Cfa L1 Session15

Study Session 15 Debt Investments: Basic Concepts
CFACENTER.COM 1
Study Session 15
Debt Investments: Basic Concepts

A. Features of Fixed Income Securities

a. describe the basic features of a bond (e.g., maturity, coupon rate, par value,
provisions for paying off bonds, currency denomination, options granted to the issuer
or investor).

A fixed income security is a Iinancial obligation oI an entity (the issuer) who promises
to pay a speciIied sum oI money at speciIied Iuture date. The promises oI the issuer and
the rights oI the bondholders are set Iorth in the indenture.

The par value (principal, face value, redemption value, or maturity value) is the
amount that the issuer agrees to repay the bondholder by the maturity date.
Bonds can have any par value, though a par value oI $1,000 is the most common.
The price oI a bond is typically quoted as a percentage oI its par value. For example,
a value oI 90 means 90 oI the par value.
A bond may trade above (trading at a premium) or below (trading at a discount) its
par value.

Maturity is the time period between today's date and the date on which the bond ceases
to exist. It deIines the remaining liIe oI the bond.
It deIines the time period over which the bondholder can expect to receive interest
payments and principal repayment.
It aIIects the yield on a bond.
It aIIects the price volatility oI the bond resulting Irom changes in interest rates: the
longer the maturity, the greater the price volatility.

Bonds Iall into Iour categories based on their maturity:
Money market instruments: 1 year or less.
Short-term notes: 1 to 5 years.
Intermediate-term bonds: 5 to 12 years.
Long-term bonds: More than 12 years.

The interest rate that the issuer agrees to pay each year is called coupon rate. The
coupon is the annual amount oI the interest payment and is Iound by: par value x coupon
rate.
The coupon has nothing to do with the bond price.
In the US most issuers pay the coupon semiannually.

II you have a "6.5 oI 12/1/2009 trading at 97", this means you have a bond that has a 6.5
coupon rate, matures at 12/1/2009 and is selling Ior 97 oI its par value.

CFACENTER.COM 2
The payments that the issuer makes to the bondholder can be in any currency. An issue in
which payments to bondholders are in US dollars is called a dollar-denominated issue.
A nondollar-denominated issue is one in which payments are not denominated in US
dollars. II an issue has coupon payments in one currency and principal payments in
another currency, it is called dual-currency issue.

For "provisions Ior paying oII bonds" and "options granted to the issuer or investor",
please see other LOSs in this section.

b. explain the purposes of a bond's indenture and describe affirmative and negative
covenants.

The indenture is the contract between the issuer and the bondholder speciIying the
issuer's legal requirements. However, bondholders may have great diIIiculty in
ascertaining whether the issuer has been IulIilling its obligations speciIied in the
indenture. The indenture is thus made out to a third-party trustee as a representative oI the
interests oI the bondholders -- a trustee acts in a Iiduciary capacity Ior bondholders.

In an indenture there are:

affirmative covenants: they set Iorth certain actions that the borrowers must take,
such as:
paying interest and principal on a timely basis.
Paying taxes and other claims when due.
Keeping assets in good conditions and in working order.
Submitting periodic reports to a trustee so the trustee can evaluate the issuer's
compliance with the indenture.

negative covenants: they set Iorth certain limitations and restrictions on the
borrower's activities, such as:
Limitations on the borrower's ability to incur additional debt unless certain
tests are met.
Limitations on dividend payments and stock repurchases.
Limitations on sale oI assets.


CFACENTER.COM 3
c. identify and describe the diversity of coupon rate structures (e.g., zero-coupon bonds,
step-up notes, deferred coupon bonds, floating-rate securities).

The coupon rate is the interest rate that the issuer agrees to pay each year. The bond
expression "6s oI 11/1/2020" means a bond with a 6 coupon rate maturing on
11/1/2020.

coupon coupon rate x par value

Zero-coupon bonds: A zero coupon bond promises to pay a stipulated principal amount
at a Iuture maturity date, but it does not promise to make any interim interest payments.
The value oI a zero-coupon bond increases overtime, and approaches par value at
maturity. The return on the bond is the diIIerence between what the investor pays Ior the
bond at the time oI purchase and the principal payment at maturity. The implied interest
rate is earned at maturity. For example, a zero-coupon bond with a par value oI $1,000 is
quoted at 70. The price oI the bond is $700 and the interest is $300.

Although accrual bonds do NOT make any coupon payments UNTIL the maturity date,
they have contractual coupon payments but these payments are accrued and distributed
along with the maturity value at the maturity date. They are sold at or near par values. At
maturity they pay holders the par value and coupon interest compounded at the coupon
rate over the term to maturity.

Step-up bonds: they have low initial and gradually increasing coupon rates, that is, their
coupon rates "step up" over time.


CFACENTER.COM 4
Deferred coupon bonds: they do not make any coupon payments Ior an initial period oI
typically 3 - 7 years. Then a lump-sum coupon is paid, and regular coupon payments
begin.

Floating-rate securities: their coupon payments are reset periodically according to some
reIerence rate. See los d Ior details.

d. describe the structure of floating-rate securities and the different types of
floating-rate securities.

A Iloating-rate security's coupon payments are reset periodically according to some
reIerence rate. The typical coupon Iormula is: coupon rate reference rate + quoted
margin:
examples oI reIerence rates are LIBOR, US Treasury yields.
the quoted margin is the additional amount that the issuer agrees to pay above the
reIerence rate. It is a constant value and can be positive or negative. It is oIten
quoted in basis points.

The coupon rate is determined at the coupon reset date but paid at the next coupon date.

A Iloating-rate security may have upper and/or lower limits on the coupon rate to be paid.
A cap is the maximum coupon rate oI a Iloater. It is an attractive Ieature Ior the investor
since it limits the coupon rate. A floor is the minimum coupon rate, and an attractive
Ieature Ior the investor. A collar is a Iloater with both a cap and Iloor.

Types oI Iloating-rate securities that have constant quoted margin:

CFACENTER.COM 5
Inverse floaters. A typical Iloater's coupon rate increases when the reIerence rate
increases, and decreases when the reIerence rate decreases. However, an inverse
Iloater's (also called a reserve floater) coupon rate moves in the opposite direction
Irom the change in the reference rate: coupon rate K - L x reIerence rate, where K
and L are constant values set Iorth in the prospectus Ior the issue. To prevent a
negative coupon rate there is a Iloor imposed on the coupon rate.

Example: An inverse Iloater's coupon rate 12 - 2 x 3-month LIBOR. II the 3-
month LIBOR is 2, then the coupon rate Ior the next interest payment period is:
12 - 2 x 2 8.

Dual-indexed floaters. The coupon rate is typically a Iixed percentage plus the
diIIerence between two reIerence rates: coupon rate ReIerence rate 1 - ReIerence
rate 2 Quoted margin.

Range notes. Their coupon rate is equal to the reIerence rate as long as the reIerence
rate is within a certain range at the reset date. II the reIerence rate is outside the range,
the coupon rate is zero Ior the period.

Ratched bonds. A ratched bond's coupon rate is adjusted periodically at a Iixed
margin over a reIerence rate. However, it can only adjust downward, and once it is
adjusted down, it cannot be readjusted up iI the reIerence rate subsequently increases.

Deleveraged floater: It has a coupon Iormula where the coupon rate is computed as a
Iraction oI the reIerence rate plus a quoted margin: coupon rate b x reIerece rate
quoted margin, where b is a constant value between 0 and 1.
Example: the coupon rate oI a Iloating-rate bond is reset every April 30 to 75 oI the
5-year T-bond plus 3. Suppose that the 5-year Treasury yield is 6 on April 30,
then the coupon rate Ior the next interest payment period is: 0.75 x 6 3 7.5.

Types oI Iloating-rate securities that have adjustable quoted margin:

Stepped spread floaters. Their quoted margin can step to either a higher or a lower
level over the security's liIe.
Example: a 5-year Iloating-rate note's coupon rate may be 6-month LIBOR 1 Ior
the Iirst 2 years, and 3-month LIBOR 3 Ior the remaining years.

Extendible reset bond:. It requires the issuer to reset the coupon rate so that the issue
will trade at a predetermined price (typically above par). The new rate will reIlect: (1)
the level oI interest rates at the reset date, and (2) the margin required by the market
at the reset date.

Drop-lock bond. The Iloating coupon rate is automatically changed into a Iixed
coupon rate under certain circumstances.


CFACENTER.COM 6
Non-interest rate indexes. A Iloater's coupon can be indexed to movements in
Ioreign exchange rates, the price oI a commodity, the return on an equity index, etc.
For example, the Treasury InIlation Protection Securities (TIPS)'s coupon is based on
inIlation rate: coupon rate rate oI inIlation quoted margin

e. define accrued interest, full price, and clean price.

Coupon interest is paid not daily, but monthly, semiannually or annually. II an investor
sells a bond between coupon payments and the buyer holds it until the next coupon
payment, then the entire coupon interest earned Ior the period will be paid to the buyer.
The seller gives up the interest Irom the time oI the last coupon payment to the time until
the bond is sold. The amount oI interest over this period that will be received by the
buyer even though it was earned by the seller is called accrued interest. The amount that
the buyer pays the seller the agreed upon price Ior the bond plus accrued interest is called
the full price (dirty price). The agreed upon bond price without accrued interest is
simply reIerred to as the price (clean price).

