Fixed-Income Securities

Question 1

Debt securities that have a maturity of less than one year are also called

Answer 1

Money market instruments

Question 2

Debt securities that mature in over one year’s time are typically called

Answer 2

Bonds

Question 3

The principal amount of the loan that the purchaser of the fixed-income security is lending the issuer

Answer 3

The par value

Question 4

The date that the loan would be repaid is known as

Answer 4

The maturity date

Question 5

The interest paid is known as

Answer 5

The coupon rate (sometimes referred to as the nominal rate)

Question 6

Discount bond.

Answer 6

When interest rates increase above the stated interest of the debt (the coupon rate), then new debt will be paying a higher rate than the existing debt. Therefore, in order for the existing debt to be as appealing to buyers in the secondary market, its market price must decrease below par value, otherwise known as a discount bond.

Question 7

Premium bond.

Answer 7

When interest rates decrease below the stated interest of the debt (the coupon rate), the security will be worth more since new debt pays less interest. Therefore, the market price for the debt would be above par value, otherwise known as a premium bond.

Question 8

Which of the following is True

1) The value of a fixed-income security is derived from the future value of all of its present cash flows, including the return of principal or par value at maturity.

2) The value of a fixed-income security is derived from the present value of all of its future cash flows, including the return of principal or par value at maturity.

Answer 8

2) The value of a fixed-income security is derived from the present value of all of its future cash flows, including the return of principal or par value at maturity.

Question 9

Which of the following is True

1) Callable debt provides a benefit to the issuer

2) Callable debt provides a benefit to the holder

3) Put provision benefits the issuer

4) Put provision benefits the holder

Answer 9

1) Callable debt provides a benefit to the issuer
4) Put provision benefits the holder

Question 10

Yield–to-call

Answer 10

The most relevant metric of a callable bond is the yield–to-call, which measures the total return until the bond is called. If the bond isn’t called, the yield-to-maturity will be the most relevant measure of total return.

Question 11

Investment-grade and speculative-grade bonds

Answer 11

Bonds that have the highest ratings are referred to as investment-grade bonds or high-quality. They fall into a rating of AAA through BBB for S&P, Aaa through Baa for Moody’s. Any bond rated below BBB (S&P) or Baa (Moody’s) ratings are considered speculative-grade.

Question 12

Money Market Mutual Funds

Answer 12

Investment companies (mutual funds) offer this product, and as such, these instruments are not protected under FDIC insurance. However, considering the underlying instruments that money markets invest in, they are generally considered to be safe. Money market funds are also an acceptable investment alternative for an emergency fund due to their high degree of liquidity.

Question 13

Certificate of Deposit (CD)

Answer 13

Certificates of deposit (CDs) represent time deposits at commercial banks or savings and loan associations. Large-denomination (or jumbo) CDs are issued in amounts of $100,000 or more, have a specified maturity, and are generally negotiable, meaning that they can be sold by one investor to another. Such certificates are insured by the Federal Deposit Insurance Corporation (FDIC) or the National Credit Union Administration (NCUA). It is important not to confuse these negotiable CDs with the non-negotiable ones sold in smaller denominations to consumers.

Question 14

Commercial Paper

Answer 14

Commercial paper is an unsecured (not backed by any assets) short-term promissory note. Both financial and non-financial companies issue instruments of this type. The dollar amount of commercial paper outstanding exceeds the amount of any other type of money market instrument except for Treasury bills, with the majority being issued by financial companies. Such notes are often issued by large firms that have unused lines of credit at banks, making it highly likely that the loan will be paid off when it comes due. The interest rates on commercial paper reflect this small risk by being relatively low in comparison with the interest rates on other corporate fixed-income securities.

Commercial Paper Features:

Denominations of $100,000 or more
Maturities of up to 270 days
Large institutional investors
Terms are non-negotiable
Issuer may prepay the note

Question 15

Bankers’ Acceptance (BA)

Answer 15

The buyer of the goods may issue a written promise to the seller to pay a given sum within 180 days or less. A bank then “accepts” this promise, obligating itself to pay the amount when requested, and obtains in return a claim on the goods as collateral. The written promise becomes a liability of both the bank and the buyer of the goods and is known as a bankers’ acceptance.

