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FCA Paper 1: Securities > Chapter 2 - Asset Classes - Debt > Flashcards

Chapter 2 - Asset Classes - Debt Flashcards

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1
Q

Components of a bond

A
  • Nominal/par value - amount the borrower will return to the lender at maturiy.
  • Redemption/maturity date - date the borrower will pay teh nominal value to the lender
  • Coupon - fixed interest rate the borrower pays the lender.
  • Issuer - Who issued the bond e.g. Gov/corp
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2
Q

Coupons (what they can be based on and types - FRNs, ILBs)

A

Some bonds coupons are referenced to a published interest rate (SOFR) and change the coupon paid based on this.

Floating rate notes (FRNs) - bonds with variable coupon IR and nominal value based on published IRs

Index linked bonds - bonds that are based on inflation rate (e.g. CPI).

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3
Q

Yields

3 types of yield

A

=measure of % return provided by an investment.

3 ways to calculate yield
* Flat yield
* Gross redemption yield (GRY)
* Net redemption yield (NRY)

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4
Q

Flat yield and calculation

A

Only considers the coupon and ignores capital gains/losses if the bond is held to redemption.

Calculation
Flat yield= (annual coupon/price) X 100

e.g. 5% gilt at price £100 = (5/100) X 100 = 5% flat yield

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5
Q

Relationship between bonds and base interest rates

A

IR/bond price relationship = If IRs go up bond prices fall as investors would make more money from having money n savings than in bonds, reducing demand and in turn price

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6
Q

Gross redemption yield (GRY)/Yield to maturity (YTM)

A

Considers coupons and gains/losses due to maturity. Holding a bond to maturity represents a more complete view of return.

  • Does not consider the impact of taxation
  • Especially useful for non tax paying, long term investors - pension funds

Add calculation from 2.6 and explaination of present value

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7
Q

Net redemption yield

A

Considers coupon, gains/losses made during the time period to maturity and the after tax cash flow of the bond (rather than gross cashflow). Good measure for tax paying investors holding bonds to maturity.

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8
Q

Modified duration

A

Lower coupon bonds tend to have a more volatile price due to IR fluctuations affecting their price. Also, Long dated bonds will be more responsive than short dated bonds

Modified duration shows volatility by showing the expected change in price given a specific change in IR.The higher the modified duration, the more the price will move.

Modified duration=approximate % change in the price of a bond as a result of a 1% change in IR.

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9
Q

Convertible Bonds

A

Give the holder the right but not obligation to convert bonds into a set number of ordinary shares.

Typically trade at a premium to the share value.

Only available on corp bonds

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10
Q

Conertible bonds - conversion ratio calculation

A

Conversion ratio=Nominal value/conversion price of shares

Conv. bonds are issued with the share price being set from the outset. The conversion share price will be adjusted to take into account bonus or rights issues.
E.g. Issuing company had a 1-1 bonus issue, conersion price would half and the conversion ratio would double.

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11
Q

Flat yield - calc and limitations

A

Flat yield %=(annual coupon rate/mkt price) X 100

Flat yield only considers coupon rate - ignores capital gans/losses, tax

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12
Q

Flat yield - limitations

A
  • Gives an incomplete picture of return as it does not consider nomial value repayment at maturity.
  • Overlooks the time-value of money - no DCF analysis
  • Floating rate notes returns will differ from one coupon payment to another so selecting the coupon rate to do the calculation with is challenging.
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13
Q

Clean/flat prices

Clean price, claculation

A

Clean/flat prices = the bond’s price does not inculde the accrued interest related to the bond.
* On settlement dates (when interest is paid) bond price is the same as flat price.
* Between payment dates - actual price paid for the bond = flat price + accrued interest
* Clean/flat price + accrued interest = the dirty price

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14
Q

Accrued interest calculation

A

Accrued interest = Coupon payment X
(Number of days since last payment / Number of days between payments)

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15
Q

Bond dirty price tables

A

(see book diagram)

Assumes flat price remains constant (although it will probably fluctuate with IRs).
The bond price will steadily increase each day leading up to interest payment and then drops immediately following the payment.

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16
Q

Day count conversion (ACT/360 etc)

A
  • Act/360 - correct number of days per month but assumes 360 days per year - used for US treasury bills + money mkts
  • 30/360 - 30 days in a month and 360 in a year - Used for Euro bonds, US agency+corp bonds AND ACCRUED INTEREST
  • ACT/365 - Normal months and a 365 day year ignoring leap years
  • ACT/ACT - month/year treated as normal
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17
Q

S

Spreads and pricing benchmarks - what are they expressed in

A

Spread = difference between 2 yields, expressed in basis points.

Used to compare instruments against a benchmark such as govt bonds

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18
Q

Common benchmarks for bonds

A
  • Govt bond yields= corp bonds usually use most recent issued govt bs.
  • Swap rates= swap rates used as a benchmark due to the market being very active
  • Published reference rates= Example Secured Overnight Financing Rate (SOFR). Used to be LIBOR

Swaps exchange floating rates for fixed rate bonds

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19
Q

Yield curve - overview

A

Many govt bond mkts have differing time periods until maturity. If you plot the gross redemption yield of the bonds on a graph (yield on y axis; time to maturity on x) it creates a yield curve.

