Fixed Income Textbook Questions
Agnelli Industries (Agnelli), a manufacturer of industrial machine tools based in Bergamo, Italy, has €500 million of corporate bonds outstanding. These bonds have a credit rating below investment grade. Agnelli has €400 million of receivables on its balance sheet that it would like to securitize. The receivables represent payments Agnelli expects to receive for machine tools it has sold to various customers in Europe. Agnelli sells the receivables to Agnelli Trust, a special purpose entity. Agnelli Trust then issues ABS, backed by the pool of receivables, with the following structure: Bond Class Par Value (€ millions) A (senior) 280 B (subordinated) 60 C (subordinated) 60 Total 400 2. If Agnelli Industries files for bankruptcy after the issuance of the asset-backed security: A. Bond Classes A, B, and C will be unaffected. B. Bond Classes A, B, and C will lose their entire par value. C. Losses will be realized by Bond Class C first, then by Bond Class B, and then by Bond Class A.
A is correct. The ABS have been issued by Agnelli Trust, an SPE that is bankruptcy remote from Agnelli. If the securitization is viewed as resulting in a true sale, the fact that Agnelli files for bankruptcy does not affect the ABS holders. These ABS holders face credit risk only to the extent that Agnelli's customers who bought the machine tools do not make the obligatory payments on their loans. As long as the customers continue to make payments, all three bond classes will receive their expected cash flows. These cash flows are completely and legally independent of anything that happens to Agnelli itself.
Fran Martin obtains a non-recourse mortgage loan for $500,000. One year later, when the outstanding balance of the mortgage is $490,000, Martin cannot make his mortgage payments and defaults on the loan. The lender forecloses on the loan and sells the house for $315,000. What amount is the lender entitled to claim from Martin? A. $0. B. $175,000. C. $185,000.
A. $0.
In a securitization, the special purpose entity (SPE) is responsible for the: A. Issuance of the asset-backed securities. B. Collection of payments from the borrowers. C. Recovery of underlying assets from delinquent borrowers.
A. Issuance of the asset-backed securities.
Market evidence shows that short holding-period returns on short-maturity bonds most often are: A. Less than those on long-maturity bonds B. About equal to those on long-maturity bonds C. Greater than those on long-maturity bonds.
A. Less than those on long-maturity bonds
Which of the following characteristics of a residential mortgage loan would best protect the lender from a strategic default by the borrower? A. Recourse B. A prepayment option C. Interest-only payments
A. Recourse
Used Luxury Auto (ULA) is a hypothetical company that has established a nationwide business in buying used luxury autos and then refurbishing them with the latest in electronic equipment (for instance, USB ports and rearview cameras). ULA Corp then sells these autos in the retail market, often financing the sales with promissory notes from the buyers via its ULA Credit Corp. The following information is taken from a theoretical filing by ULA with the Securities and Exchange Commission for a securitization: Issuer: ULA Trust 2020 Seller and Servicer: ULA Credit Corp Notes: - $500,000,000 4.00% ULA Trust contract-backed Class A notes, rated AAA - $250,000,000 4.80% ULA Trust contract-backed Class B notes, rated A Contracts: The assets underlying the notes are fixed-rate promissory notes relating to the purchase of used automobiles refurbished by ULA Corp. 3. ULA Credit Corp is responsible for: A. Selling the collateral to the SPE and collecting payments from borrowers on the underlying promissory notes. B. Refurbishing the used luxury automobiles and collecting payments from borrowers on the underlying promissory notes. C. Selling the contract-backed Class A and Class B notes to investors and making the cash interest and principal payments to them.
A. Selling the collateral to the SPE and collecting payments from borrowers on the underlying promissory notes.
Which of the following describes a typical feature of a non-agency residential mortgage-backed security (RMBS)? A. Senior/subordinated structure B. A pool of conforming mortgages as collateral C. A guarantee by a government-sponsored enterprise
A. Senior/subordinated structure
A goal of securitization is to: A. Separate the seller's collateral from its credit ratings. B. Uphold the absolute priority rule in bankruptcy reorganizations. C. Account for collateral's primary influence on corporate bond credit spreads.
A. Separate the seller's collateral from its credit ratings.
In 2010, the Committee of European Securities Regulators created guidelines that restricted weighted average life (WAL) to 120 days for short-term money market funds. The purpose of this restriction was to limit the ability of money market funds to invest in long-term, floating-rate securities. This action is most consistent with a belief in: A. The preferred habitat theory B. The segmented markets theory C. The local expectations theory
A. The preferred habitat theory The preferred habitat theory asserts that investors are willing to move away from their preferred maturity if there is adequate incentive to do so. The proposed WAL guideline was the result of regulatory concern about the interest rate risk and credit risk of long-term, floating-rate securities. An inference of this regulatory action is that some money market funds must be willing to move away from more traditional short-term investments if they believe there is sufficient compensation to do so.
