Fixed Income Flashcards
A series of interest payments in fixed amounts and to repay the principal amount at maturity, is more commonly known as…?
A bond
What is the relationship between bond yields and underlying prices?
They have an inverse relationship
What are the five specific features of a bond?
Currency in which payments will be made. Coupon rate and frequency. The par value (principal value to be repaid). The maturity date of the bond. The issuer of the bond.
Who typically issue bonds?
Corporations Sovereign national governments Non-sovereign governments Quasi-government entities Supranational entities
What is the difference between the maturity date and the term/tenor of a bond?
Maturity date of a bond is the date on which the principal is to be repaid
Term to maturity or tenor of a bond: time remaining until maturity
Principal amount that will be repaid at maturity, is called the…
Par value
Bonds with no maturity date. Require perpetual interest repayments but no principal payment, are known as…?
Perpetual bonds
What is the difference between a money market and a capital market security?
Money market securities: Bonds with initial maturities of < 1 year
Capital market securities: Bonds with initial maturities of > 1 year
A bond that makes coupon interest payments in one currency and the principal repayment at maturity in another currency, is called a…?
Dual currency bond
A bond that gives bondholders a choice of which of two currencies they would like to receive their payments in, is called a…?
Currency option bond
What is a bond that is trading at a premium?
A bond that is selling for more than its par value is said to be trading at a premium to par
A bond whose periodic payments are all equal is said to have what sort of structure?
Amortising structure
How do fixed income securities define short term, medium term and long term?
Short term = < 5 years
Medium term = 5-12 years
Long term = > 12 years
What is a company that exhibits a “top-heavy” debt structure?
Most of the companies debt is made up of secured bank debt
The legal contract agreed between the bondholder and the issuer, is called a…?
Bond indenture
What is a negative covenant?
Prohibitions on the borrower
What is an affirmative covenant?
Actions the borrower promises to perform
What are some examples of affirmative covenants?
make timely interest and principal payments to bondholders,
to insure and maintain assets, and
to comply with applicable laws and regulations.
What is the difference between domestic and foreign bonds?
Domestic bonds: Bonds issued by a firm domiciled in country A and also traded in that country A’s currency
Foreign bonds: Bonds issued by a firm incorporated in a foreign country that trade on the national bond market of another country in that country’s currency
A bond market that contains both domestic and foreign bonds, is known as what sort of market?
A national bond market
What are yankee bonds, eurobonds and global bonds?
Yankee bonds: bonds issued by non-US entities that trade in the US and are denominated in US dollars
Eurobonds are issued outside the jurisdiction of any one country and denominated in a currency different from the currency of the countries in which they are sold
Global Bonds: Eurobonds that also trade in a domestic market
What is the difference between unsecured and secured bonds?
Unsecured Bonds: Holder has a claim to all of the issuers total assets
Secured Bonds: Holder has a claim to specific assets the issuer has pledged as collateral
Why does a company form an SPV?
A parent company creates an SPV to isolate or securitise assets in a separate company that is often kept off the balance sheet
What are covered bonds?
Covered bonds Similar to ABS’ but remain on the balance sheet of the issuing corporation (i.e., no SPE is created)
What is a balloon payment?
Balloon payment: The final interest payment and principal payment combined
What is a fully amortising bond?
Fully amortising: the principal is fully paid off when the last periodic payment is made. Equal payments made at each period.
A fund containing money set aside or saved to pay off a debt or bond is called a…?
A sinking fund
A bond whose coupon rate increases as time increases according to a predetermined schedule, is better known as a…?
Step up bond
A type of bond that pays interest in additional bonds rather than in cash during the initial period is called a?
PIK bond
A bond where coupons kick in in a future period after issue, is known as a…?
Deferred coupon bond
Bonds that issuers can redeem prior to maturity, are known as a…?
Callable bonds
Initial periods where the bond cannot be recalled are known as…?
Call protection
The value to recall an option is known as what kind of provision?
Make whole provision
How do S&P and Fitch define investment grade bonds?
For S&P and Fitch, the highest bond ratings are AAA, AA, A, and BBB, and are considered investment grade bonds.
How do Moodys define investment grade bonds?
The equivalent ratings by Moody’s are Aaa through Baa3.
How do the ratings agencies define high-yield bonds?
Bonds BB+ or lower (Ba1 or lower) are high-yield
What is the interbank money market?
The market where banks unsecured lend between one another
What does LIBOR stand for?
London Inter Bank Offer Rate
Describe the four mechanisms for issuing bonds in the primary markets?
