Fixed Income Flashcards

Question

fiduciary Because it would be impractical for the issuer to enter into a direct agreement with each bondholder, the indenture is usually held by a trustee. The trustee is typically a financial institution acting as a fiduciary

Answer 1

An entity designated to represent the rights and responsibilities of a beneficiary whose assets they are managing, such as a bond trustee acting on behalf of fixed-income investors.

Answer 2

the legal identity of the bond issuer and its legal form; the source of repayment proceeds; the asset or collateral backing (if any); the credit enhancements (if any); and the covenants (if any)

Answer 3

The first source is the general taxing authority of the issuer. The second source is from the cash flows of the project the bond issue is financing. The third source is from special taxes or fees established specifically for the purpose of funding interest payments and principal repayments.

Answer 4

Collateral backing is a way to alleviate credit risk. Investors should review where they rank compared with other creditors in the event of default and analyze the quality of the collateral backing the bond issue.

Answer 5

Bonds secured by assets or financial guarantees pledged to ensure debt repayment in case of default. unsecured bonds have no collateral; bondholders have only a general claim on the issuer’s assets and cash flows. Thus, unsecured bonds are paid after secured bonds in the event of default. By lowering credit risk, collateral backing increases the bond issue’s credit quality and decreases its yield.

Answer 6

the systematic way in which lenders are repaid in case of bankruptcy or liquidation The ranking refers to the priority of payment in the event of a default. The most senior or highest-ranking debt have the first claim on the cash flows and assets of the issuer, with the remaining going towards the next highest-ranking debt

Answer 7

Type of bond that can be secured or unsecured.

Answer 8

Bonds secured by securities, such as common shares, other bonds, or other financial assets. These securities are pledged by the issuer and typically held by the trustee

Answer 9

Bonds secured by specific types of equipment or physical assets.

Answer 10

Debt obligation secured by a segregated pool of assets called the cover pool. The issuer must maintain the value of the cover pool. In the event of default, bondholders have recourse against both the issuer and the cover pool. Covered bonds are debt securities issued by a bank or mortgage institution and collateralized against a pool of assets that, in case of failure of the issuer, can cover claims at any point of time. They are subject to specific legislation to protect bond holders.

Answer 11

Internal credit enhancement relies on structural features regarding the bond issue. External credit enhancement refers to financial guarantees received from a third party, often called a financial guarantor.

Answer 12

The most common forms of internal credit enhancement are subordination, overcollateralization, and reserve accounts

Answer 13

Form of internal credit enhancement that relies on creating more than one bond tranche and ordering the claim priorities for ownership or interest in an asset between the tranches. The ordering of the claim priorities is called a senior/subordinated structure, where the tranches of highest seniority are called senior followed by subordinated or junior tranches. Also called credit tranching.

Answer 14

Form of internal credit enhancement that refers to the process of posting more collateral than needed to obtain or secure financing.

Answer 15

Form of internal credit enhancement that relies on creating accounts and depositing in these accounts cash that can be used to absorb losses. Also called reserve funds. An excess spread account is an allocation of any asset cash flows remaining after paying interest to bondholders. The excess spread (or excess interest cash flow) can be retained and deposited into a reserve account as a first line of protection against losses. In a process called “turboing,” the excess spread can be used to retire the principal, with the most senior tranche having the first claim on these funds.

Answer 16

The most common forms of external credit enhancement are bank guarantees and surety bonds, letters of credit, and cash collateral accounts.

Answer 17

Form of external credit enhancement whereby a rated and regulated insurance company guarantees to reimburse bondholders for any losses incurred up to a maximum amount if the issuer defaults. Bank guarantees and surety bonds are very similar in nature because they both reimburse bondholders for any losses incurred if the issuer defaults. However, there is usually a maximum amount that is guaranteed, called the penal sum. The major difference between a bank guarantee and a surety bond is that the former is issued by a bank, whereas the latter is issued by a rated and regulated insurance company. Insurance companies that specialize in providing financial guarantees are typically called monoline insurance companies or monoline insurers. Monoline insurers played an important role in securitization until the 2007–2009 global financial crisis, but they are now a less common form of credit enhancement due to the credit downgrades of these insurers during the crisis.

Answer 18

Form of external credit enhancement whereby a financial institution provides the issuer with a credit line to reimburse any cash flow shortfalls from the assets backing the issue.

Answer 19

Form of external credit enhancement whereby the issuer immediately borrows the credit-enhancement amount and then invests that amount, usually in highly rated short-term commercial paper. . Because a cash collateral account is an actual deposit rather than a pledge of cash, a cash collateral account provider downgrade will not necessarily result in a downgrade of the bond issue backed by that provider.

Answer 20

Bond covenants are legally enforceable rules that borrowers and lenders agree on at the time of a new bond issue. An indenture will frequently include affirmative (or positive) and negative covenants. Affirmative covenants enumerate what issuers are required to do, whereas negative covenants specify what issuers are prohibited from doing

Answer 21

Covenant or contract clause that ensures a debt obligation is treated the same as the borrower’s other senior debt instruments and is not subordinated to similar obligations.

Answer 22

Covenant or contract clause that specifies a borrower is considered in default if they default on another debt obligation.

Answer 23

Affirmative covenants are typically administrative in nature negative covenants are frequently costly and materially constrain the issuer’s potential business decisions. They protect bondholders from the dilution of their claims, asset withdrawals or substitutions, and suboptimal investments by the issuer

Answer 24

The global bond markets consist of national bond markets and the Eurobond market A national bond market includes all the bonds that are issued and traded in a specific country and are denominated in the currency of that country. Bonds issued by entities that are incorporated in that country are called domestic bonds bonds issued by entities that are incorporated in another country are called foreign bonds Bonds for which ownership is not recorded; only the clearing system knows who the bond owner is. Bonds for which ownership is recorded by either name or serial number

Answer 25

Bond interest is usually taxed at the ordinary income tax rate, which is typically the same tax rate that an individual would pay on wage or salary income. Tax-exempt securities are the exception to this rule. The tax status of bond income may also depend on where the bond is issued and traded.

Answer 26

a bond investment will generate a capital gain or loss if sold prior to maturity at a price different from the purchase price. This change will generate a capital gain if the bond price has increased or a capital loss if the bond price has decreased. Capital gains or losses usually face different tax treatment from taxable income, which often varies for long-term and short-term capital gains

Answer 27

For bonds issued at a discount, the tax status of the original issue discount is an additional tax consideration. The original issue discount is the difference between the par value and the original issue price.

Answer 28

Bond in which the principal repayment is made entirely at maturity.

Answer 29

Bond with a payment schedule that calls for periodic payments of interest and repayments of principal.

Answer 30

A fully amortized bond is characterized by a fixed periodic payment schedule that reduces the bond’s outstanding principal amount to zero by the maturity date

Answer 31

A partially amortized bond also makes fixed periodic payments until maturity, but only a portion of the principal is repaid by the maturity date.

Answer 32

Large payment required at maturity to retire a bond’s outstanding principal amount.

Answer 33

Provision that reduces the credit risk of a bond issue by requiring the issuer to retire a portion of the bond’s principal outstanding each year. A sinking fund is an account containing money set aside to pay off a debt or bond. Sinking funds may help pay off the debt at maturity or assist in buying back bonds on the open market. Callable bonds with sinking funds may be called back early removing future interest payments from the investor.

Answer 34

Bond for which the coupon, fixed or floating, increases by specified margins at specified dates Bonds with step-up coupons offer bondholders some protection against rising interest rates, and they may be an important feature for callable bonds. When interest rates increase, there is a higher likelihood that the issuer will not call the bonds, particularly if the bonds have a fixed rate of interest.

Answer 35

Bond for which the coupon changes when the bond’s credit rating changes

Answer 36

A payment-in-kind (PIK) coupon bond typically allows the issuer to pay interest in the form of additional amounts of the bond issue rather than as a cash payment. Such bonds are favored by issuers who are concerned that the issuer may face potential cash flow problems in the future.

Answer 37

Bond that pays no coupons for its first few years but then pays a higher coupon than it otherwise normally would for the remainder of its life. Also called split coupon bond. One of the main advantages of investing in a deferred coupon bond is that these bonds are typically priced at significant discounts to par. Investors may also find the deferred coupon structure to be very helpful in managing taxes. If taxes due on the interest income can be delayed, investors may be able to minimize taxes. This tax advantage, however, depends on the jurisdiction concerned and how its tax rules apply to deferred coupon payments. A zero-coupon bond can be thought of as an extreme form of deferred coupon bond. These securities pay no interest to the investor and thus are issued at a deep discount to par value. At maturity, the bondholder receives the par value of the bond as payment. Effectively, a zero-coupon bond defers all interest payments until maturity.

Answer 38

Bond for which coupon payments and/or principal repayment are linked to a specified index.

Answer 39

Type of index-linked bond that offers investors protection against inflation by linking the bond’s coupon payments and/or the principal repayment to an index of consumer prices. Also called linkers.

Answer 40

pay no coupon, so the inflation adjustment is made via the principal repayment only pay a fixed nominal principal amount at maturity but an index-linked coupon during the bond’s life pay a fixed coupon rate, but it is applied to a principal amount that increases in line with increases in the index during the bond’s life. are fully amortized bonds, in contrast to interest-indexed and capital-indexed bonds that are non-amortizing coupon bonds. The annuity payment, which includes both payment of interest and repayment of the principal,

Answer 41

Clause in a legal document that allows for some action if a specific event or circumstance occurs.

Answer 42

Contingency provisions that provide the issuer or the bondholders the right, but not the obligation, to take action. These options are not part of the security and cannot be traded separately

Answer 43

callable bond putable bonds convertible bonds.

Answer 44

A bond containing an embedded call option that gives the issuer the right to buy the bond back from the investor at specified prices on pre-determined dates. The primary reason why issuers choose to issue callable bonds rather than non-callable bonds is to protect themselves against a decline in interest rates. Callable bonds present investors with a higher level of reinvestment risk than non-callable bonds the issuer can benefit from a decline in interest rates by being able to refinance its debt at a lower interest rate. callable bonds have to offer a higher yield and sell at a lower price than otherwise similar non-callable bonds. The higher yield and lower price compensate the bondholders for the value of the call option to the issuer.

Answer 45

American-style call, sometimes referred to as continuously callable, for which the issuer has the right to call a bond at any time starting on the first call date. European-style call, for which the issuer has the right to call a bond only once on the call date. Bermuda-style call, for which the issuer has the right to call bonds on specified dates following the call protection period. These dates frequently correspond to coupon payment dates.

Answer 46

Bonds that give the bondholder the right to sell the bond back to the issuer at a predetermined price on specified dates. Putable bonds are beneficial for the bondholder by guaranteeing a pre-specified selling price at the redemption dates. If interest rates rise after issuance and bond prices fall, the bondholders can put the bond back to the issuer and reinvest the proceeds in bonds that offer higher yields, in line with higher market interest rates. the yield on a bond with a put provision will be lower than the yield on an otherwise similar non-putable bond. The lower yield compensates the issuer for the value of the put option to the investor.

Answer 47

Putable bonds that incorporate a single sellback opportunity include a European-style put and are often referred to as one-time put bonds. Putable bonds that allow multiple sellback opportunities include a Bermuda-style put and are known as multiple put bonds. Multiple put bonds offer more flexibility for investors, so they are generally more expensive than one-time put bonds

Answer 48

Bond that gives the bondholder the right to exchange the bond for a specified number of common shares in the issuing company. Because the conversion provision is valuable to bondholders, the price of a convertible bond is higher than the price of an otherwise similar bond without the conversion provision. Similarly, the yield on a convertible bond is lower than the yield on an otherwise similar non-convertible bond. However, most convertible bonds offer investors a yield advantage; the coupon rate on the convertible bond is typically higher than the dividend yield on the underlying common share. From the issuer’s perspective, convertible bonds offer two main advantages. The first is reduced interest expense. Issuers are usually able to offer below-market coupon rates due to the conversion feature’s value. The second advantage is the elimination of debt if the conversion option is exercised, but this is dilutive to existing shareholders.

