Debt Investments Flashcards
(136 cards)
1
Q
t
What is a sinking fund?
A
A separate fund established and funded each year by the bond issuer to accumulate an amount required to pay off the debt at maturity.
Sinking funds are used to reduce the default risk associated with some bonds.
2
Q
What is the primary purpose of a sinking fund?
A
To accumulate funds required to pay off the debt at maturity.
This helps ensure that the bond issuer can meet its financial obligations.
3
Q
True or False: A sinking fund increases the default risk of bonds.
A
False.
A sinking fund is included to reduce the default risk associated with bonds.
4
Q
Fill in the blank: A sinking fund is designed to _______.
A
[accumulate an amount required to pay off the debt at maturity].
This accumulation occurs each year by the bond issuer.
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Q
stated annual interest rate that will be paid each period for the term of the bond and is stated as a percentage of the par value of the bond.
A
The coupon rate or nominal yield
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Q
pledges specific assets that may be sold by the bond purchaser in the event that the bond issuer defaults in paying either the interest or principal on the bond.
A
A secured bond
7
Q
bond that promises payments of interest and principal but pledges no specific assets.
A
Debenture.
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Q
Another word for a debenture.
A
Unsecured bond.
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Q
Junk bonds.
A
Otherwise known as high-yield bonds.
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Q
A
11
Q
A ____ Bond has a single maturity date
A
Term bond.
12
Q
What is the general expectation about yields under a normal yield curve?
A
The longer the term, the greater the yield.
13
Q
True or False: In a normal yield curve, short-term investments typically have higher yields than long-term investments.
A
False.
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Q
Fill in the blank: Under a normal yield curve, investors expect to receive a __________ yield for longer-term investments.
A
greater
15
Q
Which of the following best describes a normal yield curve? A) Downward sloping B) Flat C) Upward sloping
A
C) Upward sloping
16
Q
Short answer: Why do investors expect higher yields for longer-term investments in a normal yield curve?
A
Investors seek compensation for the increased risk and uncertainty over a longer time horizon.
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A
18
Q
What factors are positively related to bond ratings?
A
Profitability, lack of other debt issues, cash-flow coverage of the issuer
These factors indicate a stronger financial position of the issuer.
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Q
How does profitability affect bond ratings?
A
Greater profitability leads to higher bond ratings
Higher profitability indicates a stronger ability to meet debt obligations.
20
Q
What is the relationship between outstanding debt and bond ratings?
A
Less outstanding debt correlates with higher bond ratings
Lower debt levels suggest lower financial risk for the issuer.
21
Q
What role does cash-flow coverage play in determining bond ratings?
A
More cash-flow coverage of debt payments results in higher bond ratings
Adequate cash flow indicates the issuer’s ability to meet payment obligations.
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Q
What factors contribute to lower bond ratings?
A
Excessive financial leverage, earnings instability
High leverage increases risk, and unstable earnings make it harder to predict financial health.
23
Q
True or False: Higher financial leverage positively affects bond ratings.
A
False
Excessive financial leverage typically leads to lower bond ratings due to increased risk.
24
Q
Fill in the blank: The greater the _______ of the company, the higher the bond rating.
A
profitability
Profitability is a key indicator of an issuer’s financial health.
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What is the effect of earnings instability on bond ratings?
It contributes to lower ratings
## Footnote
Earnings instability makes it difficult to assess the issuer's ability to repay debt.
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What happens to bond yields when there is an upward revision in ratings?
**Yield declines**
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What happens to bond yields when there is a downward revision in ratings?
The market yield on the bond increases
## Footnote
This reflects the bond's decline in quality.
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Define the effect of an upward rating revision on bond yields.
Market yield declines due to improved bond quality.
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What is financial risk?
The risk associated with the level of debt an issuer has outstanding.
## Footnote
Financial risk increases with higher levels of debt.
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What legal obligation does a firm have regarding its debts?
A firm is under a legal obligation to repay the interest and principal of its debts.
## Footnote
This obligation increases the risk to bondholders.
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How does high debt levels affect bondholders?
High debt levels increase the risk that the firm will not generate sufficient cash flow to meet its obligations.
## Footnote
Insufficient cash flow can lead to default on interest or principal repayments.