Public offering
Shelf registration
Private placement
Underwritten offerings
The unofficial market for financial securities is called…?
The grey market
What is a best efforts offering?
Banks do there best effort, do not buy up entire issue, sell what they can on a commission basis
Where does the majority of secondary bond trading happen?
OTC
What does the bid ask spread depend on?
The issuers liquidity
How long does trade settlement take for corporate bonds?
T+2 or T+3
How long does trade settlement take for govt bonds?
T+1
How long does trade settlement take for MM securities?
Same day
Debt issued by the government is called?
Sovereign debt
How are sovereign bonds usually offered to new investors
Via an auction
Bonds that are part of the most recent issue are called?
On the run bonds
Governments that aren’t national governments, are known as?
Nonsovereign governments
Why do non-sovereigns raise debt?
To fund local services and infrastructure such as hospitals, airports and other municipal services
What are quasi-government / agency bonds?
Issued by government-sponsored entities such as Fannie Mae
What is the difference between a bilateral loan and a syndicated loan?
Bilateral loans are funds provided to a borrower by one lender.
Syndicated loans: a form of loan in which two or more lenders jointly provide loans for one or more borrowers on the same loan terms and with different duties and sign the same loan agreement
What sort of companies is commercial paper a good option for?
Good quality businesses with very good creditworthiness
Is commercial paper a short term or long term funding option?
Commercial paper is always short term, with repayment within 9 months
Explain the rollover risk associated with commercial paper?
Rollover risk: risk associated with the refinancing of debt.
What is the difference between a term maturity structure and a serial bond issue?
Term maturity structure: Entire bond issue matures on the same date
Serial bond issue: Bond issue matures on multiple different maturity dates
An arrangement by which one party sells a security to a counterparty with a commitment to buy it back at a later date at a specified (higher) price is called a?
Repo agreement
What is a reverse repo agreement?
Opposite of repurchase agreement, dealer acts as lender
What is a repo rate?
The interest rate implied by the two prices is called the repo rate, which is the annualized percentage difference between the two prices.
What is a repo margin?
The % difference between the initial sale price and the value of the bond
What are the risks associated with taking on a repurchase agreement?
Both sides have counterparty risk
Security may decline in value
Security lender may experience financial distress
What is credit risk?
The failure of a borrower to pay off interest or principal balances.
What are the 2 components of credit risk?
Default risk and loss severity
What is recovery rate and its relationship with expected loss?
recovery rate is the percentage of a bond’s value an investor will receive if the issuer defaults
EL = 1 – RR
What is yield spread?
The difference in yield between a bond with no credit risk and one with credit risk
What is the relationship between bond prices and spreads?
Greater spread equals greater risk and therefore lower bond price
The risk of receiving less than market value for a bond, is known as…?
Market liquidity risk
The possibility that spreads will increase because the issuer has become less creditworthy, is called?
Credit migration risk
Do investors look for higher or lower yields when there is high credit risk involved in an investment?
Higher yield
Is priority of claims always strictly followed in a bankruptcy proceeding?
Not always as there is a risk as time goes on that the firm will lose employees due to loss of customers, reputation etc sometimes a different outcome may be negotiated to avoid long delays and increased bankruptcy costs
Which type of debt is likely to have the same credit rating as the issuer?
Unsecured debt
What do credit ratings rate exactly?
Rating agencies rate both the issuer (i.e., the company issuing the bonds) and the debt issues, or the bonds themselves
What is the difference between corporate family ratings (CFRs) and corporate credit ratings (CCRs)?
CFRs rate the issuer(ie the company), CCRs rate the issue (the debt)
What is a cross default provision?
If a corporation defaults on one line of bonds it may end up defaulting on all of its issues as part of the bond indenture
What is notching?
Notching: When a rating of a certain issue is higher or lower than the rating of the issuer
What are the 4 risks on relying on ratings agencies?
Credit ratings may change over time, be upgraded or downgraded
Ratings agencies are not perfect they make mistakes
Event risk is difficult to foresee, issuer default, economic crisis
Credit ratings lag market prices
What are the four Cs of credit?
Capacity to repay
Character of management
Collateral
Covenants
What are porters five forces?
Substitutes Suppliers Customers New entrants Competitors
What are the two types of covenants?
Affirmative covenants
Negative covenants
What sort of character do lenders look at when they lend to management teams?
Track record, qualification capabilities
Prior treatment of bondholders
Accounting and tax policies
Record of fraud
What is the formula for yield spread?
Yield Spread = Liquidity premium + credit spread
Which 5 factors affect yield spread?
