Fixed Income
Zero-coupon bonds
A bond that does not pay interest during its life. It is issued at a discount to par value and redeemed at par. Also called pure discount bond.
Clauses that specify the rights of the bondholders and any actions that the issuer is obligated to perform or is prohibited from performing are: covenants. collaterals. credit enhancements.
A is correct. Covenants specify the rights of the bondholders and any actions that the issuer is obligated to perform or is prohibited from performing.
David Smith purchased a mortgage-backed security with a coupon rate of 8% and a par value of $1,000 for $960. Coupon payments are made monthly. The monthly interest payment is closest to: $6.67. $6.40. $6.94.
A is correct. The annual coupon is 8% × $1,000 = $80. The coupon payments are made monthly, and therefore $80/12 = $6.67 is paid twelve times a year.
A money market security most likely matures in: one year or less. between 1 and 10 years. over 10 years.
A is correct. The primary difference between a money market security and a capital market security is the maturity at issuance. Money market securities mature in one year or less, whereas capital market securities mature in more than one year.
National bonds
A national bond market includes all the bonds that are issued and traded in a specific country and are denominated in the currency of that country.
fiduciary
An entity designated to represent the rights and responsibilities of a beneficiary whose assets they are managing, such as a bond trustee acting on behalf of fixed-income investors.
Yield-to-maturity
Annual return that an investor earns on a bond if the investor purchases the bond today and holds it until maturity. It is the discount rate that equates the present value of the bond's expected cash flows until maturity with the bond's price. Also called yield-to-redemption or redemption yield.
Index-linked bond
Bond for which coupon payments and/or principal repayment are linked to a specified index. Ex. inflation-linked bonds (aka linkers)
Bullet bond
Bond in which the principal repayment is made entirely at maturity.
Plain Vanilla Bond
Bond that makes periodic, fixed coupon payments during the bond's life and a lump-sum payment of principal at maturity. Also called conventional bond.
Domestic Bonds vs. Foreign Bonds
Bonds issued by entities that are incorporated in that country are called domestic bonds, whereas bonds issued by entities that are incorporated in another country are called foreign bonds.
Collateral trust bonds
Bonds secured by securities, such as common shares, other bonds, or other financial assets.
Currency option bonds
Bonds that give bondholders the right to choose the currency in which they want to receive interest payments and principal repayments.
Perpetual Bonds
Bonds with no stated maturity date.
An investor in a country with an original issue discount tax provision purchases a 20-year zero-coupon bond at a deep discount to par value. The investor plans to hold the bond until the maturity date. The investor will most likely report: a capital gain at maturity. a tax deduction in the year the bond is purchased. taxable income from the bond every year until maturity.
C is correct. The original issue discount tax provision requires the investor to include a prorated portion of the original issue discount in his taxable income every tax year until maturity. The original issue discount is equal to the difference between the bond's par value and its original issue price. A is incorrect because the original issue discount tax provision allows the investor to increase his cost basis in the bond so that when the bond matures, he faces no capital gain or loss. B is incorrect because the original issue discount tax provision does not require any tax deduction in the year the bond is purchased or afterwards.
Market reference rate (MRR)
Collective name for a set of rates covering different currencies for different maturities, ranging from overnight to one year. The spread is set when the bond is issued based on the issuer's creditworthiness at issuance: The higher the issuer's credit quality, the lower the spread. The MRR, however, resets periodically. Thus, as the MRR changes, the coupon rate and coupon payment change accordingly.
Bond
Contractual agreement between the issuer and the bondholders. Three important elements that an investor needs to know about when considering a fixed-income security are: The bond's features, including the issuer, maturity, par value, coupon rate and frequency, and currency denomination. These features determine the bond's scheduled cash flows and, therefore, are key determinants of the investor's expected and actual return. The legal, regulatory, and tax considerations that apply to the contractual agreement between the issuer and the bondholders. The contingency provisions that may affect the bond's scheduled cash flows. These contingency provisions are options providing either issuers or bondholders certain rights affecting the bond's disposal or redemption.
pari passu
Covenant or contract clause that ensures a debt obligation is treated the same as the borrower's other senior debt instruments and is not subordinated to similar obligations.
Debentures
Debentures are a type of bond that can be secured or unsecured. In many jurisdictions, debentures are unsecured bonds, with no collateral backing assigned to the bondholders
Letter of credit
Form of external credit enhancement whereby a financial institution provides the issuer with a credit line to reimburse any cash flow shortfalls from the assets backing the issue. Letters of credit have become a less common form of credit enhancement since the credit downgrades of financial institutions during the financial crisis.
Overcollateralization
Form of internal credit enhancement that refers to the process of posting more collateral than needed to obtain or secure financing.