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When is the risk of not meeting debt obligations most likely to occur?
When the company’s business prospects deteriorate.
## Footnote
Deterioration in business prospects can lead to insufficient cash inflow.
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Fill in the blank: Financial risk is associated with the level of _______.
[debt]
## Footnote
Debt levels directly impact the financial risk faced by a firm.
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What type of risk do Treasury securities have related to fluctuating interest rates?
Interest rate risk
## Footnote
This risk arises because the value of existing bonds decreases when interest rates rise.
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What is purchasing power risk?
Purchasing power risk is the risk associated with the devaluation of cash flows from inflation.
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True or False: Purchasing power risk only affects fixed-income investments.
**False**. While purchasing power risk significantly affects fixed-income investments, it impacts all types of investments to varying degrees
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Fill in the blank: Purchasing power risk is primarily caused by ______.
inflation
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Which of the following best describes the impact of inflation on purchasing power? A) Increases value B) Decreases value C) No effect
B) Decreases value
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What are cash flows?
Cash flows are the inflows and outflows of cash that an individual or business receives or pays over a given period.
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Spreads tend to be wider for small issues that are less often traded and small dollar trades.
Thinly traded securities, such as. OTC trades, Small cap stocks, hedge funds, private equity investments, high yield corporate bonds. .
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What is the maturity range for U.S. Treasury notes?
2, 3, 5, 7, and 10 years
## Footnote
These maturity dates allow for different investment strategies.
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What is the maturity period for U.S. Treasury bonds?
30 years
## Footnote
T-bonds are typically considered long-term investments.
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Name three uses for U.S. Treasury notes and bonds.
* Diversifying a portfolio
* Funding college education expenses
* Supplementing retirement income
## Footnote
These investments can serve various financial goals.
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Fill in the blank: U.S. Treasury notes are issued with maturity dates of _______.
2, 3, 5, 7, and 10 years
## Footnote
This variety allows investors to choose based on their financial needs.
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What happens when a note or bond is sold before its maturity date?
Proceeds from the sale must be separated into components
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What is recovered tax free when a note or bond is sold?
An amount equal to the investor’s adjusted basis in the note or bond
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How is the investor’s adjusted basis in a note or bond usually calculated?
Purchase price plus any accrued Original Issue Discount (OID)
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What amount does the seller usually receive from the buyer if the sale occurs before an interest date?
An amount separately stating interest accrued but not yet due
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How is the amount received for accrued interest reported by the seller?
As interest income
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What is the treatment of the excess of proceeds received over basis and interest?
It is treated as capital gain (or loss)
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For federal income tax purposes (remember, as a U.S. Treasury security, the obligation is free of income taxes at both the state and local levels), all interest received from TIPS is taxable at ordinary income tax rates in the year earned.
Also, during any year when the principal value of TIPS increases as a result of the inflation adjustment, the increase in principal is also taxed as ordinary income for that year.
The tax basis of TIPS is also adjusted upward to account for this increase in principal.
**For example** Sally purchases an 8%, 10-year TIPS. In Year 1, the inflation adjustment increases the principal from $980 to $1,010. Sally’s taxable income will include any interest payments received on the TIPS, *as well* as the $30 increase in principal.
If Sally sells the bond for $1,015 immediately after the principal increase, she will recognize a gain on the sale of $5 (not $35) for income tax purposes.
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Series EE bonds must be held for a minimum of __ months, and a 3-month interest penalty is assessed if the bond is redeemed within _ years of issue.
Series EE bonds must be held for a minimum of **12 months**, and a 3-month interest penalty is assessed if the bond is redeemed within **five years of issue.**
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What makes U.S. savings bonds attractive for investors in high-tax states?
The exemption of interest from state and local income taxes.
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What types of loans back the securities guaranteed by Ginnie Mae?
Federally insured loans
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True or False: Ginnie Mae directly issues mortgage loans.
False
Ginnie Mae, officially known as the Government National Mortgage Association, is a federal government corporation that plays a crucial role in the mortgage market, but it *does not* originate or provide financing for mortgages directly.
Instead, **Ginnie Mae's primary functions are:**
- Guaranteeing mortgage-backed securities (MBS) issued by approved lenders.
- Packaging government-backed loans into pools that are traded as MBS.
