Section 2 - Fixed income securities - characteristics

Question 1

what is a gilt?

Answer 1

Gilts are a UK government sterling bond

Question 2

how is a conventional Gilt denoted?

Answer 2

by its coupon rate and maturity (e.g. Treasury stock 8% 2020)

Question 3

key features of a Gilt?

Answer 3

• holder is paid a fixed cash payment every six months until maturity
• at maturity the final coupon is paid and the return of the principal
• prices of conventional gilts are quoted in terms of £100 nominal
• specific maturity date

Question 4

features of index-linked gilts

Answer 4

• • Protect investors against the erosive effects of inflation
  • Both coupons and redemption value linked to the retail price index (RPI)
  • Three-month indexation lag if issued after Sept 2005 prior to this was an 8 month lag

Question 5

how are gilts categorised in terms of maturity

Answer 5

BASIC
categorised according to their remaining respective maturities. Long for more than 15 years; medium for 7-15 years and short for less than 7 years. ultra-short for under 3 years.

MORE SPECIFIC

o	Undated (perpetual) e.g. war loan, 2 ½ consols (all finally redeemed 5th July 15)
o	Double dated, last issue matured – Treasury 12% 2013/2017 – four year callable issue when the government can call the redeeming in – is a period of time not an or option.

Question 6

what does stripping a gilt refer to?

Answer 6

breaking it down to its individual cash flows, which can be traded separately as zero-coupon gilts.

Question 7

how many cash flows would a three year gilt have?

Answer 7

7

6 semi-annual coupon payments
one principal repayment

Question 8

characteristics of a gilt strip

Answer 8

• Cash flows separately traded
• Manufactured zero coupon bond
• Registered interest = coupons Principal = nominal value
• Computer shares investor services handle the Gilt register

Question 9

how are gilt prices quoted?

Answer 9

clean

Question 10

what is a clean price

Answer 10

price excluding accrued interest - so that reported price changes reflect changes in market conditions and not changes in accrued interest

thus makes it easier to compare bond prices where the bond pays coupons on different dates

Question 11

what is the dirty price

Answer 11

when the gilt is purchased, the actual price paid is known as the dirty price which is the clean price plus any accrued interest.

This is because the seller of the bond will have earned some fraction of the coupon, but will not receive it from the DMO since they are selling the bond prior to the next coupon date. It is therefore rilled into the actual price paid for the bond.

Question 12

what is the ex-dividend date?

Answer 12

7 days (or less) before the payment of the next coupon and the investor is not entitled to that coupon payment

when a gilt is quoted cum-dividend the investor is entitled to the next coupon

Question 13

what index do UK index linked bonds use?

Answer 13

retail price index

Question 14

what index do US index linked bonds use?

Answer 14

Consumer price index (CPI)

Question 15

what do index linked gilts aim to offer investors? and explain how

Answer 15

a fixed real return ie. a return above and over the prevailing rate of inflation.

The nominal payments from other gilts are reduced in real terms by inflation. However, ILGs have both their coupon and redemption values linked to the PRI.

As overall retail/ consumer prices rise so do the nominal income streams from ILGs.

The timing of the uplift to the coupon and principle payments usually refers to a recent past value of the chosen price index e.g. lag og three months

Question 16

hypothesis of the real fisher effect

Answer 16

there will be a real interest rate for each economy (currency) and that if investors can choose which currency to invest in without restriction, the real interest rate will be the same everywhere.

In such a world if interest rates were not equal then arbitrageurs would act in such a way as to eliminate any differences

Question 17

standard settlement of a Gilt

Answer 17

Standard settlement of T+1

Question 18

what is bond indenture?

Answer 18

• Legal document outlining the rights of the bondholders, obligations of the issuer and characteristics of the issue for example:

o Sinking funds: proportion of the bond redeemed each year
o Protective covenants: limitations on future actions
o Call/ put provisions: early redemption features

Question 19

what is a sinking fund provision

Answer 19

requires that a firm ‘retires’ (buys back) a certain proportion fo the bond issue throughout the life of the bond each year.

This is seen as an advantage to the remaining bondholders, since it reduces the final amount that the firm has to pay when the issue finally matures

Question 20

What is a protective covenant

Answer 20

specifies the limitations on the future actions of the issuing firm. These are design to ensure that the stream of income required to meet coupon and principal payments from the bond is not exposed to undue risk.

Question 21

give e.g.’s of items a covenant might place limitations on

Answer 21

• the proportion of earnings that can be paid to shareholders
• the amount of additional debt that can be raised by the company
• the ranking of any future debt
• the amount that company execs pay themselves

Question 22

what does a call provision on a corporate bond allow?

Answer 22

Usually allows the firm to redeem the issue at its discretion on pre-specified dates at pre-determined prices.

Question 23

when may a firm use a call provision on a corporate bond

Answer 23

if interest rates fall retiring the issue that pays a higher yield and issuing new debt at a lower rate

Question 24

who do call provisions only serve to benefit

Answer 24

the firm issuing the bond

Question 25

what does a put prevision in a corporate bond allow

Answer 25

an investor to sell the bond back to the issuer at a pre-specified price.

Question 26

who do put provisions only serve to benefit? and when may these be used

Answer 26

the investor - who will take up this option if interest rates rise, by selling the bond back to the issuer and purchasing new higher yielding fixed income securities

Question 27

what is a secured bond?

Answer 27

a bond that is secured against specific collateral - usually land or buildings

Question 28

what are debentures

Answer 28

Debentures: floating security – backed by a range of assets e.g. the stock within the warehouse – effectively whatever can be sold

Question 29

what is a zero coupon bond?

Answer 29

corporate bonds that pay no coupon but only a redemption value

these are therefore issued at a deep discount to their par value.

Question 30

what is the pro of a zero coupon bond

Answer 30

they emboy to reinvestment rate risk

Question 31

what is the risk of a zero coupon bond

Answer 31

they carry substantial price risk - which is the risk relating to the price change as interest rates change

Question 32

What is a Contingent Convertible (CoCo) bond? and where are these popular?

Answer 32

• Major innovation, issued mainly by banks
• Debt which is converted into equity if a pre-specified trigger event occurs (e.g. capital of bank falls below a specified percentage of risk weighted assets)
• Popular in the banking sector as part of the toolkit for crisis management. They are intended to be a readily available source of capital in times of crisis when private investors are usually unwilling to provide additional external capital

Question 33

what is the trigger for a contingent convertible bond?

Answer 33

the point at which the loss-absorbtion mechanism is activated

A CoCo can have one or more triggers, the activation of any of which will trigger the conversion

Question 34

what is a conversion to equity CoCO

Answer 34

raises the capital ration by converting the bond into equity at a pre-defined conversion rate

Question 35

what is a principal write-down CoCo

Answer 35

raises equity by incurring a write down

Question 36

what is a Eurobond?

Answer 36

• Eurobonds (‘international bonds’) – taking a currency outside of its jurisdiction

UK Company  raising £ in the UK markets (this is a domestic bond – everything is matched)
UK company  raising $ in the US markets (this is a foreign bond – foreign entity raising capital) ‘yankie bond’ in this case
UK Company  raising $  Japanese markets (this is a Eurobond – where there is a mismatch between the currency and the region used to raise the currency)