Answer 49

For a convertible bond, the price per share at which the bond can be converted into shares. For a convertible bond, the number of common shares that each bond can be converted into. The indenture sometimes does not stipulate the conversion ratio but only mentions the conversion price. The conversion ratio is equal to the par value divided by the conversion price. For a convertible bond, the current share price multiplied by the conversion ratio. The difference between the convertible bond’s price and its conversion value. Conversion parity occurs if the conversion value is equal to the convertible bond’s price

Answer 50

A warrant is an “attached” rather than embedded option entitling the holder to buy the underlying stock of the issuing company at a fixed exercise price until the expiration date. . Warrants are considered yield enhancements; they are frequently attached to bond issues as a “sweetener.” Warrants are actively traded in some financial markets, such as the Deutsche Börse and the Hong Kong Stock Exchange.

Answer 51

Bonds that automatically convert into equity if a specific event or circumstance occurs, such as the issuer’s equity capital falling below the minimum requirement set by the regulators. Also called CoCos.

Answer 52

``` Common criteria used to classify fixed-income markets include the : type of issuer the bonds’ credit quality maturity currency denomination type of coupon where the bonds are issued and traded ```

Answer 53

``` four bond market sectors: households, non-financial corporates, government, financial institutions ```

Answer 54

Investors who hold bonds are exposed to credit risk, which is the risk of loss resulting from the issuer failing to make full and timely payments of interest and/or principal. Bond markets can be classified based on the issuer’s creditworthiness as judged by credit rating agencies. In contrast, ratings below these levels(BBB) are referred to as non-investment grade, high yield, speculative, or “junk.” An important point to understand is that credit ratings assess the issuer’s creditworthiness at a certain point in time; they are not a recommendation to buy or sell the issuer’s securities. Credit ratings are not static, however; they will change if a credit rating agency perceives that the probability of default for an issuer has changed. Globally, investment-grade bond markets tend to be more liquid than high-yield bond markets.

Answer 55

Fixed-income securities can also be classified by the original maturity of the bonds when they are issued. Securities may be issued with maturities at issuance (original maturity) ranging from overnight to 30, 40, 50, and up to 100 years

Answer 56

The currency denomination of the bond’s cash flows influences the yield that must be offered to investors to compensate for the potential impact of currency movements on bond investment returns

Answer 57

Another way of classifying fixed-income markets is by type of coupon. Some bonds pay a fixed rate of interest; others, called floating-rate bonds, floating-rate notes (FRNs), or floaters, pay a rate of interest that adjusts to market interest rates at regular, short-term intervals (e.g., quarterly).

Answer 58

The coupon rate of a floating-rate bond is typically expressed as a reference rate plus a constant spread or margin. It is primarily a function of the issuer’s credit risk at issuance: The lower the issuer’s credit quality (the higher its credit risk), the higher the spread. The reference rate, however, resets periodically. Therefore, the coupon rate adjusts to the level of market interest rates each time the reference rate is reset.

Answer 59

A distinction is very often made among the domestic bond, foreign bond, and Eurobond markets. Bonds issued in a specific country, denominated in the currency of that country, and sold in that country are classified as domestic bonds if they are issued by an issuer domiciled in that country and foreign bonds if they are issued by an issuer domiciled in another country. Domestic and foreign bonds are subject to the legal, regulatory, and tax requirements that apply in that particular country. In contrast, a Eurobond is issued internationally, outside the jurisdiction of the country in whose currency the bond is denominated. The Eurobond market has traditionally been characterized by fewer reporting, regulatory, and tax constraints than domestic and foreign bond markets. This less constrained environment explains why approximately 80% of entities that issue bonds outside their country of origin choose to do so in the Eurobond market rather than in a foreign bond market. In addition, Eurobonds are attractive for issuers because it enables them to reach out to more investors globally. Access to a wider pool of investors often allows issuers to raise more capital, usually at a lower cost. Along these lines, Eurobond markets are attractive for investors because they offer investors the ability to take on sovereign credit risk without being exposed to risks that are germane to the individual jurisdiction of the issuer countries, such as potential changes to capital control rules, which would restrict the return of capital, and other country risks.

Answer 60

Specific market sectors that are of interest to some investors are inflation-linked bonds and, in some jurisdictions, tax-exempt bonds. Inflation-linked bonds or linkers are typically issued by governments, government-related entities, and corporate issuers that have an investment-grade rating. They offer investors protection against inflation by linking the coupon payment and/or the principal repayment to an index of consumer prices Tax-exempt bonds can be issued only in those jurisdictions that recognize such tax exemption In particular, local governments can issue municipal bonds (or munis) that are tax exempt (they can also issue taxable municipal bonds, although tax-exempt munis are more frequently issued than taxable munis). Tax-exempt bonds also exist in other jurisdictions

Answer 61

A fixed-income index is a multi-purpose tool used by investors and investment managers to describe a given bond market or sector, as well as to track and quantify the performance of investments and investment managers. Most fixed-income indexes are constructed as portfolios of securities that reflect a particular bond market or sector. The index construction—that is, the security selection and the index weighting—varies among indexes. Index weighting may be based on price, value (market capitalization), or total return. Many other fixed-income indexes are available to investors and investment managers to measure and report performance. It is important to note that constructing a fixed-income index is more challenging than constructing an equity index, because fixed-income markets feature far more securities of different types and more frequent changes in the index as new bonds are issued while others reach maturity

Answer 62

it is important to consider the demand side because demand for a particular type of bond or issuer may affect supply. After all, market prices are the result of the interaction between demand and supply; neither one can be considered in isolation. There are different types of investors in fixed-income securities. Major categories of bond investors include central banks, institutional investors, retail investors. The first two typically invest directly in fixed-income securities. In contrast, retail investors often invest indirectly, traditionally through fixed-income mutual funds and, during the last two decades, through exchange-traded funds (ETFs), described later. ``` CENTRAL BANKS-Central banks use open market operations to implement monetary policy. By purchasing (selling) domestic bonds, central banks increase (decrease) the monetary base in the economy. Central banks may also purchase and sell bonds denominated in foreign currencies as part of their efforts to manage the relative value of the domestic currency and their country’s foreign reserves. ``` INSTITUTIONAL INVESTORS-Institutional investors, including pension funds, hedge funds, charitable foundations and endowments, insurance companies, and banks, represent the largest groups of investors in fixed-income securities. Another major group of investors is sovereign wealth funds, which are state-owned investment funds that tend to have very long investment horizons and aim to preserve or create wealth for future generations. RETAIL INVESTORS-Finally, retail investors often invest heavily in fixed-income securities because of the attractiveness of relatively stable prices and steady income production.

Answer 63

The purchase or sale of bonds by the national central bank to implement monetary policy. The bonds traded are usually sovereign bonds issued by the national government.

Answer 64

A market in which issuers first sell bonds to investors to raise capital. Different bond issuing mechanisms are used depending on the type of issuer and the type of bond issued. A bond issue can be sold via a public offering (or public offer), in which any member of the public may buy the bonds, or via a private placement, in which only a selected investor, or group of investors, may buy the bonds.

Answer 65

The most common bond issuing mechanisms are underwritten offerings, best-efforts offerings, auctions.

Answer 66

A type of securities issue mechanism in which the investment bank guarantees the sale of the securities at an offering price that is negotiated with the issuer. Also known as firm commitment offering. Underwritten offerings are typical bond-issuing mechanisms for corporate bonds, some local government bonds (such as municipal bonds in the United States), and some asset-backed securities (such as mortgage-backed securities). The underwriting process typically includes six phases.

Answer 67

1. The determination of the funding needs- Often with the help of an adviser or advisers, the issuer must determine how much money must be raised, the type of bond offering, and whether the bond issue should be underwritten. 2. The selection of the underwriter- The underwriter of a bond issue takes the risk of buying the newly issued bonds from the issuer, and it then resells them to investors or to dealers that then sell them to investors. The difference between the purchase price of the new bond issue and the reselling price to investors is the underwriter’s revenue (syndicated offering). A lead underwriter invites other investment banks to join the syndicate and coordinates the effort. The syndicate is collectively responsible for determining the pricing of the bond issue and for placing (selling) the bonds with investors. 3. The structuring and announcement of the bond offering- the issuer and the lead underwriter discuss the terms of the bond issue, such as the bond’s notional principal (total amount), the coupon rate, and the expected offering price. The issuer must also choose a trustee, which is typically a trust company or the trust department of a bank, to oversee the master bond agreement The bond offering is formally launched the day the transaction is announced, usually in the form of a press release. The announcement specifies the new bond issue’s terms and conditions, including the bond’s features, such as the maturity date, the currency denomination, and the expected coupon range, as well as the expected offering price 4. Pricing- The pricing day is the last day when investors can commit to buy the bond issue, and it is also the day when the final terms of the bond issue are agreed on. The following day, called the “offering day,” the underwriting agreement that includes the bond issue’s final terms is signed 5. Issuance- The underwriter or the syndicate purchases the entire bond issue from the issuer, delivers the proceeds, and starts reselling the bonds through its sales network 6. Closing.- The underwriting process comes to an end about 14 days later, on the closing day, when the bonds are delivered to investors

Answer 68

A type of public offering that allows the issuer to file a single, all-encompassing offering circular that covers a series of bond issues. A shelf registration allows certain authorized issuers to offer additional bonds to the general public without having to prepare a new and separate offering circular for each bond issue Because shelf issuances are subject to a lower level of scrutiny compared with standard public offerings, they are an option only for well-established issuers that have convinced the regulatory authorities of their financial strength. Additionally, certain jurisdictions may allow shelf registrations to be purchased only by “qualified” institutional investors—that is, institutional investors that meet a set of criteria set forth by the regulators.

Answer 69

An auction is a method that involves bidding. It is helpful in providing price discovery (i.e., it facilitates supply and demand in determining prices) and in allocating securities. In many countries, most sovereign bonds are sold to the public via a public auction The public auction process used in the United States is a single-price auction through which all the winning bidders pay the same price and receive the same coupon rate for the bonds a multiple-price auction process, which generates multiple prices and yields for the same bond issue. The US sovereign bond market is one of the largest and most liquid bond markets globally, so we will illustrate the US single-price auction process. This process includes three phases: announcement, bidding, and issuance. First, the US Treasury announces the auction and provides information about the bond issue, such as the amount of securities being offered, the auction date, the issue date, the maturity date, bidding close times, and other pertinent information. After the auction announcement is made, dealers, institutional investors, and individual investors may enter competitive or non-competitive bids With competitive bids, a bidder specifies the rate (yield) that is considered acceptable; if the rate determined at auction is lower than the rate specified in the competitive bid, the investor will not be offered any securities. In contrast, with non-competitive bids, a bidder agrees to accept the rate determined at auction; non-competitive bidders always receive their securities. On the issue day, the US Treasury delivers the securities to the winning bidders and collects the proceeds from investors. After the auction process is complete, the securities are traded in secondary markets like other securities. Financial institution that is authorized to deal in new issues of sovereign bonds and that serves primarily as a trading counterparty of the office responsible for issuing sovereign bonds

Answer 70

A private placement is typically a non-underwritten, unregistered offering of bonds that are sold only to an investor or a small group of investors. Typical investors in privately placed bonds are large institutional investors. A private placement can be accomplished directly between the issuer and the investor(s) or through an investment bank. Because privately placed bonds are unregistered and may be restricted securities that can be purchased by only some types of investors, there is usually no active secondary market to trade them. Even if trading is possible, privately placed bonds typically exhibit lower liquidity than publicly issued bonds. Insurance companies and pension funds are major buyers of privately placed bonds because they do not need every security in their portfolios to be liquid and they often value the additional yield offered by these bonds.

Answer 71

A loan from a group of lenders to a single borrower.

Answer 72

Secondary markets, also called the “aftermarket,” are where existing securities are traded among investors. Securities can be traded directly from investor to investor, through a broker or dealer, or directly from issuer to investor by way of bond tender offer. The major participants in secondary bond markets globally are large institutional investors and central banks. The direct presence of retail investors in secondary bonds markets is limited, unlike in secondary equity markets. Retail investors do participate in secondary bond markets, albeit indirectly, through mutual and exchange-traded funds (ETFs) offered by fund management companies. There are three main ways for secondary markets to be structured: as an organized exchange, as an over-the-counter market, or as a bond tender offer

Answer 73

A securities marketplace where buyers and seller can meet to arrange their trades. Although buy or sell orders may come from anywhere, the transaction must take place at the exchange according to the rules imposed by the exchange A decentralized market where buy and sell orders initiated from various locations are matched through a communications network. A bond tender offer involves an issuer making an offer to existing bondholders of the company to repurchase a specified number of bonds at a particular price and a specified time

Answer 74

The key to understanding how secondary bond markets are structured and function is to understand liquidity. Liquidity refers to the ability to trade (buy or sell) securities quickly and easily at prices close to their fair market value. Liquidity involves much more than “how quickly one can turn a bond into cash.” This statement implicitly assumes a long position, but some market participants need to buy quickly when covering a short position. The other aspect of liquidity that is often ignored is that speed of trading alone does not constitute a liquid market. One can always buy something quickly by offering a very high price or sell something quickly by accepting a very low price. In a liquid market, trading takes place quickly at prices close to the security’s fair market value.

