Chapter 2 - Corporate and Municipal Debt Securities

Question 1

Bond definition

Answer 1

represents a loan to the issuer in exchange for its promise to repay the face amount of the bond known as the principal amount at maturity.

Question 2

key facts about Corporate Bonds

Answer 2

• Bondholders not owners of company
• They are creditors of the company
• Bondholders do not have voting rights as long as their interest/principal payments are paid in a timely fashion
• Bondholders will always be paid before preferred and common stockholders in the event of liquidation
• Interest income is taxable at all levels

Question 3

Types of bonds

Answer 3

• Bearer Bonds
  
  • Issued in coupon
  • Do not have owner on record
  • Anyone who possess the bond is entitled to receive the interest payments
  • Entitled to receive principal payments at maturity
  • No longer issued in US, but available outside the US
• Registered bonds
  
  • Has the owners name on it
• Principal-Only bonds
  
  • Has the owners name on it
  • Bondholders will still be required to clip the coupons to receive semiannual payments.
• Fully registered
  
  • Has the owners name on it
  • Owner is not required to clip coupons
  • Issuer will send the principal payments along with the last semiannual interest payments directly to the owner at maturity
  • Most bonds in the US are issued in fully registered form
• Book entry / journal entry
  
  • Has no physical certificate issued to the bondholder
  • They are fully registered
  • The investor’s only evidence of ownership is the trade confirmation generated from the brokerage firm when the purchase order was executed
• Bond certificate must include:
  
  • Name if issuer
  • Principal amount
  • Issuing date
  • Maturity date
  • Interest payment dates
  • Place where interest is payable
  • Type of bond
  • Interest rate
  • Call feature if any, or callable
  • Reference to the trust indenture

Question 4

bond pricing

Answer 4

• Trade in secondary market
• Price depends on:
  
  • Rating
  • Interest rates
  • Term
  • Coupon rate
  • Type of bond
  • Issuer
  • Supply and demand
  • Callable or convertible
• Always priced as percentage of par
• Par value is always $1000 unless otherwise stated
• The terms par value, face value and principal amount are all the same and equal to $1000
• Investor who paid $1000 for a bond is said to paid par
• Investor who pays below par value is said to be paying at a discount
• Investor who pays above par value is said to be paying at a premium
• EXAMPLE
  
  • A quote for a corporate bond reading 95 actually translates into:
    
    • 95% x $1000 = $950
  • A quote for a corporate bond of 97 ¼ translates into:
    
    • 97.25% x $1000 - $972.50

Question 5

Bond yields are what?

factors that affect it are?

Answer 5

• A bond’s yield is the investor’s return for holding the bond
• Factors that affect yield:
  
  • Current interest rates
  • Term of the bond
  • Credit quality of the issuer
  • Type of collateral
  • Convertible or callable
  • Purchase price

Question 6

Nominal Yield (NY)

Answer 6

• Its the interest rate that is printed or “named” on the bond
• Always states as percentage of par
• It is fixed at the time of issuance and never changes
• May also be called coupon rate
• EXAMPLE
  
  • Corporate bond with a coupon rate of 8% will pay the holder $80.00 per year in interest
  • 8% x $1000 = $80. The nominal yield is 8%

Question 7

Current Yield (CY)

Answer 7

• It is the relationship between the annual interest generated by the bond and the bond’s current market price
• FORMULA
  
  • Annual income / current market price
• EXAMPLE
  
  • Take the same 8% yield used in the previous example on the nominal yield and see what the current yield would be if we paid $1100 for the bond
    
    • Annual income = 8% x $1000 = $80
    • Current market price = 110% x $1000 = $1100
    • Current yield = $80/$1100 = 7.27%
    • Note: the bond was purchased at a premium but the current yield is lower than the nominal yield
  • Another example when the bond is purchased instead at a discount of $900
    
    • Annual income = 8% x $1000 = $80
    • Current market price = 90% x $1000 = $900
    • Current yield = $80/$900 = 8.89%
    • Note: when bond is purchased at a discount the current yield is higher than the nominal yield