Agnelli Industries (Agnelli), a manufacturer of industrial machine tools based in Bergamo, Italy, has €500 million of corporate bonds outstanding. These bonds have a credit rating below investment grade. Agnelli has €400 million of receivables on its balance sheet that it would like to securitize. The receivables represent payments Agnelli expects to receive for machine tools it has sold to various customers in Europe. Agnelli sells the receivables to Agnelli Trust, a special purpose entity. Agnelli Trust then issues ABS, backed by the pool of receivables, with the following structure: Bond Class Par Value (€ millions) A (senior) 280 B (subordinated) 60 C (subordinated) 60 Total 400 3. If one of Agnelli's customers defaults on its €60 million loan: A. Bond Classes A, B, and C will realize losses of €20 million each. B. Bond Class C will realize losses of €60 million, but Bond Classes A and B will be unaffected. C. Bond Classes B and C will realize losses of €30 million each, but Bond Class A will be unaffected.
B is correct. The rules for the distribution of losses are as follows. All losses on the collateral are absorbed by Bond Class C before any losses are realized by Bond Class B and then Bond Class A. Consequently, if the losses on the collateral are €60 million, which is the par value of Bond Class C, Bond Class C loses its entire par value, but Bond Classes A and B are unaffected.
A bank advertises a mortgage with the following interest rate: 2.99% (12-month Euribor + 2.50%), resetting once a year. The mortgage is most likely: A. A hybrid mortgage. B. An adjustable-rate mortgage. C. An initial period fixed-rate mortgage.
B. An adjustable-rate mortgage.
If the borrower fails to make the contractual mortgage payments on a non-recourse mortgage, the lender: A. Cannot foreclose the property. B. Can only recover the outstanding mortgage balance through the sale of the property. C. Can recover the outstanding mortgage balance through the sale of the property and the borrower's other assets and/or income.
B. Can only recover the outstanding mortgage balance through the sale of the property.
The monthly cash flows of a mortgage pass-through security most likely: A. Are constant. B. Change when interest rates decline. C. Are equal to the cash flows of the underlying pool of mortgages.
B. Change when interest rates decline.
If a mortgage borrower makes prepayments without penalty to take advantage of falling interest rates, the lender will most likely experience: A. Extension risk. B. Contraction risk. C. Yield maintenance.
B. Contraction risk.
In an interest-only mortgage, the borrower: A. Does not have to repay the principal as long as she pays the interest. B. Does not have to make principal repayments for a certain number of years, after which she starts paying down the original loan amount. C. Does not have to make principal repayments over the entire life of the mortgage and pays down the original loan amount as a balloon payment.
B. Does not have to make principal repayments for a certain number of years, after which she starts paying down the original loan amount.
A non-conforming mortgage: A. Cannot be used as collateral in a mortgage-backed security. B. Does not satisfy the underwriting standards for inclusion as collateral for an agency residential mortgage-backed security. C. Does not give the lender a claim against the borrower for the shortfall between the amount of the outstanding mortgage balance and the proceeds from the sale of the property in the event that the borrower defaults on the mortgage.
B. Does not satisfy the underwriting standards for inclusion as collateral for an agency residential mortgage-backed security.
If interest rates increase, an investor who owns a mortgage pass-through security is most likely affected by: A. Credit risk. B. Extension risk. C. Contraction risk.
B. Extension risk.
Securitization is beneficial for banks because it: A. Repackages bank loans into simpler structures. B. Increases the funds available for banks to lend. C. Allows banks to maintain ownership of their securitized assets.
B. Increases the funds available for banks to lend.
The unbiased expectations theory assumes investors are: A. Risk averse B. Risk neutral C. Risk seeking
B. Risk neutral The unbiased expectations theory asserts that different maturity strategies, such as rollover, maturity matching, and riding the yield curve, have the same expected return. By definition, a risk-neutral party is indifferent about choices with equal expected payoffs, even if one choice is riskier. Thus, the predictions of the theory are consistent with the existence of risk-neutral investors.
