Fixed Income

Question 1

tenor

Answer 1

The tenor of a bond refers to time remaining until maturity

Question 2

Money market securities

Answer 2

Money market securities are bonds with original maturities that are less than or equal to 1 year

Question 3

Capital market securities

Answer 3

Bonds with original maturities that are greater than 1 year

Question 4

Supranational entities

Answer 4

Global organizations (i.e. World Bank, IMF etc)

Question 5

Quasi-government entities

Answer 5

Quasi-government entities are created to benefit the public in some way. These private-operating companies (e.g. Sallie Mae) are presented with a government-chartered mission and, in exchange for their services, usually receive some form of partial funding from the state.

Question 6

Non-sovereign governments

Answer 6

Issued by government entities that are not national governments, such as the state of California or the city of Toronto.

Question 7

plain vanilla or conventional bond

Answer 7

A bond with a fixed coupon rate

Question 8

Zero-coupon or pure discount bonds

Answer 8

Bonds that pay no interest prior to maturity (hence zero coupon). The ‘pure discount’ refers to the fact that these bonds are sold at a discount to their par value and the interest is all paid at maturity when the bondholder receives par value

Question 9

dual-currency bonds

Answer 9

Dual currency makes coupon interest payments in 1 currency and principal repayment at maturity in another currency

Question 10

currency option bond

Answer 10

A currency option bond gives bondholders a choice of which of two currencies they would like to receive their payments in (for both interest and principal)

Question 11

Bond indenture

Answer 11

A bond indenture is a legal contract between the issuer and bondholder. The indenture defines the obligations of and restrictions on the borrower and forms the basis for all future transactions between the bondholder and the issuer.

Contains:

• legal ID of bond issuer and its legal form (company, subsidiary etc.)
• affirmative/negative covenants
• Any assets (collateral) pledged to support repayment of the bond.
• Any additional features that increase the probability of repayment (credit enhancements).

Question 12

Covenants

Answer 12

Covenants are provisions in bond indentures and there are negative and affirmative covenants

Question 13

Negative covenants

Answer 13

Negative covenants serve to protect the interests of bondholders and prevent the issuing firm from taking actions that would increase the risk of default. They include restrictions such on asset sales (i.e. company can’t sell an asset it pledged as collateral) or can’t borrow more money unless certain conditions have been met . Basically, negative covenants specify what the issuing firm will not do. Think of a negative covenant as a promise not to do something.

Question 14

Affirmative covenants

Answer 14

Affirmative covenants don’t typically restrict the operating decisions of the issuer. Common affirmative covenants are to make timely interest and principal payments to bondholders, to insure and maintain assets, and to comply with applicable laws and regulations. Basically, affirmative covenants specify what the issuing firm will promise to do

Question 15

Eurobonds

Answer 15

Eurobonds are issued in one country’s currency and sold in a different country. E.g. let’s say an Australian company issues a Eurobond denominated in USD and sells it to Japan. The Australian company could issue the Eurobond in any country except for the US

Most Eurobonds aren’t typically registered; they’re bearer bonds

Question 16

YTM

Answer 16

Yield to maturity, simply put, is an estimate of the bond’s expected return if held until maturity

Inverse relationship between the bond price and YTM (b/c of amortization) higher price, lower YTM lower price, higher YTM

Question 17

domestic bond

Answer 17

Bonds issued by a firm domiciled in a country and also traded in that country’s currency are referred to as domestic bonds.

Question 18

foreign bond

Answer 18

A foreign bond is a bond issued in a domestic market by a foreign entity in the domestic market’s currency as a means of raising capital. E.g. A samurai bond is a corporate bond issued in Japan by a non-Japanese company. A Matilda bond is a bond issued in the Australian market by a non-Australian company.

Question 19

debenture

Answer 19

unsecured bonds (no collateral)

Question 20

collateral trust bond

Answer 20

a bond that’s backed by financial assets (such as stocks or bonds)

Question 21

equipment trade certificate

Answer 21

Equipment trust certificates are debt securities backed by equipment such as railroad cars and oil drilling rigs. They’re typically used to engineer a lease

• An equipment trust certificate refers to a debt instrument that allows a company to take possession of and enjoy the use of an asset while paying for it over time.
• Investors supply capital by buying certificates, allowing a trust to be set up to purchase assets that are then leased to companies.
• After the debt is satisfied, the asset’s title is transferred to the company.
• ETCs are commonly used by airlines for the purchase of aircraft.

Question 22

Mortgage-backed securities (MBS)

Answer 22

The underlying assets are a pool of mortgages, and the interest and principal payments from the mortgages are used to pay the interest and principal on the MBS.

