Equity and Fixed Income (debt sec/risk bonds/bond sect/yield spread)

Question 1

Explain the purposes of a bond’s indenture and describe affirmative and negative covenants

Answer 1

A bond’s indenture contains the obligations, rights, and any options available to the issuer or buyer of a bond

Cocenants are the specific conditions of the obligation:

• Affirmative covenants specify actions that the borrower/issuer must perform
• Negative covenants prohibit certain actions by the borrower/issuer

Question 2

Describe the basic features of a bond, the various coupon rate structures, and the structure of floating-rate securities

Answer 2

Bonds have the following features:

• Maturity - the term of the loan agreement
• Par value (face value) - the principal amount of the fixed income security that the bond issuer promises to pay the bondholders over the life of the bond
• Coupon rate - the rate used to determine the periodic interest to be paid on the principal amount Interest can be paid annually or semiannually, depending on the terms. Coupon rates may be fixed or variable

Types of coupon rate structures:

• Option free (straight) bonds pay periodic interest and repay the par value at maturity
• Zero-coupon bonds pay no explicit periodic interest and are sold at a discount to par value
• Step-up notes have a coupon rate that increases over time according to a specified schedule
• Deferred-coupon bonds initially make no coupon payments (they are deferred for a period of time). At the end of the deferral period, the accrued (compound) interest is paid, and the bonds then make regular coupon payments until maturity.
• A floating (variable) rate bond has a coupon formula that is based on a reference rate (usually LIBOR) and a quoted margin. A cap is a maximum coupon rate the issuer must pay, and a floor is a minimum coupon rate the bondholder will receive on any coupon date.

Question 3

Define accrued interest, full price, and clean price

Answer 3

Accrued interest is the interest earned since the last coupon payment date and is paid by a bond buyer to a bond seller

Clean price is the quoted price of the bond without accrued interest

Full price refers to the quaoted price plus any accured inter

Question 4

Explain the provisions for redemption and retirement of bonds

Answer 4

Bond retirement (payoff) provisions:

• Amortizing securities make periodic payments that include both interest and principal payments so that the entire principal is paid off with the last payment unles prepayment occurs
• A prepayment option is contained in some amortizing debt and allows the borrower to pay off principal at any time prior to maturity, in whole or in part.
• Sinking fund provisions require that a part of a bond issue be retried at specified dates, typically annually
• Call provisions enable the borrower (issuer) to buy back the bonds from the investors (redeem them) at a call price(s) specified in the bond indenture
• Callable but nonrefundable bonds can be called prior to maturity, but their redemption cannot be funded by the issuance of bonds with a lower coupon rate.

Question 5

Identify common options embedded in a bond issue, explain the importance of embedded options, and identify whether an option benefits the issuer or the bondholder.

Answer 5

Embedded options that benefit the issuer reduce the bond’s value (increase the yield) to a bond purchaser. Examples are:

• Call provisions
• Accelerated sinking fund provisions
• Caps (maximum interest rates) on floating-rate bonds

Embedded options that benefit bondholders increase the bond’s value (decrease the yield) to a bond purchaser. Examples are:

• Coversion options (the option of bondholders to convert their bonds into shares of the bond issuer’s common stock)
• Put options (the options of bondholders to return their bonds to the issuer at a predetermined price).
• Floors (minimum interest rates) on floating-rate bonds.

Question 6

Describe payment methods used by institutional investors in the bond market to finance the purchase of a security (i.e., margin buing and repurchase agreements)

Answer 6

Institutions can finance secondary market bond purchases by margin buying (borrowing some of the purchase price, using the securities as collateral) or, more commonly, by repurchase (repo) arrangement in which an institution sells a security with a promise to buy it back at an agreed-upon higher price at a specified date in the future.

Question 7

Explain the risks associated with investing in bonds

Answer 7

There are many types of risk associated with fixed income securities:

• Interest rate risk* - uncertainty about bond prices due to changes in market interest rates
• Call risk* - the risk that a bond will be called (redeemed) prior to maturity under the terms of the call provision and that the funds must then be reinvested at the then-current (lower) yield
• Prepayment risk* - the uncertainty about the amount of bond principal that will be repaid prior to maturity

Yield curve risk - the risk that changes in the shape of the yield curve will reduce bond values

• Credit risk* - includes the risk of default, the risk of a decrease in bond value due to a ratings downgrade, and the risk that the credit spread for a particular rating will increase
• Liquidity risk* - the risk that the domestic currency value of bond payments in a foreign currency will decrease due to exchange rate changes
• Volatility risk* - the risk that changes in expected interest rate volatitlity will affect the values of bonds with embedded options
• Inflation risk* - the risk that inflation will be higher than expected, eroding the purchasing power fo the cash flows from a fixed income security
• Event risk* - the risk o decrreases in a security’s value from disasters, corporate restructurings, or regulatory changes that negatively affect the firm
• Sovereign risk* - the risk that governments may repudiate debt or not be able to make debt payments in the future

Question 8

Identify the relations among a bond’s coupon rate, the yeild required by the market, and the bond’s price relative to par value (i.e. discount, premium, or equal to par).