It shows the yeild available to investors in govt bonds with different time horizons. AKA term structure of IRs - showing relationship of yeilds from the same issuer with different times to maturity.

Shows investors wanting a higher yeild on longer dated bonds to indicate the time they are exposed to the risk

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20
Q

Normal yield curve

A

physical- shows investors have a liquidity preference and will accept lower yeild for liquidity. This means they will want higher GRY for longer dated securities

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21
Q

inverted yield curve

A

physical- Yields on short term bonds exceed long term
* Indiciator of poor economic conditions to come or a reduction in IRs
* long term IRs expected to be lower tan short term as investors will want high returns for the securities they are holding now that could be impacted by a recession

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22
Q

Negative yields

A

Meant banks had to pay to leave their cash with the central bank = promotes lending=boosts economy

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23
Q

Cons of negative yields

A
  • negative rates would encourage savers to hold their savings in physical cash, severly affecting banks profitability and liquidity = systemic risk
  • Pensions funds with long term low risk investments will struggle to see positive return, resulting in difficulty in them meeting future liabilities
  • Encourgaes yield chasing - buying risky, high yield bonds to try and generate returns, causes asset price bubbles = fucked economy
24
Q

Negative coupon bonds

A

early 2022 saw negative coupon bonds. Investors were willing to pay govs to lend them money to preserve most of their capital for the security.

25
Q

Inflation relationship with the yield curve

A

‘Nominal yields’ are taken from conventional debt instruments and anticipate infaltion.
Real yield curves can be obsereved which have already had inflation priced in.

Investors expect yields to rise to reward them for predicting a rise in inflation = yield curve rises.

To counter this, centeral banks can raise IRs in the short term to counter this pressure but this means medium/long dated bond prices fall. because it is assumed action from the central bank will remove the impact of inflation in the med/long term.

26
Q

Bond present value - time value of £

A

Time value of money can be expressed as the value of a recievable sum of £ in the future in today’s terms by considering the prevailing IR = sum’s present value.

Establishing present values AKA discoutning with the IR acting as the discount rate.

Basically how much your money will be worth in the future compared to how much it is worth now.

27
Q

Bond present value calculation

A

1/(1+r)^n

r=prevailing IR
n= years

E.g £1000 nominal value paying 10% coupon annually. 5% IR over 2 years =
* Y1: 100X 1/(1+0.05)
* Y2:1100X 1/(1+0.05)^2 = £1100 total return after 2 years (10% coupon at end of first year + nominal payout at maturity)

28
Q

Government debt - who issues bonds in the UK

A

Debt Management Office (DMO)

Same features of a corporate bond - coupon, nominal value, typically bi-annual coupon payment

29
Q

Ex dividend and cum dividend

A

Ex dividend= determines who recieves the coupon payment. Period of time prior to coupon payment to determine who the holder of th bond is/who recieves coupon

30
Q

Cum dividend

A

Normal trading time for the bond. There is a coupon payment in the future that has not been paid out yet.

31
Q

Risk free rate of return

A

The amount of moeny invested that is guaranteed to be returned to the investor (as it holds no risk).

32
Q

Index linkeded bonds example

A
  • Examples: Index linked guilts (ILG) and US TIPS. They are based on published inflation indexes such as the retail price index (RPI) and CPI.
  • The + is that their price will increase with inflation, preserving the true value.
  • In 0% inflation ILBs will pay coupon rate with no adjustment.
  • There is no deflation floor in gilts which protects bonds returning less nominal value
33
Q

Real interest rate calculation

A

**Real IR=
[(1+nominal IR)
——————————- -1
(1 + inflation rate)]

34
Q

Measures of inflation in the UK

A
  • Harmonised index of consumer prices - later renamed to consumer price index (CPI). CPI target inflation = 2%. Set by monetary policy comittee in the BoE. EU wide
  • Producer price indicies (PPI) measure inflationary pressures at early stages in the production process, e.g. raw materials at wholesale level.
  • Retail price index (RPI) - avrg. measure of change in the prices of goods and services. once published, it is not revised.
35
Q

Seperate Trading of Registered Interest and Principal Securities (STRIPS)

Stripping bonds

A

Zero coupon bonds (ZCBs) - only return nominal value at maturity, the coupon is stripped off the bond and sold seperately.

36
Q

International Govt. bonds

A

P 48 table

37
Q

Corporate debt features

A

Can be split into money borrowed from banks and money borrowed from investors (bonds)

Debt financing is cheaper than equity as it is less risky for investors a bond holders are paid before equity holders.

38
Q

Secured debt - fixed and floating charges

A

Secured debt decreases the risk of default as assets of the issuer are offered as guarantee in the case of default.