Credit cycle Economic conditions Market performance Broker dealer capital Supply of new issues
What at are 6 sources of liquidity, that are critical for high yield issuers?
Cash Working cap Operating cash flow Bank credit Equity issued Sale of assets
What is the issue for bondholder if sovereign debt defaults?
Bond holders have very little power to make sovereign issuers pay outstanding debts!
What are the two types of municipal bonds?
General obligation
Revenue bond
What do we use to discount coupon payments in a bond value calculation?
YTM
Outline the relationship between the YTM and a bond value?
When bond yields increase, the present value of a bond’s payments, its market value, decreases and vice versa
Price increases from a decrease in yield are larger than a price decrease from an increase in yield, is the concept of…?
Convexity
Are bonds with longer maturities are more sensitive to changes in YTM?
Yes
Is the price of a bond with a lower coupon rate more sensitive to a change in yield than is the price of a bond with a higher coupon rate?
Yes
Discount rate for a single payment which is due to be made in the future, are called?
Spot rates
What is the difference between the flat price and full price of a bond?
Clean price: Price at the date of last coupon
Dirty price: Price at the date bond is acquired, makes up the delta between the clean price and the accrued interest
What is the formula for the full price?
( Full\ Price = Price\ at\ last\ coupon\ payment * (1+ YTM/m)^\frac{time\ since\ last\ coupon}{time\ between\ coupons} )
What is the formula for the accrued interest?
( Accrued\ interest = Coupon * \frac{time\ since\ last\ coupon}{time\ between\ coupons} )
What is the formula for the flat price?
( Flat\ price = Full\ price - Accrued\ interest )
Do bond dealers usually quote the flat price or the full price?
Flat price
What is the name of the method of estimating the YTM of bonds that are illiquid?
Matrix pricing
What is the formula for the current yield?
( Current\ yield = \frac{annual\ coupon}{flat\ price} )
What is the formula for the simple yield?
( Simple\ yield = \frac{annual\ coupon \pm amortisation}{flat\ price} )
How do you calculate yield to first par call?
Calculate YTM with N = second call date
How do you calculate yield to first call?
Calculate YTM with N = first call date
How do you calculate yield to worst call?
Calculate YTM at lowest yield to call date
How do you calculate the option-adjusted yield?
Add the value of the call option to the bond’s current flat price
What is the formula for the BEY?
( BEY = \frac{(FV-P_0)}{P_0}*\frac{365}{t} )
What does the yield curve show the relationship between?
yields and maturity
What does a forward rate of 1y2y mean?
Borrow money for 2 years, 1 year from now
What is the general form of the forward rate formula?
( Forward\ rate\ formula = (\frac{(1+S_1)^{n_1}}{(1+S_2)^{n_2}})^\frac{1}{n_1 - n_2} - 1 )
What is the yield spread on a fixed income security?
The difference in yield between a risky security and a risk free security (ie government bond)
What is the G-spread?
The yield spread between a corporate bond and a government bond with the same maturity
What is an I-spread?
The yield spread over or under the standard swap rate in that currency of the same tenor.
What is the Z-spread?
The constant yield spread over the benchmark spot curve such that the present value of the cash flows matches the price of the bond.
Financial assets, purchased by an SPV that then issues securities supported by the cash flows from those financial assets, desribes what sort of process…?
The process of securitisation
What are the primary benefits of securitisation?
a reduction in funding costs sellers
an increase in the liquidity of the underlying financial assets
Offers investors exposure to new asset classes
Provides diversification benefits compared to investing in individual loans
An organisation that collects principal and interest payments, sends out delinquency notices, is known as a …?
Servicer
Who are the four different parties in a securitisation process?
- Issuer
- SPV
- Investor
- Servicer
Explain the waterfall structure in a securitisation process?
Each tranche is paid sequentially from the underlying loan portfolio.
What types of securities typically back ABS’?
Automobile loans, credit card receivables, home equity loans, manufactured housing loans, student loans
What is the benefit to a company of setting up the ABS’ through an SPV?
An SPV is a separate legal entity therefore investors have no legal claim to the assets of the parent company
Is it possible for ABS’ from the SPV to have a higher credit rating than bond issued by the seller?
Yes
Are total cash flows to the investors in a new ABS issue, more or less than the total interest and principal payments from the underlying asset pool?
Less as fees need to be paid to the servicer as well as to the investors
What is credit tranching?
Tranche B and C bonds are subordinated to tranche A bonds ie senior, mezzanine, junior
What is time tranching?
The first (sequential) tranche receives all principal repayments from the underlying assets up to the principal value of the tranche. The second tranche would then receive all principal repayments from the underlying assets until the principal value of this tranche is paid off
What is a residential mortgage loan?
