer of mortgage backed pass-through certificates
III. Freddie Mac is a corporation that is publicly traded
IV. Freddie Mac debt issues are directly guaranteed by the U.S. Government
i,iii,iii
Freddie Mac - Federal Home Loan Mortgage Corporation - buys conventional mortgages from financial institutions and packages them into pass through certificates. This agency has been partially sold off to the public as a corporation that was listed on the NYSE. Freddie is now bankrupt due to excessive purchases of bad “sub prime” mortgages and has been placed in government conservatorship. Its shares have been delisted from the NYSE and now trade OTC in the Pink OTC Markets.
Freddie Mac buys conventional mortgages from financial institutions and packages them into pass through certificates. These pass through certificates are not guaranteed by the U.S. Government (unlike GNMA pass through certificates).
Which of the following securities would be used as “collateral” for a collateralized mortgage obligation?
I “Ginnie Maes”
II “Fannie Maes”
III “Sallie Maes”
IV “Freddie Macs”
I,II,IV
Sallie Mae issues debentures, and uses the funds to make student loans (Sallie Mae stands for Student Loan Marketing Association). Only mortgage backed pass-through certificates are used as the backing for CMOs - and Ginnie Mae (Government National Mortgage Assn.), Fannie Mae (Federal National Mortgage Assn.), and Freddie Mac (Federal Home Loan Mortgage Corp.) all issue pass-throughs.
The collateral backing private CMOs consists of:
mortgage backed securities issued by government agencies and the bank-issuer
Private CMOs (Collateralized Mortgage Obligations) are also called “private label” CMOs. Instead of being backed solely by mortgages guaranteed by Fannie, Freddie or Ginnie, they are backed by a mix of these agency mortgages and “private label” mortgages - meaning mortgages that do not qualify for sale to these agencies (either because the dollar amount of the mortgage is above their purchase limit or they do not meet Fannie, Freddie or Ginnie’s underwriting standards).
If the bank issuer wants to offer a CMO with a higher yield, it will increase the proportion of “private label” mortgages included in the CMO. Of course, along with a higher yield comes higher risk.
When comparing CMOs to their underlying pass-through certificates, which of the following statements are TRUE?
I. CMOs receive a higher credit rating than the underlying mortgage backed pass-through certificate
II. CMOs receive the same credit rating as the underlying mortgage backed pass-through certificate
III. CMOs are subject to a lower degree of prepayment risk than the underlying pass-through certificate
IV. CMOs are subject to the same degree of prepayment risk as the underlying pass-through certificate
II,III
CMOs receive the same credit rating (AAA or AA) as the underlying mortgage backed pass-through certificates held in trust. CMOs are subject to a lower degree of prepayment risk than the underlying pass-through certificates. During periods of falling interest rates, prepayments of mortgages in a pool are applied pro-rata to all holders of pass-through certificates. CMOs divide the cash flows into “tranches” of varying maturities; and apply prepayments sequentially to the tranches in order of maturity. Thus, prepayments are applied to earlier tranches first, so the actual date of repayment of the tranche is known with more certainty.
Which of the following statements are TRUE regarding CMOs?
I. CMOs make payments to holders monthly
II. CMOs receive the same credit rating as the underlying pass-through securities held in trust
III. CMOs are subject to a lower level of prepayment risk than the underlying pass-through certificates
IV. CMOs are available in $1,000 denominations
ALL
Most CMOs make payments to holders monthly; though there are some issues that pay quarterly or semi-annually. CMOs are subject to a lower degree of prepayment risk than the underlying pass-through certificates. During periods of falling interest rates, prepayments of mortgages in a pool are applied pro-rata to all holders of pass-through certificates.
CMOs divide the cash flows into “tranches” of varying maturities; and apply prepayments sequentially to the tranches in order of maturity. Thus, prepayments are applied to earlier tranches first, so the actual date of repayment of the tranche is known with more certainty.
