fixed income interview Flashcards
What is the default premium?
Default premium is the difference between the yield on a corporate bond and the yield on a government bond, both having the same maturity (compensates the investor for the default risk of corporation)
In simpler terms it’s the additional amount a borrower must pay to compensate a lender for default risk. All companies/ borrowers must pay this risk but the rate varies on the obligation.
Typically the government does not have to pay this (but the U.S. treasury has paid this before), companies with junk bonds or lower-credit individuals pay this.
Default premium is measured by the yield over issuance over the government bond yield based
on the coupon or maturity.
What is the default risk?
Default risk is the risk associated with a given company and their likelihood of not being able to pay back interest payments or the principal amount of their debt. The higher a company’s default risk the higher the interest rate they receive.
In simpler terms, default risk is the risk taken on by the lender when the borrower is unable to make required payments on their debt obligations. A higher level of default risk leads to a higher required return, and in turn a higher interest rate.
All lenders/investors are open to this risk in all forms of credit extension (the right to defer credit payments and defer its payment offer).
Free cash flow figures (near zero or in the negatives) can confirm higher default risk, FICO credit score determine corporation or government bond default risk.
What is “face value”?
face/par value of a bond is known as the amount a bond issuer must pay back by the time of maturity (common face val is $1000)
Financial term to describe the monetary value of security. Par is the amount paid to the lender by the end of maturity, as long as the issuer doesn’t default. Face value is determined by the issuer.
The actual market value of a bond cannot be reliably indicated as the face value because of other influencing forces (supply and demand).
What is the coupon payment?
Coupon payment (bond/loan) is the interest payment a company will pay to holders of the bond/loan.
Stated as interest rate times the face value of bond/loan.
Bond payments are typically annually, semi-annually, or quarterly.
Coupon is determined by adding the sum of all coupons paid per year, then dividing that total by the face value of the bond.
What is the difference between an investment grade bond and a “junk bond”?
An investment grade bond is a bond issued by a company that has a relatively low risk of bankruptcy and therefore has a low interest payment. A “junk bond” is one issued by a company that has a high risk of bankruptcy but is paying high interest payments.
In simpler terms, investment grade bonds are known as higher quality investments compared to junk bonds (aka lower quality). Investment grade consists of bonds rated from AAA (Standards & Poors) or Aaa (Moody’s) to BBB or Baa. These bonds consist of high quality companies, borrowers that will almost always pay you back. These have shorter maturity times (making it less likely for the investment to fall through). But to make up for this being a safe investment, the interest rates are lower (meaning you make less money) and the prices are more expensive. On the other hand there are junk bonds which have ratings of BB (Standards & Poors) and Ba (Moody’s) and everything else lower than this, these companies are more prone to bankruptcy. These bonds will have longer maturity dates making it more likely for the investment to fall through. But for this extra risk there are benefits. Such has higher interest rates (making you more money) and lower prices. Investment grade bonds have higher consistencies of cash flows while high-yield bonds have lower grades of this, or are considered to have more volatility.
What is the difference between a corporate bond and a consumer loan?
Corporate bonds and consumer loans are similar for various reasons, but the main difference is the way the money is lended.
Typically, the “issuer” of the bond is like the “borrower” of a loan, and the “holder” of the bond is like the “creditor” of the loan.
The main difference between these two is the market they are traded on. Bond issuance is for a larger amount of capital, hence why bigger companies are sold this (and trade) from the public market. Whereas individuals do not need access to that much capital, making it easier to issued from banks, which is not traded on the public market.
Corporate bonds are debt security investments that typically go to larger businesses in need of capital. Deemed riskier than government bonds hence why they have higher interest rates for investors.
How do you determine the discount rate on a bond?
Discount rates are determined by the default risk of a company (aka how likely that is to make required interest payments on time).
The discount rate on a bond is the amount by which the market price of a bond is lower than the principal due by the rate of maturity. This creates a capital appreciation upon maturity since the higher face value is paid at maturity.
Factors that vary this are a company’s credit rating, volatility of their cash flows, the interest rates on comparable U.S. bonds, the amount of current outstanding debt, and the leverage and interest coverage.
