Fixed Income (13%) Flashcards
Yield-to-Maturity (YTM)
Definition: The internal rate of return (IRR) on the bond if held until maturity, assuming all payments are made as scheduled.
Calculation: Solving for 𝑟
r in the present value equation of the bond’s cash flows.
Yield Curves
Definition: A graph showing the YTM of bonds with the same credit quality but different maturities.
Purpose: Helps investors understand the relationship between bond yields and maturities, and assess the risk and return profile of the bonds.
Par Value
The amount of principal on a bond, also known as face value.
asset-backed securities (ABS)
A type of bond issued by a legal entity called a special purpose entity created solely to own assets such as loans, receivables, and mortgages and to distribute cash flows to ABS investors. Generally, ABS backed by mortgages are known as mortgage-backed securities (MBS) while ABS refer to non-mortgage ABS.
Tenor
The remaining time to maturity for a bond or derivative contract. Also called term to maturity.
Perpetual Bonds
Bonds with no stated maturity date.
floating-rate notes
Notes on which interest payments are not fixed but instead vary from period to period depending on the current level of a reference interest rate. Also known as floaters.
market reference rate
A market-determined interest rate used as the underlying in financial instruments and contracts such as variable-rate debt and interest rate swaps. An example is the Secured Overnight Financing Rate (SOFR), which is an overnight cash borrowing rate collateralized by US Treasuries. Other MRRs include the euro short-term rate (€STR) and the Sterling Overnight Index Average (SONIA).
credit spread
The compensation for the risk of default in a debt security, typically measured by the yield-to-maturity difference between a bond and a comparable government benchmark security.
zero-coupon bonds
Bonds that do not pay interest during their life. They are issued at a discount to par value and redeemed at par. Also called pure discount bond.
Junior debt, or subordinated debt
A class of unsecured debt that ranks below a firm’s senior unsecured obligations.
contingency provision
Clause in a legal document that allows for some action if a specific event or circumstance occurs.
embedded options
Contingency provisions found in a bond’s indenture representing rights that enable their holders to take advantage of interest rate movements. They can be exercised by the issuer, by the bondholder, or automatically depending on the course of interest rates.
Current Yield
The sum of the coupon payments received over the year divided by the flat price. Also called the income, interest yield, or running yield.
Calculate the coupon payment on a 2.5% coupon bond with GBP100,000 par value and a semiannual payment frequency.
The correct answer is GBP1,250.
Bond indenture
A written contract between a lender and borrower that specifies the terms of the loan, such as interest rate, interest payment schedule, or maturity.
Affirmative Covenants
These require the issuer to take certain actions, such as:
Using proceeds for specified purposes.
Providing regular financial statements.
Maintaining insurance on assets.
Ensuring new debt is treated pari passu (on equal footing) with existing debt.
Negative Covenants
These restrict the issuer from taking specific actions that could harm bondholders, such as:
Limiting additional debt issuance.
Restricting dividend payments and share buybacks.
Prohibiting certain asset sales or leasebacks.
Restricting mergers and acquisitions unless conditions are met.
Sources of Repayment:
Sovereign Bonds
National governments can use taxation or currency issuance.
Sources of Repayment:
Municipal Bonds
Local governments may use taxes or revenue from projects like toll roads.
Sources of Repayment:
Corporate Bonds
Issuers use operating cash flows, and sometimes secure bonds with assets.
Sources of Repayment:
Asset-Backed Securities (ABS)
Repayment comes from cash flows of pooled loans or receivables.
bullet bond
A bond whose principal repayment is made entirely at maturity.
amortizing debt
A loan or bond with a payment schedule that calls for periodic payments of interest and repayments of principal.
fully amortizing loan
A loan or bond with a payment schedule that calls for the complete repayment of principal over the instrument’s time to maturity.
balloon payment
A large payment required at maturity to retire a bond’s outstanding principal amount.
partially-amortizing bond
A loan or bond with a payment schedule that calls for the complete repayment of principal over the instrument’s time to maturity.
mortgage-backed securities
Debt obligations that represent claims to the cash flows from pools of mortgage loans, most commonly on residential property.
sinking funds
Provisions that reduce the credit risk of a bond issue by requiring the issuer to retire a portion of the bond’s principal outstanding each year.
waterfall structures
These represent the distribution order for cash flows and risk to different tranches in a financing structure.
