Chapters 5/6 Flashcards
Debt service
The total of all of the interest payment’s over a bond’s life and the par value at maturity.
Leverage financing
Raising capital through debt
- When a company has more debt than equity outstanding, it’s considered a leveraged issuer.
Long coupon vs short coupon
Typically bonds pay interest on the 1st or 15th of the month it’s due. However, on the first payment, since the investors who bought the bond usually won’t buy it on the stated date, there will be either a larger than normal or small than normal payment. If the first coupon is for more than six months, it’s a long coupon and if smaller it’s a short coupon.
Accured interest
If a bondholder sells the bond in between interest payments they’re entitled to the amount that accrued up to the point it was sold.
Interest on coporate bonds and munis accrue on the basis of a 360 day year with each month having 30 days.
Example: On Sept. 15, an investor purchases $10k of 6% corporate bonds that mature on Dec. 1, 20XX. How many days have accrued and what $ amount of accrued interest is the investor required to pay?
The bond pays interest on Dec. 1 and June 1 of each year. June, July, plus August is 30 * 3 + 15 days in Sept. = 105 days of accrued interest.
The buyer will pay the seller $10k * 6% * (105/360) = $175.
- If a coupon date is on the 15th of the month for a corporate or municipal bond, there will be 16 days remaining in that month.
How is accrued interest determined for Treasuries?
Treasury bonds and Treasury notes calculate accrued interest on a 365 day basis.
- Treasury bills do not pay accrued interest since they have no coupon.
- When a bond trades w/o accrued interest it’s called trading flat.
Term bond issue vs serial bond issue
Term bond issue= When all of the bonds in an offering are due to mature on the same date.
Serial bond issue= When bonds in an offering mature sequentially over a period of years. The interest payments and principal amounts will decline over time.
Level debt service
When a serial bond is structured so that principal and interest payments represent equal annual payments over the life of the offering.
Why do bond prices fluctuate from par?
Becuase there’s a change in market interest rates or creditworthiness of the issuer. A bond’s market value will rise if interest rates decline and vice versa. This is because as int. rates rise, investors will want to purchase new bonds at a higher yield. Therefore, existing bonds will need to be offered at a discount.
- In general, when interest rates change the price of LT bonds fluctuate more than ST bonds.
True or false: If a company is perceived as risky, the price of their bonds must rise to entice investors?
False, the yields of the bonds will need to rise and thus the price will fall. Makes sense- the riskier the bond, the cheaper it is.
True or false: Only relatively large bond issues are rated by ratings agencies?
True. This does not mean that an unrated issue is necessarily poor quality, however.
Reinvestment risk
The risk that a bondholder will not be able to reinvest their principal and get an equal yield once the bond matures. This occurs when interest rates have fallen.
In this case, the bondholder will either have to accept a lower rate of return once the bond matures, or the bondholder will have to reach for yield by looking into riskier bonds.
Call risk
When interest rates decline, callable bonds are more likely to be called so that issuer can re-issue them at lower rates.
3 measures for determining a bond’s yield:
- Nominal yield
- Current yield
- YTM
Nominal yield
The bond’s coupon rate
- Fails to take into account whether the bond was purchased at a premium or discount.
Current yield
Annual interest ÷ current market price
- Current yield fails to take into account the payment at maturity.
Yield-to-maturity (YTM)
Takes into account everything the bondholder receives from the time they purchase the bond until the time it matures.
Ex: An investor purchases a 6% bond w/ a par value of $1k at $800 w/ a 10 year maturity. What’s the YTM?
- The seminannual interest payments for the next 10 years ($600)
- The $200 gain from buying the bond at a discount ($200)
- The interest earned from reinvesting the semiannual coupon payments.
Calculation not required on exam, just a conceptual understanding.
- YTM assumes the bondholder will reinvest coupon payments at the original YTM rate
- YTM may be described as a yield or basis- 7.44% yield and 7.44 basis are equivalent.
If purchased at a discount, what is the ranking of nominal yield, current yield, and YTM?
YTM > current yield > nominal yield
- If confused, look back at page 116 of the study manual to remember the triangle.
