Unit 2 - Session 5 - Fixed Income Securities / Valuation Methods

Question 1

Indenture

Answer 1

Terms of a loan between an issuer and investor in the issuer

Question 2

Long Term Debt

Answer 2

debt capital - money borrowed for minimum of five years more frequently 20-30

Question 3

What are the two types of government backing

Answer 3

1. ) government backing or guarantee - Treasury issues

2. ) moral guarantee - federal agencies

Question 4

Treasury Bills

Answer 4

direct short-term debt obligations of the US Government. Issued every week by using a competitive bidding process with maturities of 4 weeks, 13 weeks, 26 weeks, 52 weeks(this one issued once per month). Treasuries pay no interest and are issued at a discount of par value. 13 week treasury is usually referred to as “risk free”. Only treasury security issued without an interest rate and at a discount.
Note: on the exam par value for treasuries will be $1000

Question 5

U.S. Treasury Notes

Answer 5

direct debt obligations of the U.S. Treasury that:

1. ) semiannual interest as a % of stated par value
2. ) have intermediate maturities (2,3,5,7, 10 years)
3. ) mature at par value

Question 6

U.S. Treasury Bonds

Answer 6

direct debt obligations of the U.S. Treasury with the following characteristics

1. ) pay semiannual interest as a % of the stated par value
2. ) long-term maturities, generally 10-30 yrs
3. ) 30 yr bonds are usually callable at par beginning 25 yrs after issue
4. ) mature at par value

Question 7

Treasury Inflation Protection Securities (TIPS)

Answer 7

A special issue that helps protect investors against purchasing power risk. Notes are issued with a fixed interest rate but the principal amount is adjusted semiannually by the an amount equal to the change of the consumer price index, the standard measure of inflation. They are issued with 5, 10, & 30 yr maturities. Exempt from state and local income taxes on interest generated but are subject to federal taxation. The principal adjustment for inflation for any given year is reportable for income of that year even though it is not received until maturity. The inflation increase is received every six months. If inflation is 4%, you receive the inflation increase in two installments of 2% each.

Question 8

What is the minimum denomination of Ginnie Mae certificates?

Answer 8

$25,000

Question 9

Taxation of Ginnie and Finne Mae securities

Answer 9

All subject to local, state, and federal income tax

Question 10

Equipment Trust Certificate

Answer 10

financing the acquisition of rolling stock, locomotives or airplanes. The company usually makes a 20% down payment of the cost and finances the balance over a course of time

Question 11

Collateral Trust Bonds

Answer 11

When companies do not have equipment or real estate they will put corporate securities into a trust as collateral

Question 12

Debenture

Answer 12

Debt obligation of a corporation backed by it word and creditworthiness. Unsecured, sold on general credit of the company

Question 13

Guarantee Bond

Answer 13

Bond that is guaranteed as to payment of interest and principal by a corporate entity that is only as good as the guarantor behind it

Question 14

Liquidity priority

Answer 14

Secured Creditors, Unsecured Creditors, Subordinated debt holders, preferred stockholders, common stockholders

Question 15

General Obligation Bonds

Answer 15

Backed by the pledge of the issuer’s full faith and credit for prompt payment of principal and interest. Most cities, counties, and school district bonds have the further distinction of being secured by pledge of unlimited property taxes to be levied against all taxable property

Question 16

Revenue Bonds

Answer 16

Payable from the earnings of a revenue-producing enterprise, such as water, electric or gas system, toll bridge, airport, college dormitory or other income-producing facility

Question 17

Investment Grade

Answer 17

Bonds rated in the first four categories (BBB or Baa or higher) and generally only quality institutions invest in

Question 18

It what circumstances are bonds not rated?

Answer 18

1. ) The issuer does not want to pay the cost of receiving the rating
2. ) The issuer does not have a sufficient credit history to enable the rater to make a fair judgment

Question 19

High Yield Bonds

Answer 19

Lower-grade bonds, known in the industry as junk bonds. Their lower ratings and additional risk of default, high-yield bonds may be subject to substantial price erosion during slow economic time or the the issuer’s creditworthiness is questioned. Higher volatility than investment-grade bonds. These may be suitable for sophisticated investors seeking higher returns and possible capital appreciation from speculative fixed-income investments

Question 20

Yield Spread

Answer 20

Common measurement between treasuries and common bonds. Yield spreads widen when economic conditions sour and narrow when economic times are stronger

Question 21

Foreign Bonds

Answer 21

Investing in bonds issued by sovereign foreign governments. Depending on the how established the financial structure is, some the risks vary.

