Chapter 3 – (LOTS OF MARKS) Bonds

Question 1

Capital gains on gilts and most corporate bonds (beside convertibles) is tax-free to individual investors.

Therefore are losses claimable?

Answer 1

No losses are not claimable because CGT is not payable so why would you be able to claim losses

Question 2

Bonds & Gilts are ‘negotiable fixed-interest long-term debt instrument’

What does this mean?

Answer 2

This means they are:

tradable investments (negotiable)

that pay a fixed return (fixed interest)

over a period of up to 30 years (long-term)

just a loan to someone (debt instruments).

You will also hear fixed-interest securities referred to as stock, loan stock, debentures, debt securities or loan notes. All these are variations on the same theme. As we’ve said before, why have one term when you can have several?

Question 3

3.1.2: Coupons

Coupons are expressed as a percentage of the par amount, and are usually paid twice a year, although that will vary from country to country depending on the market convention.

Par value = Face value/nominal value (the amount paid back on redemption date)

Bonds are traded by their nominal value. This means that if you have a holding of £100,000, nominal value, £100,000 is the amount that you will receive at maturity. However, it will probably not be the current market value of the bond. In fact, the nominal value and the price paid for the bond can be very different

Although the face value of the bond never changes, its ‘real-time’ value or price does, as the level of interest rates in the market changes.

Answer 3

To help illustrate the point, if we assume that the price would be £110.58, and its nominal value/par value is £100, then the bond would be said to be trading ‘over par’ or ‘at a premium to par’.

If the price of the bonds was £100, then the bond would then be ‘priced at par’ (New bonds are usually issued with a coupon close to the current level of interest rates, which means that their initial prices are often very close to par.)

If price of bond was less than £100 nominal value, for example £95.17, the bond would then be trading ‘below par’ or ‘at a discount to par’.

Question 4

How do you sell a bond and what rights does the seller lose after selling it?

Answer 4

On the secondary market. This is where bonds can be sold to, or bought from, someone else. The seller will usually receive a gain or suffer a loss. It would be quite unusual for a seller to receive the same amount from their bond as they paid for it.

Once you sell the bond you are no longer entitled to the coupon or the par value; the buyer becomes entitled to the income and the nominal value at maturity.

Question 5

There is an inverse relationship between prices and interest rates.

This is one of the most important concepts to remember in the bond market.

Explain this

Answer 5

If interest rates exceed the coupon, the bond will be less desirable and therefore the price of the bond will fall due to less demand and vice versa

As one rises, the other falls (inverse)

Question 6

Do bonds always have fixed redemption dates?

Answer 6

No, some bonds have a range of dates during which they are redeemable, e.g. 2027 – 2029.

The issuer can choose when they pay the bonds back, within the date range. This means the earliest redemption date will be 2027 and the latest 2029, as long as the issuer gives the investor a minimum 3 months’ notice.

Also, some bonds are ‘undated’ and are redeemable whenever the issuer wants

These bonds will usually only be redeemed by issuers if general interest rates have fallen below the level of the coupon. In those circumstances, the issuer may then feel that they are paying out a coupon that’s too high; they might choose to issue new bonds with a lower coupon and use the proceeds to redeem the old bonds.

Question 7

What are some other variations of bonds that have non standard redemption dates (ie not fixed)?

Answer 7

Different types of bonds with non-standard redemption are callable bonds, puttable bonds and convertible bonds, undated bonds, etc

Question 8

3.2.1: Some different types of Government Bond
Conventional bonds
Index-linked bonds
Treasury bills

Tell me the difference

Answer 8

Conventional bonds - fixed coupon/fixed maturity

Index-linked bonds - coupon and principle payment uplifted by inflation

Question 9

Who issues bonds?

Answer 9

Issued by the Debt Management Office by a group of dealers known as Gilt Edge Market Makers (GEMMS)

Question 10

The main types of GILTs are:

Conventional
index- linked
dual-dated
undated
Green
Sovereign Sukuk
Strips

Tell me about each

Question 11

Conventional GILTS are categorised in 3 ways by the DMO. This is:

Shorts
Mediums
Longs

Answer 11

Shorts = Less than 7 years
Mediums = 7 - 15 years
Longs = more than 15 years

NOTE: ultra-long gilts issued can be more than 50 years but these are still counted within the ‘long’ classification. Same for for ultra short GILTS too

Question 12

What do index linked GILTS track?

