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Investment Planning > Debt Investments > Flashcards

Debt Investments Flashcards

1
Q

What is a bond?

A

A debt security obligating the issuer to make a periodic interest payment and repay the principle at the time of maturity

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2
Q

In bond issuance, what is the difference between registered form, bearer form, and book-entry form?

A

Registered form: payments are made to the owner of record
Bearer form: payments are made to whoever holds or possess the bond
Book-entry: payments are made to the electronically recorded owner

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3
Q

What is the bond indenture?

A

The agreement, or contract, between the issue and bondholder

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4
Q

What is par value?

A

The face value of a bond which is assumed to be $1000 for the purposes of the exam

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5
Q

What is the coupon rate of a bond?

A

The stated interest rate that will be paid either annually or semi-annually.

Ex: $1000 at 4% will return $40 ann or $20 semi-ann yield

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6
Q

What is a basis point?

A

A measurement of the bond’s yield in 1/100ths of a percentage. A 2% increase is stated as 200 basis points

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7
Q

What is the discount and premium of a bond?

A

A discount is when the bond is selling at a lower price in the secondary market than the par value

A premium is when the bond is selling at a higher price in the secondary market than the par value

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8
Q

What is a bond call provision?

A

A stipulation in the bond indenture that allows the issuer to pay off the bond principle after a specified period, usually at a price higher than the par value.

The issuer can call the bond if the interest rates have decreased which would then allow the issuer to refinance the bond at a lower coupon rate.

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9
Q

What is a secured bond?

A

Pledges certain assets that may be sold by the purchaser in the event the issuer defaults in paying interest or principle.

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10
Q

What is a bond debenture?

A

The opposite of a secured bond - this is an unsecured bond. More risky and therefore higher yield for the same period by the same issuer.

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11
Q

What is an investment grade bond?

A

A bond that is rated BBB or higher by S&Ps. Generally, a higher rate bond with little risk of default

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12
Q

What is a high-yield bond?

A

AKA a junk bond or non investment grade bond, these are rated BB+ or lower by S&Ps. Generally a lower-quality bond with high risk of default

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13
Q

What are the three bond maturity categories?

A

Short term: matures between 1-5 years
Intermediate term: matures between 5-10 years
Long term: matures at more than 10 years

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14
Q

What is the relationship between a bond’s yield and it’s credit rating?

A

Inverse. Yield goes up with credit rating goes down.

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15
Q

What is interest on interest?

A

It is the additional income from reinvesting the coupon payments

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16
Q

What is a zero coupon bond?

A

One that does not payment regular coupon payments. It only pays a single yield at the end of the term

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17
Q

What is call risk?

A

This is risk to the bondholder that the bond will be called in order for the issuer to save money by refinancing the bonds at a lower rate.

Disadvantages to bondholder of a callable bond:

  1. Full-cash flow pattern is not known (term is not defined)
  2. Exposure to reinvestment risk (that the bonds will yield less now)
  3. Capital gains potential is likely reduced (not what the investor probably signed up for)
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18
Q

With bonds, what is financial risk?

A

The risk that the issuer cannot pay it’s debts

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19
Q

In bonds, what is default (credit) risk?

A

The risk that the issuer will default on both the principle and the interest payments. Usually associated more with noninvestment grade, or junk bonds.

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20
Q

With bonds, why is inflation risk high?

A

The yield of a bond is usually fixed. Therefore the longer the bond, the higher the risk to inflation and the loss of purchasing power

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21
Q

What is event risk to a bond?

A

The risk that some catrostrophic event will affect the value of the bond, such as a major tax overhaul, company fraud, or the company capital structure

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22
Q

What are the 5 types of bond issuers?

A

Federal government: funds programs and operations - not taxed at state

Federal government agencies: funds specific agencies. Not a direct debt of the government

Municipalities: funds state government agencies, schools, fire, police, other. Not taxed by the state if owned by a resident of that state

Corporations: divided into several segments of broad company types such as public utilities, transportation, etc

International issuers: any bond issuer which exists outside the US

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23
Q

What is the maturity difference between US T-Bonds and T-Notes?

A

T-Bonds have a maturity of 30 years. T-Notes have a maturity of 2, 3, 5, 10 years

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24
Q

How are T-Bonds and T-Notes taxed?

