Chapter 2: Debt Securities

Question 1

is the interest rate that a bond issuer agrees to pay to bondholders over the life of the bond. It is usually expressed as a percentage of the bond’s par value (face value).

• is fixed at the moment of issue.

Answer 1

Coupon rate

A higher coupon rate generally means a higher yield, which can make the bond more attractive to investors. However, a high coupon rate may also indicate that the issuer is perceived to be more risky, which could affect the bond’s market value.

Question 2

Principal of the whole issue matures at once. What type of bond is this?

Answer 2

Term bond

Because the entire principal is repaid at one time, issuers may establish a sinking fund (cash reserve) to accumulate money to retire bonds at maturity.

Question 3

Also called the stated yield or nominal yield. It is calculated from the bond’s par value

Usually stated as a percentage of par

Answer 3

Coupon rate

Question 4

This bond schedules portions of the principal to mature at intervals over a period of years

Answer 4

Serial bond

Question 5

When trading in the secondary market, this type of securities pricing is measured in points with each point. Equaling 1% of face value

Answer 5

Bond

Question 6

Total return that will be paid out by a bonds expiration date

Answer 6

Yield to Maturity

• The yield to maturity takes into account the bond’s current market price, its face value, the coupon rate, and the time remaining until maturity. It is often used as a measure of the bond’s overall profitability and is a key metric for investors who are considering buying or selling bonds.

Question 7

Offer a higher yield for the risk of losing out on future interest payments.

Answer 7

Callable bonds

• This risk is often reflected in the bond’s yield to call, which is the yield an investor would earn if the bond is called at the earliest possible date.

Question 8

Define Yield to Call

Answer 8

The price that will be paid if the issuer of a callable bond ops to pay it off early

Question 9

Lower grade bonds typically known as junk bonds or speculative bonds.

• high reward due to their level of risk

Answer 9

High yield bonds

Ba or lower rating

Question 10

As a rule the more ____ left to maturity, the more ____ a bonds price will be given a change in interest rates

Answer 10

Time, volatile

• the lower the bonds coupon rate the more volatile it is

Question 11

Defined as a way of measuring a bond’s volatility that combines maturity and coupon rate is called

Answer 11

Duration

Higher duration means more volatility

The lower the duration the lower the volatility

Question 12

Why would an issuer pay a bond off early?

Answer 12

Interest rates have gone down so debt is less expensive

Question 13

is a feature of some bonds that allows the bondholder to sell the bond back to the issuer before it reaches its maturity date.

Also, why would a holder of a bond do this?

Answer 13

Put feature

Rates have gone up therefore the cost of debt has gone up

So the bond holder can now get a better rate

Question 14

Defined as the ability for a bond holder to convert their debt into a security

Why do this?

Answer 14

Convertible feature

Bond holder can exchange debt for security and therefore benefit from capital appreciation

And ownership rights

Question 15

Treasury _____ are U.S. bonds sold at a discount to their face value and pay full face value at their maturity.

• can only be held through a financial institution or broker
• are created when a bond’s coupons are separated from the bond
• considered Zeroes.
• book entry only
• created in 1985 and issued by the U.S. Treasury

Answer 15

STRIPS

Question 16

Though Zero’s do not make regular interest payments. The difference between the discount price and par is the interest payment earned at maturity.

• this is taxed annually - by dividing the total interest payment by the years remaining to maturity.

This tax is often referred to as ?

Answer 16

Phantom income otherwise known as annual creation of the discount

Question 17

In the case where a corporation wants to borrow money but, has neither real estate, nor equipment, to use as collateral.

• made up of securities either held by the corporation or are issued by them. Securities are placed into a trust and held as collateral.
• the more marketable the security, the better the quality of the certificate.

Answer 17

Collateral Trust Bond

Question 18

No assets held as collateral for this type of debt

Answer 18

Unsecured debt or debentures

Though keep in mind that some debentures can be seen as safer than even some secure issuers. As debentures are often chosen based off the issuers creditworthiness.

Question 19

Written promises to pay the principal at its due date and interest on a regular basis is defined as a ?

• promise is binding and often based off the creditworthiness of the issuer.

Answer 19

Debentures

Question 20

is a type of bond that is backed by a third party, typically a corporation or government, which promises to make interest and principal payments on the bond if the issuer is unable to do so. This third party guarantee adds an extra layer of security for bondholders, making the bond less risky and potentially more attractive to investors.