II the issuer is in deIault (not making the periodic payments), the bond is sold without
accrued interest and is said to be traded flat.

f. explain the provisions for early retirement of debt, including call and refunding
provisions, prepayment options, sinking fund provisions, and the construct of index
amortizing notes.

Provisions Ior paying oII bonds:

call provisions: a call provision is the right oI the issuer to retire the issue prior to the
stated maturity date. However the issuer has no obligation Ior early retirement. A
bond issue that permits the issuer to call or reIund an issue prior to the stated maturity
date is reIerred to as a callable bond.
The price which the issuer must pay to retire the issue is the call price.
Bonds can be called in whole or in part.
Typically, a call schedule speciIies a number oI call dates, and sets a call price
Ior each call date. The call price at the Iirst call date generally has a premium
over the par value. II the bond is not called in whole or not called at all, the
call price scales down to the par value over time.

CFACENTER.COM 7

refunding provisions: a reIunding provision permits the issuer to redeem bonds
using proceeds Irom issuing LOWER cost debt obligations ranking equal to or
SUPERIOR to the original debt.

prepayment options: Any principal repayment prior to the scheduled data is called a
prepayment, and the right Ior borrowers to prepay is called the prepayment option. It
is basically the same as a call option. Typically the price at which a loan is prepaid is
par value. Prepayment options are commonly used in amortizing securities that are
backed by loans (e.g. mortgage and car loans).

sinking fund provisions: they are set Iorth in a bond's indenture to retire a speciIied
portion oI the bond each year to reduce credit risk. II only a part is paid, the
remainder is called a ballon maturity.
The issuer can IulIill the sinking Iund requirement in one oI the Iollowing ways:
Make a cash payment oI the required sinking Iund to the trustee, who then
retires the bonds using a lottery; or
Purchase bonds in the open market, and deliver them to the trustee.

index amortizing notes: their principal repayments are made prior to the started
maturity date based on the prevailing value Ior some reIerence rate. The principal
payments are structured to accelerate when the reIerence rate is low.

Noncallable Bonds vs NonreIundable Bonds:

ReIunding means to replace an old bond issue with a new one, oIten at a lower interest
cost. ReIunding prohibition merely prevents redemption only Irom certain sources,
namely the proceeds oI other debt issues sold at a lower cost oI money. The holder is
protected only iI interest rates decline and the borrower can obtain lower-cost money to
pay-oII the debt. A non-reIundable bond can be callable iI cash Ilows are Irom other
sources, such as operations, common stock sale, sale oI property, etc.

Call protection is much more absolute than reIunding protection, and investors should not
be lulled by a non-reIunding provision. Noncallable bonds, not nonreIundable bonds,
have complete protection against early retirement.

g. explain the difference between a regular redemption price and a special redemption
price.


CFACENTER.COM 8
A regular redemption price is the normal call price Ior a typical callable bond. It is
usually above par until the Iirst par call date. Special redemption prices are Ior bonds
redeemed Irom through the sinking Iund and through other provisions, and the proceeds
Irom the conIiscation oI property through the right oI eminent domain or the Iorced sale
or transIer oI assets due to deregulation. A special redemption price is usually par value.
Issuers have the incentive to use all means possible to call the bond at the special
redemption price. A par call problem arises when an issuer uses all means possible to
maneuver a call so that the special redemption price applies.

h. explain the importance of options embedded in a bond issue and indicate whether
such options benefit the issuer or the bondholder.

An embedded option is a provision in the bond indenture that gives the issuer and/or the
bondholder an option to take some action against the other party.
These options are embedded because they are an integral part oI the bond structure. In
contrast, "bare options" trade separately Irom any underlying security.
A bond may have more than one embedded option.

Embedded options may beneIit either the issuer or the bondholder. An embedded option
beneIits the issuer iI it gives the issuer a right or it puts an upper limit on the issuer's
obligations. An embedded option beneIits the bondholder iI it gives the bondholder a
right or it puts an lower limit on the bondholder's beneIit.

Embedded options granted to issuers:
call option: the right to call the issue back at some pre-determined price level.
prepayment option: the right oI the underlying borrowers in a pool oI loans to
prepay an amount in excess oI the scheduled principals repayment.
accelerated sinking fund provision: the issuer can call more than is necessary to
meet the sinking Iund requirement when interest rates decline.

CFACENTER.COM 9
the cap of a floater: it requires no action by the issuer to take advantage oI a rise
in interest rates.

Note the Iirst three options become more valuable when interest rates Iall, but the last one
becomes more valuable when interest rates rise. For example, iI interest rates Iall, the
issuer can retire the bond paying high coupon rate, and replace it with lower coupon
bonds. However, call provisions are detrimental to the bondholders as the proceeds can
only be reinvested at a lower interest rate.

Embedded options granted to bondholders:
conversion option: a convertible bond is an issue that grants the bondholder the
right to convert the bond Ior a speciIied number oI shares oI common stock. The
Ieature allows the bondholder to take advantage oI Iavorable movements in the
price oI the issuer's common stock.
put option: it grants the bondholder the right to sell the issue back to the issuer at
a speciIied price (called put price) on designated dates.
floor on a floater: it beneIits the bondholder iI interest rates Iall.

The importance oI options embedded in a bond issue:
They aIIected the value oI a bond, as well as the perIormance oI a bond measured
by the rate oI return. They aIIect both the timing and the level oI the Iuture cash
Ilows Irom the bond.
Because oI the embedded options, it is necessary to develop models oI interest
rate movements and rules Ior exercising these options. Such models are typically
based on a number oI assumptions.
Investors are exposed to the risk that the valuation models may produce the wrong
value due to incorrect assumptions. Such a risk is called the model risk.

i. describe a repurchase agreement.

It is the sale oI a security with a commitment by the seller to buy the same security back
Irom the purchaser at a speciIied price at a designated Iuture date. It is actually a
collateralized loan, and the implied interest rate is called the repo rate. The diIIerence
between the purchase (repurchase) price and the sale price is the dollar interest cost oI the
loan. The repo rate is lower than the cost oI bank Iinancing, but credit risks are Iaced by
both parties. It is like a Iorward market without a clearinghouse.
A loan Ior 1 day is called an overnight repo.
A loan Ior more than 1 day is called a term repo.

The more diIIicult it is to obtain the collateral, the lower the repo rate. Hot collateral or
special collateral is collateral that is highly sought aIter by dealers and can be Iinanced
at a lower repo rate than general collateral.

CFACENTER.COM 10

When a non-dealer uses the repo market to borrow Iunds, it is called a reverse
repurchase transaction; when a dealer uses the repo market to borrow Iunds it is called
a repurchase transaction.

j. describe the typical method used by institutional investors in the bond market to
finance the purchase of a security (margin buying versus repurchase agreement).

There are several sources oI Iunds available to an investor to purchase a security:

Margin buying: the Iunds borrowed to buy the securities are provided by the
broker, and the broker gets the money Irom a bank. The bank charges the broker
an interest rate (known as call money rate), and the broker charges the investor
the call money rate plus a service charge. This is the most common collateralized
borrowing arrangement Ior common stock but not the common borrowing vehicle
Ior institutional bond investors.

In the US, the percentage oI a bond's value that can be bought on margin is
regulated by the Federal Reserve.

Repurchase agreement: see LOS l please.

Own Iunds:

Borrowing Irom a bank:


CFACENTER.COM 11
B. Risks Associated with Investing in Bonds

a. explain the following risks associated with investing in bonds: interest rate risk, call
and prepayment risk, yield curve risk, reinvestment risk, credit risk, liquidity risk,
exchange-rate risk, volatility risk, inflation risk, and event risk.

The risks associated with investing in bonds are:

interest rate risk: also called market risk. It is the major risk Iaced by investors
in the bond market. Since the price oI a bond Iluctuates with market interest rates,
the risk that an investor Iaces is the price oI a bond held in a portIolio will decline
iI market interest rates rise. The magnitude oI interest rate risk can be measured
by a bond's price sensitivity to changes in interest rates. The degree of sensitivity
depends on many Iactors such as coupon rate, maturity, and embedded options.
See LOS b, c, d, I.

call and prepayment risk: Ior an investor, the cash Ilows oI a bond are uncertain.
The proceeds has reinvestment risk (the interest rate is usually low when the bond
is called), and the price oI bond is capped. It is only second to interest rate risk in
importance. The magnitude oI the call risk depends on various parameters oI the
call provisions, as well as on market conditions. Prepayment risk is Ior investors
on mortgage. See LOS e and n.

yield curve risk: see LOS l, m.

reinvestment risk: Variability in the reinvestment rate oI a given strategy
because oI changes in market interest rates. The additional income Irom
reinvestment oI cash Ilows received (income on income) depends on the
prevailing interest rate levels at the time oI reinvestment, as well as on the
reinvestment strategy. It has oIIsetting eIIects oI interest rate risk, which creates a
strategy oI immunization. See LOS o, p.

credit risk: also called default risk, and is gauged by quality ratings assigned by
commercial rating companies. Investors are normally more concerned with the
changes in the perceived deIault risk and/or the cost associated with a given level
oI deIault risk than with the actual event oI deIault. See LOS q, r, s.

liquidity risk: depends on the ease with which an issue can be sold at or near its
value. The primary measure is the size oI spread between the bid price and ask
price quoted by the dealer. See LOS t, u, v.

exchange-rate risk: See LOS w.

volatility risk: it is the risk that a change in volatility will aIIect the price oI a
bond adversely (embedded with call or prepayment options). The value oI an

CFACENTER.COM 12
option rises when expected interest rate volatility increases. This has opposite
eIIects on borrowers and investors. See LOS y.

inflation risk: also called purchasing power risk. Floating-rate bonds has a
lower level oI inIlation risk. See LOS x.

event risk: See LOS z.

b. identify the relationship between a bond's coupon rate, the yield required by the
market, and the bond's price relative to par value (i.e., discount, premium, or par
value).