Indenture
Legal contract that describes the form of a bond, the obligations of the issuer, and the rights of the bondholders. Also called the trust deed. The indenture references both the issuer and the features of the bond issue, such as the principal value, the interest or coupon rate, the interest payment dates, the maturity date, and any contingency provisions. The indenture also identifies the funding sources for interest and principal payments and any collateral, credit enhancements, or covenants.
Sinking fund arrangement
Provision that reduces the credit risk of a bond issue by requiring the issuer to retire a portion of the bond's principal outstanding each year.
Credit enhancements
Provisions that may be used to reduce the credit risk of a bond issue.
Capital Market Securities
Securities with maturities at issuance longer than one year.
current yield
The sum of the coupon payments received over the year divided by the flat price; also called the income or interest yield or running yield. The current yield is a measure of income that is analogous to the dividend yield for a common share.
Tenor
The time-to-maturity for a bond or derivative contract. Also called term to maturity.
Eurobonds
Type of bond issued internationally, outside the jurisdiction of the country in whose currency the bond is denominated.
internal credit enhancement
subordination, overcollateralization, and reserve accounts
A bond issued by Sony in Japan, denominated in US dollars but not registered with the SEC, and sold to an institutional investor in the Middle East, is most likely an example of a: Eurobond. global bond. foreign bond.
A is correct. A Eurobond is a bond that is issued internationally, outside the jurisdiction of any single country. Thus, a bond issued by Sony from Japan, denominated in US dollars but not registered with the SEC, is an example of a Eurobond. B is incorrect because global bonds are bonds that are issued simultaneously in the Eurobond market and in at least one domestic bond market. C is incorrect because if Sony's bond issue were a foreign bond, it would be registered with the SEC.
Which of the following type of debt obligation most likely protects bondholders when the assets serving as collateral are non-performing? Covered bonds Collateral trust bonds Mortgage-backed securities
A is correct. A covered bond is a debt obligation backed by a segregated pool of assets called a "cover pool." When the assets that are included in the cover pool become non-performing (i.e., the assets are not generating the promised cash flows), the issuer must replace them with performing assets.
A plain vanilla bond has a maturity of 10 years, a par value of £100, and a coupon rate of 9%. Interest payments are made annually. The market interest rate is assumed to be constant at 9%. The bond is issued and redeemed at par. The principal repayment the first year is closest to: £0.00. £6.58. £10.00.
A is correct. A plain vanilla (or bullet) bond does not make any principal repayment until the maturity date. B is incorrect because £6.58 would be the principal repayment for a fully amortized bond.
An example of a covenant that protects bondholders against the dilution of their claims is a restriction on: debt. investments. mergers and acquisitions.
A is correct. A restriction on debt typically takes the form of a maximum acceptable debt usage ratio or a minimum acceptable interest coverage ratio. Thus, it limits the issuer's ability to issue new debt that would dilute the bondholders' claims. B and C are incorrect because they are covenants that restrict the issuer's business activities by preventing the company from making investments or being taken over, respectively.
The major advantage of issuing bonds through a special legal entity is: bankruptcy remoteness. beneficial tax treatments. greater liquidity and lower issuing costs.
A is correct. A special legal entity is a bankruptcy-remote vehicle. Bankruptcy remoteness is achieved by transferring the assets from the sponsor to the special legal entity. Once this transfer is completed, the sponsor no longer has ownership rights. If the sponsor defaults, no claims can be made to recover the assets that were transferred or the proceeds from the transfer to the special legal entity.
Contrary to positive bond covenants, negative covenants are most likely: costlier. legally enforceable. enacted at time of issue.
A is correct. Affirmative covenants typically do not impose additional costs to the issuer, while negative covenants are frequently costly. B is incorrect because all bond covenants are legally enforceable rules, so there is no difference in this regard between positive and negative bond covenants. C is incorrect because borrowers and lenders agree on all bond covenants at the time of a new bond issue, so there is no difference in this regard between positive and negative bond covenants.
The individual or entity most likely responsible for the timely payment of interest and repayment of principal to bondholders is the: trustee. primary or lead bank of the issuer. treasurer or chief financial officer of the issuer.
A is correct. Although the issuer is ultimately the source of the contractual payments, it is the trustee that ensures timely payments. Doing so is accomplished by invoicing the issuer for interest payments and principal repayments and holding the funds until they are paid.
On 15 December 2013, Alpha Corp. issued a 10-year callable bond paying an annual coupon of 8%. The bond is callable in whole or in part at any time after 15 December 2018. This type of callable bond is most likely referred to as: American style. European style. Bermuda style.
A is correct. An American-style callable bond is a bond in which the issuer has the right to call the bonds at any time starting on the first call date. B is incorrect because in a European-style callable bond the issuer has the right to call the bonds only once on the call date. C is incorrect because a callable bond where the issuer has the right to call the bonds on specified dates after the call protection period has elapsed is a Bermuda-style callable bond.
The type of collateral used to secure collateral trust bonds is most likely: securities. mortgages. physical assets.