1) Buyer promises to make payment at later date upon delivery of goods.
2) Bank accepts the promise to pay. The bank can sell the promise as a bankers’ acceptance.
3) Seller delivers the goods to the buyer.
4) Buyer pays the bank who in turn pays the holder of the banker’s acceptance.

Question 16

Eurodollars

Answer 16

In the world of international finance, large short-term CDs denominated in U.S. dollars and issued by banks outside the United States are known as Eurodollar CDs or Euro CDs. Also available for investment are U.S. dollar-denominated time deposits in banks outside the United States, known as Eurodollar deposits.

A key distinction between Euro CDs and Eurodollar deposits is that Euro CDs are negotiable, meaning that they can be traded, whereas Eurodollar deposits are non-negotiable, meaning that they cannot be traded.

One difference from CDs issued by U.S. banks is that the Euro CDs do not have federal deposit insurance.

Question 17

Repurchase Agreement (Repo)

Answer 17

One investor will sell another investor a money market instrument and agree to repurchase it for an agreed-upon price at a later date. It is similar to individuals who sell a personal possession to a pawnshop for a sum of money, but later return to repurchase the item.

1) Investor loans the issuer money.
2) Issuer puts up T-bills as collateral and issues the buyer a repo agreement.
3) Issuer pays off the loan with interest.
4) Buyer returns the T-Bills.

Question 18

Money Rates Listing

Answer 18

Interest rates on money market instruments are often reported on what is known as a bank discount basis. As an example, a note would be described in the media as having a discount of 2% per quarter, or 8% per year. However, the discount does not represent the true interest rate on the note. The discount rate is expressed as a percent of the face value, when in fact the investor is actually purchasing the discounted amount. Therefore, the true interest rate realized would always be higher than what is reported on a bank discount basis. In this case it equals $2,000/$98,000=2.04%
per quarter, or the equivalent of 8.16% per year (with quarterly compounding, it would equal 8.41%=1.02044−1)
.

Question 19

If there was a money market instrument with a $1,000,000 denomination quoted with a discount rate of 1.5%, how much would the investor pay for the security and what would be the investor’s real interest rate?

Answer 19

The investor will purchase the security for $985,000 or $1,000,000 X .985. The bank discount basis which is the investor’s real interest rate = 1.52% or $15,000/$985,000.

Question 20

U.S. Savings Bonds - Series EE bonds

Answer 20

Series EE bonds are accrual bonds, issued in the face amounts of $50, $75, $100, $200, $500, $1,000, $5,000 and $10,000. The purchase price is half of the face amount. Series EE bonds have no secondary market, therefore they must be redeemed and cannot be used as gifts or as collateral. An attractive feature is that these bonds are not subject to state and local taxes.

Question 21

U.S. Savings Bonds - Series HH bonds

Answer 21

Series HH bonds are acquired through an exchange of Series E bonds, which the Treasury issued prior to July 1, 1980, or Series EE bonds held for 6 months or longer. With Series EE bonds, the interest accrued will remain tax-deferred until the HH bonds are redeemed. Like EE bonds, HH bonds are not marketable securities.
Series HH bonds are purchased at face value in denominations of $500, $1,000, $5,000 and $10,000.

Question 22

U.S. Savings Bonds - Series I bonds

Answer 22

Series I bonds are sold in denominations ranging from $50 to $10,000. The Treasury sets the interest every May and November for the next six-month period. The interest rate is based on a fixed rate plus an additional amount, which is determined by the Consumer Price Index. This is a major distinction with HH bonds, which have no adjustment for inflation. The maturity is 20 years from the date of issue, with an option to extend interest payments for an additional ten years. Interest is exempt from state and local taxation, and may also be exempt from federal taxation as long as the interest is used to pay qualified higher education expenses.

Question 23

T-Bills

Answer 23

Treasury Bills are money market instruments issued on a discount basis, with maturities of up to 52 weeks and in denominations of $1,000 or more. All are issued in book-entry form. The buyer receives a receipt at the time of purchase and the bill’s face value at maturity. Although Treasury Bills are sold at discount, their dollar yield (the difference between the purchase price and the face value if the bill is held to maturity) is treated as interest income for tax purposes. Since T-Bills are sold at a discount, the true interest that investors are earning should be figured using the Bond Equivalent Yield.