  • Fixed charge= debt secured by a specific physcial asset e.g. a buidling
  • Floating charge= debt secured by a group of non current assets (e.g. bonds)

Call debenture in the UK

39
Q

Asset backed securities

A

Bonds backed by specific pool of assets (mortgages, credit card recieveables and car loans). This debt is securitised by big banks.

Assets provide bondholders collateral as the cash generated from the pool of assets is used to pay off bonds coupons and nominals at maturity.

40
Q

Securitisation definition

A

Financial instruments (credit card debt, mortgages, etc) are packaged together and used as a way to obtain funds/profit.

41
Q

Mortgage backed securities

A

An example of an asset backed security.

A group of mortgage loans that are packaged together and sold to investors. As the homeowner pays their mortgage, the investor recieves coupons and a nominal repayment.

Typically divided into sub classes (tranches) with differing risk levels and payment schedules e.g. first tranche is paid first and teh fourth paid last= higher risk.

42
Q

Special purpose vehicles role in ABSs - 2 purposes

A

SPVs used to lower the risk of default on ABSs. usually a trust of the issuer of the assets. 2 purposes
1. Seperate from the issuing entity=the assets leave the issuers balance sheet and are replaced by cash payment from teh SPV. AKA off-balance sheet arangement.

  1. SPVs are standalone entities so if the issuer of the assets goes bankrupt, the SPV remains and can continue to pay bondholders. AKA bankrupty remote = increased credit worthiness
43
Q

SPV diagram

A

physical

44
Q

Covered bonds

A

Instances where no SPV is created AB bonds are referred to as covered bonds

Classed as senior secured debt securities issued by a regulated financial institution. If the bank defaults, collateral is used to pay bondholders regardless if the bank has defaulted (as long as there is enough collateral)

45
Q

Role of trusts in secured debt - Trustees

A

The property of the issuing company is mortgaged to the bondholders as collateral for the money the company owes.
However, a trust deed is put in place between the firm and investors saying they will be repaid the money trusted to the firm.

46
Q

UK Debenture trustee roles4 of them

A
  • Note trustee - represents the interests of the bondholders+provides guidance to the issuer
  • Security trustee - holds the securities for the benefit of the bondholders.
  • Share trustee - Holds the shares in an issuing SPV to achieve off balance sheet treatment - basically it is the SPV
  • Successor trustee - role is provided for banks in the event they need to resign from being the debt issuer to avoid conflict of interest
47
Q

Benefits of a trust deed

A
  • Outlines the powers of the trustee acting on behal of all of the investors.Enables clear management/organisation.
  • Ensures all holders are paid what they are owed
    • to the issuer as if the trust does something illegal, it is a seperate entity so the disputes stops at the trust.
  • Cheaper to have 1 trustee running the show than loads.
48
Q

Represenation of the bondholders interests by the trustee

A
  • Trustee is assigned to represent the interests of teh bondholders.
  • Engages the services of a credit rating agency to give potential investors a risk profile. However trustees can essential pay credit agencies for higher ratings
  • Trustee responsible for tracking bondgolers/ensuring obligations are met
    *
49
Q

3 Tiers of debt

A

Ranks bondholders in seniority marking who is entitled to be repaid first.
* Senior debt - debt ranks above all other debt/equity in a business and is paid first. Lowest IR as it is the most secure. Has strcit requirements
* Subordinated debt - ranks below senior debt - Less strict requirements and a higher interest rate.
* Mezzanine debt - High risk form of subordinated debt. Ranks last from the above and unsecured debt. Much higher IR compared to the above to reflect high risk. If not all interest or paid it can be marked as payment in kind and given to the investor as options.

50
Q

Unsecured debt

A
  • No protection for the investor if the firm defaults.
  • Higher interest to compensate the investor for the higher risk
  • Subordinated debt is typically unsecured and investors will be paid after other creditors if there is enough cash left after winding up
51
Q

Guaranteed debt/guarantor role

A

A guarantee is provided by someone other than the issuer (a guarantor) to pay the sum due if teh issuer defaults in return for a fixed payment every month eg.

52
Q

Table comparing the characteristics of subordinated, guaranteed and convertible bonds.

A

Physical

53
Q

Credit ratings - 3 main agencies

A
  • Standard and Poor’s
  • Moody’s
  • Fitch ratings

Bonds are ranked into investment grade or non investment grade (junk).
Some ABSs can have a ‘credit enhanced’ rating due to insurance protection in teh event of default.
See table page 58

54
Q

Bonds with the highest modified duration are

A

Lower coupon and longer dated

55
Q

How does the repo mkt improve the gilt mkt’s liquidity and what function facilitates the reverse repos

A

Facilitates reverse repos from GEMMs to cover shorts. Facilitated by the standing repo function

56
Q

US treasury bond with 10+ YTM

A

T bonds

57
Q

Bond profiles

A

US, UK, German - max maturity 30years
Japan max maturity 40
France max maturity 50

UK, US, Japan semi annual coupon
German and French is annual coupon

FCA Paper 1: Securities (11 decks)

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