Answer 12

RPI

In the UK, both the interest payments and the principal repayment of index-linked gilts are adjusted in line with the UK Retail Price Index (RPI). For example, if RPI gradually doubles between the start date and the redemption date, the par value will double and the coupon will rise year on year.

This means that investors are protected against the value of their investments being eroded by inflation. However, if RPI falls, i.e. there is a period of deflation, the interest and principal amount will also fall; there is no ‘deflation floor’.

Question 13

What are the 2 main types of Corporate Bonds

Answer 13

Secured (debentures)

Unsecured (Loan Stock)

Question 14

What are the main difference between Government Bonds & Corporate Bonds

Answer 14

Although corporate bonds are very similar to gilts, there are several differences that an investor needs to consider:

They are riskier, with a higher chance of default.
Prices are more volatile.

They can be more difficult to trade, particularly smaller company bonds.

The difference between the buying and selling price is greater.

The creditworthiness of the companies changes more regularly.

Yields are often greater to reflect the higher risks being taken.

Question 15

What is the meaning of debenture?

Answer 15

The word ‘debenture’ means a written acknowledgement of debt.

Question 16

Debentures can be secured by either a fixed charge or a floating charge. What is the difference?

Answer 16

Fixed Charge - A charge over specific assets of the company. (ie land, machines etc). Because of this, the company can not sell the asset whilst it has a charge against it. Preferred option for the lender (the debentures owner)

Floating Charge - A general charge over the company assets. This means the company can deal with and sell teh assets as normal. Preferred option for the company as its less restrictive.

Question 17

What are subordinated bonds?

Answer 17

A variation of loan stock

For these, if the company were to wind up, it would only be paid after other more senior creditors had been repaid and only if there was anything left over. (Therefore more risky than typical loan stock)

Question 18

3.3.4: What are Medium Term Notes?

Answer 18

A type of corporate bond

The main difference between MTNs and other types of bonds is the fact that they are issued as part of an MTN programme. (Chapter 8.)

NOTE: The name ‘medium term’ is a bit of a misnomer because they can in fact have any maturity date / term.

Question 19

What are Floating Rate Notes (FRNs)?

Answer 19

3.3.5: Floating Rate Notes (FRNs)

Type of corporate bond

Question 20

3.3.6: What are Zero Coupon corporate bonds?

What does it mean if they are deeply-discounted?

Answer 20

As the name suggests these bonds do not pay any coupons. As a result, they are issued at a discount to the par value. You may hear the term ‘deeply-discounted’ used to describe zero coupon bonds.

Question 21

Do deeply discounted bonds pay tax?

Answer 21

These are Zero Coupon Bonds so all return is linked to the capital gain at redemption (as they are sold well below PAR)

Therefore, the capital gain is taxable as income rather than a gain (like GILTs and other qualifying corporate bonds that are not subject to CGT but instead income tax at saving rates on the coupon received)

Question 22

3.3.7: What are Permanent Interest-Bearing Shares (PIBS)?

Answer 22

These are only issued by building societies in the UK. The name is a bit of a misnomer as they are not really shares but more akin to an irredeemable bond, with no stated redemption date.

No redemption date (higher risk)

Half-yearly fixed coupon that is liable to income tax like any other bond.

Returns are high, but ‘interest’ payments can be missed under certain conditions and there is no obligation for the building society to make up missed payments. (higher risk)

PIBS rank behind all depositors and other creditors in liquidation.

If the building society demutualises (i.e. it lists on the LSE and is owned by its shareholders rather than the members of the building society) the PIBS convert to perpetual subordinated bonds (PSBs).

Question 23

3.3.8: What are Step-up and Step-down bonds

What are multi step up bonds & single step up bonds

Answer 23

With these bonds the coupon is fixed in advance but changes over the life of the bond, either stepping up or stepping down. Although they have varying coupons like FRNs, they are not the same. With FRNs the coupon is unknown, but a step up / step down’s coupons are known at inception.

