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Investment Management Techniques > Chapter 9 - Debt Securities > Flashcards

Chapter 9 - Debt Securities Flashcards

1
Q

What are the types of government debt issuers?

A
  • Federal government
  • Federal agencies and Crown corporations
  • Provincial governments
  • Municipal governments
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2
Q

What are Federal Agencies and Crown Corporations (with respect to debt issuance)?

A

Agencies the Canadian Parliament establishes that serve as the federal government’s agents, including CMHC, Farm Credit Canada, etc.
Legally, the liabilities of these agencies are direct obligations of the federal government.

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3
Q

Which type of instrument does the federal government issue that provincial governments do not?

A

Fed & prov issue T-bills and fixed-coupon marketable bonds. Fed governments also issue Real Return Bonds, which prov governments do not.

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4
Q

What backs debt securities issued by governments?

A

The government’s general credit, rather than specific assets.

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5
Q

What types of debt securities do municipal governments typically issue?

A

Mostly fixed-coupon marketable bonds, though other variations and infrastructure-backed issues exist.

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6
Q

What are the types of non-Canadian government debt issuers?

A

Corporations, asset-backed securities, foreign bonds and Eurobonds.

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7
Q

What are asset-backed securities?

A

Debt securities backed by a pool of financial assets. Generally, these are mortgage-backed securities, which is a collection/pool of mortgages.

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8
Q

How can the perceived credit quality of asset-backed securities be enhanced?

A

Third-party guarantees, letters of credit, recourse to the issuer, overcollateralization.

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9
Q

When would a US dollar denominated bond issued in the US market be considered a “foreign bond” to US investors?

A

For non-US companies. An example is Rogers issuing bonds in the US market. This is a foreign bond to US investors as Rogers is a Canadian company.

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10
Q

What are Eurobonds?

A

Bonds issued in a foreign market in a currency other than that of the market in which the bonds are issued. (Such as the Province of Ontario issuing Australian denominated-bonds).

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11
Q

How do bond issuers bring issues to market today, as opposed to the old physical certificates?

A

Issue bonds in a book-based format only, with participating debt-clearing providers offering depository, trade clearing and settlement services. In Canada, this is The Canadian Depository for Securities Limited (CDS).

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12
Q

What are Govt of Canada auctions and how do they work?

A

Canadian government issues fixed-coupon marketable bonds and T-bills at regularly scheduled auctions. Only recognized government securities distributors are permitted to submit bids to the BoC.

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13
Q

What does it mean if debt securities are awarded on a competitive tender basis or non-competitive tender basis?

A

Competitive tender basis - the amount won at the auction is based on the bids submitted, accepted in rising order of yield until the full amount has been allocated.
Non-competitive tender basis - bids are concurrently submitted at an auction on this basis, where the bid is accepted in full and bonds are awarded at the auction average.

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14
Q

How are new provincial and municipal bond issues normally brought to market?

A

As bought deals.

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15
Q

What are “bought deals”?

A

A bought deal involves a group of investment dealers committing to buying an entire issue of debt securities and then selling or distributing it to investors.

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16
Q

How do corporate entities issue debt?

A

They first file a prospectus with the applicable securities regulator. Their deals may be bought deals or marketed deals.

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17
Q

What is a “marketed deal”?

A

Investment dealers attempt to pre-sell issues to clients before bringing them to market.

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18
Q

Why are most corporate issues of debt targeted specifically at the institutional market, unlike the government issues?

A

Most corporations prefer not to pay the extra fees for wider distribution. Retail investors get access to corporate bonds normally in the secondary market.

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19
Q

How are most new filings in the Canadian corp bond market and Eurobond market now brought to market?

A

Under medium-term note (MTN) programs.

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20
Q

What are medium-term note (MTN) programs?

A

Issuers, typically corp bonds and Eurobonds, file shelf prospectuses that allow them to issue a wide variety of securities over an extended period of time. This means securities can be issued on shot notice since the issuer does not need to prepare a new prospectus each time one if brought to market.

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21
Q

Why are retail investors usually not able to buy new medium-term note (MTN) issues of debt?

A

Due to the commission structure. In the MTN program, issuers pay dealers less in underwriting fees, with no commissions available to pay retail IAs.

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22
Q

What is an indenture?

A

Documents the contract between the borrower (issuer) and lender (investor), outlining the security’s features, the issuer’s obligations and the investor’s rights.

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23
Q

What is the most common option embedded into a debt security?

A

Call features - the borrower has the right to buy back the issue at specified times before its final maturity date.

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24
Q

What are call features?

A

The borrower (issuer) has the right to buy back the issue of debt at specified times before its final maturity date. The call date is the first date (typically a few years after issue) where this is allowed.

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25
Q

What happens to the call price on a callable bond over time?

A

The call price declines over time, so it’s more expensive for a borrower to call an issue earlier in the schedule.

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26
Q

What is an exchangeable bond?