Variable Interest Debt
FRN coupon = MRR + Credit spread.
Leveraged Loans
Loans made to a borrower or issuer with relatively lower credit quality and/or higher leverage.
Credit-Linked Notes
Bonds whose coupon changes when the bonds’ credit rating changes.
Payment-In-Kind
A bond feature whereby coupon payments can be fully or partially paid in the form of additional issuance or added to the principal amount.
Index-linked bonds
A bond whose coupon payments or principal repayment is linked to a specified index.
inflation-linked bonds
A type of index-linked bond that offer investors protection against inflation by linking the bonds’ coupon payments and/or the principal repayment to an index of consumer prices. Also called linkers.
Treasury Inflation-Protected Securities (TIPS)
US Treasury bonds with a principal that is adjusted for changes in the Consumer Price Index. TIPS are issued in 5-, 10-, and 30-year maturities.
Deferred coupon bonds
Bonds that pay no coupons for their first few years but then pay a higher coupon than they otherwise normally would for the remainder of their life. Also called split coupon bonds.
Compared to a bullet bond, an otherwise identical amortizing bond would most likely have:
A. lower credit risk.
B. lower reinvestment risk.
C. lower near-term cash flows.
A is correct. Compared to a bullet bond, an otherwise identical amortizing bond would have early principal repayments each period instead of all principal paid at maturity, lowering exposure to the issuers credit risk. However, larger periodic payments increase reinvestment risk.
Callable Bonds
A bond containing an embedded call option that gives the issuer the right to buy the bond back from the investor at specified prices on predetermined dates.
Fixed Price Calls
A contingency provision that grants an issuer the right to buy back a bond at a predetermined price in the future.
Call Protection Period
The time during which the issuer of a callable bond is not allowed to exercise the call option.
Call Period
The time during which the issuer of a callable bond can exercise the call option.
Call Price
The price at which the issuer of a callable bond has the right to purchase the bond from investors.
Call Risk
The uncertain maturity and limited price appreciation associated with callable bonds.
A convertible bond will closely track its conversion value if the issuer’s share price is:
A. below the conversion price.
B. equal to the conversion price.
C. above the conversion price.
C is correct. In general, a convertible bond’s price will vary with that of the issuer’s shares. If the issuer’s share price far exceeds the conversion price, the bond’s price will more closely track its conversion value.
domestic bonds
A type of bond for which the issuer’s domicile and jurisdiction of issuance are the same.
foreign bonds
A type of bond for which the issuer’s domicile and jurisdiction of issuance are different.
Eurobonds
A type of bond issued internationally, outside the jurisdiction of the country in whose currency the bond is denominated.
bearer bonds
Bonds for which ownership is not recorded; only the clearing system knows who the bond owner is.
foreign bonds
A type of bond for which the issuer’s domicile and jurisdiction of issuance are different.
registered bonds
Bonds for which ownership is recorded by either name or serial number.
Identify the following statement as true or false: A bond’s coupon payment is most likely to be taxed as ordinary income.
True. Bond interest is usually taxed at the ordinary income tax rate, which is typically the same tax rate that an individual would pay on wage or salary income.
reopening
Issuing bonds by increasing the size of an existing bond issue with a price significantly different from par.
Uncommitted Lines of Credit
Sources of bank credit that a bank can refuse to honor. Uncommitted credit lines are made up to a certain principal amount for a pre-determined maximum maturity, charging a market reference rate plus an issuer-specific spread on only the principal outstanding for the period of use.
Committed Lines of Credit
Bank commitments to extend credit; the commitment is considered a short-term liability and is usually in effect for 364 days (one day short of a full year).
