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CISI Introduction to Securities & Investment (L4) > Chapter 4: Bonds > Flashcards

Chapter 4: Bonds Flashcards

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SIE Exam flashcards
1
Q

What is a Bond?

A

Interest-bearing securities which entitle holders to annual interest and repayment at maturity.

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2
Q

Who issues bonds?

A

Issued by both companies and gov’ts.

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3
Q

What is the Nominal value?

A

Amount of stock purchased, and the amount on which interest will be paid and eventually repaid at maturity (also known as par/face value of a bond).

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4
Q

What is the Coupon Rate?

A
  • Nominal interest rate payable on the stock.
  • The rate is quoted gross and is paid in 2 separate half-yearly interest payments.
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5
Q

How do you calculate the amount of interest paid on a stock?

A

Nominal amount of stock held x the coupon.

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6
Q

What is the Redemption/Maturity date?

A
  • The year in which the stock will be repaid.
  • Repayment takes place at the same time as the final interest payment.
  • Amount repaid is the same as the nominal amount of stock held.
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7
Q

What is the convention on bond prices?

A

Prices are quoted per £100 nominal of stock.

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8
Q

How do you calculate the Value of a bond?

A

Take the price per £100 nominal of stock and scaling up based on the total nominal value held.

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9
Q

Why do gov’ts issue bonds?

A
  • Finance spending and investment.
  • Bridge gap between their spending and tax alongside other forms of income they receive.
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10
Q

When is bond issuance high?

A

When tax revenues are significantly lower than gov’t spending.

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11
Q

What are UK bonds known as?

A

Gilts (or gilt-edged stock when they used to have a gold/gilt edge to them).

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12
Q

What are the 2 main types of gov’t bonds?

A
  • Conventional bonds
  • Index-linked bonds.
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13
Q

What are Conventional bonds?

A

Instruments that carry a fixed coupon and single repayment date, e.g. 0.375% Treasury stock by 2030.

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14
Q

What percentage of bonds issues do conventional bonds make up?

A

Around 75% of bonds issue.

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15
Q

What are the coupon and redemption amount for index-linked bonds increased by?

A

Inflation over its lifetime, e.g. 0.125% Treasury index-linked stock. Coupon of 0.125% is uplifted by amount of inflation at each interest payment, and repayment by 2029 will have adjusted in line with inflation.

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16
Q

When are Index-linked bonds attractive?

A
  • During periods when gov’ts have control of inflation as it provides extra protection to investor.
  • Attractive as long-term investments, e.g. pension funds. Long-term investors need to invest their funds and know returns will maintain their real value after inflation so they can meet obligations to pay pensions.
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17
Q

What can Conventional bonds be stripped into?

A

Their individual cash flows - coupon payments and bond repayments.

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18
Q

What is meant by ‘Stripping’ a gilt?

A

Breaking it down into it individual cash flows which can be traded separately as 0 coupon gilts.

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19
Q

How many individual cash flows are 3 yr gilts stripped into? What are these known as?

A

7 STRIPs’:
* 6 (semi-annual) coupon payments.
* 1 final maturity repayment.

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20
Q

What are the other types of gov’t bonds?

A
  • Dual-dated
  • Undated
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21
Q

What are Dual-dated bonds?

A

Carried a fixed coupon, but showed two dates between which they can be repaid. The gov’t decides when to repay and depends on prevailing rates of interest at that time.

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22
Q

What are Undated bonds?

A

Limited number of gov’t stocks which were irredeemable, i.e they had no fixed repayment date.

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23
Q

What is a Corporate bond?

A

Bond issued by a company.

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24
Q

What is the difference between a Corporate Bond and Commercial Paper?

A

Corporate bond applies to longer-term debt instruments, with a maturity date of 12+ months, whereas commercial paper is used for instruments with a shorter maturity.

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25
Q

What should companies credit ratings be if they want to issue a bond with a maturity of < 10yrs at an acceptable cost?

A

High.

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26
Q

Where are corporate bonds listed?

A

Some on stock exchanges, but majority OTC.

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27
Q

How can corporate bonds be differentiated?

A
  • Security
  • Redemption provisions
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28
Q

What is Bond Security?

