Fixed Income Flashcards
In using matrix pricing to estimate the required yield spread on a new corporate bond issue, the benchmark rate used is:
the YTM on a government bond with similar time to maturity
A source of
- interim financing for long term projects, until permament financing is found
- funding for working capital and seasonal demand for cash
- Only available to large corporations with high credit ratings
- supported by credit enhancement
Commercial paper
Sinking fund:
Requires that the issuer retire a portion of the ____ through a series of principal payments over the life of the bond
Requires that the issuer retire a portion of the principal through a series of principal payments over the life of the bond
Similar to serial maturity bond structures
US company, issuing a bond in the US, in dollars
Is an example of:
Domestic bond
Japanese company, issuing a bond in the US, in dollars
Is an example of:
Foreign bond
Bond issued internationally, outside the jurisdiction of the country in whose currency the bond is denominated
Eurobonds
Japanese company, issuing a bond in the US, in Yen
- buy and sell orders are initiated from various locations and then matched through a communications network;
- most bonds are traded in this market
OTC/dealer market
Bonds settle how many days after the trade date?
- Corporate bonds: T + 2 or T + 3
- Government bonds: T+1
- unsecured obligations of the national government issuing the bonds;
- not backed by collateral, but by the taxing authority of the national government
sovereign bonds
Bonds with a floating rate of interest that resets periodically based on changes in the level of a reference rate, such as Libor.
Floating rate bonds
Which type of sovereign bond has the lowest interest rate risk for an investor?
Floaters
Because changes in the reference rate reflect changes in market interest rates, price changes of floaters are far less pronounced than those of fixed-rate bonds, such as coupon bonds and discount bonds.
Thus, investors holding floaters are less exposed to interest rate risk than investors holding fixed-rate discount or coupon bonds
Bonds issued by a government sponsored/owned issuer, that typically have higher yields
Quasi government bonds
Agency bonds are issued by:
quasi government
government sponsored/owned
Issued by federal agency: Government national mortgage association (Ginnie Mae)
Issued by government sponsored agencies: Federal national mortgage association (Fannie Mae) & federal home loan mortgage corporation (Freddie Mae)
A sinking fund arrangement is a way to reduce ____ risk, but increases _ risk:
Credit risk
* Sinking funds add an element of security and lowers default risk
* Due to the lower interest rates on the bonds, the company is usually seen as creditworthy, which can lead to positive credit ratings for its debt
* Sinking funds have higher reinvestment risk
the difference between the market value of the underlying collateral and the value of the loan
repo margin
supply & demand conditions of collateral
When the credit quality of the counterparty decreases, the repo margin will:
Increase
If the collateral is in short supply or if there is a high demand for it, repo margins are ?
lower
The market for loans and deposits between banks, for maturities up to one year
interbank money market
- The most recently issued sovereign securities, of a particular maturity
- Are the most active in the secondary market because they are highly liquid
on the run Treasury bonds of a particular maturity
benchmark issue for other bond yields
A form of short-term collateralized borrowing in which a bondholder sells a security and agrees to buy it back at a higher price:
Repurchase agreement
A source of short-term funding for a bondholder
Rate based on the actual rates of repurchase transactions and reported daily by the federal reserve
structured overnight financing rate (SOFR)
Unsecured short-term loans from one bank to another
interbank funds market
issuance of sovereign debt is usually issued in which market?
primary market, by auctions
Do fixed or floating rates have more price variability?
