Brainscape's Knowledge GenomeTM

Browse over 1 million classes created by top students, professors, publishers, and experts.


See full index

CFA > 2024 L1 Fixed Income > Flashcards

2024 L1 Fixed Income Flashcards

You may prefer our related Brainscape-certified flashcards:
CFA flashcards
1
Q

What is fixed income?

A
  • Debt, such as loans and bonds
  • Includes private agreements between borrower annd lender, ie individuals and corporations and banks or funds
  • Also includes public securities i.e., many lenders, one borrower. When you buy a treasury you are actually lending the govt money. This involves investors as lenders, and corporations and govts as borrowers
  • All fixed income involves periodic interest payments plus principal

2024 L1 Fixed Income - LM1 Fixed-Income Instrument Features

How well did you know this?
1
Not at all
2
3
4
5
Perfectly
2
Q

What is a capital market security?

A
  • A bond with greater than 1yr initial maturity at issuance
  • Less than 1yr is a money market security

2024 L1 Fixed Income - LM1 Fixed-Income Instrument Features

How well did you know this?
1
Not at all
2
3
4
5
Perfectly
3
Q

What is an amortising bond?

A
  • Payments over the life of the bond also include principal.
  • This is contrasted to a bullet bond where the whole principal is paid at the end
  • MBS often include principal in every coupon payment

2024 L1 Fixed Income - LM1 Fixed-Income Instrument Features

How well did you know this?
1
Not at all
2
3
4
5
Perfectly
4
Q

What is a floating coupon?

A
  • Coupon payment by the bond varies i.e., US treasury rate plus 2%

2024 L1 Fixed Income - LM1 Fixed-Income Instrument Features

How well did you know this?
1
Not at all
2
3
4
5
Perfectly
5
Q

What is seniority?

A
  • Position of the bond in the capital structure (i.e., priority of claim or assets)
  • Senior secured is highest, then senior unsecured
  • All senior unsecured ranks equally
  • Junior or subordinated debt is next
  • Contingency provisions are often included in lower quality debt that alow for an action if an event or circumstance happens. I.e., calls, puts, or convertibility to equity

2024 L1 Fixed Income - LM1 Fixed-Income Instrument Features

How well did you know this?
1
Not at all
2
3
4
5
Perfectly
6
Q

What are premium, discount, and par bonds?

A
  • Premium bonds are where price is above par. The yield is less than the stated coupon payment. This will happen if rates fall from when it was issued.
  • Discount bonds are where price is less than par. Yield is greater than coupon. This will happen if rates rise from when it was issued
  • Par bonds are where price = par price and yield = coupon stated.

2024 L1 Fixed Income - LM1 Fixed-Income Instrument Features

How well did you know this?
1
Not at all
2
3
4
5
Perfectly
7
Q

Why is bond IRR affected by interest rate changes?

A
  • IRR assumes coupon is reinvested at YTM rate
  • Therefore if interest rates change the rate might increase or decrease

2024 L1 Fixed Income - LM1 Fixed-Income Instrument Features

How well did you know this?
1
Not at all
2
3
4
5
Perfectly
8
Q

What is a bond indenture?

A
  • The legal contract for a bond
  • Contains form of the bond, obligations of the issuers, rights of bondholders, SOURCES of repayments
  • For sov govts, taxation and printing currency
  • For local govts, taxes and project cash flows
  • For corporations, operating cash flows to pay interest and principal
  • Plus for all, pledge of specific assets when secured bond

2024 L1 Fixed Income - LM1 Fixed-Income Instrument Features

How well did you know this?
1
Not at all
2
3
4
5
Perfectly
9
Q

What are the 2 types of bond covenants?

A
  • Affirmative and negative
  • Affirmative impose no cost or restriction on operating the biz
  • States what the issuer is required to do, usually administrative
  • Often includes passi passu clause: equal footing for senior unsecured debt
  • Also poften includes cross default clause: a default on one is a default on all
  • Negative imposes costs and restrictions on operating the biz
  • I.e., might ask if secured that you will not pledge any other asset
  • There might be restrictions on issuance of debt more senior (negative pledge clause)
  • There may be limitations on additional debt

2024 L1 Fixed Income - LM1 Fixed-Income Instrument Features

How well did you know this?
1
Not at all
2
3
4
5
Perfectly
10
Q

What does a fully amortising bond look like?

A
  • Equal amount of principal paid on each payment
  • Interest payment drops each time as the total principal decreases
  • Therefore total payment starts high and decreases
    • Higher reinvestment risk, in the case that rates are falling and what you reinvest you get returns on at a lower risk
  • But you also get decreasing credit risk, as the payments are covering your principal too
  • A bullet bond is where the full principal is paid back at maturity

2024 L1 Fixed Income - LM2 Fixed Income Cash Flows and Types

How well did you know this?
1
Not at all
2
3
4
5
Perfectly
11
Q

What is a partially amortising bond?

A
  • Part of the principal is amortised, part is paid back at the end
  • ie half the principal amortised, half paid back at the end

2024 L1 Fixed Income - LM2 Fixed Income Cash Flows and Types

How well did you know this?
1
Not at all
2
3
4
5
Perfectly
12
Q

Along what 3 dimensions can fixed income markets be categorised?