• Often referred to as guaranteed but are in fact unsecured debt securities

Answer 20

Guaranteed bonds

Question 21

____ is a type of debt security in which only the face value of the bond is promised to be paid to the investor, with any coupon payments paid only if the issuing company has enough earnings (income) to pay for the coupon payments (interest).

Answer 21

Income bonds

Question 22

True or false

All debentures (including income and general obligation bonds) are senior to subordinate debt in order of priority

Answer 22

True

Question 23

Has a claim that is behind any other creditor but still senior to any stockholder

Answer 23

Subordinated debt

Subordinated debt, also known as junior debt, is a type of debt that ranks lower than senior debt in terms of priority for repayment in case of a default or bankruptcy. This means that in the event of liquidation, subordinated debt holders will only receive payment after senior debt holders have been paid in full.

Question 24

Sometimes referred to as senior debt

Answer 24

Debentures

Question 25

Will come after all creditors have been paid

Answer 25

Preferred shareholders

Question 26

Why do conservative investors often prefer bonds over securities?

Answer 26

• Priority of payment
• low risk of loss of investment (default)
• offer income

Question 27

are bonds issued by state and local governments, as well as their agencies and authorities to finance public projects such as schools, highways, and water systems.

• settle T+2
• accrue interest is calculated via 30-day-month / 360-day-year

Answer 27

Municipal bonds

Question 28

• The interest income from most _____ bonds is exempt from federal income taxes as well as state and local taxes if the investor resides the issuers state.

2 types of such bonds.

• GOs
• Revenue Bonds

Answer 28

Municipal bonds

When an investor sells a municipal bond at a profit, the capital gains are subject to taxes. However, if the bond has been held for more than one year, the gain is typically taxed at a lower long-term capital gains rate.

Question 29

True or false

Municipal securities settle T+2 and pay accrued interest on a 30-day month/ 360 day year

Answer 29

True

Question 30

Typically the projects these funds are funding do not produce revenues

So the principal and interest owed to the bondholder will be paid by taxes collected by the municipal issuer (government)

Because of this backing ___ bonds are known as full faith and credit issues

Answer 30

General Obligation Bonds (Go Bonds)

Question 31

True or false

The amount of debt that a municipal government may incur can be limited by state or local statutes to protect taxpayers from excessive taxes

Answer 31

True

Question 32

This type of bond is often associated with requiring voter approval. As it creates an obligation to pay back the funds.

Answer 32

Go bonds

Remember, these bonds are paid from taxe revenues

Question 33

are a type of municipal bond that are issued by a state or local government, or a special-purpose entity created by the government, to finance a specific revenue-generating public project, such as a toll road, airport, or sports stadium.

• backed by the revenue generated by the specific project being financed.

Answer 33

Revenue bonds

Question 34

are short-term debt instruments issued by state and local governments to cover short-term financing needs. They are typically used to bridge the gap between the time when funds are needed for a specific project or operation and the time when expected revenue is received

Answer 34

Known as anticipation notes

Question 35

Calculated as

Tax-free yield / (1 - investors tax rate)

Answer 35

Tax benefit or Tax-Equivalent Yield (TEY)

Question 36

Issued by the Dept of the Treasury

Bought at a discount to par. The difference between the purchase price and the par paid at maturity = interest earned.

• settle T+1
• accrued interest is calculated based on actual calendar days elapsed.
• considered zero’s
• book entry only
• interest earned pays federal taxes.

Answer 36

Treasury Bills or “T-Bills”

• Are subject to federal, but not state and local taxes.

Question 37

Pay semi-annual interest as a percentage of stated par and mature at par value

Are intermediate maturities (2-10 years)

Answer 37

Treasury Notes

Question 38

Pay semiannual interest as a percentage of stated par and mature at par value

Considered long term maturities (10-30 years)

Answer 38

Treasury bonds

Question 39

A type of bond created by brokerage firms from US Treasury notes and bonds.

• do not pay interest regularly
• instead the interest is rolled into the principal and paid at maturity

Answer 39

Treasury receipts

Question 40

_____ can have maturities of just a few days or up to a maximum of 52 weeks, but common maturities are 4, 13, 26, and 52 weeks.

