BKM14 - 2

Question 1

Credit risk

Investment grade

Speculative grade/junk bonds

Answer 1

Credit risk: bond default risk; measured by firms such as Moody’s, Standard & Poor’s, and Fitch

Investment grade: bonds rated BBB or above

Speculative grade/junk bonds: lower rated bonds

Question 2

determinants of bond safety

Answer 2

coverage ratio

liquidity ratio

leverage ratio

cash flow to debt ratio

profitability ratio

Question 3

coverage ratio

Answer 3

Ratio of company earnings to fixed costs. 

*low/falling ratios may signify possible cash flow difficulties

Times interest earned ratio = earnings before interest payments and taxes / interest obligations

Fixed charge coverage ratio = earnings/all fixed cash obligations

Include lease payments, sinking fund payments, and interest obligations

Question 4

Leverage ratio

Answer 4

Leverage ratio = Ratio of debt to equity

-if too high, firm may be unable to satisfy its obligations

Question 5

Liquidity ratios

Answer 5

measures the insurer’s ability to pay bills with its most liquid assets. 

Current ratio = current assets / current liabilities 

Quick ratio = current assets excluding inventories / current liabilities

Question 6

Profitability ratios

Answer 6

Return on assets = earnings before interest & taxes / total assets 

Return on equity = net income / equity

Question 7

Cash flow to debt ratio

Answer 7

Cash flow to debt ratio = total cash flow / outstanding debt

Question 8

due to default risk, stated yield

Answer 8

is maximum possible yield to maturity that the bondholder can earn

• if the financial condition of a firm deteriorates and it becomes likelier that the bonds will default, bond price should fall, resulting in an increase to promised yield to maturity for someone who purchases the bond today
• on other hand, expected yield to maturity should be much less affected

Question 9

bonds need to offer a

Answer 9

bonds need to offer a default premium to compensate for the chance of default

Question 10

Default premium

Answer 10

difference between yield of corporate bond and yield of comparable government bond which has no credit risk

Question 11

credit default swap

Answer 11

essentially an insurance policy on the default risk of a bond/ loan

• CDS buyer needs to pay the seller an annual premium
• seller will compensate buyer in event of default
• CDS typically would be purchased by large bondholders
• investor who holds a bond with BB rating can purchase CDS on issuer to effectively raise the position to that of holding an AAA rated bond

Question 12

CDS played large role in

Answer 12

2008 financial crisis

-when subprime mortgage market collapsed, obligation on these CDS’ increased to an unimaginable level

Question 13

Collateralized debt obligation (CDO)

Answer 13

tool that can reallocate credit risk

A financial institution would create a separate entity to buy a portfolio of bonds/ loans. These are pooled together, and then split into different tranches.

• As the securities in the pool make their interest payments, the proceeds are distributed to pay interest to tranches in order of seniority.
• Lower seniority tranches would suffer default losses before higher seniority.

Question 14

Bond Indentures

Answer 14

• Contract between the bond issuer & bondholder.
• Includes protective covenants that protect the rights of the bondholders.

Question 15

protective covenants

Answer 15

sinking funds

serial issue

subordination of further debt

dividend restrictions

collateral

Question 16

sinking funds

Answer 16

the issuer needs to establish a sinking fund to spread burden of repaying principal over several years: 

Option 1: repurchase % of outstanding bonds in the open market annually 

Option 2: purchase a fraction of the bonds at either the market price or the sinking fund price

Question 17

2 main difference between a sinking fund call and conventional bond call:

Answer 17

1. firm can only repurchase a limited fraction of bonds at the sinking fund call price
2. call price of callable bonds usually exceeds par value whereas sinking fund call price is usually set at par value
   - sinking funds are designed to protect the bondholders but can actually hurt them because firm would choose to buy back discount bonds at the market price but would buy back the premium bonds at par

Question 18

Serial bond issue

Answer 18

type of bond issue that does not require sinking fund in which firm issues bonds with staggered maturity dates

• sinking fund is not as necessary because the repayment burden is spread
• main disadvantage is that bonds with different maturities are not interchangeable thus reducing liquidity of issue

Question 19

Subordination of Further Debt

Answer 19

restricts the amount of additional borrowing and requires additional debt may be subordinate in priority to existing debt

Question 20

problem with subordination clause

Answer 20

• perhaps the issuer would really need cash, but due to this clause, it will not be able to borrow any additional money. This lack of cash flow could cause it to go into bankruptcy, in which case the bondholder would lose financially

Question 21

Dividend Restrictions

Answer 21

limit the dividends that the firm can pay.

Question 22

what bonds are unsecured?

Answer 22

General debenture bonds

• more credit risk, level of which depends on earning power of insurer
• due to higher credit risk, these bonds have to offer higher yields than collateralized bonds

Question 23

examples of bonds and associate collateral

Answer 23

Mortgage bond & property

Collateral trust bond & other securities

Equipment obligation bond & equipment