Fixed Income Flashcards

Question

Current Yield

Answer 1

Is the bond's annual coupon divided by the bond's price, expressed as a percentage. Take the annual coupon payment and divide it by the price paid for the bond.

Answer 2

The way I think of current yield is that it's the rate of return on the interest payments from the bond, and YTM includes both the interest and any change in the bond's price from the purchase date through maturity. In this case, you have a bond priced at $90 that's paying $5, so the yield on that $5 payment is 5.56% (which is higher than the coupon rate because the bond is trading at a discount). However, at maturity, you'll receive both $5 in interest + a $10 gain on price. The YTM reflects both of those numbers.

Answer 3

Bond that reimburses investors for any losses incurred if the issuer defaults

Answer 4

Gov bond that pays perpetual interest rate--has no stated maturity date

Answer 5

The coupon rate is multiplied by the par value of the bond and not the purchase price

Answer 6

Legal contract that describes the type of bond it is, the obligations of the issuer and the rights of the bondholders.

Answer 7

Assets or financial guarantees underlying the debt obligation above and beyond the issuer's promise to pay.

Answer 8

Provisions used to reduce credit risk of the bond issued. It is a technique that improves the credit profile of structured financial products. Implemented to improve the credit rating of securitized products.

Answer 9

Clauses that specify the rights of the bondholders and any actions that the issuer is obligated to perform or prohibited from performing.

Answer 10

Appointed by the issuer; A financial institution with trust powers, such as the trust department of a bank or a trust company and acts as fiduciaries to the bondholders. Role is to monitor that the issuer complies with the obligations specified in the indenture and to take action on behalf of the bondholders when necessary.

Answer 11

Duties tend to be administrative. Usually include: - maintaining required documents/records - appraising collateral - holding funds until they are paid - call meetings of bondholders of actions to take in case of default

Answer 12

The legal obligation to repay the bondholders often lies with the special legal entity that was created by the financial institution in charge of the securitization process aka the sponsor or originator

Answer 13

Sponsor transfers the assets to the special legal entity to carry out some specific transaction or series of transactions. This transfer is considered a legal sale and once the assets have been securitized the sponsor no longer has ownership rights. Key reason for SPE is bankruptcy remoteness.Any investor trying to make claims after the sponsors default would be unable to recover the assets. So the SPE should be able to maintain principal and pay interest regardless of whether the sponsor defaults of not

Answer 14

Payment on loans they issued out or Paid-In Capital from members. Can call on members for additional resources

Answer 15

Increase in tax revenues and printing money will provide the funds needed for repayment

Answer 16

Taxing authority of the issuer CFs of the project the bond issue is financing Special taxes or fees established for the purpose of funding interest payments and principal repayments

Answer 17

Is based on the issuer's ability to generate CFs through operations More risky than sovereign/non-sovereign gov bonds

Answer 18

Dependent on the CFs generated by one or more of the underlying assets such as the mortgage or auto loan. Investors must pay attention to the quality of assets backing the ABS

Answer 19

Bonds backed by assets or financial guarantees pledged to ensure debt repayment in the case of default

Answer 20

Have no collateral; bondholders have only a general claim on the issuer's assets and CFs.

Answer 21

Types of bonds that can be secured or unsecured.

Answer 22

Secured by securities such as common shares, other bonds, or other financial assets Pledged by the issuer and held by the trustee

Answer 23

Bonds secured by specific types of equipment or physical assets like cars and shipping containers Issued to take advantage of the tax benefits of leasing. Ex.) Airline finances new purchase of aircraft with Equipment Trust Certificates--the legal title to the aircraft is held by the trustee which issues equipment trust certificates to investors in the amount of the aircraft purchase price. The trustee leases the aircraft to the airline and collects lease payments from the airline to pay the interest on the certificates. When the certificates mature, the trustee sells the aircraft to the airline, uses the proceeds to retire the principal and cancels the lease.

Answer 24

Mortgage backed securities These loans are purchased from banks, insurance companies, mortgage companies and are assembled into pools by a governmental, quasi-governmental or private entity.

Answer 25

Debt obligation backed by a segregated pool of assets called a cover pool Similar to ABS but offer additional protection FI that sponsors ABS transfers the assets backing the bonds to a SPE. If the FI defaults, investors who hold bond in the FI havae no recourse against the SPE and its assets because its a bankruptcy remote vehicle. If they have covered bonds, the pool of assets remains on the FI's balance sheet and under default investors have recourse against both the FI and the covered pool.

Answer 26

Most popular internal credit enhancement technique relies on creating tranches and ordering claim priorities The CFs generated by the assets are allocated with different priority to tranches of different seniority.

Answer 27

Excess collateral is used to back the security issued to enhance credit in order to get a better rating from a rating agency. This limits credit risk--issuer defaulting. Achieved when the value of assets in the pool is greater than the amount of the ABS so that even if payments on principal and interest are late the excess collateral will cover that and make up for that loss. Ex.) One of the most significant contributors to the 2007-2009 credit crisis was a valuation problem. Many ABS in the market were overcollateralized, with securities backed by assets in excess of their values. This lowered credit risks and made the financial instruments appealing to investors, however it was uncovered that the value of the assets used as collateral was actually much lower than presented. As property prices fell and homeowners started to default on their mortgages the credit quality of many MBS started to decline sharply. The result was a rapid rise in yields and panic among investors in these securities.

Answer 28

Form of internal credit enhancement Comes in form of a cash reserve fund or an excess spread account A cash reserve fund is a deposit of cash that can be used to absorb losses. An excess spread account involves the allocation into an account of any amounts left over after paying out the interest to bondholders. Excess spread is the difference between the CFs received from the assets used to secure the bond issue and the interest paid to investors.

Answer 29

The excess spread from CFs and interest paid out to investors on an ABS can be used to retire the principal with the most senior tranche having the first claim on these funds

Answer 30

Most common forms are bank guarantees, surety bonds, letters of credit and cash collateral accounts

Answer 31

Reimburses bondholders for any losses incurred if the issuer defaults. Penal Sum: max amount that can be guaranteed This is issued by a rated and regulated insurance company (monoline insurance companies are those that specialize in providing financial guarantees)

Answer 32

Same as surety bond but are issued by banks

Answer 33

Another form of external credit enhancement for a bond issue--the FI provides the issuer with a credit line to reimburse any CF shortfalls from the assets backing the issue.

Answer 34

External credit enhancements expose investors to the third party risk that the guarantor cannot meet its obligations A cash collateral account mitigates this because the issuer immediately borrows the credit-enhancement amount and then invests the amount usually in highly rated short term commercial paper; Because a cash collateral account is an actual deposit of cash rather than a pledge of cash, a downgrade of the cash collateral account provider will not result in a downgrade of the bond issued back by the provider.

Answer 35

Legally enforceable rules that borrowers and lenders agree on at the time of a new bond issue Indenture will include affirmative and negative covenants

Answer 36

Enumerate what issuers are required to do

Answer 37

Specify what issuers are prohibited from doing Frequently costly to issuers and materially constrain their potential business decisions Used to protect bondholders from problems such as dilution of their claims, asset withdrawals by the issuer..etc.

Answer 38

Negative covenant that regulates the issue of additional debt. Metrics used: leverage ratios and interest coverage ratios New debt can only be issued when justified by the issuer's financial condition

Answer 39

Negative covenant that prevent the issuance of debt that would be senior to or rank in priority ahead of the existing bondholder's debt

Answer 40

Negative covenant that protects unsecured bondholders by preventing the issuer from using assets that are not collateralized (unencumbered assets) to become collateralized.

Answer 41

Includes all the bonds that are issued and traded in a specific country and denominated in the currency of that country.