Ie it might pay a coupon of 6% and in one year it is set to step up to 7% and then in 2 years it is set to step down to 8% etc (This is a muliti step up bond but you can get single step up bonds and same for step down bonds too)

Question 24

What are 3.3.9: Convertible Bonds?

Answer 24

These bonds are a ‘hybrid’ of debt and equity.

They are unsecured bonds that give the holder the right to convert their bond(s) to a predetermined number of ordinary shares in the issuing company on either on a set date or between a range of dates.

Once converted they cannot go back

Question 25

Convertible bonds are also ‘dilutive’ . What does this mean?

Answer 25

Convertible bonds are ‘dilutive’ because new shares in the company are created so they dilute the capital value of the company’s shares

Question 26

Convertible Bonds

How does an investor know if they should convert of not?

Answer 26

Conversion Ratio/value = Number of shares that £100 nominal can be converted into. ie, value IF the shares were converted

Conversion Value = How much the conversion would be worth if the bond was converted into the current share price. Current value of the bond basically.

Effectively, it is a direct comparison: the investor needs to compare the conversion value with the value of the convertible bond i.e. the price of the convertible.

If the conversion value is greater than the convertible price, then the bond is worth converting, as it will be worth more in shares than it is as a bond.
If the conversion value is less than the convertible price, then the bond is not worth converting. In this case you could sell the convertible bond and be able to buy a greater number of shares with the proceeds.
We can think of a convertible bond as a conventional bond plus the option to buy shares in the issuing company.

Question 27

Convertible bonds.

Conversion value = The value of shares youd get if it was converted to shares

Convertible value = The value of the bond itself, ie, the value that comes with it being convertible

Answer 27

If the conversion value is greater than the convertible price, then the bond is worth converting, as it will be worth more in shares than it is as a bond.

If the conversion value is less than the convertible price, then the bond is not worth converting. In this case you could sell the convertible bond and be able to buy a greater number of shares with the proceeds.

This option means that convertibles generally trade at a higher price than conventional bonds. If the share price is low, then convertible bonds will trade like conventional bonds as the likelihood of conversion is low. If the share price is high, then likelihood of conversion is high and the bond trades more like the underlying shares.

Question 28

3.3.10: What are Exchangeable bonds

What are they used for?

What is the main difference to convertible bonds?

Answer 28

These are very similar to convertible bonds, except that bonds can be converted into shares of a different company.

Issuers issue them so that they are able to sell holdings they have in other companies.

Investors buy them to give them exposure to a different company to the one issuing the bond.

Exchangeable bonds are not dilutive like convertibles are, because new shares are not issued. Existing shares are used only instead.

Question 29

3.3.11: What are Callable bonds?

What are Puttable bonds?

Mention advantages and disadvantages of both?

Answer 29

These are two additional types of bonds that also have an option included.

Callable bonds = The issuer has control. They have right to call the bond when they want

Puttable = Investor has control. Investor has right to sell bond to issuer when they want

callable bonds = The issuer (the institution that is borrowing the money) has the right to call the bond. This means that they can repay the investor their principal amount in full or part before the final maturity date. There will usually be a published schedule as to exactly when the bond can be called, but generally issuers would want to do so if interest rates fall. They would issue another bond with a lower coupon and use the proceeds to repay the callable bond. Obviously, this is a massive disadvantage to the investor. They can’t ‘lock in’ to the rates, so any investor purchasing a callable bond would demand a higher coupon than a conventional bond. (Basically, a corporate bond without a redemption date)

Puttable bonds = investor has the right to sell their bonds back to the issuer. The investor will xercise this right to put the bond back to the issuer if interest rates rise; that way, the money the investor receives can then be used to buy a bond with a higher coupon.

As a result of this extra feature, puttable bonds pay a lower coupon than a conventional bond. This clearly represents a greater risk for the issuer as if the bond is put back to them they will need to refinance at a higher interest rate.

Question 30

What is a sinking fund bond?

Answer 30

A type of callable bond where the issuer repays the principle in regular intervals rather than in one go

Some bonds may see the issuer repay a set amount of the principal at regular intervals

Question 31

3.5 - repos

What is the Repo’s market technical name?

Tell me how it works?

