Chapter 2

Question 1

Define credit investors.

Answer 1

Institutional investors that have large bond holdings.

Question 2

Define Securitisation.

Answer 2

1. The process of grouping an asset or group of assets into a marketable security.
2. The securitised assets are divided into different tranches, tailored to the investment risk tolerance of the types of investors.

Question 3

Define Primary Market Origination.

Answer 3

Where a borrower issues a bond with advice and assistance from an investment bank to arrange, distribute and underwrite the issue.

Question 4

What are bonds known as?

Answer 4

Fixed income instruments - because interest is usually fixed.

Question 5

What are Gilt?

Answer 5

UK government bonds issued by the government through the debt management office (DMO), an agency of HMT.

Question 6

What are basis points used for?

Answer 6

Calculating interest rates.
1 basis point = 1/100 of 1% or 0.1%

1bp - 0.01% 10bp - 0.1%
10bp - 0.1% 100bp - 1%
1000bp - 10% 10000bp - 100%

Question 7

What do rating agencies do?

Answer 7

1. Issue ratings for bonds;
2. Provide a rating to the issuer and charge them for doing so;
3. The top rating is AAA or Tripple A.

Question 8

What are Zero Coupon Bonds/Deep Discount bonds?

Answer 8

1. Debt security that doesn’t pay interest but is traded at a deep discount;
2. Profit is made when the bond is redeemed for its full face value.

Question 9

Explain how a Zero coupon bond works.

Answer 9

1. A 5 year bond has a face value of £10,000 and is issued at a deep discount of £6,000.
2. This rolls up interest until amount investor gets back at bond maturity which will be the face value;
3. This is not subject to income tax in some countries.

Question 10

What is a Yield?

Answer 10

1. The interest rate a bond pays as a function of its price.

Question 11

Explain how a yield works.

Answer 11

1. investor buys bond with a 10% annual coupon rate and par value of £1,000;
2. Each year the bond pays £100 or 10%;
3. The bond’s nominal yield is 10%, the same as the coupon rate.
4. If the investor sells the bond for £900, the new owner will continue to receive £100 annually until the bond matures;
5. Because he only paid £900 for the bond, his rate of return is £100/£900 x 100 = 11.1%.
6. Increased bond price – lower yield;
   Decreased bond price – higher yield.

Question 12

Define a high yield bond.

Answer 12

1. Issued with very low credit rating;
2. The yield is high because investors demand higher return to compensate on default risk;
3. It pays a high rate of interest in relation to its market price.

Question 13

What is acquisition finance.

Answer 13

A form of short term finance through the purchase of a high yield bond.

Question 14

Explain acquisition finance

Answer 14

1. A company taking over another needs money quickly;
2. It may raise the money through a high yield bond to acquire the target;
3. Then refinance the bond immediately after completing the takeover with a longer-term issue paying lower interest rate.

Question 15

Define ‘Junk’.

Answer 15

1. When a rating agency downgrades an issuer because the risk of default has increased;
2. If rating goes below investment grade, institutional investors that hold the issue will have to sell it;
3. The market value of the bond will go down, as fewer institutions will want it;
4. Value down = Yield Up.

Question 16

What is a Commercial Paper?

Answer 16

1. Bonds with very short duration.
2. They’re made by large listed companies to fund short-term financial needs;
3. It has a duration of 90 days and does’t pay interest;
4. It’s issued at a discount to its face value;
5. At the end of the 90 days the commercial paper is rolled over;
6. A fresh issue of debt is made to replace the paper that has expired.

Question 17

What are Medium Term Notes (MTNs)?

Answer 17

1. Bonds with maturities around 5 years;
2. Often issued as part of an MTN programme;
3. The company has a panel of 3 or 4 banks that have agreed to meet all the company’s debt requirements including loans and MTNs;
4. The company decides at any point what it needs and tells the pane;
5. Bank offering cheapest rate gets the business.

Question 18

What is the maturity term of long bonds?

Answer 18

10 years or more.

Question 19

What are Perpetual bonds?

Answer 19

1. Small number of bonds;
2. No redemption date;
3. Will never be redeemed unless issuer (bank) chooses to retire them.

Question 20

What are Depository Receipts?

Answer 20

A form of security (shares or bonds) that enable it to be bought and sold in markets where it would otherwise not be available.

Question 21

What is a repurchase agreement (REPO)?

Answer 21

1. The equivalent of a short term collateralised loan;
2. An owner of a market security sells those securities to a buyer for cash;
3. As part of the deal the seller agrees to buy back the security at a later date;
4. That date can be any date;
5. The price to be paid to repurchase the security is higher than the original selling price as the spread between the original price and repurchase price is equivalent to interest.
6. Repos are often used by institutions with available cash that are looking for a quick easy way to get a return on their money with little risk.

Question 22

What are interest rates?

Answer 22

The amount charged, expressed as a % of principal, by a lender to a borrower for the use of assets.

Question 23

What happens if interest rates RISE?

Answer 23

1. It’s more expensive to borrow money;
2. Interest rates on variable mortgages and other credit facilities increases meaning that Consumers spend less;
3. Business revenues are affected;
4. Bond prices may go down.

Question 24

What happens if interest rates FALL?

Answer 24

1. It’s cheaper to borrow money;
2. Interest rates on variable mortgages and other credit facilities is low meaning that Consumers spend more;
3. Business revenues goes up;
4. Bond prices go up.

Question 25

Explain Inflation.

Answer 25

1. The increase in price of goods or services over time;
2. It leads to higher prices and lower purchasing power;
3. It usually caused by a country printing more money than is justified by the country’s wealth;
4. When more pounds are issued for a limited amount of assets the value of each pound is decreased;
5. Many countries central banks set an inflation rate target of 2-3% per year.