- This will be the opposite if it’s bought at a premium.
- If the bond is bought at par, all 3 are equal.
Yield to call (YTC)
W/ a callable bond, the yield-to-call and YTM must be calculated. The worse of the two, referred to as the yield-to-worst, must be disclosed to clients.
In general, if callable at par, a callable bond selling at a discount will be quoted on a YTM basis, and if selling at a premium, will be quoted on a YTC basis.
- A prerefunded bond will be quoted on a YTC basis.
Call protection period
A period of time where a callable bond CANNOT be called. Typically 5 or 10 years. Typically there is a call premium in order to compensate the bondholder for the early redemption.
Bonds may be called in-whole or partially (a.k.a lottery calls)
- Whether the call provision is in-whole or partial must be disclosed to the bondholder prior to the bond’s purhase and noted in the confirmation.
What is returned to bondholders when the bond is called?
The bond’s principal and any accrued interest.
Continuous call vs catastrophe call
Continuous call= A call feature that may be exercised any time after the first call date.
Catastrophe call= Call provisions which are only enacted if a bond’s underlying collateral is destroyed (ex: bonds were used to fund the construction of a bridge and the bridge gets destroyed).
- Catastrophe calls do not have to be disclosed due to the unlikelihood of their occurance.
Refunding bond
When an issuer issues a new bond and uses the proceeds to pay off an existing bond by calling it. This benefits the issuer when market rates fall.
Prerefunded bond/Advance refunding
Same concept as a refunding bond, however imagine that there is a call protection period. In this case, an issuer will issue the refunding issue and the proceeds are then placed into an escrow account and managed by a trustee and the issuer will wait until the call protection period is up. At this point, the amount that was deposited is enough to pay the remaining int. payments and the amount due at the call date, and the bonds are considered prerefunded.
Escrowed-to-maturity (ETM) and Escrowed-to-call (ETC)
When money is deposited into an escrow account and used to pay off a bond at its maturity, it’s referred to as being escrowed-to-maturity. If it will be paid off at the call date, it’s escrowed-to-call.
Crossover refunding
W/ prerefunded bonds, when the new issue proceeds are placed into escrow, there is a revenue stream to make the required interest payments on the outstanding bonds. Once it’s the call date, the proceeds crossover and are used to pay the principal and call premium to extinguish the original issue.
Sinking fund provision
When issuers deposit funds each year to redeem their bonds, whether it be early or when they mature.
- Bond indentures may require sinking fund provisions or issuers may set them up independently.
- Sinking fund provisions may be a disadvantage to investors because it makes the issuer more likely to call the bonds.
- Issuers of term bonds are more likely to establish a sinking fund provision.
True or false: Yields on putable bonds are generally higher than callable bonds?
False, there’s no need to entice investors to buy putable bonds.
Taxation of bond interest
Interest received from a bond is taxed at the ordinary income rate. The interest is subject to federal, state, and local taxation and taxable in the year in which it’s received.
True or false: If a corporate bond is sold in the secondary market, the seller must include the amount of accrued interest received and treat it as ordinary income. When reporting income, the buyer must include the
amount of the interest payment minus any accrued interest paid at the time of purchase?
True
Taxation of zero-coupon bonds
Investors are required to adjust their cost basis annually. Every year, the discount must be accreted into earnings. This accretion is taxed as ordinary income.
Ex: A bond priced at $60 w/ par value of $100 and a maturity of 20 years will accrete $2 ($100 - $60 = $40/20) every year.
- Many investors purchase zero-coupon bonds in tax-deferred accounts to avoid this.
- The same process happens in reverse (amortization) for bonds bought at a premium.
Secured bonds vs unsecured bonds
Secured bonds= Bonds backed by specific assets.
Unsecured bonds= Bonds not backed by assets. These forms of debt are referred to as notes or debentures.
All bonds are backed by the full faith and credit of the issuer
Mortgage bonds
1/3 primary types of secured bonds. These bonds are secured by a piece of RE that’s owned by the company and used by the business (ex: the office building that it owns). These bonds are typically issued serially over a # of years.