What institution uses the Repo mark?

Answer 31

sale and repurchase agreement market

Gilts are used as colleterial.

The mechanics are as follows:

The ‘borrower’ (who needs cash) sells securities, such as gilts, to a ‘lender’ in return for a cash loan.
At the same time, the borrower agrees that they will buy the gilts back (repurchase them) from the lender on a date agreed in the future.

When the date arrives, the lender returns the gilts and receives the original cash loan back, plus interest on the loan charged at the repo rate.

Extra :
The repo rate will be lower than other forms of borrowing, as the loan is secured by the gilts.

If the borrower does not pay the cash plus the interest, then the lender can sell the gilts in the market and receive their cash that way instead.

Question 32

The Repo market

GILTS ARE USED AS COLLATRIAL

Answer 32

The repo rate = When the date arrives for the agreement to end, the lender returns the gilts and receives the original cash loan back, plus interest on the loan. The interest charged is at the ‘repo rate’

Question 33

The repo market is used by WHO as part of their strategies to influence interest rates.

Answer 33

the Bank of England

Question 34

3.6: What is Securitisation?

Answer 34

securitisation is where assets are pooled and repackaged into interest-bearing securities. (this is the stuff that caused the crash in 2008 where mortgages were used as the backed security, )

The two types to know for exam:
-Asset backed bonds /securities (ABS)
-Covered bonds

HOW THEY WORK:

This process takes a basket of non-marketable assets, i.e. assets that could not be bought by regular investors such as mortgages, and packages them together to create a security or bond.

Other assets that have been ’securitised’ include credit card debt, car loans and even music royalties. For example, David Bowie was the first to sell his royalties in 1997 to create the ‘Bowie bond’.

The cash flows from the assets (both interest and principal payments) are used to pay the investors who buy the securities. ABSs are tradeable, meaning that technically investors are easily able to buy and sell them on the market, although in practice liquidity can vary greatly.

Question 35

3.6.2: Covered bonds

Answer 35

Covered bonds - Type of bond backed by a pool of assets, such as mortgages or public sector debt. The bank does not sell the assets (like with Asset-backed securities) but retains them on its balance sheet. The mortgages then act as a form of collateral or security for the bondholders, meaning that they will have a preferential claim compared to other creditors of the bank in the event of the bank defaulting.

Asset Backed Security -
Same as above except the bank sells the mortgages to a SPV who creates the bond (the ABS) which investors then buy into.

How it works:
ABC Bank has lent money out via mortgages.

They have hundreds if not thousands of mortgages on their books, with their customers making monthly payments that consist of both interest and principal payments.

The bank sells these mortgages to a special purpose vehicle (SPV) who creates the securities which are sold to investors.

2. The investors pay for the securities, with the proceeds being passed to ABC Bank.
3. The interest and principal payments paid by the customers on the mortgages are then ‘passed through’ to the investors.

The problem in 2007-2008 was that the mortgages were of poor quality. The banks didn’t care who they were lending to as they were selling the mortgages on. It wasn’t their problem if their customers defaulted! As interest rates rose, people could no longer afford their mortgage payments and large-scale defaults occurred. The SPVs repossessed the properties but found that, due to a fall in the property market, the values of the properties were less than the value of the mortgages. As a result, the value of the subprime mortgage-backed securities plummeted. All but a few astute investors (see again ‘The Big Short’) failed to conduct proper research into exactly what the portfolio of assets were comprised of.

Question 36

3.7.1: Credit Ratings Agencies (CRAs)

Prior to exam look at the table with the different ratings

Answer 36

The role of the credit ratings agencies is to assign a credit rating to a bond when it is first issued. This provides information to investors about the likelihood of the bond defaulting.

The three main CRAs are Standard & Poor’s, Moody’s and Fitch.

Prior to exam look at the table with the different ratings

NOTE:

We mentioned earlier that the issuing company will pay the rating agency a fee to provide them with a rating at issue.

They will provide the rating agency with the terms of the bond via a published prospectus, offering document, or official statement.

