IP - Chapter 7 - Fixed Income Securities* Flashcards
Credit instruments with fixed maturity dates
Fixed income securities
Short Term
A year or less
These pay interest during the life of the security and make a final FV payment at maturity.
Long Term Fixed Income Securities
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
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
Two largest fixed income markets…
1) US Treasury
2) Mortgage Related Bond Markets
What are the maturities of T-Bills?
4 week , 13 week , 26 week : Auctioned on a weekly basis
52 week : Auctioned every 4 weeks
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
For non-competitive bids made to the purchase of T-Bills, the IR received is the same as the _________________ .
Stop-Out Yield
All non-competitive bidders are guaranteed to receive the dollar amount of their bid up to _______ per auction.
$5MM
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
Tax rules with T-Bills?
- Earnings subject to Federal Income Tax
- State and Local tax free
How do corporations regularly raise short term funds?
Issuing Commercial Paper
Serve as a proxy for the RFR?
T-Bills
Commercial paper is issued in denominations of ____________ and matures in ___________ .
$100,000 or more
270 days or less (more commonly 6 months or less)
CDs come in 2 forms:
Negotiable (JUMBO)
Non-Negotiable
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
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
Negotiable instruments used to finance short term debt needs for small companies.
Bankers Acceptances
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
Short Term Securities that banks use to borrow money from each other using an underlying security as collateral
Repurchase Agreements
Bank to bank lending rate
Federal Funds Rate
FED interest rate charged to financial institutions for loans
Discount Rate
Muni Bond Interest taxation?
- Exempt from federal tax
- Exempt from state tax (if resident is state of issue)
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.
30
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.
35
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