fixed, since the coupon is fixed, the price changes as interest rates change
floating prices are more fixed, because the coupons are adjusting to interest rates
An entire issue is registered with securities regulators but the bonds are sold to the public over a period of time as the issuer needs to raise funds
Shelf registration
Issuer can offer additional bonds to the general public without preparing a new and separate offering
shelf registration;
as a part of auctions in the primary market
The risk of future interest rates being less than the YTM at the time the bond is purchased:
reinvestment risk;
* the investor reinvests the coupons at the market interest rate and the risk is that reinvesting will earn less when putting the coupons into a new investment
* the potential that the investor will be unable to reinvest cash flows at a rate comparable to their current rate of return
* More problematic when the current coupons being reinvested are large
Convexity:
- Demonstrates how the duration of a bond changes as the:
- If a bond’s duration increases as yields increase, the bond is said to have:
- If a bond’s duration rises and yields fall, the bond is said to have:
- Demonstrates how the duration of a bond changes as the interest rate changes
- If a bond’s duration increases as yields increase, the bond is said to have negative convexity
- If a bond’s duration rises and yields fall, the bond is said to have positive convexity
Conevexity effect
When interest rates rise & fall by the same amount:
- Rise: bond price decrease by:
- Fall: bond price increases by:
- interest rates rise = price falls by less (overestimate)
- Interest rates fall= price increase by more
moreconvexity effect (underestimate)
Flat price of a bond=
Flat price (clean) = Full price (dirty) - Accrued interest
Bond dealers most often quote the:
flat (clean) price; to avoid misleading investors about the market price, since the full (dirty) price includes the accrued interest
Z-spread:
- Z-spread is the spread that is added to each:
- Cause the present value of the bond cash flows to equal:
- Z-spread is the spread that is added to each zero-coupon bond spot rate (treasury bond)
- Cause the present value of the bond cash flows to equal:the bond’s price
does not include value of embedded options
Nominal spread:
- The difference between _ & _ , with a similar maturity
- A nominal yield spread is the difference between a Treasury and non-Treasury security with the same maturity
Nominal Spread = Treasury YTM - Corporate bond YTM
- The spread is frequently used in pricing certain types of mortgage-backed securities
- It is the amount that, when added to the yield at one point on the Treasury yield curve represents the discount factor that will make a security’s cash flows equal to its current market price
If the I-spread increases, credit risk:
If the I-spread increases, the credit risk also increases
We can use LIBOR as an example. It shows the difference between a bond’s yield and a benchmark curve
Interpolated spreads (I-spreads) are:
- The difference between:
- The difference between a bond’s yield and the swap rates
We can use LIBOR as an example. It shows the difference between a bond’s yield and a benchmark curve
An obligation of the corporation that issues them, but their interest and principal payments are provided by a pool of assets that are legally recognized as bankruptcy remote:
Covered Bonds
Oftenly used in Europe
- Similar to ABS, but the underlying assets remain on the balance sheet of the issuer
- Thus, no SPE is created
Issued by a special purpose entity to which the underlying assets are sold:
Securitized bonds (i.e., asset-backed securities)
Bonds with multiple maturity dates are issued at the same time
Serial bond issue
Unsecured debt, in the United States is referred to as:
Debentures
Backed by a claim to specific assets of a corporation:
Secured Bonds
Reduces default risk, and thus lowering yield
- Overcollateralization
- Cash reserve fund
- Excess spread account: setting aside amounts to protect against losses
- Tranches
Internal Credit Enhancement methods
Built into the structure of a bond issue
- Surety bonds
- Bank gaurantees
- Letters of credit
External Credit Enhancement methods
90-day LIBOR plus 125 bps
Floating rate note
125 bps in constant (fixed)
For a reference rate note:
For a variable rate note: there is a spread above the reference rate, that fluctuates
A bond initially does not make periodic payments but instead accrues them over a pre-determined period and then pays a lump sum at the end of that period. The bond subsequently makes regular periodic payments until maturity:
Deferred-coupon bonds
Deferred coupon bonds carry coupons, but the initial coupon payments are deferred for some period. The coupon payments accrue, at a compound rate, over the deferral period and are paid as a lump sum at the end of that period. After the initial deferment period has passed, these bonds pay regular coupon interest for the rest of the life of the issue (i.e., until the maturity date)
Has a coupon rate that increases on one or more specified dates during the note’s life:
Step-up note
The Lender is the:
Bondholder
The Borrower is the:
Bond Issuer
What all is included in a bond indenture?
- Obligations of the issuing firm (positive covenants)
- Restrictions of the issuing firm (negative covenants)
- Source of funds for repayment
Not included: the identity of the lender (bondholder) since bonds can be traded throughout their lives
Clause that states that a bond will have the same priority of claims as the issuer’s other senior debt issues:
Pari Passu
Affirmative Covenant
Clause that states that if the issuer defaults on any other debt obligation, they will also be considered in default on this bond:
Cross-default
affirmative covenant
A corporation has borrowed $10 million. It will repay this by making payments of $1.3 million each year for 9 years and a payment of $8 million at the end of the 10th year. This type of bond is referred to as:
Partially amortizing bond
8M at year 10 is the balloon payment
If two banks fund a loan to a corporation, the loan is most accurately described as a:
Syndicated Loan
Loans funded by more than one bank
A bilateral loan involves:
One bank
Bilateral refers to the lender (Bank) and borrower (corporation)
Describe the bid-ask spread for liquid and illiquid issues, in the secondary market:
Narrow spread: highly liquid issues
Wider spread: less liquid issues
Secondary Market: OTC/Dealer Market
Credit quality & liquidity are reflected in:
Yield spreads
Reference rate for a floating rate note should match:
- Currency
- Frequency of coupon resets
90-day yen Libor for a yen-denominated note that resets quarterly.
