fixed income Flashcards
zero-coupon bond
promises to pay a stipulated principal amount at a future maturity date, but it does not promise to make any interim interest payments. The value of a zero-coupon bond increases overtime, and approaches par value at maturity. The return on the bond is the difference between what the investor pays for the bond at the time of purchase and the principal payment at maturity. The implied interest rate is earned at maturity.
floating-rate security
oupon rate = reference rate + quoted margin.
Examples of reference rates are LIBOR, U.S. Treasury yields.
The quoted margin is the additional amount that the issuer agrees to pay above the reference rate. It is a constant value and can be positive or negative. It is often quoted in basis points.
The coupon rate is determined at the coupon reset date but paid at the next coupon date.
maturity date
is the date when the bond issuer is obligated to pay the outstanding principal amount. It defines the remaining life of the bond.
It defines the time period over which the bondholder can expect to receive interest payments and principal repayment.
It affects the yield on a bond.
It affects the price volatility of the bond resulting from changes in interest rates: the longer the maturity, the greater the price volatility.
Source of Repayment Proceeds
Supranational bonds: repayment of previously loans, or the paid-in capital from members
Sovereign bonds: taxing authority and money creation
Non-sovereign government bonds: general taxing authority of the issuer, project cash flows, and special taxes
Corporate bonds: the issuer’s operating cash flows
Securitized bonds: cash flows from the underlying financial assets
Source of Repayment Proceeds
Supranational bonds: repayment of previously loans, or the paid-in capital from members
Sovereign bonds: taxing authority and money creation
Non-sovereign government bonds: general taxing authority of the issuer, project cash flows, and special taxes
Corporate bonds: the issuer’s operating cash flows
Securitized bonds: cash flows from the underlying financial assets
A special-purpose vehicle/entity (a separate legal entity) can issue bonds collateralized by
assets transferred from its sponsor. If bankruptcy occurs, the sponsor’s creditors cannot go after such assets; this is known as bankruptcy remote.
Covered bonds
debts issued by banks that are fully collateralized by residential or commercial mortgage loans or by loans to public sector institutions.
Internal credit enhancement considerations include:
Tranche structure. The senior tranches get paid first, and the subordinated tranches get paid only if there are enough funds left. The subordinated tranches absorb the credit risk, making the senior tranches less risky.
Overcollateralization. The amount of overcollateralization can be used to absorb losses. If the liability of the structure is $100 million and the collateral’s value is $105 million, then the first $5 million loss will not result in a loss to any of the tranches.
Excess spread. Underlying assets support a higher level of payment than that promised to security holders.
External credit enhancements are
financial guarantees from third parties. Examples include surety bonds, bank guarantees, and letters of credit. If the third-party defaults, the external credit enhancement will fail. A cash collateral account can mitigate this concern.
Affirmative covenants
Paying interest and principal on a timely basis
Paying taxes and other claims when due
Keeping assets in good conditions and in working order
Submitting periodic reports to a trustee so that the trustee can evaluate the issuer’s compliance with the indenture
Negative covenants
Limitations on the borrower’s ability to incur additional debt unless certain tests are met
Limitations on dividend payments and stock repurchases
Limitations on the sale of assets
bond indenture
contract between the issuer and the bondholder specifying the issuer’s legal requirements. It contains the promises of the issuer and the rights of the holder of the bond.
a surety bond is issued by
an insurance company
for external credit enhancement, an investor would most likely pick ___ to counter third party risk
cash collateral ccount
for external credit enhancement, an investor would most likely pick ___ to counter third party risk
cash collateral ccount
covered bond assets remain on the issuer’s consolidated balance sheet because
the security is not transferred to a third party like securitised bonds are
which type of secured bond is issued to take advantage of tax benefits of leasing
equipment trust certificates
collateral trust bonds provide
bondholders a lien on stocks, bonds, other securiites on firm
secured debt
tax exemption for municipal securities applies to
interest income
Bullet bond.
issuer pays the full principal amount at the maturity date.
