Bonds

Question 1

Which US Treasuries are not marketable?

Answer 1

EE bonds

I bonds

HH bonds - Not issued since 2004.

Question 2

Describe Series I Bonds

Answer 2

Series I are inflation indexed bonds with no guaranteed rate of return.

They are sold at face value.

They pay a fixed rate of interest, and have an inflation component that adjusts every six months.

Question 3

Describe T-bills, -notes, and -bonds

Answer 3

T-bills mature in one year, and are sold at a discounted yield basis; they don’t pay interest, but mature at face value.

T-notes mature between 2 and 10 years, and pay interest semi-annually.

T-bonds mature in more than 10 years and pay interest semi-annually.

All sold in $100 denominations.

Question 4

What are OID bonds?

Why do they create phantom income?

Answer 4

Original Issue Discount or zero coupon bonds. They’re sold at a discount but pay out at face when they mature.

Owner must pay interest on imputed income every year.

Question 5

What are TIPS?

Answer 5

Treasury Inflation Protected Securities.

They pay a fixed coupon rate but (unlike series I) the par value adjusts with inflation.

Question 6

What are STRIPS?

Answer 6

Individual separate coupon and par value payments, essentially zero coupon bonds.

Low risk, highly liquid investment for ST time horizon.

Question 7

Are federal agency securities backed by the full faith and credit of the US govt.?

What’s the exception to the rule?

Answer 7

Fed. Agency Securities are moral obligations but aren’t backed by the full faith and cred.

The exception is Ginnie Mae, which are.

Question 8

What is the biggest risk with US mortgage backed securities?

Answer 8

If interest rates fall, the loans may be paid off early and investors will have a reinvestment problem.

Question 9

What are secured corporate bonds?

Answer 9

Mortgage backed securities—backed by a pool of mortgages.

Collateralized trust bonds—securing object is held in trust by 3rd party.

Question 10

What are CMO’s?

Answer 10

Collateralized mortgage obligations. Investors are divided into short, intermediate, and long-term “tranches” for principal repayment as a way to guard against pre-payment risk.

Question 11

What are 3 types of unsecured corporate debt?

Answer 11

Debentures—only backed by faith in the company.

Subordinated debentures—behind debentures if company fails and must be liquidated.

Income bonds—Only pay interest if the company makes income.

Question 12

How do Moody’s and Standard and Poor’s rate bonds?

Answer 12

On income, total debt, earnings, and stability of earnings.

Moody’s: Aaa-C. Ba and below are junk.

S&P: AAA-D. BB and below are junk.

All bonds are either investment grade or junk; no in-between.

Question 13

What is a GIC?

Answer 13

Guaranteed Investment Contract.

Issued by insurance companies.

Yield is superior to treasuries.

Question 14

What are the three types of municipal bonds?

How are municipal bonds taxed?

Answer 14

General obligation, revenue (toll bridge type project) and private activity (stadium) bonds.

Muni’s aren’t taxed at any level if you live in their state and municipality.

Question 15

What are the four risks of corporate bonds?

US bonds?

Muni bonds?

Answer 15

1. Default risk. 2. Reinvestment rate risk. 3. Purchasing Power risk. 4. Interest rate risk.

US bonds don’t have default risk.

Muni’s have default risk unless they’re insured.

Question 16

What are tax exempt and tax equivalent yield?

Answer 16

Tax exempt yield is the after tax yield of a corporate bond:
Tax exempt yield = corp. rate x (1 - marginal tax rate).

Tax equivalent yield is what a corporate bond would need to pay to be equivalent to a tax exempt bond. Tax equivalent yield = r ÷ (1 - marginal tax rate), where r is the tax exempt yield.

Question 17

How do you calculate TEY, if the investor itemizes, and deducts SALT from his federal return?

Note: the word “itemizes” has to be in the question for this to apply.

Answer 17

Itemized TEY =

TEY ÷ (1 - (Fed tax rate + State tax rate(1 - fed tax rate)))

Question 18

Which bonds are exempt from which taxes?

Answer 18

Treasuries pay fed tax, but don’t pay state and municipal tax.

State and muni’s are exempt from fed tax, and SALT if you live in that state and locality.

Question 19

What is the duration of a zero coupon bond?

Why?

Is this a higher or lower duration than other bonds of the same term?

Answer 19

The duration of a zero is always equal to its term.

This is because dividends aren’t being re-invested to insulate from interest rate risk.

A zero will almost always have the highest duration.