Answer 75

The process that occurs after a trade is completed, the securities are passed to the buyer, and payment is received by the seller.

Answer 76

A bond issued by a national government. Also called “Sovereign.” Sovereign bonds denominated in local currency have different names in different countries

Answer 77

The most recently issued and most actively traded sovereign securities. The latest sovereign bond issue for a given maturity. It serves as a benchmark against which to compare bonds that have the same features but that are issued by another type of issuer.

Answer 78

Sovereign bonds are usually unsecured obligations of the sovereign issuer—that is, they are backed not by collateral but by the taxing authority of the national government. When a national government runs a budget surplus, excess tax revenues over expenditures are the primary source of funds for making interest payments and repaying the principal. In contrast, when a country runs a budget deficit, the source of the funds used for the payment of interest and repayment of principal comes either from tax revenues and/or by “rolling over” (refinancing) existing debt into new debt. Highly rated sovereign bonds denominated in local currency are virtually free of credit risk. Credit rating agencies assign ratings to sovereign bonds, and these ratings are called sovereign ratings. Credit rating agencies distinguish between bonds issued in the sovereign’s local currency and bonds issued in a foreign currency. In theory, a government can make interest payments and repay the principal by generating cash flows from its unlimited power (in the short run at least) to tax its citizens. A national government also has the ability to print its own currency, whereas it is restricted in being able to pay in a foreign currency only what it earns in exports or can exchange in financial markets. Thus, it is common to observe a higher credit rating for sovereign bonds issued in local currency than for those issued in a foreign currency If the local currency is liquid and freely traded, the sovereign issuer may also attract international investors who may want to hold that sovereign issuer’s bonds and have exposure to that country’s local currency.

Answer 79

Fixed-Rate Bonds Floating-Rate Bonds Inflation-Linked Bonds

Answer 80

Fixed-rate bonds (i.e., bonds that pay a fixed rate of interest) are by far the most common type of sovereign bond two types of fixed-rate bonds: zero-coupon bonds (or pure discount bonds) - A zero-coupon bond does not pay interest. Instead, it is issued at a discount to par value and redeemed at par at maturity coupon bonds - Coupon bonds are issued with a stated rate of interest and make interest payments periodically, such as semi-annually or annually. They have a terminal cash flow equal to the final interest payment plus the par value.

Answer 81

The price of a bond changes in the opposite direction from the change in interest rates investors who hold fixed-rate bonds are exposed to interest rate risk: As interest rates increase, bond prices decrease, which lowers the value of their portfolio. In response to public demand for less interest rate risk, some national governments around the world issue bonds with a floating rate of interest that resets periodically based on changes in the level of a reference rate such as Libor.

Answer 82

Fixed-income investors are exposed to inflation risk. The cash flows of fixed-rate bonds are fixed by contract. If a particular country experiences an inflationary episode, the purchasing power of the fixed cash flows erodes over time. The inflation adjustment can be made via the coupon payments, the principal repayment, or both.

Answer 83

Levels of government below the national level, such as provinces, regions, states, and cities, issue bonds called non-sovereign government bonds or non-sovereign bonds. These bonds are typically issued to finance public projects, such as schools, motorways, hospitals, bridges, and airports. The sources for paying interest and repaying the principal include the taxing authority of the local government, the cash flows of the project the bond issue is financing, or special taxes and fees established specifically for making interest payments and principal repayments. Non-sovereign bonds are typically not guaranteed by the national government. Credit ratings for non-sovereign bonds vary widely because of the differences in credit and collateral quality. Because default rates of non-sovereign bonds are historically low, they very often receive high credit ratings. However, non-sovereign bonds usually trade at a higher yield and lower price than sovereign bonds with similar characteristics. The additional yield depends on the credit quality, the liquidity of the bond issue, and the implicit or explicit level of guarantee or funding commitment from the national government. The additional yield is the lowest for non-sovereign bonds that have high credit quality, are liquid, and are guaranteed by the national government.

Answer 84

National governments establish organizations that perform various functions for them. These organizations often have both public and private sector characteristics, but they are not actual governmental entities. They are referred to as quasi-government entities, although they take different names in different countries. These quasi-government entities often issue bonds to fund specific financing needs. These bonds are known as quasi-government bonds or agency bonds. Most quasi-government bonds, however, do not offer an explicit guarantee by the national government, although investors often perceive an implicit guarantee. Because a quasi-government entity typically does not have direct taxing authority, bonds are repaid from the cash flows generated by the entity or from the project the bond issue is financing. Quasi-government bonds may be backed by collateral, but this is not always the case. Quasi-government bonds are usually rated very high by the credit rating agencies because historical default rates are extremely low. Bonds that are guaranteed by the national government receive the highest ratings and trade at a lower yield and higher price than otherwise similar bonds that are not backed by the sovereign government’s guarantee.

Answer 85

A form of often highly rated bonds is issued by supranational agencies, also referred to as multilateral agencies. Bonds issued by supranational agencies are called supranational bonds. Supranational bonds are typically plain-vanilla bonds, although floating-rate bonds and callable bonds are sometimes issued.

Answer 86

A bilateral loan× A loan from a single lender to a single borrower. is a loan from a single lender to a single borrower. Companies routinely use bilateral loans from their banks, and these bank loans are governed by the bank loan documents. Bank loans are the primary source of debt financing for small and medium-size companies as well as for large companies in countries where bond markets are either underdeveloped or where most bond issuances are from government, government-related entities, and financial institutions. Access to bank loans depends not only on the characteristics and financial health of the company but also on market conditions and bank capital availability.

Answer 87

A syndicated loan is a loan from a group of lenders, called the “syndicate,” to a single borrower. A syndicated loan is a hybrid between relational lending and publicly traded debt. Syndicated loans are primarily originated by banks, and the loans are extended to companies but also to governments and government-related entities. The coordinator, or lead bank, originates the loan, forms the syndicate, and processes the payments. In addition to banks, a variety of lenders participate in the syndicate, such as pension funds, insurance companies, and hedge funds. Syndicated loans are a way for these institutional investors to participate in corporate lending while diversifying the credit risk among a group of lenders.

Answer 88

Commercial paper is a short-term, unsecured promissory note issued in the public market or via a private placement that represents a debt obligation of the issue

Answer 89

Commercial paper is a valuable source of flexible, readily available, and relatively low-cost short-term financing. It is a source of funding for working capital and seasonal demands for cash. It is also a source of bridge financing—that is, interim financing that provides funds until permanent financing can be arranged. The market conditions for issuing long-term bonds may currently be volatile, which would translate into a higher cost of borrowing. Rather than issuing long-term bonds immediately, the company may opt to raise funds with commercial paper and wait for a more favorable environment in which to sell long-term bonds. The maturity of commercial paper can range from overnight to one year, but a typical issue matures in less than three months

Answer 90

Traditionally, only the largest, most stable companies issued commercial paper. Although only the strongest, highest-rated companies issue low-cost commercial paper, issuers from across the risk spectrum can issue commercial paper with higher yields than higher-rated companies. Thus, investors in commercial paper are exposed to various levels of credit risk depending on the issuer’s creditworthiness. Many investors perform their own credit analysis, but most investors also assess a commercial paper’s credit quality by using the ratings provided by credit rating agencies

Answer 91

In most cases, maturing commercial paper is paid with the proceeds of new issuances of commercial paper, a practice referred to as “rolling over the paper.” This practice creates a risk that the issuer will be unable to issue new paper at maturity, referred to as rollover risk. As a safeguard against rollover risk, credit rating agencies often require that commercial paper issuers secure a backup line of credit from banks. The purpose of the backup lines of credit is to ensure that the issuer will have access to sufficient liquidity to repay maturing commercial paper if rolling over the paper is not a viable option. Therefore, backup lines of credit are sometimes called “liquidity enhancement” or “backup liquidity lines.” Issuers of commercial paper may be unable to roll over the paper because of either market-wide or company-specific events

Answer 92

Historically, defaults on commercial paper have been relatively rare, primarily because commercial paper has a short maturity. Each time existing paper matures, investors have another opportunity to assess the issuer’s financial position, and they can refuse to buy the new paper if they estimate that the issuer’s credit risk is too high. Thus, the commercial paper markets adapt more quickly to a change in an issuer’s credit quality than do the markets for longer-term securities. This flexibility reduces the exposure of the commercial paper market to defaults. In addition, corporate managers realize that defaulting on commercial paper would likely prevent any future issuance of this valuable financing alternative. The combination of short-dated maturity, relatively low credit risk, and a large number of issuers makes commercial paper attractive to a diverse range of investors, including money market mutual funds, bank liquidity desks, corporate treasury departments, and other institutional investors that have liquidity constraints. Most commercial paper investors hold their position to maturity. The result is little secondary market trading except for the largest issues. Investors who wish to sell commercial paper prior to maturity can sell it either back to the dealer, to another investor, or in some cases, directly back to the issuer. The yield on commercial paper is typically higher than that on short-term sovereign bonds of the same maturity for two main reasons. First, commercial paper is exposed to credit risk unlike most highly rated sovereign bonds. Second, commercial paper markets are generally less liquid than short-term sovereign bond markets. Thus, investors require higher yields to compensate for the lower liquidity. In the United States, the yield on commercial paper also tends to be higher than that on short-term municipal bonds for tax reasons. Income generated by investments in commercial paper is usually subject to income taxes, whereas income from many municipal bonds is tax exempt. Thus, to attract taxable investors, bonds that are subject to income taxes must offer higher yields than those that are tax exempt.

Answer 93

US Commercial Paper US dollar Overnight to 270 daysa Interest-- Discount basis (instrument is issued at a discount to par value) Settlement-- T + 0 (trade date) Negotiable-- Can be sold to another party Euro commercial Paper Any currency Overnight to 364 days Interest-- Interest-bearing (instrument issued at par and pays interest) or discount basis Settlement-- T + 2 (trade date plus two days) Negotiable-- Can be sold to another party

Answer 94

companies and sovereigns have issued 100-year bonds;

Answer 95

A corporate bond offered continuously to investors by an agent of the issuer, designed to fill the funding gap between commercial paper and long-term bonds.

Answer 96

Zero-coupon bonds pay no coupon. Deferred coupon bonds pay no coupon initially but then offer a higher coupon. Payment-in-kind (PIK) coupon bonds make periodic coupon payments, but not necessarily in cash; the issuer may pay interest in the form of securities, such as bonds or common shares. These types of coupon payment structures increase issuers’ flexibility regarding the servicing of their debt.

Answer 97

Structure for a bond issue in which the maturity dates are spread out during the bond’s life; a stated number of bonds mature and are paid off each year before final maturity. securities with maturities greater than 12 years are considered bonds and securities with maturities between 1 and 12 years are often considered notes

Answer 98

Structure for a bond issue in which the bond’s notional principal is paid off in a lump sum at maturity.

Answer 99

There is a wide range of bonds that are secured by some form of collateral. Companies that need to finance equipment or physical assets may issue equipment trust certificates. Corporate issuers also sell collateral trust bonds that are secured by securities, such as common shares, bonds, or other financial assets. Banks, particularly in Europe, may issue covered bonds, which are a type of debt obligation that is secured by a segregated pool of assets. Asset-backed securities are also secured forms of debt.

Answer 100

Contingency provisions are clauses in the indenture that provide the issuer or the bondholders rights that affect the disposal or redemption of the bond. The three commonly used contingency provisions are call, put, and conversion provisions.

