Chapter 2 - Asset Classes - Debt

Question 1

Components of a bond

Answer 1

• Nominal/par value - amount the borrower will return to the lender at maturiy.
• Redemption/maturity date - date the borrower will pay teh nominal value to the lender
• Coupon - fixed interest rate the borrower pays the lender.
• Issuer - Who issued the bond e.g. Gov/corp

Question 2

Coupons (what they can be based on and types - FRNs, ILBs)

Answer 2

Some bonds coupons are referenced to a published interest rate (SOFR) and change the coupon paid based on this.

Floating rate notes (FRNs) - bonds with variable coupon IR and nominal value based on published IRs

Index linked bonds - bonds that are based on inflation rate (e.g. CPI).

Question 3

Yields

3 types of yield

Answer 3

=measure of % return provided by an investment.

3 ways to calculate yield
* Flat yield
* Gross redemption yield (GRY)
* Net redemption yield (NRY)

Question 4

Flat yield and calculation

Answer 4

Only considers the coupon and ignores capital gains/losses if the bond is held to redemption.

Calculation
Flat yield= (annual coupon/price) X 100

e.g. 5% gilt at price £100 = (5/100) X 100 = 5% flat yield

Question 5

Relationship between bonds and base interest rates

Answer 5

IR/bond price relationship = If IRs go up bond prices fall as investors would make more money from having money n savings than in bonds, reducing demand and in turn price

Question 6

Gross redemption yield (GRY)/Yield to maturity (YTM)

Answer 6

Considers coupons and gains/losses due to maturity. Holding a bond to maturity represents a more complete view of return.

• Does not consider the impact of taxation
• Especially useful for non tax paying, long term investors - pension funds

Add calculation from 2.6 and explaination of present value

Question 7

Net redemption yield

Answer 7

Considers coupon, gains/losses made during the time period to maturity and the after tax cash flow of the bond (rather than gross cashflow). Good measure for tax paying investors holding bonds to maturity.

Question 8

Modified duration

Answer 8

Lower coupon bonds tend to have a more volatile price due to IR fluctuations affecting their price. Also, Long dated bonds will be more responsive than short dated bonds

Modified duration shows volatility by showing the expected change in price given a specific change in IR.The higher the modified duration, the more the price will move.

Modified duration=approximate % change in the price of a bond as a result of a 1% change in IR.

Question 9

Convertible Bonds

Answer 9

Give the holder the right but not obligation to convert bonds into a set number of ordinary shares.

Typically trade at a premium to the share value.

Only available on corp bonds

Question 10

Conertible bonds - conversion ratio calculation

Answer 10

Conversion ratio=Nominal value/conversion price of shares

Conv. bonds are issued with the share price being set from the outset. The conversion share price will be adjusted to take into account bonus or rights issues.
E.g. Issuing company had a 1-1 bonus issue, conersion price would half and the conversion ratio would double.

Question 11

Flat yield - calc and limitations

Answer 11

Flat yield %=(annual coupon rate/mkt price) X 100

Flat yield only considers coupon rate - ignores capital gans/losses, tax

Question 12

Flat yield - limitations

Answer 12

• Gives an incomplete picture of return as it does not consider nomial value repayment at maturity.
• Overlooks the time-value of money - no DCF analysis
• Floating rate notes returns will differ from one coupon payment to another so selecting the coupon rate to do the calculation with is challenging.

Question 13

Clean/flat prices

Clean price, claculation

Answer 13

Clean/flat prices = the bond’s price does not inculde the accrued interest related to the bond.
* On settlement dates (when interest is paid) bond price is the same as flat price.
* Between payment dates - actual price paid for the bond = flat price + accrued interest
* Clean/flat price + accrued interest = the dirty price

Question 14

Accrued interest calculation

Answer 14

Accrued interest = Coupon payment X
(Number of days since last payment / Number of days between payments)

Question 15

Bond dirty price tables

Answer 15

(see book diagram)

Assumes flat price remains constant (although it will probably fluctuate with IRs).
The bond price will steadily increase each day leading up to interest payment and then drops immediately following the payment.

Question 16

Day count conversion (ACT/360 etc)

Answer 16

• Act/360 - correct number of days per month but assumes 360 days per year - used for US treasury bills + money mkts
• 30/360 - 30 days in a month and 360 in a year - Used for Euro bonds, US agency+corp bonds AND ACCRUED INTEREST
• ACT/365 - Normal months and a 365 day year ignoring leap years
• ACT/ACT - month/year treated as normal

Question 17

S

Spreads and pricing benchmarks - what are they expressed in

Answer 17

Spread = difference between 2 yields, expressed in basis points.

Used to compare instruments against a benchmark such as govt bonds

Question 18

Common benchmarks for bonds

Answer 18

• Govt bond yields= corp bonds usually use most recent issued govt bs.
• Swap rates= swap rates used as a benchmark due to the market being very active
• Published reference rates= Example Secured Overnight Financing Rate (SOFR). Used to be LIBOR

Swaps exchange floating rates for fixed rate bonds

Question 19

Yield curve - overview

Answer 19

Many govt bond mkts have differing time periods until maturity. If you plot the gross redemption yield of the bonds on a graph (yield on y axis; time to maturity on x) it creates a yield curve.