A loan with a residential property pledged as collateral
What is LTV?
% of loan value divided by market value of property
What is the difference between agency RMBS and nonagency RMBS?
Agency RMBS are issued by government agencies whereas nonagency RMBS are issued by private entities and individuals
What has greater credit risk agency RMBS or non-agency RMBS?
Nonagency RMBS therefore they need greater credit enhancement
What is the weighted average maturity?
Maturities weighted based on the outstanding principal of mortgages in the pool
What is the weighted average coupon?
Interest rates weighted by outstanding principal of mortgages in the pool
What are a few examples of external credit enhancement?
Corporate guarantee by seller
Bank letter of credit
Bond insurance
What are some examples of internal credit enhancements?
Reserve funds
Overcollateralisation
Senior/subordinated structure
What are the two types of prepayment for a traditional mortgage product?
The borrower increasing the amount/frequency of payments above the required amount; or
The borrower refinances the loan
The risk of the premature return of principal on a fixed-income security, meaning the investor loses out on future interest paid on the principal, is known as…?
Prepayment risk
The risk that interest rates decline. Homeowners will then refinance at the available lower interest rates and prepayment of mortgages will be higher than the lender / bank expected, is known as…?
Contraction risk
The risk that when interest rates rise, prepayment of the mortgage will be lower than the bank / lender expected, is known as…?
Extension risk
What are the differences between RMBS’ and CMBS’?
Residential MBS loans are repaid by homeowners
Commercial MBS loans are repaid by real estate investors
What is the formula for the debt to service coverage ratio?
( Debt\ to\ service\ coverage\ ratio = \frac{net\ operating\ income}{debt\ service} )
What are the means of creating loan-level call protection?
Prepayment lockout
Defeasance
Prepayment penalty points
Yield maintenance charges
What are some properties of auto loan ABS?
Backed by loans for automobiles.
Maturities from 36 to 72 months.
Issuers include banks, credit unions, finance companies
Auto loans prepay if the cars are sold, traded in, or repossessed
What is a CDO?
A CDO is a structured security issued by an SPE for which the collateral is a pool of debt obligations.
What is the collateral for a CLO?
Leveraged bank loans
What is the collateral for a structured finance CDO?
Structured finance CDOs are those where the collateral is ABS, RMBS, other CDOs, and CMBS.
What is the collateral for a synthetic CDO?
Synthetic CDOs are those where the collateral is a portfolio of credit default swaps
What are the three sources of returns for fixed income bonds?
Coupon and principal payments.
Interest earned on coupon payments that are reinvested over the investor’s holding period for the bond.
Any capital gain or loss if the bond is sold prior to matur
What is fixed income risk?
Fixed Income Risk: risk arising from uncertainty about future interest rates and the knock on impact on cash flow.
In the short term what is a greater risk market price risk or reinvestment risk?
Market price risk as there isn’t much time for reinvestment gains to compound
In the long term what is a greater risk market price risk or reinvestment risk?
Reinvestment risk
What is macaluay duration?
Duration is a measure of a bond’s interest rate risk or sensitivity of a bond’s full price to a change in its yield
The approximate % change in price for a 1% change in yield, is known as…?
Modified Duration
What is the formula for modified duration?
( Modified\ Duration = \frac{Macaulay\ Duration}{1+ \frac{YTM}{n}} )
What is the formula for the approximate percentage change in bond price?
( -\Delta YTM \times Modified\ Duration)
What is the formula for approximate modified duration?
( \frac{Price\ with\ lower\ YTM - Price\ with\ higher\ YTM}{2 \times initial\ price \times \Delta YTM} )
When do we use effective duration?
Used for bonds with embedded options
How does an increase in maturity impact interest rate risk?
Increases interest rate risk
How does an increase in coupon rate impact impact IR risk?
Decreases interest rate risk
How does an increase in YTM impact interest rate risk?
Increases interest rate risk
What are the 2 methods to calculate portfolio duration?
You can either calculate weighted average number of periods until portfolio cash flows are due to be earned, or calculate the weighted average of bonds durations
What is the formula for money duration?
Money duration = Modified annual duration * full price
What is the impact of increased convexity on duration?
The greater the convexity the greater the adjustment on the duration approximation that is required
What is the formula for a change in bond price given modified duration and annual convexity?
( - Annual\ modified\ duration \times YTM + \frac{1}{2} \times annual\ convexity \times YTM^2 )
What is the formula for the duration gap?
Duration gap = Macaulay duration - investment horizon
