Debt Flashcards
1
Q
How can a company raise cash? (2)
A
- Through equity or debt financing (issuing shares/bonds)
- Cash income does not always cover expenditure and therefore capital (debt/equity) must be raised to fund shortfalls. While companies can issue equities, government’s cannot and so they rely on debt financing
2
Q
How can a company raise cash? (2)
A
- Through equity or debt financing (issuing shares/bonds)
- Cash income does not always cover expenditure and therefore capital (debt/equity) must be raised to fund shortfalls. While companies can issue equities, government’s cannot and so they rely on debt financing
3
Q
What is a loan? (3)
A
- An advance of cash
- Usually from a bank
- Interest and capital are repaid over the term of the loan
4
Q
What is a debt security? (3)
A
- Unlike a loan, debt securities (gilts/bonds) are traceable instruments issued to investors in return for borrowed funds
- Pay a coupon
- The capital amount (principal) is repaid in full at some point in the future (maturity)
5
Q
What is a bond vs a bill? (2)
A
- A bill/gilt is a short term debt security usually with a term time of up to a year
- A bond is a medium-to-long term debt security with a maturity of over a year from its issue date
6
Q
Who issues UKG and Treasury Bills (T Bills)? (4)
A
- Debt Management Office (DMO) - an executive agent of the Treasury
- Through the method of auctions
- Issues in the secondary as well as the primary market
- DMO is also responsible for approve GEMMs on the LSE.
7
Q
What is a gilt edged market? (2)
A
- The market for UK debt securities
- Forms a large part of national debt with the remaining being funded by national savings, short term borrowing from the BoE and overseas borrowing
8
Q
What are the features of a gilt? (8)
A
- Gilts have the following features: Name, coupon, a redemption date e.g. United Kingdom 1.75% 31.01.25
- The quoted coupon represents the annual amount of interest paid per £100 nominal value
- E.g. a gilt with a 9% coupon will pay £9 each year for evert £100 nominal value
- Gilt coupons are usually paid semi-annually, on fixed days 6 months apart e.g. 25 Jan and 25 July
- Coupons are quoted gross of income tax and paid gross - tax is due later
- Floating rate gilts pay quarterly coupons
- Examples of gilt loans include: Treasury, Consolidated, War Loan (names are just an identifier and serve no purpose)
- Redemption - the date of repurchase and is usually at par e.g. £100 per £100 nominal value
9
Q
What are different categories of gilts? (2)
A
- Index linked
- Non index linked - shorts, mediums, longs, undated
10
Q
What are conventional (non index linked) gilts? (5)
A
- Medium dated bonds considered to have between 7 and 15 years to redemption by the DMO
- LSE uses 5 to 15 years as their measure
- Fixed coupon and fixed redemption date
- Shorts < 7 yrs
- Longs > 15 yrs
11
Q
What are the 6 type of non-conventional bonds? (6)
A
- Undated/irredeemable - currently non of these in issue. If no redemption date is specified, then the gilt can be redeemed at the government’s discretion
- Index linked - the coupon and redemption value are linked to the RPI. Each payment is related to the RPI three months prior to the month of payment and 8 months for issues before 23 Sept 2005
- Double dated - gives choice of dates on which the issue can be redeemed by the govt but has to be within the range
- Convertible - can convert into other gilts
- Floating - variable coupon - coupon floats in line with interest rates. Pays interest quarterly
- STRIPS - can be stripped into their constituent cash flows e.g. coupons and redemption amount, and traded separately
12
Q
What is a gilt repo? (8)
A
- The sale and repurchase of gilts
- One party sells gilts to another, agreeing the same time to repurchase the equivalent securities at an agreed price and an agreed date in the future
- A reverse repo is the other side of the same trade - purchase and subsequent resale of a gilt at a pre-agreed price
- The one performing the repo is acquiring cash to enhance liquidity
- The one performing the reverse repo is acquiring gilts to cover a short position
- The difference between a sale price and repurchase price = implied interest rate - repo rate e.g. £100/£900 = 0.1111 / 11%
- Most common term for gilt repos is overnight. Maturity over one night = term repos. Also open repos where there is no fixed time and repo is rolled on at the end of each day
- Bilateral repos (2 parties), tripartite repo (third part is custodian bank(
13
Q
What is a corporate bond? (5)
A
- Debt securities where the issuing company is committed to repaying capital and associated interest
- Interest can be fixed or variable in relation to the redemption
- The timing is set ou tin the terms of issue
- The final redemption date is non-optional
- Any remaining stock is automatically repaid at redemption
14
Q
What is included in a corporate bonds terms and conditions (the indenture)? (5)
A
- Call provisions - gives the company the right to repay the bond early
- Put provisions - gives the company the right to demand early repayment
- Sinking funds - enables the company to repay a part of the nominal value each year prior to redemption
- Protective covenants - to protect the income streams for investors
- Convertibility terms
15
Q
What is a debenture? (4)
A
- Secured debt instruments
- Gives the holder rights to enforce the security should the company default on payment
- Fixed charge over assets - mortgage bonds (MBS)
- Floating charge over assets - debenture
16
Q
What is a loan stock? (2)
A
- Unsecured debt instruments
- Lenders have no legal charge over the company’s assets
17
Q
What is a CDO? (3)
A