It shows the yeild available to investors in govt bonds with different time horizons. AKA term structure of IRs - showing relationship of yeilds from the same issuer with different times to maturity.

Shows investors wanting a higher yeild on longer dated bonds to indicate the time they are exposed to the risk

Question 20

Normal yield curve

Answer 20

physical- shows investors have a liquidity preference and will accept lower yeild for liquidity. This means they will want higher GRY for longer dated securities

Question 21

inverted yield curve

Answer 21

physical- Yields on short term bonds exceed long term
* Indiciator of poor economic conditions to come or a reduction in IRs
* long term IRs expected to be lower tan short term as investors will want high returns for the securities they are holding now that could be impacted by a recession

Question 22

Negative yields

Answer 22

Meant banks had to pay to leave their cash with the central bank = promotes lending=boosts economy

Question 23

Cons of negative yields

Answer 23

• negative rates would encourage savers to hold their savings in physical cash, severly affecting banks profitability and liquidity = systemic risk
• Pensions funds with long term low risk investments will struggle to see positive return, resulting in difficulty in them meeting future liabilities
• Encourgaes yield chasing - buying risky, high yield bonds to try and generate returns, causes asset price bubbles = fucked economy

Question 24

Negative coupon bonds

Answer 24

early 2022 saw negative coupon bonds. Investors were willing to pay govs to lend them money to preserve most of their capital for the security.

Question 25

Inflation relationship with the yield curve

Answer 25

'Nominal yields' are taken from conventional debt instruments and anticipate infaltion. Real yield curves can be obsereved which have already had inflation priced in. Investors expect yields to rise to reward them for predicting a rise in inflation = yield curve rises. To counter this, centeral banks can raise IRs in the short term to counter this pressure but this means medium/long dated bond prices fall. because it is assumed action from the central bank will remove the impact of inflation in the med/long term.

Question 26

Bond present value - time value of £

Answer 26

Time value of money can be expressed as the value of a recievable sum of £ in the future in today's terms by considering the prevailing IR = sum's present value. Establishing present values AKA discoutning with the IR acting as the discount rate. Basically how much your money will be worth in the future compared to how much it is worth now.

Question 27

Bond present value calculation

Answer 27

**1/(1+r)^n** r=prevailing IR n= years E.g £1000 nominal value paying 10% coupon annually. 5% IR over 2 years = * Y1: 100X 1/(1+0.05) * Y2:1100X 1/(1+0.05)^2 = £1100 total return after 2 years (10% coupon at end of first year + nominal payout at maturity)

Question 28

Government debt - who issues bonds in the UK

Answer 28

Debt Management Office (DMO) Same features of a corporate bond - coupon, nominal value, typically bi-annual coupon payment

Question 29

Ex dividend and cum dividend

Answer 29

Ex dividend= determines who recieves the coupon payment. Period of time prior to coupon payment to determine who the holder of th bond is/who recieves coupon

Question 30

Cum dividend

Answer 30

Normal trading time for the bond. There is a coupon payment in the future that has not been paid out yet.

Question 31

Risk free rate of return

Answer 31

The amount of moeny invested that is guaranteed to be returned to the investor (as it holds no risk).

Question 32

Index linkeded bonds example

Answer 32

* Examples: Index linked guilts (ILG) and US TIPS. They are based on published inflation indexes such as the retail price index (RPI) and CPI. * The + is that their price will increase with inflation, preserving the true value. * In 0% inflation ILBs will pay coupon rate with no adjustment. * There is no deflation floor in gilts which protects bonds returning less nominal value

Question 33

Real interest rate calculation

Answer 33

**Real IR= [(1+nominal IR) ——————————- -1 (1 + inflation rate)]

Question 34

Measures of inflation in the UK

Answer 34

* Harmonised index of consumer prices - later renamed to consumer price index (CPI). **CPI** target inflation = 2%. Set by monetary policy comittee in the BoE. EU wide * **Producer price indicies (PPI)** measure inflationary pressures at early stages in the production process, e.g. raw materials at wholesale level. * **Retail price index (RPI)** - avrg. measure of change in the prices of goods and services. once published, it is not revised.

Question 35

Seperate Trading of Registered Interest and Principal Securities (STRIPS) Stripping bonds

Answer 35

Zero coupon bonds (ZCBs) - only return nominal value at maturity, the coupon is stripped off the bond and sold seperately.

Question 36

International Govt. bonds

Answer 36

P 48 table

Question 37

Corporate debt features

Answer 37

Can be split into money borrowed from banks and money borrowed from investors (bonds) Debt financing is cheaper than equity as it is less risky for investors a bond holders are paid before equity holders.

