Debt Investments Flashcards
What is a sinking fund?
A separate fund established and funded each year by the bond issuer to accumulate an amount required to pay off the debt at maturity.
Sinking funds are used to reduce the default risk associated with some bonds.
What is the primary purpose of a sinking fund?
To accumulate funds required to pay off the debt at maturity.
This helps ensure that the bond issuer can meet its financial obligations.
True or False: A sinking fund increases the default risk of bonds.
False.
A sinking fund is included to reduce the default risk associated with bonds.
Fill in the blank: A sinking fund is designed to _______.
[accumulate an amount required to pay off the debt at maturity].
This accumulation occurs each year by the bond issuer.
stated annual interest rate that will be paid each period for the term of the bond and is stated as a percentage of the par value of the bond.
The coupon rate or nominal yield
pledges specific assets that may be sold by the bond purchaser in the event that the bond issuer defaults in paying either the interest or principal on the bond.
A secured bond
bond that promises payments of interest and principal but pledges no specific assets.
Debenture.
Another word for a debenture.
Unsecured bond.
Junk bonds.
Otherwise known as high-yield bonds.
A ____ Bond has a single maturity date
Term bond.
What is the general expectation about yields under a normal yield curve?
The longer the term, the greater the yield.
True or False: In a normal yield curve, short-term investments typically have higher yields than long-term investments.
False.
Fill in the blank: Under a normal yield curve, investors expect to receive a __________ yield for longer-term investments.
greater
Which of the following best describes a normal yield curve? A) Downward sloping B) Flat C) Upward sloping
C) Upward sloping
Short answer: Why do investors expect higher yields for longer-term investments in a normal yield curve?
Investors seek compensation for the increased risk and uncertainty over a longer time horizon.
What factors are positively related to bond ratings?
Profitability, lack of other debt issues, cash-flow coverage of the issuer
These factors indicate a stronger financial position of the issuer.
How does profitability affect bond ratings?
Greater profitability leads to higher bond ratings
Higher profitability indicates a stronger ability to meet debt obligations.
What is the relationship between outstanding debt and bond ratings?
Less outstanding debt correlates with higher bond ratings
Lower debt levels suggest lower financial risk for the issuer.
What role does cash-flow coverage play in determining bond ratings?
More cash-flow coverage of debt payments results in higher bond ratings
Adequate cash flow indicates the issuer’s ability to meet payment obligations.
What factors contribute to lower bond ratings?
Excessive financial leverage, earnings instability
High leverage increases risk, and unstable earnings make it harder to predict financial health.
True or False: Higher financial leverage positively affects bond ratings.
False
Excessive financial leverage typically leads to lower bond ratings due to increased risk.
Fill in the blank: The greater the _______ of the company, the higher the bond rating.
profitability
Profitability is a key indicator of an issuer’s financial health.
What is the effect of earnings instability on bond ratings?
It contributes to lower ratings
Earnings instability makes it difficult to assess the issuer’s ability to repay debt.
What happens to bond yields when there is an upward revision in ratings?
The market yield on the bond declines
This reflects the bond’s improved quality.
What happens to bond yields when there is a downward revision in ratings?
The market yield on the bond increases
This reflects the bond’s decline in quality.
Define the effect of an upward rating revision on bond yields.
Market yield declines due to improved bond quality.
Define the effect of a downward rating revision on bond yields.
Market yield increases due to decline in bond quality.
What is financial risk?
The risk associated with the level of debt an issuer has outstanding.
Financial risk increases with higher levels of debt.
What legal obligation does a firm have regarding its debts?
A firm is under a legal obligation to repay the interest and principal of its debts.
This obligation increases the risk to bondholders.
How does high debt levels affect bondholders?
High debt levels increase the risk that the firm will not generate sufficient cash flow to meet its obligations.
Insufficient cash flow can lead to default on interest or principal repayments.
When is the risk of not meeting debt obligations most likely to occur?
When the company’s business prospects deteriorate.
Deterioration in business prospects can lead to insufficient cash inflow.
Fill in the blank: Financial risk is associated with the level of _______.
[debt]
Debt levels directly impact the financial risk faced by a firm.
What are US Treasury securities considered to be free of?
Default risk
This means that the likelihood of the US government failing to repay its debt is extremely low.
Are Treasury securities risk-free securities?
No
While they have low default risk, they are subject to other types of risks.
What type of risk do Treasury securities have related to fluctuating interest rates?
Interest rate risk
This risk arises because the value of existing bonds decreases when interest rates rise.
What is the risk called that involves the uncertainty of reinvesting cash flows?
Reinvestment rate risk
This occurs when interest rates are lower than the original investment rate, affecting the returns.
What risk do Treasury securities face related to inflation?
