Overview of bond sectors and instruments (Reading 55)

Exercise Problems:

1. On January 1st of the year, an investor purchases $100,000 in par value of a new Treasury Inflation Protection Security (TIPS) issue that has a 3% coupon rate. The annual rate of inflation over the first six months of the year is 3.5% and the annual rate of inflation for the second six months of the year is 4.0%. The amount of coupon interest paid to the investor after the second six months of the year is closest to:

A. 1,557.

B. 1,577.

C. 1,597.

Ans: A;

The inflation-adjusted principal after the six month period is

$100,000 1.01751.02 = $103,785

And $103,785 (3%/2) = $1557

2. All U.S. Treasury coupon strips are:

A. zero-coupon securities.

B. issued directly by the U.S. Treasury.

C. created from pooled coupon payments of U.S. Treasury securities.

Ans: A;

A is correct. Since the U.S. Treasury does not issue zero-coupon notes and bonds, investment bankers began stripping the coupons from Treasuries to create zero-coupon securities of various maturities to meet investor demand.

B is not correct because Treasury strips are not issued directly by the U.S. Treasury but are stripped from the principal or interest payments of U.S. Treasury securities become direct obligations of the U.S. government.

C is not correct because Treasury coupon strips are strips created from coupon payments stripped from the original security.

3. An investor is considering floating-rate debt and other investments to protect against unexpected increases in inflation. Her friend states: 1) Treasury Inflation Protected Securities (TIPS) is suitable because the coupon rate is adjusted for inflation semiannually. 2) On-the-run Treasury issues have narrower bid-ask spreads than other Treasury issues.

A. Only statement 1 is correct.

B. Only statement 2 is correct.

C. Both statement 1 and 2 are correct.

Ans: B;

The friend is incorrect about TIPS because the coupon is fixed and par value is adjusted for inflation.

The friend is correct about the bid-ask spread for the on-the-run issues because they are more liquid and, thus, have a narrower-bid-ask spread.

4. A level payment, fixed-rate, fully amortizing mortgage loan for $220,000 is obtained with a term of 15 years, a mortgage rate of 6.0% with monthly compounding, and a monthly payment of $1,856.49. Assuming that the borrower does not prepay or default, the principal that is repaid during the first 3 months is closest to:

A. $660.

B. $2,281.

C. $3,667.

Ans: B;

Principal repaid the first 3 months =$756.49+760.27+764.07

=$2,280.83

5. The primary motivation for creating a collateralized mortgage obligation (CMO) is best described as the desire to redistribute which risk of investment in residential mortgages:

A. interest rate risk.

B. default risk.

C. prepayment risk.

Ans: C;

C is correct because the motivation for creating a CMO is to distribute prepayment risk among different classes of bonds.

6. A fixed income portfolio manager is evaluating investments in the mortgage market but is concerned about prepayment risk. The security that will most likely minimize prepayment risk is:

A. a mortgage passthrough security.

B. a portfolio of interest-only mortgage loans.

C. tranche B of a collateralized mortgage obligation.

Ans: C;

C is correct because a collateralized mortgage obligation or CMO, is structured to distribute prepayment risk among different tranches of bonds. Tranche A would be repaid first, followed by tranche B, then C, etc.

A is not correct. A mortgage passthrough security passes the payments made on a pool of mortgogages through proportionally to each security holder. A holder of a mortgage passthrough security that owns a 1% portion of the issue will receive 1% share of all the monthly cash flows from all the mortgages. Since each holder receives a percentage of all cash flows, a mortgage passthrough security has prepayment risk as a single mortgage would.

B is not correct. A holder of a portfolio of interest-only mortgage loans will receive less total payments when prepayment rates are higher since interest is only paid on the outstanding principal amount, which is decreased by prepayments. It does not minimize prepayment risk.

7. For collateralized mortgage obligations (CMOs), are prepayment risk and interest rate risk, respectively, different for the various tranches of bonds?

Prepayment risk Interest rate risk

A. No No

B. Yes No

C. Yes Yes

Ans: C;

CMOs are structured so as to redistribute prepayment risk and interest risk among the different tranches of bonds using rules for the distribution of interest and principal. For example, if there are three tranches of bonds the distribution rules ensure that the first class of bonds receives all principal until they are paid off. Finally, the last class receives principal payments. Effectively, the first tranche has the shortest maturity/duration while the last tranche has the longest maturity/duration.