The term structure theory that asserts that investors cannot be induced to hold debt securities whose maturities do not match their investment horizon is best described as the: A. Preferred habitat theory B. Segmented markets theory C. Unbiased expectations theory
B. Segmented markets theory Segmented markets theory contends that asset/liability management constraints force investors to buy securities whose maturities match the maturities of their liabilities. In contrast, preferred habitat theory asserts that investors are willing to deviate from their preferred maturities if yield differentials encourage the switch. The unbiased expectations theory makes no assumptions about maturity preferences. Rather, it contends that forward rates are unbiased predictors of future spot rates.
Market evidence shows that forward rates are: A. Unbiased predictors of future spot rates B. Upwardly biased predictors of future spot rates C. Downwardly biased predictors of future spot rates.
B. Upwardly biased predictors of future spot rates
A French company files for bankruptcy, triggering various CDS contracts. It has two series of senior bonds outstanding: Bond A trades at 30% of par, and Bond B trades at 40% of par. Investor X owns €10 million of Bond A and €10 million of CDS protection. Investor Y owns €10 million of Bond B and €10 million of CDS protection. Determine the recovery rate for both CDS contracts.
Bond A is the cheapest-to-deliver obligation, trading at 30% of par, so the recovery rate for both CDS contracts is 30%.
Agnelli Industries (Agnelli), a manufacturer of industrial machine tools based in Bergamo, Italy, has €500 million of corporate bonds outstanding. These bonds have a credit rating below investment grade. Agnelli has €400 million of receivables on its balance sheet that it would like to securitize. The receivables represent payments Agnelli expects to receive for machine tools it has sold to various customers in Europe. Agnelli sells the receivables to Agnelli Trust, a special purpose entity. Agnelli Trust then issues ABS, backed by the pool of receivables, with the following structure: Bond Class Par Value (€ millions) A (senior) 280 B (subordinated) 60 C (subordinated) 60 Total 400 Bond Class A is given an investment-grade credit rating by the credit-rating agencies. 1. Why does Bond Class A have a higher credit rating than the corporate bonds?
Bond Class A are issued by Agnelli Trust, an SPE that is bankruptcy remote from Agnelli. Thus, the investors who hold Agnelli's bonds and/or common shares have no legal claim on the cash flows from the securitized receivables that are the collateral for the ABS. As long as Agnelli's customers make the interest payments and/or principal repayments on their loans, Agnelli Trust will be able to make cash payments to the ABS investors. Because of the credit tranching, even if some of Agnelli's customers were to default on their loans, the losses would be realized by the subordinated Bond Classes B and C before any losses are realized by the senior Bond Class A. The credit risk associated with Bond Class A is, therefore, lower than that of Bond Classes B and C and the corporate bonds, justifying the investment-grade credit rating.
A one-year zero-coupon bond yields 4.0%. The two- and three-year zero-coupon bonds yield 5.0% and 6.0%, respectively. The rate for a one-year loan beginning in one year is closest to: A. 4.5% B. 5.0% C. 6.0%.
C. (1+0.05)^2 = (1+0.04 * (1+X) 1.1025 / 1.04 - 1 = X X = 0.06 or 6% Note that X = the one-year forward rate, one-year from now or f1,1
A one-year zero-coupon bond yields 4.0%. The two- and three-year zero-coupon bonds yield 5.0% and 6.0%, respectively. The forward rate for a one-year loan beginning in two years is closest to: A. 6% B. 7% C. 8%.
C. (1+0.06)^3 = (1+0.05)^2 * (1+X) 1.191016 = 1.102 * (1+X) X = 0.08 or 8%
Assume that a company with several debt issues trading in the market files for bankruptcy (i.e., a credit event takes place). What is the cheapest-to-deliver obligation for a senior CDS contract? A. A subordinated unsecured bond trading at 20% of par B. A five-year senior unsecured bond trading at 50% of par C. A two-year senior unsecured bond trading at 45% of par
C. A two-year senior unsecured bond trading at 45% of par
A benefit of securitization is the: A. Reduction in disintermediation. B. Simplification of debt obligations. C. Creation of tradable securities with greater liquidity than the original loans.
C. Creation of tradable securities with greater liquidity than the original loans.
Used Luxury Auto (ULA) is a hypothetical company that has established a nationwide business in buying used luxury autos and then refurbishing them with the latest in electronic equipment (for instance, USB ports and rearview cameras). ULA Corp then sells these autos in the retail market, often financing the sales with promissory notes from the buyers via its ULA Credit Corp. The following information is taken from a theoretical filing by ULA with the Securities and Exchange Commission for a securitization: Issuer: ULA Trust 2020 Seller and Servicer: ULA Credit Corp Notes: - $500,000,000 4.00% ULA Trust contract-backed Class A notes, rated AAA - $250,000,000 4.80% ULA Trust contract-backed Class B notes, rated A Contracts: The assets underlying the notes are fixed-rate promissory notes relating to the purchase of used automobiles refurbished by ULA Corp. 1. The collateral for this securitization is: A. ULA Trust contract-backed Class A and Class B notes. 2. Used automobiles refurbished by ULA Corp. C. Fixed-rate promissory notes relating to the purchase of used automobiles refurbished by ULA Corp.
