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CISI Securities > 2.2 Debt: Types and Features > Flashcards

2.2 Debt: Types and Features Flashcards

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1
Q

What is nominal value

A

The amount that the borrower will pay back to the holder on maturity / the capital payment the holder receives at redemption

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2
Q

What is the coupon

A

Expressed as an annual % of the nominal value. UK pay this semi-annually

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3
Q

What are floating rate notes (FRNs)

A

Bonds that state the coupon by reference to a published interest rate, such as the SOFR and reset the coupon paid when the published interest rate changes

Trade near par (Price=NV)

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4
Q

Who issues government bonds in US and UK

A

Bureau of Fiscal Service in US
Debt Management Office (DMO) in UK

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5
Q

What is the ex-dividend period and how long is it for gilts

A

Because of possible ownership changes before the coupon payment date, the period prior to each coupon date when a bond is dealt without entitlement to the impending coupon payment is called the ex-dividend period (despite its a bond)

For most gilts its 7 working days prior to the coupon payment date

For the remainder of time, the bond is described as trading cum-dividend

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6
Q

What is the risk free rate

A

..

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7
Q

Describe the 2 types of government bond

A

Index linked- Bonds where coupon payments and principal (redemption amount) are adjusted in line with a published index of price inflation (RPI/CPI). Lower yield

Conventional- Fixed coupons, fixed maturity, eroded by inflation

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8
Q

Give examples of US and UK index-linked bonds

A

UK Index-linked gilts (ILGs)
US TIPS

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9
Q

What is the effect of inflation on index-linked bonds

A

If CPI positive, there is inflation and principal increases, if CPI negative there is deflation and principal decreases

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10
Q

What happens to index-linked bonds in times of zero inflation

A

In a period of zero inflation, index-linked bonds will pay the nominal coupon rate with no adjustment
and simply pay back the nominal value at maturity.

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11
Q

What happens to index-linked bonds in times of deflation

A

In periods of deflation (negative inflation, with prices persistently falling), some sovereign index-linked
bonds (eg, in the US and France) have a ‘deflation floor’, with the issuer guaranteeing that the redemption
payment will not be less than the original par value.

However, there is no deflation floor for the UK’s
index-linked gilts, where the possibility exists of returning less than the nominal value at redemption

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12
Q

Real interest rate formula

A

Real interest rate = [(1 + nominal interest rate) / (1 + inflation rate)] – 1

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13
Q

CPI

A

Based on an EU-wide formula that was originally called the HICP,
allowing direct comparison of the inflation rate in the UK against that in the rest of Europe. CPI at
2% is the current target for the BoE’s Monetary Policy Committee (MPC).

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14
Q

RPI

A

An average measure of change in the prices of goods and services using basket of 300 goods.
Once published, it is never revised.

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15
Q

PPI

A

– this is based on measuring inflation further up the supply chain at
the wholesale level, including ‘factory gate’ inflation

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16
Q

What are Separate Trading of Registered Interest and Principal of Securities
(STRIPS)

A

Stripping
a bond involves trading the interest (each individual coupon) and the principal (the nominal value)
separately.

Each individual strip forms the equivalent of a ZCB. Each strip will trade at a discount to its
face value, with the size of the discount being determined by prevailing interest rates and time.

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17
Q

What are zero coupon bonds (ZCBs)

A
  • Pay no interest
  • Bought at discount and redeemed at nominal value
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18
Q

Who are the permitted parties who can strip gilts

A
  • Only gilt-edged market makers:
  • GEMMS
  • HM Treasury
  • Bank of England
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19
Q

What is the advantage of STRIPS

A

The key advantage of STRIPS is that investors can precisely match their liabilities, removing
any reinvestment risk. STRIPS can meet the liabilities of the investor precisely, removing
any reinvestment risk that is normally faced when covering liabilities with coupon-paying bonds.