Question 8

Yield to maturity

Answer 8

• It is the investors total annualized return for investing the bond
• Takes into consideration the annual income along with any difference between the price the investor paid for the bond and the par value that will be received at maturity
• It also assumes the investor is reinvesting the semiannual interest payments at the same rate.
• This is the most important yield for an investor who purchased the bond
• Premium bond
  
  • Bond purchased at a premium will be the lowest of all the investor’s yields because the issuer is only responsible to pay the bondholder the par value upon maturity
• Discount bond
  
  • Bond purchased at a discount will be the highest of all the yields because the issuer is responsible to pay the bondholder par value at maturity

Question 9

Many bond questions on the exam can be answered by memorizing and being able to draw the following illustration:

Answer 9

Question 10

Calculating yield to call

Answer 10

• If the bond has a call feature, an investor may calculate the approximate yield to call by using the approximate number of years left until the bond may be called.
• If the bond is callable at par, the yield to call will always extend past the investor’s yield to maturity
• If the bond was purchased at a discount, the yield to call will be the highest yield
• If the bond was purchased at a premium
  
  • the yield to call will be the lowest yield
  • The investor will receive a price that is greater than the stated par value of the bond
  • The yield to call will be even greater impact on the yield to call
  • It will be closer to the bond’s yield at maturity
  • The yield to call may exceed the yield to maturity due to the fact that the investor will be receiving a price greater than par when the bond is called.

Question 11

You can determine how changing interest rates will affect a bond’s yield to maturity by calculating its what?

Answer 11

• realized compound yield
• It measures a bond’s annual return based on the semiannual compounding of coupon payments
• Will largely depend on the purchase price of the bond and the rate at which the interest payments are reinvested
• Longer holding periods will have higher total dollar and percentage returns

Question 12

what is the the yield spread?

Answer 12

The difference in yields offered by two bonds

Question 13

what is the spread over treasuries?

Answer 13

Many bonds are measured by the relationship between the bond’s yield and the yield offered by similar term

Question 14

During times of uncertainty, investors will be less likely to hold what?

Answer 14

• more risky debt securities resulting in wider yield spreads

Question 15

The increase in yield spreads can be seen as an indication of what?

Answer 15

• hat the economy is going to go into a recession and the that issuers of lower quality debt will likely default

Question 16

Decrease in yield spreads is seen as a what?

Answer 16

• predictor if an improving economy

Question 17

what is the Real interest rate?

Answer 17

• The interest rate received by an investor before the effects of inflation are considered is known as the nominal interest rate
• The real interest rate is what the investor will receive after inflation is factored in
• EXAMPLE
  
  • An investor receiving an 8% interest rate on a corporate bond when inflation is running at 2%, the investors real interest rate would be 6%
  • The nominal interest rate consists of the real interest rate plus an inflation premium
    
    • The inflation premium factors in the expected rate of inflation during various bond maturities

Question 18

what are the types of Bond maturities?

Answer 18

• Term maturity
  
  • Most common type of corporate bond issue
  • The entire principal amount becomes due on a specific date
  • EXAMPLE
    
    • If XYZ corporation issued $100,000,000 worth of 8% bonds due on 7/1/25, the entire $100,000,000 would be due to bondholders on 7/1/25, as well as their semiannual interest payment and their principal payment
• Serial Maturity
  
  • It has a portion of the issue maturing over a series of years
  • Traditionally these bonds have larger portions of the principal maturing in later years
  • The portion of the bonds maturing in later years will carry a higher yield to maturity because investors who have their money at risk longer will demand a higher interest rate
• Balloon maturity
  
  • It repays a portion of the issuer’s principal over a number of years just like serial bond, BUT this type has the largest portion of the principal amount is due on the last date

Question 19

Corporate bonds are divided into what two main categories?

Answer 19

• secured and unsecured

Question 20

types of Secured bonds?