CMOs receive the same credit rating (AAA or AA) as the underlying mortgage backed pass-through certificates held in trust.
CMOs are available in $1,000 denominations, as opposed to pass-through certificates that are $25,000 denominations. This makes CMOs more accessible to small investors.
All of the following statements are true regarding CMOs EXCEPT:
A CMO holders are paid interest semi-annually
B as interest payments on the underlying mortgages are received, they are distributed pro-rata to all tranches
C as mortgages are prepaid, payments are applied to earlier tranches first
D CMOs are a derivative security
A
CMO holders are paid interest monthly, not semi-annually. As payments are received from the underlying mortgages, interest is paid pro-rata to all tranches; but principal repayments are paid sequentially to the first, then second, then third tranche, etc. Thus, as mortgages are prepaid, payments are applied to earlier tranches first. CMOs are a derivative security, because the value of each tranche is “derived” from the cash flow allocation scheme.
When comparing the effect of changing interest rates on prices of a CMO issues versus the prices of regular bond issues, which of the following statements are TRUE?
I. When interest rates rise, mortgage backed pass through certificates fall in price faster than regular bonds of the same maturity
II. When interest rates rise, mortgage backed pass through certificates fall in price slower than regular bonds of the same maturity
III. When interest rates fall, mortgage backed pass through certificates rise in price faster than regular bonds of the same maturity
IV. When interest rates fall, mortgage backed pass through certificates rise in price slower than regular bonds of the same maturity
I, IV
When interest rates rise, mortgage backed pass through certificates fall in price - at a faster rate than for a regular bond. This is true because when the certificate was purchased, assume that the expected life of the underlying 15 year pool (for example) was 12 years. Thus, the certificate was priced as a 12 year maturity. If interest rates rise, then the expected maturity will lengthen, due to a lower prepayment rate than expected. If the maturity lengthens, then for a given rise in interest rates, the price will fall faster.
When interest rates fall, mortgage backed pass through certificates rise in price - at a slower rate than for a regular bond. This is true because when the certificate was purchased, assume that the expected life of the underlying 15 year pool (for example) was 12 years. Thus, the certificate was priced as a 12 year maturity. If interest rates fall, then the expected maturity will shorten, due to a higher prepayment rate than expected. If the maturity shortens, then for a given fall in interest rates, the price will rise slower.
Which statements are TRUE about changes in market interest rates and collateralized mortgage obligations?
I. If interest rates drop, homeowners will refinance their mortgages, increasing prepayment rates on CMOs
II. If interest rates rise, homeowners will refinance their mortgages, increasing prepayment rates on CMOs
III. If interest rates drop, the market value of CMO tranches will decrease
IV. If interest rates drop, the market value of the CMO tranches will increase
I,IV
If market interest rates drop substantially, homeowners will refinance their mortgages and pay off their old loans earlier than expected. Thus, the prepayment rate for CMO holders will increase. Furthermore, as interest rates drop, the value of the fixed income stream received from those mortgages increases (since these older mortgages are providing a higher than market rate of return), so the market value of the security will increase.
Treasury bills:
I are issued in minimum $100 denominations
II are issued in minimum $10,000 denominations
III mature at par
IV mature at par plus accrued interest
the best answer is A.
treasury bills are original issue discount obligations that mature at par, in minimum denominations of $100 each.
Treasury notes:
I are issued in minimum $100 denominations
II are issued in minimum $10,000 denominations
III mature at par
IV mature at par plus accrued interest
The best answer is A.
Treasury notes are issued at par in minimum denominations of $100 each, and pay interest semi-annually. At maturity, the bondholder receives par.
Which statements are TRUE about TIPS?
I The coupon rate is less than the rate on an equivalent maturity Treasury Bond
II The coupon rate is more than the rate on an equivalent maturity Treasury Bond
III The coupon rate is a market approximation of the real interest rate
IV The coupon rate is a market approximation of the discount rate
The best answer is A.