A

Ordinary income in the year earned

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25
What is the tax impact of a original issue discount (OID) bond or note?
The holder must pay tax on phantom income each year and then the investors basis increases by that tax amount.
26
What are Treasury STRIPS (Separate Trading of Registered Interest and Principle of Securities)?
They STRIP the interest payments from the bond to create zero-coupon bonds. Zero-coupon bonds created by separating semi-annual coupon payments and the principle repayment portion of a T-Note or Bond. Ex: A 5-Yr 4% T-Note w/ value of $10,000 can be separated into 11-zero coupon bonds. 1st 6th month payment is $200, the next at 12 months is $200 and so on...
27
What are Treasury Inflation Protection Securities (TIPS)?
Marketable securities whose principle is adjusted by changes in the Consumer Price Index every 6 months, but to keep up with the original rate or better. Issued in terms of 5, 10, and 30 years. Taxes are on the adjusted principle and interest payments and the basis increases with those payments
28
What is the E / EE savings bonds?
Sold at 100% face value and is eligible for interest payments for up to 30 years. Must be held for minimum of 12 months and there is a 3-month interest penalty if sold within 5 years
29
What a H / HH savings bonds?
Not available anymore. Provide a semi-annual interest payment for up to 20 years. No penalty for early redemption
30
What is the I savings bond?
Fixed and/or inflation indexed or inflation protected bond. Interest payments are made semi-annually and like the E / EE bonds, they cannot be redeemed within 12 month of issue and there is a 3-month interest penalty if redeemed within 5 years. The fixed interest rate is combined with a CPI-calculated interest rate every 6 months
31
What are US government agency securities?
These are agencies (or Government-sponsored enterprises (GSE)) that were created by Congress in order to flow money to certain segments of the economy, such as farming, homeowners, and students. While these agencies are indirectly backed by the government, they aren't the government and therefore carry a slightly higher coupon rate, but are also taxed at all levels
32
What is the Government National Mortgage Association (GNMA)?
They buy FHA and VA home mortgages and auction them to private lenders that pool the mortgages to create pas-through certificates for sale to investors
33
What is the Federal Home Loan Mortgage Corporation (FHLMC) (Freddie Mac)?
Created to promote the development of a nationwide secondary market in mortgages by purchasing conventional mortgages from financial institutions and then package them into mortgage-back securities for sale to investors
34
What is the Federal National Mortgage Association (FNMA) (Fannie Mae)?
Competes with Freddie Mac. However Fannie Mae is a government sponsored corporation that is owned entirely by private stockholders. Its securities are backed by credit, not the US government.
35
What are pass through securities?
Ginnie Mae, Freddie Mac, or Fannie Mae, purchase, pool and resell mortgage securities to investors. When someone makes a principle and interest payment on their mortgage, that payment and interest will "pass-through" the bank, the association, and onto the investor, less any service fees.
36
What are the two types of muni bonds?
General and revenue
37
What are general obligation bonds (GO)?
Issued to finance projects benefiting the community. Backed by taxes and so they must be voted on by that community. But that also makes them less risky
38
What are revenue bonds?
Bonds uses to finance any municipal facility (airport) that generates sufficient income to pay the ongoing debt obligation. These are a bit more risky than GOs.
39
What are private activity (private purpose) bonds?
Bonds that are part of a state of local issue wherein more than 10% of the proceeds of that issue are to be used for a private business purpose (such as financing a sports stadium)
40
What are qualified private activity bonds?
Tax-exempt bonds issued by state or local government, the proceeds of which are used for a defined, qualified purpose. Must used at least 95% of the net proceeds for a qualified purpose as described in the IRC.
41
What are insured municipal bonds?
Backed muni bonds in the hopes that they will receive a better rating and can therefore lower the coupon rate
42
What is the taxable equivalent yield (TEY) and what is the formula?
Compares the difference in yield amounts between corporate taxable and muni tax exempt bonds. TEY = tax-exempt yield / 1 - marginal tax bracket
43
What is the after-tax yield and what is its computation?
ATY produces the after tax percentage to be compared with a tax exempt bond (or other investment) for its worthiness ATY= pretax return / (1 - marginal tax rate)
44
What are corporate bonds?
Bonds issued by private and public companies to raise capital. Usually divided into 4 segments: - Industrials - Public utiliites - Transportation - Financial
45