A
  1. Issuer type (sector)
  2. Credit quality
  3. Time to maturity

2024 L1 Fixed Income - LM3 Fixed Income Issuance and Trading

How well did you know this?
1
Not at all
2
3
4
5
Perfectly
13
Q

Do treasuries have risk?

A
  • Yes, they still have risk
  • But not default risk

2024 L1 Fixed Income - LM3 Fixed Income Issuance and Trading

How well did you know this?
1
Not at all
2
3
4
5
Perfectly
14
Q

What are the components of credit quality?

A
  1. Probability of default (PoD)
  2. Loss given default (LGD)

These are summarised by the credit rating, a qualitative letter-based measure that combines both PoD and LGD

2024 L1 Fixed Income - LM3 Fixed Income Issuance and Trading

How well did you know this?
1
Not at all
2
3
4
5
Perfectly
15
Q

What are the largest rating agencies?

A

Moody’s and S&P

2024 L1 Fixed Income - LM3 Fixed Income Issuance and Trading

How well did you know this?
1
Not at all
2
3
4
5
Perfectly
16
Q

What are fallen angels?

A
  • Debt issuers that drop below BBB- to BB+ or higher
  • They move from investment grade to high yield
  • High yield is sometimes called junk or speculative bonds because in the 80s when the market was created it was rare for companies to issue bonds
  • Therefore people thought they would be high risk
  • High yield bonds can be high quality especially at the top ie BB+

2024 L1 Fixed Income - LM3 Fixed Income Issuance and Trading

How well did you know this?
1
Not at all
2
3
4
5
Perfectly
17
Q

Why do fixed income indices exist?

A
  1. Track broad risk/return of different markets
  2. Enable evaluation of market performance
  3. Benchmarks for portfolios and investment managers
  4. Form the basis for indexed instrument strategies and products

2024 L1 Fixed Income - LM3 Fixed Income Issuance and Trading

18
Q

What are the differences between equity and bond indexes?

A
  • Bond indexes have many more constituents
  • Far more changes (issuance, maturity, monthly rebalancing)
  • Market value of debt weighted
  • Bond funds rarely hold all bonds, and instead use sampling
  • Bonds are priced once a day: it’s a dealer market and there is no minute to minute pricing
  • There will be monthly rebalancing

2024 L1 Fixed Income - LM3 Fixed Income Issuance and Trading

19
Q

What are the types of lines of credit?

A

Uncommitted, committed (regular), and revolving credit agreements (i.e., revolvers)

2024 L1 Fixed Income - LM4 Fixed Income Markets for Corporate Issuers

20
Q

What is an uncommitted credit line?

A
  • Banks can cancel anytime
  • Least reliable source
  • Up to a certain amount (credit line) for a maximum period of time (less than 1yr)
  • Floating credit plus spread
  • No costs other than interest payments

2024 L1 Fixed Income - LM4 Fixed Income Markets for Corporate Issuers

21
Q

What is committed credit?

A
  • A formal written commitment from the bank
  • Max term is less than 365 days, and then you must finish paying off the credit
  • i.e., rest the line
  • Will involve a commitment fee on the full or unused amount
  • Borrower does face renewal risk

2024 L1 Fixed Income - LM4 Fixed Income Markets for Corporate Issuers

22
Q

What is a revolving credit agreement?

A
  • Multi-year agreement
  • You must ‘rest the line’ and pay off the loan every year
  • However you don’t have rollover risk
  • The bank will add covenants (lender protections)

2024 L1 Fixed Income - LM4 Fixed Income Markets for Corporate Issuers

23
Q

What are the kinds of secured loans?

A
  • Secured loans: asset backed loans (fixed assets, high quality receivables, marketable securities)
  • Factoring: selling accounts receivable, typically at a discount (the factor collects the AR payments)

2024 L1 Fixed Income - LM4 Fixed Income Markets for Corporate Issuers

24
Q

What is commercial paper?

A
  • usually less than three months
  • Issued by large highly rated firms
    -Typically rolled over (which introduces rollover risk)
  • usually requires a backup line of credit (committed)

2024 L1 Fixed Income - LM4 Fixed Income Markets for Corporate Issuers

25
Q

What are sources of funding for financial companies?

A
  • desposits: household or commercial operational deposits. Checking accounts, demand deposits that pay little to no interest. No duration or maturity, but they do have a behavioural maturity (fee rebates, min balances)
  • Savings deposits: ie a certificate of deposit like a CD or term deposit. Less than 1yr maturity, pays interest at maturity.
  • Interbank market: short term lending/borrowing among financial institutions as either secured or unsecured. Overnight to 1yr at market maker rate. Interbank rate is used to price derivatives (ie between large investment banks) because they are the market makers. Banks hold funds with the central bank (reserves). Excess reserves can be lent in the CB funds market

2024 L1 Fixed Income - LM4 Fixed Income Markets for Corporate Issuers

26
Q
A
27
Q

How does the Fed control interest rates?