Corporate issues that can be structured to meet the requirements of investors
Medium term notes
Does not imply anything about the maturity
Issuer agrees to pay the entire amount borrowed in one lump-sum payment at maturity:
Term maturity structure
- Structured securities combine:
- Designed to change the:
- Medium term notes & Derivatives
- Designed to change the risk profile of an underlying debt security, by combining a debt security with a derivative
Creates features designed by an investor
Interest rates used to discount a single cash flow to be received in the future
Spot rates
- YTM on a zero coupon bond
- Gives the yield broken out into components, instead of blended
All of the return from a zero-coupon bond comes from:
Price appreciation
The increase from purchase price to face value at maturity is interest income
The yield spread:
- Is difference of yields in two different bonds with:
- the same maturity
- different credit quality
Usually it is a comparison of a bond to a US treasury (benchmark)
In a CPI interest-indexed bond, how does a CPI increase affect:
- Coupon rate:
- The par value:
- Coupon rate is adjusted for inflation
- The par value remains unchanged
(CPI * PMT)
- “Max acceptable debt usage ratios”
- “Minimium acceptable interest coverage ratios”
- Limit on the level of share buybacks
examples of negative covenants
“What the issuer will do with the proceeds of a bond issue”
Example of affirmative covenants
Typically administrative in nature
The price sensitivity of a bond or portfolio to a change in the interest rate at one specific maturity on the yield curve.
Key rate duration
Used to estimate interest rate risk for non-parallel shifts in the yield curve
Zero coupon bonds have the highest sensitivity to:
Since the only cash flows made is the principal payment at maturity of the bond. Therefore, it has the highest interest rate sensitivity
The duration of a zero-coupon bond is:
equal to its time to maturity
Macaulay, modified, and effective duration are examples of:
analytical duration
Key rate duration:
Used to estimate the price sensitivity & interest rate risk for a:
non-parallel shift in the yield curve
Duration and convexity are most likely to produce more accurate estimates of interest rate risk when the term structure of yield volatility is:
flat
Relationship between time to maturity and yield (YTM) volatility
term structure of yield volatility
What causes an increase in a bond’s yield spread to the benchmark yield curve?
Widening of the spread is caused by:
* credit risk (deteriorating credit quality)
* liquidity issues
When convexity is ____, duration will be less accurate in predicting a bond’s price for a given change in interest rates
higher
Portfolio duration approximates the sensitivity of the value of a bond portfolio to:
Parallel shifts in the yield curve
Describes the yield curve when: yields for all maturities increase or decrease by equal amounts
Parallel shifts of the yield curve
The difference between a bond’s Macaulay duration and the bondholder’s investment horizon
Duration gap
Duration gap= Macaulay duration - Investment horizon
Bond investors with shorter time horizons are more concerned about:
Market price risk
If an investor is planning to sell a bond before maturity, they are more worried about what price they could sell this bond for in the market
Bond investors with long time horizons are more concerned about:
Reinvestment risk
The risk that interest rates are lower than what your bond is yielding, and therefore you’re reinvesting your coupons at lower rates
If Macaulay duration is less than the investment horizon, the bondholder is said to have a negative duration gap and is more exposed to:
Reinvestment risk dominates, over market price risk
The investor is at risk over lower interest rates
If Macaulay duration is greater than the investment horizon, the bondholder is said to have a positive duration gap and is more exposed to:
Market price risk dominates, over reinvestment rate risk
The investor is at risk over higher interest rates
Market price risk increases when:
Interest rates rise
Which decreases the price of the bond
Effective duration:
- Duration measure used for bonds with:
- Used to measure the sensitivity of a ____ to a parallel shift in a flat yield curve
- Duration measure used for bonds with embedded options (future cash flows depend on the path of interest rate changes)
- Used to measure the sensitivity of a bond price to a parallel shift in a flat yield curve
Used to measure the sensitivity of a bond price to a parallel shift in a flat yield curve
