Chapter 1 Study Notes

Question 1

The primary reason that municipal securities are purchased

Answer 1

by investors is the interest income received is typically exempt from federal income tax. For this reason, these securities are referred to as tax-free.

Question 2

Types of Notes that have variable rates 3

Answer 2

floating-rate notes (FRNs),

adjustable -rate notes

variable-rate notes (or bonds)

Question 3

step-up bond

Answer 3

The interest rate on a step-up bond is reset as well, but this adjustment occurs only Once and is typically changed to a predetermined higher rate. Once reset, the bond pays the higher fixed rate until maturity.

Question 4

Zero-Coupon Bonds Correlation Between Price and Maturity

Answer 4

Typically, the longer the period until the bond matures, the deeper the discount.

Question 5

Zero-Coupon Bonds INterest

Answer 5

The difference between the purchase price and the amount that the investor receives when the bond matures is considered interest.

Question 6

OID

Answer 6

The difference between the purchase price and the amount that the investor receives when the bond matures is considered interest.

Question 7

Zero-Coupon Bonds VOLATILITY

Answer 7

The yields on zero-coupon bonds are usually slightly higher than those on comparable interest-bearing bonds. However, the prices of zero-coupons also tend to be more volatile than other bonds. Therefore, if an investor needs to sell a Zero-coupon bond before it matures, he may lose a significant amount of principal.

Question 8

capital appreciation bond (CAB).

Answer 8

CABs differ from traditional zeros in that the difference between the amount paid and the amount received at maturity is Considered compounded interest and not accreted OID interest.

Question 9

Zero-Coupon Bonds Conversion

Answer 9

Some zero-coupon and capital appreciation bonds may be issued with a provision that allows the holder to convert the bond into an interest paying bond. These bonds are referred to as convertible bonds. At the time of issuance, the interest rate that the Investor will receive and the date on which the conversion can occur must be disclosed

Question 10

Initial Interest Payment

Answer 10

Traditionally, bonds pay interest on the 1st or 15th of the month to ease paperwork issues. However, newly issued bonds pay interest from the dated date(the date from which interest begins to accrue), which may not fall on the 1st or 15th. For this reason, the very first coupon on a newly issued bond may be for more or less than the traditional six-month period as the issuer tries to get synchronized with the 1st or 15th payment date.If the first coupon is for more than six months, it’s referred to as a long coupon; however, if the first coupon is for less than six months, it’s referred to as a short coupon

Question 11

Municipals Interest accruel

Answer 11

Interest on corporate and municipal bonds accrues on the basis of a 360-day year with each month having 30 days. The amount of accrued interest is calculated from the last interest payment date up to, but not including, the settlement date.

Question 12

Municipal Bond Settlement

Answer 12

two business days

Question 13

Term Bond Issue

Answer 13

If all of the bonds of an offering are due to mature on the same date, it’s referred to as a term bond issue .

Question 14

Serial Bond Issue

Answer 14

if the bonds of an offering will mature sequentially over several years, it’s referred to as a serial bond issue .

Question 15

level debt service

Answer 15

Total of principal and interest remains substantially level throughout life of issue

Question 16

Interchangeable bonds

Answer 16

Interchangeable bonds are bearer bonds that can be converted into registered bonds. Once converted, the investor will receive the interest payments automatically, rather than being required to clip and remit the coupon. The investor will ultimately receive the principal at maturity rather needing to present the bond

Question 17

A bond registered as to principal only

Answer 17

will have the owner’s name and address recorded for purposes of receiving any written notices and payment of the principal amount at maturity. Interest payments are received by means of attached interest coupons (as with bearer bonds).

