Fixed Income Securities

Question 1

Par Value of a Fixed Income Security

Answer 1

The par value of a fixed-income security is also known as its face value. It is the initial price of the security. Some of the shorter-term fixed-income securities, like money market instruments, are typically issued at higher par values such as $100,000 or $1,000,000. Longer-term corporate bonds are typically set at a par value of $1,000.

Question 2

TVM and its effects on fixed income securities

Answer 2

The time to maturity has a great affect on a fixed-income security’s exposure to risk as well as the perceived value of the security. The longer the maturity of a fixed-income security, the greater the amount of time its coupon payments would be affected by interest rates and reinvestment risks. Therefore, longer-term fixed-income securities are perceived as higher risk and typically pay a higher coupon rate than shorter-term issues to compensate for that risk. However, there are occasions when the yield curve changes direction and becomes flat or inverted. In those cases, longer term bonds could pay the same, or less, yield than shorter-term securities.

Question 3

Duration

Answer 3

Duration is a more accurate measure of the risk of a bond. Duration helps to determine how quickly your money is returned. It is expressed in number of years. All things being equal, the higher the coupon, the shorter the duration and vice versa. Also, the lower the duration, the less responsive the market price of a fixed-income security to interest rate changes.

Question 4

Call Provisions

Answer 4

Issuers may want the right to pay off their bonds at par before maturity. This ability provides management with flexibility because debt could be reduced or its maturity altered by refunding. Most importantly, expensive high-coupon debt that was issued during a time of high interest rates could be replaced with cheaper lower-coupon debt if rates decline.

Despite the cost of obtaining this sort of flexibility, many issuers include call provisions in their bond indentures. This gives the corporation the option to call (essentially refinance their debt at better rates or terms) some or all of the bonds from their holders at stated prices during specified periods before maturity. In a sense, the firm sells a bond and simultaneously buys an option from the holders. Thus, the net price of the bond is the difference between the value of the bond and the option.

Question 5

Put Provisions

Answer 5

Put provisions 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.

Question 6

Credit Risk

Answer 6

An important distinction among fixed-income securities is the likelihood of the issuer to default on payment of interest and principal of the loan. This risk is called default or credit risk. Any security backed by the full faith and power of the U.S. government is considered the highest quality (considered to have absolutely no default risk). For all other fixed-income securities, there are rating systems.

Question 7

Par Value

Answer 7

Par Value: the principal amount of the loan that the issuer will pay back when the fixed-income security matures. The market price will change inversely with movements in interest rates. Bonds trade at a discount when the market price is below par and they trade at a premium when the market price above par.

Question 8

Time to Maturity

Answer 8

Time to Maturity: the maturity date of the issue affects the bond’s coupon rate as well as its market price movements. The greater the maturity date, the greater the risk exposure of the security.

Question 9

Coupon Rate

Answer 9

Coupon Rate: the stated rate on the face of the bond upon which the amount of income paid to the investor is calculated. The greater the risk of the issue, the higher the coupon rate.

Question 10

Call Provision

Answer 10

Call Provision: when interest rates decrease, issuers may want to pay off their debt early by calling their outstanding debt and reissuing debt at a lower financing cost.

Question 11

Likelihood to Default

Answer 11

Likelihood to Default: Bonds are rated on their ability to make payments of principal and interest. The lower the rating, the higher the default risk and the higher the coupon rate.

Question 12

Which of the following would typical fixed-income securities investors seek?

A. Par

B. Call Provision

C. Maturity

D. Coupon

Answer 12

Correct Answer: D. Coupon

Explanation: Most bond investors are seeking a steady income generated from the coupon payments. Investors of high-yield bonds may also be seeking capital appreciation from the high volatility associated with those types of bonds. Par is the principal amount that investors will receive at maturity. Call provisions are more of an advantage for issuers. Maturity is the length of time before a fixed-income security will come due.

Question 13

Which of the following contribute to the movement in the market price of a fixed-income security?