Question 23

Covered bonds

Answer 23

Covered bonds are debt securities that are backed by segregated pool of assets that aren’t transferred to the special purpose entity. If those assets become non-performing (fails to generate income), they must be replaced by other assets -> in short, the bonds will be covered

Question 24

Credit enhancements

Answer 24

Credit enhancements are meant to reduce credit risk. You can have internal credit enhancement, which means that the credit enhancement is built into the structure of the bond issue or you can have external credit enhancement, which is credit enhancement provided by the 3rd party

Question 25

Internal credit enhancements

Answer 25

1. Overcollateralization 2. Credit tranching 3. Cash reserve fund 4. Excess spread account

Question 26

Overcollateralization

Answer 26

Overcollateralization is a form of internal credit enhancement. In short, this is when the value of the collateral pledged is more than you need

Question 27

Credit tranching

Answer 27

Credit tranching is a form of internal credit enhancement. This entails dividing up the bond issues into different tranches (French - levels) based on seniority (aka priority of claims).

Question 28

Cash reserve fund

Answer 28

Cash reserve fund is a form of internal credit enhancement. It’s a deposit of cash that can be used to absorb losses

Question 29

excess spread account

Answer 29

Excess spread is the surplus income from bonds. It’s the difference between the interest received by the security-issuer on the mortgages sold and the interest paid to the security holders (e.g. 8% in, 6.5% paid out to holders)

Question 30

external credit enhancements

Answer 30

1. Bank guarantees 2. surety bonds 3. Letter of credit

Question 31

Bank guarantees

Answer 31

Bank guarantees are guarantees from the bank that any outstanding debt will be paid off even if the issuer defaults

Question 32

Surety bonds

Answer 32

Surety bonds are issued by insurance companies and play the same role that bank guarantees do (guarantee payment of any outstanding debt in the event that the issuer fails to make payments)

Question 33

Letter of credit

Answer 33

A letter of credit is a promise to lend money to the issuing entity if it does not have enough cash to make the promised payments on the covered debt.

Question 34

Tax considerations

Answer 34

1. Interest - typically taxed as ordinary income (unless it’s tax-exempt)
2. Capital gains/losses - long-term vs short-term
3. Discount bonds - Discount is amortized over the life of the bond and treated as implied interest (opposite effect for premium bonds)

Question 35

Bullet Bond

Answer 35

A bullet bond is a debt instrument whose entire principal value is paid at once on maturity date, as opposed to amortizing the bond over its lifetime. They can’t be redeemed early by the issuer, so they’re non-callable. Majority of corporate and gov bonds are bullet bonds.

Question 36

Fully amortized bond

Answer 36

A fully amortized bond is one in which the principal value on the debt is paid down regularly along w/the interest expense over the life of the bond. Most auto loans and home loans are fully amortizing loans

Question 37

Partially amortized bond

Answer 37

It’s midway between a bullet bond and a fully amortized bond. You’re paying down a certain amount of the principal down over the life of the bond, but there needs to be some balloon payment at maturity

Question 38

Sinking Fund Provision (or Arrangement)

Answer 38

Specifies the portion (e.g. 5%) of the bonds outstanding principal amount that must be repaid each year throughout the bond’s life

Question 39

Floating rate notes

Answer 39

Floating rate notes are bonds that have variable interest rate. A floating rate note promises to pay the reference rate (market rate of interest i.e. LIBOR) + spread (margin, denoted in bps)

Question 40

Inverse floater

Answer 40

An inverse floater is a type of floating rate note.

If reference rate goes down, coupon rate increases

If reference rate goes up, coupon rate decreases

Question 41

cap and floor (for floating rate notes)

Answer 41

Floating rate notes usually have cap and floor.

A cap is a limit on how high a coupon rate can rise

A floor places a minimum on the coupon rate

Question 42

Step-up coupons

Answer 42

• Coupon increases by a specified amount at specified dates

Question 43

Credit-linked coupon bonds

Answer 43

Coupon changes with the issuer’s credit rating:

• Coupon rate goes up by a certain amount if credit rating goes down
• Coupon rate goes down by a certain amount if credit rating improves

Offers bondholder protection against credit downgrade of the issuer

Question 44

Payment in kind (PIK) bond

Answer 44

• Deferred payment, accrued interest on interest
• Interest paid with more amounts of the bond

Question 45

Deferred coupon bond

Answer 45

Regular coupon payments don’t begin immediately; they’re deferred until some time after the bond issuance. These are issued by firms that anticipate cash flows will increase in the future to allow them to make coupon interest payments.

