4.1 Fixed Income Securities

4.1 Fixed Income Securities

Question 1

PE2018Q4
Which of the following statements regarding the trustee named in a corporate bond indenture is correct?

A. The trustee has the authority to declare a default if the issuer misses a payment.
B. The trustee may take action beyond the indenture to protect bondholders.
C. The trustee must act at the request of a sufficient number of bondholders.
D. The trustee is paid by the bondholders or their representatives.

Answer: A
Learning Objective: Describe a bond indenture and explain the role of the corporate trustee in a bond indenture.

According to the Trust Indenture Act, if a corporate issuer fails to pay interest or principal, the trustee may declare a default and take such action as may be necessary to protect the rights of bondholders. Trustees can only perform the actions indicated in the indenture, but are typically under no obligation to exercise the powers granted by the indenture even at the request of bondholders. The trustee is paid by the debt issuer, not by bond holders or their representatives.

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Question 2

Suppose that the yield curve is upward sloping. Which of the following statements is TRUE?

A. The forward rate yield curve is above the zero-coupon yield curve, which is above the coupon-bearing bond yield curve.
B. The forward rate yield curve is above the coupon-bearing bond yield curve, which is above the zero-coupon yield curve.
C. The coupon-bearing bond yield curve is above the zero-coupon yield curve, which is above the forward rate yield curve.
D. The coupon-bearing bond yield curve is above the forward rate yield curve, which is above the zero-coupon yield curve.

Answer: A
With an upward sloping curve, the coupon curve is the lowest, the zero-coupon curve is above the coupon curve and the forward curve is above the zero-coupon curve. The order is reversed if the curve is downward sloping.

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Question 3

Relative to coupon-bearing bonds of same maturity, zero-coupon bonds are not subject to which type of risk?

A. Interest rate risk
B. Credit risk
C. Reinvestment risk
D. Liquidity risk

Answer: C
Since zero-coupon bonds have no coupons, there is nothing to reinvest. They are subject to all of the other risks listed, however.

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Question 4

Peter is given the opportunity to pay $ $100.00$ in exchange for his choice of one of the following annuities:

I. The first annuity pays $ $2.00$ per month ($ $24.00$ per annum) over the next five years when the discount rate is $12.0\%$ per annum with monthly compound frequency.
II. The second annuity pays $ $18.00$ per year over the next ten years when the discount rate is $12.0\%$ annum with annual compound frequency.

Both annuities pay in arrears; that is, respectively, at the end of each month and at the end of each year. Assuming Peter’s discount rate of $12.0\%$ is a flat curve (i.e., insensitive to maturity) and fully reflects his risk preferences, which of the following statements is TRUE?

A. Neither is worth the cost (the present value of both is below $ $100.00$).
B. The monthly annuity is worth more than the annual annuity.
C. The annual annuity is worth more than the monthly annuity.
D. Both are worth the cost (the present value of both is above $ $100.00$).

Answer: B
The present value(PV) of a stream of $ $1.00$ payments over an annuity of (T) periods is given by

$$A(T)=\frac{1}{y}\times \left[1-\frac{1}{(1+y/k{)}^{k\times T}}\right]$$

The present value of the monthly annuity is equal $89.10$

The present value of the annual annuity is equal $101.704$

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Question 5

A ten (10)-year bond pays a semi-annual coupon with a coupon rate of $7.0\%$ and the bond’s yield (YTM) is $6.0\%$. If the yield remains unchanged, what happens to the price of the bond in six months?

A. Lower price
B. Same price
C. Higher price
D. Need more information (the initial bond price)

Answer: A
As yield coupon rate, the bond currently trades at a premium to par. With unchanged yield, the price will get “pulled to par” and therefore must decrease.

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Question 6

A hedge fund manager wants to change her interest rate exposure by investing in fixed-income securities with negative duration. Which of the following securities should she buy?

A. Short maturity calls on zero-coupon bonds with long maturity
B. Short maturity puts on interest-only strips from long maturity conforming mortgages
C. Short maturity puts on zero-coupon bonds with long maturity
D. Short maturity calls on principal-only strips from long maturity conforming mortgages

Answer: C
In order to change her interest rate exposure by acquiring securities with negative duration, the manager will need to invest in securities that decrease in value as interest rates fall (and increase in value as interest rates rise). Zero coupon bonds with long maturity will increase in value as interest rates fall, so calls on these bonds will increase in value as rates fall but puts on these bonds will decrease in value and this makes C the correct choice. Interest-only strips from long maturity conforming mortgages will decrease in value as interest rates fall, so puts on them will increase in value, while principal strips on these same mortgages will increase in value, so calls on them will also increase in value.