Equipment trust certificates
1/3 primary types of secured bonds. These bonds are backed by a specific piece of equipment. A trustee holds the title on the equipment until the bonds are paid off. These bonds are typically issued by transportation companies.
Rolling stock
Assets that move (ex: cars, trains, etc.). This is often the collateral for equipment trust certificates.
Collateral trust bonds
1/3 primary types of secured bonds. Bonds that are secured by 3rd party securities and are owned by the issuer. The securities are placed in escrow as collateral.
Two types of bankruptcies
- Chapter 7 (liquidation)
- Chapter 11 (reorganization)
The order in which corporations pay stakeholders in a Chapter 7 bankruptcy:
- Secured creditors
- Wages of employees
- Taxes
- General creditors
- Subordinated creditors
- Preferred stockholders
- Common stockholders
Chapter 13 bankruptcy
A way INDIVIDUALS can file for bankruptcy. This allows the individuals to negotiate w/ their creditors.
Chapter 15 bankruptcy
Bankruptcies involving foreign issuers, foreign assets, or foreign investors.
High-yield bonds/Junk bonds
Bonds rated below BBB by S&P or Baa by Moody’s.
- If bonds start out with an investment-grade rating, but are later lowered to below investment grade, they’re referred to as fallen angels.
Income bonds
Bonds issued by companies that have filed Chapter 11. These bonds do not pay interest unless it has sufficient earnings, trade flat (w/o interest), and are priced at a deep discount.
These bonds repay principal at maturity.
Guarenteed bond
A bond that is secured by the guarentee of another corporation. Typically this is done by parent companies.
Stepped coupon bond
A bond that is issued w/ a low coupon that increases at regular intervals. Typically, the issuer can call the bond at the step up dates.
True or false: Placing zero-coupon bonds into tax protected accounts, such as IRAs, allows for the avoidance of taxation on the cost basis adjustment?
True
True or false: For exam purposes, if any reference is made to a capital appreciation bond (CAB), it’s a bond that’s similar to a zero-coupon bond?
True
Eurodollar
A dollar-denominated deposit that’s made outside the U.S.
Eurodollar bond
Bonds that are issued outside the U.S. (typically Europe) but pay principal and interest in USD. Since these bonds are not registered w/ the SEC, they may not be sold in the U.S. until 40 days have elapsed from the date of issuance.
These are different from Eurobonds!!!!
Yankee bond
A Yankee bond is a debt instrument, denominated in US dollars, issued by a foreign entity and sold in the United States and registered w/ the SEC
Eurobond
Any bond that’s sold in one country but denominated in the currency of another country.
- It is very possible that a Eurobond may have a different issuer, currency, and primary market.
Sovereign bond
Debt that’s issued by foreign national governments. The credit rating of this kind of debt is dependent on the credit rating of national governments.
Types of money market securities
- Commercial paper
- Bankers’ acceptances
- Negotiable CDs
- Fed Funds
- Money-market funds
- Repo agreements
Money market instruments are often referred to as cash equivalents.
Commercial paper
Unsecured corporate debt that typically matures in 270 days or less. Due to its short maturity, these bonds are exempt from registration and prospectus requirements.
Commercial paper is typically issued at a discount in denominations of $100k.
- Commercial paper is typically issued by corporations with high credit ratings.
Directly placed commercial paper vs dealer-placed commercial paper
Directly placed commercial paper= The issuer of commercial paper sells its issues directly to the public using its own sales force.
Dealer-placed commercial paper= The issuer sells to a large commercial paper dealers who then resells the issue to the public.
Bankers’ Acceptances (BAs)
Instruments where a bank rather than an account holder guarantees the payment. These are often used to facilitate foreign trade.
Disclosures that SHOULD be made if a brokered CD is callable:
- The issuer can call the CD prior to its stated maturity.
- If called, the client may be unable to reinvest at the same or better market rates.
- A CD called prior to its maturity may offer a client a return that’s less than its YTM.
- If the CD isn’t called by the issue, the client may be required to hold the security until maturity.