A
  • By setting an upper and lower bound between which all interbank lending rates much fall
  • i.e., CB lends money at 5%, borrows money at 4.75%. Therefore any bank cannot set interbank rates beyond this range since otherwise someone will go to the CB instead

2024 L1 Fixed Income - LM4 Fixed Income Markets for Corporate Issuers

28
Q

What is commercial paper?

A
  • Unsecured debt
  • Dominated by large financial institutions (about 60% pa)
  • asset backed commercial paper (ABCP) is off balance sheet. There is less capital required for banks, the upside for investors being that they get access to bank loan returns

2024 L1 Fixed Income - LM4 Fixed Income Markets for Corporate Issuers

29
Q

What are repos?

A
  • Secured short term funding
  • The pledge of a security under a repurchase agreement
  • Not exactly a security in itself
  • It could be a bond or MBS
  • If you want to maximise value you use sovereign bonds
  • It looks like you are selling and repurchasing it but really you retain ownership during the repo term
  • The buyer just gets the repo rate
  • There is usually something called a haircut where the cash lender will not give you the full amount back
  • Under repo, you get the same security back, under a dollar roll, you get a slightly differet one
  • When you post general collateral you pay the general collateral repo rate, which is typically higher than the specific collateral repo rate

2024 L1 Fixed Income - LM4 Fixed Income Markets for Corporate Issuers

30
Q

What is the variation margin?

A

The value of the haircut which makes the repo overcollateralised

2024 L1 Fixed Income - LM4 Fixed Income Markets for Corporate Issuers

30
Q

Why use repos?

A
  • Finance ownership of a security (for asset owners. Gives high leverage with less rollover risk than overnight borrowing)
  • earn short term income by lending funds on a secured basis (for lenders)
  • Borrow a security in order to short it (reverse repo)

2024 L1 Fixed Income - LM4 Fixed Income Markets for Corporate Issuers

31
Q

What is a reverse repo?

A
  1. Borrow a security and give cash
    - Typically a ‘special’ security i.e., an on the run bond (higher rate) which can become a lower rate one
    - Typically negative repo rates: security buyer pays interest
  2. you call sell the security and get cash (and earn the cash rate)
  3. you could buy the security back, hopefully at a lower price
  4. You return the security, and get back the cash, less the reverse repo rate

2024 L1 Fixed Income - LM4 Fixed Income Markets for Corporate Issuers

32
Q

What are repo rates affected by?

A
  1. Money market interest rates
  2. Collateral quality
  3. Repo term
  4. Collateral uniqueness - more unique, lower the repo rate
  5. Collateral delivery: higher rate if collateral is not delivered

2024 L1 Fixed Income - LM4 Fixed Income Markets for Corporate Issuers

33
Q

What are the risks for repo?

A
  1. Default risk: counterparty not repurchase
  2. Collateral risk: w low quality collateral
  3. Margining risk: counterparty may not meet margin calls if collateral drops in value
  4. Legal risk: you don’t have a formal legal ownership claim
  5. Writing/settlement risk: money and collateral might not actually transfer. A heavy reliance on repo market can create rollover and liquidity risks under adverse market conditions

Risks can be reduced by using a triparty repo, where the triparty has collateral and holds the cash and securities as the custodian

2024 L1 Fixed Income - LM4 Fixed Income Markets for Corporate Issuers

34
Q

What is the tradeoff between duration and rollover risk of corporate debt?

A
  • Higher yields over longer maturities usually
  • However when you issue short term debt if spreads jump this creates rollover risk. Sudden increase when you return to get more debt

2024 L1 Fixed Income - LM4 Fixed Income Markets for Corporate Issuers

34
Q

Why do high yield bonds have low sensitivity to increases in rates?

A
  • They have more distance from the risk free rate so value should not fall as much

2024 L1 Fixed Income - LM4 Fixed Income Markets for Corporate Issuers

35
Q

What is the composition of govt debt?

A
  • Short term: 1-12 months T bills
  • Medium term to long term: Notes, bonds, fixed rate generally. Limited issuance of FRNs, Treasury Inflation Protected Securities
  • Govt guarantees: govt agency debt (i.e., Ginnie Mae, the agency for mortgage backed securities)

2024 L1 Fixed Income - LM5 Fixed Income Markets for Government Issuers

36
Q
A

2024 L1 Fixed Income - LM6 Bond Valuation: Prices and Yields

37
Q

What is the trade off between coupon and price stability for floating vs fixed rate bonds?

A
  • Floating rate usually = more stable price
  • fixed rate usually = changing price

2024 L1 Fixed Income - L8 Yield and Yield Spread Measures for Floating-Rate Instruments

38
Q

How to calculate present value of a T-Bill?

A

PV = FV x (1 - days/year x DR)
- Where PV = present value
- FV = future value
- DR = discount rate

2024 L1 Fixed Income - L8 Yield and Yield Spread Measures for Floating-Rate Instruments

39
Q
A

CFA (4 decks)

Brainscape helps you reach your goals faster, through stronger study habits.
© 2024 Bold Learning Solutions. Terms and Conditions