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Question 7

A U.S. Treasury note with $1.5$ years to maturity has a market price of $ $101.75$ and pays a semi-annual coupon with a coupon rate of $5.50$. The market’s discount function is the following set of discount factors: $d(0.5)=0.970$, $d(1.0)=0.950$, and $d(1.5)=0.920$. Is the bond trading cheap, rich, or fair?

A. Trading cheap
B. Trading fair
C. Trading rich
D. Cheap at six months, fair at one year, and rich at 1.5 years.

Answer: C
$P=2.75\times d(0.5)+2.75\times d(1)+102.75\times d(1.5)=99.81<101.75$

Thus, the bond is trading rich.

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Question 8

PE2018Q11 / PE2019Q11 / PE2020Q11 / PE2021Q11 / PE2022Q11
An analyst have been asked to check for arbitrage opportunities in the Treasury bond market by comparing the cash flows of selected bonds with the cash flows of combinations of other bonds. If a 1-year zero-coupon bond is priced at USD $98$ and a 1-year bond paying a $8\%$ coupon semiannually is priced at USD $103$, what should be the price of a 1-year Treasury bond that pays a coupon of $6\%$ semiannually?

A. USD $99.3$
B. USD $101.1$
C. USD $101.8$
D. USD $103.9$

Answer: C
Learning Objective: Construct a replicating portfolio using multiple fixed income securities to match the cash flows of a given fixed income security.

To determine the price ($F_3$) of the $6\%$ coupon bond by replication, where $F_1$ and $F_2$ are the weight factors in the replicating portfolio for the zero-coupon bond and the $8\%$ coupon bond, respectively, corresponding to the proportions of the zero-coupon bond and the $8\%$ coupon bond to be held, and given a 1-year horizon:

The three equations below express the requirement that the cash flows of the replicating portfolio, on each cash flow date (t, in years), be equal to the cash flow of the 6% coupon bond:

$$\{\begin{array}{l}98\times F_1+103\times F_2=F_3\\ 0\times F_1+4\times F_2=3\\ 100\times F_1+104\times F_2=103\end{array}\to \{\begin{array}{l}{F}_1=0.25\\ F_2=0.75\\ F_3=101.8\end{array}$$

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Question 9

PE2018Q13 / PE2019Q13 / PE2020Q13 / PE2021Q13 / PE2022Q13
An investment advisor is advising a wealthy client of the company. The client would like to invest USD $500,000$ in a bond rated at least AA. The advisor is considering bonds issued by Company X, Company Y, and Company Z, and wants to choose a bond that satisfies the client’s rating requirement, but also has the highest yield to maturity. The advisor has gathered the following information:

Company/Bond	X	Y	Z
Bond Rating	AA	A+	AAA
Semiannual Coupon	$3.5$	$3.56$	$3.38$
Term to Matruity	$5$	$5$	$5$
Price(USD)	$975$	$973$	$989$
Par Value(USD)	$1,000$	$1,000$	$1,000$

Assuming semi-annual coupon payments, which bond should the investment advisor purchase for the client?

A. Bond X
B. Bond Y
C. Bond Z
D. Either Bond X or Bond Z

Answer: A
Learning Objective: Compute a bond’s YTM given a bond structure and price.

To reach the correct answer, find the bond with the highest yield to maturity (YTM) that qualifies for inclusion in the client’s portfolio. Although we can calculate the YTM for each bond using a business/financial calculator, it is unnecessary to do so in this case. Of the three bonds, Bond Y does not qualify for the portfolio as its rating of A+ is below the AA rating required by the client. This leaves Bond X and Bond Z only. Comparing the two bonds, Bond X pays a higher coupon than Bond Z, yet it is cheaper as well. Therefore, the yield on Bond X is higher.