Answer 20

• Mortgage bonds
  
  • It has been back by a pledge of real property owned by the company
• Equipment trust certificates
  
  • It has been backed by a pledge of large equipment that the corporation owns
  • EXAMPLES: airlines, railroads and ships
• Collateral trust certificates
  
  • It has been backed by a pledge of securities that the issuer has purchased for investment purposes
  • EXAMPLES: stocks and bonds
    
    • NOTE: bondholders do not want to take title to the collateral, they want the semiannual interest payments and the return on their principal at maturity

Question 21

Unsecured bonds are known as?

Answer 21

debentures

Question 22

types of Unsecured bonds?

Answer 22

• Subordinated debentures
  
  • It has a junior claim on the issuer in the event of default relative to the straight debenture
  • Should the issuer default, the holders of the debentures are other general creditors will be paid before the holders of the subordinated debentures will be paid anything
• Income / Adjustment bonds
  
  • Issued when corporations are usually in severe financial difficulty
  • The investor is only promised to be paid interest if the corporation has enough to do so
  • Since it is a large risk, the interest rate is very high and bonds are issued at a deep discount from par value
  • This option is never recommended for an investor seeking income or safety of principal
• Zero-coupon bonds
  
  • Pays no semiannual interest
  • Issued at deep discount
  • The appreciation of the purchase price up to par value at maturity is the investor’s interest
  • Corporations, US government and municipalities issue these bonds
  • Since there is no semiannual interest and the price is so deeply discounted from par, the price of the bond will be the most sensitive to a change in the interest rates
  • Corporate and US government collect federal income taxes on the annual appreciation which is known as phantom income

Question 23

what are Guaranteed bonds?

Answer 23

• Interest and principal payments are guaranteed by a third party such as a parent company
• The higher the rating of the company who is guaranteeing the bonds the better the guarantee

Question 24

what are Convertible bonds?

Answer 24

• May be converted or exchanged for common shares of the corporation at a predetermined price known as the conversion price. ONLY CORPORATIONS CAN ISSUE THESE BONDS
• Benefit issuer and bondholder
  
  • Can save the corporation lots of money because the bond usually pays a lower rate if interest than a non convertible bond
  • As an investor, the bond could realize significant capital if the underlying common stock appreciates. So they maintain a senior position as a creditor while enjoying the potential for capital appreciation.

Question 25

what is the formula for Convertible bonds?

Answer 25

• Par value / conversion price
• Conversion price also means current price of common stock
• EXAMPLE:
  
  • XYZ has a 7% subordinated debenture trading in the marketplace at 120. The bonds are convertible into XYZ common stock at $25 per shar. How many shares can the investor receive upon conversion?
  • $1000/$25 = 40 shares

Question 26

what is the Parity Price?

Answer 26

• Determines the value at which the stock must be priced in order for the value of the common stock to be equal to the value of the bond that the investor already owns.
• The value of the stock upon conversion must be equal to (or parity with) the value of the bond, otherwise converting the bonds into common stock would not make economic sense

Question 27

what is the parity price formula?

Answer 27

• Two step process
  
  • First find out how many shared upon conversion (formula before this one)
  • Then determine the parity price
    
  • EXAMPLE
    
    • The convertible bond was quoted at 120 which equals $1200. We determined the investor could receive 40 shares of stock for each bond so the parity price equals:
    • $1200/40 = $30

Question 28

if the question on the test is looking for the number of shares or the parity price for a convertible preferred stock, then what?

Answer 28

• the formulas are the same and the only thing that changes is the par value

Question 29

what are the Advantages of issuing convertible bonds?

Answer 29

• Makes it more marketable
• Can offer lower interest rates
• If the bonds are converted, the debt obligation is eliminated
• Does not immediately dilute ownership or earnings per share

Question 30

what are the Disadvantages of issuing convertible bonds?

Answer 30

• Reduced leverage upon conversion
• Causes loss of tax-deductible interest payments
• Conversion dilutes shareholders equity
• Conversion by a large holder my shift control of the company

Question 31

what is the The trust indenture act of 1939?

Answer 31

• Requires that corporate bond issues in excess of $5,000,000 that are to be repaid during a term in excess of one year, issue a trust indenture for the issue
• It is a contract between the issuer and the trustee
• The trustee acts on behalf of the bondholders and ensures the issuer is in compliance with all the promises and covenants made to the bondholders
• Trustee is appointed by the corporation and is usually a bank or a trust company
• This act only applies to corporate issuers
• Both federal and municipal are exempt

Question 32

what is a Bond indenture?