- Providing liquidity to the mortgage market by enabling lenders to sell their mortgages.
Ginnie Mae's role is to support the secondary mortgage market and make homeownership more affordable, particularly for low- to moderate-income buyers. It accomplishes this by guaranteeing the timely payment of principal and interest on MBS backed by federally insured or guaranteed loans,
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Fill in the blank: Ginnie Mae guarantees investors the timely payment of principal and interest on _______.
mortgage-backed securities
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What are Government-sponsored enterprises (GSEs)?
GSEs are financial services corporations created by Congress to enhance the flow of credit to specific sectors of the economy.
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True or False: GSEs operate independently of the federal government.
False
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Fill in the blank: GSEs were primarily created to increase the flow of credit to ______.
housing
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Which act established the first GSE, the Federal National Mortgage Association (Fannie Mae)?
The National Housing Act of 1938
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What is the Federal Home Loan Mortgage Corporation commonly known as?
Freddie Mac
## Footnote
Freddie Mac purchases mortgage loans and issues guaranteed mortgage-related securities.
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What is the primary function of the Federal National Mortgage Association?
The primary function of the **Federal National Mortgage Association**, commonly known as ***Fannie Mae***, is to provide liquidity, stability, and affordability to the U.S. housing market.
It achieves this by purchasing mortgages from lenders and pooling them into mortgage-backed securities (MBS), which are then sold to investors. This process helps free up capital for lenders, allowing them to offer more mortgages to homebuyers, particularly those with moderate to low incomes.
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What does the Student Loan Marketing Association specialize in?
Offers solutions for college expenses
## Footnote
Also known as Sallie Mae, it helps families save, plan, and finance education.
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Fill in the blank: The Federal Home Loan Mortgage Corporation is abbreviated as _______.
FHLMC
## Footnote
The abbreviation is sometimes also referred to as Freddie Mac.
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True or False: Fannie Mae primarily focuses on issuing student loans.
False
- Providing liquidity to the U.S. mortgage market by purchasing mortgage loans from lenders.
- Securitizing these loans into mortgage-backed securities (MBS) for sale to investors.
- Guaranteeing timely payment of principal and interest on the MBS to investors.
*Fannie Mae's work is centered on two main areas of housing:*
**Single-Family:** Helping homebuyers purchase and refinance homes.
**Multifamily:** Financing quality, affordable rental housing
## Footnote
Fannie Mae is focused on the mortgage market, not student loans.
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What role does Freddie Mac play in the mortgage market?
helps create a secondary market by purchasing mortgages from banks, credit unions, and other loan originators and selling them as mortgage-backed securities. With this, it provides market liquidity, allowing institutions to free up capital for more lending opportunities.
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What is one of the key objectives of Sallie Mae?
Help families save, plan, and finance college expenses
## Footnote
This includes providing various financial solutions for education.
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What are general obligation bonds (GOs)?
Municipal bonds issued to finance capital improvements benefiting the community
## Footnote
These improvements typically do not produce revenues.
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What is typically required for municipalities to approve new issues of general obligation bonds?
A taxpayer vote
## Footnote
This requirement stems from the fact that G.O. bonds are backed by the full faith, credit, and taxing power of the municipality, which directly impacts taxpayers
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What limits may exist regarding the amount of debt a municipal government can incur?
State or local statutes may limit the amount
## Footnote
These statutes are in place to protect taxpayers from excessive taxes.
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True or False: General obligation bonds are considered more risky for investors.
False
## Footnote
GOs are considered less risky due to their backing by taxes.
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Fill in the blank: General obligation bonds are issued to finance _______.
capital improvements benefiting the community
## Footnote
These improvements enhance community infrastructure.
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What is the typical yield comparison between revenue bonds and GOs?
Revenue bonds offer higher yields for similar maturities compared to GOs.
## Footnote
This is a compensation for the additional risk involved.
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True or False: Revenue bonds can only finance projects that are guaranteed to generate income.
True.
## Footnote
They are specifically tied to income-generating municipal facilities.
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Fill in the blank: Revenue bonds may be used to finance any municipal facility (e.g., _______) that generates sufficient income to satisfy the ongoing debt obligation.
