04 Fixed Income Flashcards

Question

Credit Risk - Credit Spread Risk

Answer 1

- Measured by the **amount of yield differential above the return on a default-free security** (e.g. Treasury securities) and is referred to as **risk premium or credit spread** - Credit spread is **demanded by investors to compensate for the risk of buying the security**, which is at risk of default -> The riskier the security, the higher the yield differential

Answer 2

- Risk that a **bond will be reclassified riskier by a credit rating agency** - Lowering the rating (downgrade) causes the **spread to rise**

Answer 3

- Represents the **likelihood that an investor will be unable to sell the security quickly and at a fair price** - Can be estimated quantitively through the **bid-ask spread**, which is the **difference between the price for which a dealer is willing to sell the security (ask price) and the price for which a dealer is willing to buy the security (bid price)** - The **higher the bid-ask spread**, the **more illiquid the security** and the **greater the exposure to liquidity risk** - Bid-ask spread and therewith liquidity risk can change over time as investors interest in a given class of securities changes

Answer 4

- Present **when bond payments (coupon and/or principal) are denominated in a currency other than home currency of the bondholder** - When home currency appreciates (depreciates), each foreign currency unit will be worth less (more) in terms of the home currency - Resulting exchange risk is also referred to as currency risk

Answer 5

- Refers to **variability in the price of the instrument** - Value of embedded options are affected by bond price variability, i.e. the greater the volatility of the underlying price, the greater the value of an embedded option

Answer 6

- Refers to the **possibility that prices of goods and services in general will increase** - Increasing prices **erode the buying power associated with bond payments**

Answer 7

- Occurs when **something significant happens to a company** that has **sudden and substantial impact on its financial location** and on the **underlying value of an investment** - Examples for items that can cause event risk: Disasters, corporate restructurings, regulatory issues and political events

Answer 8

- Treasury Securities - Stripped Securities (treasury strips) - Securities issued by Federal Agencies - Securities issued by State and Local Government (Municipal Bonds) - Corporate Bonds - Asset backed securities - International Securities

Answer 9

- Issued by the U.S. Treasury Department - Considered to be **free of credit risk** as being backed by full credit of U.S. government

Answer 10

**T-Bills** - Maturity < 1 year - No coupon - Sold for a price less than par, paid back to par **T-Notes** - Maturity of 2-10 years - Explicit coupon rates - Non-callable **T-Bonds** - Maturity > 10 years - Explicit coupon rates - Non-callable **Treasury inflation protected securities (TIPS)** - Applied to notes and bonds - Fixed coupon rate - Principal is adjusted by inflation semiannually

Answer 11

- Creation of **synthetic zero coupon bonds** out of **T-Notes and T-Bonds** - **Not issued** by the U.S. Treasury - Stripped and offered by **investment bankers**

Answer 12

Almost no risk of default **Mortgage-Backed Securities (MBS)/Mortgage pass-through securities** - Backed (or secured) by pool of mortgage loans (loans with physical asset as collateral), which not only provide collateral but also cash flow to service the debt - Sold as participation certificates - Interest, principal payments and prepayments (-> prepayment risk present) from the underlying mortgages are passed through to investors (after deducting fees) **Collateralized Mortgage Obligations (CMO)** - MBS that redistributes the (pre-)payment risk among investors - Different tranches are created, which reprioritize principal and interest payment

Answer 13

- Issues of states, counties, cities or other political subdivisions Two common specifications - **General Obligations (GO) Bonds** are bonds that are backed by full faith, credit and taxing power of the issuer (-> tax-backed debt) - **Revenue Bonds** are only serviced by the income generated from specific income-producing projects (e.g. toll roads). -> Payment only occurs if a sufficient level of revenue is generated (-> higher risk)

Answer 14

- Debt is secured by pledge or assets (collateral) - **Unsecured debt (debentures)** is a bond raised without any collateral and represents a claim on the assets of the issuer, which have not been pledged to other securities - **Debt with credit enhancement** offers third party financial guarantees (i.e. by parent corporation); letters of credit (usually issued by a bank) - **Commercial paper** is a type of short-term debt instrument (maturity of less than 270 days)

Answer 15

- Similar to MBS, **cash flows are linked to a pool of underlying loans/financial instruments** - ABS is structured into different tranches, which are entitled to different cash flows - To isolate the securitized assets from the corporation’s other activities and to shield them from other lenders, the securitized assets are sold to a so called **special purpose vehicle (SPV)**