Answer 8

When a bond’s coupon rate is less than its market yield, the bond will trade at a discount to its par value

When a bond’s coupon rate is greater than its market yield, the bond will trade at a premium to it’s par value

Question 9

Explain how a bond maturity, coupon, embedded options and yield level affect its interest rate risk

Answer 9

The level of a bond’s interest rate risk (duration) is:

• Positively related to its maturity
• Negatively related to its coupon rate
• Negatively related to its market YTM
• Less over some ranges for bonds with embedded options

Question 10

Identify the relation of the price of a callable bond to the price of an option-free bond and the price of the embedded call option

Answer 10

The price of a callable bond equals the price of an identical option-free bond minus the value of the embedded call.

Question 11

Explain the interest rate risk of a floating-rate security and why its price may differ from par value

Answer 11

Floating-rate bonds have interest rate risk between reset dates, and their prices can differ from their par values, even at reset dates, due to changes in liquidity or in credit risk after they have been issued.

Question 12

Calculate and interpret the duration and dollar duration of a bond

Answer 12

duration = -percentage chance in bond price / yield change in percent

The duration of a bond is th eapproximate percentage price change for a 1% change in yield

dollar duration of a bond is the approximate dollar price change for a 1% change in yield

Question 13

If a bond has a duration of 5 and the yield increases from 7% to 8%, calculate the approximate percentage change in the bond price

Answer 13

-5 * 1% = -5%, or a 5% decrease in price. Because the yield increased, the price decreased

Question 14

A bond has a duration of 7.2. If the yield decreases from 8.3% to 7.9%, calculate the approximate percentage change in the bond price

Answer 14

-7.2 * (-0.4%) = 2.88%. Here the yield decreased and the price increased

Question 15

If a bond’s yield rises from 7% to 8% and its price falls 5%, calculate the duration

Answer 15

duration = -percentage change in price / change in yield = -5.0%/1.0% = 5

Question 16

If a bond’s yield decreases by 0.1% and its price increases by 1.5%, calculate its duration

Answer 16

duration = -percentage change in price / change in yield = -1.5%/-0.1% = 15

Question 17

A bond is curretnly trading at $1,034.50, has a yield of 7.38%, and has a duration of 8.5. If the yield rises to 7.77%, calculate the new price of the bond

Answer 17

The change in yield is 7.77% - 7.38% = 0.39%

The approximate price change is -8.5 * 0.39% = -3.315%

Since the yield increased, the price will decrease by this percentage

The new price is (1-0.0315) * $1,034.50 = $1,000.21

Question 18

Describe yield-curve risk and explain why duration does not account for yield-curve risk

Answer 18

Yield curve risk of a bond portfolio is the risk (in addition to interest rate risk) that the portfolio’s value may decrease due to a non-parallel shift in the yield curve (change in it shape).

When yield curve shifts are not parallel, the duration of a bond portfolio does not capture the true price effects because yields on the various bonds in the portfolio may change by different amounts.

Question 19

Explain the disadvantages of a callable or prepayable security to an investor

Answer 19

Disadvantages to an investor of a callable or prepayable security:

• Timing of cash flows is uncertain
• Principal is most likely to be returned early when interest rates available for reinvestment are low
• Potential price appreciation is less than that of option-free bonds

Question 20

Identify the factors that affect the reinvestment risk of a security and explain why prepayable amortizing securities expose investors to greater reinvestment risk than nonamortizing securities

Answer 20

A security has more reinvestment risk when

• it has a higher coupon
• is callable
• is an amortizing security
• or has a prepayment option

A prepayable amortizing security has greater reinvestment risk because of the probability of accelerated prinicpal payments when interest rates, including reinvestment rates, fall.

Question 21

Describe types of credit risk and the meaning and role of credit ratings

Answer 21

Credit risk includes:

• Default risk- the probability of default
• Downgrade risk - the probability of a reduction in the bond rating
• Credit spread risk - uncertainty about the bond’s yield spread to Treasuries based on its bond rating

yield on a risky bond = yield on a default-free bond + credit spread

Credit ratings are designed to indicate to investors a bond’s relative probability of default. Bonds with the lowest probability of default receive rating of AAA. Bonds rated AA, A, and BBB are also considered investment grade bonds. Speculative or high yield bonds are rated BB or lower.

