Module 2 Flashcards
Debt Investments
What are the categories of bonds based on the issuer of the debt obligation?
U.S. government or Treasury securities, municipal obligations, corporate debt
Categories include Treasury notes, Treasury bonds, general obligation bonds, and debentures.
What type of bonds are issued by the U.S. government?
Treasury securities
Examples include Treasury notes and Treasury bonds.
What are municipal obligations?
Bonds issued by local or state governments
An example is general obligation bonds.
What is corporate debt?
Debt issued by corporations
An example is debentures.
What type of debt obligations can government agencies issue?
Debt obligations that are sometimes backed or guaranteed by the U.S. government
Some agency obligations involve mortgages.
What are asset-backed securities?
Securities created by pooling or collateralizing certain debt obligations
Often involves agency obligations related to mortgages.
Fill in the blank: U.S. government securities include Treasury notes and _______.
Treasury bonds
True or False: Corporate debt includes general obligation bonds.
False
General obligation bonds are a type of municipal obligation.
What is a debenture?
A type of corporate debt instrument
It is generally unsecured and relies on the creditworthiness of the issuer.
What is a bond?
A debt security obligating the issuer to make periodic interest payments and to repay the principal at maturity.
What are the three ways a bond can be issued?
- Registered form
- Bearer form
- Book-entry form
In which form of bond are payments made to the owner of record?
Registered form
In which form of bond are payments made to whoever holds or possesses the bond?
Bearer form
What is the characteristic of a bond held in book-entry form?
Ownership record is held electronically in a central depository.
What is a bond indenture?
The formal agreement or contract between the issuer and the bondholder.
What are the provisions in the bond indenture known as?
Covenants
What do covenants in a bond indenture include?
- Prohibitions on the borrower
- Actions the borrower promises to perform
What is a sinking fund?
A separate fund established and funded each year by the bond issuer to accumulate an amount required to pay off the debt at maturity.
What is the purpose of a sinking fund?
To reduce the default risk associated with some bonds.
What is the par value of a bond?
The amount of principal that the bond owner will receive at maturity.
True or False: A bondholder receives interest payments only at maturity.
False
Fill in the blank: The amount that the bond owner will receive at maturity is known as the _______.
par value
What is the coupon rate of a bond?
The stated annual interest rate that will be paid each period for the term of the bond, expressed as a percentage of the par value of the bond.
If a bond has a par value of $1,000 and a coupon rate of 4%, what is the annual interest payment?
$40
The annual interest payment of a bond with a coupon rate of 4% and a par value of $1,000 is _______.
$40
How much will a bond with a 4% coupon rate pay semiannually?
$20
What is the relationship between the coupon rate and the par value of a bond?
The coupon rate is stated as a percentage of the par value of the bond.
True or False: The coupon rate is the same as the yield to maturity.
False
A bond with a $1,000 par value and a 4% coupon rate will return interest payments of _______ annually.
$40
What does a coupon rate of 4% indicate about the bond’s interest payments?
It indicates that the bond will pay 4% of its par value in interest each year.
What is a basis point?
A measurement of a bond’s yield equal to 1/100 of 1% of yield
How many basis points are in a 2% increase in bond yield?
200 basis points
What does it mean when a bond is selling at a discount?
Its price in the secondary market is less than the bond’s par value
What is an original issue discount (OID) bond?
A bond that is issued at a discount
What does it mean when a bond is selling at a premium?
Its price in the secondary market is greater than the bond’s par value
What is a call provision in a bond indenture?
It allows the issuer to pay off the bond principal after a specified period at a stipulated price higher than par value
When is an issuer most likely to call a bond?
When market interest rates have declined
What is a secured bond?
A bond that pledges specific assets that may be sold if the issuer defaults
What is a debenture?
A bond that promises payments of interest and principal but pledges no specific assets
How does the yield of a debenture compare to a secured bond?
A debenture will have a higher yield due to greater default risk
What is an investment-grade bond?
A bond rated BBB– or higher by Standard & Poor’s, indicating little risk of default
What is a high-yield bond?
A bond rated BB+ or lower by Standard & Poor’s, indicating higher risk of default
True or False: High-yield securities correlate more highly with common stocks than other bonds.
True
What increases the possibility of default for high-yield bonds?
Poor business prospects of the issuer
Fill in the blank: A high-yield bond is sometimes referred to as a _______.
junk bond
What is the general quality of an investment-grade bond?
High-quality with little risk of default
What is the maturity date of a bond?
The date when the principal of the bond will be repaid
It is also referred to as the bond’s maturity or term.
What does the term to maturity refer to?
