FI: Debt Securities

Question 1

Bond Indenture =

Answer 1

contract of rights and obligations of issuer and owner

Question 2

Covenants (negative and affirmative) =

Answer 2

contract provisions

Negative: company can’t: back several debt issues with the same collateral, sell assets pledged as collateral, borrow additional money unless restrictions are met.

Affirmative: include maintenance of certain financial ratios, possibly leading to ‘technical default’ if breached.

Question 3

Straight bond =

Answer 3

regular, non callable, typically semi annual coupon.

ie US tsy, many corporates

Question 4

Zero- coupon =

Answer 4

do not pay periodic interest.

pay par at maturity

initially sold at a discount to par

aka PURE DISCOUNT SECURITIES

Question 5

Step-up notes =

Answer 5

coupon rates that increase over time at a specified rate - increase may take place one or more times

Question 6

Deferred coupon bonds =

Answer 6

initial coupon payments are deferred for some period.

coupon payments accure at a compound rate over the deferral period and are paid as a lump sum

after the initial deferment period these bonds pay coupon interest like a regular bond.

Question 7

Floaters =

Answer 7

coupon interest is based on a specific interest rate or index.

In essence, the coupon rate resets every period (3, 6, 12 months) based on prevailing market interest rates.

normally REFERENCE RATE +/- STATED MARGIN

the stated margin may vary according to the ‘coupon formula’

CAN ALSO HAVE CAPS AND FLOORS ON THE COUPON - BOTH A CAP AND A FLOOR IS CALLED A COLLAR

Question 8

Inverse floater =

Answer 8

coupon rate increases as the reference rate decreases

ie coupon formula, coupon = 12% - ref rate

Question 9

inflation-linked bonds (infl indexed) =

Answer 9

floater based on inflation ie 3% + annual change in CPI

Question 10

Accrued interes, dirty/clean price =

Answer 10

FULL (DIRTY) PRICE = CLEAN PRICE + ACCRUED INTEREST

a bond trading with the right to the next coupon is termed ‘cum coupon’ (this is the case in the US)

if an issuer is in default (and will not pay coupon) the bond is said to trade ‘flat’, without accrued interest.

Question 11

Non amortizing/bullet =

Answer 11

interest paid until maturity and face value paid at maturity

ie coupon tsy, most corps

Question 12

Amortizing security =

Answer 12

makes periodic interest and principal payments over the bond’s life - ie a conventional mortgage

a fully amortizing loan retires the last remaining principal on the final maturity date/payment

Question 13

Prepayment options =

Answer 13

gives the issuer/borrower the right to accelerate the principal repayment on the loan

for mortgages and other amortizing loans

(when a borrower sells the underlying asset they are required to pay the loan off in full)

SIGNIFICANCE: increased uncertainty in the cash flows for the lender of funds.

Question 14

Call provision =

Answer 14

bond holders have no choice but to surrender bonds at the call price - and the bondholder will no longer have to pay interest

allow issuers to replace HIGHER THAN MARKET coupon bonds with LOWER COUPON BONDS.

may have multiple call dates, typically with declining call prices

bondholder may have a period of ‘call protection’ before bonds become callable.

Question 15

‘Non refundable’ vs callable =

Answer 15

a bond may be NON REFUNDABLE but CALLABLE - this means the issuer cannot issue a lower coupon bond in order to pay for the call on the bond (termed a REFUND, as opposed to when a bond is REDEEMED (called without a refund))

Question 16

Sinking fund provisions =

also ‘special redemption’

Answer 16

provide for the repayment of principal through a series of payments over the bonds life via

a) Cash - issuer deposits cash with trustee who retires necessary amount of outstanding bonds (selection method may be lottery, bonds usually retired at par)

or

b) Delivery - issuer may purchase bonds in the market place and deliver them to the trustee to retire.

ACCELERATING SINKING FUND - allows issuer choice of retiring more the the specified sinking fund amount.

the price for redeeming due to sinking fund provisions is called ‘special redemption price’, also used for forced sales (by a regulatory authority) - regualr call prices are referred to as ‘regular redemption price’

Question 17

Embedded option: security owner x3 =

Answer 17

conversion option - ability to convert into a fixed number of common shares. exchange option is similar but for conversion to security other than common stock.

put provision - allows holder to put back to the issuer, typically around par if bonds were originally sold around par

coupon floors

Question 18

Embedded options: Issuer =

Answer 18

Call provisions -

Prepayment options -

Accelerated sinking fund provisions -

Caps

Question 19

Methods of financing security purchase (insto) =

Margin

Repo

Answer 19

Margin Buying - borrow funds from a broker or bank to purchase securities - which are pledged as collateral for the margin loan.

margin amount is regulated by the FED under the SEC act of 1934

Repo - institution sells a security with commitment to repurchase it later at a higher price

could be overnight or term repo (longer than overnight)

repo rate is typically lower what a bank/brokerage would charge on a margin loan.