Answer 101

Callable bonds give issuers the ability to retire debt prior to maturity. The most compelling reason for them to do so is to take advantage of lower borrowing rates. By calling the bonds before their maturity date, the issuer can substitute a new, lower-cost bond issue for an older, higher-cost one. In addition, companies may also retire debt to eliminate restrictive covenants or to alter their capital structure to improve flexibility. Because the call provision is a valuable option for the issuer, investors demand compensation ex ante (before investing in the bond). Thus, other things equal, investors require a higher yield (and thus pay a lower price) for a callable bond than for an otherwise similar non-callable bond. Companies also issue putable bonds, which give the bondholders the right to sell the bond back to the issuer at a pre-determined price on specified dates before maturity. Most putable bonds pay a fixed rate of interest, although some bonds may have step-up coupons that increase by specified margins at specified dates. Because the put provision is a valuable option for the bondholders, putable bonds offer a lower yield (and thus have a higher price) than otherwise similar non-putable bonds. The main corporate issuers of putable bonds are investment-grade companies. Putable bonds may offer them a cheaper way of raising capital, especially if the company estimates that the benefit of a lower coupon outweighs the risk associated with the put provision. A convertible bond is a hybrid security that lies on a continuum between debt and equity. It consists of a long position in an option-free bond and a conversion option that gives the bondholder the right to convert the bond into a specified number of shares of the issuer’s common shares. From the issuer’s point of view, convertible bonds make it possible to raise funds that may not be possible without the incentive associated with the conversion option. The more common issuers of convertibles bonds are newer companies that have not established a presence in debt capital markets but who are able to present a more attractive package to institutional investors by including an equity upside potential. Established issuers of bonds may also prefer to issue convertible bonds because they are usually sold at a lower coupon rate than otherwise similar non-convertible bonds as a result of investors’ attraction to the conversion provision. There is a potential equity dilution effect, however, if the bonds are converted. From the investor’s point of view, convertible bonds represent a means of accessing the equity upside potential of the issuer but at a lower risk–reward profile, because there is the floor of the coupon payments in the meantime.

Answer 102

issuing and settling corporate bonds depending on where the securities were registered. This is no longer the case; the processes of issuing and settling bonds are now essentially the same globally. New corporate bond issues are usually sold to investors by investment banks acting as underwriters in the case of underwritten offerings or brokers in the case of best-efforts offerings. They are then settled via the local settlement system. These local systems typically possess a “bridge” to the two Eurobond systems, Euroclear and Clearstream. As for Eurobonds from the corporate sector, they are all issued, traded, and settled in the same way, irrespective of the issuer and its local jurisdiction. Most bond prices are quoted in basis points. The vast majority of corporate bonds are traded in OTC markets through dealers that “make a market” in bonds and sell from their inventory. Dealers do not typically charge a commission or a transaction fee. Instead, they earn a profit from the bid–offer spread. For corporate bonds, settlement differences exist primarily between new bond issues and the secondary trading of bonds. The issuing phase for an underwritten offering usually takes several days. Thus, settlement takes longer for new bond issued than for the secondary trading of bonds, for which settlement is typically on a T + 2 or T + 3 basis.

Answer 103

A financial instrument that shares the common attribute of repackaging risks. Structured financial instruments include asset-backed securities, collateralized debt obligations, and other structured financial instruments such as capital protected, yield enhancement, participation, and leveraged instruments. A common attribute of all these financial instruments is that they repackage and redistribute risks These instruments typically have customized structures that often combine a bond and at least one derivative. Some of these instruments are called structured products. The use of derivatives gives the holder of the structured financial instrument exposure to one or more underlying assets, such as equities, bonds, and commodities. The redemption value and often the coupons of structured financial instruments are linked via a formula to the performance of the underlying asset(s). Thus, the bond’s payment features are replaced with non-traditional payoffs that are derived not from the issuer’s cash flows but from the performance of the underlying asset(s). Although no universally accepted taxonomy exists to categorize structured financial instruments, we will present four broad categories of instruments: capital protected, yield enhancement, participation, and leveraged instruments.

Answer 104

Capital Protected Instruments: We can attempt to explain this instrument with the help of an example. Let us suppose that an investor has $1,000 to invest. The investor buys zero-coupon bond for $990 that will pay off $1,000 one year from now. From the $10 left-over, the investor buys a call option that will expire in one year. The investor will receive $1,000 when the zero-coupon bond on maturity and may also gain from the upside potential of the call option, if any This combination of the zero-coupon bond and the call option can be prepackaged as a structured financial instrument called a guarantee certificate Capital protected instruments offer different levels of capital protection. A guarantee certificate offers full capital protection. Other structured financial instruments may offer only partial capital protection. Note that the capital protection is only as good as the issuer of the instrument. Should the issuer of guarantee certificates go bankrupt, investors may lose their entire capital. These instruments are naturally more prevalent when the general level of interest rates is high and/or implied volatilities (the key driver of option prices, as we will explain later) are low. The cost of the options in the structure must be absorbed by the forfeited interest

Answer 105

Yield enhancement refers to increasing risk exposure in the hope of realizing a higher expected return. Yield Enhancement Instruments: A credit-linked note (CLN) is an example of a yield enhancement instrument. A CLN is a type of instrument that pays regular coupons but whose redemption value depends on the occurrence of a credit event (rating downgrade or the default of an underlying asset). CLNs are usually issued at a discount. Thus, if the specified credit event does not occur, investors will realize a significant capital gain on the purchase of the CLN.

Answer 106

Participation Instruments: These instruments allow investors to participate in the return of an underlying asset. Floating-rate bonds is one of the best examples of participation instrument.

Answer 107

Leveraged Instruments: As the name suggests, these instruments are created to magnify returns and offer the possibility of high payoffs from small investments. One of the examples of leveraged instruments is an inverse floater which is an opposite of a traditional floater. when the reference rate decreases, the coupon payment of an inverse floater increases. A general formula for an inverse floater’s coupon rate is: Inverse floater coupon rate = C –(L ×R) where C is coupon rate, L is leverage and R is interest rate Inverse floaters with a coupon leverage greater than zero but lower than one are called deleveraged inverse floaters. Inverse floaters with a coupon leverage greater than one are called leveraged inverse floaters

Answer 108

Funding refers to the amount of money or resources necessary to finance some specific project or enterprise. Accordingly, funding markets are markets in which debt issuers borrow to meet their financial needs. Companies have a range of funding alternatives, including bank loans, commercial paper, notes, and bonds. Financial institutions such as banks have larger financing needs than non-financial companies because of the nature of their operations.

Answer 109

One of the primary sources of funding for deposit-taking banks is their retail deposit base, which includes funds from both individual and commercial depositors. There are several types of retail deposit accounts. Demand deposits, also known as checking accounts, are available to customers “on demand.” Depositors have immediate access to the funds in their deposit accounts and use the funds as a form of payment for transactions. Because the funds are available immediately, deposit accounts typically pay no interest. In contrast, savings accounts pay interest and allow depositors to accumulate wealth in a very liquid form, but they do not offer the same transactional convenience as demand deposits. Money market accounts were originally designed to compete with money market mutual funds. They offer money market rates of return and depositors can access funds at short or no notice. Thus, money market accounts are, for depositors, an intermediate between demand deposit and savings accounts.

Answer 110

1. Reserve Funds 2. Interbank Funds 3. Large-Denomination Negotiable Certificates of Deposit

Answer 111

Many countries require deposit-taking banks to place a reserve balance with the national central bank. The reserve funds help to ensure sufficient liquidity should depositors require withdrawal of funds. When a bank cannot obtain short-term funding, most countries allow that bank to borrow from the central bank. In aggregate, the reserve funds act as a liquidity buffer, providing comfort to depositors and investors that the central bank can act as lender of last resort. Treatment of interest on reserve funds varies among countries, from a low interest payment, to no interest payment, to charges for keeping reserve funds. Additionally, there is an opportunity cost to the banks for holding reserves with the central bank, in that these funds cannot be invested with higher interest or loaned out to consumers or commercial enterprises. Some banks have an excess over the minimum required funds to be held in reserve. At the same time, other banks run short of required reserves. This imbalance is solved through the central bank funds market, which allows banks that have a surplus of funds to lend money to banks that need funds for maturities of up to one year. These funds are known as central bank funds and are called “overnight funds” when the maturity is one day and “term funds” when the maturity ranges from two days to one year. The interest rates at which central bank funds are bought (i.e., borrowed) and sold (i.e., lent) are short-term interest rates determined by the markets but influenced by the central bank’s open market operations. These rates are termed the central bank funds rates In the United States, the central bank is the Federal Reserve (Fed). The central bank funds and funds rate are called Fed funds and the Fed funds rate, respectively. Other short-term interest rates, such as the yields on Treasury bills, are highly correlated with the Fed funds rate. The most widely followed rate is known as the Fed funds effective rate, which is the volume-weighted average of rates for Fed fund trades arranged throughout the day by the major New York City brokers. Fed funds are traded between banks and other financial institutions globally and may be transacted directly or through money market brokers

Answer 112

The interbank market is the market of loans and deposits between banks. The term to maturity of an interbank loan or deposit ranges from overnight to one year. The rate on an interbank loan or deposit can be quoted relative to a reference rate, such as an interbank offered rate, or as a fixed interest rate. An interbank deposit is unsecured, so banks placing deposits with another bank need to have an interbank line of credit in place for that institution. Usually, a large bank will make a two-way price, indicating the rate at which it will lend funds and the rate at which it will borrow funds for a specific maturity, on demand. Interest on the deposit is payable at maturity. Much interbank dealing takes place on the Reuters electronic dealing system, so that the transaction is done without either party speaking to the other. Because the market is unsecured, it is essentially based on confidence in the banking system. At times of stress, such as in the aftermath of the Lehman Brothers’ bankruptcy in 2008, the market is prone to “dry up” as banks withdraw from funding other banks.

Answer 113

A certificate of deposit (CD) is an instrument that represents a specified amount of funds on deposit for a specified maturity and interest rate. CDs are an important source of funds for financial institutions. A CD may take one of two forms: non-negotiable or negotiable. If the CD is non-negotiable, the deposit plus the interest are paid to the initial depositor at maturity. A withdrawal penalty is imposed if the depositor withdraws funds prior to the maturity date. Alternatively, a negotiable CD allows any depositor (initial or subsequent) to sell the CD in the open market prior to the maturity date. Negotiable CDs were introduced in the United States in the early 1960s when various types of deposits were constrained by interest rate ceilings. At the time, bank deposits were not an attractive investment because investors earned a below-market interest rate unless they were prepared to commit their capital for an extended period. The introduction of negotiable CDs enabled bank customers to buy a three-month or longer negotiable instrument yielding a market interest rate and to recover their investment by selling it in the market. This innovation helped banks increase the amount of funds raised in the money markets. It also fostered competition among deposit-taking institutions. There are two types of negotiable CDs: large-denomination CDs and small-denomination CDs. Thresholds between small- and large-denomination CDs vary among countries. For example, in the United States, large-denomination CDs are usually issued in denominations of $1 million or more. Small-denomination CDs are a retail-oriented product, and they are of secondary importance as a funding alternative. Large-denomination CDs, in contrast, are an important source of wholesale funds and are typically traded among institutional investors. Like other money market securities, CDs are available in domestic bond markets as well as in the Eurobond market. Most CDs have maturities shorter than one year and pay interest at maturity. CDs with longer maturities are called “term CDs.” Yields on CDs are driven primarily by the credit risk of the issuing bank and to a lesser extent by the term to maturity. The spread attributable to credit risk will vary with economic conditions and confidence in the banking system in general and in the issuing bank in particular. As with all debt instruments, spreads widen during times of financial turmoil in response to increased risk aversion

Answer 114

Repurchase agreements are another important source of funding not only for banks but also for other market participants. A repurchase agreement or repo is the sale of a security with a simultaneous agreement by the seller to buy the same security back from the purchaser at an agreed-on price and future date. In practical terms, a repurchase agreement can be viewed as a collateralized loan in which the security sold and subsequently repurchased represents the collateral posted. One party is borrowing money and providing collateral for the loan at an interest rate that is typically lower than on an otherwise similar bank loan. The other party is lending money while accepting a security as collateral for the loan. Repurchase agreements are a common source of money market funding for dealer firms in many countries. An active market in repurchase agreements underpins every liquid bond market. Financial and non-financial companies participate actively in the market as both sellers and buyers of collateral depending on their circumstances. Central banks are also active users of repurchase agreements in their daily open market operations; they either lend to the market to increase the supply of funds or withdraw surplus funds from the market.

