Finance 3 Flashcards
partial call
When callable bonds are called, it can be for the entire issue or for just a part of it. A partial call can
be done on a random basis, like picking numbers out of a hat.
pro rata call
A pro rata call allows all holders to redeem a certain percentage of their holdings while with a random, partial call it could be anyone’s guess as to which bonds will be called by the issuer.
Price based on a Make-Whole Premium
This structure incorporates various formulas that can be structured to develop the price. The
formula is structured to protect the yield the investor had been receiving on his bond.
Price based on Schedule
This call provision bases its price on stated dates with the price decreasing as the bond nears
maturity.
Prepayment
This form of redemption occurs in ABS and MBS securities. In this instance the investor could
receive additional principal payments before the maturity date. For example, a homeowner with a
mortgage payment of $500 a month could pay more than that amount, say $700 a month. This
additional $200 would constitute a prepayment of principal. If this were to happen in the payment of
a bond, the bond would be redeemed before maturity.
Sinking Fund Provisions
This helps redeem and retire bonds. It requires an issuer to retire or pay for the retirement of a
specific portion of the issue at certain times. This helps reduce credit risk by having something in the
“kitty” each year as a protection against a default. It can be structured to retire the entire issue at
its maturity date or only a portion of the balance of the issue. If provision is only for a balance of the
issue, the final payment is paid by a balloon payment.
Which options benefit the issuer?
call options, prepayment, caps
Which options benefit the investor?
put options, floors, conversion privilege
conversion privilege
This allows the bondholders to exchange their current bond with equity in the same firm using convertible bonds. They may also receive equity or fixed income securities in another firm by the use of exchangeable bonds. This benefits the holder because if the equity or other securities of the firm is outperforming the bonds, the bonds can be converted, allowing the holder to realize a higher return.
buying on margin
In this form of financing the buyer borrows funds from a broker/dealer who in turn gets the cash from a bank. The institution is charged an interest rate plus some additional charges for using this method. Regulations T and U, as well as the Securities Act of 1934, limit the degree to which the margin can be extended to the buyer.
repo rate
an implied interest rate, which is the cost that the institution incurs for funding the position. Its benefit is that it is a very cheap way to finance a position because the repo rate tends to be set around the Federal Funds rate.
Repurchase agreements
These are collateralized loans in which the institution sells a security with the commitment to purchase the same security at a later date. The length of time could be as short as overnight or extend all the way to the maturity of the security. The price that is agreed upon is the repurchase price and the institution is charged a repo rate.
interest rate risk (bonds)
Interest rate risk is concerned with a decline in the price of a bond or a portfolio of bonds due to an
increase in market rates. As rates increase, bond prices decline and vice versa.
What does the length of maturity of a bond do to interest rate risk?
The longer the maturity of the bond, the more sensitive it is to interest rate movements. The reason for this effect is that more cash flows will be affected over a longer period of time.
What effect would low coupon rates have on interest rate risk?
Lower coupon rates are more sensitive to interest rates. Why? If your bond is
paying 4% and rates are in an upward swing, the difference in the market yield and your yield
will continue to widen, which will push your bond values down.
If interest rates decline, do call options become more valuable to the issuing company?
As interest rates decline the value of the option becomes more valuable to the issuing company. The price will increase as rates decline but will be held at the call or redemption price. This is because as rates decline it will become more likely that the issuer will call the bonds and that the holder will only receive the call price and not a true market price. Likewise, when rates rise the price will not drop as much because the option will maintain some sort of value when compared to a bond with no options.
How are market yield volatility and interest rate risk related?
As market yield volatility increases, the interest rate risk increases. This is because there is a
greater chance of rates breaking out of their current ranges, either by rising or declining. Typically,
as rates increase there is a greater chance of this risk occurring because market prices of bonds will
decline as interest rates rise.
What are three disadvantages of investing in bonds that are callable or prepayable?
difficult to develop and forecast cash flows; reinvestment risk; price compression
What is price compression?
When rates decline there is a greater chance that the issuer will call the bonds. This compresses or holds the bond at its call price while bonds without this option will continue to increase in market value as rates continue to decrease.
What is reinvestment risk?
As rates decrease and bond are called or prepaid,
investors will not be able to invest their proceeds at the old rates and will have to use new, lower
market rates to put their cash to work.
What’s the reinvestment risk on zero-coupon bonds?
Zero coupon bonds have no reinvestment risk because there are no coupon payments made to the investor. Because of the lower coupon rate, however, zeros expose the investor to a higher interest rate risk.
yield curve risk
The yield curve risk is how your portfolio will react with different exposures based on how the yield curve shifts. Because any measure of interest-rate risk assumes an equal amount of basis point moves on the yield curve, anything will be an approximation of how an investor’s portfolio will react. The risk involved here is the degree to which this approximation will not match of the actual yield curve movement.
default risk
Default risk is the risk that the issuer will go belly up and not be able to pay its obligations of interest and principle. To help measure this risk, an investor can look at default rates. A default rate is the percentage of a population of bonds that are expected to default. Another ratio that an investor can look at is the recovery rate. This rate indicates how much and investor can expect to get back if a default occurs.
credit spread risk
This second type of credit risk deals with how the spread of an issue over the treasury curve will react. For example, Ford five-year bonds may trade at 50 basis points above the current five-year treasury. If the five-year bond is trading at 3.5%, then the Ford bonds are trading at a yield of 4%. If this spread of 50 bps widens out compared to other bond issues, it would mean that the Ford bonds are not performing as well as the other bonds in the marketplace. Spreads tend to widen in poor performing economies.