• on average, the longer the maturity date, the higher the interest rate that the _____ will pay to the investor.

Answer 40

Treasury bills or “T-Bills”

Question 41

Only 2 types of Treasury Securities issued at a discount to par.

• Considered Zero’s

Answer 41

T-bills and STRIPS

Question 42

Special type of treasury security. They are issued with maturities of 5, 10, or 20 years.

• have a fixed coupon rate and pay interest every 6 months
• the principal value of the bond is adjusted every 6 months based on the inflation rate.
• interest payments will increase with the principal during periods of inflation and decrease during periods of deflation.
• The final principal payment will never be less than the original $1,000 par

Answer 42

T-reasury
I-nflation
P-rotected
S-ecurities

Question 43

Is sometimes used to refer to entities that are not technically government agencies but that have ties to the government?

Answer 43

Agency

Question 44

is a publicly held corporation that provides mortgage capital.

• purchases conventional and insured mortgages from agencies such as the Federal Housing Association (FHA) and the Veterans Administration (VA).
• Securities it creates are backed by FNMA’s general credit.

Answer 44

Federal National Mortgage Association (FNMA)

Question 45

This type of risk is associated with a mortgage that is paid off before its stated maturity

Answer 45

Prepayment Risk.

A risk for mortgage lenders and mortgage-backed securities (MBS) investors.

Question 46

True or false?

The federal home loan mortgage corporation is a public corporation

Answer 46

True

FNMA is also publicly held.

Question 47

Created to promote the development of a nationwide secondary market and mortgages by buying residential mortgages from financial institutions and packaging them into mortgage-backed securities for sale to investors

• publicly owned
• interest earned pay Federal & State taxes

Answer 47

Federal home loan mortgage corporation (FHLMC)

Question 48

True or false

Federal National Mortgage Association

Is also referred to as Fannie Mae

Answer 48

True

Question 49

Sometimes called government sponsored entities (GSE)

Are publicly owned (held) corporations

These two names are synonymous with the 2008 financial crisis

Answer 49

Fannie Mae and Freddie Mac

Question 50

Investors receive monthly payments of principal and interest, which are based on the underlying mortgages.

• is a government owned corporation.
• Supports the Department of Housing and Urban Development.
• only agency securities backed by the full faith and credit of the federal government.

Answer 50

GNMA

Prepayment risk is a GNMA’s investors greatest risk

Question 51

GNMA
Strips
Treasury bills

All have what in common ?

Answer 51

They are backed by the full faith and credit of the US Treasury

Question 52

are fixed-income (bonds) securities with one year or less left to maturity

• considered to be low-risk, highly liquid investments
• generally do not receive interest payments; instead, these securities are often issued at a discount and mature at face value.

Answer 52

Money market instruments

Question 53

considered a post-dated check or line of credit, often called bills of exchange

• payment is guaranteed by a bank rather than an individual account holder.
• trade in the secondary market at a discount (similar to Treasuries)
• payment date is normally between 1 and 180 days and never more than 270 days.

Answer 53

Bankers acceptance

Question 54

Once the ___ and _____ have only a year left to maturity, they are considered to be money market instruments

Answer 54

Treasury notes and treasury bonds

Question 55

an agreement between a buyer and seller to conduct a transaction (sale) and then reverse that transaction (repurchase) in the future.

• contract includes a repurchase price and a maturity date.
• often used by banks to raise needed capital, either with another bank or with the Federal Reserve Board (FRB)

Answer 55

Repurchase agreements

REPOS

Question 56

A dealer agrees to buy securities from an investor and sell them back later at a higher price

What is this known as?

Answer 56

Reverse repurchase agreement or reverse repo

Question 57

ones whose value and income payments are derived from or backed by a specific pool of underlying assets.

Such as:
- Mortgages
- CMOs

Answer 57

Asset-backed security

Question 58

Refers to a type of asset-backed security that pool a large number of mortgages, usually single-family residences.

• Structured into maturity classes called tranches
• issued by private-sector financing corporations and
• are often backed by Ginnie Mae, Fannie Mae, and Freddie Mac pass-through securities.
• pay principal and interest from the mortgage pool monthly; however it repays principal to only
  one tranche at a time.

Answer 58

Collateralized Mortgage Obligation (CMO)

investors in a short-term tranch must receive all of their principal before the next tranche begins to receive principal
repayments.