Question 22

Explain liquidity risk and why it might be important to investors even if they expect to hold a security to the maturity date.

Answer 22

Lack of liquidity can have adverse effects on calculated portfolio values and, therefore, on performance measures for a portfolio. Thi smakes liquidity a concern for a manager even though sale of th ebonds in not anticipated.

Question 23

Describe the exchange rate risk an investor faces when a bond makes payments in a foreign currency

Answer 23

An investor who buys a bond with cash flows denominated in a foreign currency will see the value of the bond decrease if the foreign currency depreciates (the exchange value of the foreign currency declines) relative to the investor’s home currency.

Question 24

Explain inflation risk

Answer 24

If inflation increases unexpectedly, the purchasing power of a bond’s future cash flows is decreased and bond values fall

Question 25

Explain how yield volatility affects the price of a bond with an embedded option and how changes in volatility affect the value of a callable bond and a putable bond

Answer 25

Increases in yield volatility increase the value of put and call options embedded in bonds, decreasing the value of a calable bond (because the bondholder is short the call) and increasing the value of putable bonds (becuase the bondholder is long the put).

value of a callable bond = value of an option-free bond - value of the call

value of a putable bond = value of an option-free bond + value of the put

Question 26

Describe sovereign risk and types of event risk

Answer 26

Event risk encompasses non-financial events that can hurt the value of a bond, including disasters that reduce the issuer’s earnings or diminish asset values; takeovers or restructurings that can have negative effects on the priority of bondholders’ claims; and changes in regulation that can decrease the issuer’s earnings or narrow the market for a particular class of bonds.

Sovereign risk is the possibility that a foreign government will refuse to pay or become unable to repay its debts due to poor economic conditions and government deficit spending.

Question 27

Describe features, credit risk characterisitics, and distribution methods for government securities

Answer 27

Sovereign debt refers to the debt obligations of governments. US Treasury securities are sovereign debt of the US government and are considered free of credit risk. Sovereign debt of other countries has varying degrees of credit risk.

Sovereign debt is typically issued using one of four methods:

• Regular auction cycle with the entire issue sold at a single price
• Regular auction cycle with bonds issued at multiple prices
• Ad hoc auction system with no regular cycle
• Tap system, auctioning new bonds identical to previously issued bonds

Question 28

Describe the types of securities issued by the US Department of Treasury (e.g. bills, notes, bonds, and inflation protection securities), and distinguish between on-the-run and off-the-run Treasury securities.

Answer 28

Securities issued by the US Treasury include:

• Bills - pure discount securities maturing in four weeks, three months, or six months
• Notes - coupon securities maturing in two, five, and ten years
• Bonds - coupon securities maturing in 20 or 30 years

Treasury Inflation Protected Securities (TIPS) and US Treasury issues in which the coupon rate is fixed but the par value is adjusted periodically for inflation, based on changes in the CPI.

US Treasuries from the most recent auction are referred to as on-the-run issues, while Treasuries from previous auctions are referred to as off-the-run issues.

Question 29

Describe how stripped Treasury securities are created and distinguish between coupon strips and principal strips.

Answer 29

Stripped Treasury securities are created by bond dealers who buy Treasury securities, separate each of their scheduled coupon and principal payments, and resell these as zero-coupon securities.

Treasury strips are traded in two forms - coupon strips and principal strips - and are taxed by the IRS on the basis of accrued interest, like other zero-coupon securities

Question 30

Describe the types and characterisitics of securities issued by US federal agencies

Answer 30

Agencies of the US government, including federally related institutions and government-sponsored enterprises, issue bonds that are not obligations of the US Treasury but are considered to be almost default risk free.

Question 31

Describe the types and characterisitics of mortgage-backed securities and explain the cash flow and prepayment risk for each type.

Answer 31

A mortgage passthrough securitiy is backed by a pool of amortizing mortgage loans (the collateral) and has monthly cash flows that include interest payments, scheduled principal payments, and prepayments of principal.

Prepayment risk is significant for investors in passthrough securities because most mortgage loans contain a prepayment option, which allows the issuer (borrower) to make additional principal payments at any time.

