Unit 2: Debt Securities Flashcards
Have neither ownership interest in the issuing corporation nor voice in management; as creditors, ___________ receive preferential treatment over common and preferred stockholders if a corporation files for bankruptcy.
Bondholders
_______ are considered senior securities
Bonds
Corporate bonds with maturities of five years or more are known as ______ debt
Funded debt
Who is the nation’s largest borrower and the most secure credit risk?
The federal government
Debt securities with less than one year maturity
Treasury Bills
Debt securities with 2-10 years of maturity
Notes
Debt Securities with more than 10 years maturity
Bonds
The debt obligations of state and local governments and their agencies.
Municipal Securities
Par Value, also known as _____ value, is normally $______ per bond, meaning each bond will be redeemed for $_______ when it matures
face value
$1,000 per bond
$1,000
When the loan principal is repaid to the investor
Maturity Date
Three basic types on bond maturity structires
Term, serial and balloon
Structured so that the principal of the whole issue matures at once
Term bond
Schedules proportions of the principal to mature at intervals over a period of years until the entire balance has been repaid
Serial bond
Physical evidence that designates the bond’s ownership and characteristics (in essence an IOU)
Certificates
A common form of bond issued today; the issuer’s transfer agent records the bondholder’s name. The buyer’s name appears on the bond certificate’s face
Registered bond
Most corporate bonds are issued in _____ ______ form
Fully Registered Form
Owners do not receive certificates. The transfer agent maintains the security’s ownership records. Must U.S. Govt bonds are available only in this form.
Book-entry form
A rating of BBB/Baa or higher to be suitable for purchase by banks.
Investment grade
Investment grade bonds are also known as _______ bonds
Bank-grade bonds
The ease with which a bond or any other security can be sold. The term ______ and marketability are synonymous. Ether term refers to how quickly a security can be converted into cash.
Liquidity
The schedule of interest and principal payments due on a bond issue
Debt Service
When a bond’s principal is repaid
Redeemed
Allows the issuer to redeem a bond issue before its maturity date; either in whole or in part
Call feature
An issuer pays bondholders a premium, a price higher than par
Call premium
If a bond issue’s trust indenture does not include a call provision, the issuer normally can buy bonds in the open market known as _______
Tendering
An advantage to bondholders in periods of declining interest rates.
Call protection feature
An investor purchases 5M ABD J&J 15 8s of ‘21
What will the investor receive at maturity of the bond?
$5,200
Bond Principal = $5,000 (Annual interest is $80 per thousand with semiannual interest of $200 for 5 bonds)
which form a bond must be in for an investor to receive interest and principal payments by mail?
Bonds must be fully registered or in book-entry form
New bonds are issued only in _______ and _______ form.
Fully registered and book-entry form
How much is 80 basis points? I. $8 II. $80 III. .8% IV. 8%
We know that 100 basis points = $10 = 1% of a bond’s face value.
Therefore, 80 basis points = .8% and is worth $8.00 (80 x .10)
As a general rule, highly rated issuers do not establish _______ _______. Lower-rated issuers do so to make their issues more marketable
Sinking funds
______ is the difference between the cal price and par
Call premium
The two primary factors affecting a bond’s market price are the:
Issuer’s financial stability and the overall trends in interest rates.
Generally, the higher a bond’s rating, the ______ its yield.
lower
The highest degree of safety
U.S. Government
Types of U.S. Government Securities:
U.S. Treasury Bills, notes, bonds and savings bonds like Series EE and HH bonds
The second highest degree of safety is in securities issued by __________.
Government agencies
Under what economic circumstances do issuers call bonds?
calls occur when interest rates are declining. Put yourself in the issuer’s shoes. Would you want to pay more interest for the use of money that is necessary?
Investors who purchase callable bonds face what types of investment risk?
Call risk is the risk that the bonds will be called and the investor will lose the stream of income from the bond. Remember that bonds do not pay interest after they have been called. The call feature also causes reinvestment risk. If interest rates are down when the call takes place, what likelihood does the investor have of investing the principal received at a comparable rate?
Both call risk and reinvestment risk also apply to callable preferred stock.
