Section 3

Question 1

What are the two elements of interest rate risk?

Answer 1

1) price risk

2) reinvestment risk

Question 2

what is price risk

Answer 2

as interest rates and thus yields rise (fall), bond prices fall (rise)

Question 3

what is reinvestment risk

Answer 3

As interest rates rise (fall) the return from re-investing coupons received prior to maturity rise (fall)

Question 4

what is credit risk

Answer 4

the risk that the credit rating of a bond issuer will fall. this will make the bond less valuable, because the risk of default has increased

Question 5

what is default risk

Answer 5

the risk that default occurs and the cash returns are received only partially or not at all

Question 6

what is inflation risk?

Answer 6

the risk that inflation will eat into the fixed cash flow returns of a bond investment, thus reducing the real returns.

Index-linked gilts are an inflation hedge instrument that address this problem.

Question 7

what is currency risk?

Answer 7

the risk that if investing in overseas bonds, currency fluctuations will affect the returns in domestic currency

Question 8

what is call risk

Answer 8

if a bond is callable, there is risk that when rates fall, the bond will be redeemed early by the issuer. this forces cash into the investor’s hand sooner than expected at a time when reinvestment returns are lower

Question 9

what do credit agencies specialise in?

Answer 9

specialise in assessing the probability that a firm will be late with interest or principal payments, or indeed default on its issued debt.

Question 10

Highest quality of Moody’s S&P and Fitch ratings

Answer 10

Moodys- Aaa
Standard and poor - AAA
Fitch - AAA

Question 11

Lowest quality of Moody’s S&P and Fitch ratings

Answer 11

Moodys- C
Standard and poor - D
Fitch - D

Means in bankruptcy

Question 12

What is the lowest investment grade rating given by rating agencies before going sub-investment grade?

Answer 12

Moodys- Baa3
Standard and poor - BBB-
Fitch - BBB-

Question 13

Who is debt seniority important to?

Answer 13

the seniority of a particular bond issue is important to investors who are trying to determine the likelihod of being repaid should the firm default

Question 14

what does seniority refer to?

Answer 14

the order in which bonds will be repaid in the event of a default

Question 15

list the bond ranking of senority bonds?

Answer 15

• senior secured - secured on the underlying assets of a firm
• senior unsecured
• subordinated

Question 16

when conducting a credit rating assessment what do rating agencies typically focus on in terms of key factors?

Answer 16

• financial statement analysis, including capital structure, leverage and asset protection
• macro economic forecasts
• industry trends
• regulatory developments
• management quality
• the bonds covenant

Question 17

what financial ratios are considered by credit rating agencies analysis

Answer 17

• the ability to meet payments - defined as profit before interest and tax / interest payable
• indebtedness - defined as interest-bearing debt / ordinary shareholders funds
• profitability - defined as operating income / sales