Thus prepayment risk and interest rate risk have been redistributed across the bond classes with the first tranche experiencing the greatest prepayment risk the last tranche experiencing the most interest rate risk.

8. Which of the following statements about debt securities is most likely correct?

A. Insured bonds are bonds collateralized by an escrow of securities guaranteed by the U.S. government.

B. Tax backed municipal bonds are supported through revenues generated from projects that are funded in whole or in part with the proceeds of the original bond issue.

C. Creating CMOs does not reduce the overall prepayment risk of a mortgage passthrough security.

Ans: C;

C is correct because creating a CMO can redistribute the prepayment risk among the tranches, but it does not alter the overall prepayment risk of a mortgage passthrough security.

A is not correct. Prefunded municipal bonds are bonds collateralized by an escrow of securities guaranteed by the U.S. government.

B is not correct. Revenue bonds are supported through revenues generated from projects that are funded in whole or in part with the proceeds of the original bond issue.

9. A moral obligation bond is also known as:

A. a general obligation debt.

B. a prerefunded bond.

C. an appropriation-backed obligation.

Ans: C;

A moral obligation bond is also known as an appropriation-backed obligation. States sometimes act as a back up source of funds for issuers and may appropriate funds from its general fund during times of shortfall. However, the state’s obligation is not legally binding, but is a “moral obligation.”

10. An investment banking firm offers a corporation a binding bid to purchase an amount of new debt securities to be issued by the corporation with a specified coupon rate and maturity. The corporation can accept or reject this bid. This type of security distribution is best described as:

A. competitive bidding.

B. best efforts.

C. bought deal.

Ans: C;

C is correct because bought deal underwriting occurs when an underwriter solicits securities from an issuer and the issuer accepts the offer.

11. Corporate debt securities that are offered continuously to investors by an agent of the issuer are best described as:

A. medium-term notes.

B. structured notes.

C. range notes.

Ans: A;

A is correct. One characteristic in which Medium-term notes differ from a regular corporate bond is that once registered medium-term notes can be “placed on the shelf” and sold in the market over time at the discretion of the issuer.

B is not correct. A structured note is a debt security created when the issuer combines a typical bond or note with a derivative.

12. An analyst is evaluating various debt securities issued by a company. The type of security that is most likely to yield the lowest recovery in a bankruptcy is a:

A. debenture bond.

B. collateral trust bond.

C. mortgage bond.

Ans: A;

A debenture bond is unsecured and would be expected to recover less should the company file for bankruptcy, while mortgage and collateral trust bonds are secured by real property.

13. When a bank creates a collateralized loan obligation (CLO) to divest of commercial loans that it owns, the process is best described as a(n):

A. arbitrage transaction.

B. balance sheet transaction.

C. capital infusion transaction.

Ans: B;

B is correct because a balance sheet transaction is one that removes assets from the balance sheet of the institution and is often motivated by the desire to reduce the institution’s risk.

14. 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:

A. allow the corporation to retain a first lien on the assets of the SPV.

B. segregate the assets into a bankruptcy-remote entity for bondholders.

C. receive a guaranty from the SPV to improve the corporation’s credit rating.

Ans: B;

B is correct because a key motivation for a corporation to establish a special purpose vehicle (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 not correct. SPV does not allow the corporation to retain a first lien on its assets.

C is not correct. The SPV receives a higher rating than the unsecured debt of the corporation, because the assets are transferred into a separate entity and shielded from the claims of the corporation’s general creditors.

15. Mingle Corporation sold its receivables to a special purpose vehicle, MGT Corporation, created by Mingle for that purpose. If MGT sells securities backed by the receivables, the credit rating associated with those securities will most likely be based on the:

A. creditworthiness of Mingle.

B. creditworthiness of MGT.

C. collateral and credit enhancement mechanisms used.

Ans: C;

C is correct because the rating of asset-backed securities typically is independent of the issuer or originating firm’s credit; the rating depends on the collateral offered and the strength of any external or internal credit enhancements.