A is correct. Collateral trust bonds are secured by securities, such as common shares, other bonds, or other financial assets. B is incorrect because MBS are secured by mortgages. C is incorrect because equipment trust certificates are backed by physical assets, such as aircraft, railroad cars, shipping containers, or oil rigs.
The risk of loss resulting from the issuer failing to make full and timely payment of interest is called: credit risk. systemic risk. interest rate risk.
A is correct. Credit risk is the risk of loss resulting from the issuer failing to make full and timely payments of interest and/or repayments of principal. B is incorrect because systemic risk is the risk of failure of the financial system. C is incorrect because interest rate risk is the risk that a change in market interest rate affects a bond's value.
Relative to domestic and foreign bonds, Eurobonds are most likely to be: bearer bonds. registered bonds. subject to greater regulation.
A is correct. Eurobonds are typically issued as bearer bonds (i.e., bonds for which the trustee does not keep records of ownership). In contrast, domestic and foreign bonds are typically registered bonds for which ownership is recorded by either name or serial number. B is incorrect because Eurobonds are typically issued as bearer bonds, not registered bonds. C is incorrect because Eurobonds are typically subject to lower, not greater, regulation than domestic and foreign bonds.
The coupon payment is most likely to be taxed as: ordinary income. short-term capital gain. long-term capital gain.
A is correct. Interest income is typically taxed at the ordinary income tax rate, which may be the same tax rate that individuals pay on wage and salary income.
An analyst reviews a corporate bond indenture that contains these two covenants: The borrower will pay interest semiannually and principal at maturity. The borrower will not incur additional debt if its debt-to-capital ratio is more than 50%. What types of covenants are these? Covenant 1 is affirmative, and Covenant 2 is negative. Both are affirmative covenants. Covenant 1 is negative, and Covenant 2 is affirmative.
A is correct. Paying interest and principal is one of the most common affirmative covenants. Negative covenants set forth certain limitations and restrictions on the borrower's activities. The more common restrictive covenants are those that impose limitations on the borrower's ability to incur additional debt, such as specifying a debt-to-capital ratio, unless certain tests are satisfied.
Which of the following is least likely to be a negative covenant associated with a coupon-paying corporate bond issue? A requirement to pay withholding taxes to foreign governments in a timely manner A prohibition from investing in long-term projects in emerging market countries A requirement to hedge at least 50% of the firm's revenues generated from foreign sales
A is correct. Requiring compliance with the existing rules and regulations of foreign governments is administrative in nature and thus an affirmative covenant. B is incorrect because this is a negative covenant that is likely to materially constrain the firm's operational decisions and is likely to be costly to the firm. C is incorrect because this is a negative covenant that is likely to materially constrain the firm's operational decisions and is likely to be costly to the firm.
A bond has a par value of £100 and a coupon rate of 5%. Coupon payments are made semi-annually. The periodic interest payment is: £2.50, paid twice a year. £5.00, paid once a year. £5.00, paid twice a year.
A is correct. The annual coupon payment is 5% × £100 = £5.00. The coupon payments are made semi-annually, so £2.50 paid twice a year.
The term most likely used to refer to the legal contract under which a bond is issued is: indenture. debenture. letter of credit.
A is correct. The contract between a bond issuer and the bondholders is very often called an indenture or deed trust. The indenture documents the terms of the issue, including the principal amount, the coupon rate, and the payments schedule. It also provides information about the funding sources for the contractual payments and specifies whether there are any collateral, credit enhancement, or covenants. B is incorrect because a debenture is a type of bond. C is incorrect because a letter of credit is an external credit enhancement.
The structure that requires the largest repayment of principal at maturity is that of a: bullet bond. fully amortized bond. partially amortized bond.
A is correct. The entire repayment of principal occurs at maturity for a bullet (or plain vanilla) bond, whereas it occurs over time for fully and partially amortized bonds. Thus, the largest repayment of principal at maturity is that of a bullet bond.
The coupon rate of a floating-rate note that makes payments in June and December is expressed as six-month MRR + 25 bps. Assuming that the six-month MRR is 3.00% at the end of June 20XX and 3.50% at the end of December 20XX, the interest rate that applies to the payment due in December 20XX is: 3.25%. 3.50%. 3.75%.
A is correct. The interest rate that applies to the payment due in December 20XX is the six-month MRR at the end of June 20XX plus 25 bps. Thus, it is 3.25% (3.00% + 0.25%).
The individual or entity that most likely assumes the role of trustee for a bond issue is: a financial institution appointed by the issuer. the treasurer or chief financial officer of the issuer. a financial institution appointed by a regulatory authority.
A is correct. The issuer chooses a financial institution with trust powers, such as the trust department of a bank or a trust company, to act as a trustee for the bond issue.
A 10-year bond was issued four years ago. The bond is denominated in US dollars, offers a coupon rate of 10% with interest paid semi-annually, and is currently priced at 102% of par. The bond's: tenor is six years. nominal rate is 5%. redemption value is 102% of the par value.
