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Course 3: Investment Planning > Module 2: Debt Securities > Flashcards

Module 2: Debt Securities Flashcards

1
Q

Ways a bond can be issued

A

registered form, bearer form, and book-entry form.

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2
Q

Registered Form

A

payments will be made to the owner of record

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3
Q

Bearer form

A

payments will be made to whoever holds or possesses the bond

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4
Q

Book-Entry form

A

its record of ownership is held electronically in a central depository, allowing for greater efficiency in bond transactions

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5
Q

Bond Indenture

A

Formal agreement, or contract, between the issuer and the bondholder

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6
Q

Sinking Fund

A

A separate fund established and funded each year by the bond issuer; it is designed to accumulate an amount required to pay off the debt at maturity.

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7
Q

OID Bond

A

A bond that is issued at.a discount

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8
Q

Secured Bond

A

pledges specific assets that may be sold by the bond purchaser in the event that the bond issuer defaults in paying

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9
Q

Debenture

A

An bond that pledges no specific assets. Unsecured

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10
Q

Investment Grade

A

BBB- or higher by SP

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11
Q

High Yield Bond

A

BB+ or lower

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12
Q

Term vs. Serial Obligation Bond

A

Term Bond - single maturity date

Serial Obligation Bond - series of maturity dates, each maturity date being a subset of the original issue.

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13
Q

Types of Risk Associated with Bonds (8)

A 
Interest Rate Risk 
Reinvestment Rate Risk 
Call Risk 
Financial Risk 
Default (Credit) Risk 
Purchasing Power Risk 
Liquidity Risk 
Event Risk
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14
Q

Reinvestment Rate Risk

A

There is a risk that you are reinvesting the coupon payments at a lower interest rate than the bond you’re receiving the coupon payments from. Zero-Coupon Bonds are not subject to reinvestment rate risk.

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15
Q

Financial Risk

A

Associated with the level of debt an issuer has outstanding.

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16
Q

Liquidity Risk

A

MEasured by the spread between the bid price and the ask price quoted by a dealer. The wider the spread, the more liquidity risk.

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17
Q

Event Risk

A

The possibility that a bond issue will be affected by an unanticipated and damaging event.

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18
Q

Types of Bond Issuer

A 
Federal Government
Federal Government Agencies
Municipalities 
Corporations 
International Issuers
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19
Q

US Treasury Notes

A

Maturity Dates of 2,3,5,7,10 years

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20
Q

US Treasury Bonds

A

Maturity of 30 years

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21
Q

US Government Notes and Bonds

A

Issued at their stated par value and provide semiannual coupon payments. Sold in increments of $100 with a $100 minimum purchase.

  • Competitive and Noncompetitive Yield Bids
  • Exempt from taxation at both state and local levels, but taxable as ordinary income rates for federal tax purposes.
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22
Q

Competitive yield bids

A

the Treasury determines the highest yield it must offer to achieve its sales goals

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23
Q

Bond Tax Characterstics (OID)

A

Original Issue Discount (OID) must be calculated for anyone who did not pay more than the Face Value for their bond. This is considered phantom income, and the investors basis is then increased by the amount of the OID included in income each year.

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24
Q

Types of US Government Securities

A
  • Notes and Bonds
  • Treasury STRIPS
  • TIPS
  • Savings Bonds
  • US Government Agency Securities
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25
Q

Treasury STRIPS

A

zerp-coupon bonds created by separating the semiannual coupon payments and the principal repayment portions of a U.S T-note or T-Bond. Purchased through financial institutions and government securities broker dealers; are not purchased directly fromt he US Treasury.
- Interest onf STIPS is taxed at ordinary income as it accrues, even though no actual interst is paid until the bond matures.

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26
Q

STRIPS Calculation Process

A 
FV = Face Value of the STRIP
I/YR = Interest Rate divided by 2
N = Number of years * 2

The reason they are broken down /2 and *2 is because a STRIP is a bond that is broken up into 6 month portions, so we must change the calculation to a twice a year event

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27
Q

TIPS

A

Marketable security whose principal is adjusted by changes in the CPO. 5,10,30 year maturity issues. The interest payments are determined by ultiplying the inflation adjusted principal value by half of the fixed interest rate. So the coupon rate stays the same but the principal is changed by inflation. At maturity the investor will receive the greater of the original principal r the adjusted principal.