The value oI a bond is determined by the present value oI its cash Ilows, discounted at the
yield required by the market. The cash Ilows are the periodic coupon payments, and the
principal repayment at maturity. Yield required by the market is aIIected by market
interest rates.
A bond will trade at par value when the coupon rate is equal to the yield required
by market. That is,
coupon rate yield required by market --~ price par value

A bond will trade below par (sell at a discount) or above par (sell at a premium) iI
the coupon rate is diIIerent Irom the yield required by the market.
coupon rate yield required by market --~ price par value (discount)
coupon rate ~ yield required by market --~ price ~ par value.(premium)

The price oI a bond changes in the opposite direction to the change in interest
rates. Thus, there is an inverse relationship between changes in interest rates and
bond prices.
iI interest rates increase --~ price oI a bond decreases.
iI interest rates decrease --~ price oI a bond increases.

c. explain how features of a bond (e.g., maturity, coupon, and embedded options) affect
the bond's interest rate risk.

The degree oI sensitivity oI a bond's price to changes in market interest rates depends on
various Ieatures oI the issue:
Maturity: the longer the bond's maturity, the greater the bond's price sensitivity
to changes in interest rates, and the higher the interest rate risk.

CFACENTER.COM 13
Coupon rate: the lower the coupon rate, the greater the bond's price sensitivity to
changes in interest rates, and the higher the interest rate risk. ThereIore, all else
equal, a zero-coupon bond has greater interest rate risk than a standard coupon
bond.

Embedded option: a callable bond can be viewed as a bundle oI two positions -
holding an option-Iree (straight) bond, and giving an embedded call option to the
issuer. The value oI a bond with embedded options will change depending on
how the value oI the embedded options change when interest rates change. For
example,

price of callable bond price of option-free bond - price of embedded call option

In other words,
long a callable bond long a non-callable bond + sold a call option

When interest rates decline both components on the right side increase, but the change in
the price oI the callable bond depends on the relative price change oI the two
components. Typically, a decline in interest rates will result in an increase in the price oI
the callable bond but not by as much as the price change oI an otherwise comparable
option-Iree bond.

Similarly, a putable bond can be viewed as a bundle oI two positions - holding an option-
Iree (straight) bond, and holding an embedded put option to the issuer. As a result, the
price oI a putable bond can be computed as:

CFACENTER.COM 14
Price of putable bond price of option-free bond + price of embedded put option

Summary: all else equal, the price oI a bond with an embedded option is less sensitive to
changes in interest rates, so it has less interest risk than a option-Iree bond.

d. identify the relationship between the price of a callable bond, the price of an option-
free bond, and the price of the embedded call option.

See LOS c please.

e. explain how the market yield environment affects the interest rate risk of a bond.

Market yield environment reIers to the level oI interest rates in the market. DiIIerent
bonds trade at diIIerent yields, even iI they have the same coupon rate, maturity, and
embedded options. The required yield is determined by investigating the yields oIIered
on comparable bonds in the market. By comparable it means same credit quality and
maturity.

CFACENTER.COM 15
The bond that trades at a lower yield is more volatile in both percentage price change and
absolute price change, as long as the other bond characteristics are the same. ThereIore,
Ior a given change in interest rates, price sensitivity is lower when the level oI interest
rates in the market is high, and price sensitivity is higher when the level oI interest rates
is low.

f. explain the interest rate risk of a floating-rate security and why such a security's
price may differ from par value.

As the market interest rate changes, the coupon rate oI a Iloating-rate security will change
to reIlect the prevailing market conditions. As a result, a Iloating-rate security sells at or
close to its par value. Because the price oI a Iloating-rate security is less sensitive to
changes in interest rates, a Iloating-rate security has lower interest rate risk than a similar
Iixed-rate bond.

The price oI a Iloating-rate security will Iluctuate depending on three Iactors:

The longer the time to the next coupon reset date, the greater the potential price
Iluctuation. Why? The coupon rate is reset on speciIied reset dates but market
interest rates change continuously. II market interest rates change aIter the coupon

CFACENTER.COM 16
has just been reset, there is a mismatch between the coupon rate and the rate
required by the market.

Usually the coupon rate oI a Iloating-rate security is reset based on a reIerence
rate plus a Iixed quoted margin. However, the margin required by the market may
change, resulting in a bond price that Iluctuates.

A Iloating-rate security will typically have a cap. AIter the coupon rate as
speciIied by the coupon Iormula rises above the cap rate, the coupon will be Iixed
at the cap rate and the security's price will decline (as interest rates rise). This risk
is called cap risk.

g. compute the duration of a bond, given the bond's change in price when interest rates
change.

Investors use duration to estimate the interest rate risk oI a bond. It is the approximate
percentage change in price given a 100 basis point change in market yield (1 basis point
0.01). For example, a bond with a duration oI 3 will gain approximately 3 in value iI
yield Ialls 100 basis points.

All else equal, the longer the duration oI a bond, the greater its interest rate risk.

Duration (Price iI yields decline - Price iI yields rise) / (2 x initial price x change in
yield in decimal)

For speciIic calculation examples, reIer to basic questions please.

h. interpret the meaning of the duration of a bond.

It is a measure oI the price sensitivity oI a bond to a change in yield.

The limitations oI duration as an estimate oI a bond's interest rate risk exposure:

Convexity: percentage change estimates using modiIied duration only are good
Ior small-yield changes.


CFACENTER.COM 17
Nonparallel shift: When yields change, the yield curve seldom experiences a
parallel shiIt. Barbell portIolio would beneIit iI the yield curve had Ilattened or
inverted.

Embedded option: When interest rates declined with an embedded option, the
convexity oI the bond went Irom some positive value to negative convexity,
because the price oI the callable bond increased at a slower rate, or it did not
change when the yield declined (price compression).

i. compute the approximate percentage price change of a bond, given the bond's
duration.

The Iormula is:
approximate percentage price change -duration x yield change x 100

Note: as the bond prices and yields move in opposite directions, there is a negative sign
in the Iormula.

For speciIic calculation examples, reIer to basic questions please.

j. compute the approximate new price of a bond, given the bond's duration and new
yield level.

Given the duration oI the bond, we can estimate the price change that will result Irom a
given change in yield. The approximate dollar change in the price oI a bond Ior a 100
basis point change in yield is called the dollar duration.

Dollar Duration (Duration x Dollar Price) / 100

Then:
Estimated dollar price change Dollar Duration x Change in Yield in Decimal

For example, consider bond A with a duration oI 10.44. Suppose the market value oI this
bond that a manager owns is $5 million. Then Ior a 100 basis point change in yield, the
approximate dollar price change is equal to 10.44 x 5 million, or $522,000. Then Ior a
50 basis point change in yield, the approximate dollar price change is $261,000; Ior a 25
basis point change in yield the approximate dollar price change is $130,500.

CFACENTER.COM 18
k. explain why duration does not account for yield curve risk for a portfolio of bonds.

There is NOT one interest rate or yield in the economy. The bond market has a structure
oI yields. The yield curve is the graphical depiction oI the relationship between yield and
maturity Ior bonds oI the same credit quality.

As market conditions change, the yield at each maturity changes too, causing the yield
curve to shiIt up or down. II the yields at all maturities change by the same amount, the
entire yield curve will shiIt in a parallel manner. However, when interest rates change,
typically yields do not change by an equal amount oI basis points Ior all maturities. This
results in a non-parallel shiIt oI the yield curve.

A bond portIolio has many bond issues usually with diIIerent maturities. When interest
rates change, the price oI each bond issue in the portIolio will change and the portIolio's
value will change. PortIolios have diIIerent exposures to how the yield curve shiIts
(parallel or nonparallel). This risk exposure is called yield curve risk. It reIers to the risk
that the price change oI a bond portIolio varies depending on the shape oI the yield curve.
The implication is that any measure oI interest rate risk that assumes that the interest rates
changes by an equal number oI basis points Ior all maturities (parallel shiIt) is only an
approximation.

A duration Ior a portIolio is the approximate percentage change in the portIolio's value
Ior a 100 basis point change in the yield Ior all maturities. It's possible to determine the
percentage change in the value oI a portIolio iI only one yield changes while the yield Ior
all other maturities is unchanged. This Iorm oI duration is called rate duration, where
the word "rate" means an interest rate oI a particular maturity. In theory there is not one

CFACENTER.COM 19
rate duration but a rate duration Ior each maturity. In practice, a rate duration is not
computed Ior all maturities. Instead, the rate duration is computed Ior several key
maturities on the yield curve and this is reIerred to as key rate duration.

l. explain the disadvantages of a callable and prepayable security to an investor.

The disadvantages oI a callable security to an investors are:
Uncertain cash flows: the cash Ilow pattern oI a callable bond is not known with
certainty.
Reinvestment risk: the investor will have to reinvest the proceeds when the bond
is called at interest rates lower than the bond's coupon rate.
Price compression: the price appreciation potential will be reduced relative to an
otherwise comparable option-Iree bond, as the issuer will redeem the bond at the
call price.

