Debt Investments Flashcards
What is a bond?
A debt security obligating the issuer to make a periodic interest payment and repay the principle at the time of maturity
In bond issuance, what is the difference between registered form, bearer form, and book-entry form?
Registered form: payments are made to the owner of record
Bearer form: payments are made to whoever holds or possess the bond
Book-entry: payments are made to the electronically recorded owner
What is the bond indenture?
The agreement, or contract, between the issue and bondholder
What is par value?
The face value of a bond which is assumed to be $1000 for the purposes of the exam
What is the coupon rate of a bond?
The stated interest rate that will be paid either annually or semi-annually.
Ex: $1000 at 4% will return $40 ann or $20 semi-ann yield
What is a basis point?
A measurement of the bond’s yield in 1/100ths of a percentage. A 2% increase is stated as 200 basis points
What is the discount and premium of a bond?
A discount is when the bond is selling at a lower price in the secondary market than the par value
A premium is when the bond is selling at a higher price in the secondary market than the par value
What is a bond call provision?
A stipulation in the bond indenture that allows the issuer to pay off the bond principle after a specified period, usually at a price higher than the par value.
The issuer can call the bond if the interest rates have decreased which would then allow the issuer to refinance the bond at a lower coupon rate.
What is a secured bond?
Pledges certain assets that may be sold by the purchaser in the event the issuer defaults in paying interest or principle.
What is a bond debenture?
The opposite of a secured bond - this is an unsecured bond. More risky and therefore higher yield for the same period by the same issuer.
What is an investment grade bond?
A bond that is rated BBB or higher by S&Ps. Generally, a higher rate bond with little risk of default
What is a high-yield bond?
AKA a junk bond or non investment grade bond, these are rated BB+ or lower by S&Ps. Generally a lower-quality bond with high risk of default
What are the three bond maturity categories?
Short term: matures between 1-5 years
Intermediate term: matures between 5-10 years
Long term: matures at more than 10 years
What is the relationship between a bond’s yield and it’s credit rating?
Inverse. Yield goes up with credit rating goes down.
What is interest on interest?
It is the additional income from reinvesting the coupon payments
What is a zero coupon bond?
One that does not payment regular coupon payments. It only pays a single yield at the end of the term
What is call risk?
This is risk to the bondholder that the bond will be called in order for the issuer to save money by refinancing the bonds at a lower rate.
Disadvantages to bondholder of a callable bond:
- Full-cash flow pattern is not known (term is not defined)
- Exposure to reinvestment risk (that the bonds will yield less now)
- Capital gains potential is likely reduced (not what the investor probably signed up for)
With bonds, what is financial risk?
The risk that the issuer cannot pay it’s debts
In bonds, what is default (credit) risk?
The risk that the issuer will default on both the principle and the interest payments. Usually associated more with noninvestment grade, or junk bonds.
With bonds, why is inflation risk high?
The yield of a bond is usually fixed. Therefore the longer the bond, the higher the risk to inflation and the loss of purchasing power
What is event risk to a bond?
The risk that some catrostrophic event will affect the value of the bond, such as a major tax overhaul, company fraud, or the company capital structure
What are the 5 types of bond issuers?
Federal government: funds programs and operations - not taxed at state
Federal government agencies: funds specific agencies. Not a direct debt of the government
Municipalities: funds state government agencies, schools, fire, police, other. Not taxed by the state if owned by a resident of that state
Corporations: divided into several segments of broad company types such as public utilities, transportation, etc
International issuers: any bond issuer which exists outside the US
What is the maturity difference between US T-Bonds and T-Notes?
T-Bonds have a maturity of 30 years. T-Notes have a maturity of 2, 3, 5, 10 years
How are T-Bonds and T-Notes taxed?
Ordinary income in the year earned
What is the tax impact of a original issue discount (OID) bond or note?
The holder must pay tax on phantom income each year and then the investors basis increases by that tax amount.
What are Treasury STRIPS (Separate Trading of Registered Interest and Principle of Securities)?
They STRIP the interest payments from the bond to create zero-coupon bonds.
Zero-coupon bonds created by separating semi-annual coupon payments and the principle repayment portion of a T-Note or Bond.
Ex: A 5-Yr 4% T-Note w/ value of $10,000 can be separated into 11-zero coupon bonds. 1st 6th month payment is $200, the next at 12 months is $200 and so on…
What are Treasury Inflation Protection Securities (TIPS)?
Marketable securities whose principle is adjusted by changes in the Consumer Price Index every 6 months, but to keep up with the original rate or better.
Issued in terms of 5, 10, and 30 years.
Taxes are on the adjusted principle and interest payments and the basis increases with those payments
What is the E / EE savings bonds?
Sold at 100% face value and is eligible for interest payments for up to 30 years. Must be held for minimum of 12 months and there is a 3-month interest penalty if sold within 5 years
What a H / HH savings bonds?
Not available anymore.
Provide a semi-annual interest payment for up to 20 years. No penalty for early redemption
What is the I savings bond?
Fixed and/or inflation indexed or inflation protected bond. Interest payments are made semi-annually and like the E / EE bonds, they cannot be redeemed within 12 month of issue and there is a 3-month interest penalty if redeemed within 5 years.
The fixed interest rate is combined with a CPI-calculated interest rate every 6 months
What are US government agency securities?
These are agencies (or Government-sponsored enterprises (GSE)) that were created by Congress in order to flow money to certain segments of the economy, such as farming, homeowners, and students. While these agencies are indirectly backed by the government, they aren’t the government and therefore carry a slightly higher coupon rate, but are also taxed at all levels
What is the Government National Mortgage Association (GNMA)?
They buy FHA and VA home mortgages and auction them to private lenders that pool the mortgages to create pas-through certificates for sale to investors
What is the Federal Home Loan Mortgage Corporation (FHLMC) (Freddie Mac)?
Created to promote the development of a nationwide secondary market in mortgages by purchasing conventional mortgages from financial institutions and then package them into mortgage-back securities for sale to investors
What is the Federal National Mortgage Association (FNMA) (Fannie Mae)?
Competes with Freddie Mac. However Fannie Mae is a government sponsored corporation that is owned entirely by private stockholders. Its securities are backed by credit, not the US government.
What are pass through securities?
Ginnie Mae, Freddie Mac, or Fannie Mae, purchase, pool and resell mortgage securities to investors. When someone makes a principle and interest payment on their mortgage, that payment and interest will “pass-through” the bank, the association, and onto the investor, less any service fees.
