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Investment Practice > Fixed Income > Flashcards

Fixed Income Flashcards

1
Q

What are Treasury Bills and how are they issued?

A

Short-term (< 1 year) govt. securities. They are issued at a discount to par value so the return is all capital gain.

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2
Q

How do you calculate the holding period of return (if the investor holds the T-Bill until maturity)?

A

Holding Period of Return = (Par - Purchase Price) / Purchase Price

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3
Q

How do you calculate the annualised yield of a T-Bill (if the investor holds the T-Bill until maturity)?

A

((Par - Purchase Price) / Purchase Price) x 365/days until maturity.

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4
Q

How do you calculate the true compounded yield rate of a T-Bill?

A

( 1 + ( Par - Purchase Price / Purchase Price ) ) ^365/No. of days - 1

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5
Q

What does a commercial paper refer to?

A

Short-term (7 days - 12 mths) discount instrument issued by corporations. Unlike T-Bills there is a default risk.

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6
Q

What are Certificate of Deposits (CDs)?

A

Tradable deposits issued by banks. Minimum value is £100,000 and they are issued in £10,000 denominations. (The interest rate will be slightly below fixed term deposits. These trade at face value plus a share of final interest).

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7
Q

What are Floating Rate Notes (FRNs)?

A

Bonds that are issued at par value with a coupon linked to a market interest rate (e.g. LIBOR). They are NOT short-term instruments, but they pay out a coupon linked to a short-term rate.
The price will remain close to par (£100) and the duration is close to 0.

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8
Q

What is a Gilt Repo?

A

A form of secured lending where a borrower agrees to sell a bond and buy it back later at a pre-agreed (higher) price.
The difference in price represents the cost of borrowing (‘repo rate’). The low risk of this arrangement allows the repo rate to be lower than conventional borrowing.

For the borrower: A cheap method of funding bond purchases.
For the counter-party: A cheap way of of borrowing securities (cash) to cover short-term priorities.

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9
Q

What happens when the yield of the bond is equal to its coupon rate?

A

It will trade at its par value.

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10
Q

What is true regarding the price of a bond and its par value?

A

The price of a bond is always greater than its par value. This is because the price of bonds is the PV of its future cashflows, discounted at the required rate of return of the bond investors.

PV of Bond = CF (coupon) x DF (/ADF)

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11
Q

What is the difference between clean and dirty pricing?

A

Clean pricing refers to quotes for bonds that are priced excluding accrued interest e.g. UK Govt. Bonds quotes.
The dirty price refers to the price paid for a bond, which includes accrued interest. This compensates the seller of the bond for interest earned.

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12
Q

How is the dirty price of a bond calculated?

A

Dirty Price = Clean Price + ( Semi-Annual Coupon x (Days since last coupon / 182.5 days (6mths) )

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13
Q

What happens if bond is bought 7 days or less before the next coupon date?

A

The bond is “ex-div”. This means that the whole coupon goes to the seller of the bond. Any other time, the bond is trading “cum-div” and the whole coupon goes to the buyer.

Ex-Div: You buy bond w/o coupon.
Cum-Div: You buy bond with coupon.

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14
Q

What is the Gross Redemption Yield (GRY)?

A

Also known as Yield to Maturity (YTM), is the total return (R) for a bond investor. If given a bond’s market price, the GRY is the IRR of the cashflows.

R = IRR = GRY

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15
Q

For what reason is the GRY (total return) of a bond not guaranteed (even if it is held to maturity)?

A

Due to reinvestment risk: as the coupons would need to earn the GRY as well for the total return to be the GRY..

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16
Q

What is the Net Redemption Yield (NRY)?

A

It is the GRY, after tax.

NRY = GRY - ( 1 - Coupon Tax Rate)

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17
Q

How do you work out the Flat (Interest) Yield?

A

Coupon / Bond Price

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18
Q

What is the settlement time of Gilts on the LSE?

A

T+1

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19
Q

What are Index Linked Gilts (ILGs) and why are they used?

