Bond Ratings and Features

Question 1

What are the 3 major credit rating agencies?

Answer 1

Fitch Ratings, Inc
Moody’s Investor Service, Inc
Standard and Poor’s Rating Service (S&P)

Question 2

Rating Method used by Moody’s and S&P?

Answer 2

Letter rating system - these are most notable companies in the borrower rating market. If Fitch is brought up, it follows the same method as S&P.

Question 3

S&P and Moody’s Grading System Chart

Answer 3

S&P             Moody's
AAA             Aaa
AA                Aa
A                   A
BBB              Baa
BB                 Ba
B                   B
C                   Caa
D                   D

Question 4

These bonds are the only quality eligible for purchase by the institutions )i.e. banks or insurance companies), and by fiduciaries and, therefore, have greater liquidity than lower-grade instruments.

Answer 4

Investment grade bonds.

Question 5

All other things equal, the higher the rating, the _______ the yield.

Answer 5

Lower. The more risk of payments not being made on time, the greater the reward in that an increased interest rate is applied to borrow money.

Question 6

Lower grade bonds also known as junk bonds, are also known as?

Answer 6

High yield bonds.

Question 7

Who may high yield bonds be suitable for?

Answer 7

A sophisticated investor seeking higher returns, and possible capital appreciation from speculative fixed income investments.

Question 8

Rating organizations rate organizations when one of these two things happen:

Answer 8

They pay to be rated, or they have enough outstanding bonds to generate constant investor interest.

Question 9

Call Feature Bond

Answer 9

Allows the Issuer to call in a bond prior to maturity. Benefits the issuer, usually when interest rates are falling so the issuer can then issue a lower interest rate bond.

Question 10

Put Feature Bond

Answer 10

Opposite of Call Feature, this benefits the Bondholder and allows them to put the bond to the issuer prior to maturity. Usually when interest rates are rising so they can take the principal amount and invest into a higher interest rate bond.

Question 11

Convertible Bond

Answer 11

Benefits the bondholder, issued by corporations and allows the bondholder to convert portions of their bond for shares of common stock. Generally the coupon rate will be lower on these due to the benefit of the bondholder.

Question 12

Duration

Answer 12

Duration is measured by a combination of coupon rate and maturity to determine a bond’s volatility. The lower the duration, the less price volatility within the bond, the higher the duration the greater the price volatility.

Lower coupon rate and greater time to maturity brings higher duration.

Question 13

Describe phantom income.

Answer 13

When an organization issues a zero bond (without coupon) it issues at a deep discount and with interest to be paid at maturity. That interest is to be paid taxes on by the bondholder until maturity, and is calculated by dividing the total interest by the years to maturity (i.e. $500 in interest / 10 years to maturity = $50 in income per year to be paid taxes on, or $50 per year in phantom income).

Question 14

What’s the difference between and STRIP and a T-bond?

Answer 14

a STRIP is a zero bond issued with the full faith of the US treasury, while a T-bond is a basket of treasury receipts issued by broker dealers not guaranteed by the US Treasury.

Question 15

What types of collateral are used in secure debts?

Answer 15

Real Estate (Mortgage Bonds)
Assets/Equipment (Equipment Trust Certificates)
Securities (Collateral Trust Bonds)

Question 16

These are backed by the full faith and standing of a corporation.

Answer 16

Unsecured debt securities.

Question 17

These are backed by various assets owned by the issuer.

Answer 17

Secured debt securities.

Question 18

What is a debenture?

Answer 18

It is a written promise from a corporation to pay back the principal at its due date and interest regularly based on its word and credibility. It is binding, but not as secured as pledge of property etc.

Question 19

Is a guaranteed bond a secured debt security?

Answer 19

No, it is only backed by a parent company in case the issuer defaults. But there are no assets on the line to back the debt security.

Question 20

Are income bonds ideal for someone interested in adding fixed income to their portfolio?

Answer 20

No - income bonds only pay income if and when the BOD declares for interest to be paid according to profits being high enough to do so.

Question 21

Income and Guaranteed Bonds are examples of ….

Answer 21

Debentures

Question 22

Where does subordinated debt rank when paying out creditors and stockholders?

Answer 22

Creditors are always paid first, but any debt that is subordinated would be paid after the debentures, followed by preferred stockholders, and then common stockholders.

Secured Debt holders, Senior Debt, Junior Debt, Preferred Stockholders, Common Stockholders

Question 23

Benefits of owning debt securities

Answer 23

Income - steady, predictable, obligated

Safety - less volatile, higher seniority when in default

Question 24

Risks of owning debt securities

Answer 24

Default - failure to pay interest or principal when due. Depend on creditor ratings.
Interest Rate Risk - All debt securities will fluctuate in response to changing interest rates.
Purchasing Power Risk (Inflation) - As fixed payment stays the same over time, inflation increases and that purchasing power isn’t what it was.

Question 25

Tell me about Municipal Bonds. What tax, trade, interest guidelines do they follow?

Answer 25

Municipal Bond funds are issued by local or state governing bodies and the funds go to support public works. Second in security only to the US government.

They are federal and state income tax free if the investor lives in the state of issuance.

Trades settle T+2 and pay accrued interest on a 30 day/month 360 year calendar.

Question 26

What are TAN’s?

Answer 26

Tax anticipations notes issued by municipal governments with short term maturities to even out cash flow in anticipation of of future tax receipts.

Question 27

What are RAN’s?

Answer 27

Revenue anticipation notes issued with short term maturities to cover operating expenses until revenue from upcoming project comes in.

Question 28

What are TRAN’s?

Answer 28

Combo RAN and TAN - tax and revenue anticipated combined.

Question 29

Why use BAN instead of RAN, TAN, or TRAN?

Answer 29

BAN’s are bond anticipation notes issued for interim financing but will be converted to long term funding through sale of bonds.