The same disadvantages apply to mortgage-backed and asset-backed securities where the
borrower can prepay.

m. identify the factors that affect the reinvestment risk of a security.

II an investor is to realize the required yield on an investment in a coupon bond, then
he/she must be able to invest all oI the coupon payments at that same yield as well. This
yield is called yield to maturity, which reIers to the percentage rate oI return paid on a
bond iI the investor buys and holds it to its maturity date. II the coupon payments arrive
when yields are lower, then they can only be invested at lower rates. This is
reinvestment risk. It is the risk that proceeds available Ior reinvestment must be
reinvested at a lower interest rate than the instrument that generated the proceeds.

Three Iactors aIIect this risk:

Maturity: the yield to maturity measure Ior long-term coupon bonds tells little
about the potential yield that an investor may realize iI the bond is held to
maturity. The risk that the coupon payments will be reinvested at less than the
original yield to maturity is the reinvestment risk. The longer the maturity, the
bigger the reinvestment risk.


CFACENTER.COM 20
Coupon rate: the higher the coupon rate, the larger the size oI the cash Ilows to
be reinvested, and the bigger the reinvestment risk. ThereIore a zero-coupon bond
has zero reinvestment risk iI held to maturity, and a premium bond has bigger
reinvestment risk than a discount bond.

Call, prepayment options and amortizing securities: the reinvestment risk is
even greater Ior these kinds oI securities. A callable bond has higher reinvestment
risk than a standard bond, because it is likely that the cash Ilows oI the callable
bond may be received Iaster due to the call Ieature. In a declining interest rate
environment borrowers will accelerate their prepayments and Iorce the investor to
reinvest more proceeds at lower interest rates.

n. explain why prepayable amortizing securities expose investors to greater
reinvestment risk than nonamortizing securities.

Since a typical amortizing security holder receives interest and principal monthly, and it
permits the borrower to prepay, amortizing security pay cash Ilows Iaster. When interest
rates are declining, the borrower may accelerate the prepayments and Iorce the investor to
reinvest at lower interest rate. The Iaster the cash Ilows are received, the greater the
reinvestment risk.

In addition, amortizing securities pay cash Ilows more Irequently, as cash Ilow payments
are typically monthly, not semiannually. The more Irequently the cash Ilow are paid, the
more Irequently the reinvestments occur, and the higher the reinvestment risk is.

The eIIect, the coupon rate oI an amortizing security is virtually higher, which Iorces the
investor to reinvest more proceeds in the middle oI the original investment process. The
uncertainty oI interest-on-interest (given the same rate) increases.

o. describe the various forms of credit risk (i.e., default risk, credit spread risk,
downgrade risk).

There are three types oI credit risk.

Default risk: the risk that the issuer will deIault on its obligations (timely
payment oI interest and repayment oI the amount borrowed). The percentage oI
bonds expected to deIault in a speciIied population oI bonds is called a default

CFACENTER.COM 21
rate. II a bond deIaults, investors can still expect to recover a certain percentage
oI the bond, and that percentage is called the recovery rate.

Quality spread or credit spread: it is the risk premium which is the premium
above the yield on a deIault-Iree bond issue necessary to compensate Ior the risks
associated with the bond. It is attributable to deIault risk, and varies over business
cycles. The risk that the price oI a bond will drop due to an increasing credit
spread is called credit spread risk (investors "Ilight to quality" during economic
recessions).

Downgrade risk: it is the risk caused by unanticipated deterioration in the credit
rating oI an issue. It is closely related to credit spread risk.

Rating agencies examine the issuer's ability to service its debt obligations in a
timely manner. They assign a credit rating to each issue. In all systems the term
high grade means low credit risk. Investors can use the credit ratings to gauge the
deIault risk oI an issue. Three major rating agencies in the US are S&P, Moody's
and Fitch.

Both deIault potential and credit ratings changes drive credit spread risk.

p. explain why liquidity risk is important to investors even if they expect to hold a
security to the maturity date.

Liquidity risk is the risk that the investor will have to sell a bond below its true value
where the true value is indicated by a recent transaction. The primary measure oI
liquidity is the size oI the spread between the bid price and the ask price. The wider the
bid-ask spread, the greater the liquidity risk.

Market bid-ask spread is determined by the diIIerence between the highest bid price and
the lowest ask price Ior a bond issue across all dealers.

For investors who plan to hold a bond until maturity and need not mark a position to
market (valuing the bond at the current market price), liquidity risk is not a major
concern. However, iI an investor is periodically marked-to-market (even iI he plans to
hold an issue to maturity), he will be concerned with liquidity risk: the security is
revalued in the portIolio based on its current market price. These investors are typically
institutional investors. For example, mutual Iunds are required to mark to market at the
end oI every day the holdings in their portIolio.

Bonds are marked to market using bid prices solicited Irom dealers. The less liquid the
issue, the greater the variation oI bid prices submitted by the dealers. An issue with poor

CFACENTER.COM 22
liquidity may lack active dealer bid prices. In practice, valuation models are used to
estimate the Iair value oI such a bond. The Iair value obtained using these models is
prone to errors. ThereIore, high liquidity risk may lead to less reliable bond price to be
used in marking to market, thereby impairing the accuracy oI the current market value oI
the bond holdings.

q. explain the causes of changes in liquidity risk.

Liquidity risk changes over time.

For example, there are typically Iew dealers making a market Ior a new issue at
the beginning. II subsequently the new issue becomes popular, more dealers will
enter the market and liquidity improves. However, iI the new issue becomes
unpopular, liquidity risk will increase since some existing dealers will exit the
market and the remaining dealers will oIIer unattractive bids.

Another example is an unexpected change in interest rates, which might cause a
widening oI the bid-ask spread since investors and dealers are reluctant to take
new positions until they have had a chance to assess the new inIormation.

r. describe the exchange rate risk an investor faces when a bond makes payments in a
foreign currency.

The risk oI receiving less oI the domestic currency when investing in a bond issue that
makes payments in a currency other than the manager's domestic currency is called
exchange rate risk or currency risk. For an US investor, the dollar cash Ilows are
dependent on the exchange rate at the time the payment is received, as the investor
measures the payment Irom the bond in US dollar (domestic currency).

s. describe inflation risk and explain why it exists.

Inflation risk (also called purchasing power risk) arises because oI the variation in the
value oI cash Ilows Irom a security due to inIlation, as measured in terms oI purchasing

CFACENTER.COM 23
power. For all but inIlation protection bonds, an investor is exposed to inIlation risk
because the interest rate the issuer promises to make is Iixed Ior the liIe oI the issue.
InIlation reduces the purchasing power oI these cash Ilows. For example, iI an investor
buys a 5 treasury bond at par, but the rate oI inIlation is 4, the purchasing power oI
the investor has not increase by 5. Instead, the investor's purchasing power has
increased by 1 only.

t. explain how yield volatility affects the price of a bond with an embedded option and
how changes in volatility affect the value of a callable bond and a putable bond.

Volatility risk is the risk that the price oI a bond with an embedded option will decline
when expected yield volatility changes. A major Iactor aIIecting the value oI an option is
"expected volatility". For bonds, the expected volatility reIers to the "expected yield
volatility". The greater the expected yield volatility, the greater the value (price) oI an
option.

The changes will have opposite impact on callable and putable bonds. For example, since
the price oI a callable bond equals to the price oI a similar option-Iree bond minus the
price oI embedded call option, the price oI a callable bond will decrease iI expected yield
volatility increases (holding all other Iactors constant).

u. describe the various forms of event risk (e.g., natural catastrophe, corporate
takeover/restructuring, regulatory risk, and political risk).

Event risk is the risk that the ability oI an issuer to make interest and principal payments
changes dramatically and unexpectedly because oI certain events.

DiIIerent Iorms oI event risk:

natural catastrophe: earthquake, hurricane, or an industrial accident. It can
impair the issuer's ability to meet debt obligations, resulting in a downgrading oI
the issuer by rating agencies and is thereIore a Iorm oI downgrade risk.

corporate takeover or corporate restructurings: this can cause a substantial
increase in the issuer's debt borrowings, resulting in a downgrade oI its credit
rating.


CFACENTER.COM 24
regulatory change: this risk comes in a variety oI Iorms. Regulations oI many
Iinancial institutions is in terms oI the acceptable securities in which they may
invest and/or the treatment oI the securities or regulatory accounting purposes.
Changes in regulations may require a regulated entity to divest some types oI
securities, causing bond price to plummet due to increased supply.

political risk: it reIers to the risk that the actions by a government entity
(domestic or Ioreign) results in a deIault or increase the likelihood oI deIault.


CFACENTER.COM 25
C. Overview of Bond Sectors and Instruments

a. describe U.S. 1reasury bills, notes, bonds, and inflation protection securities.

Treasury securities are issued by the US Department oI Treasury, and are backed by the
Iull Iaith and credit oI the US government. They are considered as having no credit risk.

There are two types oI T-securities: discount and coupon securities. Treasury coupon
securities come in two Iorms: Iixed rate and variable-rate securities.

T-Bills are also called discount securities. They have the Iollowing Ieatures:
Issued at a discount to par value.
No coupon rate.
Mature within a year or less. There are three initial maturities: 91 days (3-
month), 182 days (6-month), and 364-days (1-year).
The return to the investor is the diIIerence between the maturity value (par
value) and the purchase price.