Clearly, the higher the rating the better for the issuer. It will mean there is greater demand for the bond from investors because it has been independently deemed to be lower risk, and it means the issuer’s funding costs will be cheaper because they can pay a lower coupon. THIS IS WHAT HAPPENED IN THE CRASH WHERE CRAs effectively lied so the issuer did buisness with them (Nowadays CRAs are supervised to ensure they are independent and not influenced)

Question 37

The are two categories of bond, known as investment grade and speculative grade. Tell me the difference

Answer 37

Investment grade bonds are the most secure and most liquid bonds. (may have a triple AAA or double AA rating from a CRA)

Some investors such as pension funds are only allowed to invest in investment grade bonds, so it’s a really big deal if your bonds are assigned an investment grade rating. On the other hand, these bonds will have the lowest returns, as they are considered to be safer investments.

Speculative grade bonds are also known as high-yield bonds (as well as also being referred to as non-investment, sub-investment or junk bonds). and are the opposite of the above

Question 38

Companies that are assigned lower credit ratings may choose to include some form of credit enhancement.

What does this mean?

Answer 38

Firstly, this is bad for the company/issuer as it means they will have to pay a higher coupon and their bond will be less in demand due to being higher risk

A credit enhancement therefore might be used:

credit enhancement. This provides extra security for the investors, making it more likely that they would be willing to buy the bonds.

Credit enhancements include things such as:

over-collateralisation (where they have a greater amount of collateral to cover the bond payments)
third party guarantees
pool insurance
senior / junior classes of bonds
step-up bonds (where if the issuer does not call the bond (remember callable bonds) the coupon increases)

Question 39

Soverign issuers, like companies, receive credit ratings

Ie, argentina might be rated BBB as they are likely to default

Answer 39

REMEMBER:

‘if a factor has a negative impact on the economy then that will lead to a lower credit rating’.

SEE ALL MAIN FACTORS IN A LIST IN 3.7

Question 40

Bonds are quoted in the market at their clean price. What does this mean?

What is the dirty price? How can the dirty price change?

Answer 40

This means that the accrued interest (i.e. how much interest has accrued on the bond so far) is not included in the price.

The dirty price is paid by the buyer. This is the price that includes the accrued interest. (obvs would be unfair if the buyer receives a full distribution when they have only held the bond for part of the period where the distribution accrued. To see what level the dirty price will be you must look at how the bond is traded.

Bonds are traded cum dividend or ex dividend

Cum dividend = buyer receives next full coupon. The buyer therefore needs to pay some back to seller (by paying a higher dirty price)

Ex dividend = When the bond is bought after the ex dividend date. The seller receives the full next coupon. The seller will need to give some money back to buyer (the dirty price will be lower)

Remember: Bonds accrue interest daily from the last settlement date. This potential income increases until the next coupon payment (settlement) date. Then, the coupon is paid and the interest/income resets back to zero.

Question 41

Bond returns

Answer 41

This is where the bond’s return or yield comes in. The yield will give us a measure of what the return on the bond will be given the price and coupon, so what return you receive as a percentage of what you paid for it.

The Interest yield looks at the income and the Redemption yield looks at the complete return.

Question 42

Interest yield = Coupon x 100 / clean price

It is basically the annual income from the bond, expressed as a percentage of the price paid. DOES NOT TAKE INTO ACCOUNT CAPITAL GAIN/LOSS

Gross Redemption yield = Interest yield
+/- ((gain or loss at maturity/number of years to maturity) / clean price)

The redemption yield is a more accurate calculation of the yield on a bond, as it takes into account the running yield and the loss / gain that would be experienced at maturity.

Answer 42

Interest Yield = It is basically the annual income from the bond, expressed as a percentage of the price paid. DOES NOT TAKE INTO ACCOUNT CAPITAL GAIN/LOSS

The redemption yield is a more accurate calculation of the yield on a bond, as it takes into account the running yield and the loss / gain that would be experienced at maturity.

If redemption yield is less than interest yield there will be a capital loss at maturity and vice versa

Question 43

If redemption yield is less than interest yield there will be a capital loss at maturity and vice versa

Question 44

3.9.4: Bond yield curves

Normal
Flat
Inverted

The yield curve is a graph comparing the redemption yields on similar bonds that are being traded ‘today’ but with different redemption periods. It helps answer questions like: Should I go for a longer-term bond in the hope of getting a better yield?