A. Inflation

B. Interest rates

C. Coupon rates

D. Call provision

Answer 13

Correct Answer: B. Interest rates

Explanation: The movement of interest rates can cause existing fixed-income securities to be worth more or less than their original par value. Inflation causes the purchasing power of the future payments to decrease and affects the real return of the investment. Coupon rates are set when the issue is created. Call provision gives issuers the right to pay off their debt before maturity.

Question 14

Money Market Funds

Answer 14

Money market funds specialize in short-term securities and provide investors an alternative to savings accounts and other time deposits offered by banks. They invest in commercial paper, repurchase agreements, bankers acceptances, negotiable CDs, Treasury bills, and tax anticipation notes.

Question 15

Certificate of Deposit

Answer 15

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 16

Commercial Paper

Answer 16

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.

Question 17

Commercial Paper Features

Answer 17

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 18

Bankers Acceptance

Answer 18

Earlier bankers’ acceptances were created to finance goods in transit but now they are used to finance foreign trade. For example, 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.

Question 19

What does an investor seek when they purchase money market instruments?

A. Potentially high returns from aggressive growth

B. A liquid investment that can be sold quickly at fair value

C. High quality investments with low risk

D. A long term investment

Answer 19

Correct Answer: B. and C.

Explanation: Money market instruments are fixed-income securities that are highly liquid. Since many businesses use them for business transactions, they are constantly traded in the secondary market as cash equivalents. Since they are issued in high denominations, the issuers typically have low credit risk. Their shorter-term maturity also partially shields them from interest rate risk. Since there is less risk associated with them, they would not provide a high return. The relatively lower return makes them less likely to overcome inflation risk than other securities for long-term investing.

Question 20

Treasury Securities

Answer 20

The U.S. government issues U.S. Treasury securities to finance its expenses, pay off existing debt, and control the supply of money. US Treasury securities are considered direct obligations of the U.S. government. About two thirds of the United States’ public debt is marketable, meaning that it is represented by securities that can be sold at anytime by the original purchaser. These marketable securities can include Treasury Bills, Treasury Notes, and Treasury Bonds. Since U.S. Treasury securities are backed by the government’s power of taxation and the government’s ability to issue more debt, they are considered the safest debt instruments in their respective maturity categories. Often the rate of U.S. Treasury Bills is used as the risk-free rate of return for investment calculations.

Since U.S. Treasuries are considered to be the safest fixed-income securities, they are highly sought after in the U.S. and throughout the world. Federal, state and local governments hold a significant portion of their funds in U.S. Treasuries. They also represent a significant portion of financial institutions’ portfolios, and individual investor’s holdings are substantial as well. Holdings by foreigners continue to increase as a means to hold a more stable currency than their own.

Question 21

U.S. TREASURIES

Answer 21

U.S. TREASURIES

Type Maturity
T-Bills Less than 1 year
T-Notes 1 to 10 years
T-Bonds 10 to 30 years

Question 22

Savings Bonds

Answer 22

The US government issues savings bonds as a convenient way for people to save money.

Question 23

Series EE Bonds

Answer 23

Series EE bonds are accrual bonds, issued in the face amounts of $25, $50, $75, $100, $200, $500, $1,000, $5,000 and $10,000. 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.

Series EE Savings Bonds dated on or after May 1, 2005, will earn a fixed rate of interest for 20 years. After the initial 20-year period, an additional 10-year extension and rate update will be initiated, for a total of 30 years of interest earning. These EE bonds will increase in value every month, and interest is compounded semiannually.

Another tax advantage is that the interest on Series EE bonds purchased in 1990 and later may be tax-free if they are used for college education expenses for the bondholder, spouse or dependant. This occurs if the entire proceeds when redeemed are used to pay for tuition, books and fees for the family members. The bonds must be purchased and owned by the parents of a child attending college, and the parents’ adjusted gross income (AGI) will determine if all or only part of the interest on the bonds is excluded from taxes in the redemption year.