Answer 16

- **Foreign bonds** are issued in a country’s bond market by an issuer who is not resident there and can be denominated in any currency and may be privately or publicly issued - **Eurobonds** are unsecured, issued in any currency and outside the legal system of any one country and therefore usually not registered through a regulatory agency

Answer 17

All bonds are priced in 3 steps according to the present value of their future cash flows 1. Estimate the **cash flows** (coupon payment and recovery of principal at maturity) 2. Determine the **appropriate discount rate** 3. Calculate the **present value**

Answer 18

**Assumptions** Cash flows are assumed to be fix and predictable with a high degree of certainty, what implies a high-quality option-free bond **However**, there could be some conditions that make the estimation more difficult - **Credit risk** (risk of default) - Presence of **embedded options** (such as call/put features, convertible bonds) - Presence of a **variable coupon rate**

Answer 19

- **Constant** (yield to maturity, required rate of return) **or variable** (spot rates) - **Risk-free rate plus risk premium** (credit risk, call risk, liquidity risk, etc.)

Answer 20

- As coupon payment, par value and maturity date are fixed (i.e. cash flows will not change), **any changes that do occur in market yield will be reflected in the price of the bond** - **Price of a bond will move inversely with interest rates** until its yield is compatible with the (new) prevailing market yield - Price-yield curve is not a straight line but positive convex -> **Higher prices are associated with lower yields**

Answer 21

As maturity approaches the price of a bond converges toward its par value

Answer 22

- Using a **constant single discount rate** (yield to maturity) assumes a **flat term structure** - A flat term structure is **very rare in reality** and therefore in many cases **yields an approximation or weighted average of a set of spot rates only** - Using a **series of spot rates reflects better the current term structure** - This will result in **more accurate bond pricing** and eliminate arbitrage opportunities (-> arbitrage free valuation)

Answer 23

- **Nominal yield** represents the coupon rate the bond carries - **Current yield** represents the annual cash coupon payment divided by current bond price - **Yield to maturity (YTM)** is the promised yield

Answer 24

- Bond is **held to maturity** (not called or redeemed and not sold before maturity) - All principal and interest **payments are received promptly and timely** (-> **no credit risk**) - Coupon **payments are reinvested** at a **rate of return equal to the YTM** (-> **no reinvestment risk**)

Answer 25

Bond Equivalent Yield (BEY) requires the conversion of YTM of a semiannual paying bond to YTM of an annual paying bond or vice versa to **compare two bonds with different coupon paying structure**

Answer 26

- Considers the impact of a bond being called (callable bond) - Measures expected yield on a deferred-call bond (call possible after a certain period of time has expired) assuming that the issue is retired at the end of the call deferment period

Answer 27

- Considers the impact of a bond being put (i.e. back to the issuer prior to maturity) - Assumed that the bond will be sold according to a fixed schedule

Answer 28

Yield to worst (YTW) involves calculation of YTC and YTP for every possible call or put date and determining which of the results is the lowest expected return

Answer 29

- Spot rate is the **interest rate used to discount a single cash flow** to be **received at some specific date in the future** - For determining spot rates for a n-year bond at least n bonds with maturities from 1 until n from the same issuer as the n-year bond are needed - **Assuming** that the **spot rates are purely a function of expectations** (-> expectation theory), spot rates can be used to **estimate the market’s consensus on future interest rates**

Answer 30

- Future interest rates are referred to as forward rates - Forward rate nfm is the interest rate we expect in period m, for a n-year horizon

Answer 31

**Inverse relationship** between price and yield for option-free bonds - When **yield goes up**, the **future cash flows are discounted with a higher rate** and hence the **present value (price) goes down** -> Negative correlation between bond price and yield - The **magnitude of the percentage change on a bond** for a given change in interest rate **depends on its coupon rate, its maturity and its initial yield**

Answer 32

- Yield spread is the **differential in yields between different bond issues** - Every market segment (e.g. industrial or utility) has its own unique level of interest rates - Non-Treasury bond must offer **risk premium above treasury yield** (riskfree benchmark), which is also referred to as **yield spread** - **Absolute yield spread** = yield bond 1 with maturity t – yield bond 2 with maturity t - **Relative yield spread** = absolute yield spread / yield bond 2 with maturity t

Answer 33

Shows **yields on different treasuries plotted against their maturities** - Upward sloping - Downward sloping (inverted) - Flat

Answer 34

Spread **between two sectors of the bond market** (e.g. treasury and corporate) - Important: **Use comparable bonds** (maturity, coupon, call features, credit risk etc.) so as to isolate the spread between the sectors