refers to the value a bond investor will lose if the issuer defaults
Loss severity (loss given default)
Expected loss=
default risk * loss severity
percentage of a bond’s value an investor will receive if the issuer defaults
recovery rate
Recovery rate=
1- Loss severity (%)
Wider spread = ____ bond prices
lower bond prices
reflects the creditworthiness of the issuer and liquidity of the market for the bonds
The size of the spread
Spread risk is the possibility that a bond’s spread will widen due to:
- downgrade risk
- market liquidity risk
the risk of receiving less than market value when selling a bond, reflected in the bid-ask spread
market liquidity risk
-greater for less creditworthy and smaller issuer bonds
ranks the categories of debt in the event of a default
priority of claims
Yield spread=
liquidity premium + credit spread
Represent a general claim to the issuer’s assets and cash flows; lower priority of claims
unsecured debt
increases default risk, and thus increases yield
Borrower’s ability to repay its debt obligations on time
capacity
Asses the quality of tangible assets and their ability to be sold, especially important for less creditworthy companies
Collateral
Terms and conditions the borrowers and lenders agree to as part of a bond issue
covenants
Refers to management’s integrity and its commitment to repay the loan
character
Trust certificates are ____ bonds
secured
A change of control put option protects lenders by requiring the borrower to buy back its debt in the event of an acquisition, reducing:
reducing credit risk
A limitation on liens limits the amount of secured debt that a borrower can carry, reduces:
reducing credit risk
cash flows from a subsidiary are used to pay the subsidiary’s debt before they may be paid to the parent company to service its debt
Structural subordination
Parent company debt is effectively subordinate (lesser in rank) to the subsidiary’s debt
Structural subordination
Yield volatility is combined with duration to estimate the:
price risk of a bond
The components of credit risk are:
- default probability
- loss severity
Credit risk= probability of default & recovery rate
calculated with the probability of default (estimated from the bond rating) and the estimated recovery value should the bond default
Credit risk
rating reflects the borrower’s overall creditworthiness
An issuer credit
As the credit cycle improves, the credit spread will:
narrow
As economy strengthens and metrics improve, the credit spread will:
narrow;
making corporate bonds a good investment, since their prices increase compared to Treasuries
= real risk free interest rate
+ expected inflation rate
+ maturity premium
+ yield spread (liquidity premium + credit spread)
yield on an option free corporate bond
In times of high demand for bonds, credit spread:
narrows
In periods of high demand, bond prices will increase and yields will decrease
Consequently, yield spreads (the difference in yield between a corporate bond and default-free bond) will tighten (narrow)
covenant protects lenders by limiting the amount of cash that may be paid to equity holders
A restricted payment covenant
net income from operations
+depreciation/amortization
+deferred taxes
+noncash items
Funds from operations (FFO)
When supply of bonds is low, credit spreads will:
narrow
The possibility that the issuer will fail to meet its obligations under the indenture, for which investors demand a premium above the return on a default-risk-free security
Default risk
The type of credit risk most directly reflected in a bond’s rating:
Default risk;
A bond’s rating indicates it’s default risk
Credit risk= probability of default & recovery rate
When estimating the credit risk of a bond, the two main factors include:
bond rating (probability of default) & Recovery rate (of the default)
The risk that a bond will be reclassified as a riskier security by a credit rating agency
Downgrade risk
The risk that the default risk premium on a bond can increase:
Credit spread risk
Those whose cash flows and assets are designated to service the debt of their holding company:
Restricted subsidiaries
Used to calculate duration based on the weighted average time until a bond portfolio’s cash flows are scheduled to be received, by measuring the weighted average of the durations of each bond in the portfolio
Cash flow yield
A bond-equivalent yield for a money market instrument is:
add-on yield on a 365 day year
Option adjusted yield is the yield for a bond with an embedded option, as if:
as if it were option free
what would the yield on a callable bond be, if it did not have a call option?