Question 24

The current price of the T-Bill can be determined by applying equation:

Answer 24

Current Price=Face Value×[1−(Days to Maturity/360)×Discount Yield]

Question 25

6-month T-Bill maturing in 30 days with a discount yield of 2.4% would have a current price of ?

Answer 25

$1000×[1−(30/360)×.024]=$998

Question 26

Review Question
You own a 9-month T-Bill ($1,000 face value) with a discount rate of 3% that matures in 180 days. If you were to sell this T-Bill now, how much would you get for it?

Answer 26

$1000×[1−(180/360)×.03]=$985

Question 27

T-Notes

Answer 27

Treasury Notes are issued with maturities from one to ten years and generally make coupon payments semiannually. The 10 year treasury note is arguably the most important market-based interest rate.
Treasury Notes are issued in denominations of $1,000 or more.
This rate is the best indication for broader interest rate movements and is considered a benchmark rate for other lending throughout the economy, such as mortgages. While it does not directly show up as a reference in other debt, it heavily influences it.

Question 28

T-Bonds

Answer 28

Treasury Bonds have maturities from more than ten to thirty years. Those issued before 1983 may be in either bearer or registered form while subsequent issues are all in registered form. Denominations range from $1,000 and upward. Unlike Treasury Notes, some Treasury Bond issues have call provisions that allow them to be “called” during a specified period that usually begins five to ten years before maturity and ends at the maturity date. The Treasury has the right to force the investor to sell the callable U.S. Treasury Bonds back to the government at par value. In 2001, the U.S. Treasury discontinued issuing new T-Bonds but started re-issuing 30-year Treasury bonds again in 2006.

Question 29

Treasury Inflation-Protected Securities (TIPS)

Answer 29

In January of 1997, the United States Treasury issued its first inflation-adjusted securities called Treasury Inflation-Protected Securities (TIPS). They are similar to U.S. Treasury Bonds in every way, except their principal amount increases by the change in the Consumer Price Index (CPI) and their coupon payments are then calculated based on the inflated principal. This difference gives investors protection against inflation eroding the purchase power of future payments of interest and principal.

Question 30

Review Question
An investor buys $100,000 of TIPS bearing a 3.5% coupon. For the next 6 months, the inflation rate averages 3% per year. What will be the coupon payment made to the investor?

Answer 30

An investor buys $100,000 of TIPS bearing a 3.5% coupon. For the next 6 months, the inflation rate averages 3% per year. What will be the coupon payment made to the investor?

The coupon rate (3.5% in this case) is fixed. The principal is adjusted every six months to reflect the inflation rate. In this case the principal would be increased to $101,500 ($100,000×.03/2)
, and therefore the payment of the first coupon would be $1,776.25 ($101,500×.035/2)

It is important to note that the principal amount can be increased or decreased every payment period. However, on the maturity date, the treasury guarantees that the principal will not decline below par value ($100,000 in this case).

Question 31

Types of Federal Sponsored Agencies

Answer 31

Federal Home Loan Banks::
Makes loans to thrift institutions, primarily savings and loan associations.

Federal National Mortgage Association::
Fannie Mae: purchases and sells real estate mortgages by Federal Housing
Administration, Veterans Administration and conventional mortgages.

Federal Home Loan Mortgage Corporation::
Freddie Mac: purchases and sells conventional mortgages.

Student Loan Marketing Association::
Sallie Mae: purchases federally guaranteed student loans.

Farm Credit Bank::
Lends to farmers, farm associations and cooperatives.

Farm Credit Financial Assistance Corporation::
Supports the Farm Credit Bank System.

Financing Corporation::
Recapitalizes the Federal Savings and Loan Insurance Corporation.

Funding Corporation::
Assists recovery of thrift industry by assisting bankrupt or near bankrupt savings and loans.