A is correct. The tenor of the bond is the time remaining until the bond's maturity date. Although the bond had a maturity of ten years at issuance (original maturity), it was issued four years ago. Thus, there are six years remaining until the maturity date. B is incorrect because the nominal rate is the coupon rate (i.e., the interest rate that the issuer agrees to pay each year until the maturity date). Although interest is paid semi-annually, the nominal rate is 10%, not 5%. C is incorrect because it is the bond's price, not its redemption value (also called principal amount, principal value, par value, face value, nominal value, or maturity value), that is equal to 102% of the par value.
Floating-rate notes (FRNs)
A note on which interest payments are not fixed but instead vary from period to period depending on the current level of a reference interest rate. aka floaters The coupon rate of an FRN includes two components: a market reference rate (MRR) plus a spread The spread is set when the bond is issued based on the issuer's creditworthiness at issuance: The higher the issuer's credit quality, the lower the spread. The MRR, however, resets periodically. Thus, as the MRR changes, the coupon rate and coupon payment change accordingly.
Payment-in-kind (PIK) coupon bond
A payment-in-kind (PIK) coupon bond typically allows the issuer to pay interest in the form of additional amounts of the bond issue rather than as a cash payment. Such bonds are favored by issuers who are concerned that the issuer may face potential cash flow problems in the future. They are used, for example, in financing companies that have a high debt burden, such as companies going through a leveraged buyout (a form of acquisition in which the financing consists primarily of debt). Investors usually demand a higher yield for holding bonds with PIK coupons in exchange for assuming their additional credit risk. Other forms of PIK arrangements can also be found, such as paying the bondholders with common shares worth the amount of coupon due. With a PIK "toggle" note, the borrower has the option, for each interest period, to pay interest in cash, to make the interest payment in kind, or some mix of the two. Cash payments or payments in kind are frequently at the discretion of the borrower, but whether the payment is made in cash or in kind can be determined by an earnings or cash flow trigger identified in the indenture.
Asset-backed securities (ABS)
A type of bond issued by a legal entity called a special purpose entity (SPE) on a collection of assets that the SPE owns. Also, securities backed by receivables and loans other than mortgages. Created from a process called securitization, which involves moving assets from the owner of the assets into a SPE
An example of a domestic bond is a bond issued by: LG Group from South Korea, denominated in British pounds, and sold in the United Kingdom. the UK Debt Management Office, denominated in British pounds, and sold in the United Kingdom. Wal-Mart from the United States, denominated in US dollars, and sold in various countries in North America, Europe, the Middle East, and Asia Pacific.
B is correct. A domestic bond is issued by a local issuer, denominated in local currency, and sold in the domestic market. Gilts are British pound-denominated bonds issued by the UK Debt Management Office in the United Kingdom. Thus, they are UK domestic bonds. A is incorrect because a bond issued by LG Group from South Korea, denominated in British pounds, and sold in the United Kingdom is an example of a foreign bond. C is incorrect because a bond issued by Wal-Mart from the United States, denominated in US dollars, and sold in various countries in North America, Europe, the Middle East, and Asia Pacific is most likely an example of a global bond, particularly if it is also sold in the Eurobond market.
Which of the following is a type of external credit enhancement? Covenants A surety bond Overcollateralization
B is correct. A surety bond is an external credit enhancement (i.e., a guarantee received from a third party). If the issuer defaults, the guarantor who provided the surety bond will reimburse investors for any losses, usually up to a maximum amount called the penal sum. A is incorrect because covenants are legally enforceable rules that borrowers and lenders agree upon when the bond is issued. C is incorrect because overcollateralization is an internal, not external, credit enhancement. Collateral is a guarantee underlying the debt above and beyond the issuer's promise to pay, and overcollateralization refers to the process of posting more collateral than is needed to obtain or secure financing. Collateral, such as assets or securities pledged to ensure debt payments, is not provided by a third party. Thus, overcollateralization is not an external credit enhancement.
An affirmative covenant is most likely to stipulate: limits on the issuer's leverage ratio. how the proceeds of the bond issue will be used. the maximum percentage of the issuer's gross assets that can be sold.
B is correct. Affirmative (or positive) covenants enumerate what issuers are required to do and are typically administrative in nature. A common affirmative covenant describes what the issuer intends to do with the proceeds from the bond issue. A and C are incorrect because imposing a limit on the issuer's leverage ratio or on the percentage of the issuer's gross assets that can be sold are negative covenants. Negative covenants prevent the issuer from taking actions that could reduce its ability to make interest payments and repay the principal.
An example of an affirmative covenant is the requirement: that dividends will not exceed 60% of earnings. to insure and perform periodic maintenance on financed assets. that the debt-to-equity ratio will not exceed 0.4 and times interest earned will not fall below 8.0.