Purchasing power risk
This risk affects the real return on investment as inflation erodes the value of future cash flows.
What is purchasing power risk?
Purchasing power risk is the risk associated with the devaluation of cash flows from inflation.
True or False: Purchasing power risk only affects fixed-income investments.
False
Fill in the blank: Purchasing power risk is primarily caused by ______.
inflation
Which of the following best describes the impact of inflation on purchasing power? A) Increases value B) Decreases value C) No effect
B) Decreases value
What are cash flows?
Cash flows are the inflows and outflows of cash that an individual or business receives or pays over a given period.
Spreads tend to be wider for small issues that are less often traded and small dollar trades.
Thinly traded securities, such as. OTC trades, Small cap stocks, hedge funds, private equity investments, high yield corporate bonds. .
What is the maturity range for U.S. Treasury notes?
2, 3, 5, 7, and 10 years
These maturity dates allow for different investment strategies.
What is the maturity period for U.S. Treasury bonds?
30 years
T-bonds are typically considered long-term investments.
Name three uses for U.S. Treasury notes and bonds.
- Diversifying a portfolio
- Funding college education expenses
- Supplementing retirement income
These investments can serve various financial goals.
Fill in the blank: U.S. Treasury notes are issued with maturity dates of _______.
2, 3, 5, 7, and 10 years
This variety allows investors to choose based on their financial needs.
Fill in the blank: U.S. Treasury bonds have a maturity of _______.
30 years
This makes T-bonds suitable for long-term investment strategies.
What happens when a note or bond is sold before its maturity date?
Proceeds from the sale must be separated into components
What is recovered tax free when a note or bond is sold?
An amount equal to the investor’s adjusted basis in the note or bond
How is the investor’s adjusted basis in a note or bond usually calculated?
Purchase price plus any accrued Original Issue Discount (OID)
What amount does the seller usually receive from the buyer if the sale occurs before an interest date?
An amount separately stating interest accrued but not yet due
How is the amount received for accrued interest reported by the seller?
As interest income
What is the treatment of the excess of proceeds received over basis and interest?
It is treated as capital gain (or loss)
For federal income tax purposes (remember, as a U.S. Treasury security, the obligation is free of income taxes at both the state and local levels), all interest received from TIPS is taxable at ordinary income tax rates in the year earned.
Also, during any year when the principal value of TIPS increases as a result of the inflation adjustment, the increase in principal is also taxed as ordinary income for that year.
The tax basis of TIPS is also adjusted upward to account for this increase in principal.
For example Sally purchases an 8%, 10-year TIPS. In Year 1, the inflation adjustment increases the principal from $980 to $1,010. Sally’s taxable income will include any interest payments received on the TIPS, as well as the $30 increase in principal.
If Sally sells the bond for $1,015 immediately after the principal increase, she will recognize a gain on the sale of $5 (not $35) for income tax purposes.
Series EE bonds must be held for a minimum of __ months, and a 3-month interest penalty is assessed if the bond is redeemed within _ years of issue.
Series EE bonds must be held for a minimum of 12 months, and a 3-month interest penalty is assessed if the bond is redeemed within five years of issue.
True or False: GSEs operate independently of the federal government.
False
Kate owns a municipal bond with a coupon rate of 6%. She is in the 32% federal marginal income tax bracket. Therefore, to achieve the same yield on a taxable corporate bond, the corporate bond must have a coupon rate of at least
When you pay a premium for a bond you may offset said premium against the interest income by?
Amortizing the premium paid over the term of the bond.
This is the case for all bonds except a municipal bond where the amortization is handled differently (because the bond returns tax-free interest). The amortization of the premium must reduce the basis annually but is not a tax-deductible event.
a fundamental concept in the world of bonds that helps investors understand how sensitive a bond’s price is to changes in interest rates.
This curve has a tendency to slope upward and outward, denoting that as the maturity date of bonds lengthens, the corresponding bond yields increase. The increased yields reflect the potential for changes in credit quality and the effect of purchasing power risk over time. If the curve assumes this shape, it is referred to as a normal, or positive, yield curve, indicating that long-term market interest rates are higher than short-term rates.
Sometimes, yield curves may be flat (denoting no difference in the yield of bonds relative to their maturity) or inverted (denoting that current short-term borrowing costs are higher than long-term borrowing costs).
remember that a dividend on a preferred stock, just like common stock, is not guaranteed. It is just preferential, meaning that the dividend will go to the preferred stock holder before the common stockholder. And if dividends are missed, before future dividends can be given to a common stockholder, they must be paid to the preferred stockholder first.
The following image demonstrates that preferred stocks are subject to interest rate risk. Similar to bonds. Even more so, given they do not have a time to maturity.