Question 32

Mortgage-Backed Securities

Answer 32

Mortgage-Backed Securities (MBS) are securities that are backed by pools of mortgage loans. Because the underlying mortgages can be prepaid, prepayment risk is a major concern for MBS investors. MBS include:

Mortgage pass-through securities
Collateralized Mortgage Obligations (CMOs)
Stripped mortgage-backed securities

Question 33

Mortgage Pass-Through Securities
A mortgage pass-through security represents a claim against a pool of mortgages. Any number of mortgages may be used to form a pool, and any mortgage in the pool is often referred to as a securitized mortgage. These pass-through securities may be traded in the secondary market, and therefore have the economic effect of converting illiquid mortgages into liquid mortgages - a process known as securitization.

Answer 33

Ginnie Mae::
Issued by the Government National Mortgage Association (GNMA), an agency of the U.S. Government under the Department of Housing and Urban Development. The payments from a GNMA fund are guaranteed and backed by the full faith and credit of the U.S. Government.

Fannie Mae::
Issued by the Federal National Mortgage Association (FNMA), a corporation originally created by the federal government.

Freddie Mac::
Issued by the Federal Home Loan Mortgage Corporation (FHLMC), a corporation originally created by the federal government.

It is important to note that Fannie Mae and Freddie Mac are not truly governmental agencies, and therefore are not backed by the full faith and credit of the U.S. Government.

Question 34

Collateralized Mortgage Obligations (CMOs)

Answer 34

Collateralized mortgage obligations (CMOs) are a means to allocate a mortgage pool’s principal and interest payments among investors in accordance with their preferences for prepayment risk. A CMO originator (or “sponsor”) transforms a traditional mortgage pool into a set of securities, called CMO tranches.

Each tranche represents a different investment. They differ in the amount of principal that is distributed over time. The tranches will retire, or be paid down, at different speeds. The tranche that receives more principal in the beginning will retire before the others. The primary purpose of dividing a mortgage pass-through pool’s principal and income flows into various tranches is to create a set of securities with varying levels of interest rate and prepayment risks. Investors can match their risk preferences and predictions with the appropriate securities.

Question 35

Stripped Mortgage-Backed Securities

Answer 35

Unlike the traditional pass-through securities, the principal and interest of stripped instruments is not allocated to the bondholders on a pro rata basis. This results in a price/yield relationship that is significantly different from the underlying pass-through. The two most common types of stripped MBS are principal-only (PO) and interest-only (IO) strips.

Principal-only strips just receive the principal payment of each mortgage payment. The payments start out small and grow over time as the principal component of the mortgage payment grows. Even though they are sold at a large discount to par, eventually the entire amount of principal will be repaid to the PO investor. The only question is will the realized prepayment rates cause it to be paid sooner or later than expected.

Interest-only strips just receive the interest payment of each mortgage payment. The payments start out large and get smaller over time. IO investors face a huge risk in that the cash flow over the life of the IO may be less than expected. It is even possible that the amount received will be less than the amount originally invested. This is due to the fact that as the mortgages are pre-paid (or even worse re-financed) the mortgage pool will be paid off sooner than expected, leaving the IO investor with no interest cash flow.

Question 36

Municipal Bonds

Answer 36

State and local governments borrow money to finance their operations. Their securities are called municipal bonds or simply “municipals” or “munis”. Municipal bonds and notes are similar to other bonds in every way, except that investors of municipal debt securities enjoy a federal tax break on the interest generated from these securities. If the investor purchases municipal bonds and notes from their state of residence, they may receive a state and local tax break on the interest.

States cannot be sued without their consent. Thus bondholders may have no legal recourse in the event of default, and state-issued bonds that are dependent on particular revenues from some capital project may involve considerable risk. However, bonds backed by the ‘full faith and credit’ of a state government are generally considered quite safe despite the inability of the bondholders to sue.

Unlike state governments, local governments can be sued against their will, making it possible for bondholders to force officials to collect whatever amount is needed in order to meet required debt payments. Local governments and authorities carry more credit risk because of their limited source of revenue to pay off the debt. Orange County of California defaulted and had to restructure their debt in 1996.

Question 37

Types of Municipal Bonds

Answer 37

General obligation bonds

Revenue bonds.

Question 38

General obligation bonds

Answer 38

General Obligation Bonds are issued by state and local agencies and are backed by the full faith and credit of the agency. In other words, the bonds are backed by their full taxing power which means they are safer than other municipal bond types.

