Chapter 7 Flashcards
What is a debt security?
Is one whereby the issuer borrows money in exchange for interest.
What are the two major debt issuers categories?
- Government Issuers
Government of Canada
Federal and Crown corporations
Provincial governments
Municipal governments - Non-Government Issuers
Corporations
Asset-backed securities or mortgage-backed securities
Foreign bond/Eurobond
What is the difference between Foreign bonds vs Eurobonds?
Foreign bonds: issued by a non-domestic issuer but in the currency of where it is being issued. Ex. A British company issuing a bond in Canada denominated in Canadian dollars would be considered a foreign bond.
Eurobonds: Issued by a non-domestic issuer in non-domestic currency. Ex. A British company issuing a bond in Canada denominated in American dollars would be considered a Eurobond.
In the event of liquidation, what is the rankings of creditors?
- First mortgage and asset-backed securities
- Secured debt
- Unsecured debt, such as debenture
- Preferred shares
- Common shares
What are some examples of Money Market securities?
- Commercial paper
- A banker’s acceptance
- Treasury bill
They are short-term debt securities (one year or less) and are sold at a discount and mature at the face value, with the difference being the investor’s interest.
What are some of the specifics on Treasury bills?
- Issued by the federal government with virtually no risk of default
- Issued with initial terms of approximately, three, six and 12 months
- Offered in multiples of $1,000 face value
- Can be traded in the open market
What are some of the specifics on banker’s acceptance (BA)?
- Issued by good-quality corporations
- The debt obligation is also guaranteed by a bank
- Low chance of default since both the issuer and bank would need to fail
- Offered in multiples of $1,000 face value, starting at $25,000
What are some of the specifics on commercial paper?
- Issued by good-quality corporations, backed (ie. secured) by a pool of financial securities or by the borrower’s creditworthiness
- Otherwise like banker’s acceptance, except the paper has not been guaranteed by a bank
- Offered in multiples of $1,000 face value, starting at $25,000
What is the difference between Bonds vs Debentures?
The key difference is securitization.
Bond: Secured by specific assets, such as a mortgage lien on a property owned by the issuer.
Debenture: An unsecured debt security. The promise to pay is backed only by the issuer’s willingness and ability to pay indicated by its credit rating.
What is the difference between Strip Bonds and Residuals?
A strip bond is created, not issued. In other words, it is a traditional bond that has had its coupons ‘stripped’ off, with the coupon payments and face value (referred to as the residual) being sold separately to various investors.
What are Real Return Bonds (RRBs)?
A bond that is indexed to inflation.
- They are issued by governments
- The principal amount is adjusted upwards (if there is inflation) or downwards (if there is deflation), which in turn impacts the coupon payment
- The principal repaid at maturity will also be adjusted
What is the formula for determining the first coupon payment on an RRB?
Step 1: Determine the inflation rate
divide the increase by the original CPI x 100
Step 2: Adjust the principal (face value) amount by the rate of inflation
face value x (1 + change in inflation)
Step 3: Calculate the annual coupon payment based on the adjust principal and then convert to semi-annual
adjusted face value (from step 2) x annual coupon rate / 2
How is a bond impacted by volatility?
- All else being equal, longer-term bonds are more volatile in price than shorter-term bonds.
- All else being equal, low-coupon bonds are more volatile in price than high-coupon bonds.
What are the three type of Durations?
- Macaulay duration
- Modified duration
- Dollar duration
What is Macaulay Duration?
- It is the weighted average term to maturity of the present value of a bond’s future interest payments and principal repayment.
- It can be thought of as the average life of the bond expressed in years.
- A strip bond (which has no coupons) would have a Macaulay duration equal to its term.
What is Modified Duration?
- Considers the coupon rate and term to maturity.
- Is always less than the term to maturity.
- All else being equal, the longer the term, the greater the modified duration (ie. more volatile)
- All else being equal, the lower the coupon rate (or yield), the greater the modified duration (ie. more volatile)
How to calculate the approximate price change for Dollar duration?
For every 1% change in interest rates (up or down), the bond price will move in the other direction. If interest rates go up, bond prices go down. If interest rates go down, bond prices go up. Multiple duration x change in interest rates.
Calculate the percentage price change of a bond using convexity.
Duration price change + Convexity price change + Total price change
What is the formula for convexity?
Convexity x (yield change)2 x 100
2
Name a few risks?
- Credit risk
- Default risk
- Credit downgrade risk
- Credit spread risk
- Interest rate risk
- Monetary policy
- Fiscal policy
- Yield curve risk
- Reinvestment risk
- Call risk
- Inflation risk (also called Purchasing power risk)
- Liquidity risk
- Currency risk
- Volatility risk
- Political risk
- Event risk
- Sector risk
Define a traditional yield curve?
An upward-sloping line would appear if long-term rates were higher than short-term rates (this is the norm).
Define an inverted yield curve?
A downward-sloping line would occur if long-term rates were lower than short-term rates. This is considered to be a leading indicator of a recession.
Define a flat yield curve?
A horizontal line would occur when long-term and short-term rates are similar.
Define a twist?
Occurs when yields at only one end of the yield curve move up or down, essentially making the yield curve flatten or become steeper
Define a parallel shift?
Occurs when all yields move up and down by the same or nearly the same amount.