Credit rating: when the credit rating of a bond goes down, it isn’t actually the credit rating that directly lowers the price. It’s actually the perceived value of the bond that lowers this. The securities issuer’s credit standing isn’t rated, but actually the quality of risk associated.
How do you price a bond?
The price of a bond is the net present value of all future cash flows (cash flows being coupon payments and par value) expected from the bond using current interest rate.
Bond prices have inverse relationships to interest rates; when prices fall, interest rates rise.
Bond prices (in the open market) are greatly influenced by the creditworthiness (credit quality) of the issuer, supply and demand, and the term to maturity.
The current yield (annual interest relative to current market price) (annual interest from investments divided by the current price of a security) for a bond fluctuates as the bond’s prices change.
The price of a bond is determined by discounting the expected cash flows to the present using a discount rate (the interest rate used in discounted cash flows (DCF) to determine future values of cash flows). Bonds are issued with a face value and a trade at par value when the current price is equal to the face value. Bonds trade at a premium when the current price is above par.
If the price of a bond goes up, what happens to the yield?
There is an inverse relationship between prices and yields for bonds. When the prices increase, the yield decreases vise versa.
To understand this better, most bonds pay a fixed income rate (the borrower is obliged to make interest payments on a fixed schedule). For this reason it is more attractive for bonds to have lower interest rates so they can pay money, but this happens when prices increase and so does the demand. If the interest rates increase, more money will have to be paid. So, the demand falls and so do the prices (hopefully increasing the chances of people investing).
If you believe interest rates will fall, and are looking to make money due to the capital appreciation on bonds, should you buy them or short sell them?
As I stated previously, there is a converse relationship between interest rates and prices for bonds. If a bond price is to fall, that means interest rates will be increasing. If you plan on making money on the capital appreciation of interest rates, the most optimal decision would be to buy the bonds. This is because when buying bonds with higher interest rates,there becomes time for that interest to compound until the maturity date, increasing your revenue.
What is the current yield on the 10-year Treasury note?
This information changes daily, but at the moment it is 3.45% (9-16-2022).
If the price of the 10-year Treasury note rises, what happens to the note’s yield?
Treasury notes and yields have the same inverse relationship that bonds and interest rates do. So if the treasury note prices are to rise, the yield will decline. But if the price of the treasury note is to decrease, yields will increase.
What would cause the price of a Treasury note to rise?
Treasury notes are known to be backed by the government, deeming them as one of the safest investments. Factors that would cause the price of treasury notes to increase would be increased interest rates, inflation, economic despair. If there are higher inflation rates and economic uncertainty, people will become more afraid to invest in the stock market due to its high volatility and the risk of lost money. So instead they would invest in the safer, government back treasury note. With increased demand, the prices would also go up.
If you believe interest rates will fall, should you buy bonds or sell bonds?
The price of bonds will increase when interest rates fall, making it a safer investment. This should be a reason for you to purchase more bonds.
How many basis points equal 0.5 percent?
One basis point is equal to 0.01 or one-hundredth of a percent. With 0.5 percent or fifty-hundredths of a percent, you would have 50 basis points.
used to express differences of interest rates
What is the order of creditor preference in the event of company bankruptcy?
The order would go with senior debt holders (bondholders or banks that have issued revolving credit lines) first. With their investments they are guaranteed the first repayment if asset liquidation occurs, meaning they have the least risk. Nest would be the subordinated debt holders (unsercure loans/bonds) (any type of debt that’s repaid after all other corporate loans and debts are paid off incase of borrower default. Borrowers of this are typically large corporations and business entities). After this is preferred stockholders (doesn’t have right to vote in company, gives them payment advantage over common stock). Finally common stockholders are paid (investors in common that have a small say in the company)
What is the difference between senior secured debt or “bank debt” and bonds?
Bank Debt is the most common form of corporate debt, which at the most basic level is conceptually the same as any other loan or credit product from a bank.
A corporate bond is debt issued by a company in order for it to raise capital (type of debt security that is issued by a firm and sold to investors).
