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FP513 Investments > Module 2: Debt Investments > Flashcards

Module 2: Debt Investments Flashcards

1
Q

A bond can be issued in one of three ways

A

Registered form - Payments made to owner of record

Bearer form - Payments made to whoever holds or possesses the bond.

Book-entry form - Record of ownership held electronically in a central depository, allowing for greater efficiency in bond transactions.

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2
Q

Default Risk

A

The risk that a business will be unable to service its debt obligations.

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3
Q

par value (face value)

A

amount of principal that the bond owner or holder will receive at the time of maturity.

For CFP exam: Par value is assumed to be $1,000 unless stated otherwise.

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4
Q

The coupon rate or nominal yield

A

Annual interest rate, paid each period for the term of the bond. Is a percentage of the par value.

$1,000 par value bond with a coupon rate of 4% will return an interest payment of $40 (i.e., 4% of $1,000) annually or $20 semiannually.

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5
Q

basis point

A

measurement of a bond’s yield and is equal to 1/100 of 1% of yield.

Example: a bond that increases in yield by 2% is said to increase by 200 basis points.

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6
Q

A bond is selling at a discount when

A

Its price in the secondary market is less than the bond’s par value.

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7
Q

A bond is selling at a premium when

A

its price in the secondary market is greater than the bond’s par value.

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8
Q

Call provision

A

In bond indenture allows the issuer to pay off the bond principal after a specified period, usually at a stipulated price higher than par value.

The issuer is most likely to call the bond if market interest rates have declined, thereby making it possible for the issuer to refinance the bond issue with one that is paying a lower coupon rate.

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9
Q

substitution swap

A

selling bonds with identical characteristics but different YTM (selling prices.)

capitalizes on bond market inefficiency

This price difference is an arbitrage opportunity and will exist only shortly (i.e., until the market corrects the price inefficiency).

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10
Q

intermarket spread swap

A

the exchange of one type of bond (e.g., government bond) with another type of bond (e.g., corporate bond). This occurs when investors believe one type of bond is currently mispriced in relation to the other. The goal of this type of swap is to capitalize on a YTM disparity across bond markets.

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11
Q

rate anticipation swap

A

seeks to take advantage or avoid the impact of expected changes in interest rates.

For example, if rates are expected to increase, long-term bonds are swapped for short-term bonds. If rates are expected to decline, short-term bonds are swapped for bonds with long maturity dates.

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12
Q

pure yield pickup swap

A

a bond with a lower YTM is exchanged for a bond with a higher YTM.

involves selling short-term bonds and purchasing long-term bonds

The new bond that replaces the old bond is either a longer-term bond or a lower-quality bond sufficient to generate a higher overall YTM.

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12
Q

tax swap

A

involves gaining from a capital loss by selling a previously purchased bond at a loss due to rising interest rates.

For example, two years ago, an investor bought a bond for $1,000. The bond currently trades for $800 in the secondary market. The investor may sell the bond for a $200 loss, reinvest the $800 proceeds, and hold the new bond to maturity. Assuming a 25% tax bracket, the investor would experience a tax savings of $50 ($200 × 0.25)

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13
Q

conversion price

A

stock price at which a convertible bond can be exchanged for shares of the issuer’s common stock.

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14
Q

conversion ratio (conversion rate)

A

expresses the number of shares of stock into which a bond may be converted.

Conversion ratio = par value of convertible security/Conversion Price

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15
Q

conversion value (straight value)

A

represents the value of the bond if it were converted on the basis of current market conditions

Conversion value = conversion ratio x market price of common stock

convertible bond will never sell for less than the greater of its conversion value.

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16
Q

Bond sells for a premium

A

Current Market Value > conversion value.
Therefore, the bond should not be converted.

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17
Q

corporate bond is taxable by

A

the state and the federal government

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18
Q

State of municipal bond is taxed by

A

it’s not taxable by either government entity

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19
Q

Treasury note is taxable by

A

the federal government

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20
Q

Downside risk of a bond formula

A

current market price - investment value

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21
Q

Percentage of Downside risk formula

A

downside risk / current market price

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22
Q

Treasury STRIPS
(Separate Trading of Registered Interest and Principal of Securities).

A

Zero-coupon bonds created by separating the semiannual coupon payments and the principal repayment portions of a U.S. Treasury note and bond.

Although the securities underlying Treasury STRIPS are the U.S. government’s direct obligation, major banks and dealers perform the actual separation and trading.

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23
Q

How are STRIPS purchased

A

financial institutions and government securities brokers and dealers;

they cannot be purchased directly from the U.S. Treasury.

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24
Q

What risk does STRIPS have

A

not subject to call risk and have virtually no liquidity risk or default risk

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25
Q

How are STRIPS taxed

A

taxed as ordinary income

best positioned in a tax-deferred account.