Which of the following would an issuer most likely call?
A. high-interest bond, callable at a premium
B. high-interest bond, callable at par
C. Low-interest bond, callable at a premium
D. Low-interest bond, callable at par
Answer: B. Issuers want to call bonds that are costly to them at as low a price as possible. A high-interest bond with no call premium is the best combination. The issuer would be least likely to call a low-interest bond with a high call premium.
The practice of raising money to call a bond. Specifically, the issuer sells a new bond issue to generate funds to retire an existing issue.
Refunding
Refunding, like a call, can occur in full or in part. Refunding is common for bonds approaching ____________.
maturity
A new issue is sold at a lower coupon before the original bond issue can be called.
Pre-refunded (also known as advance refunding)
The proceeds from the new issue are placed in an escrow account and invested in U.S. government securities. ____________ bonds are generally rated AAA or Aaa, the highest rating available.
Pre-refunded
Advance refunding is a form of ____________, or termination, of the issuer’s obligation; pre-refunded bonds are considered __________ and no longer count as part of the issuer’s debt.
Defeasance; defeased
A bond’s ____________ reflects the annualized return of the bond if held to maturity
Yield to Maturity
A bond with a call feature may be redeemed before maturity at the issuer’s option. __________ calculations reflect the early redemption date and consequent acceleration of the discount gain or premium loss from the purchase price.
Yield to Call
Another term for yield to maturity is ______
basis
Example: A 4% bond trading on a 5% basis is trading at a price to yield 5% to maturity.
The YTC for a premium bond called at par is always ______ than the nominal yield, current yield and YTM
lower
For a bond bought at a discount, YTC is always _______ than the nominal yield, current yield and YTM.
higher
If the bond has a YTC lower than its CY, it is trading at _______
premium
If the bond has a YTM and CY that are equal, the bond is trading at ________
par
If the bond has a YTM less that its YTC, the bond is trading at __________
discount
If a bond has a YTM greater than its coupon, the bond is trading at
discount
Bond prices and yields have a _______ relationship
inverse: as interest rates rise, prices decline
Under normal circumstances, the longer a bond’s maturity, the ______ its yeild
greater
What two risks are associated with an increased yield?
the potential for credit quality and inflation risk
The difference in yields between short-term and long-term bonds of the same quality is known as the _____ ______.
yield curve
In a _______ yield curve, the difference between short-term and long-term rates is about three percentage points (300 basis poits), but may be much larger or smaller at any given time.
normal (positive)
When long-term interest rates are lower than short-term rates, the yield curve is considered _______
inverted.
When short-term and long-term rates are the same, the yield curve is ______
flat
a _______, or ascending, yield curve occurs during periods of economic expansion - it generally predicts that interest rates will rise in the future.
normal
A _______ yield curve occurs when the economy is peaking, and no change in interest rates is expected.
flat
an _______, or descending, yield curve occurs when the Federal Reserve Board has tightened credit in an overheating economy; it predicts that rates will fall in the future.
inverted
If the yield curve spread between corporate bonds and government bonds is widening, a ______ is expected. Meaning, investors have chosen the safety of government bonds over higher corporate yields, which occurs when the economy slows down.
recession
If the yield curve between corporate bonds and government bonds is narrowing, an economic _____ is expected and investors are willing to take risks. They will sell government bonds to buy higher-yielding corporates.
expansion
As interest rates change, ______-term bond prices move more in price than ______-term bonds
long-term bond prices move more in price than short-term bonds.
if you are given two callable bonds and asked which will appreciate the most if rates fall, choose the bond with the _______________ call date.