Amortizing bond
payment schedule requires periodic payment of interest and repayment of principal. If the entire principal is not amortized over the life of the bond, a balloon payment is required at the end of the term.
sinking fund arrangement
allows a bond’s principal outstanding amount to be repaid each year throughout the bond’s life or after a specific date.
call provision
right of the issuer to retire the issue prior to the stated maturity date. When only part of an issue is called, the bond certificates to be called are selected randomly or on a pro rata basis.
cap / floor / collar
A cap is the maximum coupon rate of a floater. It is an attractive feature for the issuer since it limits the coupon rate. A floor is the minimum coupon rate, and it is an attractive feature for the investor. A collar is a floater with both a cap and floor.
inverse floater
coupon rate moves in the opposite direction from the change in the reference rate: coupon rate = K - L x reference rate, where K and L are constant values set forth in the prospectus for the issue. To prevent a negative coupon rate there is a floor imposed.
Step-up coupon bonds
low initial and gradually increasing coupon rates; that is, their coupon rates “step up” over time.
Stepped spread floaters.
The quoted margins for these coupons can step to either a higher or a lower level over the security’s life. For example, a five-year floating-rate note’s coupon rate may be six-month LIBOR + 1% for the first two years, and three-month LIBOR + 3% for the remaining years.
Credit-linked coupon bonds
These coupons change when the issuer’s credit rating changes.
Payment-in-kind coupon bonds
These coupons allow the issuer to pay coupons with additional amounts of the bond issue rather than in cash.
inflation-linked bond
links its coupon payments and/or principal repayments to a price index.
Call protected bond
provision of some bonds that prohibits the issuer from buying it back for a specified period of time
A sinking fund
is a fund containing money set aside or saved to pay off a debt or bond.
when a firm has problem making payments, it shows signs of a potential default
Prepayment risk
the risk involved with the premature return of principal on a fixed-income security
interest expense
principal * rate * time
Credit risk
is most simply defined as the potential that a bank borrower or. counterparty will fail to meet its obligations in accordance with agreed terms.
Reinvestment risk
chance that cash flows received from an investment will earn less when put to use in a new investment.
there is no cash inflow from a project. which bond would you pick?
deferred coupon bonds
equity-linked note (ELN)
equity-linked note (ELN) is an investment product that combines a fixed-income investment with additional potential returns that are tied to the performance of equities.
Convertible Bonds
Suppose you can buy a 10%, 15-year, $100 par value bond today for $110 that can be converted into 10 shares at $10 per share. The market price of stock = $8; no dividends.
The conversion price is the price per share at which a convertible bond can be converted into common stock. In the example above, the conversion price would be $10.
The conversion ratio is the number of common shares each bond can be converted into (in this case, 10). It is the par value / conversion price. It is determined at the time the convertible bond is issued.
The conversion value, also known as parity value, is the market price of stock x conversion ratio ($8 x 10 = $80).
The conversion premium is the difference between the bond’s price and its conversion value ($110 - $80 = $30). Conversion parity occurs when the conversion premium is zero (here, when the stock price is $11 ($11 x 10 = $110)).
Warrants
securities entitling the holder to buy a proportionate amount of stocks at some specified future date at a specified price
interbank money market maturities
overnight - one year
Any member of the public may buy the bonds in a public offering. type:
Underwritten offerings. The function of buying the bonds from the issuer is called the underwriting. An investment bank (called the underwriter) takes the risk of buying the whole issue as firm commitment underwriting. It makes a profit by selling the bonds for more than what it paid for them.
There are six phases: the determination of the funding needs, the selection of the underwriter, the structuring and announcement of the bond offering, pricing, issuance, and closing.
Best effort offerings. The investment bank serves only as a broker to sell the bonds. It agrees to do its best, receives a commission for selling the bonds and incurs less risk associated with selling the bonds.
Shelf registrations. An issuer files the bond registration with regulators before it makes an actual public offering of the issue. The issuer may be able to offer additional bonds to the general public without preparing a new and separate offering circular.