A

A form of charge over issuer’s assets so that if the issuer defaults, the bondholder has a claim on those assets before other creditors (regards their borrowings as safer).

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29
Q

What would third party guarantee be for bond security?

A

Guarantee by a bank that if issuer defaults the bank will repay bondholders.

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30
Q

What’s the relationship between security and borrowing cost?

A

Greater the security, the lower the borrowing cost.

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31
Q

What’s meant by fixed security?

A

Specific assets (e.g. a building) of the company are charged as security for the loan.

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32
Q

What’s meant by floating security?

A

The general assets of the company are offered as security for the loan (e.g. cash at the bank, trade debtors and stock).

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33
Q

What is a Call Provision?

A

The issuer has the option to buy back all or part of the issue before maturity.

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34
Q

Why are Call Provisions attractive to issuers?

A

They get option to refinance the bond (i.e. replace it with one at a lower rate of interest) when interest rates are lower than the coupon that is being paid.

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35
Q

Are Call Provisions attractive to investors?

A

No, because if issuers replace the coupon with a lower interest then investors will receive less yield. Therefore, will probably demand a higher yield as competition.

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36
Q

What forms can Call Provisions take?

A
  • Sinking fund requirement.
  • Put Provisions.
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37
Q

What’s a Sinking Fund Requirement?

A

Requirement for issuer to redeem a specified amount at regular intervals.

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38
Q

What’s a Put Provision?

A

Gives bondholder right to require issuer to redeem early on a set date or between specific dates.

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39
Q

Are Put Provisions attractive for issuers?

A

No. Increases the issuer’s risk that it will have to refinance the bond at an inconvenient time.

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40
Q

Are Put Provisions attractive for investors?

A

Yes. Increases the chances of selling a bond issue in the first instance.

41
Q

What are the different types of Corporate bonds?

A
  • Medium-Term Notes (MTNs)
  • Fixed-Rate Bonds
  • Floating Rate Notes (FRNs)
  • Permanent Interest-Bearing Shares (PIBS)
  • Convertible Bonds
  • Zero Coupon Bonds
42
Q

What are MTNs?

A
  • Corporate bonds with up to 5yr maturity.
  • Offered to investors continually over a period of time, instead of in a single tranche of one sizeable underwritten issue.
43
Q

What are Fixed-Rate Bonds?

A
  • Fixed coupons paid either half-yearly or annually
  • Predetermined redemption dates.
44
Q

What are FRNs?

A

Bonds with variable rate of interest.
* Rate of interest linked to benchmark rate
* FRN will usually pay interest at benchmark rate plus a quoted margin or spread.

45
Q

What are examples of benchmark rates?

A
  • Sterling Overnight Index Average (SONIA), UK - rate of interest at which banks will lend to one another in London and is replacement for LIBOR. Used as a basis for financial instrument cash flows.
  • Secured Overnight Reference Rate (SOFR), US.
46
Q

What are Permanent Interest-Bearing Shares (PIBS)?

A
  • They’re issued by building societies,
  • Carry fixed coupons.
  • Irredeemable.
  • A bond that pays interest and is taxable.
47
Q

What is a Convertible bond? What 2 choices does it offer the investor?

A

Issued by a company that gives the investor holding the bond 2 choices:
* Collect interest payments and then the repayment of the bond on maturity.
* Convert the bond into predefines number of ordinary shares in the issuing company, on a range of set dates, prior to the bond’s maturity.

48
Q

Why are Convertible bonds attractive?

A
  • Share prices rise if company does well, therefore leads capital gains.
  • If the company hits problems, investor can retain the bond - interest will be earned and, as the bondholder, investor would rank ahead of shareholders if the company goes bust.
49
Q

What are the cons of convertible bonds to a company?

A
  • Prospect of dilution of current shareholder interests, as convertible bondholders exercise their options.
50
Q

What are the pros of convertible bonds to a company?

A
  • Cheap finance is acquired. Investors pay higher price for a bond that is convertible because of possibility of a capital gain.
51
Q

What are Hybrid bonds?