The number of years over which the issuer has promised to meet the conditions of the debt obligation
What is the most prominent condition of a debt obligation?
Making interest payments
What is a term bond?
A bond that has a single maturity date
What is a serial obligation bond?
A bond that has a series of maturity dates, each being a subset of the original issue
Give an example of maturity dates for a serial obligation bond.
2024, 2025, 2026, …, 2034
Who are the largest issuers of serial bonds?
Municipalities
What are debt securities with maturities under one year referred to as?
Cash equivalents or money market instruments
What is an example of a money market instrument that sells at par?
Negotiable certificates of deposit
True or False: T-bills are traded at a premium.
False
What do T-bills sell for compared to their principal?
Less than their principal
Fill in the blank: Issues that have been outstanding in the secondary market will move from long term to _______ to short term.
Intermediate term
What happens to the price volatility of an issue as it moves from long term to short term?
It will decline
What is the relationship between the maturity of debt securities and their price volatility?
As maturity decreases, price volatility declines
What do bond rating agencies analyze to determine credit ratings?
The financial information of thousands of bond issuers
Examples of bond rating agencies include Standard & Poor’s and Moody’s.
What are the two main categories of bonds based on quality?
- Investment-grade bonds
- Noninvestment-grade bonds
Noninvestment-grade bonds are also known as high-yield or junk bonds.
Why do noninvestment-grade bonds typically have higher yields?
They carry higher default risk than investment-grade bonds.
What is the role of bond rating agencies in the market?
To inform the market of their analyses through ratings.
Fill in the blank: Bonds are categorized as investment-grade or _______.
noninvestment-grade bonds.
True or False: All bonds are evaluated the same way regardless of their quality.
False.
What is the fundamental analysis provided by bond rating agencies used to determine?
The probability of default.
What is considered a noninvestment-grade (junk) bond according to Standard & Poor’s and Moody’s?
Anything below BBB– (Standard & Poor’s) and Baa (Moody’s)
Noninvestment-grade bonds are typically associated with higher risk and potential for default.
What factors are positively related to bond ratings?
Profitability, lack of other debt issues, cash-flow coverage of the issuer
Higher profitability and lower debt levels generally lead to better bond ratings.
What contributes to lower bond ratings?
Excessive financial leverage and earnings instability
These factors increase the risk associated with the issuer’s ability to meet debt obligations.
What happens to bond ratings after they are issued?
They can go up or down depending on the creditworthiness of the issuer
Ratings are dynamic and can change based on the issuer’s financial situation.
How do changes in bond ratings affect yields?
Yields will decrease with an upward revision and increase with a downward revision
This reflects the bond’s quality change as perceived by the market.
What is the effect of an upward revision in bond rating?
Market yield on the bond will decline
This indicates an improvement in the bond’s quality.
What is the effect of a downward revision in bond rating?
Market yield on the bond will increase
This reflects a decline in the bond’s quality.
Fill in the blank: The greater the profitability of the company, the ______ the rating.
higher
Profitability is a key determinant in the bond rating process.
Fill in the blank: As the price of bonds increases, their yields will ______.
decrease
This is an inverse relationship commonly observed in bond markets.
True or False: Investors often change bond prices faster than rating agencies change ratings.
True
This can lead to changes in yields before official rating updates occur.
What is interest rate risk?
The risk associated with a decline in the price of a bond as market interest rates rise.
What happens to the price of a bond as market interest rates decline?
The price of a bond rises.
Why do changes in market yield affect the price of a bond?
Because a typical bond has a fixed coupon.
What is a bond’s value equal to?
The present value of its interest payments plus the present value of its maturity value.
What occurs when market rates increase in relation to bond value?
Discounting cash flows by higher market rates results in a lower bond value.
What effect does a lower bond value have on the bond’s yield?
It pushes the bond’s yield up to market rates.
What is the fundamental principle of bond investing regarding interest rates?
The inverse relationship between changes in interest rates and changes in bond prices.
Fill in the blank: A bond’s value is equal to the _______ of its interest payments plus the present value of its maturity value.
present value
True or False: A bond’s price increases when market interest rates rise.
False
What is the additional income from reinvesting coupon payments called?
interest-on-interest
It depends on the prevailing interest rates at the time of reinvestment.
What happens if a bond pays 5% interest but current interest rates are at 3%?
There is a risk of reinvesting interest payments at the current lower rates.
What is the term for variability in the rate at which reinvestments are made?
reinvestment rate risk
What must occur for a bond to earn its promised yield to maturity (YTM)?
Coupon payments must be reinvested at the promised yield.
What happens to reinvestment income if prevailing interest rates decline?
Reinvestment income may decline as well.