Answer 42

Bonds issued by entities that are incorporated in that country Ford Motor issues bonds that are denominated in US dollars in the US

Answer 43

Bonds issued by entities that are incorporated in a different country Toyota Motor Corp. (Japanese company) issue bonds denominated in US dollars in the US Foreign Bonds have nicknames: - Yankee Bonds: US - Panda Bonds: China - Samurai Bonds: Japan - Kangaroo Bonds: Australia - Kimchi Bonds: South Korea - Bulldog Bonds: UK - Matrioshka Bonds: Russia - Maple Bonds: Canada

Answer 44

Created to bypass legal, regulatory, and tax constraints imposed on bond issuers and investors in the US

Answer 45

A Eurobond is an international bond issued outside the jurisdiction of any one country and not denominated in the currency of the country where it is issued. Refers only to the fact that the bond is issued outside of the borders of the currency's home country; it does not mean the bond was issued in Europe or denominated in the euro currency. For example, a company can issue a Eurobond denominated in U.S. dollars in Japan. They are named after the currency in which they are denominated. Eurodollar Euroyen Bonds denominated in Euros are called euro-denominated Eurobonds They are less regulated than any domestic and foreign bonds because they are issued outside the jurisdiction of any single country. Unsecured and can be denominated in any currency They are underwritten by a group of international syndicates (group of FI from different jurisdictions)

Answer 46

Most Eurobonds are bearer bonds meaning the trustee does not keep records of who owns the bond; only the clearing system knows who the bond owners are

Answer 47

Contrast from bearer bonds, most domestic and foreign bonds are registered bonds meaning ownership is recorded by either name of serial number.

Answer 48

Issued simultaneously in the Eurobond market and at least one domestic bond market--this ensures sufficient demand for the large bond issues The World Bank is a regular issuer of global bonds.

Answer 49

The currency in which a bond is denominated has a stronger effect on its price than where the bond is issued or traded--this is because the market interest rates have a strong influence on a bond's price and the market interest rates that affect a bond are those associated with the currency in which the bond is denominated.

Answer 50

The income portion of a bond investment is taxed at the ordinary income tax rate, which is typically the same tax rate that an individual would pay wage or salary income

Answer 51

Interest income received by holders of local gov bonds (municipal bonds in the US) are exempt from federal income tax and from income tax of the state in which the bonds are issued.

Answer 52

< 12 months is short term and taxed as short term capital gains tax rate which is equal to the ordinary income tax rate >12 months then is it taxed at a long term tax rate which is usually lower than the tax rate for short terms capital gains

Answer 53

Requires investors to include a prorated (divided proportionately) portion of the original issue discount in his taxable income every tax year until maturity. The original issue discount is the difference between the par value and the original issue price. This allows the investor to increase his cost basis in the bond so that at maturity the investor faces no capital gain or loss

Answer 54

Make periodic, fixed coupon payments and a lump-sum payment of principal at maturity. Also known as a bullet bond because the entire payment of principal occurs at maturity.

Answer 55

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

Answer 56

Characterized by a fixed periodic payment schedule that reduces the bond's outstanding principal amount to zero by the maturity date. Therefore, bond payments include the interest rate as well as the amortized principal payment monthly. Interest payment each year is recalculated based on how much of the principal there is left to pay Can be viewed as an annuity because the payments are constant and have an end date.

Answer 57

Makes fixed periodic payments until maturity, but only a portion of the principal is repaid by the maturity date Balloon payment required at maturity to retire the bond's outstanding principal amount Can be viewed as an annuity plus a balloon payment at maturity. Except at maturity, the principal repayments are lower for a partially amortized bond than for an otherwise similar fully amortized bond. Consequently, the principal amounts outstanding and, therefore, the amounts of interest (coupon) payments are higher for a partially amortized bond than for a fully amortized bond, all else equal. The only exception is the first interest payment, which is the same for both repayment structures. This is because no principal repayment has been made by the time the first coupon is paid.

Answer 58

Is the amount of unpaid principal left that is required at maturity to retire the bond's outstanding principal owed.

Answer 59

Refers to an issuer's plans to set aside funds over time to retire the bond. It ensures that a formal plan is in place for retiring the debt. It specifies the portion of the bond's principal outstanding, perhaps 5%, that must be repaid each year throughout the bond's life or after a specified date. The issuer will forward repayment proceeds to the bond’s trustee. The trustee will then either redeem bonds to this value or select by lottery the serial numbers of bonds to be paid off. The bonds for repayment may be listed in business newspapers, such as the Wall Street Journal or the Financial Times. Also operates by redeeming a steadily increasing amount of the bond’s notional principal (total amount) each year. Any remaining principal is then redeemed at maturity.

Answer 60

Gives the issuer the option to repurchase the bonds before maturity. The issuer can usually repurchase the bonds at the market price, at par, or at a specified sinking fund price, whichever is the lowest. Bonds are retired at random in order to allocate the burden of the call provision evenly among bondholders. Usually the issuer can only repurchase a small portion of the bond issue.

Answer 61

Investors face reinvestment risk--if market rates have fallen since the investor purchased the bond he/she will not be able to purchase another bond offering the same return. Another disadvantage--if the issuer has the option to repurchase bonds at below market prices. Say, an issuer could exercise a call option to buy back at par on bonds priced above par. The investors would suffer a loss in this case because they paid above par for the bond and now have to sell it back at par.

Answer 62

The risk associated with having to reinvest cash flows at an interest rate that may be lower than the current yield to maturity. If the serial number on an investors bonds is selected, the bonds will be repaid and the investor will have to reinvest the proceeds.

Answer 63

Some future event or circumstance that is possible but not certain

Answer 64

Clause in a legal document that allows for some action if the event or circumstance does occur. Aka embedded options in bond indentures

Answer 65

Gives issuer the right to redeem all or part of the bond before the specified maturity date Issuers do this to protect themselves against a decline in interest rates--this decline comes from market rates falling or credit quality improves (the issuer has the right to place an old and expensive bond with a new and cheaper bond issue) This presents investors with a high level of reinvestment risk--if bonds are called bondholders have to reinvest funds in a lower interest rate environment--for this reason callable bonds have to offer a higher yield. Issuers usually don't add this provision--this is only to be a sweetener for investors that allow the issuers to pay lower coupon rates.

Answer 66

Requires issuer to make a lump-sum payment to the bondholders based on the PV of the future coupon payments and principal repayment not paid because the bond is being redeemed early--the price is significantly greater than the bond's current market price. Rate is usually the YTM plus some spread

Answer 67

Continuously callable; the issuer has the right to call a bond at any time starting on the first call date.

Answer 68

The issuer has the right to call a bond only once on the call date

Answer 69

The issuer has the right to calls bonds on specified dates following the call protection period--dates frequently correspond to coupon payment dates.

Answer 70

Gives the bondholders the right to sell the bond back to the issuer at a pre-determined price on specified dates. If the interest rates rise after the issue date, thus depressing the bond's price, the bondholders can put the bond back to the issuer and get cash. This cash can be reinvested in bonds that offer higher yields that are in line with the higher market interest rates. Because this adds value for bondholders the price of this bond will be higher than bonds without the put provision. The yield will also be lower as well--this compensates the issuer for the value of the put option to the bondholder. Selling price is usually par value of the bond. This gives bondholders the right to convert their claims into cash before other creditors of the issuer.

Answer 71

Hybrid security with both debt and equity features. It gives the bondholders the right to exchange the bond for a specified number of common share in the issuing company. The price on this bond is high and yield is lower because it adds value to bondholders. Benefits to investors: - potential share price appreciation and therefore participate in equity upside - bond still offers coupon payments and the promise of principal repayment at maturity even if the share price and call option of the bond decline the price of the bond cannot fall below the price of a straight bond (option-free bond) - value of the straight bond acts as a floor for the convertible bond

Answer 72

Reduced interest expense--issuers offer below market coupon rates because of the attraction of convertible bonds to investors The elimination of debt if the conversion option is exercised--however this is dilutive to existing shareholders.

Answer 73

The price per share at which the convertible bond can be converted into shares

Answer 74

The number of common shares that each bond can be converted into Is equal to the par value divided by the conversion price Ex.) Par value = $1,000 and the conversion price is $20 then the conversion ratio is 1,000/20 = 50:1, or 50 common share per bond.