What is the difference in tax consequences between an original issue discount (OID) and a market discount bond?
The OID, you pay taxes annually on the (phantom) interest. With market discounts, you have a choice, but usually makes sense to pay the interest when the bond is sold. The tax is on "interest income"
46
What is the tax issue with premium bonds?
The bondholder is paying a premium AND paying higher taxes on that bond, but won't see the premium until they sell the bond.
47
What are the different types of foreign bonds?
Yankee bonds: foreign bonds payable in US dollar - not subject to exchange rate risk. Eurodollar bonds: another type of US dominated bond sold outside the US, but not registered with the SEC Eurobonds: bonds dominated in a currency not native to the country where they are issued. Not limited to Europe. Subject to exchange rate risk
48
What are convertible bonds?
Bonds that can be converted into stock. Usually lower coupon rates, but also less volatile. The coupon rate however, is usually larger than the underlying stocks dividends
49
What is the conversion price, the conversion ratio/rate, and the conversion rate calculation?
The conversion price is the stock price at which a convertible bond can be exchanged for shares The conversion ratio/rate expresses the number of shares of stock into which a bond may be converted. Conversion rate = Par value of convertible security / conversion price
50
What is conversion value and what is its calculation?
The conversion value represents the value of the bond if it were converted on the basis of current market conditions. In other words, given the number of shares of stock the bond can convert to, is the bond worth more or less than the current market value of the bond in hand? Conversion value = conversion ratio/rate x market price of common stock A convertible bond will sell if the market price is less than the conversion value, but not more.
51
What is a bonds straight value?
The value of the bond on the secondary market if it did not contain a convertible option
52
What is the investment premium and its calculation?
Investment premium is the difference the market price and the investment value of a convertible bond. Investment premium = Market price - investment value
53
What is the conversion premium and what is its calculation?
The conversion premium is the difference between the market price and the conversion value of a convertible bond. Conversion premium = (current market price of the bond - conversion value) / conversion value
54
What is downside risk and what is its calculation?
It is the dollar or percentage decline from the current market price of the convertible bond to the investment value of the bond. ``` Downside risk ($) = Market value - investment value Downside risk (%) = DR$ / market value ```
55
What is portfolio immunization?
An interest rate management technique which offsets interest rate risk against reinvestment rate risk. As interest rates increase, the value of the bond portfolio decreases, but reinvestment rates increase which offset. It is the same in the opposite direction.
56
What is a bond ladder?
The combined use of short and long-term bonds to break-up interest rate risk and cash availability This is a relatively easy way to immunize a portfolio against interest rate risk
57
What are bond barbells?
An active strategy of a long term bond to lock in attractive rates and short term bonds in the middle to insure the investor will have the opportunity to reinvest cash into other opportunities.
58
What is a bond bullet?
A strategy of purchasing bonds at different times with differing maturities, but they all mature at the same time. Ex: time horizon 10 years. 2 bonds now, 2 at 4 years and 2 more at 6 years, with 10, 6, and 4 year terms respectively.
59
What are the goals of bond swaps?
Increase the yield to maturity (YTM), save on income taxes, or reduce the overall interest rate risk
60
What are the various types of bond swaps:
- Substituion swap: swapping bonds with identical characteristics, but different prices. Quick opportunity until the market corrects itself - Intermarket spread swap: exchanges one type of bond (gov) for another (corp) when investors believe one is mispriced in relation to the other - Rate anticipation swap: takes advantage of rate changes usually by exchanging long term with/for short term bonds - Pure yield pickup: swapping a lower YTM bond with a higher YTM bond - Tax swap: using tax law to gain an advantage in the selling of bonds
61
ROT - If an investor expects a decline in market interest rates, what should he do?
Construct a portfolio of long maturity bonds with low coupon rates. Why? This presents the most interest sensitivity for expected capital gains when the market interest rates decrease
62
ROT - If an investor suspects market interest rates are on the rise, what should he do?
Build a portfolio of short maturity bonds with high coupon rates in order to minimize market interest rate sensitivity and loses
63
ROT - if the investor is above the 24% marginal tax bracket, what kinds of bonds should he likely invest in?
