Chapter 6 - Fixed-Income Securities Flashcards
Why would an issuer consider issuing a debt instrument?
To finance and expand their operations.
What does the par value of a bond refer to?
The par value is the principal amount the bond issuer contracts to pay at maturity to the bondholder.
Can you describe the difference between the coupon rate and the yield?
The coupon rate is the interest paid by the bond issuer over the term of the bond. ie. bond holder paid 6% twice a year.
The yield to maturity is the annual return on a bond that is held to maturity. ie. if bond held to maturity the bond holder will earn 5.2% interest.
What is the primary difference between a bond and a debenture?
A bond is a long-term, fixed obligation debt security that is secured by physical assets - such as a building or a railway car - owned by the issuing company.
A debenture is a type of bond that is secured by something other than a specified physical asset - typically by a general claim on residual assets. Basically it’s backed by the general creditworthiness of the issuer. AKA unsecured bonds.
How is a strip bond created?
A strip bond is created when a dealer acquires a block of high quality bonds and separates the coupons (interest payments) from the rest of the bond (the residue). Then the coupons and residue are sold separately at significant discounts to their face value.
How does a strip bond differ from a regular bond?
On the maturity date, the investor is repaid an amount equal to the face value of the bond. The difference between the purchase price of the bond and the face value at maturity represents the investor’s return on the bond. For example, assume an investor purchased a bond residual today for $3,200. The bond has a face value of $5,000 and is set to mature in five years. At maturity, the return on the strip bond residual will be $5,000 - $3,200, or $1,800.
Let’s consider another investor that purchased the coupon, instead of the residual. The investor will receive one of the bond’s original semi-annual interest or coupon payments. If the coupon rate on the bond is 4%, the interest payment to be received twice (since it’s a semi-annual payment schedule) can be calculated as (4% ÷ 2) x $5,000 = $100. The investor will pay ($3,200 ÷ $5,000) x $100 = $64. Their return at maturity will, therefore, be $100 - $64 = $36.
What is the difference between a callable bond and a convertible bond?
A callable bond is one the issuer may redeem prior to the maturity date. A callable bond allows the issuing company to pay off their debt early. A business may choose to call their bond if market interest rates move lower, which will allow them to re-borrow at a more beneficial rate. Callable bonds thus compensate investors for that potentiality as they typically offer a more attractive interest rate or coupon rate due to their callable nature.
A convertible bond can be converted into a predetermined number of common stocks or equity shares.
Can you compare sinking funds with purchase funds?
A sinking fund is a fund of money set aside by the company or corporation to pay off the bonds once they hit maturity.
A purchase fund is set up to retire a specified amount of the outstanding bonds through purchases in the market.
Let’s say the trucking company Rev decides to issue $20 million of bonds that are due to mature in 10 years. If Rev has a purchase fund, they might be required to retire a certain amount in bonds each year for 10 years, perhaps $2 million per year. To retire those bonds, Rev must deposit $2 million a year into a purchase fund. That purchase fund has to be separate from Rev’s operating funds and used exclusively to retire debt. By using this strategy, Rev can guarantee it will pay off the $20 million in 10 years.
Can you describe five protective covenants?
- Security - clause that includes details of the assets that support the debt.
- Limitation on sale and leaseback transactions - Clause protects the debt holder against the firm selling and leasing back assets that provide security for the debt.
- Sale of assets or merger. Clause protects the debt holder in the event that all of the firm’s assets are sold or that the company is merged with another company.
- Debt test. This provision limits the amount of additional debt that a firm may issue by establishing a maximum debt-to-asset ratio.
- Sinking or purchase fund and call provisions. This clause outlines the provisions of the sinking or purchase fund, and the specific dates and price at which the firm can call the debt.
What is a treasury bill?
A treasury bill is a short-term government issued - usually 1 year or less - in denominations of $1000. They don’t pay interest instead they are sold at a discount and mature at 100.
How do federal, provincial and municipal bonds compare to each other?
Federal bonds - specific maturity date, specific coupon or interest rate, transferable, noncallable, highest quality rating.
Provincial bonds - actually debentures, second in quality to federal bonds, quality is determined by credit quality and market conditions.
Municipal bonds - most municipalities use instalment debentures, part of this bond matures in each year of its term.
Can you describe a first mortgage bond?
A mortgage bond is secured by a mortgage, or a pool of mortgages, that are typically backed by real estate holdings and real property, such as equipment.
Can you describe a collateral trust bond?
A collateral trust bond is a bond that is secured by one or more financial assets—such as shares of stock or other bonds—that is deposited and held by a trustee for the holders of the bond. The bond is perceived as a safer investment than an unsecured bond since the assets could be sold to pay the bondholder, if necessary.
What is an equipment trust certificate?
An equipment trust certificate (ETC) refers to a debt instrument that allows a company to take possession of and enjoy the use of an asset while paying for it over time. The debt issue is secured by the equipment or physical asset. During this time, the title for the equipment is held in trust for the holders of the issue.
ETCs were originally put in place to finance the purchase of railway cars, but are now used in the sale and purchase of aircraft and shipping containers.
How do floating-rate bonds differ from regular bonds?
Floating rate securities are a type of corporate bond that automatically adjusts to changing interest rates. Issued with longer terms that more conventional issues. When interest rates are rising the interest paid is adjusted upwards.