Question 39

Revenue Bonds

Answer 39

Revenue Bonds are backed by revenues from a designated project, authority, or agency or by the proceeds from a specific tax. Such bonds are only as creditworthy as the enterprise associated with the issuer. Revenue bonds may be issued for the following reasons:

financing publicly owned utilities
financing quasi-utilities, like transportation
financing by levying a tax on properties that benefit from the expenditure, for example a new sewer system, and
Industrial Development Bonds are used to finance the purchase or construction of industrial facilities that are to be leased to firms on a favorable basis.

Question 40

Municipalities also issue notes. List of municipal notes:

Answer 40

Tax anticipation notes (TANs)
Revenue anticipation notes (RANs)
Grant anticipation notes (GANs)
Tax and revenue anticipation notes (TRANs)

Question 41

Tax Equivalent Yield (TEY)

Answer 41

The Tax Equivalent Yield (TEY) helps investors determine whether or not they are better off investing in the lower yielding but tax-free municipal bond or in a higher-yielding taxable bond.

TEY=Tax free rate/(1−tax bracket)

Question 42

Review Question
Bonnie, a resident of Ohio, has an effective tax rate of 36%. If risk was not an issue for Bonnie, which of the following choices would provide her the highest yield?
Choose the best answer.

30-year T-Bond paying 6%
Disney 30-year-bond paying 7%
Ohio 30-year GO municipal bond paying 5%
Ohio 30-year revenue municipal bond paying 5.5%

Answer 42

Ohio 30-year revenue municipal bond paying 5.5%

The TEY for the revenue municipal bond = 5.5%/(1-.36) = 8.593% which is a higher yield than the other choices. The TEY for the GO municipal bond = 7.8125% which is still a higher equivalent yield than the taxable T-Bond and Disney bond.

Question 43

Municipal Bond Insurers List

Answer 43

AMBAC - American Municipal Bond Assurance Corporation
MBIAC - Municipal Bond Investors Assurance Corporation
FGIC - Financial Guarantee Insurance Company

Question 44

Which bonds needs to be registered with the SEC

1) Corporate bonds
2) Municipal bonds

Answer 44

1) Corporate bonds

Question 45

Foreign Bonds

Answer 45

The most significant advantage of investing in foreign bonds is to enhance the level of diversification within your fixed income portfolio. However, there are special risks to be aware of in any type of foreign investing.

Exchange rate risk - the relative valuations in currencies will affect your return. If the domestic currency weakens relative to the foreign currency (which the foreign bond is denominated) your return will be enhanced. If the domestic currency strengthens relative to the foreign currency, the return will be adversely affected.

Political risk - also referred to as sovereign risk, refers to possible changes in a foreign nation’s political climate, since political systems and even entire governments may change.

Tax risk - foreign bonds are subject to foreign taxation. Furthermore, these taxes are usually taken directly from the investment proceeds, reducing the overall return. Foreign investments are also subject to U.S taxation as well, even though the U.S. government allows a foreign tax credit to reduce some of the tax burden.

Question 46

Corporate Bonds

Answer 46

Corporate bonds are similar to other kinds of fixed-income securities in that they promise to make specified payments at specified times and provide legal remedies in the event of default. Restrictions are often placed on the activities of the issuing corporation in order to provide additional protection for bondholders.

Question 47

Types of Corporate Bonds

Answer 47

Mortgage Bonds
Collateral Trust Bonds
Equipment Obligations
Debentures
Subordinated Debentures
Asset-Backed Securities
Convertible Bonds
Other Types of Bonds

Question 48

Mortgage Bonds

Answer 48

Mortgage bonds represent debt that is secured by the pledge of specific property. In the event of default, the bondholders are entitled to obtain the property in question and to sell it to satisfy their claims on the firm. In addition to the property itself, the holders of mortgage bonds have an unsecured claim on the corporation.
Mortgage bondholders are usually protected by terms included in the bond indenture. The corporation may be constrained from pledging the property for other bonds (or such bonds, if issued, must be “junior” or “second” mortgages, with a claim on the property only after the first mortgage is satisfied). Certain property acquired by the corporation after the bonds were issued may also be pledged to support the bonds.