Auctions. The issuer announces the terms of the issue and interested parties submit bids for it. Auctions often yield the most money for the issue. They allow the issuer to sell directly to the public, eliminating the underwriting fee. In major developed bond markets, newly-issued sovereign bonds are most often sold to the public via auction.
Any member of the public may buy the bonds in a public offering. type:
Underwritten offerings. The function of buying the bonds from the issuer is called the underwriting. An investment bank (called the underwriter) takes the risk of buying the whole issue as firm commitment underwriting. It makes a profit by selling the bonds for more than what it paid for them.
There are six phases: the determination of the funding needs, the selection of the underwriter, the structuring and announcement of the bond offering, pricing, issuance, and closing.
Best effort offerings. The investment bank serves only as a broker to sell the bonds. It agrees to do its best, receives a commission for selling the bonds and incurs less risk associated with selling the bonds.
Shelf registrations. An issuer files the bond registration with regulators before it makes an actual public offering of the issue. The issuer may be able to offer additional bonds to the general public without preparing a new and separate offering circular.
Auctions. The issuer announces the terms of the issue and interested parties submit bids for it. Auctions often yield the most money for the issue. They allow the issuer to sell directly to the public, eliminating the underwriting fee. In major developed bond markets, newly-issued sovereign bonds are most often sold to the public via auction.
Private Placement
A private placement bond is a non-underwritten, unregistered corporate bond sold directly to a single investor or a small group of investors. Because the bonds are not registered, SEC regulations require firms to offer such bonds privately only to investors deemed sophisticated: insurance companies, pension funds, banks, and endowments.
Secondary Bond Markets
The secondary market arises after issue, when bonds are sold from one bondholder to another. Its purpose is to provide liquidity - ease or speed in trading a bond at price close to its fair market value. The buying and selling of existing bond issues is done primarily through a network of brokers and dealers who operate through organized exchanges and over-the-counter (OTC) markets. Most bonds are traded in OTC markets.
bond settlement
Corporate bonds typically settle on a T + 3 basis. Government and quasi-government bonds typically settle at T + 1.
bilateral loan is a
loan from a single lender to a single borrower.
A syndicated loan is
a loan from a group of lenders to a single borrower
Medium-term notes (MTN)
corporate debt obligations offered to investors continually over a period of time by an agent of the issuer. The maturities vary from nine months to 30 years. Note that the term “medium-term” is not related to the term to maturity of the securities=
repurchase agreement
sale of a security with a commitment by the seller to buy the same security back from the purchaser at a specified price at a designated future date. It is actually a collateralized loan.
difference between the purchase (repurchase) price and the sale price
dollar interest cost of the loan
reverse repurchase agreement.
From a dealer’s perspective, if it is lending cash
reverse repurchase agreement.
From a dealer’s perspective, if it is lending cash
repurchase rate =
money market yield formula
((new px / old px) - 1) * 360 / number of days
in a repo, any coupon paid by the security during the repurchase agreement belongs to
the borrower
Yield-to-Maturity
interest rate that will make the present value of the cash flows from a bond equal to its price. It is the promised rate of return on a bond if an investor buys and holds the bond to its maturity date.
when is a bond priced at a premium to par value?
A bond is priced at a premium above par value when the coupon rate is greater than the market discount rate. It is priced at a discount below par value when the coupon rate is less than the market discount rate. The amount of any premium or discount is the present value of the “excess” or “deficiency” in the coupon payments relative to the yield-to-maturity.
deferred tax asset
taxes payable exceed report tax expense
deferred tax liability
reported tax expense
exceeds taxes payable.
Variation margin:
Shortfall amount that needs to be
deposited by the next trading day to bring the margin
back up to initial margin for a futures contract, in the
event of a margin call is called variation margin.
Full/dirty price
Flat/clean/quoted price + Accrued interest (AI)
Maturity effect:
The longer the term to maturity, the greater the price volatility.
Coupon effect:
The lower the coupon rate, the greater the price volatility.