Furthermore, investors in government bond STRIPS have few worries about the risk that the issuer of the
bonds will default – for example, liabilities of the US and UK governments are generally considered to be
virtually free of any default risk (also known as credit risk

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20
Q

How many zero coupon bonds can a 7-year strippable gilt be stripped into

A

(7*2)(semi annual coupon payments)+1(final capital payment)=15

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21
Q

What is dedication

A

Where the investor matches the maturity of cash flows to liabilities, simply done through ZCBs. STRIPS facilitate this as act as ZCBs

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22
Q

What is reinvestment risk

A

Where the investor may not receive a required rate of return when reinvesting coupon payments (possibly because interest rate has fallen), therefore can’t meet liabilities

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23
Q

Which US and UK bonds can be stripped

A

STRIPS markets have been developed in US Treasuries and in the UK gilts market. US financial institutions are able to create STRIPS from US T-notes and bonds, including TIPS.

In the UK, only those
gilts that have been designated as strippable by the Debt Management Office (DMO) are eligible for the STRIPS market, not all gilts.

Those gilts that are stripped have separate registered entries for each of the
individual cash flows that enable different owners to hold each individual strip, and facilitate the trading
of the individual STRIPS.

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24
Q

What is reconstitution

A

‘Reconstitution’ is, effectively,
exchanging STRIPS for a conventional gilt, with the UK DMO as the counterparty to the deal

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25
Q

US T-Bills

  1. Coupon frequency?
  2. Maturity?
  3. Settlement period?
A
  1. No coupon paid
  2. Less than one year
  3. Trade date
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26
Q

US T-notes

  1. Coupon frequency?
  2. Maturity?
  3. Settlement period?
A
  1. Semi-annual
  2. 2-10 years
  3. T+1
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27
Q

USA T Bonds

  1. Legal form
  2. Coupon frequency
  3. Maturity
  4. Settlement period
A
  1. Registered
  2. Semi-annual
  3. > 10
  4. T+1
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28
Q

UK (Gilts)

  1. Legal form
  2. Coupon frequency
  3. Maturity
  4. Settlement period
A
  1. Registered
  2. Semi annal
  3. Short:<7, Med:7-15, Long:>15
  4. T+1
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29
Q

Japan (JGBs)

  1. Legal form
  2. Coupon frequency
  3. Maturity
  4. Settlement period
A
  1. Registered or bearer
  2. Semi annual
  3. 2-40 years (Long is most common:10 Superlong:20)
  4. T+1
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30
Q

France Bonds

  1. Legal form
  2. Coupon frequency
  3. Maturity
  4. Settlement period
A

1.Bearer
2. Annual
3. OATS: 2-50
4. T+2

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31
Q

Germany T Bonds

  1. Legal form
  2. Coupon frequency
  3. Maturity
  4. Settlement period
A
  1. Bearer
  2. Annual
  3. Schatz: Up to 2
    Bobl: 5
    Bund: 10-30
  4. T+2
32
Q

What are the types of corporate bonds

A

Secured debts securities- Bonds secured by assets of company (named asset e.g. property) - consists of fixed charge and floating charge over assets

Unsecured debt securities

33
Q

Describe the 2 ways of issuing secured debt

A

Fixed charge over assets– The debt carries a charge over a particular company asset, eg, a building or land. A mortgage charge is a type of fixed charge.

Floating charge over assets- the debt is secured against a group of the company’s assets (e.g. plant and machinery) ; in the event of default, a floating charge crystallises over the available assets at that point

34
Q

Another word for unsecured debt

A

Loanstock

35
Q

What is the meaning of debenture in the UK vs US

A

UK: A secured bond (with fixed charge)
US: Unsecured bond

In US they call secured debt asset backed security (ABS)

36
Q

What is meant be secured debt and give examples

A

Bonds secured by assets of company (named asset e.g. property) - consists of fixed charge and floating charge over assets

Eg. ABS, MBS, Covered Bonds

37
Q

What is meant by unsecured debt and give examples

A

Has typical life of 7-30 years

Convertible bonds
Exchangeable bonds
Guaranteed bonds
Floating rate notes (FRNs)
Payment in kind notes (PIK)

38
Q

What are Asset-Backed Securities (ABS)

A

Asset-backed securities (ABSs) are bonds that are backed by a particular pool of assets sch as property, loans, credit card receivables

39
Q

What are Mortgage-Backed Securities (MBS)

A

Mortgage-backed securities (MBSs) are one example of ABSs. They are created from mortgage loans
made by financial institutions like banks and building societies. MBSs are bonds that are created when
a group of mortgage loans are packaged (or pooled) for sale to investors. As the underlying mortgage
loans are paid off by the homeowners, the investors receive payments of interest and principal.