most distant
Because of the fixed interest payments that an investor receives, debt securities are also known as _____-income securities
Fixed-income securities
________, ________ and the U.S. Government are issuers of debt securities
Corporations, Municipalities and U.S. Government
Bonds are often called _____ securities
Senior securities
In the secondary market, bonds can sell for any price - ____ par, _____par or _____ par
at par;
below par;
above par
Corporate bond quotes are commonly stated as percentages of par in increments of _____
1/8
Bond ratings are based on an issuer’s ______ stability
financial stability
A bond’s _____ expresses the cash interest payments in relation to the bond’s value
bond’s yield
A bond is _______ when the issuer has identified specific assets as collateral for interest and principal payments
secured
A type of secured bond, _______ bonds have the highest priority amount all claims on assets pledged as collateral
Mortgage bonds
______-end indenture permits the corporation to issue more bonds of the same class later.
open-end indentures
_______-end indentures does not permit the corporation to issue more bonds of the same class in the future.
closed-end indentures
_______ trust bonds are issued by corporations that own securities of other companies as investments
Collateral trust bonds
______ trust certificates (ETC) are railroads, airlines, trucking companies, and oil companies used to finance the purchase of capital equipment
Equipment trust certificates (ETC)
_______ bonds have no specific collateral backing and are classified as either debentures or subordinated debentures
Unsecured bonds
Types of unsecured bond, _______ are backed by the general credit of the issuing corporation
Debentures
Type of unsecured bond, _______ debentures riskier status, often have conversion features, are paid last of all debt obligations including general creditors
Subordinated Debentures
______ bonds are backed by a company other than the issuer, such as a parent company
Guaranteed bonds
_______ bonds (also known as adjustment bonds) are used when a company is reorganizing and coming out of bankruptcy. Not suitable for investors seeking income
Income bonds
______-_______ bonds are an issuer’s debt obligation that does not make regular interest payments
Zero-coupon bonds
_______-______ bonds are sold at a deep discount to their face value and mature at par.
Zero-coupon bonds
Investors in ______-______ bonds owe income tax each year on the amount by which the bonds have accreted.
Zero-coupon bonds
A legal contract between the bond issuer and a trustee representing the bondholders. (a contract between the issuer and the trustee for the benefit of the bondholders)
Trust Indenture
The ________ provides a central marketplace for trading corporate bonds.
New York Stock Exchange (NYSE)
______ bonds are corporate bonds that may be exchanged for a fixed number of shares of the issuing company’s common stock
Corporate bonds
Most government securities are issued in _____-______ form, meaning that no physical certificate exist.
book-entry
Treasury securities are classified as either ______ , _____ and ______ to distinguish an issue’s term to maturity.
bills, notes and bonds
______ are a type of asset-backed security.
CMOs
5 types of CMOs
- Principal Only – principal only CMOs
- Interest Only – interest only CMOs
- Planned Amortization Class – have targeted maturity dates; they are retired first and offer protection from prepayment risk and extension risk
- Targeted Amortization Class – transfers prepayment risk only to a companion tranche and does not offer protection from extension risk
- Zero-Tranche CMO (Z-Tranche) – receive no payment until all preceding CMO tranches are retired (the most volatile CMO tranche)
Because mortgages back CMOs, they are considered relatively safe. However, their susceptibility to interest rate movements and the resulting changes in the mortgage repayment rate means CMOs carry several risks:
1)
2)
3)
1) Rate of principal repayment varies
2) If interest rates fall and homeowner refinancing increases, principal is received sooner than anticipated
3) If interest rates rise and refinancing declines, the CMO investor may have to hold his investment longer than anticipated (extended maturity risk)
_________ – typically complex asset-backed securities. ______ do not specialize in any single type of debt
Collateralized Debt Obligations (CDOs)
Type of nonmarketable U.S. Government Security (savings bond) in which they return a fixed rate of return
Series EE bonds
Type of nonmarketable U.S. Government Security (savings bond) designed to protect against inflation with interest linked to an inflation index
Series I bonds
_________ is the FINRA-approved trade reporting system for corporate and government agency bonds trading in the OTC secondary market. (Trade-reporting system only, not an execution system); both sides of the transaction must report.
The Trade Reporting and Compliance Engine (TRACE)
________ bonds - issued with put options. In return for accepting a slightly lower interest rate, the investor receives the right to put, or sell, the bond to the issuer at full face value.