Question 18

A fully registered bond

Answer 18

has the owner’s name and address recorded for purposes of receiving any written notices, payment of the principal amount at maturity, and receiving interest payments. The interest payments are received by means of a check from the issuer every six months

Question 19

Municipal Bond Denominations

Answer 19

Originally, municipals had been issued in bearer form in $1,000 or $5,000 denominations. Today, all new municipals with maturities of more than one year must be issued in fully registered form only. Registered bonds are typically issued in denominations of $1,000 and greater, but always in increments of $1,000

Question 20

Delayed and Forward Delivery

Answer 20

Forwards, or forward delivery, is a form of delayed delivery in which a security is priced (in the primary market) or traded (in the secondary market) with a future settlement date. Delayed delivery is a transaction for which settlement is more than the standard two business days after the trade date

Question 21

discount vs. premium bond

Answer 21

A bond that’s sold for less than its par value is selling at a discount, while a bond that’s sold for more than its par value is selling at a premium

Question 22

What are the 3 Yields

Answer 22

Nominal Yield

Current Yield

Yield to Maturity

Question 23

YTM

Answer 23

Yield-to-maturity takes into account everything that an investor receives from a bond from the time she purchases it until the bond matures. This includes the bond’s regular interest payments, plus the difference between what the investor paid for the bond and what she receives when the bond matures (the bond’s par value).

Question 24

Nominal Yield

Answer 24

A bond’s nominal yield is the same as its coupon rate.

Question 25

Current Yield

Answer 25

Current yield essentially measures what a bond investor receives for what she pays. While the nominal yield is based on a bond ’s par value, current yield is based on the bond’s current market price. Current yield is calculated by dividing the bond’s annual interest payment by the bond’s current market price

Question 26

Yield Curves/Triangle

Answer 26

To summarize: If an investor purchases a bond at par, the nominal yield, current yield, and yield-to-maturity will all be equal. If an investor purchases a bond at a discount, the highest yield will be the yield-to-maturity, followed by the current yield, with the nominal yield as the lowest. If an investor purchases a bond at a premium, the highest yield will be the nominal yield, followed by the current yield, with the yield-to-maturity as the lowest.

Question 27

Interest-Rate Risk

Answer 27

Investors who purchase bonds run the risk that the market value of their investments may decline if interest rates rise. This is referred to as interest-rate risk. If market rates increase, investors will not beinterested in purchasing existing bonds at par since they can get higher yields by purchasing new issues. For that reason, existing bonds will have to be sold at a discount in order to attract purchasers. Bonds with longer maturities tend to be more vulnerable to interest-rate risk than bonds withshorter maturities. Also, bonds with lower coupon rates also tend to be more sensitive to interest-rate risk, when compared to bonds with similar maturities and higher coupon rates

Question 28

Duration

Answer 28

nother way to examine the price sensitivity of bonds is by duration. Put simply, duration measures the length of time it takes to get back invested money. Usually, maturity is thebarometer used to measure when principal is returned. But duration is a better mechanism for assessing the time characteristics of bonds than maturity because duration considers not just repayment of principal (at maturity), but it accounts for all expected cash flows (represented by thesemiannual coupons)

compares cash flows so a higher rate is a lower duration because funds came back in sooner at a higher amount.

Question 29

measure of dollar price volatility

Answer 29

Duration is also used to measure how a bond’s price responds to small changes in market yields.

The price (dollar) value of a basis point is the change in the price of a bond if the yield changes by one basis point. This is a measure of dollar price volatility rather than the percentage price volatility of a bond (price change as a percentage of the initial price).

Question 30

The term basis

Answer 30

The term basis is derived from one method of expressing yield. One basis point is equal to 1/100 of 1%; therefore, a 1% difference in yield equals 100 basis points

Question 31

Interest Rate Fluctuations

Answer 31

The prices of long-term bonds tend to fluctuate more than those with shorter maturities. A change in interest rates will affect the prices of 30-year bonds more dramatically than five-year bonds. Essentially, in periods of rising interest rates, the prices of long-term bonds will decrease more than the prices of short-term bonds; however, when interest rates decrease, the prices of long-term bonds will increase more than those of short-term bonds. This is also true of zero -coupon bonds,which are more volatile (price sensitive) to changes in interest rates than regular bonds.