Answer 32

• Corporate bonds may be issued with either an open-end or closed-end indenture
  
  • Open-end
    
    • Allows the corporation to issue additional bonds secured by the same collateral and whose claim on the collateral is equal to the original issue
  • Closed-end
    
    • Does NOT allow the corporation to issue additional bonds having an equal claim on the collateral
    • If the corporation wants to issue new bonds their claim must be subordinate to the claim of the original issue or secured by other collateral

Question 33

what are bond ratings?

Answer 33

• When rating agencies assign a rating to a debt issue, they look at many factors that affect the issuer’s financial condition:
  
  • Cash flow
  • Total amount and type of outstanding debt
  • Ability to meet interest and principal payments
  • Collateral
  • Industry and economic trends
  • Management
• S&P and Moody’s are the two biggest rating agencies
• For the corporation to have their debt rated by one of these agencies, the issuer must request it and pay for the service
• Main reason the issuer wants to have their debt rated is because many investors will not purchase bonds that have not been rated
• If the issuer receives a higher rating they will be able to sell their bonds with a lower interest rate

Question 34

what are ETNs?

Answer 34

Exchange traded notes (ETNs)

• Sometimes known as equity-linked notes or index-linked notes
• They are debt securities that base a maturity payment on the performance of an underlying security or group of securities such as an index
• They do not make coupon or interest payments
• May be purchased and sold at any time during the trading day
• May be purchased on margin and sold short
• They are unsecured
• They carry the credit risk of the issuing bank or broker dealer
• Principal protected notes (PPNs)
  
  • Similar to ETNs
  • They guarantee the return on the investors principal of the note is held until maturity
  • The principal guarantee is only as good as the issuers credit rating and therefore are never 100% guaranteed

Question 35

what are Euro and Yankee bonds?

Answer 35

• Euro bond
  
  • Issued in domestic currency of the issuer but sold outside of the issuer’s country
  • Carries significant currency risk should the value of the foriegn currency fall relative to the domestic currency of the purchaser
• Eurodollar bond
  
  • Issued by a foreign issuer denominated in US dollars and sold to investors outside of the US and outside of the issuer’s country
  • Issued in barer form by foreign corporations, federal governments, and municipalities
  • They trade with accrued interest and interest paid annually
• Yankee bond
  
  • Similar to eurodollar except yankee bonds are dollar denominated bonds issued by a foreign issuer and sold to US investors
  • The advantage is that it does NOT have any currency risk

Question 36

what are Variable rate securities?

Answer 36

• Two main types are Auction Rate Securities and Variable Rate Demand Obligations (VRDO)
  
  • Auction rate securities
    
    • Long term securities that are traded as short term securities
    • Interest rate will be reset at regular schedule auctions for the securities every 7, 28, or 35 days
    • Interest rate paid on the securities will be reset to the clearing rate until the next auction
    • If the auction fails due to a lack of demand, investors who were looking to sell the securities may not have immediate access to their funds
  • VRDOs
    
    • Interest rate is reset at set intervals daily, weekly, or monthly
    • Interest rate is set by the dealer to a rate that will allow the instruments to be priced at par
    • Investors may elect to put the securities back to the issuer or third party on the rest date
    • May be issued as debt securities or as preferred stock offerings

Question 37

what are the methods corporate bonds may be retired?