A

ILGs have a semi-annual coupon and redemption value linked to RPI. The coupon is therefore a real coupon, which is adjusted for inflation.
They are used to provide institutional investors with protection against inflation.
When the ILGs are issued, they are assigned a reference RPI. Future payments are scaled with reference to RPI changes.
ILGs issued up to September 2005 have an 8-month lag, and issues from Sep 2005 have a 3-month lag on the reference to RPI.

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20
Q

What are STRIPS?

A

Occurs when dealers buy gilts and then sell the rights to individual cashflows. The dealers are able to bundle together the coupons and principal and sell them separately.

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21
Q

How many STRIPS can a gilt with N years to maturity create?

A

2N + 1

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22
Q

Where is the demand for STRIPS?

A

Institutional investors trying to build ‘cash-matched’ portfolios. ‘Stripped’ bonds allow for occasional cash inflows where the institutional investor (e.g. pension fund) is expected to pay outflows.

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23
Q

What is the role a covenant in a corporate bond?

A

To limit the actions of the borrowing firm (so that there is a greater chance of them repaying the bond).

  • via restricting dividend payments to their shareholders.
  • ranking their debts.
  • limiting the amount paid to their executives in bonuses.
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24
Q

What are the key features of Eurobonds?

A
  • Regulated by ICMA
  • Gross annual coupon (before tax)
  • No register, bearer instruments
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25
Q

What are Contingent Convertible Bonds (Co-Cos)?

A

Bonds issued by banks that absorb losses to protect them in times of crises. The debt is converted into equity if a pre specified trigger event occurs.
They protect the banks from insolvency by to converting equity or incurring a principal write down.

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26
Q

What is the main risk associated with the bond markets?

A

Interest rate risk: As IR ↑, Yields ↑, Bond prices ↓ (as bonds become less attractive to borrowers (issuers))

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27
Q

What is interest rate risk (in bond markets)?

A

Price risk: IR ↑, Yields ↑, Bond prices ↓ (as bonds become less attractive to borrowers).
The riskiest bonds for IR risk are long-dated/low-coupon bonds, as they have a high duration measure.

28
Q

What is reinvestment risk (in bond markets)?

A

Yields ↓, Reinvestment return ↓

29
Q

What is the relationship between bond prices and bond yields?

A

Inverse: when P↑, Y↓.

30
Q

What is credit risk (in bond markets)?

A

Refers to the creditworthiness of borrowers and their risk of defaulting.

31
Q

What is default risk (in bond markets)?

A

The chance that the bond issuer (borrower) will not make the required coupon/principal payments its bondholders.

32
Q

What is inflation risk (in bond markets)?

A

Since bond interest payments are fixed, their value can be eroded by inflation.

33
Q

What is currency/exchange rate risk (in bond markets)?

A

Changes in the currency value that may create unpredictable profits/losses.

34
Q

What is call risk (in bond markets)?

A

Issuer buying the bond back early.

35
Q

Define bond yield:

A

The return the investor realises on a bond.

Current Yield (what investors will earn from a bond for holding it for one year) = Annual Interest / Current Price of Bond

Yield to Maturity (YTM, aka GRY): The anticipated return if the bond is held until maturity.

36
Q

What does the duration of a bond refer to?

A

The sensitivity of the price of a bond to a change in interest rates.
e.g. A 10 year bond is more sensitive than a 2 year bond to a change in the IR.
Higher duration = Higher Price risk

37
Q

What is the Macaulay Duration?

A

It finds the PV of a bond’s future coupon payments and maturity value i.e. the weighted average maturity of a bond.
For an annual bond the equation is:
MD = ΣPV x t / P = Weighted PV / PV

38
Q

Modified Duration:

A

This gives the approximate change in the price of a bond for a 1% change in yield.

Modified Duration = Macaulay Duration / ( 1 + GRY)

%Δ Bond Price ≈ - Mod. Duration x Δ Yield

39
Q

What does duration assume and what is the result of this?

A

A linear inverse relationship between yield and price. It is convex. As a result, any new price calculated, will also be less than the actual new price.

40
Q

What three factors do credit rating agencies use to assess the creditworthiness of borrowers?

