Lesson 3: Types of Bonds

Question 1

Convertible Bonds

Answer 1

A corporate bond that the investor can choose to convert to a specified number of common stock shares
- gives investors the debt features of a bond, but can capture the upside if the company’s stock becomes very valueable

Question 2

Parity Price

Answer 2

The price at which an investor is indifferent to owning a convertible bond or the common shares

Question 3

Conversion Price

Answer 3

The price paid per share on conversion - defined at issuance, cannot change
So basically at issuance, you know exactly how many shares you are going to get if you convert at some point in the future

Question 4

Conversion Ratio

Answer 4

The number of shares received on conversion - defined at issuance, cannot change
calculated as: par value/Conversion Price

Question 5

Mortgage Backed Securities (MBS)

Answer 5

• pools of mortgages that are turned into bonds to create more liquidity in the bond market
• each bond represents a sliver of all mortgages in the MBS
• pay interest monthly (bc the cash flows of a mortgage are monthly)
• not good for steady consistent income, good for diversification

Question 6

Collateralized Debt Obligations (CDO)

Answer 6

A type of MBS structured by broker-dealers into tranches that vary by expected maturity, credit quality, and exposure to investment risks

Question 7

General Obligation (GO) Bonds

Answer 7

A type of municipal bond to finance a non-revenue producing facility (public park, school, etc) and backed by the taxing power of the municipality

Question 8

Revenue Bonds

Answer 8

A type of municipal bond to finance a revenue producing facility (toll road, airport, etc)

Question 9

Industrial Development Bonds

Answer 9

Type of revenue Muni bond where lease payments are made by corporations
The credit quality will depend on the credit worthiness of the corporation leasing the property (ie how likely it is for them to keep making their lease payments)

Question 10

Money Market Securities

Answer 10

• very safe and liquid short term (<= 1 yr maturity) debt securities
• include treasury bills, negotiable certificates of deposit, commercial paper, bankers’ acceptances
  (note that longer term investments would be considered capital market)
• not considered stable income

Question 11

Commercial Paper

Answer 11

Type of money market instrument
- Short term, unsecured promissory note issued by corporations
- max maturity is 270 days

Question 12

Certificates of Deposits (CDs)

Answer 12

type of Money Market Instrument
- large denomination, negotiable time deposits

Question 13

Bankers’ Acceptances

Answer 13

type of Money Market Instrument
- finance international transactions of goods and services

Question 14

Security of a Bond Issuer

Answer 14

refers to the pledge of, or lien on, collateral that is granted by the borrower to the holders of a given debt instrument
remember, borrower = issuer.

Question 15

Seniority of a Bond Creditor

Answer 15

refers to the priority status of a creditor’s claims against the borrower/issuer relative to those of other creditors
remember, creditor = investor

Question 16

US Gov Bonds

Answer 16

• No credit risk (can just print money if needed: leads to inflation risk)
• safety of principal
• low yield
• interest is taxed federally

Question 17

Municipal Bonds

Answer 17

• Tax free interest income (in state is the best)
• territories are also always triple-tax free
• generally, the higher the income tax bracket of the investor the more attractive muni bonds are

Question 18

Corporate Bonds

Answer 18

• range from safe to high risk
• interest is taxable as ordinary income

Question 19

Secured vs Unsecured

Answer 19

Secured: backed by some kind of collateral
Unsecured: are backed by good faith and credit of the issuing corporation (also called debenture)

Question 20

Eurodollar Bonds

Answer 20

Bonds issued and traded outside the US, but denominated in $$
- not necessarily registered w SEC (bc they’re outside the US)
- makes company’s securities more marketable (if for example their currency is unstable)
- the issuer is then subject to more currency risk

Question 21

Eurodollar Deposits

Answer 21

Simply US dollars held in a bank abroad

Question 22

T-Bills

Answer 22

• maturity up to one year
• no semi annual coupon (too short of a lifespan)
• instead they are quoted at an annualized discount percentage (ie you pay 800, get 1000 back in a year)

Question 23

T-Notes

Answer 23

• 2-10 year maturity
• Pay semi annual coupon
• quoted as a percentage of par in 32nds
  (ie 95:16 = 95 + 16/32 = $955)

Question 24

STRIPS

Answer 24

US Gov issued zero coupon bonds
- takes a treasury note and look at each cash flow that t-note produces, and then sells them individually
- more sensitive to IRs

Question 25

T-Bonds

Answer 25

- 30 year Maturity - Pay semi annual coupon - quoted as a percentage of par in 32nds (i.e. 95:16 = 95 + 16/32 = $955)

Question 26

TIPS

Answer 26

Treasury Inflation Protected Security - US Gov issued coupon bonds that adjust based on the inflation rate (CPI)

Question 27

Treasury Receipts

Answer 27

Zero Coupon security issued by broker-dealers but backed by treasuries These don't really exist any more because STRIPS replaced them

Question 28

Series I Bonds

Answer 28

- US gov savings bond - pays a combination of fixed and variable interest - They CANNOT be traded on the secondary market (ie they are non-marketable) So, investors buy them and hold them until maturity

Question 29

Government Agencies

Answer 29

This is a specific term: - subsidiaries of the US Gov - explicit guarantee and backing of the US gov (ex: Ginnie Mae)

Question 30

Government Sponsored Enterprises (GSEs)

Answer 30

-Created/chartered by the US Gov but no longer a part of the gov - implied guarantee (ex: Fannie Mae, Freddie Mac) so the US gov has no legal responsibility to back the debt

Question 31

MBS Extension Risk

Answer 31

if interest rates rise, there will be fewer prepayments on mortgages, so your MBS could have a longer lifespan leading to: - bond price decrease (exacerbated bc this is a long term bond, which are highly sensitive to rates, and becoming longer) - bc underlying mortgages are outstanding for longer, you're stuck in the investment for longer

Question 32

Which MBSs are backed by the US Gov?

Answer 32

Ginnie Maes (Just know the one that starts w G is) Freddie Mac and Fannie Mae are only IMPLICITLY backed

Question 33

Tax Anticipation Notes (TANs)

Answer 33

muni notes issued that will be repaid from ad valorem taxes due at a future date

Question 34

Revenue Anticipation Notes (RANs)

Answer 34

Muni notes issued in anticipation of receiving non-tax income (usually sales tax)

Question 35

Bond Anticipation Notes (BANs)

Answer 35

Muni notes issued to support capital projects, repaid by proceeds from issuance of long term bonds. They're a way of interim financing until the bond issue can be prepared and sold