IP - Chapter 7 - Fixed Income Securities* Flashcards by Riley Giauque

Credit instruments with fixed maturity dates

Fixed income securities

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Short Term

A year or less

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These pay interest during the life of the security and make a final FV payment at maturity.

Long Term Fixed Income Securities

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Period of time through which issuer has control over bond proceeds and the period of time it must continue to pay interest/coupon payments

Maturity

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When a bond issuer calls bonds from a holder and then issues new bonds at a lower coupon rate thereby reducing the cost of its debt.

Refunding

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Two largest fixed income markets…

1) US Treasury

2) Mortgage Related Bond Markets

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What are the maturities of T-Bills?

4 week , 13 week , 26 week : Auctioned on a weekly basis

52 week : Auctioned every 4 weeks

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Yield in the last bid accepted in the competitive process before the Treasury needs are sold out. It is the yield that all purchasers of the T-Bills receives.

Stop Out Yield

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For non-competitive bids made to the purchase of T-Bills, the IR received is the same as the _________________ .

Stop-Out Yield

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All non-competitive bidders are guaranteed to receive the dollar amount of their bid up to _______ per auction.

$5MM

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In a typical treasury auction how is the amount available to competitive bidders determined?

Total Auction Amount minus Noncompetitive Bidders = Amount available for competitive bidders

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Tax rules with T-Bills?

Earnings subject to Federal Income Tax

- State and Local tax free

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How do corporations regularly raise short term funds?

Issuing Commercial Paper

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Serve as a proxy for the RFR?

T-Bills

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Commercial paper is issued in denominations of ____________ and matures in ___________ .

$100,000 or more

270 days or less (more commonly 6 months or less)

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CDs come in 2 forms:

Negotiable (JUMBO)

Non-Negotiable

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Non-negotiable CDs:

Can be cashed prior to maturity by __________ .
Deposits of at least ___________ .
Can/Cannot be purchased or sold in secondary market?

Foregoing interest payments (surrender penalty)
$500
Cannot

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Negotiable CDs:
Short term deposits of ___________ or more.
Can/Cannot be purchased or sold in secondary market?
Used typically by _____________ .

$100,000
CAN be purchased/sold in secondary market allowing holder to cash-out without penalty
Large Institutional investors

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Negotiable instruments used to finance short term debt needs for small companies.

Bankers Acceptances

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Similar to a line-of-credit by a bank, these are typically applied in foreign commerce where the bank acts as intermediary between US and foreign company to facilitate a business transaction

Bankers Acceptances

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Short Term Securities that banks use to borrow money from each other using an underlying security as collateral

Repurchase Agreements

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Bank to bank lending rate

Federal Funds Rate

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FED interest rate charged to financial institutions for loans

Discount Rate

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Muni Bond Interest taxation?

Exempt from federal tax

- Exempt from state tax (if resident is state of issue)

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Muni Bond Capital Gain Taxation?

Fully subject to federal and state taxes

U.S. deposits in banks outside of the U.S. providing short term loans to credit worthy foreign companies

Euro Dollar Deposits

Banks issue and sell mortgages pooled together in funds issued to investors. Interest payments go to investors.

Mortgage backed security

If borrowers default on their mortgage what happens?

Real Estate pledged as collateral for the loan is liquidated and used to pay back the investors

Unsecured bonds

Debenture

When a bond issuer anticipates that interest rates may be lower in the future it may include a _____________ in the bond.

Call provision

Bonds that rely on the creditworthiness of the issuer and are not backed by any collateral. Higher rates to compensate investors for additional risk taken.

Debenture Bonds

What kind of risk are callable bond holders most exposed to?

Reinvestment risk

What is usually paid to bond holder when bonds are called

Premium over par value

Bond that allows the owner to sell back to the issuer at a predetermined price prior the stated maturity of the bond

Puttable Bond

What do puttable bonds protect the bondholder from?

Increases in interest rates

Owners of these have the benefit of receiving fixed payments from a traditional bond but also prefer option to participate in capital gains

Convertible Bonds

Do not make regular interest payments, all interest is paid at maturity. Not subject to reinvestment risk.

Zero Coupon Bonds

Bonds with multiple maturity dates permits issuer to partially retire the bond issue at dates specified in the bond.

Serial Bond

Requires cash basis taxpayers to report income on an accrual basis

Doctrine of Constructive Receipt

Requires holders of a zero coupon bond to pay tax on interest income as earned rather than when received.

OID Rule

When bond issuer sets aside a portion of the principal of the bond each year for repayment of investors at maturity.

Sinking Fund

Interest earned if purchasing into a bond fund between coupon payments.

Accrued Interest

Interest for corporate and muni bonds calculated using a _______ day year.

360

Interest for Government Bonds calculated using ______ day year.

365

Full price of bond less interest

Clean Price

PV of future cashflows of a bond where accrued interest is included in price.

Dirty Price

Traditional normal fraction used for treasury securities prices is _______ .

1/32

T-Notes currently issued for ____________ .

2, 3, 5, 7, and 10 years

A T-Bond term is up to ____ years.

How many dollars worth of T-Notes and T-Bonds can be purchased in the non-competitive bidding process?

$5MM

Up to ____ % of the initial offering can go in the competitive bidding process.

Allow investors to hold and trade individual interest and principal components of eligible T-Notes, T-Bonds, and TIPS as separate securities.

Treasury STRIPS

How is the principal amount of a TIPS bond adjusted?

Adjusted by changes in CPI every 6-months

What happens if deflation occurs on a TIPS?

Interest Paid Decreases

What is the investor paid on a TIPS when it matures?