Answer 37

• Redemption
  
  • Bonds are redeemed upon maturity and the principal amount is repaid to investors
  • At maturity investors will also receive their last semiannual interest payment
• Refunding
  
  • Similar to refinancing a home mortgage
  • Use the dale of new bonds to pay off the principal of their outstanding bonds
  • Corporations will issue new bonds to refund their maturing bonds or call the outstanding issue in whole or in part under a call feature
• Pre-refunding (aka “advance refunded”)
  
  • If interest rates are low, a corporation may pre-refund their outstanding bonds prior to being able to retire them under a call feature
  • The proceeds from the new issue of bonds are placed in escrow and used to pay the debt service of the outstanding or prefunded issue.
  • The prerefunded issue will be called in by the company on the first call date
  • Since the pre-refunded bonds are now backed by the government securities held in the escrow account, they are automatically rated AAA
  • When the issue has been pre-refunded the issuer’s obligations under the indenture are terminated, which is called defeasance
• Exercise of a call feature by the company
  
  • Can be called at the corporations discretion of at a set schedule
  • Gives the company the ability to manage the amount of debt outstanding as well as take advantage of favorable interest rates
  • Most bonds are not callable in the first several years after issuance which is known as “call protection”
  • NOTE: call feature benefits the company, not the investor
• Exercise of a put feature by the investor
  
  • Put features and put options are added to make the bonds more attractive to investors
  • The bondholder may redeem the bonds to the company
  • Sometimes it is executed if the bond rating falls to low or if interest rates rise significantly
  • NOTE: benefits the bondholder, not the issuer
• Tender offering
  
  • The result is to reduce its outstanding debt or as a way to take advantage of low interest rates
  • May be made for both callable and noncallable bonds
  • Companies usually offer a premium for the bonds in order to make them more attractive to bondholders
• Open market purchases
  
  • In an effort to reduce the amount of outstanding debt, issuers may repurchase the bonds in the marketplace

Question 38

Types of Municipal bonds

Answer 38

• General obligation bonds (aka GOs)
• Revenue Bonds
• Industrial development bonds / industrial revenue bonds
• Lease rental bonds
• Special tax bonds
• Special assessment bonds
• Double-barreled bonds
• Moral obligation bonds
• New housing authority (NHA) / Public housing authority (PHA)
• Short term municipal financing

Question 39

what are General obligation bonds?

Answer 39

• General obligation bonds (aka GOs)
  
  • They are backed by full faith and credit of the issuer and by their ability to raise and levy taxes
  • Simply stated, tax revenues back the bonds
    
    • If issued by state, they are backed by income and sales taxes
    • If issued by local governments or municipalities, they are backed by property taxes
  • Often issued to fund projects that benefit the entire community and financed projects generally do not produce revenue of any kind
  • They are a drain on the tax revenue
  • The amount of these bonds that may be issued must be within certain debt limits known as “statutory debt limits”
  • Can not issue bonds that exceed their statutory debt limits
  • They require voter approval
  • EXAMPLES
    
    • Fund local park
    • New school building
    • New police station
  • Property taxes
    
    • If bond is issued at a local level they are mostly supported by property tax revenue received from the property owners
    • Taxes are based on the assessed value of the property, not the actual market value
    • Periodically assessors will inspect properties and determine what the assessed values are
    • EXAMPLE
      
      • A homeowner whose house has a market value of $100,000 will not be taxed on the entire market value of the home. If the town uses a 75% assessment rate, the home’s assessed value would be $75,000
  • Overlapping debt or coterminous debt is municipal debt that is issued by different municipal authorities that draws revenue from the same base of taxpayers
    
    • EXAMPLE
      
      • The county water authority issued bonds that are supported by the property taxes levied in the county. The water authority’s debt overlaps the towns’ and county’s other general obligation debt by drawing support from the same tax revenue. State issues are not included when determining overlapping debt because they are supported by other revenue sources such as state sales taxes and income taxes

Question 40

what are Revenue Bonds?

Answer 40

• Issued to finance a revenue producing project such as a toll bridge
• Proceeds from the issuance of the bond will construct or repair the facility and the debt payments will be supported by revenue generated by the facility
• They are exempt from the Trust Indenture Act of 1939
• All of these bonds must have an indenture that spells out the following:
  
  • Rate covenant
  • Maintenance covenant
  • Additional bond test
  • Catastrophe clause
  • Call or put features
  • Flow of funds
  • Outside audit
  • Insurance covenant
  • Sinking fund

Question 41

what are Industrial development bonds / industrial revenue bonds?