Repos
When a dealer sells securities (usually T-bills) to another dealer and agrees to repurchase them at a specific time and price.
In essence, the dealer is borrowing money from another entity secured w/ T bills and will pay the other entity back at some point in the future. In return for making the loan, the second dealer (the lender) receives the difference between the purchase price and the resale price of the securities.
Convertible bonds
Bonds that allow the bondholder to convert the par value into a predetermined number of shares of a firm’s common stock. Convertible bonds typically have lower coupon rates than regular bonds.
If the underlying stock changes, the price of convertible bonds will change. If the stock price increases, the bond will trade at a price based on its potential conversion value, and if the stock decreases the bond will trade at a price based on its inherent value as a bond.
- These are typically offerred by companies w/ weak credit ratings to entice investors.
Conversion ratio
Par value of a bond ÷ conversion price
!!! The conversion price * the conversion ratio should always = 1000 !!!
Conversion value
The market value of the stock the investor receives at conversion.
True or false: The conversion ratio does NOT need to be adjusted for stock splits or stock dividends?
False.
Ex: A bond that’s originally convertible at $40 with a par value of $1k has a conversion ratio of ($1k ÷ $40) = 25. If there’s a 2-1 stock split then we must adjust the stock price to reflect the split ($40 ÷ 2) = $20. The new conversion ratio = ($1k ÷ $20) = 50
Ex 2: Using the same original bond as in Ex 1, if a company declares a 20% stock dividend, the conversion ratio will increase to (25 * 1.2) = 30 shares. The conversion price will then decrease to ($1k ÷ 30) = $33.33.
Parity
When the bond’s conversion value is equal to the bond’s market price. Most bonds trade at a premium to parity.
Parity example:
If a firm issues a convertible bond w/ a conversion price of $50 and the common stock is selling at $60 per share, assuming par value of $1k then what does the bond need to trade at to be at parity?
Conversion ratio = $1k ÷ $50 = 20 shares.
Parity price= 20 shres * $60 per share = $1,200 bond price necessary
True or false: A disadvantage to a firm that’s issuing signficant amounts of convertible bonds is that if the bonds are converted into stock then that dilutes EPS?
True
This will not affect a company’s fully diluted EPS
Forced conversion
Since most convertible bonds are callable, if the call price is less than the conversion value, the bondholder may be forced to convert the bond immediately or accept less than its conversion value.
Forced conversion example:
Investor A owns a bond that’s convertible at $40 w/ the underlying stock trading at $50 per share. The corporation calls in bonds at 105 ($1,050). What actions should Investor A take?
Conversion ratio = $1k ÷ $40 = 25 shares
Conversion value = 25 shares * $50 = $1,250
Investor A should convert the bond since the bond’s conversion value ($1,250) is currently higher than the bond’s call price ($1,050).
True or false: Conversion of a convertible bond is a taxable event?
False, it is NOT a taxable event.
Structured products
Derivative securities that may be linked to a varity of underlying (reference) assets. These are typically built around a fixed-income instrument and a derivative product. While the note pays a specified rate of interest to the investor at defined intervals, the derivative component establishes the
amount of payment at maturity.
Clients MUST receive a notice that these products are NOT bank deposits and NOT insured by the FDIC.
Exchange-traded notes (ETNs)
A type of unsecured debt security thats returns are linked to the performance of some index. ETNs don’t pay coupons, but instead all gains are paid at maturity.
Investors of ETNs are taking on two risks- one that the underlying index performs well, and two, that the issuer is able to make the payment.
Reverse convertible securities
These are structured products issued by banks and BDs that pay a coupon above the market rate w/ the caveat that the buyer might HAVE to take possession of the underlying security. If the price of the underlying asset drops below a predetermined price, referred to as the knock-in level, then the holder will have to take possession.
The investor is betting that the value of the underlying will be stable or rise, while the issuer is betting that it will fall.
- The issuer benefits by being able to repay principal in the form of a set amount of the underlying asset rather than in cash.
Capital risk
The risk of an investor losing their principal. Bonds have the least amount of capital risk.
Dated date
The date from which interest begins to accrue for a new bond