The greater of inflation adjusted principal amount or the original principal investment.

What are the maturities of a TIPS?

5, 10, 30 years

These are attractive when short term interest rates are expected to rise rapidly.

Floating Rate Notes

How are Floating rate notes priced?

Based on discount rates in auctions of 13 week T-Bills plus spread. (Can be held or sold prior to maturity.)

When does the income tax on interest earned (on a savings bond) have to be paid?

Not until the bond is redeemed

How much can be purchased of a savings bond per series per year? What is the max amount that can be purchased with a tax refund?

- $10,000 | - $5,000 (of $10,000 limit)

When can savings bonds be redeemed?

Any time after 12 months, but a penalty of 3 months interest is charged if bonds are redeemed within 5 years

In some circumstances, interest earned from savings bonds redeemed to pay for education expenses is ____________________.

Exempt from Federal tax

Directly issued mortgage backed securities with government guarantees to investors.

GNMA

What are the maturities of SERIES EE and SERIES I SAVINGS BONDS?

30 years

How do I calculate interest to be earned by SERIES EE Bonds?

For Bonds issued may 1997 - April 2005 bonds earn variable rates based on 90% of 6 month average of 5 year treasury security yields For Bonds issued after April 2005 earn a fixed stated percentage.

How do I calculate the interest earned on SERIES I BONDS?

Fixed stated percentage upon issuance + Inflation Rate calculated semi-annually based CPI

What is the main risk associated with MBS's?

Prepayment Risk

Non-US Government sponsored securities that encourage investors to provide capital for home purchases referred to as 'US Government sponsored securities'

- FNMA - FHLMC (Federal Home Loan Mortgage Corp) - FHLB (Federal Home Loan Bank) - TVA (Tennessee Valley Authority)

Two types of municipal bonds

General Obligation Bonds | Revenue Bonds

How are general obligations backed?

Backed by taxing authority of government issuing bond

How are revenue bonds backed?

By a particular project with a typically higher yield

Who are collateralized mortgage obligations created by?

Private investment firms

Typically higher yield means that the investor is undertaking more _________ .

Risk

Used to finance classic government projects like schools, police stations, fire stations, roads and bridges.

Public Purpose Municipal Bonds

Use to finance some component of private business use (if more than 10% of proceeds are for private business use)

Private Activity Purpose Muni Bond Funds

Investing in private purpose municipal bonds subject to federal income tax when taxpayer subject to _________ .

AMT

What is important to consider when comparing Muni bonds to Corporate Bonds?

After Tax Yield

What is the biggest type of risk associated with owning Muni Bonds?

Credit Risk

Muni Bond insurance attempts to mitigate what type of risk?

Credit Risk

Two ways corporations can access capital markets?

1) Issuance of Bonds | 2) Issuance of Stock

What types of payments are tax deductible for corporations?

Interest paid on bonds

Legal document specifying the rights of bondholders and duties of a corporation.

Indenture

A bond issue not backed by collateral

Debenture

What has a lower yield, convertible or non-convertible stock?

Convertible because an investor has the option to convert to stock

Offers the holder equity ownership in a company but for the time being prefer the relative safety of fixed interest payments associated with bonds

Convertible Bonds

When first buying a convertible bond, bondholders are given a _____________ .

Fixed conversion rate to stock price

Stock option that can be exercised at some specific future date for a specified price

Warrant

Non-investment grade bonds are also known as

High Yield or Junk Bonds

Created by private investment firms backed by a pool of mortgages

CMO's

Issued by government agencies - guaranteed by federal government. These pool mortgages together and pass through payments of interest, principal, and prepayments.

Mortgage Backed Securities

3 Main risks associated with CMO's and MBS's

1) Prepayment Risk 2) Reinvestment Risk 3) Interest Rate Risk

CMO's in some ways are similar to STRIPS especially by their _____________ .

Tranche Payments

Another name for U.S. dollar denominated bonds issued by foreign governments and companies that state principal, interest, coupon in U.S. dollars. Protects investors against currency fluctuations.

Yankee Bonds

Legal document that specifies rights of bondholders and the duty of an issuer

Indenture

3 Forms of foreign Bonds

1) Yankee (US Dollar Denominated Bonds) 2) Eurodollar Bonds 3) Foreign Pay Bonds

These bonds are required to be registered by the SEC and are issued by foreign governments, stated in US dollars.

Yankee Bonds (US Dollar Denominated)

Bonds traded outside of the USA, not subject to SEC registration, issued by foreign governments and corporations. (Often used by foreign based institutional investors).

Euro Dollar Bonds

Bonds issued by foreign governments in their own local currency, traded outside the USA, not subject to registration by the SEC

Foreign Pay Bonds

How is interest earned subject to tax on a foreign pay bond?

Taxed in jurisdiction where bond was issued

Commonly used by individuals or businesses who need access to financing but do not have access to financing from foreign markets

Promissory Notes

This type of contract sold primarily to large institutional investors, like a CD, most are issued for $1MM or more, backed by state guarantee funds

GIC - Guaranteed Income Contract

Essentially a corporate bond with a call option to purchase a security at a specified price.

Convertible Security

If a convertible bond is called the bondholder has 2 options:

1) Accept the call value | 2) Convert to Common Stock

Bonds typically make _______________ coupon payments.

Semi-Annual

Moody's and S&P rate bonds based on their ____________ risk.

Default

Early tranches receive principal payments first while later tranches receive principal in future- therefore later tranches will require __________________ .

Higher Rates of Return

Commercial Paper is issued by ________________ .

Corporations