A
  • Bonds that share characteristics of both shares and bonds.
  • May offer investor higher yields than holding the company’s shares or bonds. (Also known as ‘preferreds’).
52
Q

What are Zero Coupon Bonds (ZCBs)?

A

Bond that pays no interest. (coupon is another word for interest).

53
Q

Why might ZCBs be attractive?

A

Tax purposes - ZCBs issued at a discount to their par value, therefore all return is provided in the form of capital growth rather than income and may be treated differently.

54
Q

What are Domestic Bonds?

A

Bond issued by domestic issuer into domestic market, e.g. UK company issuing bonds, denominated in sterling, to UK investors.

55
Q

What are Foreign Bonds?

A

Bond issued by an overseas entity into a domestic market and is denominated in the domestic currency. E.g. German company issuing a sterling bond to UK investors, or USD bond issued in US by a non-US company.

56
Q

What are Eurobonds?

A

Large international bond issues often made by gov’ts and multinational companies.

57
Q

When did the Eurobond market develop?

A

Early 1970s

58
Q

Why did the Eurobond market come about?

A

To accommodate the recycling of substantial OPEC USD revenues from Middle East Oil sales at a time where financial institutions were subject to ceilings on the interest rates that could be paid on dollar deposits.

59
Q

What does OPEC stand for?

A

Organisation of the Petroleum Exporting Countries

60
Q

“The Eurobond market is the world’s largest market for longer-term capital.” True or False?

A

True. This is a result of corresponding growth in world trade, and significant growth in international capital flows.

61
Q

Where are Eurobonds denominated?

A

In a currency different from that of the financial centre in which they are issued.

62
Q

Why is the term Eurobond a misnomer?

A

As Eurobond issues are not restricted to those of European financial centres or countries. The ‘euro’ originates from the depositing of USD in European eurodollar market, and has since been applied to the eurobond market. E.g. euro sterling bond issue is denominated in sterling and issued outside the UK but not necessarily in a European financial centre.

63
Q

Do Eurobonds provide any underlying collateral, or security, to bondholders?

A

No. But they’re almost always credit-rated by a rating agency.

64
Q

What is a ‘negative pledge’ clause?

A

Prevents interests of bondholders being subordinated to those of any subsequent bond issues; prevents company from making any secured bond issues, or issues which confer greater seniority (i.e. priority) or entitlement to the company’s assets, in event of its liquidation, unless an equivalent level of security is provided to existing bondholders.

65
Q

What are the advantages of eurobond market over domestic bond market?

A
  • Choice of innovative products to meet issuers’ needs.
  • Ability to reach potential lenders internationally rather than just domestically.
  • Anonymity to investors as issues are made in bearer form.
  • Gross interest payments to investors.
  • Lower funding costs due to competitive nature and greater liquidity of the market.
  • Less ability to make bond issues at short notice.
  • Less regulation and disclosure.
66
Q

What kind of bonds are eurobonds?

A

Issued as conventional bonds, with a fixed nominal value, fixed coupon and known redemption date.

67
Q

What are Asset-Backed Securities (ABSs)?

A

Bundled securities, so-called because they are marketable securities that result from the bundling or packaging together of a set of non-marketable assets.

68
Q

What kinds of assets are pooled in ABSs?

A
  • Mortgages
  • Credit card debt to ‘accounts receivable.’
69
Q

What does ‘accounts receivable’ mean?

A

Money owed to a company by a customer for goods and services that they have bought and is usually known as this once an invoice has been issued.

70
Q

What is the largest ABSs?

A

Mortgage-backed securities. Cash flows backed by principal and interest payments of a set of mortgages.

71
Q

How are mortgage-backed bonds created?

A

Bundle together a set of mortgages and then issuing bonds that are backed by these assets. These bonds are sold onto investors, who receive interest payments until they are redeemed (creating a bond this way is securitisation).

72
Q

What are advantages of ABSs?

A

Pool financial assets that otherwise could not be easily traded in their existing form. Pooling together a large portfolio of illiquid assets converts them into instruments that may be offered and sold freely in capital markets.

73
Q

What are Covered Bonds and who issues them?

A

Corporate bonds backed by cash flows from a pool of mortgages or public sector loans. The pool of assets provides ‘cover’ for the loan. Issued by financial institutions.

