Unit 13

Question 1

Indenture

Answer 1

Sometimes referred to as the deed of trust, states the issuers obligation to pay back a specific amount of money on a specific date. Also states the interest to be paid as well as any collateral pledged for the loan and any pertinent details.

Question 2

Long-term Debt Financing

Answer 2

Minimum 5 years. Frequently 20-30 yrs.

This is what Debt Capital refers to.

Question 3

What type of bond quote is 90 1/4, and what does this equal in dollars?

Answer 3

Corporate and Muni bonds, quoted in 1/8ths from a $10 bond point.
$902.50

Question 4

What type of bond is quoted as 90.8 or 101.24, and what does it equal in dollars?

Answer 4

Government bonds are quoted as a percentage of par. Each .1 represents 1/32 (.3125) of a $10 bond point.

90. 8 or 90.08 = $902.50.
91. 24 = $1017.50

Question 5

TIPS

• how they work
• how they’re taxed

Answer 5

Helps protect against inflation.

Fixed interest rate, but PRINCIPAL amount is adjusted semiannually by an amount equal to the CPI. Semiannual interest payment is paid off of adjusted principal. So, real rate of return is always the coupon (bc that doesn’t change)

*Federally taxed only, no state and local tax.

5, 10 and 30 yr. maturities. Backed by U.S. govt., so safety of principal.

Question 6

TIPS Taxation - Test Topic Alert*

Answer 6

Interest payments from TIPS, and the increases in the principal of TIPS, are subject to federal tax, but exempt from state and local income taxes. The increase from adjustments are considered earned income and paid that year, even though you won’t receive the increase until the note matures.

Question 7

TIPS Example - 4% inflation on a 3% coupon.

Answer 7

Interest is compounding. **Shortcut - use simple interest and choose answer slightly above that to account for compounding. Long way: Bond is now valued $1020 with a 3% coupon. ($1000 + 2% coupon). So, first interest payment will be $1020 x 1.5% = $15.30. 6 months later, new principal value = $1040.40 (102% x $1020), so that interest check = $15.61 ($1040.40 x 1.5%). Short way: 4% inflation = $1040 bond per year. $1080 for 2 years. So pick answer slightly above that. 1.5% of $1080 = $16.20 interest payment. So pick answer slightly above that.

Question 8

What is the return = rate of return

Answer 8

-

Question 9

What is a quote that reads DEF 5s35 @106?

Answer 9

DEF is issuer. 5% coupon maturing 2035 priced at $1060.

Question 10

Bond Rating Systems

• Identify both rating systems and letters all the way down.
• What is considered investment grade rating
• What is considered junk bond rating (high yield bond)

Answer 10

Standard and Poor - AAA, AA, A –> CCC,C(income bond),D(default). +/- used to show relative strength in category. Investment grade = BBB or higher
Moodys - Aaa, Aa, A, Baa, Ba, B 1-3 used with 1 being highest end of rating class. Last ones are Caa ,Ca, C. Investment grade = Baa or higher.

Question 11

Compute Parity - Test Topic*
6% debenture that is convertible to common at $50 is currently trading at $1200. Parity price of common?

Q2: 6% debenture convertible to common at $50. Common is trading at $45. Parity price of debenture?

Answer 11

Method 1:
Par = $1000
Conv. Price = $50
Conv. Ratio = 20
Bond Price = $1200
$1200 / 20 = $60 Parity price

Method 2:
$1200 = 20% more than a par bond
20% more of $50 = $60 parity price

Q2: 
$1000 par
$50 conv. price
20 conv ratio
Common trading at $45
45 x 20 = $900 parity price of debenture
-or-
45 is 10% less than 50.  10% less of $1000= $900

Question 12

Convertible Securities

Answer 12

Investors sacrifice some interest rate of convertible feature. So should not be recommended for income. ***

Generally sell for a price somewhat above parity price.

Offer stability of a debt security with upside potential of an equity security.

Ability to participate in company’s growth.

Question 13

Bond Yield - what does 6% coupon pay and when do they get payments?