Answer 35

e.g. corporate AA-bonds versus corporate BBB-bonds or long vs. short treasuries

Answer 36

Yield spread that exhibits that the **two issues are identical in all respects but credit rating**, showing the **pure effect of credit quality**

Answer 37

- Effect the yield of a bond - Effect is **often filtered out** and the consecutively obtained spreads, the so called **option-adjusted spreads (OAS)**, serve as a better measure of the credit risk of an issue - Unadjusted spreads are known as **nominal spreads**

Answer 38

- Liquidity effect says that **greater liquidity corresponds to lower yield spreads** and vice versa - **Large issues** tend to have **greater liquidity**, hence **lower yield spreads**

Answer 39

Provides and **exact estimate of the effect a given change in interest rate will have on a bond** (portfolio) It is the most straightforward method for measuring interest rate risk and comprises the **following steps** 1. Begin with **current market yield and price** 2. Estimate **hypothetical change in required yields** 3. **Re-compute bond prices** using new required yields 4. **Compare** the resulting **price changes** -> Consists of computing a series of hypothetical bond prices given a series of unexpected future market yields

Answer 40

- Duration is the most widely used **measure of bond price volatility** - **Linear approximation** of the nonlinear (curvy) **price yield function** - Shows how the **price of a bond is likely to react** to **different interest rate environments** - Captures the **impact of coupon, maturity and initial yield in a single measure** - Mathematically it is the **first derivative of the bond’s price function with respect to yield** - Sometimes described as a present value-weighted number of years of maturity - Measure of a **bond’s sensitivity to a 1 percent change in interest rate** -> Assuming a parallel shift in the yield curve

Answer 41

- Relationship between bond price and yield is not linear (as assumed by duration), but rather convex - Curvature of the actual price path is known as **degree of convexity** - **Amount of convexity** is measured and **used to supplement duration** in order to get more **accurate estimates of the price change** - It **accounts for the amount of error in the estimated price as based on duration** - Mathematically it is the **second derivative** of the **price function with respect to yield**

Answer 42

**Total percentage change in price** and therewith a **quantification of interest risk** is calculated as the **sum of the duration effect and the convexity effect**

Answer 43

**Description** Graphical representation of yield plotted against time or maturity for a particular class of bonds (e.g. AAA corporate yield curve) **Yield curve shapes** - **Normal:** Long-term rates are greater than short-term rates -> Positively sloped yield curve - **Flat:** Yield is the same for all maturities - **Inverted:** Long-term rates are less than short-term rates -> Negatively sloped yield curve - **Humped:** Rates in the middle of the maturity spectrum are higher or lower than those for both short and long maturity bonds

Answer 44

- **Parallel shift:** Change of yields on all maturities in same direction and amount -> Slope stays the same - **Twist:** Yield curve becomes steeper or flatter -> Slope changes - **Butterfly shifts:** Refers to changes in the degree to which the yield curve is humped or curved -> Positive: Afterwards less curved -> Negative: Afterwards more curved

Answer 45

- **Pure (unbiased) expectations** theory - **Liquidity preference** theory - **Predefined habitat** theory - **Market segmentation** theory

Answer 46

- Forward rates reflect investors’ expectations of future rates plus a liquidity premium to compensate for exposure to interest rate risk - Theory suggests that **liquidity premium is positively related to maturity (larger premiums for longer maturities)** - Hence, an **upward sloping yield curve** can indicate **future rise in interest rates** or be also the **consequence of the addition of the liquidity premium**, while rates are expected to remain constant

Answer 47

- Forward rates reflect investors’ expectations of future rates plus a premium, which is not directly related to maturity (in contrast to liquidity preference theory) - Suggests the **existence of an imbalance between supply and demand** for **funds in a given maturity range (habitat)** - The **offered risk premium** shall **compensate the lenders for exposure to price and/or reinvestment rate risk** in the **“less-than-preferred” maturity range**

Answer 48

- As in preferred habitat theory it is proposed that **lenders and borrowers have preferred maturity ranges** - The theory relies on the idea that **some investors have restrictions** (either legal or practical) **on their maturity structure** (as for example for money market funds or life insurance companies) - Furthermore, it is **assumed that both lenders and borrowers are unwilling to shift out their preferred** -> The **shape of the yield curve** is completely **determined by the supply and demand for securities within each maturity segment** - At the extreme, this implies that rates for a given maturity band will be determined independently of those for all other maturity bands