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26
Q

Yields-to-maturity

A

represent a bond’s promised yield if held to maturity.

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27
Q

Treasury notes and Treasury bonds

A

Considered Default Risk Free

Exempt from income tax at both state and local levels

Federal income taxed as ordinary income

Both trade in secondary market in percentage of par value

28
Q

Investment (intrinsic) value of a preferred stock formula

A

The preferred stock is a perpetuity and priced by the equation:

P = Dividend ($ amount)/Market Rate

Ex: An 8% dividend ($100 par stock) and a market interest rate of 7.5% is…
P = D ÷ r = $8.00 ÷ 0.075 = $106.67.

29
Q

To immunize a bond portfolio over a specific investment horizon, an investor would do which of the following

A

Match the average weighted duration of the bond portfolio to the investment horizon.

When a portfolio is immunized, its liabilities and expected future cash outflows are funded by making sure that the cash flow from investments (income and principal) will be there at the time that the cash outflow is needed.

That is done by matching the duration, not the maturity, of the bond portfolio to the number of years until the cash outflow will occur.

The duration of the portfolio as a whole should be matched, not the duration of each bond in the portfolio.

30
Q

What is the Investment Premium of a Bond forumula?

A

Investment Premium = current market value - investment value

31
Q

Investment Value of a Bond

A

N = yrs x 2 periods per year)

I/YR = Market yields/rates

PMT = par value x coupon rate / 2

FV = $1,000 (par value)

Solve for PV

32
Q

percentage price movement of interest rates formula

A
  1. Current market rate = Dividend ÷ price/share
  2. percentage price movement ($) = Dividend ÷ Current market rate + addt’l rate increase or decrease
  3. (Price/share - percentage price movement) ÷ price/share
33
Q

Treasury Inflation-Protected Securities (TIPS)

A

Principal value is adjusted for inflation every six months based on the CPI, and one-half of the stated coupon rate is paid semiannually on the inflation-adjusted principal value.

TIPS coupon rate stays the same for the life of the security, but the interest payment changes based on the inflation-adjusted principal or par value.

34
Q

General obligation bonds

A

Backed by the full faith and credit of the government issuing the debt and are repaid through taxes collected by the government body.

The main source of investment risk for a municipal security is interest rate risk.

General obligation bonds do not retain a claim on specific property.

The government issuing the bonds uses its taxing authority to pay the interest and repay the principal. Revenue bonds, not general obligation bonds, pay interest when sufficient revenue is collected from the financed project.

35
Q

Conversion value of the bond

A

conversion ratio x market price of common stock

36
Q

If a bond is currently selling for a premium over its conversion value should the bond be converted?

A

The bond should not be converted.

37
Q

The offsetting of these two risks in a bond portfolio takes place through immunization (the matching of the durations of bonds to the durations of liabilities).

A

Interest rate risk and reinvestment rate risk

38
Q

after-tax rate of return on the portfolio

A

corporate bond is taxable by the state and the federal government

municipal is not taxable by either government entity

Treasury note is taxable by the federal government;

39
Q

An investor pays a premium for a convertible bond because

A

the investor is buying a straight bond and buying a call option

The investor is long the straight bond (bought) and long the call option (bought).

40
Q

inverted yield curve occurs

A

Federal Reserve has tightened credit in an inflationary economy;

Predicts interest rates will fall, can signal a recession.

41
Q

flat yield curve occurs

A

economy is peaking
no change in interest rates (particularly down) is expected.

42
Q

normal (positive) yield curve occurs

A

economic expansion
Predicts that market interest rates will rise

43
Q

The reason for using a ladder bond strategy is to

A

Immunize a portfolio against interest rate risk.

44
Q

Preferred stock’s value is based on

A

Prevailing interest rates. The value for a preferred stock is its dividend divided by prevailing interest rates.

45
Q

Interest rate risk

A

When a yield curve shifts, that means that interest rates have changed.

When interest rates change, bond prices change.
If rates rise, bond prices fall
if rates fall, bond prices rise

46
Q

liquidity preference theory

A

Long-term bonds should provide higher returns than shorter-term obligations because investors are willing to sacrifice some yield to invest in short-term bonds in order to avoid the higher price volatility of longer-term issues.

short-term bonds can more easily be converted into predictable amounts of cash

yield curve should always slope upward

47
Q

Unbiased expectations theory

A

long-term rates consist of many short-term rates and that long-term rates will be the average (or geometric mean) of short-term rates.

current long-term interest rates contain an implicit prediction of future short-term interest rates

48
Q

Market segmentation theory

A

asserts that different institutional investors have different maturity needs that lead them to restrict their bond selections to only predetermined maturity segments.