Answer 13

6% = $60 per year. 2 - semi-annual payments of $30

Question 14

Current Yield or Current Return * Test Topic Alert

• What does it find
• What is the formula

Answer 14

Finds the return on investment
Return / Investment

(Return = annual interest in dollars)
(investment = current market price)

6% bond at $1200 = 60/1200 = CY

Question 15

Nominal Yield

- Effects when bond is bought at a premium or discount

Answer 15

If you pay more, you get less
If you pay less, you get more

A bond bought at a premium will have a rate of return less than the stated (nominal) yield. (Return/Investment)

Question 16

Test Topic Alert *

A bond with a 5% coupon is currently yielding 6%. Is it selling at a discount, premium or par?

Answer 16

Discount

Question 17

YTM aka Market Driven Yield

- Calculation

Answer 17

Bought at a premium:
(Annual Interest - Premium/Years to Maturity) / Average Price of Bond

Bought at a discount:
(Annual Interest + Premium/Years to Maturity) / Average Price of Bond

Average Price of bond = Bond Par + Bond Price / 2

Question 18

YTC

Answer 18

Pay attention. If bought at a premium, YTC would be less than YTM. Bad investment.

Question 19

Know the relationship of premium and discount bonds to Nominal Yield, CY, YTM, YTC

Answer 19

Pg. 246 if help needed.

Question 20

Bonds and Duration

• Duration definition
• Coupon Rate to Duration
• Maturity to Duration
• Zero-Coupon and Duration
• Coupon bonds and Duration
• Bond Duration effect on interest rate changes

Answer 20

Duration measures the sensitivity of a debt security with regards to interest rate changes.

The longer the duration, the greater the market price movement.

The higher the coupon rate the shorter the duration. The lower the coupon, longer the duration

Look at maturity dates first when comparing, then interest rate. If dates aren’t significantly different, look at rates for duration.

Lower the coupon or ytm, longer the bond duration (and vice versa)
Longer a bond’s maturity, the longer the duration
For zero-coupon bonds: Duration = Maturity
Coupon Bonds: Duration < Maturity
Longer a bonds duration, the more the price will change for a 1% movement in interest rates (and vice versa)

If you’re expecting interest rates to decline (bond prices to rise), you would lengthen the average duration of the portfolio. Longer duration = more price movement = capture more upside.

Average duration = average of all durations.

A 5-year, Zero coupon bond has a duration of 5.

Question 21

Test Topic Alert*

If you anticipate interest rates to rise, what should you do in regards to your bond and duration?

Answer 21

If you anticipate rates to rise, prices decline. So you’d want to shorten your duration of your bonds (and vice versa)

Question 22

Test Topic Alert*
Which of the following is the most useful when determining the price volatility of a bond to a significant change in interest rates?

Answer 22

Convexity (reflects a curved graph showing the bonds price movement in relation to interest rates)

• Duration is a linear straight line measurement while convexity follows a curve
• Comparing 2 bonds, The one with the higher convexity will show a greater price increase when yields fall and a smaller decrease when yields rise
• if we find two bonds with the same duration the one with the higher complexity offers greater interest rate risk protection.

If asked which of the following is the most useful in determining the price volatility of a bond to a significant change in interest rates? Answer is convexity.

Higher convexity in a bond means a greater price increase when yields fall and smaller decrease when they rise (a good thing). Higher convexity = greater interest rate protection.

Question 23

Discounted Cash Flow (DCF)

• *Another way of saying what it is? - 2 different ways.
• What do you need to know with this formula in relation to mortgage backed securities.

Answer 23

Finds the fair value of a security
Current interest rate in the market place

Need to know principal amount, coupon rate and number of payments.

The higher the discounted cash flow the more valuable the investment.

If DCF is lower than coupon, it’s market price will be higher. If DCF is higher than coupon, market price is lower.

Basically takes all the money you are scheduled to receive and adjusting for time value of money. It arrives at a present value.

The higher the DCF, the more valuable the investment.

If you’re comparing your bond to a bond just issued, and your YTM is more than the YTM being offerred, you have a positive NPV and their bond is selling at price below yours present value. 4% YTM on new compared to my 4.4% YTM = positive NPV.

When doing a cash flow analysis on a mortgage backed security, you’ll need to know the average maturities.

Question 24

Bond Ratings

Answer 24

What is considered a high yield bond rating?

SP = BB or lower
Moodys = Ba or lower