Answer 75

``` Parity/Market value of the shares that would be received upon conversion; is the current share price multiplied by the conversion ratio Ex.) Conversion Ratio = 30:1 Current Share price = $33 then Conversion value = 30 * 33 = $990 ``` If the convertible bond includes a call provision and the conversion value is above the current share price, the issuer may force the bondholders to convert their bonds into common shares before maturity.

Answer 76

The difference between the convertible bond's price and its conversion value For example, if the convertible bond’s price is $1,020 and the conversion value is $990, the conversion premium is 1,020 – 990 = 30.

Answer 77

This is when the conversion value is the same at the convertible bond's price aka a conversion premium of 0. If the current share price is 34 instead of 33, then both the convertible bond’s price and the conversion value are equal to 1,020 (i.e., a conversion premium equal to 0). This condition is referred to as parity. If the common share is selling for less than 34, the condition is below parity. In contrast, if the common share is selling for more than 34, the condition is above parity.

Answer 78

A warrant is a separate, tradable security that entitles the holder to buy the underlying common share of the issuing company. Is an attached option not an embedded option; entitles the holder to buy the underlying stock of the issuing company at a fixed exercise price until the expiration date. This benefits the bondholder if the price of shares increase they can buy the underlying stock at a cheaper price than market price. Young firms offer this as a way to borrow money and attract investors.

Answer 79

Nicknamed CoCos; are bonds with contingent write-down provisions A traditional convertible bond is convertible at the option of the bondholder, and conversion occurs on the upside—that is, if the issuer’s share price increases. In contrast, bonds with contingent write-down provisions are convertible on the downside. In the case of CoCos, conversion is automatic if a specified event occurs—for example, if the bank’s core Tier 1 capital ratio (a measure of the bank’s proportion of core equity capital available to absorb losses) falls below the minimum requirement set by the regulators. Thus, in the event that the bank experiences losses that reduce its equity capital below the minimum requirement, CoCos are a way to reduce the bank’s likelihood of default and, therefore, systemic risk—that is, the risk of failure of the financial system. When the bank’s core Tier 1 capital falls below the minimum requirement, the CoCos immediately convert into equity, automatically recapitalizing the bank, lightening the debt burden, and reducing the risk of default. Because the conversion is not at the option of the bondholders but automatic, CoCos force bondholders to take losses. For this reason, CoCos must offer a higher yield than otherwise similar bonds.

Answer 80

Is the interest payment that the bond issuer makes to the bondholder. The coupon is paid most frequently semi-annually for sovereign and corporate bonds

Answer 81

The coupon rate is linked to an external reference rate, such as Libor. Thus an FRNs interest rate will fluctuate periodically during the bond's life, following the changes in the reference rate as a result, the FRNs CF's are not known with certainty. All FRNs have quarterly coupons and usually pay a fixed spread over the specified reference rate. Occasionally the spread is not fixed--this is known as a variable-rate note FRNs are less affected when interest rates increase because their coupon rates vary with market interest rates and are reset at regular, short-term intervals. Favored by investors who expected interest rates to rise.

Answer 82

Are notes whose spread above the linked reference rate is not fixed

Answer 83

The risk that a change in the market interest rate will affect a bond's value

Answer 84

If an issuer’s credit quality does not change from one coupon reset date to the next, the FRN’s price generally will stay close to the par value. However, if there is a change in the issuer’s credit quality that affects the perceived credit risk associated with the bond, the price of the FRN will deviate from its par value. A higher level of credit risk will lead to a lower price and a higher yield.

Answer 85

Prevents the coupon from falling below a specified minimum rate. This benefits the bondholders because its sets guarantees that the interest rate will not fall below a certain point during a time of falling interest rates.

Answer 86

Prevents the coupon from rising above a specified maximum rate. This benefits issuers because it sets a limit to the interest rate paid on the debt during a time of rising interest rates.

Answer 87

Includes both a cap and a floor

Answer 88

A bond whose coupon rate has an inverse relationship to the reference rate. When interest rates fall the coupon rate on an ordinary FRN decreases, in contrast, the coupon rate on an inverse FRN increases. This is favored by investors who expect interest rates to decline

Answer 89

This bond may be fixed or floating however it increases by specified margins at specified dates. An example of a bond with a step-up coupon is the FRN that was issued by the British bank HBOS plc in 2005. This FRN had a 20-year maturity, and the coupon was linked to the three-month Libor plus an initial spread of 50 bps. The spread was scheduled to increase to 250 bps over Libor in 2015 for the bond’s tenor. Important feature for callable bonds is that when interest rates increase issuers may not call the bond with step-up coupons particularly if it is a fixed rate bond. Allows bondholders to receive a higher coupon, in line with higher market interest rates. The opposite is true with issuers during falling rate environments--the step-up feature makes them want to call the bond as soon as possible before the spread increases and their interest expense increases.

Answer 90

This may happen if: - The issuer’s credit quality has deteriorated, which would lead to a higher spread, potentially making the coupon rate on the new bond more expensive than that on the existing bond despite the stepped-up coupon - Financial crisis may make it difficult for the issuer to refinance

Answer 91

Has a coupon that changes when the bond's credit rating changes. An example of a bond with a credit-linked coupon is one of British Telecom’s bonds maturing in 2020. It has a coupon rate of 9%, but the coupon will increase by 50 bps for every credit rating downgrade below the bond’s credit rating at the time of issuance and will decrease by 50 bps for every credit rating upgrade above the bond’s credit rating at the time of issuance. This is attractive of investors that are worried about the creditworthiness of the issuer.

Answer 92

A potential problem associated with these bonds is that increases in the coupon payments resulting from a downgrade may ultimately result in further deterioration of the credit rating or even contribute to the issuer’s default.

Answer 93

Typically allows the issuer to pay interest in the form of additional amounts of the bond issue rather than as a cash payment. This is good for issuers that are considered about CFs problems in the future. Investors in bonds with PIK coupons require higher yields due to the associated credit risk Other forms of PIK arrangements: -paying investors with common shares worth the amount of the coupon due

Answer 94

Sometimes called Split Coupon Bond; pays no coupons for its first few years but then pays a higher coupon than it otherwise would for the remainder of its life Issuers of theses bonds are usually looking to conserve cash--this could indicate poor credit quality. Deferred coupon bonds are also common in project financing when the assets being developed do not generate any income during the development phase. A deferred coupon bond allows the issuer to delay interest payments until the project is completed and the cash flows generated by the assets being financed can be used to service the debt.

Answer 95

These are usually priced at a significant discount to par. It is also helpful in managing taxes. If taxes due on the interest income can be delayed--investors may be able to minimize taxes. Zero-coupon bond can be thought of as an extreme form of deferred coupon bond-defers all interest payments until maturity.

Answer 96

Has its coupon payments and/or principal repayment linked to a specified index. A bond can be indexed to any published variable.

Answer 97

Is an example of an index-linked bond; its offers investors protection against inflation by linking a bond's coupon payments and the principal payments to an index of consumer prices such as the US CPI The advantage of using the CPI is that theses indexes are well-known, transparent, and published regularly.

Answer 98

A bond's stated coupon rate represents the nominal interest rate received by the bondholders, but inflation reduces the actual value of the interest received. The interest rate that bondholders actually receive, net of inflation, is the real interest rate. Its equal to the nominal interest rate minus the rate of inflation.

Answer 99

By increasing the coupon payments and/or principal repayment in line with increases in the price index, inflation-linked bonds reduce inflation risk.

Answer 100

Zero-coupon-indexed bonds pay no coupon, so the inflation adjustment is made via the principal repayment only: The principal amount to be repaid at maturity increases in line with increases in the price index during the bond’s life. This type of bond has been issued in Sweden. Suppose that the bonds are zero-coupon-indexed bonds. There will never be any coupon payments. Following the 5% increase in the CPI, the principal amount to be repaid increases to L1,050 [L1,000 × (1 + 0.05)] and will continue increasing in line with inflation until maturity.

Answer 101