Pub Bonds (or putable bonds)
_____ yield is a fixed percentage of the bond’s par value.
Nominal yield (or coupon yield)
______ yield measures a bond’s coupon payment relative to its market price
Current yield
Coupon payment / market price = current yield
_______ reflects the annualized return of the bond if held to maturity
Yield to Maturity
_____ (zero-coupon securities) - short-term obligations issued at a discount from par. Rather than making regular cash interest payments, bills trade at a discount from par value; the return on a T-bill is the difference between the price the investor pays and the par value at which the bill matures.
T-bills
______ (T-notes)pay interest every six months. They are sold at auction every four weeks.
Treasury Notes
______ (T-bonds) long-term securities that pay interest every six months.
Treasury Bonds
a term used to describe a situation in which a bond trades without accrued interest. Zero-coupon bonds, as well as income bonds, trade flat.
Tranches – a pool or mortgages is structured into maturity classes
Trading flat
Put features are most commonly found in ________ bonds. Once putable, the investor is protected against market risk (interest rate risk) as the bonds, at that point, will not trade much below the put price, which is par.
municipal
A coupon of 6% indicates the bondholder is paid 6% of the face amount of $1,000 or $_____ in interest until the bond matures.
$60
What is the current yield of a 6% bond trading for $800?
7.5%
This bond is trading at a discount. When prices fall, yields rise. The current yield is greater than the nominal yield when bonds are trading at a discount.
What is the current yield of a 6% bond trading for $1,200.
5%
This bond is trading at a premium. The price is up so the yield is down. The current yield is less than the nominal yield when bonds are trading at a premium.
An investor who buys a 10% coupon bond at 105 ($1,050 per bond) with 10 years remaining to maturity can expect ______ in interest per year. If he holds the bond to maturity, the bondholder loses $50, the amount of the premium. This loss is
100
If the exam asks you to choose the security that has no reinvestment risk, the answer to look for is a _______ because, with no interest payments to reinvest, the investor has to reinvestment risk. Furthermore, because there is no reinvestment risk, buying a ______ is the only way to lock in a rate of return.
zero
_______ are backed in full by the U.S. government. Receipts are not. Treasury receipts are sold under names like Certificates of Accrual on Treasury Securities (CATS) and Treasury Income Growth Receipts (TIGRS). Both are quotes in yield.
STRIPs
Settlement of agency securities is ______ way (two business days).
regular
The Series 7 exam expects you to know that mortgage- backed securities (MBS) are susceptible to ________ risk. When interest rates fall, mortgage holders typically refinance at lower rates. This means that they pay off their mortgages early, which causes a prepayment of principal to holders of mortgage-backed securities. The early principal payments cannot be reinvested at a comparable return.
reinvestment
For agency securities, regular way settlement is _____ business days and accrued interest is based on a 360 day year.
two
Liquidation Order: Unpaid wages IRS taxes \_\_\_\_\_\_\_\_ debt \_\_\_\_\_\_\_\_\_ liabilities (debentures) and general creditors \_\_\_\_\_\_\_\_ debt Preferred stockholders Common stockholders
Liquidation Order: Unpaid wages IRS taxes Secured debt Unsecured liabilities (debentures) and general creditors Subordinated debt Preferred stockholders Common stockholders
__________ bonds, which are purchased at a discount and mature at face value are a suitable investment for future anticipated expenses such as college tuition.
Zero-coupon
A customer wishes to buy a security providing periodic interest payments, safety of principal, and protection from purchasing power risk. The customer should purchase: A. TIPS B. TIGRS C. CMOs D. STRIPS
Answer: A. TIPS – TIPS offer inflation protection and safety of principal because thye are backed by the U.S. Government.
Z-tranche _______ would not be suitable for an investor needing funds in a specified amount of time, due to the unpredictable nature of when payments will be received
CMOs
_______ yield more than Treasury securities and normally pay investors interest and principal monthly.
CMOs
Some varieties of CMOs, such as PAC companion tranches, may be particularly _______ for small or unsophisticated investors because of their complexity and risks. The customer is required to sign a suitability statement before buying any CMO. Potential investors must understand that the rate of return on CMOs may vary because of early repayment. Also note that the performance of CMOs may not be compared to any other investment vehicle.
unsuitable
All of the following will affect the marketability of a block of corporate bonds EXCEPT: A) maturity. B) rating. C) block size. D) bond denominations.
