Chapter 7 - Debt Securities Flashcards
List the ranking order of debts securities as it relates to creditor repayment in the event of bankruptcy.
- First mortgage and ABS
- Secured debt
- Unsecured debentures
- Preferred shares
- Common shares
List the three Money Market Securities
- Treasury Bill (T-Bill)
- Issued by the government at a discount from maturity
- Gov. of Canada T-Bill are typically issued with terms to maturity of approximately three, six, and 12 months. - Bankers’ Acceptance (BA)
- Also known as a Commercial Draft it is guaranteed by the borrowers bank.
- Issued at a discount and matures at face value.
- Trades in multiples of $1000 with a minimum investment of $25,000
- Ceased to exist after June 28th, 2024 - Commercial Paper (CP)
- Issued at a discount and matures at face value.
- Trades in multiples of $1,000 with a minimum investment $25,000.
- May be backed by a pool of assets of only the borrowers creditworthiness.
List the difference between Bonds and Debentures.
- Debentures are unsecured by specific assets and have only a residual claim on an issuer’s assets in the event of bankruptcy.
- Bonds are technically secured by physical assets that are specified in the trust deed. These assets, such as equipment or
property, can be seized by the bondholders in the event of default and sold to recover their investment.
Both are commonly referred to as ‘bonds’.
What is a Strip Coupon & Residuals?
Created when the coupon payments and principal repayment of a regular bond are
separated and sold individually.
Eliminate reinvestment risk.
What are Real Return Bonds (RRBs)?
Bonds whose principal and coupons are adjusted to inflation.
- The value of those payments can actually decrease in the event of deflation.
- The US equivalent, Treasury Inflation-Protected Securities (TIPS), return the greater of par or par plus the inflation compensation. This protects the returns from deflation.
What are Mortgage-backed securities (MBSs)?
They are investments that represent ownership of the cash flows from a group of
mortgages.
They can be structure as an Open or Closed pool.
- In Open Pools, the owners of the mortgages can prepay principal. This affect the mortgages cashflow making the return less certain
- In Closed Pools, prepayment is not allowed making the cash flows and pricing more stable
Payments are made monthly and any principal not yet prepaid at maturity is returned to investors.
What are Commercial Mortgage-Backed Securities (CMBSs).
They are backed by pools of commercial mortgages.
CMBSs are divided into tranches representing different claims in the properties cashflow.
Issuer Extendible Notes
Bonds with embedded call options which allow the issuer to pay off the bond or extend the maturity.
They yield higher than conventional bonds.
What are Bid/Ask Spreads related to Debt Securities?
Debt Securities are trades Over-The-Counter, meaning their prices are negotiated between the securities buyers and sellers.
A bid/ask quote is the price at which the dealers are willing to buy (bid) and sell (ask) a particular security.
The spread on a bid/ask quote will become wider as an issue’s liquidity thins out and as its price volatility increases.
Describe how an accounts fee structure will affect a Debt Security.
In a fee based accounts, the trading desk will give the investors the sane price they give advisors because the investor is already paying a fee for the assets in the account.
In commission accounts, the advisor will build commission into the transaction by widening the bid/ask spread.
Describe the relationship between the price and Yield of Bonds.
A basic property of all conventional bonds is that yields rise as bond prices fall, or yields fall as bond prices rise.
What is Macaulay Duration?
A bond’s Macaulay duration is the weighted average term to maturity of the present value of a bond’s interest and
principal payments. It can be thought of as the average life of the bond measured in years.
*The Macaulay Duration of Zero-Coupon or Strip Coupon is always equal to the bonds Yield-to-Maturity.
What is Modified Duration?
A bond’s modified duration is a measure of the approximate percentage price change for every 100 basis point
change in yield.
Modified Duration will always be less than Macaulay Duration.
The modified duration will always be less than the term to maturity.
How is Duration related to the different attributes of a bond?
- A bond with no coupon payments, such as a strip coupon, will have a Macaulay duration equal to its term to
maturity. - The modified duration will always be less than the term to maturity.
- All else being equal, the lower the coupon rate, the greater the modified duration.
- All else being equal, the longer the term to maturity, the greater the modified duration.
- All else being equal, the lower the yield, the greater the modified duration.
What are the three different forms of Credit Risk?
- Default risk is related to a default of interest and/or principal payments on an issuer’s part.
- Credit downgrade risk is the risk that an issuer’s credit rating will be downgraded.
- Credit spread risk is the risk that the spread relative to a benchmark bond will increase. Evaluating an issuer’s ability to meet timely payments is known as credit analysis.
What is Interest Rate Risk?
Interest rate risk is an inverse relationship that exists between interest rates and debt security prices. If interest rates rise, debt security prices decline.
Only a concern if you plan on selling the bond before maturity.
Interest Rate Risk can materialize in three ways
- Monetary Policy:
- The BoC can change interest rates and the Target Overnight Rate, which have the primary goal of increasing/decreasing inflation, but will also affect the price of your bonds. - Fiscal Policy
- This dictate the amount of government spending.
- Large and prolonged amounts of Gov. Spending can increase inflation and as a result the interest rate. - Yield Curve Risk
- Yield curve risk is the chance that changes in the yield curve’s shape can cause the debt of differing maturities to
change in value at different rates than expected.
Explain the Pricing of Callable Bonds.
Price of callable bond = price of conventional bond − price of call option
The lower yields generally fall, the greater the price compression the callable bond
experiences and the greater the spreads over conventional bonds.
Explain the Pricing on Putable Bonds.
Price of putable bond = price of conventional bond + price of put option
The higher yields become in general, the
greater the price support the putable bond experiences and the larger the spread over the conventional bond.