Answer 115

The price at which the party who sold the security at the inception of the repurchase agreement buys back the security from the cash lending counterparty

Answer 116

The date when the party who sold the security at the inception of a repurchase agreement buys back the security from the cash lending counterparty.

Answer 117

When the term of a repurchase agreement is one day, it is called an “overnight repo.” When the agreement is for more than one day, it is called a “term repo.” An agreement lasting until the final maturity date is known as a “repo to maturity.

Answer 118

The risk associated with the collateral. Repo rates are typically lower for highly rated collaterals, such as highly rated sovereign bonds. They increase with the level of credit risk associated with the collateral underlying the transaction. The term of the repurchase agreement. Repo rates generally increase with maturity because long-term rates are typically higher than short-term rates in normal circumstances. The delivery requirement for the collateral. Repo rates are usually lower when delivery to the lender is required. The supply and demand conditions of the collateral. The more in demand a specific piece of collateral is, the lower the repo rate against it because the borrower has a security that lenders of cash want for specific reasons, perhaps because the underlying issue is in great demand. The demand for such collateral means that it considered to be “on special.” Collateral that is not special is known as “general collateral.” The party that has a need for collateral that is on special is typically required to lend funds at a below-market repo rate to obtain the collateral. The interest rates of alternative financing in the money market.

Answer 119

A repurchase agreement viewed from the perspective of the cash lending counterparty

Answer 120

Each market participant in a repurchase agreement is exposed to the risk that the counterparty defaults, regardless of the collateral exchanged. Credit risk is present even if the collateral is a highly rated sovereign bond. Suppose that a dealer (i.e., the borrower of cash) defaults and is not in a position to repurchase the collateral on the specified repurchase date. The lender of funds takes possession of the collateral and retains any income owed to the borrower. The risk is that the price of the collateral has fallen following the inception of the repurchase agreement, causing the market value of the collateral to be lower than the unpaid repurchase price. Conversely, suppose the investor (i.e., the lender of cash) defaults and is unable to deliver the collateral on the repurchase date. The risk is that the price of the collateral has risen since the inception of the repurchase agreement, resulting in the dealer now holding an amount of cash lower than the market value of the collateral. In this case, the investor is liable for any excess of the price paid by the dealer for replacement of the securities over the repurchase price. Although both parties to a repurchase agreement are subject to credit risk, the agreement is structured as if the lender of funds is the most vulnerable party. Specifically, the amount lent is lower than the collateral’s market value. The difference between the market value of the security used as collateral and the value of the loan is known as the repo margin, although the term haircut is more commonly used, particularly in the United States. The repo margin allows for some worsening in market value and thus provides the cash lender a margin of safety if the collateral’s market value declines. Repo margins vary by transaction and are negotiated bilaterally between the counterparties. The level of margin is a function of the following factors: The length of the repurchase agreement. The longer the repurchase agreement, the higher the repo margin. The quality of the collateral. The higher the quality of the collateral, the lower the repo margin. The credit quality of the counterparty. The higher the creditworthiness of the counterparty, the lower the repo margin. The supply and demand conditions of the collateral. Repo margins are lower if the collateral is in short supply or if there is a high demand for it

Answer 121

On a traditional (option-free) fixed-rate bond, the promised future cash flows are a series of coupon interest payments and repayment of the full principal at maturity. The coupon payments occur on regularly scheduled dates The price of the bond at issuance is the present value of the promised cash flows.

Answer 122

The market discount rate is used in the time-value-of-money calculation to obtain the present value. The market discount rate is the rate of return required by investors given the risk of the investment in the bond. It is also called the required yield, or the required rate of return.

Answer 123

The price of the bond is the sum of the present values of the cash flows. coupon rate / 1+ req rate raised to n When the coupon rate is less than the market discount rate, the bond is priced at a discount below par value. When the coupon rate is greater than the market discount rate, the bond is priced at a premium above par value. When the coupon rate is equal to the market discount rate, the bond is priced at par value. The coupon rate indicates the amount the issuer promises to pay the bondholders each year in interest. The market discount rate reflects the amount investors need to receive in interest each year in order to pay full par value for the bond.

Answer 124

PV=PMT/(1+r)+PMT/(1+r)+⋯+PMT+FV/(1+r)N PV = present value, or the price of the bond PMT = coupon payment per period FV = future value paid at maturity, or the par value of the bond r = market discount rate, or required rate of return per period N = number of evenly spaced periods to maturity

Answer 125

The yield-to-maturity is the internal rate of return on the cash flows—the uniform interest rate such that when the future cash flows are discounted at that rate, the sum of the present values equals the price of the bond. It is the implied market discount rate. For example, suppose that a four-year, 5% annual coupon payment bond is priced at 105 per 100 of par value. The yield-to-maturity is the solution for the rate, r, in this equation: N=4, PMT=5, PV= -105, FV=100; CPT I/Y =3.634% (On calc) The yield-to-maturity is the rate of return on the bond to an investor given three critical assumptions :- The investor holds the bond to maturity. The issuer makes all the coupon and principal payments in the full amount on the scheduled dates. Therefore, the yield-to-maturity is the promised yield—the yield assuming the issuer does not default on any of the payments. The investor is able to reinvest coupon payments at that same yield. This is a characteristic of an internal rate of return.

Answer 126

The yield-to-maturity on a bond may be positive or negative. In fact, following the launch of unconventional monetary policies in many regions after the global financial crisis of 2008–2009, yields on many government bonds fell into the negative territory. The market value of negative-yielding bonds reached $17 trillion in August 2019, amounting to roughly 1 in 3 of all investment-grade bonds, according to the Bloomberg Barclays Global-Aggregate Index. Bonds with a negative yield-to-maturity include those issued at higher yields in the past that have experienced significant price appreciation, as well as newly issued zero-coupon sovereign government bonds priced at a premium to par value

Answer 127

The bond price is inversely related to the market discount rate. When the market discount rate increases, the bond price decreases (the inverse effect). For the same coupon rate and time-to-maturity, the percentage price change is greater (in absolute value, meaning without regard to the sign of the change) when the market discount rate goes down than when it goes up (the convexity effect). For the same time-to-maturity, a lower-coupon bond has a greater percentage price change than a higher-coupon bond when their market discount rates change by the same amount (the coupon effect). Generally, for the same coupon rate, a longer-term bond has a greater percentage price change than a shorter-term bond when their market discount rates change by the same amount (the maturity effect).

Answer 128

The first relationship is that the bond price and the market discount rate move inversely The second relationship reflects the convexity effect. In the percentage price changes are calculated using this equation: % Change=New price−Old price/Old price For each bond, the percentage price increases are greater in absolute value than the percentage price decreases. This implies that the relationship between bond prices and the market discount rate is not linear; instead, it is curved. It is described as being “convex.” The third relationship is the coupon effect. lower-coupon bonds have more price volatility than higher-coupon bonds, other things being equal. The fourth relationship is the maturity effect. longer-term bonds have more price volatility than shorter-term bonds, other things being equal. A bond having a coupon rate equal to the market discount rate is priced at par value on a coupon payment date

Answer 129

A graph that illustrates the change in the price of a fixed-income bond over time assuming no change in yield-to-maturity. The trajectory shows the “pull to par” effect on the price of a bond trading at a premium or a discount to par value. If the issuer does not default, the price of a bond approaches par value as its time-to-maturity approaches zero.

Answer 130

When a fixed-rate bond is priced using the market discount rate, the same discount rate is used for each cash flow. A more fundamental approach to calculate the price of a bond is to use a sequence of market discount rates that correspond to the cash flow dates. These market discount rates are called spot rates. Spot rates are yields-to-maturity on zero-coupon bonds maturing at the date of each cash flow. Sometimes these are called “zero rates.” Bond price (or value) determined using the spot rates is sometimes referred to as the bond’s “no-arbitrage value.” If a bond’s price differs from its no-arbitrage value, an arbitrage opportunity exists in the absence of transaction costs the present values of the individual cash flows discounted using spot rates differ from those using the yield-to-maturity

Answer 131

PV=PMT(1+Z1)^1+PMT(1+Z2)^2+⋯+PMT+FV(1+ZN)^N Z1 = spot rate, or zero-coupon yield, or zero rate, for Period 1 Z2 = spot rate, or zero-coupon yield, or zero rate, for Period 2 ZN = spot rate, or zero-coupon yield, or zero rate, for Period N

Answer 132

The full price of a bond minus the accrued interest; also called the quoted or clean price Interest earned but not yet paid The price of a security with accrued interest; also called the invoice or dirty price Date when the buyer makes cash payment and the seller delivers the security. The flat price usually is quoted by bond dealers. If a trade takes place, the accrued interest is added to the flat price to obtain the full price paid by the buyer and received by the seller on the settlement date. The reason for using the flat price for quotation is to avoid misleading investors about the market price trend for the bond. If the full price were to be quoted by dealers, investors would see the price rise day after day even if the yield-to-maturity did not change. That is because the amount of accrued interest increases each day. Then, after the coupon payment is made, the quoted price would drop dramatically. Using the flat price for quotation avoids that misrepresentation.

Answer 133

PVFull = PVFlat + AI.

Answer 134

AI=t/T×PMT t = number of days from the last coupon payment to the settlement date T = number of days in the coupon period t/T = fraction of the coupon period that has gone by since the last payment PMT = coupon payment per period There are different conventions used in bond markets to count days. The two most common day-count conventions are actual/actual and 30/360. For the actual/actual method, the actual number of days is used, including weekends, holidays, and leap days For example, a semiannual payment bond pays interest on 15 May and 15 November of each year. The accrued interest for settlement on 27 June would be the actual number of days between 15 May and 27 June (t = 43 days) divided by the actual number of days between 15 May and 15 November (T = 184 days), times the coupon payment. If the stated coupon rate is 4.375%, the accrued interest is 0.511209 per 100 of par value. AI=43184×4.3752=0.511209.

Answer 135

PVFull=PMT(1+r)1−t/T+PMT(1+r)2−t/T+⋯+PMT+FV(1+r)N−t/T. | PV×(1+r)t/T.

Answer 136

Process of estimating the market discount rate and price of a bond based on the quoted or flat prices of more frequently traded comparable bonds.

Answer 137

Matrix pricing also is used in underwriting new bonds to get an estimate of the required yield spread over the benchmark rate. The benchmark rate typically is the yield-to-maturity on a government bond having the same or close to the same time-to-maturity. The spread is the difference between the yield-to-maturity on the new bond and the benchmark rate. The yield spread is the additional compensation required by investors for the difference in the credit risk, liquidity risk, tax status, and other risk premiums of the bond relative to the government bond. This spread is sometimes called the spread over the benchmark. Yield spreads are often stated in terms of basis points (bps), where one basis point equals one-hundredth of a percentage point. For example, if a yield-to-maturity is 2.25% and the benchmark rate is 1.50%, the yield spread is 0.75%, or 75 bps.

Answer 138

The first step is to determine the yields-to-maturity on the observed bonds. The required yield on the three-year, 5.50% bond priced at 107.500 is 2.856%. 107.500=5.50(1+r)1+5.50(1+r)2+105.50(1+r)3; r=0.02856. The required yield on the five-year, 4.50% bond priced at 104.750 is 3.449%. 104.750=4.50(1+r)1+4.50(1+r)2+4.50(1+r)3+4.50(1+r)4+104.50(1+r)5; r=0.03449. The estimated market discount rate for a four-year bond having the same credit quality is the average of two required yields: 0.02856+0.034492=0.031525. Given an estimated yield-to-maturity of 3.1525%, the estimated price of the illiquid four-year, 4.50% annual coupon payment corporate bond is 104.991 per 100 of par value. 4.50(1.031525)1+4.50(1.031525)2+4.50(1.031525)3+104.50(1.031525)4=104.991.

Answer 139

The assumed number of periods in the year; typically matches the frequency of coupon payments.

Answer 140

The amount by which a unit of currency will grow in a year with interest on interest included. An effective annual rate has a periodicity of one because there is just one compounding period in the year.

Answer 141

An annual rate having a periodicity of two is known as a semiannual bond basis yield, or semiannual bond equivalent yield. Therefore, a semiannual bond basis yield is the yield per semiannual period times two. It is important to remember that “semiannual bond basis yield” and “yield per semiannual period” have different meanings. For example, if a bond yield is 2% per semiannual period, its annual yield is 4% when stated on a semiannual bond basis.