Additionally, the shape of the curve on any one day will give an indication of the market’s expectations of changes in interest rates and future yields

Answer 44

The three main types of curve are:

normal - expectation in normal circumstance. investors demand higher yields for purchasing longer-term bonds. Yield expectation Flattens towards as terms become longer

flat - When the economy is relatively stable and no changes to interest rates or inflation are expected, then there is less risk to be taken in buying longer-term stocks. The curve becomes flat.

inverted - Occasionally the curve can invert, so that the yield expected on longer-term bonds is lower than on short-term bonds
An expectation of rising interest rates in the short-term followed by a reduction in rates thereafter can drive this.

Question 45

3.9 Calculating Bond returns. Tell me about all of the following theories

The liquidity preference theory.

The market expectations theory.

The market segmentation theory.

Answer 45

These relate to the normal yield curve for bonds. They explain why the normal the normal yield curve is shaped the way it is.

The liquidity preference theory
Investors prefer shorter term bonds as they have quicker access to their money and therefore are prepared to accept a lower return (Why the yield is lower for bonds with short terms as seen on the normal distribution curve)

The market expectations theory
If investors were pessimistic about inflation and interest rates, the curve yield curve can rise steeply as investors would want a high yield to compensate. They want to pay less for the fixed return on longer-dated bonds

The market segmentation theory
This states that the short end of the curve is dominated by banks whereas the longer end of the curve is dominated by pension funds and life insurance companies

Question 46

What is the spot curve?

Answer 46

The spot curve or zero-coupon curve plots the redemption yields of zero-coupon bonds against time to maturity.

One of the major drawbacks of calculating the redemption yield is that it assumes all coupons will be reinvested at the redemption yield. This is unrealistic, as it is highly likely that rates will change over time. With a zero-coupon bond there are no coupons and hence no reinvestment risk. Hence, the spot curve is frequently used alongside the redemption yield curve. These can take the same shapes as above (normal / flat / inverted).

Question 47

3.9. What is credit spread

Answer 47

Corporate bonds are riskier than government bonds, so investors will require a greater return from corporate bonds compared to government bonds.

The extra return is represented by the credit spread. It is the difference between the redemption yield on a corporate bond compared to the redemption yield on an equivalent maturity government bond.

The credit spread can be plotted alongside the government redemption yield curve.

IMPORTANT = The credit spread will not be a constant across all maturities. Generally speaking, longer maturity bonds will show a greater credit spread than shorter-dated bonds, as there is more uncertainty about the company’s prospects over the longer-term than the short term.

Question 48

3.10: Duration and Modified Duration

READ 3.10 AS IT IMPORTANT TO KNOW (I CBA RN SO SORRY FUTURE JAMES )

Answer 48

Macaulay duration

The Macaulay duration is the weighted average time until a bond’s cashflows are received, expressed in years.

3.10.2: Modified duration

The modified duration is a measure of the sensitivity of a bond’s price to interest rates. It gives us the percentage change in a bond’s price for a 1% change in yield.

Question 49

remember: Bond prices and yields move in opposite directions (inverse)

Answer 49

If you pay more for a bond the yield falls as yield (calculated through the interest yield and redemption yield calc measures the return on the bond based off of the amount paid for it. ) pay more, get less back.

Question 50

Basics

Bonds have a fixed coupon and a set maturity.
The price we pay will usually be different from the nominal value we receive at maturity.
Bonds that are priced at greater than £100 are priced at a premium to par, those priced less than £100 are at a discount to par.
Bond prices and yields move in opposite directions.
Index-linked bonds adjust their coupon and principal in line with inflation since the bond was first issued. Payments could go down as well as up. 
Government bonds

UK government bonds are known as gilts.
They are considered to be risk-free.
The UK government issue conventional gilts along with index-linked gilts and green gilts. In the past, they have issued dual-dated and undated gilts.
The UK government do not issue zero-coupon bonds but instead allow the GEMMS to strip gilts into their component cash flows.
The US government issue Treasury Notes and Treasury Bonds along with Treasury Inflation Protected Securities (TIPS).
Japan issues a wide range of Japanese Government Bonds (JGBs) including index-linked bonds.
Corporate bonds

