SIE: Module 2 - Debt Securities

An Investor buys a 20-year, $1000 par value zero-coupon bond for $350 What two risks are associated with zero-coupon bonds?

1. Higher Interest rate risk (volatility) 2. Phantom income (tax) on annual accretion

What are the 5 types of bond risks?

1. Interest Rate Risk 2. Call Risk 3. Reinvestment Rate Risk 4. Inflationary Risk 5. Credit Risk

what are 3 examples of rating agencies?

1. S&P 2. Moody's 3. Fitch

Corporate & municipal bonds accrue interest using _____ - day months & ________ - day years

30 - day months & 360 - day years

Considering the Following Bond: Interest Rate: 8% Face Value: $1000 What is the current yield if the bond is quoted at "132"?

6.06% (1000*8%)/$1320

How can zero-coupon bond holders avoid taxes on accretion?

By holding the bonds in accounts that allow taxes to be deferred, such as retirement or college savings accounts

If a 9% bond is sold two years later when prevailing interest rates are 12% the bond will sell at a: A. Premium B. Par Value C. Discount D. $600

C. Discount Market Interest Rates > Coupon rate therefore sell at a discount in order for yield to be equal

If a bond is priced at a discount what is the relationship between the coupon rate and the yield to maturity of that bond?

Coupon Rate < Yield To Maturity

If a bond is priced at Par Value what is the relationship between the coupon rate and the yield to maturity of that bond?

Coupon Rate = Yield to Maturity

If a bond is priced at a Premium what is the relationship between the coupon rate and the yield to maturity of that bond?

Coupon Rate > Yield to Maturity

An investor owns a 10% bond purchased at 99 that is callable at 102. If the bond is called away by the issuer on the coupon payment date, how much money does the investor receive? A. $990 B. $1,000 C. $1,020 D. $1,070

D. $1,070 PMT $1,020 = 1000*102% + $50 = (1000*10%)/2 - coupon

A Client is concerned that the income his portfolio produces is insufficient to maintain the standard of living he is accustomed to. Which type of risk applies: A. Interest Rate Risk B. Call risk C. Reinvestment Risk D. Inflationary Risk E. Credit Risk

D. Inflationary Risk

For Premium Bonds which yield is the lowest? A. Current Yield B. Nominal Yield C. Yield to Maturity D. Yield to Call

D. Yield to Call Because if the bond is called the holder will be repaid a lower amount than they paid for it sooner.

For a Discount Bond which yield is the highest? A. Current Yield B. Nominal Yield C. Yield to Maturity D. Yield to Call

D. Yield to Call Because you paid less than face value and could be getting paid back sooner than maturity

During what period can an issuers not call on a callable bond?

During the Call Protection Period Period that provides safety for investors

An issuer faces business difficulty and is downgraded. Which type of risk applies to the investor: A. Interest Rate Risk B. Call risk C. Reinvestment Risk D. Inflationary Risk E. Credit Risk

E. Credit Risk

(T/F) the buyer pays the seller for any unearned, but received interest

False; the buyer pays the seller for any earned, but unreceived interest

(T/F) the seller pays the buyer for any earned, but unreceived interest

False; the buyer pays the seller for any earned, but unreceived interest

A bond that trades with no accrued interest is said to _________________________

Trade Flat

(T/F) the buyer pays the seller for any accrued interest

True

(T/F) the buyer pays the seller for any earned, but unreceived interest

True

Which type of risk is the following: "the risk of default i.e. that an issuer cannot make interest and/or principal payments"

credit risk

If bond prices are rising, interest rates are ____________

falling

If interest rates are rising, bond prices are _________

falling

Do bonds with good or bad credit have more liquidity?

good credit bonds have more liquidity

Who is taxed for the accrued interest on a bond during the sale of a bond?

the seller, aka the recipient of the accrued interest

During the sale of a bond what is the day/date called when the buyer finally owns the bond?

the settlement date

During the sale of a bond what is the day/date called when the trade is initiated?

the trade date

Define: Accretion

the upward adjustment of a discount bond's cost basis

For a par value bond what is special or distinct about its Nominal Yield, Current Yield, and Yield to Maturity?

They are all equal because the bond is selling at par, aka face value.

Consider a 5-year 9% coupon bond. How much will the bondholder receive (final pmt) at maturity, t=5yr?

$1,045 (face value) + (final coupon pmt) ($1,000) + [($1000*9%)/2]

Typically how often is interest, or coupons paid out on a bond?

semiannually

In accrued interest, interest accrues to the seller up to, but excluding _________________.

settlement

Conceptually what is used to calculate the total return in YTM?

the Cash flow from coupon payments on the bond plus any gain or loss the current bond holder will realize at the time of maturity. This is relative to whether the holder purchased the bond at a discount/par/or premium

Why does Accretion matter? How does the government acknowledge it?

the government acknoledges and takes income earned and not income received so zero coupon bond holders will be taxed annually on the income they assume to have been earned with in the year. This is important because will a zero-coupon bond no income is actually received until maturity so unless taxes are deferred these taxes are costs that will be paid annually before any cash flow has actually been received.