Answer 142

An important tool used in fixed-income analysis is to convert an annual yield from one periodicity to another. These are called periodicity, or compounding, conversions. A general formula to convert an annual percentage rate for m periods per year, denoted APRm = (1+APRm/m)^m=(1+APRn/n)^n. also applies to negative bond yield

Answer 143

A yield measure that neglects weekends and holidays; the internal rate of return on cash flows assuming payments are made on the scheduled dates, even when the scheduled date falls on a weekend or holiday.

Answer 144

The internal rate of return on cash flows using the actual calendar, including weekends and bank holidays. The true yield is never higher than the street convention yield because weekends and holidays delay the time to payment. The difference is typically small, no more than a basis point or two. Therefore, the true yield is not commonly used in practice.

Answer 145

A yield that restates a yield-to-maturity based on a 30/360 day count to one based on actual/actual. The government equivalent yield on a corporate bond can be used to obtain the spread over the government yield.

Answer 146

The sum of the coupon payments received over the year divided by the flat price; also called the income or interest yield or running yield.

Answer 147

The sum of the coupon payments plus the straight-line amortized share of the gain or loss, divided by the flat price.

Answer 148

Contingency provisions that provide the issuer or the bondholders the right, but not the obligation, to take action. These options are not part of the security and cannot be traded separately.

Answer 149

. A call protection period is the time during which the issuer of the bond is not allowed to exercise the call option.

Answer 150

The lowest of the sequence of yields-to-call and the yield-to-maturity.

Answer 151

The value of the embedded option plus the flat price of the bond.

Answer 152

Notes on which interest payments are not fixed but instead vary from period to period depending on the current level of a reference interest rate. The intent of an FRN is to offer the investor a security that has less market price risk than a fixed-rate bond when market interest rates fluctuate. In principle, a floater has a stable price even in a period of volatile interest rates. With a traditional fixed-income security, interest rate volatility affects the price because the future cash flows are constant. With a floating-rate note, interest rate volatility affects future interest payments. a specified yield spread is added to or subtracted from the reference rate.

Answer 153

The yield spread over or under the reference rate such that an FRN is priced at par value on a rate reset date

Answer 154

If there is no change in the credit risk of the issuer, the required margin remains same Changes in the required margin usually come from changes in the issuer’s credit risk. Changes in liquidity or tax status also could affect the required margin. Between coupon dates, its flat price will be at a premium or discount to par value if MRR goes, respectively, down or up. However, if the required margin continues to be the same as the quoted margin, the flat price is “pulled to par” as the next reset date nears. At the reset date, any change in MRR is included in the interest payment for the next period.

Answer 155

Fixed-rate and floating-rate bonds are essentially the same with respect to changes in credit risk. With fixed-rate bonds, the premium or discount arises from a difference in the fixed coupon rate and the required yield-to-maturity. With floating-rate bonds, the premium or discount arises from a difference in the fixed quoted margin and the required margin. However, fixed-rate and floating-rate bonds are very different with respect to changes in benchmark interest rates.

Answer 156

PV=(Index+QM)×FVm(1+Index+DMm)1+(Index+QM)×FVm(1+Index+DMm)2+⋯+ (Index+QM)×FVm+FV(1+Index+DMm)N,

Answer 157

Money market instruments are short-term debt securities. They range in time-to-maturity from overnight sale and repurchase agreements (repos) to one-year bank certificates of deposit. Money market instruments also include commercial paper, government issues of less than one year, bankers’ acceptances, and time deposits based on such indexes as Libor and Euribor. Money market mutual funds are a major investor in such securities. These mutual funds can invest only in certain eligible money market securities.

Answer 158

1. Bond yields-to-maturity are annualized and compounded. Yield measures in the money market are annualized but not compounded. Instead, the rate of return on a money market instrument is stated on a simple interest basis. 2. Bond yields-to-maturity can be calculated using standard time-value-of-money analysis and with formulas programmed into a financial calculator. Money market instruments often are quoted using non-standard interest rates and require different pricing equations than those used for bonds. 3. Bond yields-to-maturity usually are stated for a common periodicity for all times-to-maturity. Money market instruments having different times-to-maturity have different periodicities for the annual rate.

Answer 159

PV=FV×(1−Days/Year ×DR) PV = present value, or the price of the money market instrument FV = future value paid at maturity, or the face value of the money market instrument Days = number of days between settlement and maturity Year = number of days in the year DR = discount rate, stated as an annual percentage rate DR=(Year/Days)×(FV−PV/FV).

Answer 160

PV=FV/(1+Days/Year ×AOR), PV = present value, principal amount, or the price of the money market instrument FV = future value, or the redemption amount paid at maturity including interest Days = number of days between settlement and maturity Year = number of days in the year AOR = add-on rate, stated as an annual percentage rate AOR=(Year/Days)×(FV−PV/PV).

Answer 161

(1) some instruments are quoted on a discount rate basis and others on an add-on rate basis and (2) some are quoted for a 360-day year and others for a 365-day year. Another difference is that the “amount” of a money market instrument quoted on a discount rate basis typically is the face value paid at maturity. However, the “amount” when quoted on an add-on rate basis usually is the principal, the price at issuance. To make money market investment decisions, it is essential to compare instruments on a common basis.

Answer 162

A bond equivalent yield is a money market rate stated on a 365-day add-on rate basis. If the risks are the same, the commercial paper offers 2.5 bps more in annual return than the bank time deposit.

Answer 163

Currency—Bond X could be denominated in a currency with a higher expected rate of inflation than the currency in which Bond Y is denominated. Credit risk—Bond X could have a non-investment-grade rating of BB, and Bond Y could have an investment-grade rating of AA. Liquidity—Bond X could be illiquid, and Bond Y could be actively traded. Tax status—Interest income on Bond X could be taxable, whereas interest income on Bond Y could be exempt from taxation. Periodicity—Bond X could make a single annual coupon payment, and its yield-to-maturity could be quoted for a periodicity of one. Bond Y could make monthly coupon payments, and its yield-to-maturity could be annualized for a periodicity of 12.

Answer 164

A sequence of yields-to-maturity on zero-coupon bonds. Sometimes called zero or strip curve (because coupon payments are “stripped” off the bonds).

Answer 165

spot curve is upward sloping and a spot curve is downward sloping in that shorter-term yields are higher than longer-term yields. Such downward-sloping spot curves are called inverted yield curves. This hypothetical spot curve is ideal for analyzing maturity structure because it best meets the “other things being equal” assumption

Answer 166

Money market securities often are settled on a “same day,” or “cash settlement,” basis.

Answer 167

A forward market is for future delivery, beyond the usual settlement time period in the cash market. Agreement to the terms for the transaction is on the trade date, but delivery of the security and payment for it are deferred to a future date. A forward rate is the interest rate on a bond or money market instrument traded in a forward market.

Answer 168

Calculated from spot rates, an implied forward rate is a breakeven reinvestment rate that links the return on an investment in a shorter-term zero-coupon bond to the return on an investment in a longer-term zero-coupon bond.

Answer 169

(1 + zA)A × (1 + IFRA,B–A)B–A = (1 + zB)B

Answer 170

Forward rates are used to make maturity decisions. They are used to identify arbitrage opportunities between transactions in the cash market for bonds and in derivatives markets. Forward rates are important in the valuation of derivatives, especially interest rate swaps and options. Those applications for the forward curve are covered elsewhere. Forward rates can be used to value a fixed-income security in the same manner as spot rates because they are interconnected. The spot curve can be calculated from the forward curve, and the forward curve can be calculated from the spot curve.

Answer 171

A yield spread, in general, is the difference in yield between different fixed-income securities

Answer 172

The benchmark yield for a fixed-income security with a given time-to-maturity is the base rate, often a government bond yield.

Answer 173

The spread is the difference between the yield-to-maturity and the benchmark

Answer 174

The benchmark captures the macroeconomic factors: the expected rate of inflation in the currency in which the bond is denominated, general economic growth and the business cycle, foreign exchange rates, and the impact of monetary and fiscal policy. Changes in those factors impact all bonds in the market, and the effect is seen mostly in changes in the benchmark yield.

Answer 175

The spread captures the microeconomic factors specific to the bond issuer and the bond itself: credit risk of the issuer and changes in the quality rating on the bond, liquidity and trading in comparable securities, and the tax status of the bond. It should be noted, however, that general yield spreads across issuers can widen and narrow with changes in macroeconomic factors

Answer 176

the building blocks of the yield-to-maturity, starting with the benchmark and the spread. The benchmark is often called the risk-free rate of return. Also, the benchmark can be broken down into the expected real rate and the expected inflation rate in the economy. The yield spread is called the risk premium over the “risk-free” rate of return. The risk premium provides the investor with compensation for the credit and liquidity risks and possibly the tax impact of holding a specific bond.

Answer 177

The most recently issued and most actively traded sovereign securities. and has a coupon rate closest to the current market discount rate for that maturity.

Answer 178

Seasoned government bonds are off-the-run securities; they are not the most recently issued or the most actively traded.

Answer 179

The yield spread over a specific benchmark, usually measured in basis points.

Answer 180

The yield spread in basis points over an actual or interpolated government bond.

Answer 181

The yield spread of a specific bond over the standard swap rate in that currency of the same tenor.

Answer 182

Converts the periodic fixed coupon of a specific bond to an MRR plus or minus a spread.

Answer 183

Calculates a constant yield spread over a government (or interest rate swap) spot curve. PV=PMT(1+z1+Z)1+PMT(1+z2+Z)2+⋯+PMT+FV(1+zN+Z)N

Answer 184

OAS = Z-spread – Option value (in basis points per year).

Answer 185

A process that involves moving assets into a special legal entity, which then uses the assets as guarantees to secure a bond issue.

Answer 186

A type of bond issued by a legal entity called a special purpose entity (SPE) on a collection of assets that the SPE owns. Also, securities backed by receivables and loans other than mortgages.

Answer 187

Assets that are typically used to create asset-backed bonds; for example, when a bank securitizes a pool of loans, the loans are said to be securitized.

Answer 188

Debt obligations that represent claims to the cash flows from pools of mortgage loans, most commonly on residential property.

Answer 189

Senior debt obligations issued by a financial institution and backed by a segregated pool of assets. Covered bond investors have recourse to both the underlying assets and the financial institution.

Answer 190

1. Securitization reduces intermediation costs which results in lower funding costs for borrowers and higher risk adjusted returns for lenders 2.With securitization the investors legal claim to the mortgages or other loans is stronger than it is with only a general claim against the bank's overall assets 3.When a bank securitizes its loans, the securities are actively traded, which increases the liquidity of the bank’s assets compared to holding the loans 4.By securitizing loans, banks are able to lend more than if they could only fund loans with bank assets. When a loan portfolio is securitized, the bank receives the proceeds, which can then be used to make more loans. Securitization has led to

Answer 191

In such a structure, there is more than one bond class or tranche, and the bond classes differ as to how they will share any losses resulting from defaults of the borrowers whose loans are in the collateral. The bond classes are classified as senior bond classes or subordinated bond classes—hence, the reason this structure is also referred to as a senior/subordinated structure. The subordinated bond classes are sometimes called “non-senior bond classes” or “junior bond classes.” They function as credit protection for the more senior bond classes; that is, losses are realized by the subordinated bond classes before any losses are realized by the senior bond classes. This type of protection is also commonly referred to as a “waterfall” structure because of the cascading flow of payments between bond classes in the event of default.

Answer 192

The uncertainty that the timing of the actual cash flows will be different from the scheduled cash flows as set forth in the loan agreement due to the borrowers’ ability to alter payments, usually to take advantage of interest rate movements. For example, when interest rates decline, borrowers tend to pay off part or all of their loans and refinance at lower interest rates.

Answer 193

The creation of classes or tranches in an ABS/MBS that possess different (expected) maturities.

Answer 194

the credit spread is whether the bond is backed by collateral. A corporate bond that has collateral is often referred to as a secured bond. The collateral usually reduces the credit spread, making the credit spread of a secured bond lower than that of an otherwise identical unsecured bond

Answer 195

A loan secured by the collateral of some specified real estate property that obliges the borrower to make a predetermined series of payments to the lender.