74
Q

What are the main differences between Covered Bonds and Asset Backed Securities?

A

Covered bonds:
* Remain on issuer’s balance sheet.
* Asset pool must provide sufficient collateral to cover bondholder claims throughout the whole term of covered bond.
* Bondholders must have priority claim on the cover asset pool in case of default of the issuer.

75
Q

Why is it important to have a ‘thriving covered bond market’?

A

It’s an important part of the financing of the mortgage and public sector markets in Europe and represent a vital source of term funding for banks. It’s essential for future of European banking sector and ability of individuals to finance house loans at a reasonable rate.

76
Q

What are the main advantages of bonds?

A
  • Fixed-interest bonds, a regular and certain flow of income.
  • For most bonds, a fixed maturity date (but there are bonds which have no redemption date, and others which may be repaid on either 2 dates or between 2 dates - some at the investor’s option and some at the issuer’s option).
  • Range of income yields to suit different investment and tax situations.
  • Relative security of capital for more highly rated bonds.
77
Q

What are the disadvantages of bonds?

A
  • Real value of income flow is eroded by effects of inflation (except index-linked bonds).
  • Bonds carry various elements of risk.
78
Q

What is the relationship between interest rates and bond prices?

A

Inverse.

79
Q

What is default risk with bonds?

A

Possibility of issuer defaulting on the payment of interest or capital, e.g. the company could go bust).

80
Q

What is price risk on bonds?

A

Particularly risky for bondholders who are open to the effects of movements in general interest rates, which affects the value/price of their holdings.
*Highly-rated gov’t bonds have low risk due to it being unlikely that they default on bonds.

81
Q

Does changes in interest rates affect the amount payable at maturity?

A

No. Just affects the current value of the bonds. The amount payable at maturity remains as the nominal amount of the stock.

82
Q

What other risks are associated with holding bonds?

A
  • Early redemption
  • Seniority risk
  • Inflation risk
  • Liquidity risk
  • Exchange rate risk
83
Q

What is Early Redemption risk?

A

Risk the issuer may invoke a call provision (if bond is callable).

84
Q

What is Seniority risk?

A

Seniority with which corporate debt is ranked in the event of liquidation; so debt with the highest seniority has a greater chance of being repaid than debt with lower seniority. If the company raises more borrowing and it is entitled to be repaid before existing bonds, then the bonds have suffered from seniority risk.

85
Q

What’s Inflation risk?

A

Risk of inflation rising unexpectedly and eroding the real value of the bond’s coupon and redemption payment.

86
Q

What’s liquidity risk?

A

Ease at which bond can be sold at fair market price.

87
Q

What is Exchange rate risk?

A

Bonds denominated in a currency different from that of the investor’s home currency are potentially subject to adverse exchange rate movements.

88
Q

What are Yields?

A

Measure of returns to be earned on bonds.

89
Q

What does the coupon reflect?

A

The interest rate payable on the nominal or principal amount. But, an investor will have paid a different amount to purchase the bond, so a method of calculating the true return is needed.

90
Q

What’s a Bond Yield?

A

The return, as a percentage of the cost price, which a bond offers.

91
Q

What is the Flat/Running Yield?

A

Interest paid on a bond as a percentage of its market price.

92
Q

How do you calculate the flat yield?

A

(Annual coupon / Bond price) x 100 = flat yield (%)

93
Q

How is the bonds price typically stated?

A

As the price payable to purchase £100 nominal value.

94
Q

What are the two parts of return on a bond?

A
  • Interest earned on the bond.
  • Capital gain or loss on bond until redemption.
95
Q

What is the Redemption yield?

A

A measure that incorporates both income and capital return - assuming the investor holds the bond until its maturity - into one figure.

96
Q

What is Credit Risk?

A

Probability of an issuer defaulting on their payment obligations, and the extent of the resulting loss.

97
Q

How is credit risk assessed?

A

By reference to the independent credit ratings given to most bond issues.

98
Q

What are the 3 most prominent credit rating agencies?

A
  • Standard & Poor’s
  • Moody’s
  • Fitch Ratings

CISI Introduction to Securities & Investment (L4) (12 decks)

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