Fixed Income

Question 1

Money-market securities vs. Capital-market securities

Answer 1

original maturity <1 year vs. original maturity >1 year

Question 2

Bond price and the yield to maturity are inversely related.

Answer 2

**

Question 3

A bond that is selling for more than its par value is trading at a premium.

Answer 3

A bond that is selling for less than its par value is trading at a discount.

Question 4

Coupon rate

Answer 4

annual percentage of par value that will be paid to bondholders.

Question 5

Negative covenants = restrictions on asset sales, and restrictions on additional borrowing

• serve to protect the interests of bondholders and prevent the issuing firm from taking actions that would increase the risk of default.

Answer 5

Positive Covenants == to make timely interest and principal payments, maintain assets and comply with the laws.

Question 6

Specific Purpose Entities in US

Answer 6

= Specific Purpose Vehicles in Europe

• Both of these entities issue securitized bonds. Often, SPE can use bonds at lower interest rate than bonds issued by the originating corporation. This is because the assets supporting the loans are owned by the SPE and are used to make payments to holders of the securitized bonds even if the company itself runs into financial trouble.

Question 7

Unsecured bonds represent a claim to the overall assets and cash flows to the issuer.

Answer 7

Secured bonds are backed by a claim to specific assets of a corporation.

Question 8

Unsecured bonds represent a claim to the overall assets and cash flows to the issuer.

Answer 8

Secured bonds are backed by a claim to specific assets of a corporation, which reduces the risk of default, and consequently, the yield that investors require on the bonds.

• most popular type of securitized bonds = mortgage backed security

Question 9

A call option gives the issuer the right to redeem all or part of a bond issue at a specific price, if they choose.

Answer 9

*The issuer will only choose to exercise the call option when it is to their advantage; they can reduce the interest expense by calling the bond and issuing new bonds at a lower yield.

Question 10

A put option gives the bondholder the right to sell the bond back to the issuing company at a pre-specified price, typically par.

Answer 10

• The bondholder is likely to exercise a put option when the fair value of the bond is less than the put price because interest rates have risen or the credit quality of the issue has fallen.
• put option bonds will sell at a higher price compared to an otherwise identical option-free bond, as it has more value to the bondholder.

Question 11

Convertible bonds give bondholders the ability to exchange the bond for a specific number of shares of the issuing corporation’s common stock.

Answer 11

• The owner of a convertible bond had downside protection of a bond, but the yield is reduced, and the upside opportunity of equity shares.

Question 12

Conversion price

Answer 12

the price per share at which the bond (at its par value) may be converted to common stock

Question 13

Conversion Ratio

Answer 13

Equal to the par value of the bond, divided by the conversion price.
*ex. If a bond with an $1,000 par value has a conversion price of $40 per share, its conversion ratio is 1,000/40 = 25 shares per bond.

Question 14

Conversion Value

Answer 14

The market value of the shares that would be received upon conversion.

• a bond with a conversion ratio of 25 shares when the current market price of a common share is $50, would have a conversion value of (25*50) = $1,250

Question 15

Warrants give their holders the right to buy the firm’s common shares at a given price over a given period of time.

Answer 15

• can be dealt with a straight bond when the bond is issued.

Question 16

Yield to Maturity

Answer 16

The market discount rate appropriate for discounting a bonds value

Question 17

For bonds, when using the CF settings on your calculator,…

Answer 17

PV < 0, PMT & FV > 0

Question 18

When bond yields decrease, the PV of bonds payments, its market value, increases.

Answer 18

• A zero-coupon bond is the PV of the maturity payment.

Question 19

Relationships between price and yields for bonds

Answer 19

1. A decrease in bond YTM will increase its price
2. If coupon rate > YTM, the price will be at a premium to YTM. If coupon rate < YTM, the price will be at a discount to YTM.
3. The price-yield relationship is convex, meaning as the bond gets closer to maturity, the spread between yield and price approach zero.
4. The price of a bond with a lower coupon rate is more sensitive to a change in yield.
5. The price of a bond with longer maturity is more sensitive to a change in the yield.