The difference between the OAS and the Z-spread is the:
the extra yield required to compensate bondholders for the call option
**Option value **
The OAS for a callable bond, compared to the bond’s Z-spread:
OAS < Z- spread
If a zero-coupon bond is not held to maturity:
Capital gains can still be a component of holding period return if the bond’s YTM changed
Modified duration:
- Measures a bond’s:
- A bond’s price given a:
- Measures a bond’s price sensitivity to a change in YTM
- A bond’s price given a 1% chagne in YTM
For every 1% change in yield, a bond price changes by x%
Macaulay Duration:
Calculates the weighted average time before a bondholder would receive:
Calculates the weighted average time before a bondholder would receive the bond’s cash flows
This type of bond will have a coupon rate that moves opposite to any move in the reference rate :
coupon = 12% − (3.0 × 6-month Treasury bill rate)
Inverse floater (leveraged instrument)
Legal corporation used to seperate assets used as collateral from those of the company seeking financing through an ABS:
Special purpose entity (SPE)
Sells the assets used as collateral in an ABS
Credit rating agency assigns different ratings to different debt issues from the same issuer:
notching
For a domestic investor purchasing bonds in a foreign market and currency, the appreciation of both the asset & foreign currency benefits:
The domestic investor
- capacity
- collateral
- covenants
- character
4 C’s of Credit Anlaysis
Method of estimating the required YTM (or price) of bonds that are not currently traded or infrequently traded:
Matrix pricing
G-spreads
- Represents the difference between _ and _ bonds, with the same maturity
- Shows the:
- Shows the difference between Treasury bond yields and corporate bond yields with the same maturity
- Shows the default risk, since treasury bonds have zero default risk
G-spread= YTM corporate bond - YTM treasury bond
The default risk of a Treasury bond is:
0
The G-spread is higher for:
bearing higher credit & liquidity risks, relative to the government bond
The yield spread in basis points over an interpolated government bond:
G-spread
G & I Spreads are only theoretically correct when :
The spot yield curve is flat, so that yields are approximately the same across maturities
However, the spot yield curve is usually upward sloping
The option adjusted spread shows the spread:
with the option effect removed
OAS is the spread to the government spot rate curve that the bond would have if:
The spread if the bond were option free
The option adjusted spread removes the option yield component out of the:
option yield is removed from the **Z-spread **
Option adjusted spread is added to the:
added to the fixed-income security price to make the risk-free bond price the same as the bond.
- The potential for investment losses that can be triggered by a move upward in the prevailing rates for new debt instruments:
- When interest rates increase, the value of a bond in the secondary market will:
- The change in a bond’s price given a change in interest rates is known as its:
- Interest rate risk is the potential for investment losses that can be triggered by a move upward in the prevailing rates for new debt instruments
- If interest rates rise, for instance, the value of a bond or other fixed-income investment in the secondary market will decline
- The change in a bond’s price given a change in interest rates is known as its duration
Interest rate risk has two components from YTM changes:
- Reinvestment risk
- Market price risk
An investor is hedged against interest rate risk if the duration gap:
Duration gap = 0
Time horizon = Macaulay duration
The time horizon at which market price risk and reinvestment risk just offset:
Macaulay Duration
Can a lower- duration bond have more price volatility than the higher-duration bond?
Yes, because shifts in the yield curve may be non-parallel
A nonrecourse loan will have a higher:
Interest rate
Greater risk to the lender = higher interest rate
In the event of default, the lender has a claim only to the collateral of the loan, and if that is not enough, the lender cannot come after the borrower for more money
The convexity of a putable bond is always:
Positive
Convexity of callable bonds is:
Negative
A synthetic collateralized debt obligation is backed by a portfolio of:
Credit default swaps
An estimated price change for a bond given a shift in its benchmark yield curve
Effective duration
An upward-sloping term structure of yield volatility most likely indicates greater volatility in:
A downward-sloping term structure of yield volatility most likely indicates greater volatility in long-term bond YTM, than in short-term bond yields to maturity.
As an issuer’s size increases, the yield spread on a corporate bond will:
Narrow
liquidity risk is affected by the size and credit quality of the issuer, if an issuer’s size is increasing, they are said to have better credit quality and less liquidity risk, narrowing the yield spread
The interest earned from the previous coupon, to the sale date:
Accrued interest
A limitation of calculating a bond’s portfolio as the weighted average of the yield durations of the individual bonds:
Assumes parallel shifts in the yield curve, which is not the reality
When a yield curve is less steeply sloped (flatter) this is more accurate
Revolving credit is usually only available to:
Large corporations with high credit ratings
Similarly to CP
Modified duration is always lower than:
Macaulay duration
The difference between the OAS and the Z-spread is the:
the extra yield required to compensate bondholders for the call option
**Option value **
OAS = Z- spread - option value
A source of short term financing for smaller firms with lower credit ratings:
Nonbank finance companies
Which type of MBS is most likely to feature credit tranching?
CMBS
Subordinated tranches are the first to absorb credit losses:
Credit tranching
Trading bonds on a when-issued basis; bond that have not been issued yet occurs in which market?
Grey market
Forward yield curves are composed for forward rates of:
with the same length, starting at different periods
1y1y; 2y1y
If a specified event occurs, contingent convertible bonds will:
automatically covert to equity
CMOs with agency RMBS are created to reapportion:
Prepayment risk: extension and contraction risk