Question 22

Eurobond

Answer 22

Long term debt instrument issued and sold outside the country of the currency in which it is denominated. Issued outside the US, but P&I received in USD. Not limited to European issuers

Question 23

Eurodollar bonds

Answer 23

Issued and sold outside the US, but P&I are stated in USD. Eurobonds are paid in foreign currency.
Advantages
1.) non currency risk to US investors
2.) rated by US rating agencies
3.) may offer higher yields than domestic bonds from the same issuer

Question 24

Yankee Bond

Answer 24

US Dollar denominated bond issued by a non-US entity

Question 25

Brady Bond

Answer 25

Initiated to exchange defaulted commercial bank debt issued in less-developed counties with a security that could be carried on the bank’s books of performing assets. Partners include the IMF and World Bank. No US government guarantee

Question 26

CMOs

Answer 26

Collateralized Mortgage Obligations - Bonds that are collateralized by mortgages or by mortgage backed securities. Biggest difference between CMOs and MBSs is that CMOs have a stated maturity (short, intermediate, and long terms) . The principal on the morgage being repaid is fofr the newest maturity sequence until each maturity has been paid off. these are usually private mortgages not qualified for VA/FHA.

Question 27

CMOs

Answer 27

Collateralized Mortgage Obligations - Bonds that are collateralized by mortgages or by mortgage backed securities. Biggest difference between CMOs and MBSs is that CMOs have a stated maturity (short, intermediate, and long terms) . The principal on the mortgage being repaid is for the newest maturity sequence until each maturity has been paid off. these are usually private mortgages not qualified for VA/FHA.

Question 28

Call protection

Answer 28

the number of years into the issue before the issuer may exercise the call provision. The best call protection is as bond that is not callable

Question 29

Convertible Bonds

Answer 29

Issued by corporations only where the bond can be converted or exchanged for the company’s common stock. Regardless of the stock price, the bond always represents a debt of the corp. of $1,000. The conversion is fixed at issuance. Most convertibles contain a call provision, if the market price of the bond becomes too high, the company can force investors to convert

Question 30

Concept of Parity

Answer 30

When two things are equal, so when the convertible bond value and the stock price. For example, a bond is convertible into 50 shares of common stock and the bond is valued at $1,200 then each share is $24 and the bond is selling for $1,200 = parity.

Question 31

Nominal Yield

Answer 31

interest stated on the face of the bond, presented as a % of par. Interest rates are always stated on an annual basis. Par value is $1,000, unless stated otherwise

Question 32

Current Yield

Answer 32

Bonds: annual Interest/amount of investment required to own the security
Equity: dividend/amount of investment required to own the security

Question 33

What is it called when a bond is selling above par?

Answer 33

Premium. An investor buying a bond at a premium will always receive a rate of return less than the coupon

Question 34

What is it called when a bond is selling below par?

Answer 34

a Discount. An investor buying a bond at a discount will always receive a rate of return greater than the coupon. Also, the investor will receive the par value at maturity, principal greater than what was paid to purchase the bond

Question 35

Yield to Call

Answer 35

a bond with a call feature may be redeemed before maturity at the issuer’s option. YTC is the rate of return the bond provides from the purchase date to the call date and price. generates a lower return than than the YTM

Question 36

How is interest on corporate bonds taxed?

Answer 36

Ordinary income on both state and federal returns

Question 37

Tax Equivalent Yield

Answer 37

Yield: Coupon / (100 - tax bracket); use this to determine what a taxable security would have to pay to give the same after-tax return

Question 38

Double Tax Exemption

Answer 38

When the Tax Equivalent Yield for a municipal bond issued by an entity within a state with a state income tax will have a higher tax equivalent yield to a resident

Question 39

How much does each bond point represent?

Answer 39

$10

Question 40

What are bond point fractions in corporate and municipal bonds?

Answer 40

1/8ths or $1.25

i.e bond quoted at 90 1/4 = $902.5
101 3/4 = $1017.50

Question 41

What are bond point fractions in government bonds?

Answer 41

1/32nds or $.3125

i. e. Gov bond quoted at 90.8 = $902.5
101. 24 = $1017.5

Question 42

Zero Coupon Bond

Answer 42

The nominal rate is zero, but are issued at a substantial discount from par.

1. ) Always issued at a discount
2. ) No reinvestment risk
3. ) More volatile than other bonds of similar quality
4. ) Even though no periodic interest payments are received, the IRS requires the issuer to send Form 1099-OID indicating the taxable interest to be reported each yr
5. ) Particlarly useful when there is a target goal, such as college education or a qualified retirement plan. For college, the child generally incurs little, if any, tax liability, and the earnings in the retirement plans are tax-derred

Question 43

Bond Listings

Answer 43

Issuer, Coupon Rate, Maturity Date, Price

Question 44

Duration

Answer 44

Measures the sensitivity of a debt security when faced with the change of interest rates. The longer the duration, the greater the market volatility. It the measurement of how it takes for the interest payments to repay the invested principal. The longer the bond’s maturity the longer the duration. Duration is linear compare to convexity, which follows a curve. When two bonds are compared on an equal basis, the one with greater convexity offers greater interest rate protection

Question 45

Discounted Cash Flow

Answer 45

Assess the value of a fixed income security by looking at the future expected free cash flow (interest payments plus return of principal) and discounting to arrive at a present value. The higher the DCF, the more valuable the investment. The higher the market interest rate the higher the discount rate.