Chapter 2- Debt Securities 15-25 questions

Question 1

Most common issuers of debt securities

Answer 1

Corporations, Municipalities and Us government

Question 2

Senior security

Answer 2

Bondholders are considered senior because they are settled before common stock

Question 3

Funded debt

Answer 3

Corporate bond with 5+ years till maturity

Question 4

Treasury bill or note or bond

Answer 4

Bills are less than a year while notes are 2 to 10 year maturities.

Bonds are 10 or more years

Question 5

Interest on a bond

Answer 5

Called the coupon rate

The interest rate is calculated from the par value or face value

Usually 1000 per bond

Interest on a bond accrues daily

Final bond semiannual interest is paid when bond matures with original amount

Question 6

How to read a bond sale:

5M ABC J&J 15 8s of ‘21

Answer 6

5 1,000 dollar bonds

ABC is the issuer

January 15 and July 15

8% annually

Principal repaid in 2021

Question 7

Three basic types of bond maturity

Answer 7

Term- Principal of the whole issue repaid on a maturity date. Issuers will establish a sinking fund to retire bonds.

Serial- Principal to mature at intervals over a period of years.

Balloon- pays part of issue off before maturity and makes lump sum payment at term

Question 8

Basic bond info

Answer 8

Name of issuer
Interest rate and payment date
Maturity date
Call features
Principal amount
CUSIP
Dated date (interest starts to accrue)
Reference to bond indenture

Question 9

Bearer bond (coupon)

Answer 9

Used to be sold normally

Would clip coupons and collect interest for the bond from the company

No longer issued, no name was on bond

Were not registered so the holder could do what they pleased with them

Deliver to paying agent to receive interest

Question 10

Fully registered

Answer 10

Records the principal and interest the bond has

Transfer agent Issues a new one upon sale to another customer

Receive a physical certificate of the bond

Issued in 1000 denominations or multiples of 5000 up to 100,000

Question 11

Book entry bonds

Answer 11

Do not receive certificates rather the trade confirmation acts as the certificate

Question 12

Primary issues determining price of a bond

Answer 12

1. Issuers financial stability

2. Overall trends in interest rates

Question 13

Pricing bonds

Answer 13

Bonds are usually priced in 1/8ths increments

So a bid of 98 1/8 means a bond is worth 98.125

1 basis point is either .01% or .0001 of a dollar

80 Bp is .8% or $8 on a 1000 face value bond

Question 14

Standard and Poors Ratings

Moody’s ratings

Answer 14

SP- give either a + for the top half of a category or - for bottom half
Ratings listed top to bottom:
AAA, AA, A, BBB, (non invest grade) BB, B, C, D

Moody’s- Adds numerical qualifiers to indicate where a bond is within a category such as 1, 2, 3

A1 and Baa1 to indicate high quality within two categories

Moody’s also provides ratings on short term munis designated MIG 1-4 and SG (speculative)
Aaa, Aa, A, Baa (below is speculative), Ba (could miss), B (missed 1 or more payments), Caa (no interest being paid), D (Default)

No rating does not reflect poorly, as most issues are too small to justify the expense

Mood Swings is a creative way to remember as Moody’s uses both upper case and lower case letters

Question 15

Basis for bond ratings

Answer 15

Amount and comp of debt
Stability of cash flow
Ability to meet payment schedule
Asset protection
Management capability

Question 16

Bank grade bonds

Answer 16

Rating of BBB or Baa and up

Question 17

Ranking of safety in bonds

Answer 17

US gov Securities and series EE OR HH bonds
Gov agency though US gov does not officially back
Municipal issues (general obligation bonds protected by taxation while revenue bonds are backed by facility revenues)
Corporate debt usually ranked (Secured bonds, debentures, subordinated debentures, income bonds)

Question 18

Debt service

Answer 18

Shcedule of interest and principal payments due on bond issue

Question 19

Sinking fund

Answer 19

Facilitates the retirement of bonds

Can be used to call bonds, redeem bonds at maturity or buy back bonds

Makes bonds more marketable if low rated

Usually required by the trust indenture

Question 20

Call feature

Answer 20

Redemption before maturity date either wholly or partial

Issuer notifies bondholders that it will call bonds at particular price

Partial calls are selected by lottery

Question 21

Call premium

Answer 21

The difference between the call price and the par for the bond

If callable at 102, call premium is two points or $20 per bond

A point is $10

Question 22

Term bonds vs serial bonds

Tender

Answer 22

Term bonds are called by random drawing

Serial bonds are usually called in inverse order of their maturities because longer maturities tend to have higher interest rates. This lowers the overall interest rate

If no call option is available, the bond is usually tendered

Question 23

Call risk

Answer 23

Generally, a bond is only called when interest rates decrease

Usually a newly issued bond has a 5-10 year window of call protection

Question 24

Refunding

Pre refunding

Answer 24

Practice of raising money to call a bond or selling new bonds to close old ones

Common when maturity is approaching

Pre refunding is doing the raising before the call is ready to lock in a lower interest rate

AAA rated, escrowed in government securities

Form of defeasance, or termination, of an issuers obligation. DO NOT COUNT AS ISSUERS DEBT.