What does it mean when a bond is "called"?

the issuer of the bond repays bond holders earlier than the maturity date

Define: "Interest Rate Risk"

the relationship between how interest rates and bond price interreact. Inverted relationship

If a bond is quoted at 100 what is the price in dollars of this bond and what type of bond would this be?

$1000 Par Value Bond

An Investor buys a 20-year, $1000 par value zero-coupon bond for $350 What does the owner receive at maturity?

$1000 Par value

If a bond is quoted at 112 what is the price in dollars of this bond and what type of bond would this be?

$1120 Premium Bond

How much is each interest pmt on a 10 yr bond, $1000 par with a 6% coupon?`

$30 ($1000*6%)/2

How much interest will the investor receive if the bond is held to maturity, 10 yr bond, $1000 par with a 6% coupon?

$600 ($1000*6%)*10yrs

An Investor buys a 20-year, $1000 par value zero-coupon bond for $350 What Profit is earned if held until maturity

$650 $1000 - $350

If a bond is quoted at 83 what is the price in dollars of this bond and what type of bond would this be?

$830 Discount Bond

Considering the Following Bond: Interest Rate: 8% Face Value: $1000 What is the Nominal Yield (Aka Coupon)?

8%

Considering the Following Bond: Interest Rate: 8% Face Value: $1000 What is the current yield if the bond is quoted at "100"?

8% (1000*8%)/$1000

Considering the Following Bond: Interest Rate: 8% Face Value: $1000 What is the current yield if the bond is quoted at "90"?

8.9% (1000*8%)/$900

A 10% March & September corporate bond is traded on Monday, June 2nd: How many days of interest Accrued?

93 days

An Investor buys a 20-year, $1000 par value zero-coupon bond for $350 To entice buyers, how are these bonds priced at issuance?

A Discount

If Bond 2 has: Coupon Rate: 3% 1 yr Later - Market Rate: 4% Current Market of Bond 2? A. Discount B. Premium C. Par

A. Discount Market Interest Rates > Coupon rate therefore sell at a discount in order for yield to be equal

New bonds, similar to the one's in a clients portfolio are being issued with higher coupons Which type of risk applies: A. Interest Rate Risk B. Call risk C. Reinvestment Risk D. Inflationary Risk E. Credit Risk

A. Interest rate risk

Which of the following represents the trade date of a bond? A. T B. T+1 C. T+2

A. T

A buyer of a bond must pay out interest on which of the following periods: A. T & T+1 B. T & T+2 C. T+1 & T+2 D. T & T+1 & T+2

A. T & T+1

Bonds have an inverted yield curve, what does that mean? (interest rates & price)`

As interest rates rise, bond price falls As interest rates fall, bond price rises

New bonds, similar to those in a clients portfolio are being issued with lower coupons Which 2 types of risk applies: A. Interest Rate Risk B. Call risk C. Reinvestment Risk D. Inflationary Risk E. Credit Risk

B. & C. Call Risk & reinvestment Risk

For Premium Bonds which yield is the highest? A. Current Yield B. Nominal Yield C. Yield to Maturity D. Yield to Call

B. Nominal Yield Because the nominal yield is established at issuance using the face value the nominal yield will be higher than the other yields which factor in the current aka higher or premium price which would make those yields smaller than the nominal yield which accounts for the face value of the bond.

For Discount Bonds which yield is the lowest? A. Current Yield B. Nominal Yield C. Yield to Maturity D. Yield to Call

B. Nominal Yield Because this yield is established at the issuance of the bond using the face value coupon rate, but if the bond was purchased at a discount then this yield is lower than any yield that factors in that discounted price.

If Bond 1 has: Coupon Rate: 3% 1 yr Later - Market Rate: 2% Current Market of Bond 1? A. Discount B. Premium C. Par

B. Premium Market interest rate < Coupon Rate sell at premium in order for yield to be equal

Bond issuers are more likely to call bonds before the maturity rate when interest rates are ____________ & why

Bond issuers are more likely to call bonds before the maturity rate when interest rates are LOW Because once the bond is called the principal and final interest payment is paid out to the holders and future interest payments for that specific bond stop. This allows the issuer to create a new issuance at the new lower interest rate.

Describe what aspects of a bond and the economy would cause the reduced purchasing power within inflationary risk.

Bond: Interest Rate / Return / Coupon Rate is Fixed Economy: Costs are rising The fixed interest rate on a bond paired with inflation means that in a times of rising inflation a coupon payment, while the same fixed amount, will have less economic value

Which type of Bond is most sensitive to changes in market interest rates? A. Low Coupon & Short Maturity B. High Coupon & Long Maturity C. Low Coupon & Long Maturity D. High Coupon & Short Maturity

C. Low Coupon & Long Maturity The price of a bond with a low coupon rate and long maturity is most sensitive to changes in interest rates because as market interest rates fluctuate the price of the bond must adapt in order to maintain a similar yield to the market. Due to the fact that the interest rate on a bond is fixed, only the price can accommodate market fluctuations. The longer the maturity the more likely the bond is going to experience and be impacted more frequently by changes in the market interest rates.