C. Fixed-rate promissory notes relating to the purchase of used automobiles refurbished by ULA Corp.
All else being equal, when interest rates decline: A. Investors in mortgage pass-through securities face extension risk. B. The weighted average maturity of a mortgage pass-through security lengthens. C. The increase in the price of a mortgage pass-through security is less than the increase in the price of an otherwise identical bond with no prepayment option.
C. The increase in the price of a mortgage pass-through security is less than the increase in the price of an otherwise identical bond with no prepayment option.
A prepayment rate of 80 PSA means that investors can expect: A. 80% of the par value of the mortgage pass-through security to be repaid prior to the security's maturity. B. 80% of the borrowers whose mortgages are included in the collateral backing the mortgage pass-through security to prepay their mortgages. C. The prepayment rate of the mortgages included in the collateral backing the mortgage pass-through security to be 80% of the monthly prepayment rates forecast by the PSA model.
C. The prepayment rate of the mortgages included in the collateral backing the mortgage pass-through security to be 80% of the monthly prepayment rates forecast by the PSA model.
Used Luxury Auto (ULA) is a hypothetical company that has established a nationwide business in buying used luxury autos and then refurbishing them with the latest in electronic equipment (for instance, USB ports and rearview cameras). ULA Corp then sells these autos in the retail market, often financing the sales with promissory notes from the buyers via its ULA Credit Corp. The following information is taken from a theoretical filing by ULA with the Securities and Exchange Commission for a securitization: Issuer: ULA Trust 2020 Seller and Servicer: ULA Credit Corp Notes: - $500,000,000 4.00% ULA Trust contract-backed Class A notes, rated AAA - $250,000,000 4.80% ULA Trust contract-backed Class B notes, rated A Contracts: The assets underlying the notes are fixed-rate promissory notes relating to the purchase of used automobiles refurbished by ULA Corp. 2. The special purpose entity in this securitization is: A. ULA Corp B. ULA Credit Corp C. ULA Trust 2020
C. ULA Trust 2020
A special purpose entity issues asset-backed securities in the following structure. Bond Class Par Value (€ millions) A (senior) 200 B (subordinated) 20 C (subordinated) 5 At which of the following amounts of default in par value would Bond Class A experience a loss? A. €20 million B. €25 million C. €26 million
C. €26 million
A French company files for bankruptcy, triggering various CDS contracts. It has two series of senior bonds outstanding: Bond A trades at 30% of par, and Bond B trades at 40% of par. Investor X owns €10 million of Bond A and €10 million of CDS protection. Investor Y owns €10 million of Bond B and €10 million of CDS protection. Explain whether Investor X would prefer to cash settle or physically settle her CDS contract or whether she is indifferent.
Investor X has no preference between settlement methods. She can cash settle for €7 million [(1 - 30%) × €10 million] and sell her bond for €3 million, for total proceeds of €10 million. Alternatively, she can physically deliver her entire €10 million face amount of bonds to the counterparty in exchange for €10 million in cash.
A French company files for bankruptcy, triggering various CDS contracts. It has two series of senior bonds outstanding: Bond A trades at 30% of par, and Bond B trades at 40% of par. Investor X owns €10 million of Bond A and €10 million of CDS protection. Investor Y owns €10 million of Bond B and €10 million of CDS protection. Explain whether Investor Y would prefer to cash settle or physically settle his CDS contract or whether he is indifferent.
Investor Y would prefer a cash settlement because he owns Bond B, which is worth more than the cheapest-to-deliver obligation. He will receive the same €7 million payout on his CDS contract, but can sell Bond B for €4 million, for total proceeds of €11 million. If he were to physically settle his contract, he would receive only €10 million, the face amount of his bond.
Define the yield to maturity for a coupon bond
The yield to maturity of a coupon bond is the expected rate of return on a bond if the bond is held to maturity, there is no default, and the bond and all coupons are reinvested at the original yield to maturity
Is it possible for a coupon bond to earn less than the yield to maturity if held to maturity?
Yes, it's possible. For example, if reinvestment rates for the future coupons are lower than the initial yield to maturity, a bond holder may experience lower realized returns