T-Notes and T-Bonds: all securities with initial maturities oI two years or more
are issued as Treasury coupon securities. They have are issued at approximately
par, have a coupon rate, and mature at par value.
T-Notes are issued with maturities oI more than one year and no more
than 10 years. There are three initial maturities: 2 year, 5 year and 10
years. T-notes are identiIied with an "n" on quote sheets.
T-Bonds are issued with maturities greater than 10 years. The initial
maturity is 30 years.
None oI the currently issued Treasury coupon securities are callable,
although there are outstanding T-bonds that are callable.

Treasury Inflation Protection Securities (TIPS) are T-notes or T-bonds that are
adjusted Ior inIlation. TIPS works as Iollows:
The coupon rate on an issue is set at a Iixed rate. The rate is called the real
rate since it is the rate that the investor ultimately earns above the
inIlation rate.
Every six months some adjustments are made.
The principal that the Treasury Department will base both the dollar
amount oI the coupon payment and the maturity value is adjusted:
adjusted principal principal beIore adjustment x ( 1 inIlation rate).
This is called inflation-adjusted principal.
The coupon payment is determined as: coupon payment inIlation-
adjusted principal x Iixed coupon rate.

Because oI the possibility oI disinflation (price declines), the inIlation-adjusted
principal at maturity may turn out to be less than the initial par value. However,
TIPS are structured to be redeemed at the greater oI the inIlation-adjusted
principal and the initial par value.

CFACENTER.COM 26
For example, an investor purchases on January 1 $100,000 oI par value oI an
TIPS issue with a coupon rate oI 3.5. For the Iirst 6 months the annual inIlation
is 3 and thus the semiannual inIlation rate is 1.5. At the end oI the Iirst six-
month period the inIlation-adjusted principal is $100,000 x ( 1 1.5)
$101,500. The coupon payment is then $101,500 x 1.75 $1,776.25. At the end
oI the second six-month period (suppose the semiannual inIlation rate has been
changed to 1), the inIlation-adjusted principal is then $101,500 x ( 1 1)
$102,515. The coupon payment is then $102,515 x 1.75 $1,794.01.

b. differentiate between on-the-run and off-the-run 1reasury securities.

Treasury bills and coupon securities are auctioned on a regular basis. They are all issued
on a competitive bid basis in a single-price auction (Dutch auction). All winning bidders
are awarded securities at the same yield (the highest yield oI accepted competitive
tenders).
On the announcement date, the Treasury announces the amount oI each issue to
be auctioned, the auction date, and the maturities to be issued.
A competitive bid speciIies both the quantity sought and the yield at which the
bidder is willing to purchase the auctioned security. A non-competitive bid is
speciIies only the quantity sought, and the non-competitive bidder will accept the
yield determined by the auction. A bidder can submit a bid oI either type.
The bids are arranged Irom the lowest yield bid to the highest yield bid
(equivalent to arranging the bids Irom the highest price to the lowest price). The
highest yield accepted by the Treasury is reIerred to as the stop yield.

Note that in all pre-2004 study guides "discuss the Treasury auction process." was
required but this los is no longer there in the 2004 study guide.

The most recently auctioned Treasury issue Ior a maturity is reIerred to as on-the-run or
current coupon issue. Issues auctioned prior to the current coupon issues typically are
reIerred to as off-the-run issues. Issues that have been replaced by several on-the-run
issues are called well-off-the-run issues. OII-the-run issues are not as liquid as on-the-
run issues Ior a given maturity.

c. describe the role of government securities dealers in the secondary market.


CFACENTER.COM 27
The 24-hour over-the-counter market Ior Treasury securities is the most liquid Iinancial
market in the world. The three primary trading locations are New York, London and
Tokyo.

Government security dealers trade with the investing public and with other dealer Iirms.
When they trade with each other, it is through intermediaries known as interdealer
brokers because oI the speed and eIIiciency with which trades can be accomplished.
Dealers provide continuous bid and ask prices on outstanding Treasury securities,
creating a highly liquid market. T-security is normally settled the next business day aIter
the transaction day (next day settlement).

The bid and ask prices oI Treasury securities are quoted as a percent oI their par value.
For example, a quote oI 98 Ior a T-note (par value: $1,000) means that the price is $980.
Quotes are typically in Iactions oI 1/32. The number aIter the hyphen represents the
number oI 32nds. II the par value oI a T-note is $1,000, then this quote reIers to a price oI
$924,37.5.

d. discuss how stripped 1reasury securities are created and distinguish between coupon
strips and principal strips.

The Treasury does not issue zero-coupon notes or bonds, but the private sector has
created such securities using coupon stripping: a process oI dealers stripping the coupon
payments and principal payment oI a Treasury coupon security. Investment dealers
purchase Treasury bonds and deposit them in a bank custody account, and then issue
receipts representing an ownership interest in each coupon payment and maturity value
on the underlying Treasury bond.

Strips created Irom the coupon payments are called coupon strips, or simply corpus
(denoted ci). Strips created Irom the principals are called principal strips (denoted np iI
principal is Irom a T-note, and bp iI principal is Irom a T-bond). The distinction is made
due to diIIerent tax treatment by non-US entities.

In the past, Treasury strips were created by private entities such as investment banks.
These treasury strips were direct obligations oI the private entities that issued these strips.
The issuers held the original Treasury securities to back their obligations. Today, these
zero-coupon instruments are issued through the Treasury's Separate Trading oI
Registered Interest and Principal Securities (STRIPS) program and become the direct
obligations oI the US government. Private entities no longer issue Treasury strips.

A disadvantage oI a taxable entity investing in Treasury strips is that accrued interest is
taxed each year even though interest is not received.


CFACENTER.COM 28
e. describe the types and characteristics of securities issued by federal agencies
(including mortgage passthroughs and collateralized mortgage obligations).

Agency securities are obligations issued by the government through various political
subdivisions. Most Iederal agency securities are not obligations oI the US Treasury.

Government sponsored enterprise (GSE) are privately owned, publicly
chartered entities.
They were created by Congress to help students, Iarmers and homeowners.
The Iive GSEs that issue debentures are the Federal Farm Credit System,
Federal Home Loan Bank System, Federal National Mortgage
Association, Federal Home Loan Bank Corporation, and Student Loan
Marketing Association.
With the exception oI the securities issued by the Federal Farm Credit
Financial Assistance Corporation, GSE securities are not backed by the
Iull Iaith and the credit oI the US government and thus investors are
exposed to (but very little) credit risk.
In addition to debentures (debt securities that are not backed by a
collateral), Fannie Mae and Freddie Max issue mortgage-backed
securities, securities backed by a pool oI residential mortgage loans.

Federal related institutions are arms oI the Iederal government.
They generally do not issue securities directly in the marketplace.
They are exempt Irom SEC regulation.
The institutions obtain Iinancing Irom the Federal Financing Bank.
The securities are Ior import-export, rural telephone, small business, etc.
Generally these securities are backed by the Iull Iaith and credit oI the US
government, and thereIore most FRI securities essentially have no credit
risk.
The major issuers have been the Tennessee Valley Authority (TVA) and
the Ginnie Mae.

Agency mortgage-backed securities are issued by Fannie Mae, Freddie Mac and Ginnie
Mae, with pools oI mortgage loans as collaterals. Each month the total oI all interest and
principal payments made by the mortgage loans in the pool, less a servicing spread, goes
to the security holders. ThereIore the cash Ilows Irom a mortgage-backed security are
determined by cash Ilows Irom the underlying mortgage loans.

Note that the cash Ilows oI a mortgage-backed security is diIIerent Irom the monthly
mortgage payments oI the underlying mortgage loans. There are two Iactors that cause
the discrepancy:

Servicing fees: these are administrative costs oI servicing (collecting monthly
payments, maintaining records, etc) the mortgage loans. II the mortgage rate is
8.125 and the service Iee is 50 basis points, then the investor receives interest oI
7.625. The interest rate that the investor receives is called net interest.

CFACENTER.COM 29

Prepayments: a payment made in excess oI the monthly mortgage payment is
called a prepayment. When a prepayment is not Ior the entire amount it is called a
curtailment. Typically there is no penalty Ior prepaying a mortgage loan.
Prepayment is caused when :
a homeowner sell his/her home.
the market rate Ialls.
a homeowner becomes deIault and the property is sold.
the property is destroyed by Iire and the insurer pays oII the mortgage.

ThereIore the monthly cash Ilows oI a mortgage-backed security have three components:
net interest, scheduled principal repayment and prepayment.

There are three types oI mortgage-backed securities:

Collateralized mortgage obligations (CMOs) are bond classes (called tranches)
created by redirecting the cash Ilows oI mortgage-related products (passthroughs
and whole loans) so as to mitigate prepayment risk. Principal component (both
scheduled principal repayments and prepayments) oI the monthly cash Ilows Irom
the underlying mortgage loans are distributed to each tranch on a prioriti:ed basis.
In another word, it can transIer (not eliminate) the various Iorms oI this risk
among diIIerent classes oI bondholders so that a CMO class has a diIIerent
coupon rate Irom that Ior the underlying collateral. Investors can select the
tranches oI a CMO based on their cash Ilow and risk-return preIerences.
However, the CMO, the passthrough securities, and the pool oI underlying
mortgage loans have the same amount oI total prepayment risk.

