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15.1.A. Features of Fixed Income Securities
15.1.A. Features of Fixed Income Securities
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Explanation:
7. Dual Index Floaters: set the coupon rate equal to a margin plus the spread between two
reference rates.
8. Ratchet Bonds: are floating rate bonds; however, once the coupon rate is adjusted
downwards, it may never be revised upwards again.
9. Non-Interest Rate Index Floaters: set the coupon rate to a "non-interest rate" reference rate.
For example, the coupon rate may be set equal to a base rate plus the rate of inflation.
Question:
Which of the following statements is(are) true with respect to various coupon rate structures that
bonds may adopt?
I.
II.
A zero-coupon bond pays no coupons, however at the end of its term, both the principal
and the accumulated coupons are paid to the bondholder.
Most U.S. corporate bonds pay coupons semi-annually.
III.
IV.
Answer:
II only.
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Explanation:
(I) is incorrect because a zero-coupon bond compensates a bondholder through the difference in
the discount price that is always paid for this bond, and the par value that will be received in the
future. Again, at maturity, only the par value will be received; there is no accumulated coupon
payment.
(III) is incorrect because most U.S. government bonds pay coupons semi-annually as well.
(IV) is incorrect because most mortgage-backed securities pay interest on a monthly basis.
Bullet maturities refers to bonds that have to periodically pay back the principal with
every interest payment.
Conventional bonds require that each periodic payment be a blend of principal and
interest, with the interest being the higher component in the earlier periods of the bond's
life.
III.
IV.
Answer:
III and IV only.
Explanation:
(I) is incorrect because Bullet maturities refers to bonds that have to pay back the principal on
that one maturity date.
(II) is incorrect because conventional bonds require that entire principal be paid at the maturity
date; in other words, this is the norm.
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A call provision enables the investor to exercise the right to call in the par value in
exchange for delivering the bond back to the issuer.
II.
A non-refundable provision forbids the issuer from ever calling the bonds before their
maturity date.
III.
A sinking fund provision obligates the issuer to retire a portion of its debt every period
prior to its maturity.
IV.
Answer:
III only.
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Explanation:
(I) is incorrect because a call provision enables the issuer to call in the bond in return for paying
the investor a call price, which is really the sum of the bond's par value and some call premium.
(II) is incorrect because a non-refundable provision only forbids the issuer from calling the bonds
if the proceeds used to redeem the existing bonds came from the issuance of bonds with a lower
coupon rate.
(IV) is incorrect because non-refundable implies that a bond cannot be retired by substituting it
with lower cost debt, otherwise other company funds may be used to retire this bond. A noncallable feature, on the other hand, implies that a bond cannot be retired before its maturity under
any circumstances.
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Question:
Which of the following statements is(are) true with respect to the types of extra features that may
be incorporated into a bond?
I.
Special redemption prices allow the issuer to call its bonds at just par, if certain
circumstances prevail.
II.
Exchangeable bonds allow the holder to exchange the bonds for the common shares of
the underlying issuer.
III.
Put provisions allow the holder of the bonds to deliver the underlying bond to the issuer
in exchange for some pre-determined price.
IV.
Answer:
I and III only.
Explanation:
(II) is incorrect because exchangeable bonds allow the holder to exchange the bonds for the
common shares of corporation that is different from the issuer.
(IV) is incorrect because indexed amortization notes allows the issuer to accelerate principal
repayments if a specified reference interest rate actually decreases.
PURCHASING BONDS
1. Cash Purchase: For most individual investors, this is the primary method of purchasing
bonds. If the bond is purchased on the day that it is issued or immediately after a coupon has
been paid, then the invoice price is simply equal to the price that is quoted for the bond.
However, if the bond is traded at any other time, there is the issue of accrued interest from the
date of the last coupon payment to the settlement date of the underlying trade. In addition to
the quoted price for the bond, the seller will also demand to be compensated for that portion
of the upcoming coupon that is attributable to the period that the seller held the bond. In
other words, the full price (or "dirty price") is equal to the quoted price (or "clean price") plus
accrued interest.
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Question:
Which of the following statements is(are) true with respect to the cash method of purchasing
bonds?
I.
"Dirty price" makes reference to the sum of the bond's price plus any accrued interest that
may be accumulated on the bond.
II.
Ex-coupon bonds do not require any accrued interest to be built into the trade price for a
bond.
III.
In the U.S., bonds that are trading "cum-coupon" are usually bonds that are in default.
IV.
Accrued interest is accumulated from the date of the last coupon payment to the trade
date of the bond.
Answer:
I and II only.
Explanation:
(III) is incorrect because in the U.S., bonds that are trading "ex-coupon" are usually bonds that
are in default. A cum-coupon bond refers to those bonds whose trade prices include both the
normal price of the bond and any accrued interest.
(IV) is incorrect because accrued interest is actually accumulated from the date of the last coupon
payment to the "settlement" date of the bond. Settlement date always comes after the trade date;
hence it involves a slightly larger period of accumulation.
2. Margin Buying: For aggressive investors or institutions, bond purchases may also be financed
with borrowing. The Federal Reserve sets the margin for which an investor must post for
such trades.
3. Repurchase Agreements: are also borrowing structures used to finance the purchase of bonds.
However, instead of making interest payments on the borrowed fund, an investor borrows one
amount but repays a higher amount back to the lender. The yield between the original
lending amount and the repayment amount is referred to as the "repo rate". The lower the
repayment amount, the lower this repo rate will be.
Question:
Which of the following statements is(are) true with respect to the methods that may be used by
institutional investors when purchasing bonds?
I.
II.
III.
Call money rate refers to the rate that is charged on loans by a broker to investors who
partly finance the purchase of bonds through debt.
Repurchase agreement involves a dealer selling a bond today at one price, and
simultaneously agreeing to repurchase it back at a lower price at some future date.
Overnight repo refers to the implicit rate derived from a repurchase agreement that is
reversed the very next day.
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IV.
If the annualized implied interest rate on a repurchase agreement is high, the underlying
bond is referred to as a hot or special collateral.
Answer:
I and III only.
Explanation:
(II) is incorrect because a repurchase agreement involves a dealer selling a bond today at one
price, and simultaneously agreeing to repurchase it back at a "higher" price at some future date.
By selling the bond today, the dealer is effectively getting a loan and the lender is keeping the
bond as collateral. Hence, for the lender to earn a return, the dealer must buy back the bond at a
higher price than what it originally sold it to the lender.
(IV) is incorrect because the term hot or special collateral refers to that agreement whereby the
underlying bond is bought back at only a "slightly" higher price. Think of it this way: this
underlying bond is so hot, that the lender does not need much compensation in order hold the
bond as a collateral. This means that the original owner need only pay a slightly higher price in
order to buy the bond back from the lender.
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