  • Tax free at the state and local levels
  • Interest and increase in principal via CPI adjustements is taxed at ordinary income federal
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28
Q

TIPS Calculation Process

A

FV * (1+inflation rate) = New FV
New FV * Fixed interest Rate = new interest rate
Repeat

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29
Q

Savings Bond

A

Series E, EE, H, HH< and I bonds.

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30
Q

Series EE

A

Fixed interest rate for life, able to earn interest for 30 years, must be held for a 12 month minimum, 3-month penalty assesed if the bond is redeemed within 5 years of issue. Interest may be excluded from income tax if the proceeds are used for higher education costs.

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31
Q

Series HH Bond

A

Only be obtained by exchanging EE bonds that were at least 6 months old. Pay semiannual interest in cash for up to 20 years, with no penalty for early redemption.

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32
Q

Series I Bond

A

inflation indexed with a fixed rate that remains the same for the life of the bond and a semiannual inflation rate based on the changes of the CPI during the previous 6-month preiod. May be redeemed at any time 12 months after the issue date for the principal plus interest accrued. If redeemed with 5 years, there is a 3-month interest penalty. Interest may be excluded from income tax if the proceeds are used for higher education costs.

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33
Q

Government Agency Securities

A
  • Farm Credit Administration
  • GNMA or Ginnie Mae - Mortgage backed securities
  • PRIVATE: FHLMC or Freddie Mac, FNMA or Fannie Mae, SLMA, or Sallie Mae (indirect backing and guarantee of the federal government)
  • Taxable at both federal, state and local levels
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34
Q

Government National Mortgage Association (GNMA)

A
  • Buys Federal Housing Admin and VA mortgages and auctions them to a private lenders who create pass-through certificates for sale to investors.
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35
Q

Federal Home Loan Mortgage Corporation (FHLMC)

A
  • Was created to promote the development of a nationwide secondary market in mortgages by purchasing conventional mortgages from financial institutions and packaging them into mortgage-backed securities for sale to investors.
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36
Q

Federal National Mortgage Association (FNMA)

A

Competes with FHLMC for investor money int he secondary marketplace. But FNMA is a gonverment-sponsored corporation that is owned entirely by private stockholders.

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37
Q

Mortgage Association Agencies Risks

A
  • When interest rates fall, people refinance, creating a prepayment risk, which means the actual price of the security won’t go up when interest rates go down like a normal bond.
  • Reinvestment Rate Risk
  • Extension Risk - results from the slowing down of expected prepayments when interest rates increase, which extends the average life of a mortgage and therefore delays the receipt of any rpeviously expected principal.
38
Q

Mortgage Association Taxability

A

Part of each monthly payment from the pass-through represents a return of the investor’s own principal. So unless the investor reinvests that portion of each monthly payment, they can unknowingly lose their base of investment capital.

39
Q

Types of Municipal Bonds

A
  • General Obligation Bonds

- Revenue Bonds

40
Q

General Obligation Bonds

A

Issued to finance capital improvements benefiting the community. These improvements do not produce revenues so the principal and interest on the obligation must be paid by the revenues of hte muni issuer. “Full faith and credit” bonds and require taxpayer vote to approve new issues.

41
Q

Revenue Bonds

A

Used to finance any muni facility that generates sufficient income to satisfy the ongoing debt obligation. These are more risky the GOs and therefore offer higher yields for similar maturities.

