Fixed Income

Question 1

Bond Indenture

Answer 1

Contract between issuer and bondholder that describes the bond features and issuers obligations

Question 2

Covenants

Answer 2

Provisions of the indenture that protect the bondholder

Negative covenants- restrictions on the issuers operating decisions

Affirmative covenants - actions that the issuer must perform

Question 3

Bond Considerations

Answer 3

Foreign bonds are from foreign issuers, but denominated in the FX of the country where they trade

Eurobonds - issued outside jurisdiction of any single country and denominated in an FX other than the F X of the country it trades in…typically bearer bonds rather than registered bonds

Credit enhancements - internal (overcollateralization, excess spread, tranches) or external (surety bonds, bank guarantees or letters of credit)

Question 4

Taxation Considerations

Answer 4

Interest income = ordinary income

Gains/Losses on sale - taxed at capital gains rate

Amortization of premium or discount is taxed at capital gains rate

Question 5

Secondary markets for bonds

Answer 5

Some bonds trade on exchanges, but most trade on dealer markets

Bid-ask spreads are narrower for liquid issues

Settlements

• 3 days for corporate bonds
• 1 day for government bonds
• Same-day for money market instruments

Question 6

Short-term funding available to banks

Answer 6

Customer deposits - checking, savings, money market funds

Negotiable CDs - can be sold in the wholesale market

Central bank funds market - buying/selling excess reserves deposited with central bank

Interbank - banks make unsecured loans to another for periods up to a year

Question 7

Repurchase agreements

Answer 7

Short-term collateralized borrowing where one party sells a security to another party and agrees to buy it back at a determined price and date in the future

Repo rate = implicit interest

Repo margin (haircut) = amount borrowed and value of the security

Repo rate and margin tend to be directly related to longer repo terms

Repo margin and rate are inversely related to the credit quality of the collateral

Question 8

YTM and Price Relationship

Answer 8

YTM > Coupon = discount

Coupon >YTM = premium

Prices are more sensitive to changes in YTM for bonds with lower coupons and longer maturities

Question 9

Spot rate

Answer 9

Market discount rates for single payments to be made in the future and is used to calculate the no arbitrage price (NAP)

NAP = C PMT/ (1+S) + C PMT/(1+S)^2+ ….