Using a business/financial calculator for:
Bond X: $N=2\times 5=10$; $FV=1,000$; $PMT=(0.0350/2)\times 1,000=17.5$; $PV=-975$; $y=2.0287\times 2=4.0575\%$

Bond Y: $N=2\times 5=10$; $FV=1,000$; $PMT=(0.0356/2)\times 1,000=17.8$; $PV=-973$; $y=2.0819\times 2=4.1637\%$

Bond Z: $N=2\times 5=10$; $FV=1,000$; $PMT=(0.0338/2)\times 1,000=16.9$; $PV=-989$; $y=1.8113\times 2=3.6225\%$

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Question 10

PE2018Q14 / PE2019Q14
An asset manager at an insurance company is considering making a fixed-income investment and holding it for 2 years. The manager is comparing two bond issues that have equal yield to maturity at origination. One is a semi-annual coupon bond paying $7\%$, maturing in 2 years, and priced at USD $101.86$. The other is a zero- coupon bond, also maturing in 2 years, and priced at USD $88.85$. The manager is uncertain about the outlook for interest rates over the next 2 years but will incorporate the forecast of the company’s economist when making the investment decision. Assuming no default risk, tax implications, or liquidity constraints, which of the following statements is correct?

A. The manager should be indifferent towards the bonds if the interest rate is expected to rise since both bonds have the same yield and cash flows.
B. The manager should prefer the zero-coupon bond if the interest rate is expected to rise in the future.
C. The manager should prefer the zero-coupon bond if the expected average interest rate over the next 2 years is less than $6\%$.
D. The manager should prefer the coupon bond if the expected average interest rate over the next 2 years is less than 6%.

Answer: C
Learning Objective: Describe zero-coupon bonds and explain the relationship between original-issue discount and reinvestment risk.

C is correct. The current annual yield on both the coupon and zero-coupon bonds are the same at approximately $6\%$ ($5.9992\%$). If rates are higher than $6\%$ then the coupon bond would be preferred due to higher reinvestment income on 3 intermediate coupons to be received.

A is incorrect. If the interest rate is expected to rise, coupon bonds would be more attractive because investors can reinvest the coupon at higher interest rates.

B is incorrect. If the interest rate is expected to rise, coupon bonds would be more attractive because investors can reinvest the coupon at higher interest rates.

D is incorrect. If the interest rate falls below the yield to maturity, the coupon bond would have lower reinvestment income and become less attractive.

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Question 11

PE2018Q76 / PE2019Q76 / PE2020Q76 / PE2021Q76 / PE2022Q76
A bond trader is using current zero rates to calculate forward rates. The trader gathers the following information on the current term structure of continuously compounded zero rates:

Maturity in Years	Swap Rate
1	$2.00\%$
2	$2.50\%$
3	$3.00\%$
4	$3.50\%$
5	$4.00\%$

What is the 2-year forward swap rate starting in three years?

A. $3.50\%$
B. $4.50\%$
C. $5.52\%$
D. $6.02\%$

Answer: C
Learning Objective: Derive forward interest rates from a set of spot rates.

Annual compounding
$(1+r_3{)}^3(1+r_{3-5}{)}^2=(1+r_5{)}^5\to (1+0.03{)}^3(1+r_{3-5}{)}^2=(1+0.04{)}^5$

$r_{3-4}=5.52\%$

Countinuous compounding
$e^{0.03\times 3}\times e^{F\times 2}=e^{0.04\times 5}\to F=5.5\%$

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Question 12

PE2020Q4 / PE2021Q4
Which of the following statements regarding a corporate trustee named in a corporate bond indenture is correct?

A. The trustee is not required to conduct its own investigations to determine if the issuer is adhering to covenants.
B. The trustee may take action beyond the indenture to protect bondholders.
C. The trustee must act at the request of a sufficient number of bondholders.
D. The trustee is paid by the bondholders or their representatives.

Answer: A
Learning Objective: Describe a bond indenture and explain the role of the corporate trustee in a bond indenture.

Sometimes an indenture states that trustees can rely on the issuer and the issuer’s attorneys for information on whether some covenants are being adhered to. In such cases, the trustee is not required to conduct its own investigations. Trustees can only perform the actions indicated in the indenture, but are typically under no obligation to exercise the powers granted by the indenture even at the request of bondholders. The trustee is paid by the debt issuer, not by bond holders or their representatives.