Of course still using TEY first, but usually, tax free bonds are the way to go.
64
ROT - What kind of bonds should investors who are concerned about default risk, buy?
Treasury securities or (T-Bills, Notes, Bonds)
65
ROT - if an investor wants a better return than treasury bonds, what should he buy?
US Agency bonds have a higher yield, but be careful that they are/are not backed by the government (potential default risk)
66
ROT - if an investor would like a specific amount of money at a specified time, what kind of bond is appropriate?
A time-specific, zero-coupon treasury bond. Free from default risk, this bond will pay the face value when needed.
67
What is duration?
Measures in years, the time it would take for the bond to repay the investor the bonds total cash flow. The higher the number, the more subject to market volatility the bond is, but will likely have a higher coupon rate. The low number will have low coupon rate, but low volatility. Duration and interest rates are inversely related
68
ROT - What are the risk ROTs for duration?
Low risk - low duration, low coupon | High risk - high duration, high coupon
69
What is a positive yield curve and what economic phase can it indicate?
Denotes increasing yield for short to long term bonds. It generally occurs during periods of economic expansion and predicts that market interest rates will rise in the future
70
What is important to note about yield curves and what they mean?
Their shape varies according to changes in the economic cycle and therefore can be an indicator of the future state of the economy
71
What is a flat yield curve and what economic phase does it indicate?
Denotes no difference between yield and maturity. Usually occurs when the economy is peaking and predicts no change in market interest rates
72
What is inverted yield curve and what economic phase does it indicate?
Occurs when the Fed tightens credit in inflationary economy and predicts that interest rates will fall.
73
What is unbiased expectations theory (yield curves)?
States that long-term rates consist of many short-term rates and that long-term rates will be the average of short-term rates
74
What is liquidity preference theory (yield curve)?
This theory holds that investors prefer short term bonds to long term. In order to entice investors into long-term bonds, they must offer a higher interest rate
75
What decision could be made using a flat yield curve?
One might speculate that a long-term bond might see interest rates fall. The risk is that they don't or rise.
76
What decisions might be made on an inverted yield curve?
Interest rates are on the rise. But there is a potential for a drop in interest rates when inflation is broken which is the time for investors to grab short-term bonds first, then long term.
77
What decisions might be made on a steeply sloped yield curve?
While beneficial to coupon rates, one should be weary that inflation could be on the rise which would then cause an increase of market interest rates.
78
What is preferred stock?
A hybrid security of both debt and equity. Like a bond, shareholders receive an annual dividend that is the stated percentage of the par value. But like common stock, the dividend isn't guaranteed. If it does get paid, it will go to preferred stock first before going to common stock. Preferred stock is subject to interest rate risk because it pays a fixed annual dividend.
79
Why is a preferred stock called a perpetuity?
Because it has no maturity date. To get back the principle, one must sell the stock.
80
What is convertible preferred stock?
Stock that can be exchanged for common stock at a conversion ratio determined when the shares are originally issued
81
What does the acronym STRIPS stand for?
Separate Trading of Registered Interest and Principle of Securities
82
What is the nominal rate of a bond?
The stated interest rate that will be paid either annually or semi-annually. Ex: $1000 at 4% will return $40 ann or $20 semi-ann yield AKA, the coupon rate.
83
What is the conversion value calculation?
= (PAR value / conversion stock price = conversion ratio) x FMV stock price
84
What is yield to maturity?
The total amount of interest and principle to be paid if the bond is held to full maturity
85
What is the perpetuity equation?
Perpetuity = Dividend / (interest) rate
86
A convertible bond's market value will NOT fall below its investment value. none of the answers its conversion value. a floor guaranteed by the issuer.
It's investment value.
87
How many total inclusive days are considered to be a wash sale?
61. 30 before + date of sale + 30 after
88
Yield curves are constructed from daily information published on U.S. Treasury bond A) yields-to-maturity. B) coupon payments. C) yields-to-call. D) current yields.
A) yields-to-maturity.
89
Which of the following combinations will result in a bond with the greatest price volatility? A) High coupon and short maturity B) Low coupon and long maturity C) Low coupon and short maturity D) High coupon and long maturity
B) Low coupon and long maturity

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