A mortgage passthrough security is a security created when one or more
holders oI mortgages Iorm a collection oI mortgages and sell shares or
participation certificates in the pool. The mortgage is said to be securitized iI it
is included in such a pool. Loans that meet the requirements oI Fannie Mae,
Freddie Mac and Ginnie Mae's are called conforming loans. The cash Ilow oI a
passthrough depends on the cash Ilow oI the underlying pool oI mortgages. The
monthly payments are passed through to the certiIicate holders on a pro rata
basis. An investor oI a passthrough gains the diversiIication beneIits -- the
prepayment risk now is spread over a pool oI mortgages.

Background inIormation:

A mortgage loan is secured by the collateral oI some real estate property. The interest
rate on the mortgage loan is called the mortgage rate or contract rate. II the borrower
deIaults, the lender has the right to Ioreclose on the loan and seize the property to ensure
the timely payment oI the debt. There are many types oI mortgage designs available in
the US. The most common type has the Iollowing characteristics: Iixed interest rate,
level-payment, Iully amortized (no mortgage balance outstanding at the end oI the loan
term).

CFACENTER.COM 30

The monthly payment oI a mortgage loan has two components:
Interest (1/12) x Fixed annual interest rate x outstanding mortgage balance at
the beginning oI the month.
Scheduled principal repayment (also called amortization) Fixed mortgage
payment - interest.

Early mortgage payments mostly go toward interest. As the mortgage balance is paid
down, more and more mortgage payments are used to repay principal.

f. describe a mortgage-backed security and summarize the cash flows for a mortgage-
backed security.

See los e please.

g. define prepayments, curtailments, and prepayment risk.

Please reIer to los e Ior details.

h. state the motivation for creating a collateralized mortgage obligation.

Please reIer to los e Ior details.

i. summarize the types of securities issued by municipalities.

Municipal securities (or simply munis) are debt obligations issued by state
governments, local governments and entities created by local governments.


CFACENTER.COM 31
There are both tax-exempt AND taxable municipal securities, where "tax-exempt"
means that interest on a municipal security is exempt Irom federal income taxation.
Capital gains are still subject to Iederal income taxation. Whether interest income on a
municipal security is tax-exempt at the state and local levels depends on the speciIic tax
laws in each state.

DiIIerent Irom Treasury securities, municipal securities have credit risk.

There are basically two types:

Tax-backed debt obligations are instruments issued by states, countries, special
district, cities, towns and school districts that are secured by some Iorm oI tax
revenue. There are three types oI tax-backed debt:

General Obligation Debt (GO): these securities are backed by the
issuer's unlimited taxing power, and its Iull Iaith and credit. However,
there is a statutory limit on the tax rates that the issuer can levy to repay
the debt. Certain GOs are secured not only by the issuer's general taxing
powers but also by certain identiIied Iees, grants and special charges. Such
bonds are known as double-barreled in security.

Appropriation-Backed Obligations: in addition to being backed by the
issuer's revenue, these securities are also backed by a non-binding
appropriation oI Iunds Irom the state's general tax revenue. Since the
state's pledge is not binding, these securities are also called moral
obligation bonds. The purpose is to enhance the credit worthiness oI the
issuing entity.

Debt Obligations Supported by Public Credit Enhancement
Programs: there are two common Iorms oI credit enhancements which are
legally binding: a guarantee by the state or a Iederal agency, or an
obligation oI the state to withhold and use state aid to pay the issuer's
unpaid debt.

Revenue bonds are issued Ior enterprise Iinancings that are secured by the
revenues generated by the completed projects themselves, or Ior general public-
purpose Iinancings in which the issuers pledge to the bondholders the tax and
revenue resources that were previously part oI the general Iund. They include
utility revenue bonds, transportation revenue bonds, housing revenue bonds,
higher education revenue bonds, health care revenue bonds, sports complex and
convention center revenue bonds, seaport revenue bonds and industrial revenue
bonds. DiIIerent Irom a tax-backed debt, the issuer oI a revenue bond has the
obligation to repay the debt onlv if the underlying project generates suIIicient
revenue. II not, the issuer does not have to make additional payment.


CFACENTER.COM 32
j. distinguish between tax-backed debt obligations and revenue bonds.

See los i Ior details.

k. describe insured bonds and prerefunded bonds.

Insured bonds are backed by insurance policies written by commercial insurance
companies, AND by the credit oI the issuer's revenue. Insurance companies are required
to pay any unpaid debt obligations oI the issuer. Once insured, insurance policies cannot
be canceled by insurance companies. Insurance enhances the security's credit rating and
consequently lowers its interest rate.

Prerefunded bonds (also called Refunded bonds) originally may have been issued as
general obligation or revenue bonds, but that are now secured by an "escrow Iund". This
means that a portIolio oI securities is placed in a trust. The portIolio oI securities is
assembled such that the cash Ilows Irom the securities match the obligations that the
issuer must pay. ThereIore the municipal bond is no longer backed by the issuer's tax
revenue project revenues. Instead, it's backed by cash Ilows Irom the portIolio oI
securities held in an escrow Iund. II escrowed with securities guaranteed by the US
government, reIunded bonds are the saIest municipal bonds available.

l. summarize the bankruptcy process and bondholder rights.

A bankruptcy petition can be Iiled in the court by the company itselI (voluntary
bankruptcy), or by one oI the creditors (involuntary bankruptcy). AIter the bankruptcy
Iiling, the company becomes a "debtor-in-possession", and continues its business under
the court's supervision.

The Bankruptcy ReIorm Act oI 1978 governs the bankruptcy process in the US. The
purpose oI the act is to set Iorth the rules Ior a corporation to be either liquidated or
reorganized.

The liquidation oI a corporation (Chapter 7 bankruptcy) means that the
company's business is terminated, all the assets are sold and distributed to the
holders oI claims oI the organization, and no corporate should survive.

In a reorganization, a new corporate entity will result. This is also known as
Chapter 11 bankruptcy. In this case, a plan is created to restructure a company's

CFACENTER.COM 33
business and restore its Iinancial health. Bondholders may receive cash and/or
new securities in exchange Ior their claims. The absolute priority rule (explained
below) may not hold in reorganizations.

The holder oI a corporate debt instrument has priority over the equity owners in a
bankruptcy proceeding. In theory, creditors should receive distribution based on the
absolute priority rule to the extent assets are available; this rule means that senior
creditors are paid in Iull beIore junior creditors are paid anything. Generally, the absolute
priority rule holds in the case oI liquidation and is typically violated in reorganizations.

m. list and explain the factors considered by rating agencies in assigning a credit
rating to a corporate debt instrument.

A credit analyst must consider Iour C's oI credit:

Character relates to the ethical reputation as well as the business qualiIications
and operating record oI the board oI directors, management, and executives
responsible Ior the use oI the borrowed Iunds and its repayment. It covers many
aspects such as strategic direction, Iinancial philosophy, conservatism, track
record, succession planning, control systems, etc.

Capacity deals with the ability oI an issuer to repay its obligations. It covers such
aspects as industry trends, regulatory environment, operating and competitive
position, Iinancial conditions, company structure, parent company support
agreements, and special event risk.

Collateral involves not only the traditional pledging oI assets to secure the debt,
but also the quality and value oI those un-pledged assets controlled by the issue.

Covenants deal with limitations and restrictions on the borrower's activities. They
are important because they impose restrictions on how management operates the
company and conducts its Iinancial assets. It covers both aIIirmative and negative
covenants.

It is important to understand that a credit analysis can be Ior an entire company or a
particular debt obligation oI that company.


CFACENTER.COM 34
n. describe secured debt, unsecured debt, and credit enhancements for corporate
bonds.

A corporate debt issue is said to be secured debt iI there is some Iorm oI collateral which
is pledged to ensure repayment oI the debt. The collateral can be personal property, real
property, or Iinancial assets such as stocks, bonds, etc.

Mortgage debt is debt secured by real property such as plant and equipment.
With mortgage debt the issuer has granted the bondholders a lien against the
pledged assets. A lien is a legal right to sell mortgaged property to satisIy unpaid
obligations to bondholders. Sometimes the issuer can issue an additional layer oI
mortgage debt secured by the same asset. This secondary mortgage debt is called
general and refunding mortgage bond (G&R), and is junior to the Iirst
mortgage bond.

Collateral trust debentures, bonds and notes are secured by Iinancial assets
such as cash, receivables, other notes, debentures or bonds, and not by real
property.

Unsecured debt comes in several diIIerent layers or levels oI claim against the
corporation's assets and subordination oI the debt instrument might not be apparent Irom
the issue's name. Debenture bonds are not secured by a speciIic pledge oI property, and
bondholders have the claim oI general creditors on all assets oI the issuer not pledged
speciIically to secure other debt. One oI the important protective provisions Ior unsecured
debt holders is the negative pledge clause which prohibits a company Irom creating or
assuming any lien to secure a debt issue without equally securing the subject debt issue(s)
(with certain exceptions).

Some debt issues are credit enhanced by having other companies guarantee their loans.
Small companies with low credit ratings issue commercial papers by means oI credit
support Irom a Iirm with high credit rating (credit-supported commercial paper) or by
collateralizing the issue with high quality assets (asset-backed commercial paper). They
can also take letter oI credit Irom banks or surety bond Irom insurance companies. Both
the issuer and the provider oI credit enhancements should be evaluated Ior their ability to
satisIy Iinancial obligations.

o. distinguish between a corporate bond and a medium-term note.