Interest-indexed bonds pay a fixed nominal principal amount at maturity but an index-linked coupon during the bond’s life. Thus, the inflation adjustment applies to the interest payments only. Now, suppose that the bonds are coupon bonds that make semi-annual interest payments based on an annual coupon rate of 4%. If the bonds are interest-indexed bonds, the principal amount at maturity will remain L1,000 regardless of the CPI level during the bond’s life and at maturity. The coupon payments, however, will be adjusted for inflation. Prior to the increase in inflation, the semi-annual coupon payment was L20 [(0.04 × L1,000) ÷ 2]. Following the 5% increase in the CPI, the semi-annual coupon payment increases to L21 [L20 × (1 + 0.05)]. Future coupon payments will also be adjusted for inflation.

Answer 102

Pays 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. Thus, both the interest payments and the principal repayment are adjusted for inflation. If the bonds are capital-indexed bonds, the annual coupon rate remains 4%, but the principal amount is adjusted for inflation and the coupon payment is based on the inflation-adjusted principal amount. Following the 5% increase in the CPI, the inflation-adjusted principal amount increases to L1,050 [L1,000 × (1 + 0.05)], and the new semi-annual coupon payment is L21 [(0.04 × L1,050) ÷ 2]. The principal amount will continue increasing in line with increases in the CPI until maturity, and so will the coupon payments.

Answer 103

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, increases in line with inflation during the bond’s life. If the bonds are indexed-annuity bonds, they are fully amortized. Prior to the increase in inflation, the semi-annual payment was L36.56—the annuity payment based on a principal amount of L1,000 paid back in 40 semi-annual payments with an annual discount rate of 4%. Following the 5% increase in the CPI, the annuity payment increases to L38.38 [L36.56 × (1 + 0.05)]. Future annuity payments will also be adjusted for inflation in a similar manner.

Answer 104

Includes bonds issued by: - Supranational (international) organizations, like the World Bank - Sovereign (national) governments - Non-sovereign (local) governments - Quasi-government entities sponsored by governments

Answer 105

Refers to bond issued by financial institutions and non-financial institutions

Answer 106

Includes bonds created by securitization, a process that transforms private transactions between borrowers and lenders into securities traded in public markets.

Answer 107

Involves transferring ownership of assets from the original owners into a special legal entity. The special legal entity then issues securities backed by the assets, and the assets’ cash flows are used to pay interest and repay the principal owed to the holders of the securities.

Answer 108

Is paid off in a lump sum at maturity and therefore carries more credit risk than a serial maturity structure such as sinking fund arrangement

Answer 109

The risk of loss resulting from the issuer failing to make full and timely payments of interest and/or principal

Answer 110

Ratings of Baa3 or above by Moody’s Investors Service or BBB– or above by Standard & Poor’s (S&P) and Fitch Ratings are considered investment grade Ratings below these levels are considered non-investment grade, high yield, speculative or junk

Answer 111

Credit ratings are an assessment of 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; they will change if a credit agency perceives that the probability of default for an issuer has changed

Answer 112

Because institutional investors may be prohibited from investing in, or restricted in their exposure to, lower quality or lower-rated securities This is a result of restrictive risk-reward profile that forms part of an investors

Answer 113

Bonds that are issued with maturities at issuance

Answer 114

Issued by corporations Are fixed income securities with short maturities

Answer 115

Currency denomination of a bond's CFs influences which interest rates affect a bond's price Ex.) If a bond is denominated in yen, its price will be primarily driven by the credit quality of the issuer and by Japanese interest rates

Answer 116

The money banks raise to make loans to companies and individuals is often short-term and issued at rates that change or reset frequently

Answer 117

When there is a mismatch between the interest paid on liabilities (the money the bank borrowed) and the interest received on the assets (the money the bank lent or invested) banks are exposed to interest rate risk--the risk associated with a change in interest rate In order to migrate their net worth volatility from interest rate risk banks offering floating rate loans and invest in floating rate bonds or in other adjustable-rate assets

Answer 118

Usually set when bond is issued and remains constant until maturity--it is a function of the issuers credit quality at issuance The reference rate is reset periodically--therefore the coupon rate adjusts to the level of market rates each time the reference rate is reset. Choice of reference rate is critical because it is the primary driver of a bond's coupon rate

Answer 119

Is the reference rate for many floating rate bonds. Is a collective name for multiple rates The rate that is set at the end of a 6-month LIBOR rate plus a spread is paid at the end of a 6-month period and set based on the new rate at the beginning of the period and held constant throughout the next 6-months

Answer 120

Market of loans and deposits of up to one year in maturity between panel banks

Answer 121

Every business day a select group of 18 banks submits the BBA rates that they believe they could borrow from other banks in the LIBOR market for 10 currencies and 15 borrowing periods. The rates submitted would then be ranked from highest to lowest and the upper and bottom 4 rates would be discarded--the arithmetic mean of the remaining 10 rates became the Libor rates for a particular combination of currency and maturity These rates would then be communicated to the markets that would then use them as reference rates for different types of debt including FRNs

Answer 122

Advantage: its prevalence of use Disadvantage: Libor rate were not based on readily observable market rates but on banks' own estimates of their borrowing rates. The rates at which a bank ca borrow money is an indication of it credit risk--therefore these banks have an incentive to understate their borrowing rates Scandal in 2012 emerged showing that rates reported drifted far from the underlying reality or actual borrowing rates.

Answer 123

Constructed as the portfolios of securities that represent a particular bond market or sector.

Answer 124

Represents a broad-based measure of the global investment-grade fixed-rate bond market

Answer 125

Bonds issued by Latin American countries for the sole purpose of driving a reconstruction plan aimed at converting bank loans in tradable securities.

Answer 126

Refer to the purchase or sale of bonds usually sovereign bonds. By purchasing domestic bonds central banks increase the monetary base in the economy--the reverse is also true. Purchasing foreign bonds helps them to manage the value of domestic currency and their country's foreign reserves.

Answer 127

Where the issuance and trading of bonds primarily take place Fixed Income securities are more difficult to access than equity securities-that is why institutional investors tend to invest directly in bonds why retail investors tend to invest indirectly through ETFs or mutual funds

Answer 128

US domestic bonds issued by a state or local government

Answer 129

Asset-backed securities (ABS) are securitized debt instruments created by securitization, a process that involves transferring ownership of assets from the original owners to a special legal entity. The special legal entity then issues securities backed by the transferred assets. The assets’ cash flows are used to pay interest and repay the principal owed to the holders of the securities. Assets that are typically used to create securitized debt instruments include loans (such as mortgage loans) and receivables (such as credit card receivables). The structured finance sector includes such securitized debt instruments (also called asset-backed securities).

Answer 130

The coupon rate of a floating-rate bond is expressed as a reference rate plus a spread. Different reference rates are used depending on where the bond is issued and its currency denomination, but one of the most widely used set of reference rates is Libor.

Answer 131

Markets in which issuers usually sell to investors to raise capital

Answer 132

Markets in which existing bonds are subsequently traded among investors

Answer 133

Any member of the public may buy the bonds

Answer 134

Only a selected investor or group of investors may buy the bonds

Answer 135

The investment bank guarantees the sale of the bond issuance at an offering price under an agreement with the bond issuer. They, acting as underwriters, take on the risk associated with selling the bonds

Answer 136

The investment bank only serves as a broker. They will only try to sell the bonds at a pre-negotiated price with the issuer for a commission Therefore they have less risk and less incentive to sell the bonds in a best effort offering than in an underwritten offering

Answer 137

Bond issuing mechanism that involves bidding

Answer 138

Typically involves 6 phases: (1) Starts with the determination of the funding needs--the issuer determines how much money must be raised, the type of bond issuance, and whether the bond should be underwritten (2) The underwriter of the bond issuance typically takes the risk of buying the bonds from the issuer and then resells them to investors--the difference between the purchase price of the bond issuance and the resale price is the underwriters revenue (3) Structure the transaction--the bonds notional principal (total amount), the coupon rate, and the expected offering price. If the offering price is issued to high then the under-subscribed aka there will be insufficient demand for the bond issue and the syndicate will fail to sell the bond issue They will usually aim at a small over-subscription this will reduce their risk of not being able to sell all the bond issues. Large over-subscription signals that the offering terms were not favorable to the bond issuer in that they might have raised the amount of funds needed but but at a lower coupon rate Issuing phase: 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 The underwriting process comes to an end about 14 days later, on the closing day, when the bonds are delivered to investors.