40
Q

Who are major issuers of MBS

A

The MBS market began in the US, where the majority of issues are made (or guaranteed) by an agency of
the US government. The Government National Mortgage Association (commonly referred to as Ginnie
Mae), the Federal National Mortgage Association (Fannie Mae) and the Federal Home Loan Mortgage
Corporation (Freddie Mac) are the major issuers

41
Q

Difference between ABS and covered bonds

A

Both are same thing (secured debt) but have different names depending on who owns

If the pool of assets is owned by the originator eg the bank who lent out the mortgage, its called a covered bond

If the pool of assets is owned by a special purpose vehicle (SPV), its called an Asset Backed Security (SPV)

42
Q

What is the purpose of a SPV (Special Purpose Vehicle)

A

ABSs often utilise a special purpose vehicle (SPV) in order to lessen the default risk that investors face
when investing in the securities.

This SPV is often a trust, and the originator of the assets, such as the
bank granting the mortgage loans, sells the loans to the SPV and the SPV issues the asset-backed bonds.

43
Q

Benefits of SPV

A

The SPV is a separate entity from the originator of the assets, so the assets leave the originator’s
financial statements to be replaced by the cash from the SPV. This is often described as an offbalance-sheet arrangement because the assets have left the originator’s balance sheet

The SPV is a stand-alone entity, so, if the originator of the assets suffers bankruptcy, the SPV still
remains intact with the pool of assets available to service the bonds. This is often described as
bankruptcy-remote and enhances the creditworthiness of ABSs, potentially giving them a higher
rating than the originator of the assets.

44
Q

Purpose of a trust deed and benefits

A

When a corporation either in the UK or US issues secured debt to a large number of persons, it is
invariably the case that a trustee will be appointed.

A trust deed empowers the trustee alone to act on behalf of debenture holders - ensures organized action and parity of treatment through a single entity (instead of individual holders dealing separately)

But costly

45
Q

Different trustees

A

…

46
Q

What is mezzanine debt

A

The mezzanine level of debt will rank below other forms of debt but above the equity in a liquidation. For example, a payment in kind note (PIK)

To reflect the risk, the interest on mezzanine debt tends to be much higher than subordinated debt.
Indeed, some or all of the interest might not be paid in cash and is added to the principal outstanding
instead. This rolled up interest is often described as ‘payment in kind’ interest, or PIK. Sometimes the
mezzanine debt will also include warrants or options so that the lender can participate in equity returns

47
Q

What is senior debt

A

As the name suggests, this debt ranks above all other debt and equity capital in the business. It will be repaid before any of the other tiers of lender receive anything.

. It will have the lowest interest rate of all the tiers since, from the
lender’s perspective, it is more secure

48
Q

What is subordinated debt

A

Again, as suggested by the name, this debt ranks behind senior debt – it is subordinated to senior debt
– in the event that the company is liquidated

49
Q

List order of debt seniority in event of liquidation

A

Paid first: (Liquidator)

  1. Fixed charge holders (bond secured against named asset in company)
  2. Preferential creditors eg employees
  3. Floating charge holders (bond secured against pool of assets)
  4. Unsecured creditors (unsecured debt/loanstock) - guaranteed bonds and convertible bonds rank alongside other unsecured debt here
  5. ## MEZZANINE DEBT ( Subordinated loan stock eg PIK)
  6. Preference shareholders (fixed nominal value only except participating shareholders)
  7. Ordinary shareholders if anything left
50
Q

What are exchangeable bonds

A

Converts into stock of another, usually subsidiary of the issuer (exchange for shares of third party company)

51
Q

What are guaranteed bonds

A

Another company guarantees payment

52
Q

What are payment in kind notes (PIK)

A

Zero coupon bonds that are issued at a substantial discount to their face value

53
Q

What is LIBOR

A

LIBOR. LIBORs reflect the
average rates at which banks in London offer loans to other banks.