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Question 13

PE2019Q56 / PE2020Q56 / PE2021Q56 / PE2022Q56
A junior credit risk analyst at a US firm is preparing a research report on the attributes and investment performance of corporate bonds. In analyzing corporate bond default rates, credit-spread risk, recovery rates, and their impact on portfolio returns for a typical class of investment grade bonds, which of the following is correct?

A. The distribution of recovery rates of corporate issues is best described as a binomial distribution.
B. The size of a bond issuance is not empirically related to its recovery rates.
C. Measured over the same time period, US Treasury securities always outperform a portfolio of corporate bonds that experiences defaults.
D. Spread duration is best measured by the change in the corporate bond yield for a given 100 bp change in the Treasury rate.

Answer: B
Learning Objective:

• Differentiate between credit default risk and credit spread risk.
• Define recovery rate and default rate, and differentiate between an issue default rate and
  a dollar default rate.

B is correct. Recovery rates are not related to bond issuance size.

A is incorrect. The empirical distribution of recovery rates is bimodal, and not binomial, normal or lognormal.

C is incorrect. It is possible for a corporate bond that experiences defaults to outperform US Treasury securities.

D is incorrect. While measuring a corporate’s credit-spread risk, the Treasury rate (risk- free rate) is held unchanged. One of the measures of credit-spread risk is “spread duration,” which is the approximate percentage change in a bond’s price for a $100$ bp change in the credit-spread assuming that the Treasury rate is unchanged.

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Question 14

PE2022PSQ8
TRSC, a trust company specializing in corporate investments, is brought in as a corporate trustee for a recent bond issue by Banko, a small investment bank. The newly hired CFO of Banko is reviewing the roles of TRSC specialized in the indenture for the bond issue. Which of the following statements is correct?

A. TRSC must monitor Banko’s financial situation to foresee any covenant breaches.
B. When deemed necessary, TRSC should take action beyond the terms of the indenture in order to protect bondholders.
C. TRSC must take action according to the terms of the indenture whenever it is requested by bondholders.
D. TRSC is paid by Banko to represent in the interests of the bondholders.

Answer: D
Learning Objective: Describe a bond indenture and explain the role of the corporate trustee in a bond indenture.

D is correct. The trustee is paid by the debt issuer, not by bond holders or their representatives.

A is incorrect. Trustee are not always required to take actions to monitor indenture covenant compliance. Sometimes, the indenture states that the trustee can rely on the issuer and the issuer’s attorneys for information on whether some covenants are being adhered to. In such cases, the trustee is not required to conduct its own investigations.

B is incorrect. Trustee are under no obligation to exceed those duties assigned to them by the indenture.

C is incorrect. While a trustee’s role is to look after the interest of the bondholders, it does this through its specific duties as itemized in the bond indenture. A trustee does not act at a bondholder’s direction.

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Question 15

PE2022Q52
The treasurer of a London-based insurance company expects that $3$ years from today the company will receive GBP $800,000$. The treasurer plans to invest the funds for $1$ year after that and decides to lock in a rate of return on the funds at today’s forward rate for the period. The current $3$-year and $4$-year spot rates are $1.5\%$ and $2\%$ respectively, and the company can borrow and lend at these rates. Assuming continuous compounding, how much interest income will the company earn in the $1$-year period beginning $3$ years from today, and what transactions should the treasurer enter into today in order to lock in this return?

A. Borrow at the $3$-year spot rate and lend at the 4-year spot rate to earn a return of GBP $28,000$.
B. Lend at the $3$-year spot rate and borrow at the $4$-year spot rate to earn a return of GBP $28,000$.
C. Borrow at the $3$-year spot rate and lend at the $4$-year spot rate to earn a return of GBP $28,119$.
D. Lend at the $3$-year spot rate and borrow at the $4$-year spot rate to earn a return of GBP $28,119$.

Answer: A
Learning Objective: Interpret the forward rate and compute forward rates given spot rates.

A is correct. The forward rate for the period from the end of year $3$ to the end of year 4 is:

$F=\frac{R_2{T}_2-R_1{T}_1}{T_2-T_1}=\frac{0.02\times 4-0.015\times 3}{4-3}=3.5\%$

$3.5\%$ interest on the GBP $800,000$ invested equals GBP $28,000$ in $1$ year. To earn this interest, the company would need to borrow GBP $800,000$ today at $1.5\%$ for $3$ years and invest the proceeds at $2\%$ for $4$ years.

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