Answer 139

When the bond issuance is large and requires a group of underwriters (multiple investment banks) The syndicate is collectively responsible for determining the pricing of the bond issue and for placing the bonds with investors

Answer 140

A debt security issued by Germany's federal government and is the German equivalent of a US Treasury Bond

Answer 141

Is another way for bond issuers to gauge investor's interest--Aka "When issued" market Is a forward market for bonds about to be issued Trading in the grey market helps underwriters determine what the final offering price should be

Answer 142

This allows certain authorized issuers to offer additional bonds to the general public without having to prepare a new and separate offering for each bond issue. This document describes a range of future bond issuances all under the same document For example, the British retailer Tesco used a shelf registration in 2010 for a series of issues under a universal aggregate $10 billion of bonds. The company could have elected to issue the entire size at once. Instead, it has issued smaller notional amounts at different intervals since 2010.

Answer 143

Method that involves bidding. Helpful in facilitating supply and demand in determining prices and in allocating supplies 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. In contrast, the public auction process used in Canada and Germany is a multiple-price auction process, which generates multiple prices and coupon rates for the same bond issue.

Answer 144

The bidders specifies the rate that is acceptable and if that rate is higher than the rate determined at the auction than the bidder does not get offered any securities All bidders receive the same rate, based on the highest accepted bid.

Answer 145

with non-competitive bids, a bidder agrees to accept the rate determined at auction; non-competitive bidders always receive their securities. All bidders receive the same rate, based on the highest accepted bid.

Answer 146

Are Financial institutions that are authorized to deal in new issues of US Treasury securities They have business relationships with the NY Fed which implements monetary policy Institutional investors and Central banks are the largest investors in US treasury securities

Answer 147

A non-underwritten, unregistered offering of bonds that are sold only to an investor or a small group of investors Can be accomplished through an investment bank- these are usually restricted securities and therefore there is no active secondary market to trade them but they can be traded among qualified institutional investors investors in a private placement can influence the structure of the bond issue, including such considerations as asset and collateral backing, credit enhancements, and covenants. It is common for privately placed bonds to have more customized and restrictive covenants than publicly issued ones.

Answer 148

Loans from a group of lenders to a single borrower

Answer 149

Aka "after market" Are where existing securities are traded among investors The major participants in secondary bond markets globally are large institutional investors and central banks. The presence of retail investors in secondary bonds markets is limited, unlike in secondary equity markets.

Answer 150

The ability to trade (buy or sell) securities quickly and easily at prices close to their fair market value Speed of trading alone does not constitute a liquid market because you 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 151

as an organized exchange or as an over-the-counter market

Answer 152

Provides a place where buyers and sellers can meet to arrange their trades Buy or sell orders can come from anywhere but must take place at the exchange and go by their rules

Answer 153

buy and sell orders initiated from various locations are matched through a communications network. Thus, OTC markets need electronic trading platforms over which users submit buy and sell orders. Bloomberg Fixed Income Electronic Trading platform is an example of such a platform through which dealers stand ready to trade in multiple bond markets globally Majority of bonds are traded in OTC markets

Answer 154

Is an association of banks and financial institutions that provide regulatory framework for international bond markets

Answer 155

Reflect the prices that dealers will buy from a customer (bid) and sell to a customer (offer or ask) is used as an indicator of liquidity It can be as low as 5 bps for very liquid bond issues, such as issues of the World Bank, to no price quoted for illiquid issues. A reasonable spread is of the order of 10−12 bps, whereas an illiquid spread may be in excess of 50 bps. When there is no bid or offer price, the issue is completely illiquid for trading purposes.

Answer 156

Process that occurs after the trade is made The bonds are passed to the buyer and payment is received by the seller Secondary market settlement for government and quasi-government bonds typically takes place either on a cash basis or on a T + 1 basis

Answer 157

Trading and settlement occur on the same day Trades clear within either or both of the two main clearing systems, Euroclear and Clearstream.

Answer 158

Settlement takes place the day after the trade date Corporate bonds typically settle on a T + 2 or T + 3 basis—that is, two or three days after the trade date—although settlement can extend to T + 7 in some jurisdictions. Trades clear within either or both of the two main clearing systems, Euroclear and Clearstream.

Answer 159

they are named US Treasuries in the United States, Japanese government bonds (JGBs) in Japan, gilts in the United Kingdom, Bunds in Germany, and obligations assimilables du Trésor (OATs) in France

Answer 160

Names may also vary depending on the original maturity of the sovereign bond. For example, US government bonds are named Treasury bills (T-bills) when the original maturity is one year or shorter, Treasury notes (T-notes) when the original maturity is longer than one year and up to 10 years, and Treasury bonds (T-bonds) when the original maturity is longer than 10 years Most sovereign bonds with an original maturity of one year or less are zero-coupon bonds, whereas bonds with an original maturity longer than one year are typically issued as coupon bonds. As a general rule, as sovereign securities age, they trade less frequently. Consols in the United Kingdom, have no stated maturity date.

Answer 161

Sovereign bond securities that were most recently issued

Answer 162

The latest sovereign bond issue for a given maturity is referred to as a benchmark issue because it serves as a benchmark to compare bonds that have the same features but are issued by another type of issuer such as a non-sovereign or corporate issuer

Answer 163

T-bills are money market securities T-notes and T-bonds are capital market securities T-bills are pure discount bonds; they are issued at a discount to par value and redeemed at par. The difference between the par value and the issue price is the interest paid on the borrowing. In contrast, capital market securities are typically coupon (or coupon-bearing) bonds; these securities make regular coupon payments and repay the par value at maturity. Bunds pay coupons annually, whereas US Treasuries, JGBs, gilts, and OATs make semi-annual coupon payments.

Answer 164

When the national government has a budget surplus: excess tax revenues over expenditures is the primary source of funds for making interest payments and repaying the principal

Answer 165

When a country runs a budget deficit: the source of funds for payment of interest and repayment of principal comes from tax revenues and by rolling over (refinancing) existing debt into new debt

Answer 166

bonds that pay a fixed rate of interest is the most common type of sovereign bond National governments issue two types of fixed-rate bonds: zero-coupon bonds (or pure discount bonds) and coupon bonds

Answer 167

Investors who hold these bonds are at a higher interest rate risk because the price of the bond changes in the opposite direction of the changes in interest rates 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. Although interest rate risk still exists on floating-rate bonds, it is far less pronounced than that on fixed-rate bonds.

Answer 168

Fixed income investors are exposed to inflation risk The CFs of a rixed rate bond are fixed by contract--if a particular country experiences inflation then the purchasing power of the fixed cash flows will erode over time In order to counteract this the inflation risk, linkers or inflation-linked bonds are issued where CFs are adjusted for inflation The inflation adjustment can be made via the coupon payments, the principal repayment, or both Although linking the cash flow payments to a consumer price index reduces inflation risk, it does not necessarily eliminate the effect of inflation completely because the consumer price index may be an imperfect proxy for inflation.

Answer 169

Levels of government below the national government 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 the purpose of making interest payments and principal repayments. Non-sovereign bonds are typically not guaranteed by 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 170

National governments establish organizations that perform functions for them 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. These organizations often have both public and private sector traits Other examples of quasi-government entities that issue bonds include Hydro Quebec in Canada or the Japan Bank for International Cooperation (JBIC). In the case of JBIC’s bonds, timely payments of interest and repayment of principal are guaranteed by the Japanese government. Most quasi-government bonds, however, do not offer an explicit guarantee by the national government, although investors often perceive an implicit guarantee.

Answer 171

A form of often highly rated bonds issued by supranational agencies aka the World Bank Bonds issued are typically plain vanilla bonds--although floating rate bonds and callable bonds are sometimes issued

Answer 172

Short-term funding needs

Answer 173