Answer 196

Allows the lender to take possession of a mortgaged property if the borrower defaults and then sell it to recover funds.

Answer 197

The ratio of a property’s purchase price to the amount of its mortgage. The lower the LTV, the higher the borrower’s equity. From the lender’s perspective, the higher the borrower’s equity, the less likely the borrower is to default. Moreover, the lower the LTV, the more protection the lender has for recovering the amount loaned if the borrower does default and the lender repossesses and sells the property.

Answer 198

Prime loans generally have borrowers of high credit quality with strong employment and credit histories, income sufficient to pay the loan obligation, and substantial equity in the underlying property.

Answer 199

Subprime loans have borrowers with lower credit quality and/or are loans without a first lien on the property (that is, another party has a prior claim on the underlying property).

Answer 200

(1) the maturity of the loan, (2) how the interest rate is determined, (3) how the principal is to be repaid (that is, the amortization schedule), (4) whether the borrower has the option to prepay and, in such cases, whether any prepayment penalties might be imposed, and (5) the rights of the lender in a foreclosure

Answer 201

the mortgage rate, contract rate, or note rate.

Answer 202

Fixed rate: The mortgage rate remains the same during the life of the mortgage. The United States and France have a high proportion of this type of interest rate determination. Although fixed-rate mortgages are not the dominant form in Germany, they do exist there.

Answer 203

The mortgage rate is reset periodically—daily, weekly, monthly, or annually. The determination of the new mortgage rate for an adjustable-rate mortgage (ARM) at the reset date may be based on some reference rate or index (in which case, it is called an indexed-referenced ARM) or a rate determined at the lender’s discretion (in which case, it is called a reviewable ARM).

Answer 204

Initial period fixed rate: The mortgage rate is fixed for some initial period and is then adjusted. The adjustment may call for a new fixed rate or for a variable rate. When the adjustment calls for a fixed rate, the mortgage is referred to as a rollover or renegotiable mortgage.

Answer 205

Convertible: The mortgage rate is initially either a fixed rate or an adjustable rate. At some point, the borrower has the option to convert the mortgage to a fixed rate or an adjustable rate for the remainder of the mortgage’s life. Almost half of the mortgages in Japan are convertible.

Answer 206

Loans with a payment schedule that calls for periodic payments of interest and repayments of principal.

Answer 207

In a fully amortizing loan, the sum of all the scheduled principal repayments during the mortgage’s life is such that when the last mortgage payment is made, the loan is fully repaid.

Answer 208

In a partially amortizing loan, the sum of all the scheduled principal repayments is less than the amount borrowed. The final payment then includes the unpaid mortgage balance, sometimes referred to as a “balloon” payment.

Answer 209

A loan in which no scheduled principal repayment is specified for a certain number of years.

Answer 210

Contractual provision that entitles the borrower to prepay all or part of the outstanding mortgage principal prior to the scheduled due date when the principal must be repaid. Also called early repayment option.

Answer 211

Mortgages that stipulate a monetary penalty if a borrower prepays within a certain time period after the mortgage is originated.

Answer 212

A loan in which the lender has a claim against the borrower for any shortfall between the outstanding mortgage balance and the proceeds received from the sale of the property.

Answer 213

A loan in which the lender does not have a shortfall claim against the borrower, so the lender can look only to the property to recover the outstanding mortgage balance.

Answer 214

mortgages for which the value of the property has declined below the amount owed by the borrower.

Answer 215

(1) those guaranteed by a federal agency, (2) those guaranteed by a GSE, and (3) those issued by private entities and that are not guaranteed by a federal agency or a GSE. The first two sectors are referred to as agency RMBS, and the third sector is referred to as non-agency RMBS.

Answer 216

Agency RMBS include securities issued by federal agencies, such as the Government National Mortgage Association, popularly referred to as Ginnie Mae Agency RMBS also include RMBS issued by GSEs, such as Fannie Mae and Freddie Mac. RMBS issued by GSEs do not carry the full faith and credit of the US government.

Answer 217

First, the credit risk of the RMBS issued by Fannie Mae and Freddie Mac is reduced by the guarantee of the GSE itself, which charges a fee for insuring the issue. In contrast, non-agency RMBS use credit enhancements to reduce credit risk. The pool of securitized loans is another way in which RMBS issued by GSEs differ from non-agency RMBS. Loans included in agency RMBS must meet specific underwriting standards established by various government agencies. These standards set forth the maximum size of the loan, the loan documentation required, the maximum loan-to-value ratio, and whether insurance is required. Loans satisfying the underwriting standards for inclusion as collateral for an agency RMBS are called “conforming” mortgages; otherwise, loans are categorized as “non-conforming” mortgages.

Answer 218

A security created when one or more holders of mortgages form a pool of mortgages and sell shares or participation certificates in the pool. A pool can consist of several thousand or only a few mortgages. When a mortgage is used as collateral for a mortgage pass-through security, the mortgage is said to be securitized.

Answer 219

The cash flows of a mortgage pass-through security depend on the cash flows of the underlying pool of mortgages. The cash flows consist of monthly mortgage payments representing interest, the scheduled repayment of principal, and any prepayments. Cash payments are made to security holders each month. Neither the amount nor the timing of the cash flows from the pool of mortgages, however, is necessarily identical to that of the cash flow passed through to the security holders. In fact, the monthly cash flows of a mortgage pass-through security are less than the monthly cash flows of the underlying pool of mortgages by an amount equal to the servicing and other administrative fees. Not all mortgages included in a pool of securitized mortgages have the same mortgage rate and the same maturity. Consequently, for each mortgage pass-through security, a weighted average coupon rate (WAC) and a weighted average maturity (WAM) are determined. The WAC is calculated by weighting the mortgage rate of each mortgage in the pool by the percentage of the outstanding mortgage balance relative to the outstanding amount of all the mortgages in the pool. Similarly, the WAM is calculated by weighting the remaining number of months to maturity of each mortgage in the pool by the outstanding mortgage balance relative to the outstanding amount of all the mortgages in the pool

Answer 220

The servicing fee is the charge related to administrative tasks, such as collecting monthly payments from borrowers, forwarding proceeds to owners of the loan, sending payment notices to borrowers, reminding borrowers when payments are overdue, maintaining records of the outstanding mortgage balance, initiating foreclosure proceedings if necessary, and providing tax information to borrowers when applicable. The servicing fee is typically a portion of the mortgage rate. The other administrative fees are those charged by the issuer or financial guarantor of the mortgage pass-through security for guaranteeing the issue.

Answer 221

A mortgage pass-through security’s coupon rate is called the pass-through rate. The pass-through rate is lower than the mortgage rate on the underlying pool of mortgages by an amount equal to the servicing and other administrative fees. The pass-through rate that the investor receives is said to be “net interest” or “net coupon.”

Answer 222

Mortgage pass-through security cash flows are uncertain because they depend on actual prepayments Prepayment risk has two components: contraction risk and extension risk, both of which largely reflect changes in the general level of interest rates.

Answer 223

jabh interest rate decline hote h tabh mortgage holders apna karza jaldi chukate h resulting in prepayment of mortgage. isliye jo security is backed by a mortgage will have a shorter maturity resulting in adverse consequences : investors ko lower int rate par reinvest karna pdega aur agar callable security ho toh bhi prblm Contraction risk is the risk that when interest rates decline, actual prepayments will be higher than forecasted because homeowners will refinance at now-available lower interest rates. Thus, a security backed by mortgages will have a shorter maturity than was anticipated at the time of purchase. Holding a security whose maturity becomes shorter when interest rates decline has two adverse consequences for investors. First, investors must reinvest the proceeds at lower interest rates. Second, if the security is prepayable or callable, its price appreciation is not as great as that of an otherwise identical bond without a prepayment or call option.

Answer 224

In contrast, extension risk is the risk that when interest rates rise, prepayments will be lower than forecasted because homeowners are reluctant to give up the benefits of a contractual interest rate that now looks low. As a result, a security backed by mortgages will typically have a longer maturity than was anticipated at the time of purchase. From the investor’s perspective, the value of the security has fallen because the higher interest rates translate into a lower price for the security, and the income investors receive (and can potentially reinvest) is typically limited to the interest payment and scheduled principal repayments.

Answer 225

In describing prepayments, market participants refer to the prepayment rate or prepayment speed. The two key prepayment rate measures are the single monthly mortality rate (SMM), a monthly measure, and its corresponding annualized rate, the conditional prepayment rate (CPR). A key factor in the valuation of a mortgage pass-through security and other products derived from a pool of mortgages is forecasting the future prepayment rate. This task involves prepayment modeling. Prepayment modeling uses characteristics of the mortgage pool and other factors to develop a statistical model for forecasting future prepayments. In the United States, market participants describe prepayment rates in terms of a prepayment pattern or benchmark over the life of a mortgage pool. This pattern is the Public Securities Association (PSA) prepayment benchmark, which is produced by the Securities Industry and Financial Markets Association (SIFMA). The PSA prepayment benchmark is expressed as a series of monthly prepayment rates. Based on historical patterns, it assumes that prepayment rates are low for newly originated mortgages and then speed up as the mortgages become seasoned. Slower or faster prepayment rates are then referred to as some percentage of the PSA prepayment benchmark. Rather than going into the details of the PSA prepayment benchmark, this discussion will rely on some PSA assumptions. What is important to remember is that the standard for the PSA model is 100 PSA; that is, at 100 PSA, investors can expect prepayments to follow the PSA prepayment benchmark

Answer 226

SMM=Prepayment for the month / (Beginning outstanding mortgage balance for the month−Scheduled principal repayment for the month) Note that the SMM is typically expressed as a percentage

Answer 227

refer curriculum

Answer 228

A standard practice in the bond market is to refer to the maturity of a bond. This practice is not followed for MBS because principal repayments (scheduled principal repayments and prepayments) are made over the life of the security. Although an MBS has a “legal maturity,” which is the date when the last scheduled principal repayment is due, the legal maturity does not reveal much about the actual principal repayments and the interest rate risk associated with the MBS. weighted avg life= A measure that gives investors an indication of how long they can expect to hold the MBS before it is paid off; the convention-based average time to receipt of all principal repayments. Also called average life. the average life of the MBS is the convention-based average time to receipt of all the projected principal repayments (scheduled principal repayments and projected prepayments).

Answer 229

Securities created through the securitization of a pool of mortgage-related products (mortgage pass-through securities or pools of loans).When the cash flows of mortgage-related products are redistributed to various tranches, the resulting securities are called collateralized mortgage obligations (CMOs). The creation of a CMO cannot eliminate or change prepayment risk; it can only distribute the various forms of this risk among different bond classes. The CMO’s major financial innovation is that securities can be created to closely satisfy the asset/liability needs of institutional investors, thereby broadening the appeal of mortgage-backed products

Answer 230

Note that in contrast to a mortgage pass-through security, the collateral is not a pool of mortgages but a mortgage pass-through security. In fact, in practice, the collateral is usually a pool of mortgage pass-through securities—hence the reason market participants sometimes use the terms “collateral” and “mortgage pass-through securities” interchangeably