D) bond denominations.
Block size is a key factor. Maturity is also important-shorter maturities tend to be more marketable than longer maturities. Also, the higher the rating, the more marketable the block. Bond denominations are not relevant.
Reference: 2.1.4.5 in the License Exam Manual
The effective federal funds rate is the:
A) weekly average of all commercial banks.
B) daily average of all commercial banks.
C) weekly average of Federal Reserve System member banks.
D) daily average of Federal Reserve System member banks.
D) daily average of Federal Reserve System member banks.
The effective federal funds rate is the daily average of money center banks, all of which are Federal Reserve System members. This rate is the rate charged bank to bank for overnight loans.
Reference: 2.10.3.1 in the License Exam Manual
If all of the following bonds mature on September 1, 2020, which would have the highest price? A) 5-¾% coupon at 5.85 B) 6-¾% coupon at 6.80 C) 5-½% coupon at 5.50 D) 6-1/4% coupon at 6.10
D) 6-1/4% coupon at 6.10
A bond that is trading at a premium has a yield to maturity that is lower than its coupon rate. Of the choices given, only the 6-1/4% coupon with a 6.10 yield to maturity is trading at a premium. The other bonds shown are either trading at a discount (their yield to maturity is higher than the coupon rate) or at par (their yield to maturity is equal to the coupon rate).
Reference: 2.2.7.3 in the License Exam Manual
Because of the possibility of participating in the growth of the common stock through an increase in the market price of the common, the convertible can be issued with a _______ interest rate.
lower
A repurchase agreement is usually initiated by which of the following?
I) U.S. Treasury.
II) Federal Home Loan Bank.
III) Commercial bank.
IV) Federal Reserve Board.
III) Commercial bank.
IV) Federal Reserve Board.
Repurchase agreements are typically initiated by commercial banks or the Federal Reserve Board. They enable banks to meet reserve requirements through the sale of securities (often overnight) with an agreement to buy them back at an agreed-on price.
Reference: 2.10.2.1 in the License Exam Manual
All of the following would be found in the money market EXCEPT: A) repurchase agreements. B) commercial paper. C) Treasury bills. D) preferred stock.
D) preferred stock.
The money market consists of short-term, high-quality debt instruments. This would not include preferred stock, which is an equity instrument.
Reference: 2.10.1.1 in the License Exam Manual
Which of the following securities is an original issue discount obligation? A) 13-week U.S. Treasury bills. B) GNMA certificates. C) Corporate bonds. D) FNMA bonds.
A) 13-week U.S. Treasury bills.
U.S. Treasury bills are always originally issued at a discount and mature at par, with the investor making the appreciation between the original discounted amount and the par value at maturity. This appreciation is treated as interest, however, as opposed to a capital gain.
Reference: 2.6.1.1 in the License Exam Manual
Which of the following statements describes the discount rate?
A) Charge on loans to brokers on stock exchange collateral.
B) Charge on loans to member banks by the New York Federal Reserve Bank.
C) Base rate on corporate loans at large U.S. money center commercial banks.
D) Rate charged on reserves traded among commercial banks for overnight use in amounts of $1 million or more.
B) Charge on loans to member banks by the New York Federal Reserve Bank.
The discount rate is the charge on loans to member banks by the New York Federal Reserve Bank. The prime rate is the base rate on corporate loans at large U.S. money center commercial banks. The federal funds rate is the rate charged on reserves traded among commercial banks for overnight use in amounts of $1 million or more. The call rate, or broker call loan rate, is the charge on loans to brokers for margin loans.
Reference: 2.10.3.3 in the License Exam Manual
The _____ rate is the base rate on corporate loans at large U.S. money center commercial banks.
prime rate
The ______ ______ rate is the rate charged on reserves traded among commercial banks for overnight use in amounts of $1 million or more.
federal funds rate
The ______ rate, or broker call loan rate, is the charge on loans to brokers for margin loans.
call rate
The ________ rate is the charge on loans to member banks by the New York Federal Reserve Bank.
discount