Question 32

Interest Rate Fluctuations

Low Coupon Bonds

Answer 32

The prices of bonds that pay lower coupon rates are more sensitive to changes in interest rates than higher paying securities with similar maturities. The price of a 10-year bond paying 8% will drop more than the price of a similar 10-year bond paying 10% if overall interest rates rise.

Question 33

Yield Fluctuations

Short-Term Yields versus Long-Term Yields

Answer 33

Although long-term bond prices fluctuate more than short-term bond prices, the yields of short-term bonds will fluctuate more than those for long-term bonds. This is the opposite of what was explained about prices. When interest rates fluctuate, the change is first reflected in the yields that are offered by short-term bonds. Issuers bringing new short-term bonds to the marketplace will have to pay the higher rates of interest. The yields of new long-term bonds being brought to the market will change more slowly.

Question 34

Duration Time Periods

Risk Classes - Interest Rate Risk

Answer 34

Bonds with durations of one to three years reflect minimal interest-rate risk (they’re co

nservative); those with durations of four to seven years have moderate interest-rate risk; and those with durations of longer than seven years have greater interest-rate risk.

Question 35

Convexity

MOrtgage Backed and Callable Bonds

Answer 35

Callable bonds and mortgage-backed securities are subject to negative convexity. In other words, as yields fall, the price of the bond increases at a decreasing rate. As rates continue to fall, the probability of an early call increases dramatically, and the price of the bond declines to the stated call price. For mortgage-backed securities, falling rates make an increase in prepayments more likely.

Question 36

The Real Interest Rate

Answer 36

The real interest rate is the rate an investor in fixed-income securities actually receives once inflation is taken into account. For example, if a 10-year bond offers a 7% yield when the inflation rate is 3%, the real interest rate is 4%. The bond’s 7% yield is composed of a 4% real interest rate, plus a 3% inflation premium.

Question 37

Inflation or purchasing-power risk

Answer 37

is the risk that the money invested today won’t be worth as much as when it’s received in the future. If an investor buys a 5% bond and the rate of inflation subsequently rises to 6%, then the purchasing power of the cash flow will have decreased.

Question 38

Reinvestment risk

Answer 38

reflects the potential that future distributions of interest and principal may have to be reinvested at a lower rate of return. Since zero-coupon bonds don’t make periodic payments, they are considered an investment that eliminates reinvestment risk.

Question 39

Call Risk

Answer 39

Since issuers tend to call bonds when interest rates are falling, the bondholders are unlikely to be able to reinvest their money for the same return that they were previously receiving, unless they are prepared to increase the level of credit risk. This concept is referred to as call risk.

Question 40

Call Protection and Call Premium

Answer 40

To make callable bonds more marketable to investors, most offerings will provide a call protection period. This is the period during which the bonds cannot be called, which is typically 5 to 10 years after the date of issuance. If the bonds are subsequently called, the issuer is often required to pay the bondholders more than the par value in order to compensate them for the early redemption of the bonds. This additional amount is referred to as a call premium.

Question 41

Call Types

In-Whole

Answer 41

Some calls are in-whole, which means that the entire issue is being called at one time.

Question 42

Call Types

Lottery Calls

Answer 42

partial (lottery calls), which means the some of the bonds will be retired early, while others will remain outstanding.

Question 43

continuous call.

Answer 43

Some calls may only be exercised on a particular date(s). A call feature that may be exercised at any time after the first call date is a referred to as a continuous call

Question 44

catastrophe call

Answer 44

Finally, selected types of bonds may have catastrophe call provisions which are enacted only if a bond’s underlying collateral is destroyed.

Question 45

Confirmations

Call Disclosures

Answer 45

Both partial and in-whole calls must be disclosed to a client prior to a bond’s purchase and noted on the confirmation. However, due to the unlikelihood of occurrence, catastrophe calls are exempt from the disclosure requirement.

Question 46

Refunding

Answer 46

Refunding involves an issuer selling a new bond and using the proceeds to pay off a bond that’s currently outstanding. Refunding usually benefits issuers by providing them with the option of calling back the outstanding bonds due to a decline in interest rates. Ultimately, if interest rates do decline, the issuers are able to refinance their debt at a lower rate of interest.