49
Q

The reason for using a barbell bond strategy is to

A

offset the opposite effects of interest rates on bond prices.

If rates rise, short-term bonds can be reinvested at higher rates. If rates drop, long-term bonds are used to lock in rates.

50
Q

long-term bonds

A

If an investor anticipates a drop in interest rates, he or she should take a more bullish attitude toward interest-sensitive investments like long-term bonds.

51
Q

Government National Mortgage Association (GNMA)

A

Buys
Federal Housing Administration and Department of Veterans Affairs mortgages
and auctions them to private lenders that pool the mortgages to create pass-through certificates for sale to investors.

historically did NOT have an indirect backing and guarantee of the U.S. government.

52
Q

Federal Home Loan Mortgage Corporation (FHLMC)

A

secondary market in mortgages by purchasing conventional mortgages from financial institutions and packaging them into mortgage-backed securities for sale to investors.

53
Q

A convertible bond’s market value will not fall below its

A

investment value

54
Q

Zero-coupon bonds

A
  • Eliminate reinvestment risk
  • Sold at a deep discount from par value
  • Have no coupon payments.
  • ‘interest’ is not paid during, paid at maturity
  • Have maximum price volatility, respond sharply to interest rate changes.
    TAX
  • No periodic interest payments are made, the bondholder must recognize the accrued interest each year for income tax purposes.
55
Q

bond ladder strategy

A

investment strategy in which equal amounts of money are invested in a series of bonds with staggered maturities

The laddered portfolio will provide higher yields than a portfolio consisting entirely of short-term bonds.

56
Q

barbell strategy

A

Purchase of a mixture of very long-term and very short-term bonds.

more aggressive than the ladder strategy

57
Q

bond bullet strategy

A

effective for matching duration to cash needs of investor. Bonds mature at the same time, thus minimizing interest rate risk.

Ex: buys 2 bonds immediately, 2 bonds 2 years from now, and 2 more bonds 4 years from now.
Result, bonds purchased immediately have a maturity of 10 years, the bonds purchased 2 years later have a maturity of 8 years, and bonds purchased 4 years later have a maturity of 6 years.

58
Q

If interest rates are expected to decrease in the near future, what strategy do you recommend?

A

zero-coupon bonds with long maturities have the highest duration and can be expected to increase in price more than any other type of bond.

59
Q

Revenue bonds may be categorized different ways, including

A

Industrial development (issued by governments, assists companies)

Special assessment (financed by those directly benefiting from the project)

Special tax bonds (For specific projects, repaid by special assessments, ad valorem taxes, or excise taxes)

new housing authority (or Section 8) bonds (Finance rehabilitation or construction of affordable housing).

60
Q

Prepayment risk

A

Mortgage-backed securities consist of interest and principal payments.

When interest rates fall, we refinance, paying off the principal. This prepayment of principal is called prepayment risk.

61
Q

Advantage of Convertible Bonds

A

coupon rate on the convertible bond is usually greater than the stock’s dividend yield because the stock usually pays little, if any dividends.

This enables the investor to get a higher periodic cash flow while waiting for the stock to appreciate.

62
Q

Risk-averse investors should consider

A

bonds with low durations.

63
Q

Aggressive investors should consider

A

bonds with high durations when anticipate interest rates will decline

AND

bonds with low durations when anticipate interest rates will rise.

64
Q

Sam is nearing retirement and likes that his Series HH bonds pay interest semiannually. He would like to exchange his Series EE bonds for Series HH bonds. Which statements regarding an exchange is CORRECT.

A) Series EE bonds may no longer be exchanged for Series HH bonds.

B) Sam may exchange the bonds but must recognize the Series EE accrued interest at the time of exchange.

C) Sam may exchange the bonds but will be subject to a three-month interest penalty.

D) Only Sam’s Series EE bonds issued prior to 2004 may be exchanged.

A

A) Series EE bonds may no longer be exchanged for Series HH bonds.
Correct Answer

65
Q

Primary risks associated with a coupon-paying bond

A

Interest rate risk
Purchasing power risk
Default risk
reinvestment rate risk

66
Q

If an investor expects a decline in market interest rates, they should attempt to construct a portfolio of

A

long maturity bonds with low coupon rates.

Provides a portfolio with maximum interest rate sensitivity to take advantage of capital gains by bonds from the decrease in market interest rates.

67
Q

If the investor expects an increase in market interest rates, they should attempt to construct a portfolio of

A

short maturity bonds with high coupon rates

Provides the minimum interest rate sensitivity to minimize the capital losses experienced by bonds from the increase in market interest rates.

68
Q

Differences between preferred stock and long-term bonds

A

FP513 Investments (2 decks)

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