What must happen to a bond’s principal when it is received by an investor?
It must be reinvested either at the bond’s maturity or at its sale.
Fill in the blank: Variability in the rate at which reinvestments are made is called _______.
reinvestment rate risk
True or False: Reinvestment rate risk only applies to coupon payments.
False
What is a potential strategy to address declining reinvestment income?
Pursuing a more aggressive (and riskier) strategy.
What is call risk?
Call risk is the risk that an issuer will exercise a call option on a bond.
When will an issuer typically call a bond?
An issuer will call a bond when interest rates have fallen.
What is one reason an issuer calls a bond?
To save money by refinancing the bonds.
What is the first disadvantage to the bondholder of a callable bond?
The full cash-flow pattern of a callable bond is not known with certainty.
What is the second disadvantage to the bondholder of a callable bond?
The investor is exposed to reinvestment rate risk.
What is the third disadvantage to the bondholder of a callable bond?
The capital gains potential of a callable bond is reduced.
Why is the capital gains potential of a callable bond reduced?
The price of the bond may not rise much above the call price if investors anticipate the bond being called.
What is financial risk?
The risk associated with the level of debt an issuer has outstanding.
What legal obligation does a firm have regarding its debts?
To repay the interest and principal of its debts.
How does high debt levels affect bondholders?
It increases the risk that the firm will not generate sufficient cash flow to meet its obligations.
What can lead to insufficient cash flow for a firm?
A deterioration in the company’s business prospects.
Fill in the blank: High debt levels increase the risk to bondholders that the firm will not generate sufficient _______ to meet its obligations.
cash flow
True or False: A firm has no obligation to repay its debts.
False
What is a potential consequence of a firm not generating sufficient cash flow?
Inability to repay interest or principal when due.
What is default risk?
The risk that an issuer may not be able to make principal and interest payments when due on a bond.
How are bonds classified based on credit ratings?
Bonds may be considered investment grade or noninvestment grade depending on the credit rating given to the issuer by the rating agencies.
What factors do credit ratings affect in bonds?
They affect both the spread of interest rates among bonds with different ratings and the bid-ask spread of individual issues.
What is true about lower rated bonds?
They have wider bid-ask spreads.
Are U.S. Treasury securities considered free of default risk?
Yes, they are considered to be free of default risk.
Are Treasury securities risk-free?
No, they are not risk-free securities.
What types of risks do Treasury securities have?
They have interest rate risk, reinvestment rate risk, and purchasing power risk.
What is purchasing power risk?
The risk associated with the devaluation of cash flows from inflation, measured in terms of purchasing power.
Who is exposed to inflation risk?
The bond investor.
Why are bond investors exposed to inflation risk?
Because the coupon payment is fixed for the life of the issue.
What happens to fixed interest payments during inflation?
They lose purchasing power.
What is the effect of inflation on the fixed principal amount of bonds?
It loses purchasing power.
What is the relationship between inflation and fixed-income securities?
Inflation is the enemy of fixed-income securities.
How does the expectation of increased inflation affect fixed-income securities?
It typically has a negative effect on their prices.
Fill in the blank: Inflation is the enemy of _______.
fixed-income securities.
True or False: Fixed coupon payments remain unaffected by inflation.
False.
What does liquidity risk depend on?
The ease with which an issue can be sold at or near its current market value.
What is the primary measure of liquidity?
The size of the spread between the bid price and the ask price quoted by a dealer.
What happens to liquidity risk when the dealer spread is wider?
The more the liquidity risk.
When are spreads typically wider?
For small issues that are less often traded and small dollar trades.
How does liquidity risk affect a bondholder planning to hold the bond until maturity?
Liquidity risk is less important.
What is event risk?
The possibility that a bond issue will be affected by an unanticipated and damaging event.
What are some forms that an event risk may take? List at least two.
- Major tax or regulatory change
- Change in a company’s capital structure due to a merger or buyout
True or False: Event risk can include negative media attention to a particular product.
True.
Fill in the blank: The disclosure of _______ or other significant misdeeds can constitute event risk.
fraud
What type of events contribute to event risk?
Major, unexpected events.
What type of securities is the market for fixed-income securities larger than?
The market for common stock
This is due to various factors including corporate preferences and investor behavior.
Why do corporations prefer issuing debt over common equity?
Corporations prefer issuing debt rather than common equity
This preference influences the size of the fixed-income securities market.
What type of securities do governments issue?
Governments only issue debt securities
This contributes to the larger market for fixed-income securities.
What do many investors prefer regarding fixed-income securities?
Many investors prefer the risk/return characteristics of bonds
This preference plays a role in the market size for fixed-income securities.