A
  • The firm e.g. financials, prospects and management.
  • Macro-economic environment.
  • The seniority/covenants of the debt.
41
Q

What does the Yield Curve show?

A

The GRY from benchmark securities (gilts) plotted against maturity.

42
Q

What are the three theories that explains the upwards sloping yield curve?

A

Pure Expectations: The expectation of changes in SR interest rates. Curve slopes upwards as rates are expected to rise.

Liquidity Preference: Yields are higher for longer dates bonds and this is why it is upwards sloping.

Market Segmentation: Prices and yields are driven by supply and demand and there is higher liquidity in the SR and lower liquidity in the LR.

43
Q

What is the relationship between the forward rates, spot rates and GRY of bonds, with an upward sloping yield curve?

A

Forwards > Spots > GRY

44
Q

What is the relationship between the forward rates, spot rates and GRY of bonds, with a downward sloping yield curve?

A

Forwards < Spots < GRY

45
Q

What is a bond indenture?

A

The accompanying legal document of a corporate bond. It specifies the rights of the bondholders and the obligations of the issuing firm.

46
Q

What is a sinking fund provision?

A

It requires that the issuing firm has to ‘retire’ (buy back) a certain proportion of the bond issue throughout of the life of the bond each year. This is an advantage for the bondholders, since it reduces the final amount needed to pay when the issue finally matures.

47
Q

What are protective covenants?

A

The limitations on the future actions of the issuing firm designed to ensure that the stream of income required to meet coupon and principal payments from the bond is not exposed to undue risk. Examples include:

  • Payments to shareholders.
  • Restrictions on additional debt.
  • Ranking of any future debt.
  • The amount that company can pay themselves.
48
Q

What does a call provision on a corporate bond allow?

A

The issuing firm to redeem the issue on pre-specified dates and prices. The firm may choose to do this if interest rates fall, retiring the issue that pays the higher yield and issuing new debt at a lower rate.

49
Q

Who does a call provision benefit?

A

Only the issuing firm.

50
Q

What does a put provision on a corporate bond allow?

A

The investor (bondholder) to sell the bond back to the issuer at a pre-specified price. This only works to the advantage of the investor, who will take up this option if interest rates rise, by selling the bond back to the issuer and purchasing new higher yielding fixed income securities.

51
Q

What is a debenture?

A

A type of corporate bond that is secured by a floating charge on the assets of the company, as opposed to a fixed charge.

52
Q

What does unsecured loan stock refer to?

A

A type of corporate bond that is not backed by collateral, but only by the creditworthiness of the issuing firm.

53
Q

An investor buys a bond at a discount to par value. What can we deduce?

A

Prices will rise over time. As the bond moves towards maturity, so too it will move towards its par value.

54
Q

What is the price of a convertible debt instrument based on?

A

The value of the call option over the company’s shares.

55
Q

What is the minimum block size of treasury bills?

A

£25,000

56
Q

Certificates of Deposit may have a term of upto:

A

5 years

57
Q

As interest rates fall, what happens to the price and yield of FRNs?

A

Price stays constant as the coupon is regularly adjusted to IR changes.
Yield falls.

58
Q

Gilts which are classified as “longs” have what minimum period to run to redemption?

A

More than 15 years

59
Q

Gilts which are classified as “shorts” have what maximum period to run to maturity, according to DMO?

A

Up to 7 Years

60
Q

Gilts which are classified as “shorts” have what maximum period to run to maturity, according to LSE/FT?

A

Up to 5 Years

61
Q

What is a callable bond?

A

Where the issuer can pay off their debt before the bond’s maturity date.

62
Q

What is a serial bond?

A

Lots of bonds with staggered maturity dates put into one simplified bond and a proportion of the capital is repaid each year.

63
Q

What is a putable bond?

A

Where the bond can be sold to the issuer (borrower) at any time.

64
Q

What is the best description of an index-linked gilt?

A

Both the interest (coupon) payment and the redemption value (maturity payment) are linked to the RPI either 3 months or 8 months prior to the date in question.

65
Q

What is modified duration?

A

The approximate change in the price of a bond for a 1% change in yield. It has an inverse relationship with the change in yield.

Investment Practice (12 decks)

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