Answer 41

• It benefits a private corporation
• Proceeds from the bonds will go towards building a facility or purchasing equipment of the corporation
• The facility or equipment will then be leased back to the corporation and the lease payments will support the debt service on the bonds
• Interest earned by some high-income earners on individual development bonds may be subject to the investor’s alternative minimum tax
• States are limited to the amount of these bonds that may be issued, which is based on population of the state

Question 42

what are Lease rental bonds?

Answer 42

• Issue these bonds to build a facility for an agency such as a school district
• Proceeds of these bonds would be used to build the facility that is then leased to the agency and the lease payments will support the bond’s debt service

Question 43

what are Special tax bonds?

Answer 43

• Issued to meet a specific goal
• Bonds debt is only paid by the revenue generated from specific taxes
• Many cases supported by “sin” taxes
  
  • EXAMPLES
    
    • Alcohol
    • Tobacco
    • Gasoline
    • Hotel and motel fees
    • Business licenses
• NOTE: these bonds are revenue bonds, not general obligation bonds

Question 44

what are Special assessment bonds?

Answer 44

• Issued to finance a project that benefits a specific geographic area or portion of a municipality
• EXAMPLES
  
  • Sidewalks
  • Reservoirs
• Homeowners in the area that benefit from the project will be subject to a special tax assessment which will be used to support the debt service of the bonds
• Homeowners that do not benefit from the project are not subject to the tax assessment

Question 45

what are Double-barreled bonds?

Answer 45

• They have been issued to build or maintain a revenue producing facility such as a bridge or a roadway
• The initial debt service is supported by the user fees generated by the facility
• If the revenue generated by the facility is insufficient to support the bond’s interest and principal payments, the payments will be supported by the general tax revenue of the state or municipality
• The debt service is backed by two sources of revenue
• Because the tax revenue of the state or municipality also backs them, revenue bonds are rated and trade like general obligation bonds

Question 46

what are Moral obligation bonds?

Answer 46

• Issued to build or maintain a revenue producing facility such as a park that charges an entrance free or a tunnel that charges a toll
• If the revenue from the facility is insufficient to pay the debt, the state legislature may vote to allocate tax revenue to cover the shortfall
• BUT this bond does NOT require the state to cover any shortfall, it merely gives them the option to
• Some reasons the state may cover a shortfall are to:
  
  • Keep a high credit rating on all municipal issues
  • Ensure that interest rates on their municipal issues do not rise

Question 47

what are NHA and PHA bonds?

Answer 47

• New housing authority (NHA) / Public housing authority (PHA)
  
  • Issued to build low-income housing
  • Rental income pay the bonds
  • Should the rental income fall short, the US government will cover it
  • Because these bonds are guaranteed by the US government, they are considered to be the safest type of municipal bonds
  • They are not double barreled because they are covered by the US government, not by the state or municipal government

Question 48

what is Short term municipal financing?

Answer 48

• Short term notes and tax-exempt commercial paper are issued to manage cash flow
• They are sold in anticipation of receiving other revenue and are issued an MIG rating by Moody’s investor service
• MIG ratings
  
  • Range from 1 to 4
  • 1 is highest
  • 4 is lowest
• Types:
  
  • Tax anticipation notes (TANs)
  • Revenue anticipation notes (RANs)
  • Bond anticipation notes (BANs)
  • Tax and revenue anticipation notes (TRANs)
• Municipal tax exempt commercial paper matures in 270 days or less and usually will be backed by a line of credit at a bank

Question 49

Interest earned from municipal bonds is taxed by the federal government how?

Answer 49

• FREE from federal income taxes
• The doctrine of reciprocal immunity established by the supreme court in 1895
• The decision that established this doctrine was repealed in 1986 and allows for federal taxation on municipal bond interest but this is highly unlikely

Question 50

Tax equivalent yield for municipal bonds?