The interest rate placed on a TIPS (Treasury Inflation Protection Security) is less than the rate on an equivalent maturity Treasury Bond. For example, a 30 year Treasury Bond might have a coupon rate of 4%; but a 30 year TIPS has a coupon rate of 2.75%. The “difference” between the two is the current market expectation for the inflation rate (1.25% in this example). The coupon rate on the TIPS approximates the “real interest rate” - the rate earned after factoring out inflation. If 30 year T-Bonds have a nominal yield of 4%; and the inflation rate is expected to be 1.25%; then the “real” interest rate is 2.75%.
The reason why the TIPS sells at a lower coupon rate is that, every year, the principal amount is adjusted upwards by that year’s inflation rate. So there are really 2 components of return on a TIPS - the lower coupon rate plus the principal adjustment equal to that year’s inflation rate.
Series EE bonds:
A are issued at a discount to face
B are redeemed at par plus interest earned
C pay interest semi-annually
D are actively traded in the secondary market
The best answer is B.
Series EE bonds are “savings bonds” issued by the U.S. Government with a minimum purchase amount of $25 (or more). This is the face value of the bond, and any interest earned is added to the bond’s value. The interest rate is set at the date of issuance. Interest is “earned” monthly and credited to the principal amount every 6 months. The bonds have no stated maturity - the holder can redeem at any time, however interest is only credited to the bonds for 30 years.
Savings bonds do not trade - they are issued by the Treasury and are redeemed with the Treasury (a bank can act as agent for the Treasury issuing and redeeming Series EE bonds).
No physical certificates are issued - the bonds are issued in electronic form.
Which statement is TRUE regarding fully modified pass-through certificates issued by the Government National Mortgage Association?
A . Monthly payments of interest and principal are guaranteed by the U.S. Government
B Only interest payments are guaranteed by the U.S. Government
C Only principal payments are guaranteed by the U.S. Government
D The yield at which the investor bought the certificate is guaranteed by the U.S. Government
The best answer is A.
The “modification” to a fully modified Ginnie Mae Pass Through Certificate is the guarantee of the U.S. Government on the timely payment of both interest and principal.
A customer wishes to buy a security that provides monthly payments for his retirement. Which of the following is suitable?
A Treasury Bonds
B Income Bonds
C GNMA Pass Through Certificates
D Treasury Notes
The best answer is C.
Ginnie Mae Pass Through Certificates “pass through” monthly mortgage payments to the certificate holders. Each payment is a combination of interest and principal from the underlying mortgage pool. Treasury Bonds and Notes pay interest semi-annually. Income bonds pay interest only if the corporate issuer has sufficient earnings.
Private CMOs are:
A rated AAA because the underlying mortgages are government backed
B assigned credit ratings by independent credit agencies based on their structure, issuer, and collateral
C not rated by independent credit agencies because they are private placements that cannot be traded in the market
D not rated by independent credit agencies because of the uncertainty surrounding the quality of the mortgage loans collateralizing the issue
The best answer is B.
Private CMOs (Collateralized Mortgage Obligations) are also called “private label” CMOs. They are created by bank issuers, using a mix of mortgage-backed securities as collateral. The “mix” includes both mortgage-backed securities issued by agencies (Fannie, Freddie, Ginnie) and “private label” mortgages - meaning mortgages that do not qualify for sale to these agencies (either because the dollar amount of the mortgage is above their purchase limit or they do not meet Fannie, Freddie or Ginnie’s underwriting standards).
If the bank issuer wants to offer a CMO with a higher yield, it will increase the proportion of “private label” mortgages included in the CMO. Of course, along with a higher yield comes higher risk. Whereas CMOs backed solely by Fannie, Freddie or Ginnie mortgage-backed securities are rated AAA, the rating of “private label” CMOs is dependent on the credit quality of the underlying mortgages.