Factoring Arrangement
When a company sells its accounts receivable to a lender (known as a factor) that assumes responsibility for the credit-granting and collection process.
repurchase agreement
A form of collateralized loan involving the sale of a security with a simultaneous agreement by the seller to buy back the same security from the purchaser at an agreed-on price and future date. The party who sells the security at the inception of the repurchase agreement and buys it back at maturity is borrowing money from the other party, and the security sold and subsequently repurchased represents the collateral.
repurchase agreement:
repurchase price
The price at which the party who sold the security at the inception of the repurchase agreement buys back the security from the cash lending counterparty.
repurchase agreement:
repurchase date
The date when the party who sold the security at the inception of a repurchase agreement buys back the security from the cash lending counterparty.
repurchase agreement:
repurchase rate
The interest rate on a repurchase agreement.
master repurchase agreement
A legal document governing all repo trades between two parties.
external debt
Sovereign debt owed to foreign creditors.
single price auction
A debt securities auction in which all bidders pay the same price.
multiple price auction
A debt securities auction in which bidders receive distinct prices based on their bids.
on the run securities
The most recently issued and liquid sovereign debt securities.
General obligation bonds
Also known as GO bonds. Bonds issued by non-sovereign governments for general purposes and repaid from tax cash flows.
Revenue Bonds
Bonds issued by non-sovereign governments related to a government sponsored project expected to generate future cash flow as a primary source of repayment.
Trade Settlement Date
The date when the buyer and seller transfer consideration and securities.
Coupon Effect
The size of bond coupon cash flows affects how much a bond’s price will change for a given yield change for bonds of the same maturity. The lower a bond’s coupon, the higher the proportion of total cash flow that occurs at maturity.
Maturity Effect
The time-to-maturity of a bond also affects a bond’s price/yield relationship. Generally, all else equal, a longer-term bond has a greater percentage price change than a shorter-term bond when the market discount rates change by the same amount.
Convexity Effect
The percentage change in a bond’s price will also vary depending on how the yield changes. The percentage price increase is greater, in absolute value, than the percentage price decrease.
Matrix Pricing
An estimation process for financial instruments based on the prices of comparable instruments.
Process of Matrix Pricing:
Identify Comparable Bonds: Find bonds that are actively traded and have similar characteristics to the bond being priced.
Obtain Yields: Determine the yields to maturity for these comparable bonds.
Interpolate Yields: Use the yields of the comparable bonds to estimate the yield for the bond being priced. This can involve linear interpolation if the bond’s maturity is between the maturities of the comparable bonds.
Calculate the Price: Use the estimated yield to calculate the price of the bond using present value formulas for the bond’s cash flows.
periodicity
Number of periods in a year, used for compound interest. The periodicity of a fixed-income instrument usually matches the frequency of its coupon payments.
G-Spread
Yield spread in basis points between a bond’s yield-to-maturity and that of an actual or interpolated government bond. It represents the return for bearing risks relative to the government bond.
I-Spread
Also known as interpolated spread, it is the yield spread for a bond over the standard swap rate in that currency of the same tenor.
Z-Spread
Z-spread (or zero-volatility spread) is a constant yield spread for a bond over a government or swap curve.
Macaulay duration
The present-value weighted average time to receipt of cash flows for fixed-income instrument, also the holding period needed to balance coupon reinvestment risk and price risk for a one-time instantaneous “parallel” shift in the yield curve once the bond purchase is settled. It is named after Frederick Macaulay, the Canadian economist who introduced the concept in 1938.
duration gap
The difference between a bond’s Macaulay duration and its investor’s investment horizon.
Modified Duration
The first derivative of a bond’s price with respect to its yield, this statistic is a measure of interest rate risk used to estimate the percentage price change for a given change in yield-to-maturity.
Effective Duration
The sensitivity of the bond’s price to an instantaneous parallel shift in a benchmark yield curve—for example, the government par curve.
Bond Convexity
In finance, bond convexity is a measure of the non-linear relationship of bond prices to changes in interest rates, and is defined as the second derivative of the price of the bond with respect to interest rates. In general, the higher the duration, the more sensitive the bond price is to the change in interest rates.