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 under-developed or where most bond issuances are from government, government-related entities, and financial institutions.

Answer 174

Loan from a group of lenders to a single borrower Is a hybrid between relational lending and publicly traded debt Syndicated loans are a way for these institutional investors to participate in corporate lending while diversifying the credit risk among a group of lenders. Most bilateral and syndicated loans are floating-rate loans, and the interest rate is based on a reference rate plus a spread. The reference rate may be Libor, a sovereign rate (e.g., the T-bill rate), or the prime lending rate, also called the “prime rate.”

Answer 175

Reflects the rate that banks lend to their most creditworthy customers but is not driven by overnight rate at which banks lend to each other

Answer 176

Short-term unsecured promissory note issued in the public market via a private placement that represents a debt obligation of the issuer Maturities can range from overnight to one year, but a typical issue matures in less than three months Maturing commercial paper is paid with the proceeds of new issuances of commercial paper aka rolling over the paper Commercial paper, whether US commercial paper or Eurocommercial paper, is negotiable—that is, investors can buy and sell commercial paper on secondary markets.

Answer 177

It is a source of funding for working capital and seasonal demands for cash.

Answer 178

Interim financing that provides funds until permanent financing can be arranged Suppose a company wants to build a new distribution center in southeast China and wants to finance this investment with an issuance of long-term bonds. 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.

Answer 179

Safe-guard against rollover risk that is often required of commercial paper issuers are. This ensures that the issuer will have access to sufficient liquidity to repay maturing commercial paper if rolling over the paper is not a viable option Typically contain a materially adverse change provision that allows the bank to cancel the backup line of credit if the financial condition of the issuer deteriorates substantially

Answer 180

The risk that issuers of commercial paper will not be able to pay off the new issue of commercial paper used to cover the debt from another commercial paper issuance at maturity

Answer 181

(1) Commercial paper is exposed to credit risk unlike most highly rated sovereign bonds (2) Commercial paper markets are less liquid than short-term sovereign bond markets Thus investors require higher yields to compensate for lower liquidity It could also be tax related: Income generated by investments in commercial paper is usually subject to income taxes where as income from municipal bonds are tax exempt

Answer 182

Commercial paper issued in the international market

Answer 183

Interest Provision: USCP is typically issued at a discount to par value and pays full par value at maturity (difference between the par value and the issue price is the interest earned on the borrowing) ECP may be issued at, and trade on, an interest-bearing or yield basis or a discount basis US bank: Issues $50,000,000 180-day USCP. Interest is $1,250,000 [$50,000,000 × 0.05 × (180/360)]. Interest on USCP is on a discount basis. Proceeds received are $48,750,000 [$50,000,000 − $1,250,000]. At maturity, the bank repays the par value of $50,000,000. German industrial company: Issues $50,000,000 180-day ECP. Interest is $1,250,000 [$50,000,000 × 0.05 × (180/360)]. Interest on ECP is on an interest-bearing basis. Proceeds received are the par value of $50,000,000. At maturity, the company repays $51,250,000 [$50,000,000 + $1,250,000]. Amount of interest is the same for both however the USCP investor earns a higher return that the ECP investor: Investors earn 2.56% on their 180-day investment in USCP ($1,250,000 ÷ $48,750,000) versus 2.50% on their 180-day investment in ECP ($1,250,000 ÷ $50,000,000).

Answer 184

Those securities with maturities between 1 and 12 years are often considered notes, whereas securities with maturities greater than 12 years are considered bonds.

Answer 185

The initial purpose of MTNs was to fill the funding gap between commercial paper and long-term bonds for Financial institutions who are the primary issuers The MTN market can be broken into three segments: short-term securities that carry floating or fixed rates, medium- to long-term securities that primarily bear a fixed rate of interest, and structured notes.

Answer 186

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 give issuers more flexibility regarding the servicing of their debt.

Answer 187

With a serial maturity structure, a stated number of bonds mature and are paid off each year before final maturity. Corporate note or bond issues have either serial or term maturity structure Serial maturity is where the maturity dates are spread out during the bonds life; a stated number of bonds mature and are paid off each year before final maturity

Answer 188

A bond issue with a term maturity structure is paid off in one lump sum at maturity. The bond's notional principal is paid off in a lump sum at maturity--there is no regular prepayment of the principal outstanding throughout the bond's life, so a term maturity carries more credit risk than a serial maturity structure.

Answer 189

A way to reduce credit risk by making the issuer set aside funds over time to retire the bond issue. For example, a corporate bond issue may require a specified percentage of the bond’s outstanding principal amount to be retired each year A sinking fund arrangement, like a serial maturity structure, results in a portion of the bond issue being paid off every year. However, with a serial maturity structure, the bonds are paid off because the maturity dates are spread out during the life of the bond and the bonds that are retired are maturing; the bondholders know in advance which bonds will be retired. In contrast, the bonds retired annually with a sinking fund arrangement are designated by a random drawing. The most common approach is for the issuer to make a random call for the specified percentage of bonds that must be retired and to pay the bondholders whose bonds are called the sinking fund price, which is typically par. Alternatively, the issuer can deliver bonds to the trustee with a total amount equal to the amount that must be retired. To do so, the issuer may purchase the bonds in the open market. The sinking fund arrangement on a term maturity structure accomplishes the same goal as the serial maturity structure—that is, both result in a portion of the bond issue being paid off each year.

Answer 190

Corporate debt is structure with credit risk in mind--therefore payout structures based off seniority is important to potential investors. In the case of secured debt, there is some form of collateral pledged to ensure payment of the debt. In contrast, in the case of unsecured debt, claims are settled by the general assets of the company in accordance with the priority of payments that applies either legally or contractually and as described in the bond indenture.

Answer 191

Companies that need to finance equipment or physical assets may issue this

Answer 192

These are secured by securities such as common shares, bonds or other financial assets

Answer 193

Particularly issued by banks in Europe--these are types of debt obligations that is secured by a segregated pool of assets ABS are also a secured form of debt

Answer 194

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 195

Give issuers the ability to retire debt prior to maturity Companies may also do this to get ride of restrictive covenants or alter their capital structure to improve flexibility This is done when borrowing rates are low and they can retire the bond and reissue at a lower rate By calling the bonds before their maturity date, the issuer can substitute a new, lower cost bond issue for an older, higher cost one Because call provisions benefit the issuer, investors demand compensation in the form of higher yields (therefore paying lower price) ex ante (before investing in the bond)

Answer 196

Gives bondholders the right to sell the bond back to the issuer at a predetermined price on specified dates before maturity Putable bonds are valuable to bondholders and therefore offer a lower yield and higher price than non-putable bonds Most putable bonds pay a fixed rate of interest.

Answer 197

Bonds that increase by specified margins at specified dates.

Answer 198

Is a hybrid security that lies on a continuum between debt and equity Sold at a lower coupon rate due to the attraction to investors Consists of a long position in an option-free bond and a conversion option that gives the bondholders the right to convert the bond into a specified number of shares of the issuer's common shares. However, there is a potential equity dilution effect 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 199

CDOs are securities backed by a diversified pool of one or more debt obligations They repackage and redistribute risk

Answer 200

Financial instruments with customized structures that often combine a bond and at least one derivative The use of derivatives gives the holder of the financial instrument exposure to one or more underlying assets, such as equities. The redemption value and coupons of structured financial instruments are linked via a formula to the performance of the underlying assets.

Answer 201

This combination of the zero-coupon bond and the call option on some different asset that expires in a year can be prepackaged as a structured financial instrument called a guarantee certificate. The zero-coupon bond provides the investor capital protection; at maturity, the investor will receive 100% of the capital invested even if the call option expires worthless. The call option provides upside potential if the price of the underlying asset rises and a limited downside if the price of the underlying asset falls. The downside has to do with the price of call option which is the maximum price the investor will lose.

Answer 202

Refers to increasing risk exposure in the hope of realizing a higher expected return

Answer 203