Principle payments are made in $1,000 increments to randomly selected bonds within a tranche.

Question 59

Predicts how much a stock (equity) will outperform risk-free investments over the long term.

= Market Expected RoR - Risk Free Rate.

Answer 59

Equity risk premium

Question 60

______ is the primary financing mechanism for all government-insured or government-guaranteed mortgage loans.

• Wholly owned federal corporation that guarantees principal and interest payments on MBSs issued by approved lenders.
• part of the (UDHUD) U.S. Department of Housing and Urban Development.

Answer 60

GNMA or Ginnie Mae

Question 61

____ are bonds secured by home and other real estate loans.

• created when a number of these loans, usually with similar characteristics, are pooled together and then sold to a federal government agency like Ginnie Mae (GNMA) or (GSEs) like Fannie Mae and Freddie Mac.

Answer 61

Mortgage-Backed Securities.

Question 62

Term for the company holding the assets.

Answer 62

Originator

Question 63

What an investment pays me / what is costs me.

• measures a bonds annual coupon payment (interest) relative to its market price.

calculated as:

Annual Coupon Payment/ CMV =

Answer 63

Current yield

Question 64

________ is a type of _____ stock with a provision that stipulates that if any dividend payments have been missed in the past, the dividends owed must be paid out to _______ shareholders first.

• this is before other classes of stock shareholders and common shareholders can receive dividend payments.

Answer 64

Cumulative, preferred stock

Question 65

are subject to federal income tax, but are exempt from state and local income taxes, making them an attractive investment option for those who are subject to high state and local taxes. have maturities of one year or less and are used by the government to finance its operations.

• interest is reported on the investor’s annual tax return (in the year of maturity or when sold)

Remember: Face Value - Discount Price = Interest Earned (Capital Gains)

Answer 65

T-Bill

However,if the T-bill is held in a tax-advantaged account such as an Individual Retirement Account (IRA) or a 401(k) plan, the interest earned is not subject to current income tax. Instead, the tax liability is deferred until the investor withdraws the funds from the account.

Question 66

What is the main difference between Treasury bonds, notes, and bonds ?

Answer 66

Treasury Bills = short term. Anywhere from a few days to 52 weeks.

Treasury Notes = medium term. Usually between 2 - 10 years

Treasury Bonds = long term. Mature in 30 years.

• T-Notes & T-Bonds pay interest every 6 months. T-Bills do not make interest payments.

Question 67

True or False

Treasury receipts include regularly scheduled interest payments.

Answer 67

False

Question 68

A _____ bond is structured so that the principal the whole issue matures at once.

• issuers may establish a sinking fund account to accumulate money to retire the bonds at maturity.

Answer 68

Term bond.

A type of maturity date.

Question 69

The term _____ refers to a type of savings bond.

• savings bonds are a type of debt issued by the federal government that may be purchased and redeemed at banks or from the treasury department.
• savings bonds do not trade. It are not considered a security

Answer 69

Series

Also

Series is not a type of maturity used with debt securities

Question 70

Corporate and municipal trades use a ___- day- month/ ____ - day- year calculation for accrued interest

Answer 70

30-day-month/360-day-year

Question 71

Treasury bonds and notes transactions employ the ______ of days elapsed when calculating the mount of accrued interest.

Answer 71

Actual number of days elapsed

Question 72

This type of yield is set at the time of issue.

• Remember that the coupon is a fixed percentage of the bond’s par value.

Answer 72

Nominal Yield, Coupon, or Stated Yield.

Question 73

reflects the annualized return of the bond if held to maturity.

Answer 73

Yield to Maturity (YTM)

Test Topic Alert

if you see a bond that is trading on a basis of and the question then provides you a yield, that yield is the YTM

a basis point is a measurement of yield equal to 1/100 of 1%.

a full percentage point is made up of 100 basis points (bps).

Question 74

a more common form of zero’s built by BDs from a basket of Treasury notes & bonds; these are called __________.

• Issued by BDs not the Treasury
  
  • therefore not backed by the full faith and credit of the gov.

Answer 74

Treasury Receipts.

Question 75

An agency-like organization operated by private corporations.

• provides loans for college students in the United States

Answer 75

Student loan marketing association (SLMA or Sallie Mae)