HOFIS Ch1

Question 1

State the three largest issuers of debt.

Answer 1

1. Domestic corporations
2. Municipal governments
3. Federal government

Question 2

Describe bond maturity and state the three reasons why maturity is critical

Answer 2

Maturity is the date the bond must be redeemed and the principal paid back

Maturity is critical because:
1. Indicates expected life
2. Affects the yield
3. Affects the volatility

Question 3

Describe call provisions. State the benefits for corporations and the disadvantages for
investors.

Answer 3

A call feature / provision gives the issuer the right to retire debt prior to maturity

Benefits for corporations:
Ÿ Permits them, should market rates fall, to replace the bond issue with a
lower-interest-cost issue
Ÿ More flexibility to manage cash and restructure balance sheets

Detrimental to investors because:
Ÿ Run the risk of losing a high-coupon bond when rates begin to decline
Ÿ Reinvestment will likely be at a lower yield because of the declining interest rates
Ÿ Limits appreciation on bond value

Question 4

Describe the sinking-fund provision

Answer 4

A sinking-fund provision requires the obligor to retire a certain amount of the
outstanding debt each year

Question 5

Describe bond refunding.

Answer 5

Bond refunding - the concept of paying off higher-cost bonds with debt that has a
lower net cost to the issuer of the bonds.
When market rates are about to fall, the borrower may be tempted to replace a
high-coupon debt with a new low-coupon bond.

Question 6

State how to compute the make-whole call price.

Answer 6

The make-whole call price is the greater of:
1. 100% of the principal amount + accrued interest
2. Make-whole redemption amount
Ÿ The make-whole redemption amount is the sum of PV of remaining coupon
payments and principal + accrued interest
Ÿ PV is calculated at a discount rate given by yield on a Treasury security that matches
the bond’s remaining maturity plus a spread (e.g. Treasury Rates plus 15bps)

Question 7

Describe RMBS and compare agency vs nonagency/private-label RMBS.

Answer 7

Residential mortgage-backed security (RMBS) is an instrument whose cash-flow
depends on the cash-flows of an underlying pool of mortgages

Two main groups: agency RMBS and nonagency/private-label RMBS
Ÿ Agency RMBS are issued and fully guaranteed by a government agency like Ginnie
Mae, Freddie Mac, or Fannie Mae
Ÿ Nonagency RMBS (also called private-label RMBS) are issued by thrifts,
commercial banks, or private conduits (not backed by any government entity)