Collaterallized mortgage obligations (CMOs) are customized claims to the principal and/or interest payments of mortgage passthrough securities and redistribute the prepayment risk and/or maturity risk of the securities

Question 32

Explain the motivation for creating a collateralized mortgage obligation

Answer 32

CMOs are created to decrease borrowing costs by redistributing prepayment risk or altering the maturity structure to better suit investor preferences

Question 33

Describe the types of securities issued by municipalities in the US and distinguish between tax-backed debt and revenue bonds

Answer 33

Interest payments on state and local government securities (municipal securities, aka munis) are usually exempt from US federal taxes, and from state taxes in teh state of issuance.

Municipal bonds include:

• Tax-backed (general obligation) bonds backed by the taxing authority of the govermental unit issuing the securities
• Revenue bonds, backed only by the revenues from the project specifically financed by the bonds issue

Question 34

Describe the characterisitics and motivation for the various types of debt issued by corporations (including corporate bonds, medium-term notes, structured notes, commercial paper, negotiable CDs, and bankers acceptances).

Answer 34

Corporate debt securities include bonds, medium-term notes, and commercial paper. Bond rating agencies rate corporate bonds on capacity to repay (liquid assets and cash flow), management quality, industry prospects, corporate strategy, financial policies, credit history, overall debt levels, the collateral for the issue, and the nature of the covenants.

Corporate bonds may be secured or unsecured (called debentures). Security can be in the form of real property, financial assets, or personal property/equipment.

Medium-term notes (MTN) are issued periodically by corporations under a shelf registration, sold by agents on a best-efforts basis, and have maturities ranging from 9 months to more than 30 years.

Strucutred notes combine a bond with a derivative to create a security that fills a need for particular institutional investors.

Commercial paper is a short-term corporate financing vehicle and does not require registration with the SEC if its maturity is less than 270 days. CP comes in two forms:

• Directly-placed paper sold directly by the issuer
• Dealer-laced paper sold to investors through agents/brokers

Negotiable CDs are issued in a wide range of maturities by banks, trade in a secondary market, are backed by bank assets, and are termed Eurodollar CDs when denominated in US dollars and issued outside the US.

Bankers’ acceptances are ussed by banks to guarantee a future payment for goods shipped, sold at a discount to the future payment they promise, short-term, and have limited liquidity

Question 35

Define an asset-backed security, describe the role of a special purpose vehicle in an asset-backed security’s transaction, state the motivation for a corporation to issue an asset-backed security, and describe the types of external credit enhancements for asset-backed securities.

Answer 35

Asset-backed securities (ABS) are debt that is supported by the cash flows from an underlying pool of mortgages, auto loans, credit card receivables, commercial loans, or other financial assets.

A special pupose vehicle is an entity to which the assets that back an ABS are legally transferred. If the corporation transferring these assets goes bankrupt, the assets are not subject to claims from its creditors. As a result, the ABS can receive a higher credit rating than the corporation and reduce the corporation’s funding costs.

External credit enhancement for an ABS can receive a higher credit rating than the corporation and reduce the corporation’s funding costs.

External credit enhancement for an ABS can include corporate guarantees, letters of credit, or third-party bond insurance.

Question 36

Describe collateralized debt obligations.

Answer 36

Collateralized debt obligations (CDOs) are backed by an underlying pool of debt securities which may be any one of a number of types: corporate bonds, loans, emerging markets debt, mortagage-backed securities, or other CDOs

Question 37

Describe the mechanisms available for placing bonds in the primary market and distinguish between the primary and secondary markets for bonds.

Answer 37

The primary market in bonds includes underwritten and best-efforts public offerings, as well as private placements.

The secondary market in bonds includes some trading on exchanges, a much larger volume of trading in a dealer market, and electronic trading networks which are an increasingly important part of the secondary market for bonds.

Question 38

Identify the interest rate policy tools available to a central bank.

Answer 38

The Federal Reserve Board’s tools for affecting short-term interest rates are the

• discount rate
• open-market operations
• the reserve requirement
• and persuasion to influence bank’s lending policies

Question 39

Describe a yield curve and the various shares of the yield curve

Answer 39

Yield curves represent the plot of yield against maturity.

The general yield curves shares are upward, or downward sloping, flat, or humped.