Fixed-Income security in which the holder of the security has the right to withhold payment of the full amount due at maturity if a credit event occurs If the credit event does not occur then the investor receives the par value of the CLN at maturity; But if the specified credit event occurs, the investor receives the par value of the CLN minus the nominal value of the reference asset to which the CLN is linked. A CLN allows the issuer to transfer the effect of a particular credit event to investors. Thus, the issuer is the protection buyer and the investor is the protection seller. Investors are willing to buy CLNs because these securities offer higher coupons than otherwise similar bonds. CLNs are usually issued at a discount so if the credit event does not occur then the investor realizes a significant capital gain on the purchase of the CLN

Answer 204

One that allows investors to participate in the return of an underlying asset For example, floating rate bonds can be viewed as a type of participation instrument A floater has almost zero interest rate risk because changes in the cash flows limit the effect of changes in interest rates on the floater’s price. Thus, floaters give investors the opportunity to participate in movements of interest rates. Many structured products sold to individuals are participation instruments linked to an equity index. In contrast to capital protected instruments that offer equity exposure, these participation instruments usually do not offer capital protection.

Answer 205

Structured financial instruments created to magnify returns and offer the possibility of high payoffs from small investments

Answer 206

Is a leverage instrument Inverse floater coupon rate = C – (L × R) where C is the maximum coupon rate reached if the reference rate is equal to zero, L is the coupon leverage, and R is the reference rate on the reset date. Note that the coupon leverage indicates the multiple that the coupon rate will change in response to a 100 basis points (bps) change in the reference rate. For example, if the coupon leverage is three, the inverse floater’s coupon rate will decrease by 300 bps when the reference rate increases by 100 bps.

Answer 207

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 208

Markets in which debt issuers borrow to meet their financial needs

Answer 209

deposit accounts from their customers Common practice for banks to originate more loans than they have retail deposits Therefore whenever retail deposits aren't enough to meet financial needs banks go to the wholesale market

Answer 210

Wholesale funds refer to the funds that financial institutions lend to and borrow from each other. They include central bank funds, interbank funds, and certificates of deposit. Banks raise wholesale funds to minimize funding cost At the margin, wholesale funds may be less expensive (in terms of interest expense) than deposit funding Finally, financial institutions may raise wholesale funds as a balance sheet risk management tool to reduce interest rate risk

Answer 211

Aka Checking Accounts are available to customers "on demand" Depositors have immediate access to their funds in the deposit account and can use this to make payments Due to the fact that funds are available immediately, deposit accounts typically pay no interest

Answer 212

Pay interest and allow depositors to accumulate wealth in a very liquid form, but they do not offer as many transactions as demand deposits

Answer 213

Originally designed to compete with Money Market Mutual Funds Money market level rates of return are offered on these accounts and depositors can access funds at short or no notice Thus, for depositors, money market accounts are an intermediate between demand deposit and savings accounts.

Answer 214

Many countries require deposit-taking banks to place a reserve balance with the national central bank. These funds help to ensure sufficient liquidity should depositors require withdrawal of funds. Banks borrow reserve funds from the central bank when they cannot obtain short-term funding--this ensures depositors and investors that the central bank can act as lender of last resort

Answer 215

It varies among countries, from a low interest payment, to no interest payment, to charges for keeping reserve funds Opportunity cost exists because these funds cannot be lent out to borrowers or reinvested at a higher interest rate

Answer 216

In terms of reserve fund requirements--some banks have excess reserve funds and some run short or required reserves This funds market allows banks to have a surplus of funds to loan 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.

Answer 217

The interest rate at which Central Bank Funds are borrowed and lent are short-term rates that are determined by the central bank's open market operations

Answer 218

The most widely followed rate is the Fed funds effective rate It is the volume-weighted average of rates for Fed Funds futures trades arranged throughout the day

Answer 219

Interbank market is the market of loans and deposits between banks Term to maturities of these loans and deposits range from overnight to one year The rate on interbank loans or deposits can be quoted relative to a reference rate

Answer 220

Interbank deposits are unsecured so banks placing deposits with another bank need to have an interbank line of credit in place for that institution.

Answer 221

The rate at which it will lend funds and the rate at which it will borrow funds for a specific maturity.

Answer 222

Is an instrument that represents a specified amount of funds on deposit for a specified maturity and interest rate. A CD may be non-negotiable or negotiable. Yields on CDs are driven by the credit risk of the issuing bank and to a lesser extent by the term to maturity

Answer 223

The deposit plus the interest are paid to the initial depositor at maturity However a withdrawal penalty is charged if funds are withdrawn before maturity date.

Answer 224

Allows any depositor (whether initial or subsequent) to sell the CD in the market prior to the maturity date

Answer 225

Large-denomination CDs & Small-denomination CDs

Answer 226

In the US are usually issued in denominations of $1MM or more These are an important source of wholesale funding

Answer 227

Retail-oriented product and are not as important as a funding alternative

Answer 228

Important source of funding for banks Is when a security is sold to a purchaser with a simultaneous agreement from the seller to buy the same security back a future date at an agreed upon price

Answer 229

A securities dealer sells a security for cash today. At the same time the dealer agrees to repurchase the same security at an agreed upon price in the future.

Answer 230

The term: repo rates tend to increase with maturity Risk associated with the collateral--they increase with the level of risk Delivery Requirement for the collateral--Repo rates are lower when delivery to the lender is required

Answer 231

This is what the repo agreement is referred to as for the cash lending counterparty in the transaction. The counterparty agrees to buy the security and promises to sell it back the next day at the agreed-on price The reverse repurchase agreement is often used to borrow securities to cover short positions Whether the transaction is a repurchase agreement or a reverse purchase agreements depends on which side of the transaction you are on. Standard practice is to view the transaction from the dealer’s (borrower of cash) perspective. If the dealer is borrowing cash from a counterparty and providing securities as collateral, the transaction is termed a repurchase agreement. If the dealer is borrowing securities and lending cash to the counterparty, the transaction is termed a reverse repurchase agreement.

Answer 232

The difference between the market value of the security used as collateral and the value of the loan It is also known as haircut in the US

Answer 233

The length of the repurchase agreement--the longer the 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--the higher the creditworthiness of the counterparty, the lower the repo margin 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 234

is used to discount the future CFs on a bond to arrive at the PV It is the return required by investors given the risk of the investment in the bond

Answer 235

It indicated the amount the issuer promises to pay the bondholder each year in interest

Answer 236

It reflects the amount investors need to receive in interest each year in order to pay full par value for the bond

Answer 237

The amount of the discount below par value is the present value of the deficiency

Answer 238

% of interest payment on a bond that is above the market discount rate The amount of the premium is the present value of the excess cash flows

Answer 239

The price of a fixed-rate bond relative to par value depends on the relationship of the coupon rate to the market discount rate 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.

Answer 240

Interest that has been earned and not yet paid

Answer 241

Multiply the rate per period by the number of periods in a year Interest rates, unless stated otherwise, are typically quoted as annual rates.

Answer 242

If the market price of the bond is known--the YTM can be calculated YTM does not depend on the actual amount of par value in a fixed-income portfolio The YTM is the internal rate of return on the bonds future CFs aka the IMPLIED market discount rate When the future CFs are discounted at the YTM and summed it should equal the price of the bond

Answer 243

1. The investor holds the bond to maturity 2. The issuer makes all of 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. 3. The investor is able to reinvest coupon payments at that same yield which is a characteristic of an internal rate of return

Answer 244

When a bond is priced at a premium above par value the yield-to-maturity (YTM), or market discount rate is less than the coupon rate

Answer 245

1. Bond price is inversely related to the market discount rate. When the market discount rate increases, the bond price decreases (the inverse effect) 2. For the same coupon rate and time-to-maturity, the percentage price change is greater when the market discount rate goes down than when it goes up (the convexity effect) 3. For the same time 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 (coupon effect) 4. 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 (maturity effect)