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What are industrial development revenue bonds?
are a unique type of municipal debt securities issued by state or local governments on behalf of private companies. These bonds serve as a financial tool to support economic development and job creation in local communities.
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What are special assessment bonds?
a type of municipal bond used to finance specific infrastructure projects within a defined geographic area.
## Footnote
These bonds are typically used for infrastructure projects where the costs are assessed to property owners.
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What are special tax bonds?
a type of municipal bond issued by state or local governments to finance specific community projects, such as highways, schools, or hospitals.
- repaid using revenue generated from *specific taxes* levied for this purpose.
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What are new housing authority (or Section 8) bonds?
Bonds used to finance rehabilitation or construction of affordable housing
## Footnote
These bonds support initiatives to provide low-income housing options.
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Kate owns a municipal bond with a coupon rate of 6%. She is in the 32% federal marginal income tax bracket. Therefore, to achieve the same yield on a taxable corporate bond, the corporate bond must have a coupon rate of at least
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pretax return x (1 — marginal tax rate)
After tax yield.
This calculation shows how much of the yield the investor actually retains after paying taxes.
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For a taxable corporate bond that yields 4.35%, the after-tax yield to an investor with a 35% marginal tax rate is calculated as follows:
after-tax yield = 4.35% x (1 — 0.35) = 4.35% x 0.65 = 2.8275, or 2.
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The largest segments in the United States for corporate bonds are ____ & ____
industrials and utilities.
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Like bonds, it offers a fixed payment, often called a dividend, which takes priority over common stock dividends.
- However, unlike bond interest payments, dividends are *not guaranteed*.
- dividends are usually **cumulative**. This means if a company skips a dividend payment, it must pay those missed dividends before it can pay any dividends to common stockholders.
- doesn't carry voting rights
- often has a *"call provision,"* meaning the company can buy back the shares at a predetermined price after a certain date
preferred stock
## Footnote
Finally, in the event of bankruptcy, preferred stockholders have a higher claim on assets than common stockholders, but a lower claim than bondholders. This means they are more likely to get some money back than common stockholders, but less likely than bondholders.
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fixed dividends, cumulative dividends, lack of voting rights, call provisions, and priority in bankruptcy
preferred stock
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A type of municipal bond issued by state or local governments to finance projects that primarily benefit private entities, but serve a public purpose.
- Interest must qualify. As qualified, according to Rules defined by the. Internal Revenue Code.
- Interest tax treatment, often complex. It may vary depending on the specific type of bond and the investor's tax situation.
*Private Activity Bond (PAB)*
- Projects funded include airports, hospitals, affordable housing and student loans.
- Generally, interest is often exempt from federal income tax if the bond meets certain qualifications.
- Interest may be subject to the *Alternative Minimum Tax.*
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- Occur in the secondary market.
- Purchased at a price below par value after issuance.
- Discount results from market conditions, such as interest rate changes or issue credit rating changes.
- The market discount is the difference between the purchase price and the stated redemption price at maturity.
*Market Discount Bonds*
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- Discounted at initial issuance.
- Sold at a price below par value when first issued.
*Original Issue Discount (OID) bonds*
- Examples include zero coupon bonds.
**Key Point:**
Deferring tax on market discount bonds until sale is generally more beneficial, as it delays income recognition.
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When you pay a premium for a bond you may offset said premium against the interest income by?
***Amortizing*** the premium paid over the term of the bond.
This is the case for all bonds except a municipal bond where the amortization is handled differently (because the bond returns tax-free interest). The amortization of the premium must reduce the basis annually but *is not a tax-deductible event*.
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What are zero-coupon bonds?
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What must investors include in their taxable income when holding zero-coupon bonds?
Accrued interest, also known as phantom income.
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In which type of account are taxable zero-coupon bonds usually most appropriate?
Retirement plans or other tax-deferred accounts.
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True or False: Investors receive cash payments annually from zero-coupon bonds.
False
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are foreign bonds payable in U.S. dollars (e.g., bonds issued by Deutsche Bank in the United States).
- not subject to exchange rate risk and may be effective diversification tools within a portfolio.
- issued by foreign governments, banks, or corporations
- traded in the United States in the secondary market and are generally of very high quality.
Yankee bonds
The taxes withheld on the interest from the foreign bonds can often be taken as a deduction on your taxes. As the United States has Treaties with several countries to avoid double taxation.