Question 38

Secured debt - fixed and floating charges

Answer 38

Secured debt decreases the risk of default as assets of the issuer are offered as guarantee in the case of default. * Fixed charge= debt secured by a specific physcial asset e.g. a buidling * Floating charge= debt secured by a group of non current assets (e.g. bonds) Call debenture in the UK

Question 39

Asset backed securities

Answer 39

Bonds backed by specific pool of assets (mortgages, credit card recieveables and car loans). This debt is securitised by big banks. Assets provide bondholders collateral as the cash generated from the pool of assets is used to pay off bonds coupons and nominals at maturity.

Question 40

Securitisation definition

Answer 40

Financial instruments (credit card debt, mortgages, etc) are packaged together and used as a way to obtain funds/profit.

Question 41

Mortgage backed securities

Answer 41

An example of an asset backed security. A group of mortgage loans that are packaged together and sold to investors. As the homeowner pays their mortgage, the investor recieves coupons and a nominal repayment. Typically divided into sub classes (tranches) with differing risk levels and payment schedules e.g. first tranche is paid first and teh fourth paid last= higher risk.

Question 42

Special purpose vehicles role in ABSs - 2 purposes

Answer 42

SPVs used to lower the risk of default on ABSs. usually a trust of the issuer of the assets. 2 purposes 1. Seperate from the issuing entity=the assets leave the issuers balance sheet and are replaced by cash payment from teh SPV. AKA off-balance sheet arangement. 2. SPVs are standalone entities so if the issuer of the assets goes bankrupt, the SPV remains and can continue to pay bondholders. AKA bankrupty remote = increased credit worthiness

Question 43

SPV diagram

Answer 43

physical

Question 44

Covered bonds

Answer 44

Instances where no SPV is created AB bonds are referred to as **covered bonds** Classed as senior secured debt securities issued by a regulated financial institution. If the bank defaults, collateral is used to pay bondholders regardless if the bank has defaulted (as long as there is enough collateral)

Question 45

Role of trusts in secured debt - Trustees

Answer 45

The property of the issuing company is mortgaged to the bondholders as collateral for the money the company owes. However, a trust deed is put in place between the firm and investors saying they will be repaid the money trusted to the firm.

Question 46

UK Debenture trustee roles4 of them

Answer 46

* Note trustee - represents the interests of the bondholders+provides guidance to the issuer * Security trustee - holds the securities for the benefit of the bondholders. * Share trustee - Holds the shares in an issuing SPV to achieve off balance sheet treatment - basically it is the SPV * Successor trustee - role is provided for banks in the event they need to resign from being the debt issuer to avoid conflict of interest

Question 47

Benefits of a trust deed

Answer 47

* Outlines the powers of the trustee acting on behal of all of the investors.Enables clear management/organisation. * Ensures all holders are paid what they are owed * + to the issuer as if the trust does something illegal, it is a seperate entity so the disputes stops at the trust. * Cheaper to have 1 trustee running the show than loads.

Question 48

Represenation of the bondholders interests by the trustee

Answer 48

* Trustee is assigned to represent the interests of teh bondholders. * Engages the services of a credit rating agency to give potential investors a risk profile. However trustees can essential pay credit agencies for higher ratings * Trustee responsible for tracking bondgolers/ensuring obligations are met *

Question 49

3 Tiers of debt

Answer 49

Ranks bondholders in seniority marking who is entitled to be repaid first. * **Senior debt** - debt ranks above all other debt/equity in a business and is paid first. Lowest IR as it is the most secure. Has strcit requirements * **Subordinated debt** - ranks below senior debt - Less strict requirements and a higher interest rate. * **Mezzanine debt** - High risk form of subordinated debt. Ranks last from the above and unsecured debt. Much higher IR compared to the above to reflect high risk. If not all interest or paid it can be marked as payment in kind and given to the investor as options.

Question 50

Unsecured debt

Answer 50

* No protection for the investor if the firm defaults. * Higher interest to compensate the investor for the higher risk * Subordinated debt is typically unsecured and investors will be paid after other creditors if there is enough cash left after winding up

Question 51

Guaranteed debt/guarantor role

Answer 51

A guarantee is provided by someone other than the issuer (a guarantor) to pay the sum due if teh issuer defaults in return for a fixed payment every month eg.

Question 52

Table comparing the characteristics of subordinated, guaranteed and convertible bonds.

Answer 52

Physical

Question 53

Credit ratings - 3 main agencies

Answer 53

* Standard and Poor's * Moody's * Fitch ratings Bonds are ranked into investment grade or non investment grade (junk). Some ABSs can have a 'credit enhanced' rating due to insurance protection in teh event of default. See table page 58

Question 54

Bonds with the highest modified duration are

Answer 54

Lower coupon and longer dated

Question 55

How does the repo mkt improve the gilt mkt’s liquidity and what function facilitates the reverse repos

Answer 55

Facilitates reverse repos from GEMMs to cover shorts. Facilitated by the standing repo function

Question 56

US treasury bond with 10+ YTM

Answer 56

T bonds

Question 57

Bond profiles

Answer 57

US, UK, German - max maturity 30years Japan max maturity 40 France max maturity 50 UK, US, Japan semi annual coupon German and French is annual coupon