Fabozzi - 3 Flashcards
1
Q
The bond market of a country consists of which two main markets?
A
Internal bond market (national bond market) and external bond market (Eurobond market).
2
Q
What are the distinguishing features of Eurobonds?
A
Underwritten by an international syndicate, offered simultaneously in multiple countries, issued outside the jurisdiction of any single country, and in unregistered form.
3
Q
What is sovereign debt?
A
The obligation of a country’s central government.
4
Q
How many ratings are assigned to central government debt and by whom?
A
Two ratings, assigned by Standard & Poor’s and Moody’s.
5
Q
What types of securities does the U.S. Treasury issue?
A
Fixed-principal securities and inflation-indexed securities (TIPS).
6
Q
What are Treasury discount securities called?
A
Bills, with a maturity of one year or less.
7
Q
What is a Treasury note?
A
A coupon-bearing security with an original maturity between two and ten years.
8
Q
What is a Treasury bond?
A
A coupon-bearing security with an original maturity greater than ten years.
9
Q
What are TIPS?
A
Treasury inflation-protection securities, indexed to the Consumer Price Index.
10
Q
What are zero-coupon Treasury instruments created by?
A
Dealers stripping the coupon payments and principal payment of a Treasury coupon security.
11
Q
What are coupon strips and principal strips?
A
Coupon strips are created from the coupon payments, and principal strips are created from the principal payment.
12
Q
What is the main disadvantage of Treasury strips for taxable entities?
A
Accrued interest is taxed each year even though the interest is not received.
13
Q
What are semi-government bonds or government agency bonds?
A
Bonds issued by an agency or organization established by a central government.
14
Q
What are mortgage loans secured by?
A
The collateral of some specified real estate property.
15
Q
What does prepayment refer to in the context of mortgage loans?
A
Any payments in excess of the required monthly mortgage payment.
16
Q
What is prepayment risk?
A
The uncertainty about the cash flows due to prepayments.
17
Q
What are municipal securities?
A
Debt obligations issued by state or local governments, with both tax-exempt and taxable options.
18
Q
What is a prerefunded bond?
A
A municipal bond supported by a portfolio of Treasury securities held in an escrow fund.
19
Q
What does Chapter 7 of the Bankruptcy Reform Act deal with?
A
The liquidation of a company.
20
Q
What does Chapter 11 of the Bankruptcy Reform Act deal with?
A
The reorganization of a company.
21
Q
What are the four C’s of credit in corporate bond analysis?
A
Character, capacity, collateral, and covenants.
22
Q
What is a secured debt issue?
A
A corporate debt issue with some form of collateral pledged to ensure payment.
23
Q
What is a subordinated debenture corporate bond?
A
A type of unsecured debt that ranks after secured debt and other general creditors.
24
Q
What is a negative pledge clause?
A
A clause that prohibits a company from creating or assuming any lien to secure a debt without equally securing the existing debt.
25
What are medium-term notes (MTNs)?
Corporate debt obligations offered on a continuous basis with various maturities.
26
What is the difference between a medium-term note and a corporate bond?
A medium-term note is offered on a continuous basis, while a corporate bond is issued at a specific point in time.
27
What is a structured note?
A medium-term note customized with respect to risk-return characteristics using derivative instruments.
28
What is an asset-backed security?
A security backed by a pool of loans or receivables.
29
What is the role of a special purpose vehicle in asset-backed securities?
It separates the pool of assets from the issuer to protect creditors of the issuer from claiming the assets if the issuer defaults.
30
What is a collateralized debt obligation (CDO)?
A structure backed by a portfolio of fixed income products such as bonds, asset-backed securities, or mortgage-backed securities.
31
What distinguishes an arbitrage transaction from a balance sheet transaction in a CDO?
Arbitrage transactions aim to capture the spread between the yield on the assets and the cost of borrowing, while balance sheet transactions aim to remove assets from the balance sheet for capital relief.
32
What is a bought deal?
A form of bond underwriting where the underwriting firm offers to purchase a specified amount of bonds at a certain coupon rate and maturity.
33
How are private placements classified in the United States?
Rule 144A offerings (underwritten securities) and non-Rule 144A offerings (traditional private placements).
34
What are the two major types of electronic bond trading systems?