Question 49

Collateral Trust Bonds

Answer 49

Collateral trust bonds are backed by other securities that are usually held by the trustee in a separate structure. A common situation of this sort arises when the securities of a subsidiary firm are pledged as collateral by the parent firm.
The issuer sets up a separate Special Purpose Vehicle (SPV) and places assets into it. The SPV then issues debt backed by those assets and the funds raised from those bonds is passed through the SPV and back the issuer. Note, these types of bonds may be backed by the parent issuer/company or solely by the asset in the SPV. This backing can create a very different credit profile.

Question 50

Equipment Obligations

Answer 50

Equipment trust certificates and equipment obligations are backed by specific pieces of equipment, for example, railroad cars and commercial aircraft. If necessary, the equipment can be readily sold and delivered to a new owner. The legal arrangements used to facilitate the issuance of such bonds can be very complex. The most popular procedure uses the “Philadelphia Plan,” in which the trustee initially holds the equipment and issues obligations and then leases the equipment to a corporation. Money received from the lessee is subsequently used to make interest and principal payments to the holders of the obligations. Ultimately, if all payments are made on schedule, the leasing corporation takes title to the equipment.

Question 51

Debentures

Answer 51

Debentures are general obligations of the issuing corporation and thus represent unsecured credit. To protect the holders of such bonds, the indenture will usually limit the future issuance of secured debt as well as any additional unsecured debt.

Question 52

Subordinated Debentures

Answer 52

When more than one issue of debentures is outstanding, a hierarchy may be specified. For example, subordinated debentures are junior to unsubordinated debentures, meaning that in the event of bankruptcy, junior claims are to be considered only after senior claims have been fully satisfied.

Question 53

Asset-Backed Securities

Answer 53

Asset-backed securities are much like Mortgage-backed securities. However, instead of mortgages being pooled and pieces of ownership in the pool being sold, debt obligations such as credit card revolving loans, automobile loans, student loans, and equipment loans are pooled to serve as collateral to back the securities. The basic concept is known as securitization.
Originators of these loans pool them (often in a SPV) and sell securities that represent part ownership of the pool. A servicing company collects the payments made by the debtors over a period of time, such as a month, and then pays each owner the appropriate percentage of the aggregate amount received. Similar to investors in participation certificates associated with mortgages, two concerns for investors in asset-backed securities are default risk and prepayment risk.

Question 54

Convertible Bonds

Answer 54

Convertible bonds, a popular financial instrument, are securities that can be converted into a different security of the same firm under certain conditions. The typical case involves a bond convertible into shares of the firm’s common stock, with a stated number of shares received for each bond. Usually no cash is involved; the old security is simply traded in, and the appropriate number of new securities is issued in return. Convertible preferred stocks are issued from time to time, but tax effects make them, like other preferred stock, attractive primarily to corporate investors. For other investors, issues of convertible bonds are more attractive.

For example, if a convertible bond has a conversion ratio of 20 shares of stock per bond, then the conversion price would be equal to: $1000 / 20 shares = $50/share. So it would only be beneficial for the bondholder to convert if the stock price rises above $50.

Question 55

Review Question
If a bond’s conversion ratio is 50 shares of stock per bond and the price of the stock is at $30, would it be beneficial for the bondholders to convert?

Answer 55

If stock is a suitable investment for the investor, then it would make sense to convert. Since the conversion price is $1,000/50 or $20 per share, the investor can convert and sell the shares for $30 and earn a $10 profit each or $500.

Question 56

Other Types of Bonds

Answer 56

Income bonds are more like preferred stock than bonds. Payment of interest in full and on schedule is not absolutely required, and failure to do so need not send the corporation into bankruptcy. Interest on income bonds may not qualify as a tax-deductible expense for the issuing corporation.
Guaranteed bonds are issued by one corporation but backed in some way by another.
Participating bonds require stated interest payments and provide additional amounts if earnings exceed some stated level.
Voting bonds, unlike regular bonds, give the holders some voice in management.
Serial bonds, with different portions of the issue maturing at different dates, are sometimes used by corporations for equipment financing.
Convertible bonds may, at the holder’s option, be exchanged for other securities, often common stock.
Putable bonds give the holders an option, but this time it is to exchange their bonds for cash equal to the bond’s face value. This option generally can be exercised over a brief period of time after a stated number of years have elapsed since the bond’s issuance.