Lesson 2: Debt Securities

Question 1

Bond

Answer 1

A loan from an investor to an issuer/entity
- Default to $1,000 par value
- Market price is determined by prevailing interest rates

Question 2

Coupon Yield

Answer 2

(Nominal Yield) The annual interest rate paid on the face amount
- typically quoted as a percentage of par
- typically paid out semiannually

Question 3

Interest Rate Risk

Answer 3

When interest rates go up, bond prices go down & vice versa (they have an inverse relation)
- This is bc higher IR make the future coupon payments less valuable
- The market price is essentially an adjusted par value to make the coupon yields equivalent to what a new bond’s rate would be

Question 4

Duration

Answer 4

A measure (in years) of how much a bond’s price is likely to change when interest rates move

Question 5

Current Yield

Answer 5

= annual interest/current market value
This fluctuates because the market price does
Will need to be able to calculate this
ex: 8% bond now trading at 980 has what CY?
= 80/980 = 8.16%

Question 6

Yield to Maturity

Answer 6

Overall return if bond is held to maturity
(only need to describe and define, not calculate)

Question 7

Yield to Call

Answer 7

Same as YTM, but assumes the bond is called (ie principal is repaid early)

Question 8

Bond Quotes

Answer 8

state the price of a bond as a percentage of its par value
ex: a bond trading at par is trading at 100
a bind trading at 102 is trading at a premium (102% of it’s par value, ie $1,020)

Question 9

Zero Coupon Bond Risks

Answer 9

1: higher IR risk (so high vol)
- i don’t think this is much of an issue if you’re holding it for long periods of time
2: phantom income tax
- can be somewhat avoided by putting into tax deferred accounts
- you do receive interest, but only once at maturity (the difference between what you pay and what you receive is the interest)
- there is no IR risk when you hold a ZC bond to maturity

Question 10

Call Protection Period

Answer 10

Portion of a callable bond that the bond cannot be called

Question 11

Callable Bond

Answer 11

A bond that can be called early, meaning that the issuer can pay the principal early to stop paying the interest payments

Question 12

Puttable Bond

Answer 12

Investor can demand early repayment (lower coupon is paid out)

Question 13

Convertible Bond

Answer 13

Investor can convert toa fixed number of common shares (lower coupon is paid out)

Question 14

Call Risk

Answer 14

the risk that the bond is redeemed before its maturity (interest payments stop)
Bonds are called by the issuer when IRs are low
Leads to reinvestment risk

Question 15

Reinvestment Rate Risk

Answer 15

Risk that the investor is unable to reinvest capital at a previously earned rate of return.
No available investments will be able to provide a similar return as the called bond

Question 16

Inflationary Risk

Answer 16

Risk that an investment’s returns provide reduced purchasing power because the return is fixed, but costs are rising. This also applies to preferred stock
High inflation can also lead the Fed to increase rates, lowering bond prices

Question 17

Credit Risk

Answer 17

Risk of default by the issuer (ie they can’t make payments)

Question 18

Accrued Interest

Answer 18

The interest earned but not yet received (you accrue interest during the whole time, but only get it semi annually)
The buyer pays the seller the accrued interest because they receive the full interest payment from the issuer

Question 19

Debt Financing

Answer 19

Bond issuers are borrowing money from investors
the investors are promised the return of their money (principal) plus interest
As creditors of the issuer, they have a higher claim on assets than shareholders in the event of bankruptcy

Question 20

Escrow Account

Answer 20

An account held by a 3rd party that bond issuers use to deposit sinking funds

Question 21

Sinking Funds

Answer 21

Special account that bond issuers must regularly deposit into to ensure that they have the necessary funds at maturity to pay back lenders

Question 22

Puttable Bonds

Answer 22

reverse of callable bonds (so good for investor, therefore lower coupon payments)
The investor has the right to sell back the bond to the issuer based on some predetermined clause in the contract (like if interest rates increase above a certain threshold)

Question 23

Yield Relationships

Answer 23

When a bond is trading at a premium, NY > CY > YTM > YTC
When a bond is trading at a discount, NY < CY < YTM < YTC
When a bond is trading at par, NY = CY = YTM = YTC

Memorize this order, then think of the see saw image

Question 24

Accrued Interest Settlement Rules

Answer 24

• corporate, muni, and agency bonds use 360/30 notation
• t notes and t bonds use 365/actual notation
• corporate, muni, and treasuries use T+1 for regular way settlement, but same day for cash settlement

Question 25

Accretion

Answer 25

Bonds purchased at a discount must have their cost basis accreted, meaning that the cost basis must be adjusted upwards linearly towards par each year To calculate, divide the discount off par by the number of years until maturity ex: if someone buys a bond for $900 with 10 years to maturity, the annual accretion equals the $100 discount off par divided by 10. So after holding for one year, the cost basis would become $910

Question 26

Amortization

Answer 26

Bonds purchased at a premium must have their cost basis amortized, meaning that the cost basis must be adjusted downwards linearly towards par each year To calculate, divide the premium off par by the number of years until maturity

Question 27

Cost Basis

Answer 27

The value of an asset for tax purposes