Corporate bonds are riskier than government bonds, so will require a higher return to compensate investors for the greater risk.
Corporate bonds can be secured or unsecured; unsecured bonds will be riskier and pay a higher return.
A wide range of corporate bonds can be issued including floating rate notes, convertible bonds that convert into the issuers shares, exchangeable bonds which convert into someone else’s shares, and callable / puttable bonds where the nominal amount will be repaid early by either the issuer (callable) or investor (puttable).
International bonds

Foreign bonds are those issued by a foreign issuer in the domestic currency of a domestic market.
International bonds are issued in a currency different from the issuer, but are sold and marketed internationally outside of the domestic market.
Repos

Repos are a form of secured lending.
They also enable bond traders to borrow bonds in case they have a short position (agreed to sell something they don’t actually own yet).
Securitisation

Securitisation involves packaging together non-tradeable assets and then issuing bonds that are backed by those assets.
These asset-backed securities enable investors to get exposure to non-tradeable assets such as mortgages and credit card debt.
Covered bonds have a pool of assets that can be used as collateral against bonds issued by credit institutions.
Credit ratings

Credit ratings allow investors to assess the default risk of the issuer.
They are assigned by credit rating agencies.
The worse the credit rating, the higher the risk and the higher the required yield.
Bond pricing

Cash flows received in the future are worth less than cash flows received today.
Bonds are priced by calculating the present value of all its known future cashflows.
The clean price is the quoted price; the dirty price includes accrued interest and is the amount that will actually be paid.
Bond returns

Yield measures the return on the bond.
Interest yield is simple to calculate but ignores the capital gain or loss to maturity.
Gross redemption yield accounts for the capital gain or loss but ignores any tax considerations.
Net redemption yield includes the impact of income tax on the gross redemption yield.
The credit spread represents the difference between a corporate bond yield and an equivalent government bond yield.
Duration

Macaulay duration measures the average life of the bond; it is measured in years.
Bonds with long maturities, low coupons and low yields have longer durations.
The longer the duration, the riskier the bond is.
Modified duration measures the interest rate sensitivity of a bond.
The higher the modified duration, the more sensitive the bond price is to changes in interest rates, and the riskier it is.
Risks

The main risks of bonds are credit risk and market (interest rate) risk.
Other risks include inflation, seniority, liquidity, and currency risks.

Question 51

Peter is investing in various fixed interest securities. He has just purchased a Treasury 6% 2034 Gilt. The clean price that was published was £105, but Peter paid £110 dirty price to enable him to receive the next coupon distribution. The par value is £100. What running yield will Peter receive on his investment?

6.19%.

6.00%.

5.71%.

5.45%.

Answer 51

5.71%.

The clean price is always used in running yield calculations. The dirty price is used to calculate how much needs to be paid as part of an equalisation payment once the accrued interest has been added.

The running yield = coupon ÷ clean price, so 6 ÷ 105 = 5.71%.

Question 52

An investor pays a clean price of £114.60 for £100 nominal value of stock, with a 6% coupon. Assuming the stock has exactly seven years to run until maturity, what will the simplified gross redemption yield be?

Answer 52

3.42%.

Calculate the running yield first by dividing the coupon by the clean price.

£6 ÷ £114.60 x 100 = 5.24%.

Then calculate the loss or gain that would be made at redemption: £114.60 – £100 = £14.60.

This would be a loss, as they are paying over par to buy it.

Divide this loss by the number of years remaining. £14.60 ÷ 7 years = £2.09 annual loss.

Divide this annual loss by the clean price: £2.09 ÷ £114.60 x 100 = -1.82%

Deduct this figure from the running yield: 5.24% – 1.82% = 3.42%

Question 53

When considering the price of a conventional GILT…

you will always receive £100 per gilt at redemption.

a price of £109.50 is said to be below par value.

a purchaser of a gilt will usually pay a lower price than the seller will receive.

a purchase of a gilt between coupon payment dates will be transacted at the clean price.

Answer 53

you will always receive £100 per gilt at redemption.

Prices of gilts are always quoted per £100 nominal or the amount you receive at maturity.

A price of £109.50 would be above par because it is > £100.