A

The owner of the security has the right to convert the debt obligation to another debt security.

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27
Q

What are retractable debt issues?

A

Put option on a debt issue. The holder of the security has the right to request repayment of the principal from the borrower (issuer) prior to the security’s maturity date.

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28
Q

How are corporate liabilities normally ranked? (1-5)

A
  1. First mortgage and ABSs
  2. Secured debt
  3. Unsecured debentures
  4. Preferred shares
  5. Common shares
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29
Q

What are the 3 types of money market securities actively traded in Canada?

A
  1. T-Bills
  2. Bankers’ acceptances (issuance expected to have ceased this year)
  3. Commercial paper
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30
Q

How do T-bills work?

A

Issued at a price less than their face value, sold in multiples of $1,000, marketable (can be sold prior to maturity). Issued by auction, with terms of maturity of approximately 3, 6, or 12 months.

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31
Q

What is commercial paper?

A

Unsecured promissory note issued by a corporation or an ABS backed by a pool of underlying assets. Generally range in terms from <3 months to 1 year, generally trading in multiples of $1000 with a minimum initial investment of $25000. Sold at a discount and matures at face value.

32
Q

How is commercial paper rated/ranked by rating agencies?

A

According to the issuer’s ability to meet short-term debt obligations.

33
Q

Why do retail investors face lower yields on money market securities than institutional investors?

A

Due to the wholesale nature of money markets. Lower yields are a direct result of the cost required to process money market transactions, including processing fees and advisor commissions.

34
Q

How do debentures differ from bonds? Which type of issue is typically referred to as a bond, but is actually a debenture?

A

Bonds are secured by physical assets in a trust deed. Debentures are technically not secured by physical assets. They are guaranteed instead by a legal contract and have a claim on residual assets in the event of bankruptcy. Government issues are technically debentures.

35
Q

What is the “residual” amount?

A

The final principal amount.

36
Q

How is “stripping” a bond done?

A

Bonds are deposited with a trustee who then separates the bond into its individual components (the coupons and the residual) and then trades them as individual securities. When the trustee receives the repayments/coupons on the original bond, it directs the funds to the individual holders of the stripped coupons and residual.

37
Q

How is a stripped coupon/residual treated for income tax purposes?

A

Treated as interest, not a capital gain. Although no interest is paid until maturity, the investor must include notional interest that accrues each year up to the anniversary date of the bond’s issuance.

38
Q

What are real return bonds?

A

Government-issued bonds indexed to inflation. The coupon and principal are adjusted for inflation. It offers a fixed real coupon rate, which is applied to a principal balance that has been adjusted for the cumulative level of inflation (inflation compensation).

39
Q

What is the inflation compensation with real return bonds?

A

This is an amount that is determined by the Consumer Price Index and added to the semi-annual coupon payment of a Government of Canada Real Return bond.

40
Q

How do you calculate inflation compensation for a real return bond?

A

= (principal x current CPI/base CPI) - principal

Example:
= (100 x 103/100) - 100
= 103 - 100
= 3

Semi-annual coupon =
0.04 / 2 x (100 + 3)
= 0.02 x 103
= 2.06 (instead of $2)

41
Q

What does the Department of Finance call the ratio of current CPI to the base CPI?

A

The index ratio.

42
Q

Are real return bonds impacted by deflation?

A

Yes, a real return bond could see the insurance compensation fall, leading to lower nominal coupon rates and principal repayment.

43
Q

What are TIPS?

A

Treasury Inflation Indexed Securities - issued in the US, similar to Govt of Canada Real Return Bonds.

44
Q

What are mortgage-backed securities?

A

Investments that represent ownership of the cash flow from a group of mortgages.

45
Q

What are the 2 types of mortgage-backed securities in Canada?

A

Residential mortgages insured by the CMHC (National Housing Act MBSs), or commercial mortgages secured by loans with a first lien and overcollateralization.

46
Q

What is overcollateralization?

A

Such as with mortgage-backed securities, this is where there are more assets in the pool than the amount of debt issued against it.

47
Q

How do mortgage-backed securities work?

A

Each MBS is backed by a distinct group of mortgages, known as a pool. The cash flow from each is collected and redirected to investors. Most MBSs are issued with 3- or 5-year terms, though it can be longer.

48
Q

What is the MBS pool factor?

A

The % of the original principal remaining in the mortgage pool after the current month’s payments.

49
Q

What are the 4 different categories of NHA MBS pools available to investors? From there, what are the 2 different types of MBS?

A
  1. Exclusive homeowner
  2. Multi-family
  3. Social housing (co-ops/senior)
  4. Mixed
    Then…
  5. Open (borrowers can make principal prepayments)
  6. Closed (borrowers not permitted to make principal prepayments)
50
Q

How are commercial mortgage-backed securities structured?