42
Q

Types of Revenue Bonds

A
  • Industrial development revenue bonds
  • Special assessment bonds
  • Special Tax Bonds
  • New housing Authority Bonds
43
Q

Industrial Development Bonds

A

Issued by governments to assist companies with specific projects

44
Q

Special Assessment Bonds

A

Financed by those directly benefiting from the project

45
Q

Special Tax Bonds

A

Used for specific projects and repaid by special assessments, ad volarem taxes or excise taxes

46
Q

New Housing Authority Bonds

A

used to finance rehab or construction of affordable housing

47
Q

Private Activity (Private Purpose) Bonds

A

Part of a stat eor local government bond issue, more than 10% of hte proceeds of the issue are used for a private business purpose (like a sports stadium).

48
Q

Qualified Private Activity Bonds

A

tax-exempt bonds issed by a local or state government, the proceeds of which are used for a defined qualified purpose by an entity other than the government issuing the bonds. For it to be tax exempt 95% or more of the net bond proceeds must be used for one of several qualified purposes as described in the Internal Revenue Code.

49
Q

Tax-Equivalent Yield Calculation

A

Tax-exempt Yield/1-Marginal Tax Rate

50
Q

After-Tax Yield Calculation

A

Pretax Return * (1-marginal tax rate)

51
Q

Corporate Bonds Segments

A
  • Industrials
  • Public Utilities
  • Transportation Issues
  • Financial Issues
52
Q

Corporate Bonds

A

Most bonds issued are subordinated int security or safety to all other corporate creditors so they tend to feature higher coupon rates than secured bonds, muni bonds, or US Treasury Securities.

53
Q

Types of Secured Corporate Bonds

A
  • Mortgage Bonds
  • Collateral Trust Bonds
  • Equipment Trust Certificates
54
Q

Yankee Bonds

A
  • Foreign Bonds payable in U.S Dollars (e.g., bonds issued by Deutsche Bank in the United States)
55
Q

Eurodollar Bonds

A
  • U.S. Pay bond, but do not have to be registered with the SEC. (e.g., bonds issued by Toyota in Japan in U.S. dollars)
56
Q

Eurobonds

A

bonds denominated in a currency not native to the country where they are issued.

57
Q

Promissory Note

A

-Promise to pay a certain sum of money or make a series of payments to others, usually individuals. All of the interest from a promissory note is taxable to the investor at ordinary income rates in the year earned.

58
Q

Convertible Bonds

A

Corporate bonds that may be exchanged for a fixed number of shares of the issuing company’s common stock. They are typically issued by younger, less-established companies. Conversion is excercised at the direction of the investor.

59
Q

Conversion Price

A

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

60
Q

Conversion Ratio

A

Par Value of Convertible Security / Conversion Price

61
Q

Conversion Value

A

= conversion ratio * market price of common stock

62
Q

Investment Value of Convertible Bond

A

This is the same as its intrinsic value as a straight bond. Calculate the present value of cash flows from receipts of semiannuel interest payments and from the face value received at maturity

63
Q

Investment Premium for Convertible Bond

A

The amount that someone is willing to pay as a premium to have the convertible security over the ‘investment value’ of the bond

64
Q

Conversion Premium for Convertible Bond

A

the difference between the market price of the convertible bond and the conversion value. How much more are you willing to pay for the bond than it’s convertible value is worth.

65
Q

Convertible Bond Downside Risk

A

If the market price of the underlying stock falls greatly, so could the value of the bond itself. The downside risk of a convertible bond is the dollar or percentage decline from the current market price of the convertible bond to the investment value of the bond. In other words, the investment premiium is the measure of this bonds downside risk.

66
Q

Forced Conversion

A
  • Because these bonds can have a call option, a company can call the bond at an amount that’s less than the conversion value, forcing the bond holder to either take the worse call value or the better conversion value.
67
Q

Portfolio Immunization

A

Interest rate management technique, whih offsets interest rate risk against reinvestment risk. Used by insitiutional investor who have future funding needs targeted by your over a long time horizon. Full immunization takes place when the duration of the portfolio is equal to the investor’s time horizon.

68
Q

Bond Ladders

A

Long-term strategy for diversifying and staggering the maturity dates in a client’s bond portfolio.

69
Q

Bond Barbells

A

Buying only short and long-term bond issues, which requires active management by the portfolio manager.