Medium-term notes are corporate debt obligations oIIered to investors continually over
a period oI time by an agent oI the issuer.

CFACENTER.COM 35
They are oIIered to the public under SEC Rule 415 (the self registration rule).
This rule allows issuers to sell securities on a continuous basis so that issuers have
the Ilexibility to issue securities in Iavorable market conditions.

They are priced at a spread to the Treasury yield curve at the time oI the oIIering
and typically issued at par.

The maturities vary Irom 9 months to 30 years. Note that the term "medium-term
notes" is not related to the term to maturity oI the securities.

Borrowers can issue Iixed- or Iloating-rate MTNs.

MTNs diIIer Irom bonds in the manner in which they are distributed to investors when
they are initially sold.
MTNs are registered with the SEC under shelI registration, while corporate bonds
are registered with the SEC under the regular registration requirements.

MTNs are usually distributed on a best-eIIorts basis by an agent, while corporate
bonds are typically underwritten by investment bankers. Investment bankers
purchase corporate bonds Irom the issuer, and thus guarantee the issuer's proceeds
Irom bond issuance.

When they are oIIered, MTNs are usually sold in relatively small amounts on
either a continuous or an intermittent basis, while bonds are sold in large, discrete
oIIerings. It's diIIicult Ior issuers oI corporate bonds to take advantage oI
Iavorable market conditions.

Each Iorm oI debt has advantages under particular circumstances.

p. describe commercial paper and distinguish between dealer paper and direct paper.

Commercial paper is a short-term unsecured promissory note issued in the open market
that represents the obligation oI the issuing entity. It is an alternative to bank borrowing
Ior large corporations and municipalities with strong credit ratings.
It is sold on a discount basis (zero-coupon instrument).
Its maturity is typically less than 270 days.
It is typically backed by unused bank credit lines.
It is typically held to maturity so there is no active secondary market and little
liquidity in the commercial paper market.
In general it is paid oII with Iunds obtained Irom issuing new commercial paper.
Investors Iace the roll-over risk as the issuer may not able to issue new
commercial paper at maturity.

CFACENTER.COM 36
Corporate issuers oI commercial paper include Iinancial companies and nonIinancial
companies.

It can be classiIied as either direct paper (sold by the issuing Iirm directly to investors
without the help oI an intermediary) or dealer paper (an agent sells the paper to
investors), depending on its sales channel.

q. describe an asset-backed security.

Asset-backed securities (ABS) are securities backed by a pool oI loans or receivables
(not real estate). An important Ieature oI ABS involves securitizing debt. This
substantially increases the liquidity oI these individual debt instruments. The process is:
Create a separate legal entity, known as a special purpose vehicle (SPV).
Sell certain assets (e.g. receivables) to the SPV.
The SPV issues securities backed by the underlying assets. The underlying assets
are used as collateral Ior the securities. Cash Ilows generated Irom the underlying
assets will be used to service the debt obligations on the securities.

This market is dominated by securities backed by automobile loans and credit card
receivable.

Certificates for Automobile Receivables: securities collateralized by loans made
to individuals to Iinance the purchase oI cars. They are selI-amortizing, with
monthly payments and relatively short maturities. The expected actual liIe is
typically shorter than the speciIied maturity because oI early payoIIs when cars
are sold or traded in.

Credit Card Receivables: the Iastest growing segments oI the ABS market. They
are considered revolving credit ABS, in contrast to installment contract ABS (e.g.
CARs) because oI the nature oI the loan. The principal payments are not paid to
the investors but are retained by the trustee to reinvest in additional receivables.
This allows the issuer to speciIy a maturity Ior the security that is consistent with
the needs oI the issuer and the demand oI the investors.

r. summarize the role of a special purpose vehicle in an asset-backed securities
transaction.


CFACENTER.COM 37
The motivation Ior issuers to issue an asset-backed security rather than a traditional debt
obligation is that there is the opportunity to reduce Iunding cost by separating the credit
rating oI the issuer Irom the credit quality oI the pool oI loans or receivables. This is
accomplished by means oI a special purpose vehicle or special purpose corporation.

The special purpose vehicle plays a critical role in the ability to create a security -- an
asset-backed security -- that separates the assets used as collateral Irom the corporation
that is seeking Iinancing. It makes possible that the ABS has a higher credit rating than
the parent company. With a SPV, the parent company can increase the credit quality oI
the ABS by placing the highest quality assets into the SPV and/or using credit
enhancement mechanisms. The higher credit rating oI the ABS will result in lower cost oI
Iunds.

Additionally, iI bankruptcy occurs, there is the risk that a bankruptcy judge may decide
that the assets oI the special purpose vehicle are assets that the creditors oI the
corporation seeking Iinancing may go aIter. This is the reason why special purpose
vehicles are reIerred to as "bankruptcy remote" entities. They eIIectively shield the assets
Irom the parent company's creditors.

s. state the motivation for a corporation to issue an asset-backed security.

See LOS r please.

t. describe the types of external credit enhancements for asset-backed securities.

External credit enhancements are third-party guarantees, such as:
Corporate guarantees, usually provided by the issuer oI the ABS or its parent
company.
Letters of credit, usually issued by banks.
Bond issuance (also known as insurance wraps) provided by insurance
companies.

However, the third-party guarantors have credit risk. ThereIore, the credit quality oI the
ABS is only as good as the weakest link in credit enhancement.

Internal credit enhancements are mechanisms built into the ABS. The most common
Iorms are reserve Iunds, over collateralization, and senior/subordinate structures. (they
will be discussed at level II).

CFACENTER.COM 38
u. describe the different types of international bonds (e.g., foreign bonds, Eurobonds,
global bonds, sovereign debt).

A foreign bond (called Yankee bond in the US, Samurai bond in Japan, Bulldog bond
in the UK) is a bond issued in a country's national bond market by an issuer not
domiciled in that country where those bonds are subsequently traded.
Regulatory authorities in the country where the bond is issued impose rules
governing the issuance oI Ioreign bonds.
Issuers oI Ioreign bonds include national governments and their subdivisions,
corporations, and supranationals (an entity that is Iormed by two or more central
governments through international treaties).
They can be denominated in any currency.
They can be publicly issued or privately placed.

Eurobonds have the Iollowing Ieatures:
underwritten by an international syndicate.
oIIered simultaneously to investors in a number oI countries at issuance.
issued outside the jurisdiction oI any single country. ThereIore, they are not
registered through a regulatory agency.
in practice they are typically registered on a national stock exchange. Why? Some
institutional investors are prohibited Irom purchasing securities that are not
registered on an exchange. The registration is mainly intended to overcome such
restrictions. However, most oI the Eurobond trading occurs in the over-the-
counter market.
Make coupon payments annually.

Types oI Eurobonds:
There are a large variety oI Eurobonds with diIIerent Ieatures. For example,
deIerred-coupon bonds, step-up bonds, dual currency bonds, etc.
II an Eurobond is denominated in US dollars, it is called Eurodollar bond.
Example: A US$ bond issued by Ford and sold in Japan.
"Plain vanilla", Iixed rate coupon bonds are called Euro straights, which are
unsecured bonds.

A global bond is a debt obligation that is issued and traded in both the US Yankee bond
market and the Eurobond market. Issuers oI global bonds typically have high credit
quality, and have large Iund needs on a regular basis. The Iirst global bond was issued by
the World Bank. Example: A US$ bond issued by the Canadian government, and sold in
the US and Japan.

Sovereign debt is the obligation oI a country's central government. Compared with
government debt obligations by entities in a particular country, sovereign debt oI that
country have lower credit risk and greater liquidity. Government can raise Iunds by
issuing Ioreign bonds, Eurobonds and domestic bonds, or by borrowing Irom banks
through syndicated bank loans.


CFACENTER.COM 39
Governments use the Iollowing methods to issue new debt:
Regular auction cycle/single-price method: this is the same method used by the
US Treasury.
Regular auction cycle/multiple-price method: this method is similar to the one
used by the US Treasury, except that winning bidders are awarded securities at
the yield they bid, not at the stop yield.
Ad hoc auction method: auctions are announced when market conditions are
Iavorable.
Tap method: bonds Irom a previously outstanding issue are auctioned.

CFACENTER.COM 40
D. Understanding Yield Spreads

a. identify the interest rate tools available to a central bank (such as the U.S. Federal
Reserve).

The most Irequently employed interest rate policy tools used by the Fed are:
open market operations: The Fed can buy or sell Treasury securities, thereby
changing Iunds available in the economy. For example, when Treasury securities
are purchased by the Fed, Iunds are added to the market.
changing the discount rate: The Fed can change the rate at which banks can
borrow Irom the Fed's discount window. This is also the rate at which banks
borrow Irom each other. For example, increasing the discount rate makes the cost
oI Iunds more expensive Ior banks; the cost oI Iunds is reduced when the discount
rate is lowered.

Less Irequently used tools are:
changing bank reserve requirements: By changing reserve requirements on banks,
the Fed can inIluence the Iunds available Ior lending in the banking system.
verbal persuasion: The Fed can ask banks to change their lending policies to
supply credit to businesses and consumers and consequently aIIect interest rates.

Together these tools can raise or lower the cost oI Iunds in the economy.

b. explain the different types of yield spread measures (e.g., absolute yield spread,
relative yield spread, yield ratio) and compute yield spread measures given the yields
for two securities.