All of the following statements are true regarding collateralized mortgage obligations EXCEPT:
A CMOs are issued by the U.S. Treasury
B CMOs are backed by agency pass-through securities held in trust
C CMOs have the highest investment grade credit ratings
D CMOs give the holder a limited form of call protection that is not present in regular pass-through obligations
The best answer is A.
The last 3 statements a
are true. Collateralized mortgage obligations are backed by mortgage pass-through certificates that are held in trust. The underlying mortgage backed pass-through certificates are issued by agencies such as FNMA, GNMA and FHLMC, all of whom have an “AAA” (Moody’s or Fitch’s) or “AA” (Standard and Poor’s) credit rating. The CMO takes on the credit rating of the underlying collateral.
Which of the following statements regarding collateralized mortgage obligations are TRUE?
I Each tranche has a different level of market risk
II Each tranche has the same level of market risk
III Each tranche has a different yield
IV Each tranche has the same yield
The best answer is A.
Each tranche of a CMO, in effect, represents a differing expected maturity, hence each tranche has a different level of market risk. Since each tranche represents a differing maturity, the yield on each will differ, as well.
All of the following statements are true when comparing PAC CMO tranches to “plain vanilla” CMO tranches EXCEPT:
A holders of PAC CMO tranches have lower prepayment risk
B holders of “plain vanilla” CMO tranches have higher prepayment risk
C interest is paid pro-rata to all tranches for both PACs and “plain vanilla” CMOs
D principal repayments are paid pro-rata to all tranches for both PACs and “plain vanilla” CMOs
The best answer is D.
All of the statements are true except Choice D. The “plain vanilla” CMOs have a simple repayment scheme. As payments are received from the underlying mortgages, interest is paid pro-rata to all tranches; but principal repayments are paid sequentially to the first, then second, then third tranche, etc. Thus, the earlier tranches are retired first. A newer version of a CMO has a more sophisticated scheme for allocating cash flows. Newer CMOs divide the tranches into PAC tranches and Companion tranches. The PAC tranche is a “Planned Amortization Class.” Surrounding this tranche are 1 or 2 Companion tranches. Interest payments are still made pro-rata to all tranches, but principal repayments made earlier than that required to retire the PAC at its maturity are applied to the Companion class; while principal repayments made later than expected are applied to the PAC maturity before payments are made to the Companion class. Thus, the PAC is relieved of prepayment risk and extension risk; and this risk is loaded into the Companion tranches.
Which of the following statements regarding collateralized mortgage obligations are TRUE?
I. Each tranche has a different level of market risk
II. Each tranche has the same level of market risk
III. Each tranche has a different yield
IV. Each tranche has the same yield
I, III
ach tranche of a CMO, in effect, represents a differing expected maturity, hence each tranche has a different level of market risk. Since each tranche represents a differing maturity, the yield on each will differ, as well.
Which of the following statements are TRUE regarding CMO “Planned Amortization Classes” (PAC tranches)?
I. PAC tranches reduce prepayment risk to holders of that tranche
II. PAC tranches increase prepayment risk to holders of that tranche
III. Principal repayments made earlier than expected are applied to the PAC prior to being applied to the Companion tranche
IV. Principal repayments made later than expected are applied to the PAC prior to being applied to the Companion tranche
I, IV’
“Plain vanilla” CMOs are relatively simple - as payments are received from the underlying mortgages, interest is paid pro-rata to all tranches; but principal repayments are paid sequentially to the first, then second, then third tranche, etc. Thus, the earlier tranches are retired first.
A newer version of a CMO has a more sophisticated scheme for allocating cash flows. Newer CMOs divide the tranches into PAC tranches and Companion tranches. The PAC tranche is a “Planned Amortization Class.” Surrounding this tranche are 1 or 2 Companion tranches. Interest payments are still made pro-rata to all tranches, but principal repayments made earlier than that required to retire the PAC at its maturity are applied to the Companion class; while principal repayments made later than expected are applied to the PAC maturity before payments are made to the Companion class. Thus, the PAC class is given a more certain maturity date; while the Companion class has a higher level of prepayment risk if interest rates fall; and a higher level of so-called “extension risk” - the risk that the maturity may be longer than expected, if interest rates rise.