Question 24

Series HH bonds

Answer 24

Series HH bonds are acquired through an exchange of Series E bonds, which the Treasury issued prior to July 1, 1980. 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. These bonds pay interest semiannually at a fixed rate determined on date of issuance, and adjusted on the 10th anniversary. Their maturity may be extended for an additional 10 years with interest. The interest must be included in income for federal income tax purposes, but HH bonds are not subject to state or local income taxes.

Question 25

Series I bonds

Answer 25

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 26

Formula for Current Price of a T-Bill

Answer 26

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

For example, a 6-month T-Bill maturing in 30 days with a discount yield of 2.4% would have a current price of $998

$1000 X [1 - ((30/360) X .024)] = $998

Question 27

Mortgage Backed Securities

Answer 27

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 28

Mortgage Pass Through Securities

Answer 28

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.

Question 29

Three types of mortgage pass through securities

Answer 29

The three major types of pass-through securities are:

Ginnie Mae.

Fannie Mae.

Freddie Mac.

Question 30

Ginnie Mae

Answer 30

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.

Question 31

Fannie Mae

Answer 31

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

Question 32

Freddie Mac

Answer 32

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

Question 33

Fannnie Mae & Freddie Mac

Answer 33

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 as a direct obligation. They are, however, a moral obligation of the U.S. Government. This moral obligation came to fruition in the financial crisis of 2008 and 2009 where the U.S. Government stepped in to prevent the agencies from going bankrupt.

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. The tranches will retire at different times. The tranch 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. Typically, the Z tranche carries the most risk and, therefore, demands the highest yield.

Sponsors of CMOs may be government agencies, such as GNMA or FNMA, or they may be private entities, such as brokerage firms.

Question 35

What makes U.S. Government issued fixed-income securities safe relative to other issuers?

A. Inflation Protection

B. Stability of Government

C. Interest Rate Risk Protection

D. Power of Taxation

E. Prepayment Protection

Answer 35

Correct Answer: B. and D.

Explanation: U.S. Government Securities are either direct obligations that are required to be paid by either tax collecting or refunding, or they are backed by the full faith of the government. The government’s stability makes it less likely to default than less stable governments or borrowers of the private sector. Not all U.S. government issued securities are protected against inflation risk. All fixed-income securities are subject to interest rate risk, some more than others. And Government backed mortgage pass-throughs such as GNMAs and CMOs are susceptible to prepayment risks.

Question 36

Municipal Bonds

Answer 36

Municipal Bonds can be classified into general obligation bonds and revenue bonds.

General Obligation Bonds

Revenue Bonds

Question 37

General Obligation Bonds

Answer 37

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 38

Revenue Bonds

Answer 38

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 39

Municipal Notes

Answer 39

Tax anticipation notes (TANs)

Revenue anticipation notes (RANs)

Grant anticipation notes (GANs)

Tax and revenue anticipation notes (TRANs)

Question 40

Tax Equivalent Yield Formula

Answer 40

TEY = Tax free rate/ (1- tax bracket)

Question 41

Municipal Bond Insurers

Answer 41

AMBAC (American Municipal Bond Assurance Corporation)

FGIC (Financial Guarantee Insurance Company)

Question 42

Characteristics of Municipal Bonds

Answer 42

There are over 85,000 governmental units in the United States apart from the federal government itself. These units borrow money and their securities are called municipal bonds. Municipal bonds vary in credit risk depending on their issuer’s ability to make payments on the debt. Investors are attracted to municipal fixed-income securities because their income is tax-exempt from federal income taxes. If the investor purchases the municipal securities issued by the city or state where they live, the income generated may be exempt from state and local taxes as well. The tax-exempt option is particularly attractive to investors who are in higher tax brackets. They would not be suitable for investors who are in lower tax brackets or are purchasing them for a tax-deferred vehicle such as an IRA.

Question 43

What part of the municipal bond is tax exempt at the federal level?