- A security secured by the cash flows from a pool of bonds, loans and other assets
- A form of an asset backed security (ABS) secured by assets such as property, loans or credit card receivables
- Often issued by companies specially created for the purpose (SPVs - special purpose vehicles) which allows the company to be a separate legal entity from the original owner of the underlying assets leaving them unaffected by bankruptcy risk
18
Q
What are synthetic CDOs? (2)
A
- No physical transfer of bonds or loans take place from the credit institution to the spa
- Instead, CDO gains exposure to credit risk by selling a credit default swap and using the premiums as the receivables for the pool of repayments
19
Q
What is a floating rate note (FRN)? (6)
A
- Fixed coupon
- Floats in line with market rates (has interest rate sensitivity)
- Element of capital protection - buy and sell near nominal value meaning there is little fluctuation in price
- Trades near par
- Paid either semi annually or quarterly
- Market rate of interest is assessed for each period companies to the benchmark
20
Q
What is an international bond (Eurobond)? (7)
A
- Issued internationally
- Denomination of the bond and the country of issue are all different e.g. company issuing dollar bonds in Paris and Tokyo issuing Yen in Frankfurt and Dublin
- Usually issued in currency and country where issuer finds it cheapest to raise finance and then swapped into the currency the issuer wants
- Bearer security (no registered owner) - anonymous, freely transferable
- Risky to hold bearer documents - kept in safe depositaries such as Euroclear/Clearstream. This is called immobilisation
- Regulated by the ICMA - International Capital Markets Association
- Interest paid on Eurobond issues usually once a year (fixed or floating)
- Interest paid in gross to make bond more attractive to international investors
21
Q
What is a convertible loan stock? (4)
A
- A debt security with an option to convert into a specified amount of equity at a later date
- The price of the convertible debt instrument will be higher than similar non convertible instruments
- A premium is paid for the right to convert into equities
- The conversion can be calculated as a percentage of the value of the current share price
22
Q
What is a contingent convertible bond? (6)
A
- Also known as CoCos are converted into shares automatically if a pre specified condition (trigger) is met
- Mostly used by bands to provide a source of equity finance at times when investors may be unwilling to invest in the banks equity
- Triggers that will convert debt into equity could be mechanical or discretionary
- Mechanical; based on the bank’s capital ratio - if it falls below a set level, it will trigger conversion in order to prevent the bank becoming insolvent. The capital value can be based on book value or market value
- Discretionary; based on the regulator’s opinion of a bank’s solvency. This is sometimes called a point of non-viability trigger
- CoCos are typically ranked below subordinated debt - yield is highly influence on a trigger level - the lower the capital needed to trigger conversion, the more risky the bond
- Equity holders prefer CoCos with higher trigger levels
23
Q
What are callable/puttable bonds? (2)
A
- Call - ISSUER can redeem early. Allows the issuer of the bond to pay off the obligation early. This saves money as they do not need to repay the coupon in full. It also works against the holder of the bonds as they do not receive all the cash flows they were expecting. If interest rates fall, issuer may redeem the bond early and can take advanced of lower borrowing costs to issue lower coupon bonds.
- Put - INVESTOR can redeem early. Allows the holder of the bond to force the issuer to redeem the bond early if they think the issuer is unlikely to meet obligation. Investor may also redeem early if interest rates rise . They can put the bond back to buy higher yielding bonds. Could lead to the company having to find alternative cash flows to repay debt
24
Q
What is the order of debt repayment? (10)
A
- Liquidator
- Fixed charge holders
- Preferential creditors (e.g. employees)
- Floating charge holders
- Unsecured creditors (e.g. trade creditors and the government)
- Subordinated loan stock
- Preference shareholders (nominal value only except participating shares)
- Ordinary shareholders
- Deferred shareholders
- Warrants
1-6; Creditors
7-10; Owners
25
Q
What are the key risks faced by bond holders? (6)
A
- Interest rate risk - when IR rise, bond prices fall. When IR fall, bond coupon can be reinvested at a lower rate. This is less true with floating rates
- Inflation risk - most bonds offer a fixed redemption value, often after many years. Inflation will erode the true value of these redemption value. This can be avoided using index linked gilts
- Liquidity risk - the risk of not being able to sell the bond if you need the cash. Most bonds are traded OTC and can be quite illiquid. This is less of a problem for exchange traded bonds and UK government bonds
- Defualt risk - the risk of the issuer not paying you back. Credit ratings give a good idea of the default risk of an issuer. The higher the credit rating the less risk of default
- Currency risk - if investing overseas, a movement in the exchange rate could affect the return on the bond
- Call risk - if the bond is callable or dual-dated, the bond may be redeem earlier than the investor expected. This would reduce the investors reinvestment return and they would need to seek an alternative earlier than expected
26
Q
How do you calculate a strip?
A
(N*2)+1
27
Q
How do you calculate a strip?
A
(N*2)+1
28
Q
Who can approve STRIPS? (3)
A
- GEMMs
- Bank of England
- Her Majesty’s Treasury