Answer 50

• Since interest earned from municipal bonds is tax free, they offer a lower interest rate than other bonds of similar quality
• Even though the rate is lower, sometimes the investor is still better off with a municipal bond than a corporate bond at a higher rate
• Investors in a higher tax bracket will realize a greater benefit from the tax exemption than investors in a lower tax bracket
• Tax equivalent yield formula:
  
  • Tax-free yield(100% - investor’s tax bracket)
• EXAMPLE
  
  • Take an investor considering purchasing a municipal bond with a coupon rate of 7%. The investor is also considering investing in a corporate bond. The investor is in the 30% federal tax bracket and wants to know which bond to go with.
  • Tax-equivalent yield = 7%/(100%-30%) = 7%/.7 = 10%
  • In this example, if the corporate bond of similar quality does not yield more than 10% then the investor will be better off with the municipal bond
  • However if the corporate bond yields more than 10% the investor will be better off with the corporate bond

Question 51

what happens when the Purchasing of a municipal bond issued in the state in which the investor resides?

Answer 51

• then the interest earned on the bond will be free from federal state and local income taxes

Question 52

what is Triple tax free bonds?

Answer 52

• Municipal bonds issued by a territory such as puerto rico or guam are given tax-free status for the interest payments from federal, state, and local income taxes

Question 53

what are Original issue discount (OID) and secondary market discounts?

Answer 53

• Required to accrete the discount over the number of years remaining to maturity
• The investor must step up their cost base by the annualized discount each year
• EXAMPLE
  
  • If an investor purchases a municipal bond in the secondary market at $900 with 10 years remaining to maturity, the investor would be required to step up their cost base each year by the annualized discount which is found by this formula:
    
    • The investor in this example would have to step up their cost basis $10 per year
    • So if the investor sold the bond in the third year at $925 they would have a $5 loss because their cost base would be $930
    • If the investor purchases a municipal bond and sells it at a profit in the future the capital gain is taxable as ordinary income for the investor

Question 54

what is the Amortization of a municipal bond’s premium?

Answer 54

• Investors are required to amortize the premium over the number of years remaining to maturity
• So the investor must step down their cost base by the annualized premium each year
• EXAMPLE
  
  • If an investor purchases a municipal bond in the secondary market at $1100 with 10 years remaining to maturity, the investor would be required to step down their cost base each year by the annualized premium which is found by:
    
    • The investor would have to step down their cost base $10 per year so in the third year if the investor sold it at $1175, they would have a $5 gain because their cost base would be $1070

Question 55

what are Bond swaps?

Answer 55

• Investors may want to sell bonds at a loss for tax purposes
• The loss will be realized when the bond is sold
• The investor may not repurchase the bond or a bond that is substantially the same for 30 days after the sale is made
• The investor may purchase bonds that differ as to the issuer, the coupon, or maturity, thus creating a bond swap and not a wash sale
• A wash sale would result in the loss being disallowed by the IRS because a bond swap does not affect the investor’s ability to claim the loss

Question 56

Definition of a bonds duration

Answer 56

• It is a measure of the bonds price sensitivity to a small change in interest rates and is stated in years

Question 57

In normal interest rate environment, long term bonds will pay investors what?

Answer 57

• a higher interest rate than short term bonds of equal quality

Question 58

Longer term bonds and bonds with low coupons will generally have what?

Answer 58

• a higher duration than shorter term or higher yield bonds

Question 59

The higher the bonds duration, the greater the what?

Answer 59

• bonds interest rate risk and the greater its price volatility

Question 60

the duration of a bond Allows the investor to compare what?

Answer 60

• the interest rate risk associated with bonds of different maturities, quality, and coupons
• It may be stated as either modified duration or effective duration
  
  • Modified duration
    
    • Assumes that a change in interest rates will not affect the bonds expected cash flow
  • Effective or call adjusted duration
    
    • Assumes that a change in interest rates may affect the bonds cash flow if the bonds are callable or have other options for early retirement
    • Call adjusted duration is lower than the bonds duration to maturity

Question 61

All bonds that make regular interest payments will have a duration that is what?

Answer 61

• lower than the number of years to the bonds maturity

Question 62

a zero coupon bonds duration will be what?