101
What are Eurodollar bonds?
A type of U.S. pay bond sold outside the U.S. by overseas companies, denominated in U.S. dollars and underwritten by a non-U.S. bond syndicate.
## Footnote
Eurodollar bonds do not need to be registered with the Securities and Exchange Commission.
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How do Eurodollar bonds differ from Yankee bonds?
Eurodollar bonds are issued and traded outside the United States, in the international market. In contrast, Yankee bonds are issued and traded within the United States
## Footnote
Eurodollar bonds are **not** registered with the U.S. Securities and Exchange Commission (SEC) and are subject to fewer regulatory restrictions. This allows for increased flexibility and creative structuring of financial instruments. Yankee bonds, however, **must be** registered with the SEC and comply with U.S. securities laws, as they trade on U.S. exchanges
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Where are Eurodollar bonds sold?
Outside of the United States.
## Footnote
They are sold by overseas companies.
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In what currency are Eurodollar bonds denominated?
U.S. dollars.
## Footnote
This is a key characteristic that distinguishes them from other types of bonds.
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Who underwrites Eurodollar bonds?
Non-U.S. bond syndicates.
## Footnote
This means that the underwriting process is handled outside of the U.S.
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Give an example of a Eurodollar bond.
Bonds issued by Toyota in Japan in U.S. dollars.
## Footnote
This illustrates how companies outside the U.S. can issue bonds in U.S. dollars.
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What are Eurobonds?
Bonds denominated in a currency not native to the country where they are issued
## Footnote
Eurobonds are not limited to European countries or the euro currency.
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Can you give an example of a Eurobond?
A bond of a Japanese company, denominated in Japanese yen, issued and traded in the United States, Australia, and Singapore
## Footnote
This type of Eurobond is specifically called a Euroyen bond.
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Who typically underwrites Eurobonds?
International bond syndicates
## Footnote
These syndicates are groups of banks and financial institutions that collaborate to issue bonds.
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Where are Eurobonds sold?
To investors in many countries
## Footnote
Eurobonds have a global market presence.
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True or False: Eurobonds can only be issued by European companies.
False
## Footnote
Eurobonds can be issued by companies from any country.
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a fundamental concept in the world of bonds that helps investors understand how sensitive a bond's price is to changes in interest rates.
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What rule must investors be aware of to avoid complications when realizing a capital loss?
a) The short sale rule
b) The substantial equanimity rule
c) The wash sale rule
d) The income averaging rule
Answer: c) The wash sale rule
123
What is the primary purpose of a tax swap?
a) To increase taxable income
b) To take advantage of capital losses
c) To avoid selling bonds
d) To minimize investment risks
Answer: **b) To take advantage of capital losses**
Explanation: A tax swap is a strategy used to realize capital losses, which can be used to offset capital gains or, in some cases, ordinary income, thereby lowering the investor's tax bill
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This curve has a tendency to slope upward and outward, denoting that as the maturity date of bonds lengthens, the corresponding bond yields increase. The increased yields reflect the potential for changes in credit quality and the effect of purchasing power risk over time. If the curve assumes this shape, it is referred to as a normal, or positive, yield curve, indicating that long-term market interest rates are higher than short-term rates.
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Sometimes, yield curves may be flat (denoting no difference in the yield of bonds relative to their maturity) or inverted (denoting that current short-term borrowing costs are higher than long-term borrowing costs).
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remember that a dividend on a **preferred stock**, just like common stock, is *not guaranteed*. It is just preferential, meaning that the dividend will go to the preferred stock holder before the common stockholder. And if dividends are missed, before future dividends can be given to a common stockholder, they must be paid to the preferred stockholder first.
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True or false?
Preferred stocks have standards in regards to time- to-maturity.
False.
Preferred stocks have what is called *perpetuity*, meaning they ***do not*** have maturity dates. Some do have call features. But generally, in order to obtained your original investment, you must sell your preferred shares.
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The following image demonstrates that preferred stocks are subject to interest rate risk. Similar to bonds. Even more so, given they **do not** have a time to maturity.
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This formula helps investors determine the yield a taxable bond needs to achieve to match the return of a tax-exempt bond, such as a municipal bond.