Question 25

Putable bonds

Answer 25

The investor has the right to sell the bond to the issuer at full face. Must take a lower interest rate to get feature Municipal bonds sometimes do this

Question 26

Nominal yield vs current yield

Answer 26

Coupon yield set at issuance Current yield is coupon payment / market price Price and yield are inverse

Question 27

Yield to maturity formula

Answer 27

Reflects the annualized return of the bond if held to maturity. Difference between price paid for bond and par value are taken into effect Minus if premium, plus if discount Annual Interest -/+ (premium or discount / years to maturity) Divided by Average price of the bond (price paid + original / 2) Example Bought at 800, coupon of 8%, 5yrs left 80 - (200 / 5) divided by 900 = 4.4% return due to purchasing at premium Trading at a basis is referring to the yield to maturity

Question 28

Yield to call

Answer 28

Reflects the early redemption date The sooner a bond is called, the sooner a premium is lost YTC is always lower than yield, current yield and YTM if bought for a premium and sold at par

Question 29

Ranking Yields highest to lowest for a: Discount Premium

Answer 29

Discount: YTC, YTM, CY, Nominal Yiled (coupon) Premium: Nominal Yield, Current Yield, Yield to Maturity and Yield to Call This is due to the time span at which they would be called and how the different yields are calculated

Question 30

Yield Curve

Answer 30

The difference between short term and long term bonds with the same quality

Question 31

Normal Yield Curve

Answer 31

Yields typically differs by about 3% or 300 basis points in the total Curve. If rates are expected to dip, long term bond yields drop lower in anticipation while short term remain the same. Creates an inverted yield curve. If rates are expected to increase, the opposite will occur

Question 32

Yield curve predicting recessions and expansions

Answer 32

If the gap between corporate bonds and gov bonds increases, a RECESSION! might be coming due to investors seeking safety If it's narrowing, then an economic expansion may be forming as investors are willing to take risk

Question 33

Relationship between bonds and rates

Answer 33

If interest rates rise, bond prices will decrease to meet market demand If given two discount bonds, the deeper discounted bond will appreciate most with interest rates decreasing

Question 34

Mortgage bonds

Answer 34

Have the highest priority claim on assets pledged as collateral. Tend to have multiple issues so the first issued would have highest claim

Question 35

Open end indentures

Answer 35

Allows a company to issue more bonds on the same asset at a later date

Question 36

Collateral trust bonds

Answer 36

Bonds secured by securities held by a corporation of another. The corporation issuing the bonds must then hold the securities for the bonds Can be backed by subsidiaries stock or obligations of corp clients as well

Question 37

Equipment Trust Certificates

Answer 37

Used to finance capital equip Has a serial retirement schedule that is set at the same rate as the depreciation of the asset

Question 38

Debentures

Answer 38

Backed by general credit of the corporation Owners of the bonds are considered general creditors Above subordinated debentures and preferred stock in chain

Question 39

Subordinated debentures

Answer 39

Last of all debt obligations in liquidation (still above preferred stock) Often have conversion features

Question 40

Liquidation claim order

Answer 40

``` Unpaid wages IRS Secured debt Unsecured liabilities (includes debentures) Subordinated debt Preferred stock Common shareholders ```

Question 41

Income bonds (adjustment bonds)

Answer 41

Bonds issued by a company that is coming out of bankruptcy Will only pay interest if corporation has income to meet interest payments Do not accumulate for future payments Not suitable for investors seeking income

Question 42

Zero-Coupon Bonds

Answer 42

Issued at a deep discount without a regular interest payment Return is the difference between the sale price and maturity Substantially more volatile, fluctuate wildly with market rate changes Taxed on the accretion of the bond even though they do not pay interest IRS requires accretion of the discount on an annual basis, cost basis also goes up with each year

Question 43

What security has no reinvestment risk?

Answer 43

Zero coupon bond, because it locks in a return

Question 44

Trust indenture act of 1939

Answer 44

If a corporate bond is over $50 million, it must be issued under a trust indenture Trust indenture is a legal contract between bond holder and trustee, not automatically supplied Federal and municipal bonds are exempt

Question 45

Trustee

Answer 45

Usually a commercial bank or trust company Monitors covenants of the indenture

Question 46

Closed end covenants vs open end

Answer 46

Have senior claim on the underlying assets, sometimes called senior lien bonds Open- permits subsequent issues to be secured by same property

Question 47

NYSE

Answer 47

Central marketplace for trading corporate bonds NYSE Bonds also provides investors with a cost effective, autonomous way to trade Most still trade in OTC market

Question 48

Convertible bonds

Answer 48

Bond that is able to be converted into a fixed amount of common shares Pay lower interest rates, trade in line with common stock, have fixed interest payment and maturity dates so less volatile than common stock More stable pricing if stock devalues

Question 49

Advantage of Convertibles for issuer Disadvantages

Answer 49

Can be sold with lower coupon Can eliminate fixed interest rate upon conversion Does not have an adverse impact on stock price due to conversion happening over time Disadvantages: Shareholders equity is diluted when converted Substantial conversion could cause voting problems Loss of leverage in conversions Interest is deductible so conversion increases tax liability

Question 50

Conversion ratio

Answer 50

Expressed the number of shares of stock a bond may be converted into Conversion price of $40, face of $1000 25:1 conversion ratio Stated in the indenture agreement Preferred stock usually has a face of $100 Convertible bonds are protected by an antidilution covenant. Conversion price changes with a stock split or stock dividend

Question 51

Parity

Answer 51

The two securities are worth the same price Market price of bond / = parity price Conversion ratio (Shares) Market price of common x conversion ratio= Parity price

Question 52

Forced conversion

Answer 52

Issuer calls the bonds and it is in the best interest of bondholders to convert If market price for the bond is selling at a premium to the conversion price, the market will quickly remove the premium after conversion is announced

Question 53

Reverse convertibles

Answer 53

Imbedded put options allows the bond issuer to convert the bonds to common stock at predetermined date Higher interest rate for the bond holder

Question 54

Used to back collateralized loan obligations

Answer 54

Freddie Mac Ginnie Mae Fannie Mae

Question 55

Wall Street journal quoting

Answer 55

The Wall Street journal quotes yield as current yield

Question 56

Corporate bonds

Answer 56

Quoted as a percentage of par in 1/8ths