70
Q

Bond Bullets

A

A strategy for having several bonds mature at the same time, thus minimizing interest rate risk.

71
Q

Bond Swaps

A

The process of selling one debt security and replacing it with another. Hopefully to incrase the YTM on the bond portfolio, save on income taxes, or reduce the overall interest rate risk of the portfolio.

72
Q

Types of Bonds Swaps

A
  • Substitution Swaps
  • Intermarket Spread Swap
  • Rate anticipation swap
  • Pure yield pickup swap
  • Tax Swap
73
Q

Substitution Swap

A

selling bonds with identical characteristics but different selling prices, price arbitrage

74
Q

Intermarket Spread Swaps

A

exchange one type of bond for another type of bond. This happens when an investor believes that ont ype of bond is currently mispriced

75
Q

Rate anticipation swap

A

takes advantage of expected changes in interest rates. If rates are going up, switch LT bonds for ST bonds

76
Q

Pure Yield Pickup Swap

A

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

77
Q

Tax Swap

A

motivated by current tax law. One such swap involves gaining from a capital loss by sellin a previously purchased bond at a loss due to rising interest rates.

78
Q

The smaller a bond coupon rate

A

the greater its relative price fluctuation

79
Q

Yield Curve

A

A graph of interest rate yields for bonds of the same quality, ranging in maturity from 31 days to 30 years. In a normal yeild curve, the difference between ST and LT interest rates is typically 300 basis points

80
Q

Normal Yield Curve

A

occurs during period of economic expansion and gnenerally predicts that market intrest rates will rise in the future

81
Q

Flat yield curve

A

Occurs when the economy is peaking and, therefore, no change in future interest rates is expected

82
Q

Inverted Yield Curve

A

Occurs when the federal reserve has tightened credit in an inflationary economy; it predicts that interest rates will fall and sometimes, it can signal an upcoming economic recession

83
Q

Term structure of interest rates

A

AKA the yield curve, is a theory that relates the term to maturity of a sample of same-quality bonds to their YTM at any given point in time.

84
Q

Yield Curve Theories

A
  • unbiased expectations theory
  • liquidity preference theory
  • Market segmentation theory
85
Q

Unbiased Expectations Theory

A

states that long-term interest rates consist of many short-term rates and that long-term rates will be the average of short-term rates.

86
Q

Liquidity Preference Theory

A

Based on the unbiased expectations theory but incorporates a liquidity premium into the model. The thoery holds that long-term bonds should provide higher returns than shorter-term obligations because investors are willing to sacrifice some yield to invest in shot-term bonds in order to avoid the higher price volatility of long term issues.

87
Q

Market Segmentation Theory

A

Relies on the laws of supply and demand for various maturities of borrowing and lending. Lenders in each market from commercial banks to life insurance companies need to match their assets, or lending, with their liabilities or debts. The idea being that the shape of the yield curve is ultimately only a function of the investment policies of major institutional investors.

88
Q

Preferred Stock

A

A hybrid security with characteristics of both debt and equity securities. Not guarenteed to receive the dividends on the par value of the preferred stock. Corporation must pay dividends to the preferred shreholder before paying a dividend to the common stock shareholder.

89
Q

Preferred Stock Deduction

A

In the case of a corporation, there will be allowed as a deduction on amount equal to 70% of the amount received as dividends from a domestic corporation.

90
Q

Intrinsic Value Calculation

A

When the dividend is expected to remain constant, the no-growth dividend discount odel may be used to calculate the stocks intrinsic value: V = Dividend0/r

91
Q

Convertible Preferred Stock

A

Can be exchanged for commong stock at a conversion ratio determined when the shares are originally issued

92
Q

Advantages of Convertible Preferred Stock

A
  • The preferred dividend is higher than a common dividend
  • The firm is profitable, the investor can share int he profits by converting the shares into common stock
  • The conversion option becomes more valuable when the common stock price increases
  • Preferred shares have less risk than common shares because the dividend is stable and they have priority over common stock in receiving dividends an din the event of liquidation of the firm

Course 3: Investment Planning (6 decks)

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