Defining Elements

Question 1

Principal and interest are paid when

Answer 1

• interest is paid periodically

- principal is paid at maturity

Question 2

Three important elements an investor should know when investing in FI securities:

Answer 2

• a bond’s features
• legal, regulatory, and tax considerations
• contingency provisions

Question 3

Supranational organizations

Answer 3

• international organizations

- the World Bank and IMF

Question 4

Sovereign governments

Answer 4

• debt of national governments

- United States, Germany, Italy

Question 5

Non-sovereign goverments

Answer 5

• bonds issued by states, provinces, municipalities

Question 6

Quasi-government entities

Answer 6

• bonds issued by agencies that are financed either directly or indirectly by the government
• aka agency bonds or sub-sovereign
• ie Ginnie Mae, Fannie Mae, and Freddie Mac

Question 7

All bonds are exposed to:

Answer 7

credit risk

Question 8

Credit risk is

Answer 8

• the risk that interest and principal payments will not be made by the issuer as they come due
• the risk of loss resulting from the issuer failing to make full and timely payments of interest

Question 9

The coupon rate of a floating-rate note that makes payments in June and Dec is expressed as six-month L+50 bps. Assuming that the six-month L is 2% at the end of June and 2.5% at the end of Dec, what is the interest rate that applies to the payment due in December?

Answer 9

• If a semi-annual floating rate bond, the interest rate that applies to the December payment is based on the prior period rate (June)
• 2.5% (2% + 50 bps)

Question 10

The two types of yield measures

Answer 10

• current yield

- yield to maturity

Question 11

Current yield

Answer 11

• aka running yield

- current yield = annual coupon $ / current price

Question 12

Yield to maturity (YTM)

Answer 12

• the IRR of return on a bond’s expected cash flows

- compute on the calculator: I/Y

Question 13

Bond Indenture has the following information:

Answer 13

• name of the issuer
• all the terms of a bond issue such as type of bond
• its features such as the principal value, coupon rate, dates when interest payments will be made, and maturity date
• issuer’s obligations
• bondholder’s rights
• if the bond is secured or not
• covenants
• contingency provisions

Question 14

What does the Trustee do for the issuer

Answer 14

• holds the indenture
• admin
• invoices the issuer for interest and principal payments
• holds funds until paid
• calls meetings
• significant role if the issuer defaults

Question 15

A holding company will have _____ than a firm

Answer 15

• a holding company will have a higher credit risk than a firm BC it has no assets

Question 16

Credit enhancements

Answer 16

• provisions used to reduce the credit risk of a bond issue using additional collateral, insurance, or third-party guarantee.
• two types: internal and external credit enhancements

Question 17

Internal credit enhancements

Answer 17

• Senior/junior tranches
  waterfall structure
• over-collateralization: posting more collateral than is required
• excess spread aka excess interest cash flow: excess amount is deposited into a reserve account which is used to absorb losses on assets

Question 18

External credit enhancements

Answer 18

• relies on a third party, guarantor,
• surety bonds/bank guarantees (have 3rd party risk)
• letter of credit (have 3rd party risk)
• cash collateral account (no 3rd party risk)

Question 19

Domestic bonds

Answer 19

• issued and traded in a country and denominated in the currency of that country
• regulated by the authority in that nation (SEC)

Question 20

Foreign bonds

Answer 20

• issued by a foreign company but traded in the domestic market
• regulated by the authority in that nation

Question 21

Eurobonds

Answer 21

• issued internationally, outside the jurisdiction of any single country
• denoted in currency other than that of the countries in which they trade
• subject to less regulation than domestic bonds

Question 22

Bearer Bonds

Answer 22

• the trustee does not maintain a record of who owns the bonds
• most Eurobonds are bearer bonds and bearer bonds are preferred by investors for tax reasons

Question 23

Sinking Fund Arrangements

Answer 23

• allows for full or partial amortization of a bond prior to its maturity
• a portion of the bond’s principal outstanding will be repaid each year throughout the bond’s life
• three sinking fund arrangements: standard, accelerated, call provision
• a sinking fund results in:
  lower credit risk
  higher reinvestment risk

Question 24

Step-up coupons

Answer 24

• coupons increase by specified amounts on specified dates

Question 25

Credit-linked coupons

Answer 25

• coupons change when the issuer’s credit rating changes

Question 26

Index-linked coupons

Answer 26

• principal amount at maturity is fixed, coupon payments change and are linked to a price index

Question 27

Capital-linked bonds

Answer 27

Fixed coupon rate, but principal amount increases in line with increases in the index during bond’s life

Question 28

Callable bonds

Answer 28

• issuer has the right to redeem all or part of the bond before the specified maturity date
• useful to issuer when interest rates drop
• investors face reinvestment risk
• will trade at a lower prices than non-callable bonds (higher yield)

Question 29

Putable bond

Answer 29

• the bondholder has the right to sell the bond back to the issuer at a pre-determined price on specified dates
• offer a lower yield and sell at a higher price relative to non-putable bonds

Question 30

Convertible bonds

Answer 30

• gives the bondholder the right to exchange the bond for a specified number of common shares in the issuing company

Question 31

Parity:

Below parity:

Answer 31

• Parity: conversion value to stock = market value of bond price
• Below parity: conversion value < market value

Question 32

Warrent

Answer 32

• an attached option, not an embedded option

- the right to buy the underlying stock at a fixed price any time before the expiration date