Answer 231

``` sequential pay CMO Planned amortization class CMO ```

Answer 232

The first CMOs were structured so that each tranche would be retired sequentially. Such structures are called “sequential-pay CMOs.” The rule for the monthly distribution of the principal repayments (scheduled principal repayment plus prepayments) to the tranches in this structure is as follows. First, distribute all principal payments to Tranche 1 until the principal balance for Tranche 1 is zero. After Tranche 1 is paid off, distribute all principal payments to Tranche 2 until the principal balance for Tranche 2 is zero, and so on. Remember that a CMO is created by redistributing the cash flows—interest payments and principal repayments—to the various tranches based on a set of payment rules

Answer 233

A common structure in CMOs is to include planned amortization class (PAC) tranches, which offer greater predictability of the cash flows if the prepayment rate is within a specified band over the collateral’s life. Remember that the creation of an MBS, whether it is a mortgage pass-through or a CMO, cannot make prepayment risk disappear. So where does the reduction of prepayment risk (both extension risk and contraction risk) that PAC tranches offer investors come from? The answer is that it comes from the existence of non-PAC tranches, called support tranches or companion tranches. The structure of the CMO makes the support tranches absorb prepayment risk first. Because PAC tranches have limited (but not complete) protection against both extension risk and contraction risk, they are said to provide two-sided prepayment protection.

Answer 234

The greater predictability of the cash flows for the PAC tranches occurs because a principal repayment schedule must be satisfied. When the prepayment rate is within the specified band, called the PAC band, all prepayment risk is absorbed by the support tranche. If the collateral prepayments are slower than forecasted, the support tranches do not receive any principal repayment until the PAC tranches receive their scheduled principal repayment. This rule reduces the extension risk of the PAC tranches. Similarly, if the collateral prepayments are faster than forecasted, the support tranches absorb any principal repayments in excess of the scheduled principal repayments. This rule reduces the contraction risk of the PAC tranches. Even if the prepayment rate is outside the PAC band, prepayment risk is first absorbed by the support tranche. Thus, the key to the prepayment protection that PAC tranches offer investors is the amount of support tranches outstanding. If the support tranches are paid off quickly because of faster-than-expected prepayments, they no longer provide any protection for the PAC tranches.

Answer 235

Often, there is a demand for tranches that have a floating rate. Although the collateral pays a fixed rate, it is possible to create a tranche with a floating rate. This is done by constructing a floater and an inverse floater combination from any of the fixed-rate tranches in the CMO structure. Because the floating-rate tranche pays a higher rate when interest rates go up and the inverse floater pays a lower rate when interest rates go up, they offset each other. Thus, a fixed-rate tranche can be used to satisfy the demand for a floating-rate tranche.

Answer 236

Agency RMBS are those issued by Ginnie Mae, Fannie Mae, and Freddie Mac. RMBS issued by any other entity are non-agency RMBS. Entities that issue non-agency RMBS are typically thrift institutions, commercial banks, and private conduits. Private conduits may purchase non-conforming mortgages, pool them, and then sell mortgage pass-through securities whose collateral is the underlying pool of non-conforming mortgages. Because they are not guaranteed by the government or by a GSE, credit risk is an important consideration when investing in non-agency RMBS. the credit quality of a nonagency MBS depends on the credit quality of the borrowers as well as characteristics of the loans non agency RMBS include some sort of credit enhancement. the level of credit enhancement is directly proportional to the credit rating desired by the issuer. credit tranching is often used to enhance credit quality of the senior RMBS securities. a shifting interest mechanism is a method for addressing a decrease in the level of credit protection provided by junior tranches as prepayments or defaults occur in the senior/subordinate structure.

Answer 237

Two key indicators of potential credit performance are; loan-to-value ratio (LTV), debt-service-coverage (DSC) ratio 1. The DSC ratio is equal to the property’s annual net operating income (NOI) divided by the debt service (that is, the annual amount of interest payments and principal repayments). The NOI is defined as the rental income reduced by cash operating expenses and a non-cash replacement reserve reflecting the depreciation of the property over time. A DSC ratio that exceeds 1.0 indicates that the cash flows from the property are sufficient to cover the debt service while maintaining the property in its initial state of repair. The higher the DSC ratio, the more likely it is that the borrower will be able to meet debt-servicing requirements from the property’s cash flows. 2. loan to value ratio - current mortgage amount / current appraised value

Answer 238

Interest on the principal outstanding is paid to all tranches. Losses arising from loan defaults are charged against the outstanding principal balance of the CMBS tranche with the lowest priority. This tranche may not be rated by credit-rating agencies; in this case, this unrated tranche is called the “first-loss piece,” “residual tranche,” or “equity tranche.” The total loss charged includes the amount previously advanced and the actual loss incurred in the sale of the loan’s underlying property.

Answer 239

call protection- A critical investment feature that distinguishes CMBS from RMBS is the protection against early prepayments available to investors known as call protection. An investor in an RMBS is exposed to considerable prepayment risk because the borrower has the right to prepay a loan, in whole or in part, before the scheduled principal repayment date. CMBS investors have considerable call protection, which results in CMBS trading more like corporate bonds than RMBS. The call protection comes either at the structure level or at the loan level. Structural call protection is achieved when CMBS are structured to have sequential-pay tranches, by credit rating. A lower-rated tranche cannot be paid down until the higher-rated tranche is completely retired, so the AAA rated bonds must be paid off before the AA rated bonds are, and so on. Principal losses resulting from defaults, however, are affected from the bottom of the structure upward.

Answer 240

auto loan and lease receivables, credit card receivables, personal loans, and commercial loans.

Answer 241

Auto loan ABS are backed by auto loans and lease receivables. In some countries, auto loan-backed securities represent the largest or second largest sector of the securitization market. The cash flows for auto loan-backed securities consist of scheduled monthly payments (that is, interest payments and scheduled principal repayments) and any prepayments. For securities backed by auto loans, prepayments result from sales and trade-ins requiring full payoff of the loan, repossession and subsequent resale of autos, insurance proceeds received upon loss or destruction of autos, and early payoffs of the loans. All auto loan-backed securities have some form of credit enhancement, often a senior/subordinated structure. In addition, many auto loan-backed securities come with overcollateralization and a reserve account, often an excess spread account. Recall from a previous reading that the excess spread, sometimes called excess interest cash flow, is an amount that can be retained and deposited into a reserve account and that can serve as a first line of protection against losses.

Answer 242

When a purchase is made on a credit card, the issuer of the credit card (the lender) extends credit to the cardholder (the borrower). Credit cards are issued by banks, credit card companies, retailers, and travel and entertainment companies. At the time of purchase, the cardholder agrees to repay the amount borrowed (that is, the cost of the item purchased) plus any applicable finance charges. The amount that the cardholder agrees to pay the issuer of the credit card is a receivable from the perspective of the issuer of the credit card. Credit card receivables are used as collateral for the issuance of credit card receivable ABS. For a pool of credit card receivables, the cash flows consist of finance charges collected, fees, and principal repayments. Finance charges collected represent the periodic interest the credit card borrower is charged on the unpaid balance after the grace period, which may be fixed or floating. The floating rate may be capped; that is, it may have an upper limit because some countries have usury laws that impose a maximum interest rate. Fees include late payment fees and any annual membership fees. Interest is paid to holders of credit card receivable ABS periodically (e.g., monthly, quarterly, or semiannually). As noted earlier, the collateral of credit card receivable ABS is a pool of non-amortizing loans. These loans have lockout periods during which the cash flows that are paid out to security holders are based only on finance charges collected and fees. When the lockout period is over, the principal that is repaid by the cardholders is no longer reinvested but instead is distributed to investors.

Answer 243

Collateralized debt obligation (CDO) is a generic term used to describe a security backed by a diversified pool of one or more debt obligations: CDOs backed by corporate and emerging market bonds are collateralized bond obligations (CBOs); CDOs backed by leveraged bank loans are collateralized loan obligations (CLOs); CDOs backed by ABS, RMBS, CMBS, and other CDOs are structured finance CDOs; CDOs backed by a portfolio of credit default swaps for other structured securities are synthetic CDOs.

Answer 244

A CDO involves the creation of an SPE. In a CDO, there is a need for a CDO manager, also called “collateral manager,” to buy and sell debt obligations for and from the CDO’s collateral (that is, the portfolio of assets) to generate sufficient cash flows to meet the obligations to the CDO bondholders. The funds to purchase the collateral assets for a CDO are obtained from the issuance of debt obligations. These debt obligations are bond classes or tranches and include senior bond classes, mezzanine bond classes (that is, bond classes with credit ratings between senior and subordinated bond classes), and subordinated bond classes, often referred to as the residual or equity tranches. The motivation for investors to invest in senior or mezzanine bond classes is to earn a potentially higher yield than that on a comparably rated corporate bond by gaining exposure to debt products that they may not otherwise be able to purchase. Investors in equity tranches have the potential to earn an equity-type return, thereby offsetting the increased risk from investing in the subordinated class. The key to whether a CDO is viable depends upon whether a structure can be created that offers a competitive return for the subordinated tranche.

Answer 245

The basic economics of the CDO is that the funds are raised by the sale of the bond classes and the CDO manager invests those funds in assets. The CDO manager seeks to earn a rate of return higher than the aggregate cost of the bond classes. The return in excess of what is paid out to the bond classes accrues to the holders of the equity tranche and to the CDO manager. In other words, a CDO is a leveraged transaction in which those who invest in the equity tranche use borrowed funds (the bond classes issued) to generate a return above the funding cost.

Answer 246

covered bonds are senior debt obligations issued by a financial institution and backed by a segregated pool of assets that typically consist of commercial or residential mortgages or public sector assets Covered bonds are similar to ABS but offer bondholders dual recourse—that is, to both the issuing financial institution and the underlying asset pool. In the case of ABS, the financial institution that originates loans transfers securitized assets to a bankruptcy-remote special legal entity, but the pool of underlying assets in a covered bond (or “cover pool”) remains on the financial institution’s balance sheet, against which covered bondholders retain a top-priority claim.

Answer 247

Covered bonds for which a bond default is triggered and bond payments are accelerated in the event of sponsor default if payments do not occur according to the original maturity schedule.

Answer 248

Covered bonds for which bond default and payment acceleration of bond cash flows may be delayed upon sponsor default until a new final maturity date is reached.

Answer 249

Covered bonds that convert to pass-through securities after the original maturity date if all bond payments have not yet been made and the sponsor is in default.

Answer 250

Credit risk is the risk of loss resulting from the borrower (issuer of debt) failing to make full and timely payments of interest and/or principal.

Answer 251

default risk - The probability that a borrower defaults or fails to meet its obligation to make full and timely payments of principal and interest, according to the terms of the debt security. Also called default risk. loss severity Portion of a bond’s value (including unpaid interest) an investor loses in the event of default.

Answer 252

Default probability times loss severity given default. Expected loss = Default probability × Loss severity given default. The loss severity, and hence the expected loss, can be expressed as either a monetary amount (e.g., €450,000) or as a percentage of the principal amount (e.g., 45%).

Answer 253

Loss severity is often expressed as (1 − Recovery rate), where the recovery rate is the percentage of the principal amount recovered in the event of default.

Answer 254

spread risk Credit migration risk or downgrade risk Market liquidity risk.

Answer 255

Bond price risk arising from changes in the yield spread on credit-risky bonds; reflects changes in the market’s assessment and/or pricing of credit migration (or downgrade) risk and market liquidity risk.

Answer 256

The risk that a bond issuer’s creditworthiness deteriorates, or migrates lower, leading investors to believe the risk of default is higher. Also called downgrade risk.

Answer 257

The risk that the price at which investors can actually transact—buying or selling—may differ from the price indicated in the market.

Answer 258

Priority of payment of various debt obligations. The various debt obligations of a given borrower will not necessarily all have the same seniority ranking, or priority of payment.

Answer 259

The mix of debt and equity that a company uses to finance its business; a company’s specific mixture of long-term financing.

Answer 260

The ranking refers to the priority of payment, with the most senior or highest-ranking debt having the first claim on the cash flows and assets of the issuer. This level of seniority can affect the value of an investor’s claim in the event of default and restructuring

Answer 261

Debt in which the debtholder has a direct claim—a pledge from the issuer—on certain assets and their associated cash flows. Debt that gives the debtholder only a general claim on an issuer’s assets and cash flow.

Answer 262

Priority of payment, with the most senior or highest ranking debt having the first claim on the cash flows and assets of the issuer.

Answer 263

``` first lien/ senior secured second lien/ secured senior unsecured senior subordinated subordinated junior subordinated ```

Answer 264

Within each category of debt are finer gradations of types and rankings. Within secured debt, there is first mortgage and first lien debt, which are the highest-ranked debt in terms of priority of repayment. First mortgage debt or loan refers to the pledge of a specific property (e.g., a power plant for a utility or a specific casino for a gaming company). First lien debt or loan refers to a pledge of certain assets that could include buildings but might also include property and equipment, licenses, patents, brands, and so on. There can also be second lien, or even third lien, secured debt, which, as the name implies, has a secured interest in the pledged assets but ranks below first lien debt in both collateral protection and priority of payment. within unsecured debt, there can also be finer gradations and seniority rankings. The highest-ranked unsecured debt is senior unsecured debt. It is the most common type of all corporate bonds outstanding. Other, lower-ranked debt includes subordinated debt and junior subordinated debt. Among the various creditor classes, these obligations have among the lowest priority of claims and frequently have little or no recovery in the event of default.

Fixed Income Flashcards

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