Dealer-to-customer systems and exchange systems.
35
What is the difference between single-dealer and multi-dealer systems?
Single-dealer systems involve trading with one dealer, while multi-dealer systems allow customers to choose from several dealers.
36
What is continuous trading in an exchange system?
A trading system that allows trading at continuously changing market prices throughout the day.
37
What is a call auction system in bond trading?
A system where fixed price auctions are held at specific times during the day.
38
Why do rating agencies assign two types of ratings to sovereign debt?
Because the default frequency for local currency debt differs from that of foreign currency debt.
39
What is the difference between a single-price auction and a multiple-price auction?
In a single-price auction, all winning bidders receive the same yield, while in a multiple-price auction, each bidder receives the yield they bid.
40
What is a tap system?
A system where a government issues additional bonds of a previously outstanding issue through an auction.
41
What is a U.S. federal agency debenture?
A security issued by a government-sponsored enterprise without specific collateral backing it.
42
What are the three components of monthly cash flows for a mortgage-backed security?
Net interest, scheduled principal repayments, and prepayments.
43
What is the difference between a mortgage passthrough security and a collateralized mortgage obligation (CMO)?
In a passthrough security, payments are distributed pro rata, while in a CMO, payments follow rules that redistribute prepayment risk among tranches.
44
What is a moral obligation bond?
A municipal bond where a state may appropriate funds to cover the debt if the issuer defaults, though it is not legally obligated to do so.
45
What is an insured municipal bond?
A bond backed by an insurance policy guaranteeing payment of principal and interest if the issuer defaults.
46
What is the absolute priority principle in bankruptcy?
Senior creditors are paid in full before junior creditors receive anything.
47
What is the difference between liquidation and reorganization in bankruptcy?
In liquidation, all assets are sold and the company ceases to exist, while in reorganization, the company restructures and continues operating.
48
What is the recovery rate in the context of corporate bonds?
The percentage of the bond's value that investors recover if the issuer defaults.
49
What is the risk of investing in negotiable certificates of deposit (CDs) issued by U.S. banks?
Credit risk for amounts exceeding the $100,000 federal insurance limit.
50
What is LIBOR?
The London interbank offered rate, the interest rate major banks offer for Eurodollar deposits.
51
What is the advantage of issuing asset-backed securities over traditional corporate bonds?
Asset-backed securities can achieve a higher credit rating and reduce borrowing costs by separating the credit quality of the issuer from the asset pool.
52
What are external credit enhancements for asset-backed securities?
Corporate guarantees, letters of credit, and bond insurance.
53
What is the risk of using external credit enhancements in asset-backed securities?
The structure is exposed to downgrades if the guarantor's credit rating is lowered.
54
What is prepayment in the context of a mortgage loan?
Additional principal paid by the borrower beyond the required monthly payment.
55
What is a curtailment in mortgage payments?
A partial prepayment that reduces the outstanding balance of the loan and shortens its life.
56
What is prepayment risk?
The uncertainty regarding the timing of principal payments due to borrowers making prepayments.
57
Why is a collateralized mortgage obligation (CMO) created?
To redistribute prepayment risk among different tranches of the CMO structure.
58
Which two U.S. government-sponsored enterprises issue mortgage-backed securities?
Fannie Mae and Freddie Mac.
59
What is the difference between a limited and an unlimited general obligation bond?
A limited general obligation bond has a statutory limit on tax rates, while an unlimited general obligation bond is secured by the issuer’s unlimited taxing power.
60
What is a prerefunded bond?
A bond backed by a portfolio of Treasury securities that generates cash flow to meet debt service payments.
61
Why does a properly structured prerefunded municipal bond have no credit risk?
Because it is effectively collateralized by Treasury securities, ensuring timely debt service payments.
62
What is the role of covenants in corporate debt?
Covenants impose restrictions on how a company operates and manages its financial affairs to protect bondholders.
63
What is a subordinated debenture?
A type of unsecured corporate debt that ranks below other secured and unsecured debts.
64
Why is the default rate alone not an adequate measure of corporate bond performance?
Because performance also depends on recovery rates and spreads over Treasury securities.
65
What is the advantage of structured medium-term notes (MTNs)?
They offer customization of coupon rates and risk-return profiles for investors using derivative instruments.