Arrange the following CMO tranches from highest to lowest yield:
I Plain vanilla
II Targeted amortization class
III Planned amortization class
IV Companion
IV, I, II, III
Companion tranches are the “shock absorber” tranches, that absorb prepayment risk out of a TAC (Targeted Amortization Class) tranche; or both prepayment risk and extension risk out of a PAC (Planned Amortization Class) tranche. Because the companion absorbs both of these risks, it has the greatest risk and trades at the highest yield. A Plain Vanilla tranche is not relieved of either extension risk or prepayment risk, so it will offer a yield that is higher than a PAC or a TAC, but lower than the yield on a companion. A TAC is only relieved of prepayment risk, so its yield will be lower than a Plain Vanilla tranche. However, the TAC yield will be higher than the yield on a PAC, which is relieved of both extension and prepayment risk, while the TAC is only relieved of prepayment risk.
All of the following are true statements about U.S. Government Agency securities EXCEPT:
A U.S. Government Agency Securities are quoted in 1/32nds
B U.S. Government Agency Securities have an implicit backing by the U.S. Government
C U.S. Government Agency Securities trade flat
D U.S. Government Agency Securities’ accrued interest is computed on a 30 day month / 360 day year basis
C.
Government agency securities are quoted in 32nds, similar to U.S. Government securities. Government agency securities have an indirect backing (or implicit) by the U.S. Government. Unlike U.S. Governments, on which accrued interest is computed on an actual day month/actual day year basis, Agency securities’ accrued interest is computed on a 30 day month/360 day year basis. U.S. Government and Agency securities never trade flat (meaning without accrued interest), since a default is almost impossible.
U.S. Treasury securities are considered subject to which of the following risks? I Credit Risk II Purchasing Power Risk III Marketability Risk IV Default Risk
II- Purchasing power
Securities issued by the U.S. Government represent the largest securities market in the world (remember, the national debt is $28 trillion and rising) and the most actively traded. Therefore, very little marketability risk exists. Default risk and credit risk are the same - U.S. Government securities are considered to have virtually no default risk. (The government can always tax its citizens to pay the debt or can print the money to do it). All debt obligations are susceptible to purchasing power risk - the risk that inflation raises interest rates, devaluing existing obligations.
CMOs are: I available in $1,000 denominations II available in $25,000 denominations III quoted in 1/8ths IV quoted in 1/32nd
i, iv
CMOs are available in $1,000 denominations unlike the underlying pass-through certificates which are available only in $25,000 denominations. CMOs are quoted in 32nds, similar to the underlying pass-through certificates. Often CMO tranches are quoted on a “yield spread” basis to equivalent maturing Treasury issues.
The interest income earned from which of the following is subject to state and local tax?
I Federal Farm Credit Funding Corporation Note
II Real Estate Investment Trust
III Ginnie Mae Certificate
IV Fannie Mae Certificate
i,iii,iv
the interest income on U.S. Government obligations and most agency obligations is subject to Federal income tax but is exempt from state and local tax. This is the tax status for Federal Farm Credit Funding Corporation notes. However, the interest income on mortgage pass through certificates issued by Fannie Mae and Ginnie Mae is fully taxable. Income from REITs, since they are corporate securities, is fully taxable as well.