B is correct. Affirmative covenants indicate what the issuer "must do" and are administrative in nature. A covenant requiring the issuer to insure and perform periodic maintenance on financed assets is an example of an affirmative covenant. A and C are incorrect because they are negative covenants; they indicate what the issuer cannot do.
Ted Nguyen is an investor domiciled in a country with an original issue discount tax provision. He purchases a zero-coupon bond at a deep discount to par value with the intention of holding the bond until maturity. At maturity, he will most likely face: a capital gain. neither a capital loss nor gain. a capital loss.
B is correct. An original issue discount tax provision allows the investor to increase the cost basis of the bond, so when the bond matures, the investor faces no capital gain or loss.
Which of the following best describes a negative bond covenant? The issuer is: required to pay taxes as they come due. prohibited from investing in risky projects. required to maintain its current lines of business.
B is correct. Prohibiting the issuer from investing in risky projects restricts the issuer's potential business decisions. These restrictions are referred to as negative bond covenants. A and C are incorrect because paying taxes as they come due and maintaining the current lines of business are positive covenants.
The legal contract that describes the form of the bond, the obligations of the issuer, and the rights of the bondholders can be best described as a bond's: covenant. indenture. debenture.
B is correct. The indenture, also referred to as trust deed, is the legal contract that describes the form of the bond, the obligations of the issuer, and the rights of the bondholders. A is incorrect because covenants are only one element of a bond's indenture. Covenants are clauses that specify the rights of the bondholders and any actions that the issuer is obligated to perform or prohibited from performing. C is incorrect because a debenture is a type of bond.
Assume that a company issues bonds in the hypothetical country of Zinland, where the local currency is the zini (Z). There is an original issue discount tax provision in Zinland's tax code. The company issues a 10-year zero-coupon bond with a par value of Z1,000 and sells it for Z800. An investor who buys the zero-coupon bond at issuance and holds it until maturity most likely: has to include Z20 in his taxable income every tax year for 10 years and has to declare a capital gain of Z200 at maturity. has to include Z20 in his taxable income every tax year for 10 years and does not have to declare a capital gain at maturity. does not have to include anything in his taxable income every tax year for 10 years but has to declare a capital gain of Z200 at maturity.
B is correct. The original issue discount tax provision requires the investor to include a prorated portion of the original issue discount in his taxable income every tax year until maturity. The original issue discount is the difference between the par value and the original issue price—that is, Z1,000 - Z800 = Z200. The bond's maturity is 10 years. Thus, the prorated portion that must be included each year is Z200 ÷ 10 = Z20. The original issue discount tax provision allows the investor to increase his cost basis in the bond so that when the bond matures, the investor faces no capital gain or loss.
The category of bond most likely repaid from the repayment of previous loans made by the issuer is: sovereign bonds. supranational bonds. non-sovereign bonds.
B is correct. The source of payment for bonds issued by supranational organizations is either the repayment of previous loans made by the organization or the paid-in capital of its member states. A is incorrect because national governments rely on their taxing authority and money creation to repay their debt. C is incorrect because non-sovereign bonds are typically repaid from the issuer's taxing authority or the cash flows of the project being financed.
Bond Trustee's role / responsibilities
Because it would be impractical for the issuer to enter into a direct agreement with each bondholder, the indenture is usually held by a trustee. The trustee is typically a financial institution acting as a fiduciary (or representative protecting investor interests) to ensure the issuer complies with the obligations specified in the indenture and to take action on behalf of the bondholders, when necessary. The trustee's duties are administrative and include the maintenance of required documentation and records; holding beneficial title to, safeguarding, and appraising collateral (if any); invoicing the issuer for interest payments and principal repayments; and holding funds until they are paid, although the cash flow movements from issuers to the trustee are typically handled by the principal paying agent. In the event of default, the discretionary powers of the trustee increase considerably. For example, the trustee is responsible for calling bondholder meetings to discuss actions as well as bringing legal action against an issuer on behalf of bondholders, if necessary.
Credit-linked coupon bond
Bond for which the coupon changes when the bond's credit rating changes. Bonds with credit-linked coupons are attractive to investors who are concerned about the future creditworthiness of the issuer. They may also provide some general protection against a poor economy because credit ratings tend to decline the most during recessions. A potential problem associated with these bonds is that increases in the coupon payments resulting from a downgrade may ultimately result in further deteriorations of the credit rating or even contribute to the issuer's default.
Step-up coupon
Bond for which the coupon, fixed or floating, increases by specified margins at specified dates. Bonds with step-up coupons offer bondholders some protection against rising interest rates, and they may be an important feature for callable bonds. When interest rates increase, there is a higher likelihood that the issuer will not call the bonds, particularly if the bonds have a fixed rate of interest. The step-up coupon allows bondholders to receive a higher coupon, in line with the higher market interest rates. Alternatively, when interest rates decrease or remain stable, the step-up feature acts as an incentive for the issuer to call the bond before the coupon rate increases and the interest expense rises. Redeeming the bond when the coupon increases is not automatic, however; the issuer may choose to keep the bond despite its increasing cost. This may happen if refinancing the bond is necessary and alternatives are less advantageous for this issuer.