Bank debt differences include: Low Interest Rate, Floating Interest Rate, Cash Interest Payments, 4-8 Year Tenor, Small Amortization, Prepayment is Allowed, (Banks, Loan Funds, CLOs), Secured by Company Assets, Normally has Maint. and Incurrence Covenants
Corporate bond differences include: Higher Interest Rate, Fixed Interest Rate, May have PIK interest, 7-12+ Year Tenor, No Amortization, No Prepayment, Diversified Investors, May be Unsecured, Incurrence Covenants
The first difference is that bank debt is secured by the assets of the company and bonds many times are not, so the interest rate on bank debt is typically lower. Second, bank debt tends to have floating interest rates based on LIBOR plus a spread, whereas bonds normally pay at a fixed rate. Third, bank debt may carry financial maintenance covenants that require the company to maintain certain leverage levels, interest coverage levels, etc., while bonds do not. Fourth, bank debt is normally amortized at a certain percentage per year. The fifth and final difference is that bank debt tends to be pre-payable at any time, whereas bonds tend to have call protection for some years after issuance, ensuring that bonds remain outstanding. In smaller transactions, the deal may be uni-tranche (all bank debt), but in large transactions the capital structure could include first-lien bank debt, second-lien bank debt, AND bonds.
Why would a company use bank debt rather than high-yield bonds?
Bank debt is secured by the assets of the company and therefore normally commands lower interest rates (it is the safer option). The trade off is that it will typically amortize and may have maintenance covenants.
Why might two bonds with the same maturity and same coupon, from the same issuer, be trading at different prices?
One of the bonds could be callable/redeemable (a bond that can be redeemed by the issuer before the maturity date, allows the company to pay off debt early, can be called if interest rates are lowered). One of the bonds could be putable (a debt instrument that forces the issuer to repurchase securities as specified dates before maturity “gives bondholders the right to demand early repayment of principal from the issuer). One of the bonds could be convertible (fixed-income corporate debt security that yields interest payments, but can be converted into a predetermined number of common stock or equity shares. The conversion from the bond to stock can be done at certain times during the bond’s life and is usually at the discretion of the bondholder). There are a couple of explanations for the observed price difference. A bond that is putable or convertible would demand a premium, and a callable bond would trade at a discount. This is because there are benefits that go along with the putable and convertible bond, while there are many disadvantages following the callable bond.
What are bond ratings?
A bond rating is a grade given to a bond according to its risk of defaulting. The three best known and most trusted ratings agencies are Standard & Poor’s, Moody’s, and Fitch. Recently, ratings agencies have faced some skepticism about their ratings techniques because so many of the mortgage backed securities that were given very high ratings ended up defaulting. The lower the grade, the more speculative the stock, and all else equal, the higher the yield. See the chart a few pages earlier for a visualization of the different ratings and agencies. A bond rating is a grade given to a bond based on its risk of defaulting. This rating is issued by an independent firm and updated over the life of the bond. The most trusted rating agencies are S&P, Moody, and Fitch, and their ratings range from AAA to C or even D. The top rating of AAA goes to highly rated “investment grade” bonds with a low default risk; the C rated bond is “non-investment grade” or “junk,” and a rating of D means the bond is already in default and not making payments.
What is the yield to maturity on a bond?
ield to maturity (YTM) is known as the anticipated total return on a bond if it is bought at its current price and was held through its maturity date and paid off in full maturity.
YTM (or book/redemption yield) is expressed as an annual rate.
If the coupon yield of a bond (coupon/face) is lower than its current yield (coupon/price) it is selling at a discount. If the coupon yield of a bond (coupon/face) is higher than its current yield (coupon/price) it is selling at a premium. The yield to maturity on a bond is its rate of return if held through its maturity date, based on its current price, coupon payments, face value, and maturity date.
What will happen to the price of a bond if the Fed raises interest rates?
If interest rates rise, newly issued bonds offer higher yields to keep pace. This makes existing bonds with lower coupon payments less attractive, and their price must fall to raise the yield enough to compete with the new bonds.
What is the difference between yield to maturity and yield to worst?
Yield to maturity assumes the debt holder will maintain the investment through its maturity date,
collecting all interest payments and being repaid in full when it matures. Yield to worst is the lowest
potential yield an investor can earn on a debt investment short of default by the issuer. This means that
if a bond is callable, or has other provisions, an investor could earn less than yield to maturity should
the company exercise a prepayment option to get out of the bond early.
whats a euro dollar
a bond issued in europe