Question 47

Prerefunding

Answer 47

If an issuer intends to lock in a lower rate prior to a scheduled call date, it may choose to prerefund its outstanding issue. (Prerefunding is also referred to as advance refunding.) The new issue being sold is considered the refunding issue. The proceeds of this new issue are typically invested in government securities and are deposited in a bank. An escrow agreement is signed and the bank ensures that the securities on deposit, along with their earnings, will be available to pay the interest and principal on the outstanding issue. At this point, the original issue is considered to be prerefunded.

Question 48

defeasance.

Answer 48

Prerefunding

Since the original issue is now secured by government securities that are held in escrow, the issuer is no longer responsible for payment of interest and principal on these bonds. Also, the original rights and liens the bondholders had under the indenture (bond agreement) are eliminated. This elimination of the issuer’s responsibility for the offering and the elimination of the bondholder’s rights is referred to as defeasance.
Since the prerefunded bond is now secured by U.S. government securities, the creditworthiness of the offering is enhanced. Ultimately, this results in an increase in the bond’s market value due to its increased quality.

Question 49

current refunding

Answer 49

The term current refunding refers to a bond issue that’s issued no more than 90 days before the final payment of principal and interest. If the refunding issue is issued more than 90 days before the final payment of principal and interest, it’s referred to as an advance refunding issue.

Question 50

Escrowed-to-Maturity (ETM)/Escrowed-to-Call (ETC)

Answer 50

When money is deposited into an escrow account and used to pay off a bond at its maturity date, it’s referred to as being escrowed-to-maturity. However, if it’s being paid off at a call date, it’s referred to as being escrowed-to-call.

Question 51

Crossover Refunding

Answer 51

Crossover refunding is a form of advance refunding in which the revenue stream originally pledged to secure the refunded bonds continues to be used to pay debt service on the refunded bonds until they mature or are called. At that time, the pledged revenues “crossover” to pay debt service on the refunding bonds and escrowed securities are used to pay the refunded bonds. During the period when both the refunded and the refunding bonds are outstanding, debt service on the refunding bonds is paid from interest earnings on the invested proceeds of the refunding bonds.

Question 52

Sinking Funds

Answer 52

into which they deposit funds each year in order to redeem their bonds. The funds may be used to either redeem bonds early or when they mature. The bond indenture may require the establishment of a sinking fund or the issuer may choose to set one up independently.

Question 53

Extraordinary Call

Answer 53

The extraordinary call (also referred to as the catastrophe call) feature allows an issuer to call its bonds in instances of extreme unforeseen circumstances. For example, if the property being used to secure the bond is condemned and purchased for public use, the sales proceeds would be used to call the bonds or, if a property is affected by a natural disaster, the owners can use the insurance proceeds to call the bonds using the extraordinary call feature.

Question 54

Mandatory Call

Answer 54

In some cases, a bond issue may require a mandatory redemption if the assets used to collateralize the issue become undervalued

Question 55

Put Provisions

Answer 55

This feature gives the bondholder the right to redeem the bond on a specified date(s) prior to maturity. The bondholder typically receives the bond’s par value, but the bond may also be redeemable at a discount or premium.

Question 56

Yield-to-put

Answer 56

is the yield that’s calculated when the bond is put back to the issuer (or its agent). Prior to the bond’s issuance, the issuer and the investor will have agreed on a specific date on which the put option can be exercised. This calculation includes the principal amount that’s returned to the investor and the semiannual interest payments up to the put date.

Question 57

Tender Option

Answer 57

Tender option bonds are also referred to as put bonds. The holders of put bonds have the option to tender their bonds to the issuer or another entity that’s acting on behalf of the issuer at par plus accrued interest on a specified date. If the bonds are not put back, the holders typically retain this option for each interest payment date thereafter. Some tender option bonds have a mandatory provision that requires the bondholders to surrender their bonds based on a certain date or the occurrence of an event.