Issuer
Bond issuers are classified into categories based on the similarities of these issuers and their characteristics. Major types of issuers include the following: Supranational organizations, such as the World Bank or the European Investment Bank; Sovereign (national) governments, such as the United States or Japan. As sovereign bonds are backed by the full faith and credit of each respective government, they usually represent the lowest risk and most secure bonds in each market; Non-sovereign (local) governments, such as the State of Minnesota in the United States, the Catalonia region in Spain, or the City of Edmonton in Alberta, Canada; Quasi-government entities (i.e., agencies that are owned or sponsored by governments), such as postal services in many countries—for example, Correios in Brazil, La Poste in France, or Pos in Indonesia; Companies (i.e., corporate issuers). A distinction is often made between financial issuers (e.g., banks and insurance companies) and non-financial issuers; and Special legal entities (i.e., special purpose entities) that use specific assets, such as auto loans and credit card debt obligations, to guarantee (or secure) a bond issue known as an asset-backed security that is then sold to investors. Market participants often classify fixed-income markets by the type of issuer, which leads to the identification of three bond market sectors: the government and government-related sector (i.e., the first four types of issuers just listed), the corporate sector (the fifth type listed), and the structured finance sector (the last type listed).
Deferred coupon bond
Bond that pays no coupons for its first few years but then pays a higher coupon than it otherwise normally would for the remainder of its life. Also called split coupon bond. One of the main advantages of investing in a deferred coupon bond is that these bonds are typically priced at significant discounts to par. Investors may also find the deferred coupon structure to be very helpful in managing taxes. If taxes due on the interest income can be delayed, investors may be able to minimize taxes. This tax advantage, however, depends on the jurisdiction concerned and how its tax rules apply to deferred coupon payments.
Amortizing bond
Bond with a payment schedule that calls for periodic payments of interest and repayments of principal. A fully amortized bond is characterized by a fixed periodic payment schedule that reduces the bond's outstanding principal amount to zero by the maturity date. A partially amortized bond also makes fixed periodic payments until maturity, but only a portion of the principal is repaid by the maturity date. Thus, a balloon payment is required at maturity to retire the bond's outstanding principal amount.
Equipment Trust Certificates
Bonds secured by specific types of equipment or physical assets. They are often issued to take advantage of the tax benefits of leasing. For example, suppose an airline finances the purchase of new aircraft with equipment trust certificates. The legal title to the aircraft is held by the trustee, which issues equipment trust certificates to investors in the amount of the aircraft purchase price. The trustee leases the aircraft to the airline and collects lease payments from the airline to pay the interest on the certificates. When the certificates mature, the trustee sells the aircraft to the airline, uses the proceeds to retire the principal, and cancels the lease
Which of the following is most likely an example of a Eurobond? A Canadian borrower issuing British pound-denominated bonds in the UK market. A Japanese borrower issuing US dollar-denominated bonds in the US market. An Australian borrower issuing Canadian dollar-denominated bonds in the UK market.
C is correct. A Eurobond is an international bond issued outside the jurisdiction of any one country and not denominated in the currency of the country where it is issued.
A sovereign bond has a maturity of 15 years. The bond is best described as a: perpetual bond. pure discount bond. capital market security.
C is correct. A capital market security has an original maturity longer than one year.
The type of bond that allows bondholders to choose the currency in which they receive each interest payment and principal repayment is a: pure discount bond. dual-currency bond. currency option bond.
C is correct. A currency option bond gives bondholders the right to choose the currency in which they want to receive each interest payment and principal repayment. A is incorrect because a pure discount bond is issued at a discount to par value and redeemed at par. B is incorrect because a dual-currency bond makes coupon payments in one currency and pays the par value at maturity in another currency.
A bond that is characterized by a fixed periodic payment schedule that reduces the bond's outstanding principal amount to zero by the maturity date is best described as a: bullet bond. plain vanilla bond. fully amortized bond.
C is correct. A fully amortized bond calls for equal cash payments by the bond's issuer prior to maturity. Each fixed payment includes both an interest payment component and a principal repayment component such that the bond's outstanding principal amount is reduced to zero by the maturity date.
A BBB rated corporation wishes to issue debt to finance its operations at the lowest cost possible. If it decides to sell a pool of receivables into a special purpose vehicle (SPV), its primary motivation is most likely to: receive a guaranty from the SPV to improve the corporation's credit rating. allow the corporation to retain a first lien on the assets of the SPV. segregate the assets into a bankruptcy-remote entity for bondholders.