Answer 62

• Since a zero coupon bond does not provide any cash flow other than its principal payment at maturity, a zero coupon bonds duration will be equal to the number of years to maturity
  
  • EXAMPLE
    
    • A 20 year zero coupon bond would have a duration of 20

Question 63

Bonds duration formula

Answer 63

• Bond price change percentage = duration x (change in yield in basis points / 100)
• EXAMPLE
  
  • If a bond portfolio has an average duration of 7 years and interest rates rise by 1% of 100 basis points, the portfolio manager can expect the price of the bonds in the portfolio to fall by 7%

Question 64

what does Convexity mean?

Answer 64

• It measures its price volatility to large changes in interest rates

Question 65

When interest rates go lower, bonds tend to do what?

Answer 65

• increase in price more than they would fall if interest rates were to rise by an equal amount

Question 66

Bonds tends to rise faster in response to a what?

Answer 66

• fall in interest rates and fall slower in response to a rise in interest rates
• When bond prices react this way they are said to have positive convexity

Question 67

• Mortgage backed and callable bonds tend to have what type of convexities?

Answer 67

negative

• A fall in interest rates increases both mortgage prepayments and the likelihood that the bonds will be called

Question 68

Convexity is a better risk management tool than what?

Answer 68

• duration in volatile interest rate environments or when interest rates are low

Question 69

convexity is only important when comparing what?

Answer 69

• two investments with similar durations

Question 70

what are the 2 types of Bond portfolio management?

Answer 70

• Active managers
  
  • Tend to seek an above average total return on for the portfolio
• Passive managers
  
  • Includes both indexing and buy-and-hold strategies
  • They use indexing to try to match the performance of a given bond index by purchasing bonds that are included in the index
  • Advantages if indexing include lower management fee, diversification, and more predictable performance
  • They tend to purchase bonds in the primary market and hold them for long periods of time or until maturity
  • By consistently purchasing new issues of bonds, the portfolio manager can maintain diversification of terms and coupon rates

Question 71

The portfolio return includes:

Answer 71

• Coupon return
  
  • The total of all interest payments received by the portfolio plus accrued interest earned during a specific holding period
• Reinvestment return
  
  • The total interest earned from the reinvestment of interest payments during a specific holding period
• Price return
  
  • The total of the portfolios appreciation or depreciation during a specific holding period

Question 72

what are the bond Holding periods compared to importance of returns?

Answer 72

• long term holding periods 10+ years
  
  • the reinvestment return will be the most important factor when determining the return
• holding periods between 2-10 years
  
  • The coupon rate and reinvestment return will be the most important factors
• short term holding periods >2 years
  
  • The price return will be the most important factor

Question 73

Pension and insurance company portfolio managers will often try to manage the portfolio’s income to meet what?

Answer 73

• the current cash obligations of the pension plan or the insurance company’s guaranteed investment contracts

Question 74

• what are the Two methods Pension and insurance company portfolio managers use to match the portfolio’s income with current cash liabilities?

Answer 74

• Dedicated portfolio management
  
  • It matches the portfolio’s monthly income with the monthly cash liabilities
• Bond immunization
  
  • Creates a portfolio designed to generate a specific return during a known time horizon
  • They will match the bonds’ maturity dates with the known time when a lump sum payment is due
  • Because the portfolio’s maturity dates match the time when the payment is due, the portfolio is said to be immunized from interest rate risk

Question 75

what is a Bond ladder?

Answer 75

• Income oriented investors can build a portfolio of bonds to generate steady income and minimize interest rate risk by purchasing a bond ladder
• The investor will invest a stated principal amount and purchase a portfolio of multi maturity bonds
• This approach can be used to create monthly income rather than semiannual income generated from each bond individually
• It will also reduce the interest rate risk associated with bonds in a rising rate environment
• They can be constructed so that a portion of the portfolio is 12 to 24 months from maturity at any given time
• Rung
  
  • Means when a portion of the portfolio matures
• When a rung happens that portfolio can be reinvested at a new higher market rate
• Each rung should contain an equal amount of principal
• To determine to number of desired rungs, you would take the principal amount to be invested and divide by the number of years you wish to have the ladder
• The number of years is known as the height of the ladder
• The bonds ladder can be created in corporate bonds, municipal bonds, treasury bonds, or a mix of all three