Common in project financing (delay payments until project is complete)

Question 46

Index-linked bond

Answer 46

Index-linked bonds have coupon payments and/or principal value that’s linked to some index (e.g. inflation-linked bonds tied to CPI)

Inflation adjustment can be made to either coupon payments or principal

Question 47

Index annuity bonds

Answer 47

Index-annuity bonds is a form of index-linked bonds. It’s a fully amortizing bond w/periodic payments directly adjusted for inflation or deflation

Question 48

Indexed zero-coupon bonds

Answer 48

The payment at maturity is adjusted for inflation. In other words, inflation adjustment via the principal only

Question 49

Interest-indexed bonds

Answer 49

The coupon rate is adjusted for inflation while the principal value remains unchanged

Question 50

Capital indexed bonds

Answer 50

Fixed coupon rate + index-linked principal.

In other words, the principal is adjusted for inflation (or deflation). If the principal amount has been readjusted, then you have to recalculate the coupon payments by multiplying the new principal amount by the fixed coupon rate

E.g. consider a bond with a par value of $1,000 at issuance, a 3% annual coupon rate paid semiannually, and a provision that the principal value will be adjusted for inflation (or deflation). If six months after issuance the reported inflation has been 1% over the period, the principal value of the bonds is increased by 1% from $1,000 to $1,010, and the six-month coupon of 1.5% is calculated as 1.5% of the new (adjusted) principal value of $1,010 (i.e., 1,010 × 1.5% = $15.15).

Question 51

Contingency provision

Answer 51

A contingency provision in a contract describes an action that may be taken if an event (the contingency) actually occurs. In bond indentures, contingency provisions are known as embedded options

You can have:

• Call option (issuer have the right to buy back all or parto of the bond at a specific price)
• Put option (bondholder has the right to sell the bond back to the issuer at a specified price)

Question 52

American style (call option)

Answer 52

The bonds can be called anytime after the first call date

Question 53

European style (call option)

Answer 53

Bonds can only be called on the call date specified

Question 54

Bermuda style (call option)

Answer 54

The bonds can be called on specified dates after the first call date, often on coupon payment dates

Question 55

Convertible bonds

Answer 55

Convertible bonds give bondholders the right to exchange debt for a specified number of shares of the issuing corporation’s common stock. Because the conversion option is valuable to bondholders, convertible bonds can be issued with lower yields (which means higher price) compared to otherwise identical straight bonds.

Question 56

Conversion price

Answer 56

The stock price at which the bond at its par value may be converted to common stock.

Conversion price = par value/conversion ratio

The conversion price is part of determining the number of shares to be received upon conversion. If shares don’t exceed the conversion price, the convertible bond is never converted to common shares. Usually, the conversion price is set at a significant amount higher than the current price of the common stock to make conversion desirable only if a company’s common shares experience a significant increase in value.

Question 57

Conversion ratio

Answer 57

Conversion ratio = par value of the bond/conversion price

E.g. if a bond w/$1000 par value has a conversion price of $40, then the conversion ratio is $1000/$40 = 25 shares per bond

Question 58

Conversion value

Answer 58

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

E.g. 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 59

Warrants

Answer 59

Warrants are functionally equivalent to options. The only differences are that warrants are issued by companies and they’re not traded on the exchange

Question 60

Investment grade bonds

Answer 60

The bonds that have the highest credit ratings (by S&P and Fitch) AAA, AA, A, BBB are all considered investment grade bonds

The equivalent investment grade ratings for Moodys would be from: Aaa through Baa3

Question 61

Junk or speculative bond

Answer 61

Bonds w/lower credit ratings than investment grade bonds but have higher yield

Credit rankings: BB+ or lower (Ba1 or lower)

Question 62

Libor

Answer 62

Libor is the rate at which banks are willing to lend to each other (which is why it’s called the interbank rate. More specifically, it’s the rate at which banks are willing to lend unsecured loans to each other in the Interbank Money Market

Libor is actually a collection of rates ranging from overnight to up to 1 year (hence Interbank Money Market)

Question 63

Primary market (Bond)

Answer 63

The same concept as primary market for stocks. Issuers sell newly issued bonds to qualified investors directly.

Question 64

Underwritten offerings (applies to both bonds and stocks)

Answer 64

In the context of securities, underwriting entails taking on financial risk to sell all the newly issued securities. Usually underwriters can be 1 investment bank or a syndicate of investment banks

Process (not complete):

1. Issuer determines funding needs
2. Underwriter is selected. The underwriter buys all the securities from the issuing firm and sells to dealers/investors. The underwriter takes the risks that the bonds will not all the sold.