Which of the following represents the date the buyer officially owns the bond? A. T B. T+1 C. T+2

C. T+2

Which of the following represents the settlement date of the sale of a bond A. T B. T+1 C. T+2

C. T+2

What type of fixed income feature on a bond benefits the issuer of the bond?

Callable - issuer can "call" or redeem the bond at a set price (typically par) before maturity Provides a higher coupon for investor

What is a large factor in determining the amount of liquidity of a bond or its issuer?

credit ratings

What type of bonds accrue interest using the actual days in each month and year?

Government Bonds

As interest rates in the market fluctuate what effect does this have on the Coupon Yield (Nominal Yield) of a bond?

It has no effect, because the coupon yield (nominal yield) never changes and is established at the time of issuance of a bond

What features make a bond more sensitive to interest rate risk?

Long Duration 1. Low coupon 2. Long Maturity

An Investor buys a 20-year, $1000 par value zero-coupon bond for $350 What is the investment objective for zero coupon bonds?

Long term, nor need for current income e.g. retirement, college fund

Define: Yield to Call (YTC)

Overall return if the bond is held till it is called by the issuer

Inflationary Risk can also apply to what type of stock?

Preferred Stock the dividend payments can have reduced purchasing power due to inflation

As market interest rates change, what characteristic of bonds adjusts in order for previously issued bonds to have the same yield as newly issued bonds?

Price

What types of fixed income feature on a bond benefits the investor of the bond?

Puttable - The investor can demand early repayment of principal Convertible - investor can convert the bond into a fixed number of common shares Both have a lower coupon for the investor

If a Nominal Yield for a Bond is quoted as: AT&T 9's of '25 What does this mean?

That this AT&T bond has a 9% interest rate and its maturity is in 2025

The buyer of a bond pays the seller for the price of the bond and ____________________________________________________________________

The buyer of a bond pays the seller for the price of the bond and for any earned, but unreceived interest

Why does the Current Yield fluctuate over the life of the bond?

The current yield will change due to the Bond's market value(price) fluctuations which is driven by changes in market interest rates

Define: Yield to Maturity (YTM)

YTM is the overall return of a bond assuming it is held to maturity

A 10% March & September corporate bond is traded on Monday, June 2nd: Is the accrued interest taxed for the recipient?

Yes, as ordinary income

Consider a 5-year 9% coupon bond. Can the bondholder sell the bond after 2 years, if so at what price will the bond be sold?

Yes, market price

An Investor buys a 20-year, $1000 par value zero-coupon bond for $350 What is the annual interest received?

Zero, no annual interest on a Zero-coupon bond

Define: Bond

a loan from an investor to an issuer

Define: Duration

a measure (in years) of how much a bond's price is likely to change when interest rates move

What is an example of a bond that is said to "trade flat"

a zero coupon bond

Define: Coupon

annual interest rate paid as a percentage of the bond's face amount

Define: Coupon Yield (Nominal Yield)

annual interest, established at time of issuance - percentage of par value - DOES NOT CHANGE

Which of the following has the shortest duration? a. 10-year zero coupon bond b. 10-year 3% coupon bond c. 30-year zero coupon bond d. 30-year 3% coupon bond

b. 10-year 3% coupon bond Shortest time to maturity and highest coupon

Which of the following debt instruments would appreciate the most in a time of falling interest rates? a. 10-year zero coupon bond b. 10-year 3% coupon bond c. 30-year zero coupon bond d. 30-year 3% coupon bond

c. 30-year zero coupon bond longest duration (longest time to maturity, lowest coupon) , aka most sensitive to changes in interest rates

Which type of risk is the following: "the risk that a bond is redeemed before its maturity"

call risk

Define: current yield

coupon yield divided by market price Annual Interest / Current Market Value(Price)

If a bond is called when interest rates have fallen which two types of risk does the holder face? i. Interest Rate Risk ii. Call Risk iii. Reinvestment Rate Risk iv. Inflationary Risk v. Credit risk

ii. & iii. ii. Call risk is being imposed because the bond was redeemed by the issuer before the maturity of the bond iii. Reinvestment Rate risk because the investable capital of the called bond can only now be reinvested at a lower interest rate.

Which type of risk is the following: "the risk that an investment's returns provide reduced purchasing power"

inflationary risk

Which type of bond risk is the following: "the risk that the price of a bond will change due to changes in prevailing interest rates"

interest rate risk

Define accrued interest on a bond

interest that is earned but has not yet been received

If the bond issuer's business faces a downgrade what type of risk is the issuer and the investor exposed to?

liquidity risk

Which is more susceptible to interest rate risk, long or short duration?

long duration

Accrued interest on the sale of a bond is taxed as ___________________

ordinary income

What resource helps investors evaluate the credit risk associated with a bond or its issuer?

rating agencies

Which type of risk is the following: "the risk that an investor is unable to reinvest capital at a previously earned rate"

reinvestment rate risk