Ignoring charges, the purchaser will pay exactly what the seller receives.

Purchases between coupon dates are transacted at the dirty price.

Question 54

Mark invests in several gilts and corporate bonds. When comparing these, it is correct to state that…

gilts are less volatile than corporate bonds.

corporate bonds are sub investment grade, whereas gilts are investment grade.

corporate bonds are easier to trade than gilts.

gilts are only available on the primary market.

Answer 54

gilts are less volatile than corporate bonds.

Gilts are safer than corporate bonds (being government-backed) and tend to be less volatile.

Some corporate bonds will be investment grade, They are not easier to trade than gilts, as gilts have dedicated markets makers, whereas corporate bonds do not.

Gilts can be traded on both the primary and secondary markets.

Question 55

An increase in which of the following economic factors would imply a greater ability for a country to repay its debt?

Per capita income.

Debt to GDP ratio.

CPI.

Current account deficit.

Answer 55

An increase in per capita income would increase tax revenues and increase the ability for a country to repay its debt.

Question 56

A UK gilt with 5 years left to run would have how many cash flows?

5

6

10

11

Answer 56

11

A UK gilt pays coupons twice a year, so with a 5 year bond there will be 10 coupon payments and 1 principal payment, making 11 in total.

Question 57

Who will usually receive the interest payment on the gilt?

The seller and they can keep it.

The seller but they must pass it back to the buyer.

The buyer and they can keep it.

The buyer but they must pass it back to the seller.

Answer 57

The buyer and they can keep it.

To answer this question we need to be aware that most bonds are purchased cum-dividend. That means that the buyer will receive the full interest payment on the coupon date. The buyer does not have to pass anything back, because the accrued interest was already taken into account when calculating the dirty price that the buyer actually paid on the settlement date.

Question 58

Which of the following bonds would be classified as speculative grade?

Moody’s Baa.

Standard & Poor’s BBB.

Fitch A.

Moody’s Ba.

Answer 58

Anything above BBB for S&P and Fitch, or Baa for Moody’s is considered investment grade. Ba is the only one considered speculative grade.

Question 59

IMPORTANT: Anything above BBB for S&P and Fitch or Baa for Moody’s is considered investment grade.

Question 60

An investor holds three corporate bonds which have the same maturity and yield. Bond A has a coupon of 2%, Bond B has a coupon of 3%, Bond C has a coupon of 4%.

Which bond will have the longest Macaulay duration?

Bond A.

Bond B.

Bond C.

They will all have the same Macaulay duration.

Answer 60

Bond A

All the bonds have the same maturity (the same length of time) so it must be the one with the lowest coupon that has the longest Macaulay duration. Remember: long and low.

Question 61

An exchangeable bond is one where:

the issuer has the right to convert the bond into shares of the issuing company.

the investor has the right to convert the bond into shares of the issuing company.

the issuer has the right to convert the bond into shares of another company.

the investor has the right to convert the bond into shares of another company.

Answer 61

the investor has the right to convert the bond into shares of another company.

It is always the investor that has the right to convert with convertible and exchangeable bonds.

Convertible bonds have the right to convert into shares of the issuing company, exchangeable bonds have the right to convert into shares issued by another company.

Question 62

A bond has a modified duration of 2. This means that the bond price will:

increase by 2% if interest rates fall by 1%.

decrease by 2% if interest rates fall by 1%.

increase by 1% if interest rates fall by 2%.

decrease by 1% if interest rates fall by 2%.

Answer 62

increase by 2% if interest rates fall by 1%.

The modified duration represents the percentage change in the price of the bond for a 1% change in interest rates.

Remember they move in opposite directions: as interest rates fall, bond prices rise.

Question 63

In the US, Treasury Bonds are:

bonds that have been issued with a maturity between 2 and 10 years.

bonds that have been issued with a maturity of less than 12 months.

bonds that have been issued with a maturity between 10 and 30 years.

index-linked bonds.

Answer 63

bonds that have been issued with a maturity between 10 and 30 years.

Treasury bonds are issued with a maturity between 10 and 30 years.

T-bills have maturities of less than 12 months, Treasury notes between 2 and 10 years and TIPS are index-linked.