66
What is an index amortizing note (IAN)?
A structured note where principal payments are linked to a reference interest rate, with payments decreasing as interest rates rise.
67
What are the risks associated with an index amortizing note (IAN)?
Reinvestment risk when rates fall and extension risk when rates rise, prolonging the note’s duration.
68
What is the role of a special purpose vehicle (SPV) in asset-backed security structures?
It isolates the pool of assets from the issuer, ensuring that creditors of the issuer cannot claim the assets if the issuer defaults.
69
What is a collateralized debt obligation (CDO)?
A structured financial product backed by a pool of debt securities, managed by an asset manager.
70
What distinguishes an arbitrage CDO from a balance sheet CDO?
Arbitrage CDOs aim to profit from yield spreads, while balance sheet CDOs are used by financial institutions to remove assets from their balance sheets.
71
What is a bought deal in bond underwriting?
When underwriters bid to purchase bonds directly from the issuer for resale in the market, with the issuer given a short time to accept.
72
What are Rule 144A offerings in the U.S.?
Private placements that allow large institutions to trade securities among themselves without registering with the SEC.
73
What is the purpose of a negative pledge clause in corporate bonds?
To protect unsecured creditors by preventing the issuer from creating secured debt without equally securing the existing unsecured debt.
74
What is a mortgage passthrough security?
A security where monthly cash flows from the underlying mortgage pool are passed to certificate holders on a pro-rata basis.
75
What is the difference between a mortgage passthrough security and a collateralized mortgage obligation (CMO)?
A passthrough security distributes payments equally, while a CMO redistributes payments to different tranches based on predefined rules.
76
What is a general obligation bond?
A bond backed by the full taxing power of the issuer, typically a government entity.
77
What is a moral obligation bond?
A municipal bond where the state may appropriate funds to cover the issuer's defaulted debt, but without a legal obligation to do so.
78
What is the absolute priority rule in bankruptcy?
Senior creditors must be paid in full before junior creditors receive any payment.
79
What is the difference between Chapter 7 and Chapter 11 bankruptcy?
Chapter 7 deals with liquidation, where assets are sold off, while Chapter 11 deals with reorganization, where the company is restructured.
80
What is the role of character in the four C’s of credit analysis?
Character refers to the reputation, qualifications, and track record of the management and board in using borrowed funds and repaying debt.
81
What is collateral in the four C’s of credit analysis?
Collateral refers to assets pledged to secure a loan or debt obligation, ensuring repayment.
82
What is capacity in the four C’s of credit analysis?
Capacity refers to the borrower’s ability to repay the debt based on financial performance and resources.
83
What are the two types of municipal bond structures?
Tax-backed debt and revenue bonds.
84
What are tax-backed debt obligations?
Bonds secured by tax revenues, such as general obligation debt or appropriation-backed obligations.
85
What are revenue bonds?
Bonds secured by the revenue generated from the project they finance or from general public-purpose financings.
86
What is an insured municipal bond?
A bond backed by an insurance policy, ensuring payment of principal and interest if the issuer defaults.
87
What is the risk associated with investing in commercial paper?
The risk that the issuing entity will default before the short-term note matures.
88
What is a structured note?
A debt security with a coupon rate or principal repayment linked to a financial derivative, customized for investor preferences.
89
What is a special purpose vehicle (SPV)?
A legal entity created to isolate financial risk, used in asset-backed securities to separate the collateral from the issuer’s balance sheet.
90
What is credit enhancement in asset-backed securities?
Measures taken to improve the credit quality of the securities, either through internal or external support like corporate guarantees or bond insurance.
91
What are the two general types of credit enhancement structures for asset-backed securities?
External (e.g., corporate guarantees, bond insurance) and internal (e.g., overcollateralization, excess spread).
92
What is a medium-term note (MTN)?
A corporate debt instrument offered on a continuous basis with varying maturities, from nine months to 30 years.
93
What is reinvestment risk in structured notes?
The risk that principal is returned to the investor when interest rates are low, limiting the ability to reinvest at higher rates.
94
What is a collateral trust debenture?
A bond secured by financial assets such as receivables, rather than physical property.
95
What is a bankers acceptance?
A short-term debt instrument issued by a company and guaranteed by a bank, commonly used in international trade.