Answer 49

- Suggests that forward rates are **solely a function of expected future spot rates** - Long-term interest rates equal the mean of future expected short-term rates - **Implication:** Same return by investing in a 1-year bond or by sequentially investing in two 6-months bonds

Answer 50

- **Price Risk:** Uncertainty associated with future price of a bond that may be sold prior to its maturity - **Reinvestment risk:** Uncertainty associated with the rate at which bond cash flows can be reinvested over an investment horizon -> Risk difference between investing in a 1-year bond and sequential investing in two 6-month bonds is not recognized

Answer 51

- Credit Rating - Rating watch - Rating outlook

Answer 52

- Reflects **probability of default** (default rate) and the **possible loss to the investor if default occurs** (default loss rate) - The **higher the credit rating** the **lower the default rate** and the default **loss rate**

Answer 53

- The **announcement of a review** of the current rating and a resulting **possible up- or downgrade** - Example: An upgrade watch means that the agency may issue an upgrade, usually within 3 months

Answer 54

- The issue of a **long-term projection** which looks out six months to two years - It is projected whether an issue is likely to be upgraded, downgraded or to keep its current rating

Answer 55

- Character - Covenants - Collateral - Capacity to pay

Answer 56

- Management’s **integrity and commitment to repay the loan** - Management’s **business qualification** - Management’s **ability to react to unexpected events** - Corporate **governance structure** (S&P’s corporate governance rating)

Answer 57

- Affirmative covenants: Require the debtor to take certain actions - Negative covenants: Prohibit the borrower from taking certain actions, usually by requiring the borrower to maintain certain ratios at specified levels

Answer 58

- Includes the **assets offered as security for the debt** as well as other **assets controlled by the issuer** - Borrowings can be **secured with a pledge of assets** or they **may be unsecured** (value of unpledged assets very important)

Answer 59

- Refers to the **ability of the borrower to generate cash flows** or **liquidate short-term assets** to repay its debt obligations - Liquidity positions are a key determining factor as cash must be there when debt payments are due

Answer 60

- **Working capital** (current assets and current liabilities) -> short term solvency ratios - **Dependable, steady cash flow** (cash flow analysis) - **Back-up facilities**, as lending agreements or informal agreements - **Securitizing assets** (MBS and ABS) - **Third party guarantees** (e.g. by a parent company)

Answer 61

- **Profitability ratios:** As margins, access the ability to generate earnings - **Short-term solvency ratios:** Measure the ability of liquidation of short-term assets - **Capitalization (financial leverage) ratios** - **Coverage Ratios**

Answer 62

**Interpretation of ratios:** - Falling short-term solvency and coverage ratios and increasing capitalization ratios are **signs for a downgrade** **Limitations of ratios:** - Ratios are **only a snapshot** at a given point in time and are not forward looking

Answer 63

- Collateral credit quality - Seller/servicer quality - Cash flow stress and payment structure - Legal Structure

Answer 64

- Most important issue for analysis - Evaluation if it provides cash flow for interest and principal payment over the life of the issue - Concentration of loans in the collateral pool (-> diversification)

Answer 65

- Third-party **ABS servicer collects the payments, notifies the issuer of delinquencies (= Zahlungsrückstände), recovers and liquidates the collateral and is responsible for the distribution of cash flows to the bondholders** - Servicer should therefore be assessed concerning its **performance history, experience, underwriting standards, servicing capabilities, financial strength and growth** - When the servicer’s responsibility goes beyond administrative tasks (hybrid transaction), corporate credit analysis is used to evaluate the servicer’s credit quality

Answer 66

- **Passthrough**, i.e. one senior tranche with pro rata distribution of cash flow - **Paythrough**, i.e. senior tranche divided into multiple senior tranches (ABS tranches) subject to a set of rules of distribution of cash flow

Answer 67

- SPV (special purpose vehicles) constructions have the consequence that in the event of bankruptcy, the assets of the SPV are not included in corporate assets -> An ABS rating must be worked out independently of corporate credit ranking

Answer 68

**Tax-backed debt** - Issuer’s debt structure (e.g. debt per capita) - Budgetary policy - Local tax and availability of intergovernmental financial support by a higher governmental level - Issuer’s socioeconomic environment (e.g. employment level, economic environment etc.) **Revenue bonds** - Limits of the basic security (e.g. limitations on project revenues) - Flow of fund structure - Rate, or user charge, covenants - Additional-bonds test