Benchmark for interbank borrowing

54
Q

What is SONIA

A

Sterling Overnight Index Average (SONIA) in UK:

Published by the Bank of England and based on the actual overnight rates banks borrow money

55
Q

What is SOFR

A

Secured Overnight Financing Rate (SOFR) in the US:

Published by the Federal Reserve and based on actual overnight Treasury repo market

56
Q

What is a eurobond and what type of ownership does it have and how is it traded

A

Bond issued in eurocurrency (any currency other than the currency of the market its issused)

Bearer document

Traded OTC or some exchange-traded

57
Q

Who regulates Eurobonds

A

Regulated by ICMA

58
Q

Eurobonds

Coupon
Day count convention for accrued interest
Settlement

A

Gross annual coupon
30/60
T+2 settlement

59
Q

What are stepped bonds

A

Coupons increase over the life of the bond

60
Q

What is immobilization

A

As bearer documents, Eurobonds are often held in depositaries like Euroclear or Clearstream - can still be traded if held in depositary

61
Q

Who has Baa rating when others are BBB

A

Monody’s

BBB is last grade to be speculative
Below that is BB

Moodys have smaller ratings if 123 while others are +-

62
Q

When trading in the UK government bond market and cash bargains which of the following statements is TRUE?

A

The cash settlement will take place following the acquisition of the bargain and by the end of the next business day

This is a long way round of making sure you know Gilts settle T+1.

63
Q

All of the following are true of convertibles except:

A

The issuer has the right to redeem the bond early if it is in its best interests to do so

A convertible bond allows the buyer to convert into a pre-determined number of shares. It is, effectively, a ‘straight’ or ‘vanilla’ bond combined with an option to buy shares. Option A describes a CALLABLE bond, i.e. one that may be redeemed early by the issuer.

64
Q

A bond which has just defaulted on a coupon payment would be rated as by Standard and Poor’s and Fitch as:

A

D

65
Q

According to the credit ratings agency Moody’s what credit rating would be issued to a bond in default?

A

C

66
Q

Which of the following asset classes can be broken into tranches offering different levels of risk and return?

A

Mortgage-backed securities
Collateralised debt obligations

67
Q

Interest rates on index-linked gilts are linked to:

A

Retail price index

68
Q

Credit enhancements are:

A

Tools used by an issuer to enable bonds to be more highly-rated

69
Q

Who issues JGBs

A

They are issued by the Government of Japan

70
Q

Which of the following about stripped government bonds are true?

A

They are zero coupon
They are tradable

71
Q

Which of the following is not true of overseas government bonds?

A

The correct answer is: A - Bobls are bonds with a life of 10 years or less

72
Q

Which of the following is LEAST likely about Eurobonds?

A

Most bonds are quoted clean but will settle dirty, all the other statements are true.

TRUE: TRADES ARE MATCHED VIA TRAX SYSTEM

73
Q

Patrick observes that the effective price per share from a convertible bond is lower than the current market price of the underlying shares. How can he profit from this observation?

A

Buy the convertible and sell the underlying shares

74
Q

Why would a company prefer to issue a convertible bond rather than issue shares to finance a takeover?

A

To benefit from lower initial servicing costs

75
Q

A company could issue bonds in order to satisfy the needs of investors that wish to invest in it, with the coupon rate and maturity set according to market demand. This is an example of which of the following?

A

Medium-term notes

76
Q

What type of coupon does a vanilla convertible bond usually pay?

A

Fixed

77
Q

Which one of the following is the system for reporting eurobond trades?

A

TRAX

CISI Securities (15 decks)

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