A

The mortgage pool is divided up into tranches, with each tranche having a different claim on the cash flow of the underlying pool. The tranches may be arranged as different maturity classes. Typically, every tranche receives interest payments, while only the first tranche receives principal prepayments (if any). Once the first tranche’s principal is paid off, the next tranches begin to receive principal prepayments.

51
Q

What are issuer extendible notes?

A

Debt instruments for which the issuer has the right at certain points (normally the anniversary date of the issue) to either allow the bond to mature or extend the maturity. Because of the embedded options, most issuer extendible notes provide higher yields.

52
Q

How do the coupons of issuer extendible notes work?

A

If the maturity is extended by the issuer, most carry coupons that will increase. These are commonly referred to as “step-ups”.

53
Q

What are “green bonds”?

A

Fixed income securities that raise capital for a project with specific environmental benefits. The first green bond was issued in 2008.

54
Q

What types of green initiatives do green bonds usually finance?

A

Renewable energy, clean technology, transit projects, infrastructure.

55
Q

What are the 3 ways green bonds are normally structured?

A
  1. Bonds with green use of proceeds
  2. Project development green bonds
  3. Securitization bonds - collateralized by a pool of loans issued to fund a number of green projects.
56
Q

What is default risk? What are other types of credit risk?

A

The risk that an issuer may default on interest/principal payments.

There is also credit downgrade risk and credit spread risk.

57
Q

What is credit analysis? What is the process?

A

Evaluating an issuer’s ability to service and repay its debt.
This is done by determining issuer’s existing obligations and assets available, analyzing liquidity and borrowing needs, and analyzing cash flow needs. Other factors are considered for government issuers.

58
Q

Which factors of credit analysis are unique to government borrowers?

A

Economic structure, growth prospects, fiscal policy and budget flexibility, monetary policy and price stability, public debt burden, external debt levels and liquidity, political risk.

59
Q

Which services provide credit ratings for many debt securities in Canada?

A

DRBS Morningstar, Moody’s Canada, Standard & Poor’s Rating Services.

60
Q

What are credit ratings?

A

Opinions of an issuer’s creditworthiness by rating agencies based on several risk factors. Rating agencies review and update their ratings on a regular basis and conduct reviews after major financial developments.

61
Q

What is considered an “investment grade” rating from the various rating agencies in Canada?

A

DRBS is BBB and higher
S&P is BBB- and higher
Moody’s is Baa3 and higher

62
Q

How can you determine interest rate risk of a debt security?

A

Through the security’s duration. Generally, the longer the term to maturity and the lower the coupon rate, the higher the interest rate risk.

63
Q

What is reinvestment risk?

A

The risk that an investor may have to accept a lower yield at the maturity of their bond, resulting in a lower rate of return.

64
Q

What is yield curve risk?

A

The risk that changes in the shape of the yield curve will cause debt instruments with different maturity dates to change in value at different rates than originally expected.

65
Q

What is marketability risk of a debt security?

A

The risk that a debt security cannot be sold prior to maturity at or near its true value, often due to the lack of a market or illiquidity.

66
Q

How do the debt securities trade through the primary and secondary markets?

A

Investment dealers bring deals to the primary market, which is where the original pricing and sale of a debt security occurs. After being issued and distributed, the secondary market facilitates the purchase and sale for general investment purposes.

67
Q

How do bond and money market instruments trade in Canada?

A

Canada has no centralized exchange or facility. Transactions occur in an over-the-counter market, and investment dealers and other market participants interact through direct negotiations using computer networks or by phone.

68
Q

What determines overall market pricing of bonds in the secondary market?

A

The process of interaction between investment dealers and other participants.

69
Q

How do investment dealers primarily earn their profits from buying/selling bonds?

A

Through the bid/offer spread, and from fees generated by bringing new issues to market, and using capital to make bets on the market’s direction.

70
Q

What does the spread between a bond’s bid and offer price indicate?

A

The underlying security’s liquidity. Smaller spreads represent the ability to move positions more easily.

71
Q

What is the difference between on-the-run and off-the-run debt instruments?

A

On-the-run instruments are known as benchmarks are more liquid issues, off-the-run instruments are not traded as frequently and are therefore less liquid.

72
Q

How do “benchmark issues” determine overall interest rates and the shape of the yield curve?

A

Since all bonds in the market are priced in relation to the benchmarks on a yield spread basis. Given this, benchmarks are often used for hedging.

73
Q

What are some advantages of a retail trading desk for IAs?

A

Access to a wide range of securities in inventory, often allowing for the automatic execution of trades.
The trading desk services the IAs by sourcing products and providing market commentary.

74
Q

What are the two general methods that a retail trading desk could operate by?

A
  1. Cost centre - cost of maintaining a presence on the institutional trading floor is covered by commissions and fees of IAs
  2. Profit centre - buys inventory and offers it out, attempting to profit on these trades to cover costs
75
Q

How much is the typical commission on trading debt securities?

A

$0.10 per $100 face value for each year to maturity (as in $0.30 for a 3-year bond)

76
Q
A

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