Question 40

Explain the basic theories of the term structure of interest rates and describe the implications of each theory for the shape of the yield curve

Answer 40

Theories of the yield curve and their implications for the shape of the yield curve are:

• The pure expectations theory argues that rates at longer maturities depend only on expectations of future short-term rates and is consistent with any yield curve shape
• The liquidity preference theory of the term structure states that longer-term rates reflect investors’ expectations about future short-term rates and an increasing liquidity premium to compensate investors for exposure to greater amounts of interest rate risk at longer maturities. The liquidity preference theory can be consistent with a downward sloping curve if an expected decrease in short-term rates outweighs the liquidity premium
• The market segmentation theory argues that lenders and borrowers have preferred maturity ranges and that the shape of the yield curve is determined by the supply and demand for securities within each maturity range, independent of the yield in other maturity ranges. It is consistent with any yield curve shape and in a somewhat weaker form is known as the preferred habitat theory.

Question 41

Define a spot rate.

Answer 41

Treasury spot rates are the appropriate discount rates for single cash flows (coupon or principal payments) from a US Treasury security, given the time until the payment is to be received.

Question 42

Calculate and compare yield spread measures.

Answer 42

Types of yield spreads:

• The absolute yield spread is the difference between the yield on a particular security or sector and the yield of a reference (benchmark) security or sector, which is often on-the-run Treasury securities of like maturity

absolute yield spread = yield on the higher-yield bond - yield on the lower yield bond

• The relative yield spread is hte absolute yield spread expressed as a percentage of the benchmark yield. This is arguably a superior measure to the absolute spread, since it will reflect changes in the level of interest rates even when the absolute spread remains constant

relative yield spread = absolute yield spread / yield on the benchmark bond

• The yield ratio is the ratio of the yield on a security or sector to the yield on a benchmark security or sector; it is simply one plus the relative yield spread

yield ratio = subject bond yield / benchmark bond yield

Question 43

Consider two bonds, X and Y. Their respective yields are 6.50% and 6.75%. Using bond X as the benchmark bond, compute the absolute yield spread, the relative yield spread, and the yield ratio for these bonds.

Answer 43

absolute yield spread = 6.75% - 6.50% = 0.25% or 25 basis points

relative yield spread = 0.25% / 6.50% = 0.038 = 3.8%

yield ratio = 6.75% / 6.50% = 1.038

Question 44

Describe credit spreads and relationships between credit spreads and economic conditions

Answer 44

A credit spread is the yield difference between two bond issues due to differences in their credit ratings

Credit spreads narrow when the economy is health and expanding, while they increase during contractions/recessions reflecting a flight to (higher) quality investors

Question 45

Describe how embedded options affect yield spreads

Answer 45

Call options and prepayment options increase yield and yield spreads compared to option-free bonds

Put options and conversion options decrease yield and yield spreads compared to comparable option-free bonds

Question 46

Explain how liquidity and issue-size affects the yield spread of a bond relative to other similar securities

Answer 46

Bonds with less liquidity are less desirable and must offer a higher yield. Larger bond issues are more liquid and, other things equal, will have lower yield spreads.

Question 47

Calculate the after-tax yield of a taxable security and the tax-equivalent yield of a tax-exempt security.

Answer 47

To compare tax-exempt bond with a taxable issue, use either of the following:

after tax yield = taxable yield * (1 - marginal tax rate)

taxable-equivalent yield = tax-free yield / (1-marginal tax-rate)

and compare to the taxable yield

Question 48

What is the after-tax yield on a corporate bond with a yield of 10% for an investor with a 40% marginal tax rate?

Answer 48

Investors are concerned with after-tax returns. The marginal tax rate is the percentage that must be paid in taxes on one additional dollar of income, in this case interest income.

For an investor with a marginal tax rate of 40%, 40 cents of every additional dollar of taxable interest income must be paid in taxes. For a taxable bond that yields 10%, the after-tax yield to an investor with a 40% marginal tax rate will be:

10%(1 - 0.4) = 6.0% after tax

Question 49

Consider a municipal bond that offers a yield of 4.5%. If an investor is considering buying a fully taxable Treasury security offering a 6.75% yield, should she buy the Treasury security or the municipal ond, given that her marginal tax rate is 35%

Answer 49

We can approach this problem from two persepectives. First, the taxable equivalent yield on the municipal bond is 4.5%/(1 - 0.35) = 6.92%, which is higher than the taxable yield, so the municipal bond is preferred.

Alternatively, the after-tax return on the taxable bond is 0.0675 * (1 - 0.35) = 4.39%.

Thus, the after-tax return on the municipal bond (4.5%) is greater than the after-tax yield on the taxable bond (4.39%), and the municipal bond is preferred.

Either approach gives the same answer; she should buy the municipal bond.

Question 50

Define LIBOR and explain its importance to funded investors who borrow short term.

Answer 50

LIBOR for various currencies is determined from rates at which large London banks loan money to each other and is the most important reference rate globally for floating-rate debt and short-term lons of various maturities.