96
What are the risks associated with bankers acceptances?
Credit risk from both the borrower and the accepting bank, and liquidity risk due to a limited secondary market.
97
What is a Treasury inflation-protected security (TIPS)?
A U.S. Treasury security that adjusts its principal and interest payments based on inflation, as measured by the Consumer Price Index (CPI).
98
How are the principal and coupon payments of TIPS adjusted?
The principal is adjusted by the inflation rate, and the coupon payment is calculated on the inflation-adjusted principal.
99
What happens if deflation occurs over the life of a TIPS?
The U.S. Treasury guarantees that the investor will receive at least the initial par value at maturity, even if the inflation-adjusted principal is lower.
100
What is a zero-coupon bond?
A bond that does not pay periodic interest and is issued at a discount, with the full face value paid at maturity.
101
What is the tax disadvantage of zero-coupon Treasury strips for taxable entities?
Investors must pay taxes on the accrued interest each year, even though no interest is received until maturity.
102
What is a collateralized mortgage obligation (CMO)?
A type of mortgage-backed security where the cash flows from the underlying pool of mortgages are divided into tranches with different levels of risk and return.
103
What is the role of tranches in a CMO?
Tranches redistribute prepayment and default risk among different classes of investors.
104
What is a conforming loan?
A mortgage loan that meets the underwriting standards set by government-sponsored enterprises like Fannie Mae or Freddie Mac.
105
What is prepayment risk in mortgage-backed securities?
The risk that borrowers will repay their loans early, affecting the expected cash flows of the security.
106
What is a tap system in bond issuance?
A system where a government issues additional bonds from a previously outstanding bond issue, usually through auction.
107
What is the difference between an on-the-run and off-the-run Treasury security?
On-the-run refers to the most recently issued Treasury securities, while off-the-run refers to older issues that are no longer the most recent.
108
What is a sovereign credit rating?
A credit rating assigned to a country’s debt, typically divided into local currency debt and foreign currency debt ratings.
109
Why do foreign currency-denominated sovereign debts have higher default rates?
Because they are more vulnerable to currency risk and external factors beyond the control of the issuing country.
110
What is a general obligation bond?
A municipal bond backed by the full faith and credit of the issuing government, typically supported by tax revenues.
111
What is the difference between tax-exempt and taxable municipal bonds?
Tax-exempt bonds offer interest payments that are exempt from federal (and sometimes state and local) income taxes, while taxable bonds do not have this tax advantage.
112
What are the two types of bankruptcy proceedings under U.S. law?
Chapter 7 (liquidation) and Chapter 11 (reorganization).
113
What is the principle of absolute priority in bankruptcy?
It mandates that senior creditors must be paid in full before junior creditors receive any payments.
114
What is a recovery rate in the context of bond defaults?
The percentage of the bond's value that is recovered by investors after a default.
115
What is a medium-term note (MTN)?
A debt instrument offered continuously by an issuer with varying maturities, typically ranging from nine months to 30 years.
116
What is the role of a special purpose vehicle (SPV) in asset-backed securities?
It holds the pool of assets separate from the issuing company, ensuring that the assets are protected in the event of the issuer's default.
117
What is a collateralized debt obligation (CDO)?
A structured financial product backed by a pool of debt securities, which are divided into tranches based on risk.
118
What are the two main motivations behind issuing a CDO?
Arbitrage (to capture the spread between asset yields and borrowing costs) and balance sheet relief (to reduce assets and capital requirements for financial institutions).
119
What is a structured note?
A debt instrument with a payout structure linked to an underlying financial index, security, or derivative, offering customized risk-return characteristics for investors.
120
What is a negotiable certificate of deposit (CD)?
A bank-issued time deposit that is traded in secondary markets, typically offering higher yields than standard savings accounts.
121
What is the London Interbank Offered Rate (LIBOR)?
The interest rate at which major international banks lend to one another in the Eurodollar market.
122
What is an asset-backed security (ABS)?
A financial security backed by a pool of loans or receivables, such as auto loans, credit card debt, or mortgages.
123
What is credit enhancement in asset-backed securities?
Techniques used to improve the credit quality of a security, such as overcollateralization or third-party guarantees.
124
What are two forms of external credit enhancement?
Corporate guarantees and bond insurance.