Answer 246

This is the percentage price change and says that the % of price change is greater when yields are going down than when they are going up The relationship between bond prices and market discount rate is not linear. The percentage price change is greater in absolute value when the market discount rate goes down than when it goes up by the same amount (the convexity effect). % change = (New Price - Old Price)/ Old Price The percentage price change is greater in absolute value than the percentage price decreases implying that the relationship between bond prices and market discount rate is not linear but is curved

Answer 247

A higher-coupon bond has a smaller percentage price change than a lower-coupon bond when their market discount rates change by the same amount (the coupon effect) Says that lower coupon bonds have higher price volatility than higher-coupon bonds all things equal

Answer 248

A shorter-term bond generally has a smaller percentage price change than a longer-term bond when their market discount rates change by the same amount (the maturity effect). Longer-term bonds have more price volatility than shorter-term bonds other things being equal Exceptions to the maturity effect happen only for low-coupon (but not zero-coupon) long-term bonds trading at a discount

Answer 249

The relationship between the price and market discount on a bond is inversely related meaning as one increases the other one decreases

Answer 250

Illustrates the change in the price of a fixed-income bond over time. It 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 then the price of a bond approaches par value as its time-to-maturity approaches zero.

Answer 251

Generally when a fixed-rate bond is priced it is using the market discount rate to discount each future CF Another way to discount the CFs is by using the Spot Rates Spot rates are YTMs on zero-coupon bonds maturing at the date of each CF The value arrived at through this calculation is also known as the no-arbitrage value If a bond’s price differs from its no-arbitrage value, an arbitrage opportunity exists in the absence of transaction costs.

Answer 252

The YTM is below the coupon rate

Answer 253

When the bond is between coupon payment dates, its price has two parts: the flat price and the accrued interest The flat price is the full price minus the accrued interest The flat price is used to avoid misleading investors about the market price trend for the bond If the full price were quoted instead then investors would see the bond price change increase everyday due to the accrued interest increasing each day and then dropping back down once the coupon payment is made while the YTM didn't change. This could be misleading. It is the flat price that is "pulled to par" on the constant-yield price trajectory and is also affected by the market discount rate change

Answer 254

The sum of the flat price and the accrued interest is the full price

Answer 255

Is the date when the bond buyer makes cash payment and the seller delivers the security

Answer 256

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.

Answer 257

It assumes that each month has 30 days and that a full year has 360 days. Therefore, for this method, there are assumed to be 42 days between 15 May and 27 June: 15 days between 15 May and 30 May and 27 days between 1 June and 27 June. There are assumed to be 180 days in the six-month period between 15 May and 15 November.

Answer 258

= DayConvention (ex. 30/360) multiplied by the coupon rate PER PERIOD (do not add one)

Answer 259

Used to estimate the market discount rate (YTM) and price of bonds that are not issued yet or are not actively traded and therefore there is no price available to calculate the rate of return required by investors Matrix pricing estimates the market discount rate and price based on the quoted prices of more frequently traded comparable bonds based on times-to-maturity, coupon rates, and credit quality. Using Matrix Pricing to get YTM (annual rate): Calculate YTM for each stated bond and average the YTM per year then take the average of the bonds with the lowest maturities and add the following: [(Coupon Rate of bond we are estimating - Minimum coupon rate)/(Maximum coupon rate - Minimum Coupon Rate) ] multiply by the difference between the average YTMs per year

Answer 260

The YTM on a government bond having similar time to maturity

Answer 261

The difference between the YTM on the new bond and the benchmark rate This is the yield required by investors to account for liquidity risk, credit risk, tax status of the bond relative to the gov bond The primary component of the yield spread for many bonds is compensation for the credit risk

Answer 262

Yield spreads reveal the term structure of credit spreads This is the relationship between the spreads over the "risk free" or benchmark rates and times-to-maturity

Answer 263

Matrix pricing is used in underwriting new bonds to get an estimate of the required yield spread over the benchmark rate. The benchmark rate is typically 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, and tax status of the bond relative to the government bond. In matrix pricing, the market discount rates of comparable bonds and the yield-to-maturity on a government bond having a similar time-to-maturity are not estimated. Rather they are known and used to estimate the required yield spread of a new bond.

Answer 264

An effective annual rate has a periodicity of one because there is just one compounding period in the year The compounded total return is the same of any periodicity for a single annual rate. They differ in terms of the number of compounding periods per year (periodicity) For a given pair of CFs, the stated annual rate and the periodicity are inversely related

Answer 265

This rate is already expressed as an annual rate 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 266

A general rule for these periodicity conversions is compounding more frequently at a lower annual rate corresponds to compounding less frequently at a higher annual rate. NOTE: increasing the frequency of compounding lowers the annual rate while converting from more frequent to less frequent compounding raises the annual rate.

Answer 267

Are quoted yield measures that neglect weekends and holidays. The street convention YTM is the internal rate of return on the CFs assuming the payments are made on the scheduled dates

Answer 268

Is the internal rate of return on the CFs using the actual calendar of 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 between the true yield and the street convention is usually no more than 1-2 bps so for that reason it is not commonly used

Answer 269

Sometimes quoted for a corporate bond. A gov equivalent yield restates a yield to maturity based on 30/360 day-count to one based on actual/actual

Answer 270

Aka the income or interest yield. Is the sum of the coupon payments received over the year divided by the flat price. The current yield is the sum of the coupon payments received over the year divided by the flat price. For example, a 10-year, 2% semiannual coupon payment bond is priced at 95 per 100 of par value. Its current yield is 2.105%. This calculation neglects the frequency of coupon payments in the numerator and any accrued interest in the denominator--it focuses only on interest income It addition if the bond is purchased at a discount and paid back at par then the investor has a gain The investor has a loss if the bond is purchased at a premium and is redeemed at par value

Answer 271

Is the sum of coupon payments plus the straight-line amortized share of the gain or loss divided by the flat price Most often quoted for Japanese gov bonds

Answer 272

If a fixed-rate bond contains an embedded option--other yield measures are used

Answer 273

Contains 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 preset dates usually coincide with coupon payment dates after a call protection period.

Answer 274

A call protection period is the time during which the issuer of the bond is not allowed to exercise the call option. Suppose that a seven-year, 8% annual coupon payment bond is first callable in four years. That gives the investor four years of protection against the bond being called. After the call protection period, the issuer might exercise the call option if interest rates decrease or the issuer’s credit quality improves. Those circumstances allow the issuer to refinance the debt at a lower cost of funds The preset prices that the issuer pays if the bond is called often are at a premium above par.

Answer 275

The lowest of the sequence of yields-to-call and the yield-to-maturity The intent of this yield measure is to provide to the investor the most conservative assumption for the rate of return.

Answer 276

The value of the embedded call option is added to the flat price of the bond to get the option-adjusted price. The investor bears the call risk (the bond issuer has the option to call), so the embedded call option reduces the value of the bond from the investor’s perspective. The investor pays a lower price for the callable bond than if it were option-free. If the bond were non-callable, its price would be higher.

Answer 277

Is the required market discount rate that adjusts for the value of the embedded option

Answer 278

The value of the call option is the price of the option-free bond minus the price of the callable bond.

Answer 279

The value of the call option is the price of the option-free bond minus the price of the callable bond.

Answer 280

Interest payments on floating rate not could go up or down depending on the reference 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 Floaters have more stable prices 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

Answer 281

When the interest payments are made at the end of the period

Answer 282

when the credit risk of the company issuing the bond is more than the banks quoting LIBOR

Answer 283

is the rate of interest that investors actually earn as a result of compounding It is the annual rate of return actually being earned EAR = (1+ Periodic Rate/m)^m - 1

Fixed Income Flashcards

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