A. Premium

B. Discount

C. Coupon

D. Capital Appreciation

Answer 43

Correct Answer: C. Coupon

Explanation: Coupon payments from municipal securities are tax exempt from federal taxes. Premium and discount are ways to compare the price of the bond to its original price. Any capital appreciation that is recognized is taxable for municipal bonds.

Question 44

Which of the following statements are true?

A. General obligation bonds are backed by the full faith of the issuing municipality
B. Revenue bonds are backed by the full faith of the issuing municipality
C. General obligations bonds are backed by the full extent of the municipality’s taxation power
D. Revenue bonds are backed by the entity’s incoming sales

Answer 44

Correct Answer: A., C. and D.

Explanation: General Obligation bonds are more conservative because they are backed by the full faith and power of the municipality, namely the full extent of its taxing power. Revenue bonds are funded by the revenue generated by the designated project, authority, or agency. They are more risky because they are not backed by the full of faith and power of the municipality.

Question 45

Types of Corporate Bonds

Answer 45

Mortgage Bonds

Collateral Trust Bonds

Equipment Obligations

Debentures

Subordinated Debentures

Asset-Backed Securities

Convertible Bonds

Question 46

Mortgage Bonds

Answer 46

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 47

Collateral Trust Bonds

Answer 47

Collateral trust bonds are backed by other securities that are usually held by the trustee. A common situation of this sort arises when the securities of a subsidiary firm are pledged as collateral by the parent firm.

Question 48

Equipment Trust Certificates

Answer 48

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 49

Hierarchy of Debentures

Answer 49

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 50

Securitization

Answer 50

Asset-backed securities are much like participation 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.

Question 51

Convertible Bonds

Answer 51

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 52

Income Bonds

Answer 52

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.

Question 53

Guaranteed Bonds

Answer 53

Guaranteed bonds are issued by one corporation but backed in some way by another.

Question 54

Participating Bonds

Answer 54

Participating bonds require stated interest payments and provide additional amounts if earnings exceed some stated level.

Question 55

Voting Bonds

Answer 55

Voting bonds, unlike regular bonds, give the holders some voice in management.

Question 56

Serial Bonds

Answer 56

Serial bonds, with different portions of the issue maturing at different dates, are sometimes used by corporations for equipment financing.

Question 57

Convertible Bonds

Answer 57

Convertible bonds may, at the holder’s option, be exchanged for other securities, often common stock.

Question 58

Putable Bonds

Answer 58

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.

Question 59

Three Risks in Foreign Investing

Answer 59

Exchange rate risk

Political risk, or Sovereign Risk

Tax risk

Question 60

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, or 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.

Answer 60

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, or 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 61

Exchange Rate Risk

Answer 61

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.

Question 62

Political Risk, or Sovereign Risk

Answer 62

Political Risk, or Sovereign Risk, refers to possible changes in a foreign nation’s political climate, since political systems and even entire governments may change.

Question 63

Tax Risk

Answer 63

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 64

Why would an issuer decide to issue a corporate bond with collateral such as equipment or buildings?

A. Increase coupon rate
B. Decrease coupon rate
C. Fund the coupon payments
D. Lower risk of issue
E. Increase quality of issue

Answer 64

Correct Answer: B., D. and E.

Explanation: Adding collateral to a bond issue lowers the risk of the bond, which increases the quality of the issue and lowers investor’s demand for risk premium or coupon rate. Collateralized bonds would not increase coupon rate nor would it help to pay for the coupons.

Question 65

Which of the following is true about the following bond listing: GE 6 1/2 15; 98 1/8?

A. Bond is trading at discount
B. Bond is trading at premium
C. Bond is paying annual coupon rate of $6.50
D. Bond is paying annual coupon of $650
E. Bond is paying coupon of $65

Answer 65

Correct Answer: A. and E.

Explanation: Based on the listing, the 6 ½ coupon GE bond due in 2015 is trading at $981.25 = $1000 X 98.125%. Since $981.25 is less than $1000 or par, then the bond is trading at a discount. The coupon rate is $65 = $1000 X 6.5%.