Interest received from all of the following securities is exempt from state and local taxes EXCEPT:
A Fannie Mae Pass Through Certificates
B Treasury Notes
C Federal Farm Credit Funding Corporation Bonds
D Federal Home Loan Bank Bonds
A. Fannie Mae Pass Through Certificates
The interest income from direct issues of the U.S. Government and most agency obligations is subject to federal income tax but is exempt from state and local tax. An exception is the interest income received from mortgage backed pass through certificates (issued by GNMA, FNMA, FHLMC). This interest income is subject to both federal income tax and state and local tax. The logic behind this tax treatment is that the mortgage interest paid by the homeowners was fully deductible from both federal, state, and local taxes. When this interest is received by the certificate holder, both the federal and state government want to recapture this interest income and tax it.
Which statements are TRUE regarding the tax treatment of the annual adjustment to the principal amount of a Treasury Inflation Protection Security?
I.An annual upward adjustment due to inflation is taxable in that year.
II.An annual upward adjustment due to inflation is not taxable in that year.
III.An annual downward adjustment due to deflation is tax deductible in that year.
IV.An annual downward adjustment due to deflation is not tax deductible in that year.
I, III
If the principal amount of a Treasury Inflation Protection Security is adjusted upwards due to inflation, the adjustment amount is taxable in that year as ordinary interest income. Conversely, if the principal amount of a Treasury Inflation Protection Security is adjusted downwards due to deflation, the adjustment is tax deductible in that year against ordinary interest income.
(TIPS are usually purchased in tax qualified retirement plans that are tax-deferred. This avoids having to pay tax each year on the upwards principal adjustment.)
Yields on 3 month Treasury bills have declined to 1.84% from 2.21% at the prior week’s Treasury auction. This indicates that:
A Treasury bill prices are falling
B market interest rates are falling
C demand for Treasury bills is weakening
D the Federal Reserve may have to loosen credit
The best answer is B.
If Treasury bill yields are dropping at auction, then interest rates are falling and debt prices must be rising.
Which of the following statements are TRUE regarding GNMA “Pass Through” Certificates?
I The certificates are quoted on a percentage of par basis
II The certificates are quoted on a yield basis
III Accrued interest on the certificates is computed on an actual day month / actual day year basis
IV Accrued interest on the certificates is computed on a 30 day month / 360 day year basis
The best answer is B
. GNMA certificates are quoted on a percentage of par basis in 32nds. Accrued interest on “agency” securities is computed on a 30 day month / 360 day year basis. (Do not confuse this with the accrued interest on U.S. Government obligations, which is computed on an actual day month / actual day year basis).
Trades of U.S. Government bonds settle:
A next business day in payment by check
B next business day in payment by Federal Funds
C the following Thursday in payment by Federal funds
D 2 business days after trade date
The best answer is B.
Trades of U.S. Government securities settle next business day in Fed Funds (payment by check is not permitted since the clearance time is greater). Do not confuse this with settlement of the weekly Treasury Bill auctions. The Federal Reserve auctions T-Bills each Monday and Tuesday, with the bills issued, and paid for in Fed Funds, the following Thursday.
U.S. Government Agency securities are:
I Quoted in 1/8ths
II Quoted in 1/32nds
III Traded with accrued interest computed on an actual day month / actual day year basis
IV Traded with accrued interest computed on a 30 day month / 360 day year basis
The best answer is D.
Government agency securities are quoted in 32nds, similar to U.S. Government securities. Unlike U.S. Governments, on which accrued interest is computed on an actual day month / actual day year basis, Agency securities’ accrued interest is computed on a 30 day month/360 day year basis.
A government securities dealer quotes a 3 month Treasury Bill at 6.00 Bid - 5.90 Ask. A customer who wishes to buy 1 Treasury Bill will pay:
A a dollar price quoted to a 5.90 basis
B a dollar price quoted to a 6.00 basis
C $5,900
D $6,000
The best answer is A.
Treasury Bills are quoted on a yield basis. From the basis quote, the dollar price is computed. A customer who wishes to buy will pay the “Ask” of 5.90. This means that the dollar price will be computed by deducting a discount of 5.90 percent from the par value of $100. This is the discount earned over the life of the instrument.