Question 65

Grey market

Answer 65

Some bonds are traded on a “when issued” basis in what’s known as a grey market. Basically, the grey market is a forward market; dealers can place orders for clients who want those bonds once they are issued

Question 66

Shelf registration

Answer 66

Certain issuers (financially sound companies) can offer additional bonds to the public without having to prepare a new and separate offering. Can be used to cover multiple bond issues.

E.g. Let’s say a company needs 500M but they don’t need it all today (maybe 250M now, and 50M in each subsequent year). Instead of going through the underwriting process each time, the company can do shelf registration (meaning all their issues would fall under the same registration)

Question 67

Best efforts offering

Answer 67

Best efforts offering is a contract where a securities underwriter pledges to make their “best efforts” to sell as much of the securities as possible. In effect, the investment bank serves only as broker for commission

Much less riskier than a full committment underwriting

Question 68

Auction

Answer 68

Auctions are the most common way that government bonds are sold. People bidby yield, not by price

Single price auction -> all the winning bidders pay the same price and receive the same coupon rate

Final price = yield at which the issue clears

Question 69

Private placement

Answer 69

A private placement is a sale of stock shares or bonds to pre-selected investors and institutions rather than on the open market. It is an alternative to an initial public offering (IPO) for a company seeking to raise capital for expansion.

Investors invited to participate in private placement programs include wealthy individual investors, banks and other financial institutions, mutual funds, insurance companies, and pension funds.

One advantage of a private placement is its relatively few regulatory requirements.

Question 70

the lower the bid-ask spread is (bonds), the

Answer 70

more liquid the bonds are

If spread is:

<5 bps = very liquid

10-12 bps = reasonable

>50 - illiquid

Question 71

Settlement

Answer 71

Settlement is the exchange of bonds for cash

For government bonds, the settlement is either the day of or the T+1 (the next business day)

For corporate bonds, the settlement is typically T+2 or T+3, though sometimes it may take longer

Question 72

Sovereign bond

Answer 72

Bond issued by national government (sovereign = country). B/c issuing government carry high credit ratings, sovereign bonds are considered essentially free of default risk.

Question 73

On the run or benchmark issues

Answer 73

The most recently issued government securities of a particular maturity

These issues are referred to as on-the-run bonds and also as benchmark bonds because the yields of other bonds are determined relative to the “benchmark” yields of sovereign bonds of similar maturities.

Question 74

bi-lateral loan

Answer 74

When a loan is funded by 1 bank only. These bank debts are usually floating rate

Question 75

syndicated loan

Answer 75

When the loan is funded by multiple banks/group of lenders. These bank debts are usually floating rate

Question 76

Commercial paper

Answer 76

Short-term (usu.< 270 days), unsecured debt instrument

Question 77

Rollover risk

Answer 77

Commercial paper is often reissued or rolled over when it matures. The risk that a company will not be able to sell new commercial paper to replace maturing paper is termed rollover risk.

Risks stem from what if the company can’t issue new commercial paper or market isn’t receptive to new commercial paper issues? How do you pay off the rolled over commercial paper?

Question 78

Backup line of credits (context: commercial paper)

Answer 78

In order to get an acceptable credit rating from the ratings services on their commercial paper, corporations maintain backup lines of credit with banks. These are sometimes referred to as liquidity enhancement or backup liquidity lines. The bank agrees to provide the funds when the paper matures, if needed

Question 79

yield on commercial paper is greater than

Answer 79

yield on same maturity sovereign debt

This makes sense because corporations issue commercial paper, therefore, there is higher credit risk and b/c investors typically hold commercial paper to maturity, there’s very low secondary market trading, which means very low liquidity.

Question 80

Eurocommercial paper

Answer 80

The commercial paper equivalent of Eurobonds.

Like Eurobonds, Eurocommercial paper are issued internationally. Maturity is from overnight to 364 days.

• Smaller issue size and less liquidity compared to commercial paper
• Can be sold to another party

Question 81

short term notes (maturity)

Answer 81

maturity is generally less than 5 years. Can be fixed or floating

Question 82

medium term notes (maturity)

Answer 82

medium term notes generally have maturity of 5 to 12 years. Can be fixed or floating

Question 83

long term notes (maturity)

Answer 83

long term notes generally have maturity greater than 12 years. Primarily fixed

Question 84

serial bond issue (or serial maturity)

Answer 84

With serial bond issue (or serial maturity), bonds are issued w/ several maturity dates so that a portion of the issue is redeemed periodically. In other words, a stated # of bonds will mature each year.