C is correct. A key motivation for a corporation to establish a SPV is to separate it as a legal entity. In the case of bankruptcy for the corporation, the SPV is unaffected because it is not a subsidiary of the corporation. Given this arrangement, the SPV can achieve a rating as high as AAA and borrow at lower rates than the corporation. A is incorrect because the SPV does not receive a guaranty. B is incorrect because the corporation does have a lien on those assets.
Which of the following is least likely to be a form of internal credit enhancement associated with a corporate bond issue? Debt overcollateralization Debt subordination Letter of credit
C is correct. A letter of credit is a form of external credit enhancement in which a financial institution provides the issuer with a credit line to be used for any cash flow shortfalls related to its debt issue. A is incorrect because debt overcollateralization is a form of internal credit enhancement that relates to the process of having more collateral than is needed to obtain debt financing. B is incorrect because debt subordination is a form of internal credit enhancement that refers to the ordering of claim priorities of debt in relation to asset ownership.
If an issuer is required to retire a specified portion of the bond's principal each year, the bond most likely: is callable. is a step-up note. has a sinking fund provision.
C is correct. A sinking fund provision requires retirement of a portion of the bond's principal every year, rather than retirement of the entire issue at maturity. A is incorrect because a bond that is currently callable may be retired by the issuer, but the issuer is not required to do so. B is incorrect because a step-up note has a coupon rate that increases over time according to a predetermined schedule.
An example of a sovereign bond is a bond issued by: the World Bank. the city of New York. the federal German government.
C is correct. A sovereign bond is a bond issued by a national government, such as the federal German government. A is incorrect because a bond issued by the World Bank is a supranational bond. B is incorrect because a bond issued by a local government, such as the city of New York, is a non-sovereign bond.
A South African company issues bonds denominated in pound sterling that are sold to investors in the United Kingdom. These bonds can be best described as: Eurobonds. global bonds. foreign bonds.
C is correct. Bonds sold in a country and denominated in that country's currency by an entity from another country are referred to as foreign bonds. A is incorrect because Eurobonds are bonds issued outside the jurisdiction of any single country. B is incorrect because global bonds are bonds issued in the Eurobond market and at least one domestic country simultaneously.
Maersk Corp. issued bonds that are secured by its shipping containers. These bonds are most likely a type of: mortgage-backed security. collateral trust bond. equipment trust certificate.
C is correct. Equipment trust certificates are bonds secured by specific types of equipment or physical assets, such as shipping containers. A is incorrect because mortgage-backed securities are debt obligations that represent claims to the cash flows from pools of mortgage loans. B is incorrect because collateral trust bonds are secured by securities such as common shares, other bonds, or other financial assets.
Relative to a fully amortized bond, the coupon payments of an otherwise similar partially amortized bond are: lower or equal. equal. higher or equal.
C is correct. Except at maturity, the principal repayments are lower for a partially amortized bond than for an otherwise similar fully amortized bond. Consequently, the principal amounts outstanding—and, therefore, the amounts of interest payments—are higher for a partially amortized bond than for a fully amortized bond, all else equal. The only exception is the first interest payment, which is the same for both repayment structures. This is because no principal repayment has been made by the time the first coupon is paid.
If the bond's price is higher than its par value, the bond is trading at: par. a discount. a premium.
C is correct. If a bond's price is higher than its par value, the bond is trading at a premium. A is incorrect because a bond is trading at par if its price is equal to its par value. B is incorrect because a bond is trading at a discount if its price is lower than its par value.
ABL Ltd. is an Australian company that has financed a joint venture project in Singapore using a 15-year, fixed-rate bond paying semi-annual coupons that are denominated in Singapore dollars. The bond's par value, to be paid at maturity, is denominated in US dollars. This bond is an example of a: global bond. currency option bond. dual-currency bond.
C is correct. In a dual-currency bond, coupon payments are denominated in one currency, and the par value is denominated in a different currency. A is incorrect because a global bond is issued simultaneously in the Eurobond market and in at least one domestic bond market. B is incorrect because a currency option bond gives bondholders the right to choose the currency in which they wish to receive coupon payments and principal repayments.
Which of the following bonds are most likely to be bearer bonds? Foreign bonds Domestic bonds Eurobonds
C is correct. Most Eurobonds are bearer bonds, meaning that the trustee does not keep records of who owns the bonds; only the clearing system knows who the bond owners are.
Which of the following best describes a negative bond covenant? The requirement to: insure and maintain assets. comply with all laws and regulations. maintain a minimum interest coverage ratio.
C is correct. Negative covenants enumerate what issuers are prohibited from doing. Restrictions on debt, including maintaining a minimum interest coverage ratio or a maximum debt usage ratio, are typical examples of negative covenants.
Proceeds for repaying securitized bonds most likely come from the: claims-paying ability of the operating entity. cash flows of the project the bond is financing. cash flows of the underlying financial assets.
