Managing Fixed Income Portfolios: Other Bond Portfolio Construction Techniques, High Yield Bonds, and ETFs

Question 1

The process of turning relatively illiquid assets into tradable securities is known as

Answer 1

securitization

Question 2

The first step in creating an ABS

Answer 2

sell the assets to a legal entity called a special purpose vehicle (SPV).

Question 3

What is a conduit

Answer 3

An SPV that is not related to the originator

Question 4

How does an SPV work in creating an ABS?

Answer 4

SPV is set up as a trust and buys the loans of the originator and sells them as securities

Question 5

What is a bond insurance?

Answer 5

A financial guarantee from an insurance company that guarantees the timely payment of interest and principal if these cannot be satisfied from the pool

Question 6

What does a pool insurance cover?

Answer 6

losses from defaults and foreclosures

Question 7

What is a letter of credit?

Answer 7

• An unfunded commitment by a third party that protects against losses on underlying assets
• Protection is limited to a fixed percentage of collateral.
• A bank usually provides a letter of credit in exchange for a fee.

Question 8

The schedule followed by an ABS that prioritizes the manner in which the interest and principal are paid is known as

Answer 8

the cash flow waterfall

Question 9

The cash flows that remain after all payments are made are known as the____ which seeds the ____.

Answer 9

• excess spread

* reserve fund

Question 10

money market deposits held for protection against future losses.

Answer 10

Reserve funds

Question 11

CMHC guarantees an MBS up to

Answer 11

$100,000

Question 12

three factors that determine prepayment risk

Answer 12

1. Housing turnover
2. Cash-out refinancing
3. Rate/term financing

Question 13

Rate/term financing Occurs when

Answer 13

a borrower obtains a new mortgage on the same property at a lower interest cost or shorter term to maturity, with no increase in their monthly payment.

Question 14

A CDO has three main components that are similar to an ABS, as follows:

Answer 14

1. An originator, which is typically a bank
2. Investors ready to buy the credit risk
3. An SPV

Question 15

There are two main types of CDOs

Answer 15

cash and synthetic

Question 16

These are securities that repackage a collection of underlying assets and sell multiple classes (tranches) of the asset pool’s interest to investors

Answer 16

CDO’s (collatarized debt obligations)

Question 17

These are bonds issued by foreign companies and governments or by domestic companies in foreign currencies.

Answer 17

Foreign Bonds / currencies

Question 18

Over-the-counter contracts for, usually 6 to 12 months, hedging interest rates that are settled by an exchange of cash.

Answer 18

Forward rate agreements (FRAs)

Question 19

Exchange-traded contracts used by banks, corporations and individuals to hedge interest rate risk for future payments

Answer 19

Interest rate futures

Question 20

Agreements made between two parties to exchange interest payments on loans for the same amount, with each party guaranteeing to pay the other’s interest for a stated period.

Answer 20

Interest rate swaps

Question 21

Financial instruments that derive their value from an underlying credit asset or pool of credit assets, such as bonds or mortgages, and are designed to transfer and manage credit risk.

Answer 21

Credit derivatives

Question 22

Most basic type of credit derivative

Answer 22

The most basic form is the credit default swap (CDS)

Question 23

Credit derivatives transfer credit risk in the following two ways:

Answer 23

1. By diversifying a bond portfolio

2. By reducing credit risk:

Question 24

What is a Credit default Swap? (CDS)

Answer 24

A CDS is the exchange of two cash flows: a fee payment and a conditional payment, which are only made if a credit event occurs (ex: default)

Question 25

advantages of securitization (4)

Answer 25

1. reduced funding costs
2. protection of underlying assets (owned by SPV so creditors cannot go after assets of originator)
3. diverse funding sources
4. Acceleration of earnings for financial reporting purposes: The loan originators can immediately book the proceeds from the sale of the receivables as income

Question 26

The two biggest disadvantages to securitization are

Answer 26

1. The lack of transparency of the underlying assets

2. The pricing of the securitization

Question 27

two major issuers of high-yield bonds are

Answer 27

• original issuers

* fallen angels

Question 28

What is an original issuer

Answer 28

a bond issuer with a non-investment-grade credit rating at the time of underwriting

Question 29

non-investment grade is typically assigned to new issue bonds for one or more of the following 3 reasons:

Answer 29

1. highly leveraged relative to competitors
2. no demonstrable operating track record, but has above average growth and profitability prospects. (start-up)
3. experiencing financial difficulties, but does not have any bonds outstanding.

Question 30

What is a fallen angel

Answer 30

bond issuer that once had an investment-grade credit rating on its bonds outstanding, but has recently fallen into financial difficulty.

Question 31

Two Factors for successfully investing in High Yield Bonds

Answer 31

• proper fundamental analysis

* diversify to compensate for the risks associated with individual bond issues.

Question 32

List 4 High Yield Bond Markets

Answer 32

• Merrill Lynch High Yield Master II Index
• CSFB High Yield II Index
• Citigroup U.S. High-Yield Market Index
• Barclays High-Yield Index

Question 33

three main global bond credit-rating agencies are

Answer 33

• Moody’s Investor Service (Moody’s)
• Standard & Poor’s Financial Services LLC (S&P)
• Fitch Ratings Inc. (Fitch).

Question 34

Defaults are defined as bond issues where one of the following events has occurred (3):

Answer 34

• missed payment of interest and/or principal has not been paid within 30 days
• issuer filed for bankruptcy protection or liquidation
• corporate restructuring

Question 35

two main types of default rates, as follows:

Answer 35

• Dollar-denominated default rate, which is based on the dollar amount of bonds that have defaulted
• Issuer-denominated default rate, which is based on the number of issuers that have defaulted

Question 36

The amount of value/funds eventually realized by creditors as a percentage of the bond’s face or default amount

Answer 36

Recovery rate.

Question 37

High Yield Coupon structures are used to finance two types of transactions:

Answer 37

• LBO’s and MBO’s

* Startups

Question 38

Performance benchmark of a fixed income etf are chosen based on three factors:

Answer 38

• Interest rate risk
• Credit Risk
• Currency Risk

Question 39

A Total return swap (TRS) has become a mainstay in the ETF universe in recent years for two reasons:

Answer 39

• It is customizable

* It allows an ETF’s tracking error to be known in advance

Question 40

extent to which the fund attains a smaller tracking error is dependent on the following two factors

Answer 40

• Management fees

* Investment Management techniques (replication, statistical sampling, synthetic replication)

Question 41

3 types of external credit enhancement

Answer 41

• Bond Insurance
• Pool Insurance
• Letter of Credit

Question 42

What is a CMO

Answer 42

and MBS that is further divided into different segments, like principal and interest