There’s a major difference between serial bond issue and sinking fund provision: with a serial bond issue, investors know at issuance when specific bonds will be redeemed

Question 85

Term maturity

Answer 85

All bonds mature on the same date. The principal is paid all one date. Thus, more credit risk

Question 86

Structured financial instruments

Answer 86

Structured financial instruments are securities that are designed to repackage and change the risk profile of the underlying debt securities, usually by combining a debt security with a derivative. (E.g. Asset-backed securities, CDOs)

Question 87

Capital protected instrument

Answer 87

A capital protected instruments offers a guarantee of of a minimum value of maturity as well as some potential upside gain

E.g. buy a zero coupon bond + call option

Upon maturity of the zero coupon bond, you’ll get the full principal value. The call option is combined so that if the underlying asset of the option were to increase in value, then you have a chance of gaining from that payoff. Basically, no matter what the situation is, even if the call option and you get nothing from that, you still get the full principal value from the zero coupon bond (hence, capital protected)

Question 88

Yield enhancement instruments

Answer 88

A credit-linked note (CLN) has regular coupon payments, but its redemption value depends on whether a specific credit event occurs.

• A bond that pays regular coupon payments but whose principal value depends on specific credit events (e.g. credit rating downgrade or default of underlying asset)

No credit event -> CLN pays par

Credit event occurs -> CLN pays the recovery rate (estimated % of a loan that will still be repaid to creditors in the event of a default or bankruptcy.) Thus, the realized yield on a CLN will be lower if the credit event occurs.

Question 89

Participation instrument

Answer 89

A participation instrument has payments that are based on the value of an underlying instrument, often a reference interest rate or equity index. Participation is often based on the performance of an equity price, an equity index value, or the price of another asset. Participation instruments do not offer capital protection.

E.g. floating rate note (b/c coupon payments are tied directly to some short-term reference rate such as LIBOR)

Question 90

Leveraged instruments

Answer 90

E.g. Inverse floater (remember, as reference rate decreases, coupon payment increases and vice versa)

Coupon rate of leveraged instruments = coupon rate - (L x R)

L = leverage factor; R = reference rate

if L < 1, it would be a deleveraged inverse floater (b/c if R increases, coupon rate wouldn’t increase by 1:1 factor)

L = 1, it would be inverse floater

L > 1, it would be leveraged inverse floater

Question 91

short-term funding alternatives available to banks

Answer 91

1. savings and checkings (aka. retail deposits)
2. certifcate of deposits (lump sum deposits w/higher interest rates than savings accounts)
3. borrowing excess reserves from other banks in the central bank funds market
4. loan/deposits between banks thru Interbank funds

Question 92

Repurchase agreements (repo)

Answer 92

Repurchase agreement is the sale of security w/an agreement to buy it back at an agreed upon price (higher than selling price) at some future date (repurchase date).

Term: 1 day (overnight repo) or longer (term repo)

Question 93

Repo interest rate

Answer 93

The interest rate implied by the two prices is called the repo rate, which is the annualized percentage difference between the two prices.

E.g. Consider a firm that enters into a repo agreement to sell a 4%, 12-year bond with a par value of $1 million and a market value of $970,000 for $940,000 and to repurchase it 90 days later (the repo date) for $947,050.

The implicit interest rate for the 90-day loan period is 947,050 / 940,000 − 1 = 0.75% and the repo rate would be expressed as the equivalent annual rate.

Question 94

Repo interest rate is affected by

Answer 94

• risk associated w/the collateral: higher quality = lower rate (vice versa)
• term of the repo: longer term = higher rate
• physical delivery: if security needs to be physically delivered, lower rate
• Other market rates: higher rate when the interest rates for alternative sources of funds are higher.

Question 95

repo margin

Answer 95

The percentage difference between the market value of the collateral and the loan amount is called the repo margin or the haircut.

In our example, it is 940,000 (amount loaned) / 970,000 (market value) − 1 = –3.1%. This margin protects the lender in the event that the value of the security decreases over the term of the repo agreement.

Question 96

reverse repo agreement

Answer 96

A reverse repo agreement refers to taking the opposite side of a repurchase transaction, lending funds by buying the collateral security rather than selling the collateral security to borrow funds.

Question 97

Factors that affect the repo margin

Answer 97

Repo margin will be:

• Higher, the longer the repo term.
• Lower, the higher the credit quality of the collateral security.
• Lower, the higher the credit quality of the borrower.
• Lower when the collateral security is in high demand (lenders would have to compete by offering lower rates) or low supply.