C is correct. Securitized bonds typically rely on the cash flows generated by one or more underlying financial assets as the primary source of the contractual payments to bondholders rather than on the claims-paying ability of the operating entity. A is incorrect because the claims-paying ability of an operating entity is the source of payment for corporate bonds. These cash flows depend on the issuer's financial strength and integrity. B is incorrect because the cash flows of the project the bond issue is financing are a major source for payment of non-sovereign government debt issues.
A company has issued a floating-rate note with a coupon rate equal to the three-month MRR + 65 bps. Interest payments are made quarterly on 31 March, 30 June, 30 September, and 31 December. On 31 March and 30 June, the three-month MRR is 1.55% and 1.35%, respectively. The coupon rate for the interest payment made on 30 June is: 2.00%. 2.10%. 2.20%.
C is correct. The coupon rate that applies to the interest payment due on 30 June is based on the three-month MRR rate prevailing on 31 March. Thus, the coupon rate is 1.55% + 0.65% = 2.20%.
The external credit enhancement that has the least amount of third-party risk is a: surety bond. letter of credit. cash collateral account.
C is correct. The third-party (or counterparty) risk for a surety bond and a letter of credit arises from both being future promises to pay. In contrast, a cash collateral account allows the issuer to immediately borrow the credit-enhancement amount and then invest it.
Cross-default
Covenant or contract clause that specifies a borrower is considered in default if they default on another debt obligation.
Credit Enhancements
Credit enhancements refer to a variety of provisions that can be used to reduce the credit risk of a bond issue. Thus, they increase the issue's credit quality and decrease the bond's yield. Credit enhancements are very often used when creating ABS. The two primary types of credit enhancements are internal and external. Internal credit enhancement relies on structural features regarding the bond issue. External credit enhancement refers to financial guarantees received from a third party, often called a financial guarantor.
Mortgage-backed securities (MBS)
Debt obligations that represent claims to the cash flows from pools of mortgage loans, most commonly on residential property.
Dual-currency bond
Dual-currency bonds make coupon payments in one currency and pay the par value at maturity in another currency. For example, assume that a Japanese company needs to finance a long-term project in the United States that will take several years to become profitable. The Japanese company could issue a yen/US dollar dual-currency bond. The coupon payments in yen can be made from the cash flows generated in Japan, and the principal can be repaid in dollars once the project becomes profitable.
Surety Bond
Form of external credit enhancement whereby a rated and regulated insurance company guarantees to reimburse bondholders for any losses incurred up to a maximum amount if the issuer defaults. The major difference between a bank guarantee and a surety bond is that the former is issued by a bank, whereas the latter is issued by a rated and regulated insurance company. Insurance companies that specialize in providing financial guarantees are typically called monoline insurance companies or monoline insurers. Monoline insurers played an important role in securitization until the 2007-2009 global financial crisis, but they are now a less common form of credit enhancement due to the credit downgrades of these insurers during the crisis.
Cash collateral account
Form of external credit enhancement whereby the issuer immediately borrows the credit-enhancement amount and then invests that amount, usually in highly rated short-term commercial paper.
Reserve account
Form of internal credit enhancement that relies on creating accounts and depositing in these accounts cash that can be used to absorb losses. Also called reserve funds.
Subordination (credit tranching)
Form of internal credit enhancement that relies on creating more than one bond tranche and ordering the claim priorities for ownership or interest in an asset between the tranches. The ordering of the claim priorities is called a senior/subordinated structure, where the tranches of highest seniority are called senior followed by subordinated or junior tranches.
Covered bonds
Senior debt obligation secured by a segregated pool of assets called the cover pool. The issuer must maintain the value of the cover pool. In the event of default, bondholders have recourse against both the issuer and the cover pool. Covered bonds have remained a relatively stable and reliable source of funding over time because of their dual recourse nature, strict eligibility criteria, dynamic cover pool, and redemption regimes in the event of sponsor default. As a result, covered bonds usually carry lower credit risks and offer lower yields than otherwise similar ABS.
Global bonds
The global bond markets consist of national bond markets and the Eurobond market. A global bond is one issued simultaneously in the Eurobond market and in at least one domestic bond market, ensuring sufficient demand for large bond issues and access to all fixed-income investors regardless of location. For example, the World Bank is a regular issuer of global bonds. Many market participants refer to foreign bonds, Eurobonds, and global bonds as international bonds as opposed to domestic bonds.
Trust deed
The governing legal credit agreement, typically incorporated by reference in the prospectus. Also called bond indenture.
Zero-coupon-indexed bonds
Zero-coupon-indexed bonds pay no coupon, so the inflation adjustment is made via the principal repayment only: The principal amount to be repaid at maturity increases in line with increases in the price index during the bond's life. This type of bond has been issued in Sweden.
External credit enhancement
bank guarantees and surety bonds, letters of credit, and cash collateral accounts
Money market securities
debt instruments or securities with maturities of one year or less Issuers of money market securities include governments and companies. Commercial paper and certificates of deposit are examples of money market securities.