Question 20

Spot rates are the market discount rates for a single payment to be received in the future.

Answer 20

= [CPN1/(1+S1)] + [CPN2/(1+S2)^2] + … + [(CPNn + FVn)/ (1+Sn)^n]

Also equals the no arbitrage price of a bond.

Question 21

Current Yield

Answer 21

annual cash coupon payment / bond price

Question 22

Forward Rates

Answer 22

Yields for future periods.

*i.e. the rate of interest on a 1-year loan that would be made two years from now.

Question 23

Forward yield curve shows the future rates for bonds or money market securities for the same maturities for annual period in the future.

Answer 23

1y1y is the rate for a 1-year loan, 1 year from now.
2y1y is the rate for a 1-year loan, 2 years from now.
3y2y is the rate for a 2-year loan, 3 years from now

Question 24

Relationship between forward rates and spot rates

Answer 24

What it is saying is, that borrowing for three years at the 3-year spot rate, or borrowing for one year periods in three successive years, should have the same cost.

Question 25

(1+S2)^2 = (1+S1)*(1 + 1y1y)
(1+S3)^3 = (1+S1)* (1+1y1y)* (1+ 2y1y)

Answer 25

Spot rates to forward rates, and back again.

*Keep in mind that simple averages give good approximations for calculating forward prices .

Question 26

Yield spread it the difference between two sets of bonds over a specified period of time.*

Answer 26

.

Question 27

Zero-volatility spread, or Z-spread

Answer 27

When we find an amount which, when added to the benchmark spot rates, produces a value equal to the market price of the bond, we have the appropriate yield curve spread.

Question 28

Option adjusted spread is used for bonds with embedded options.The OAS takes the option yield component out of the z-spread measure; the OAS is the spread to the gov’t spot rate curve that the bond would have if it were option-free.

Answer 28

Option Value = Z-spread - OAS
OAS = Z-spread - option value

• If we calculate an OAS for a callable bond, it will be less than the Z-spread.

Question 29

Securitization is the process by which financial assets are purchased by an entity that then issues securities supported by CFs from those financial assets.

Answer 29

**

Question 30

Commercial Mortgage Backed Securities are back by income-producing real estate.

Answer 30

• Residential MBS loans are repaid by homeowners
• Commercial MBS loans are repaid by real estate investors, who in turn, rely on tenants and customers to provide the cash flow to repay the mortgage loans.

Question 31

CMBS is a non-recourse loan – meaning the lender can only look to the collateral as a means to repay a delinquent loan if the cash flows from the property are insufficient.

Answer 31

The analysis of CMBS securities focuses on the credit risk of the property and not the credit risk of the borrower.

Question 32

Debt-to-service coverage ratio

Answer 32

= net operating income / debt service

Question 33

Loan-to-Value Ratio

Answer 33

current mortgage amount / current appraised value

Question 34

Collateralized debt obligations are structured securities backed by a pool of debt obligation that is managed by a collateral manager.

Answer 34

• Collateralized Bond Obligations – backed by corporate and emerging market debt.
• Collateralized loan obligations (CLO) – backed by leveraged back loans
• Structured finance CDOs backed by residential or commercial MBS, ABS or other CLOs.
• Synthetic CDOs backed by credit default swaps on structured securities.

Question 35

Three sources of return in bonds:

Answer 35

1. ) Coupon and principal payments
2. ) Interest earned on coupon payments that are reinvested over the investor’s holding period
3. ) Any capital gain or loss if the bond is sold prior to maturity.

Question 36

For a short investment horizon:

market price risk > Reinvestment Risk

Answer 36

For a long-term investment horizon:

market price risk < Reinvestment risk

Question 37

Macaulay Duration

Answer 37

The weighted average of the number of years until each of the bond’s promised cash flows is to be paid, where the weights are the PV of Cash Flows as a percentage of the bond’s full value.