It is commonplace to reIer to the additional yield over the benchmark Treasury issue oI
the same maturity as the yield spread. Since non-treasury bond sectors oIIer a yield over
the Treasury securities, they are called spread sectors. Examples include the corporate
sector, the agency sector, etc. Non-Treasury securities in a spread sector are called
spread products.

The yield spread can be computed in one oI three ways:

absolute yield spread, which is the diIIerence between the yield on two bonds or
bond sectors: yield spread yield on bond A - yield on bond B.

relative yield spread, which is the percentage oI one yield relative to another:
relative yield spread (yield on bond A - yield on bond B) / yield on bond B.


CFACENTER.COM 41
yield ratio, which is the ratio oI one yield to another yield: yield ratio yield on
bond A / yield on bond B.

Typically when the various Iorms oI yield spread are computed, bond B is the benchmark
Treasury issue.

For example, the yield on a 5-year corporate bond is 6.51, and the yield on the on-the-
run 5-year Treasury security is 5.83:
absolute yield spread 6.51 - 5.83 68 basis points.
relative yield spread (6.51 - 5.83) / 5.85 11.7.
yield ratio 6.51/5.83 1.12.

c. explain why investors may find a relative yield spread to be a better measure of yield
spread than the absolute yield spread.

Since the magnitude oI the yield spread is aIIected by the level oI interest rates, relative
yield spread is a better measure oI yield spread than the absolute yield spread.

Continue with the example in los b. II the yield on a 5-year corporate bond is 8.51, and
the yield on the on-the-run 5-year Treasury security is 7.83, the absolute yield spread is
still 68 basis points. However, the relative yield spread is now (8.51 - 7.83)/7.83
8.7, instead oI 11.7 in the previous example. The absolute yield spread Iails to reIlect
the change in the level oI interest rate. However, the relative yield spread declines,
reIlecting the increase in the level oI interest rates.

d. distinguish between an intermarket and intramarket sector spread.

The bond market in the US is classiIied into sectors based on the type oI issuer.
US government sector.
US government agency sector.
Municipal sector.
Corporate sector: the subsectors are industrial companies, utility companies,
Iinance companies, and banks.
Mortgage sector.
Asset-backed securities sector: subsectors are credit card receivables, home equity
loans, automobile loans, manuIactured housing loans, and student loans.
Foreign sector: subsectors are sovereign, supranational, and corporate.

CFACENTER.COM 42
The intermarket sector spread is the yield spread between the interest rate oIIered in
two sectors oI the bond market with the same maturity. The most common one is the
yield spread between Treasury securities and some sector oI the non-Treasury market
with the same maturity.

The intramarket sector spread is the spread between two issues within a market sector.
For example, the spread with AAA-rated corporate bonds and BBB-rated corporate bonds
is an intramarket sector spread.

The yield spread typically increases with maturity. The Iactors that aIIect the intermarket
and intramarket yield spreads in addition to maturity are:
the relative credit risk oI the two issues
the presence oI embedded options
the liquidity oI an issue
the taxability oI the interest received by investors

e. describe a credit spread and discuss the suggested relationship between credit
spreads and the economic well being of the economy.

A credit spread or quality spread is the yield spread between non-Treasury securities
and Treasury securities that are identical in all respects except Ior credit (this means
maturities are the same and that there are no embedded options). For example, iI the yield
on a 10-year corporate bond and a 10-year on-the-run Treasury security are 6.5 and 6
respectively, the credit spread is 0.5.

There is a view that credit spreads between corporate and Treasuries change
systematically because oI expected changes in economic prospects.

They become larger during economic contractions, as investors tend to sell oII
low quality corporate issues and invest the proceeds in Treasury securities. This is
known as "flight to qualitv".

They become smaller during economic expansions as improvement in revenue
and cash Ilow oI corporations will attract investors to sell Treasury securities and
buy corporate bonds.

f. identify how embedded options affect yield spreads.

CFACENTER.COM 43

Generally investors will require a larger spread to a comparable Treasury security Ior
issues with an embedded option favorable to an issuer (such as call option or prepayment
option), and a smaller spread Ior an issue with an embedded option favorable to the
investor (such as put option).
II the embedded option is extremely Iavorable to the investors, the yield on the
bond with the embedded option may be lower than that on a comparable Treasury
security.
For mortgage-backed securities, one reason Ior the yield spread relative to a
comparable Treasury security is due to the exposure to prepayment risk.

There are two measures oI yield spread Ior bonds with embedded options:

The raw yield spread oI an issue with embedded options is reIerred to as nominal
spread -- nominal in the sense that the value oI any embedded options has not
been taken into consideration in computing the yield spread. The nominal spread
provides misleading inIormation on the credit risk Ior bonds with diIIerent
embedded option Ieatures.

The yield spread that adjusts Ior embedded options is called option-adjusted
spread (OAS), which will be discussed in Level II. It seeks to measure the yield
spread aIter adjusting Ior any embedded options. The OAS can be used to
compare bonds with diIIerent embedded option Ieatures.

g. explain how the liquidity of an issue affects its yield spread relative to 1reasury
securities and relative to other issues that are comparable in all other ways except for
liquidity.

A yield spread exists due to the diIIerence in the perceived liquidity oI two issues. One
Iactor that aIIects the liquidity oI an issue (and thereIore the yield spread) is the size oI an
issue -- the larger the issue, the greater the liquidity relative to the smaller issue, and the
smaller the yield spread. Why? As liquidity increases, investors' demand Ior the bond
issue also increases, leading to a higher bond price and thus a lower yield. ThereIore,
there is an inverse relationship between liquidity and yield spread.

There is a positive relationship between the size oI an issue and its liquidity. For example,
larger issues typically have greater liquidity, which leads to lower yield spreads.


CFACENTER.COM 44
h. describe the relationship that is argued to exist among the size of an issue, liquidity,
and yield spread.

See Los g please.

i. compute the after-tax yield of a taxable security and the tax-equivalent yield of a tax-
exempt security.

In the US, the coupon income Irom qualiIied municipal securities is exempt Irom Iederal
income taxes. The coupon income Irom other Iixed-income securities, including Treasury
securities, is taxable at the Iederal level.

Because oI the tax-exempt Ieature oI municipal bonds, the yield on municipal bonds is
less than that on Treasuries with the same maturity. The diIIerence in yield between tax-
exempt securities and Treasury securities is typically measured in terms oI a yield ratio --
the percentage oI the yield on a tax-exempt security relative to a comparable Treasury
security. This yield ratio will always be less than 1.

Yield ratio yield on the tax-exempt muni/Yield on the comparable Treasury security

Higher tax rates lead to lower yield ratio. As tax rates rise, the tax-exempt Ieature oI the
munis becomes more attractive, causing bond prices to rise and yields to Iall.

The after-tax yield is computed by multiplying the pre-tax yield by one minus the
marginal tax rate:

aIter-tax yield pre-tax yield x (1 - marginal tax rate)

Alternatively, the taxable-equivalent yield (aIter-tax) is: (tax-exempt yield)/(1 -
marginal tax rate). It is the yield (pre-tax) that a taxable security must oIIer in order to
have the same aIter-tax yield as the tax-exempt issue.


CFACENTER.COM 45
E. Bond Fundamentals

a. differentiate among mortgage bonds, collateralized mortgage obligations, asset-
backed securities (e.g., CARs and credit card receivables), and international bonds.

Mortgage Bonds

The issuer oI a mortgage bond has granted to the bondholder a Iirst-mortgage lien on
some piece oI property or possibly all the Iirm's property. Such a lien provides greater
security to the bondholder and a lower interest rate Ior the issuing Iirm. Please note that
mortgage bonds diIIer Irom mortgage-backed securities (see Section C los I) in two
aspects:

Mortgage bonds are collateralized on property oI the issuer, not limited to real
estate. Mortgage-backed securities are collateralized on mortgage loans.

Mortgage bonds are serviced by cash Ilows Irom the issuer's business operations,
not cash Ilows Irom the collateral. Mortgage-backed securities are serviced by
cash Ilows Irom the underlying mortgage loans.

Collateralized Mortgage Obligations (CMOs)

The main innovation oI the CMO instrument is the segmentation oI irregular mortgage
cash Ilows to create securities that are high-quality, short-, medium- and long-term
collateralized bonds. SpeciIically, CMO investors own bonds that are collateralized by a
pool oI mortgages or by a portIolio oI mortgage-backed securities. The bonds are
serviced with the cash Ilows Irom these mortgages, but rather than the straight pass-
through arrangement, the CMO substitutes a sequential distribution process that creates a
series oI bonds with varying maturities to appeal to a wider range oI investors.

See Section C, los I Ior details.

Asset-Backed Securities (ABSs)

They involve securitizing debt.

Certificates for automobile receivables (CARs): CARs are securities
collateralized by loans made to individuals to Iinance the purchase oI cars. They
are serviced by the cash Ilows Irom the underlying pool oI automobile loans.
They typically have monthly or quarterly Iixed interest and principal payments.
The stated maturities oI CARs are typically 3 to 5 years. However, the underlying
automobile loans are oIten paid oII early when cars are sold or traded in.
ThereIore, most CARs have expected weight average lives oI 1 to 3 years. The
cash Ilows oI CARs are comparable to short-term corporate loans.


CFACENTER.COM 46
Credit card receivables: Because the nature oI the loan, credit card receivables
are considered to be a revolving credit ABS, in contrast to auto loan receivables
that are reIerred to as an installment contract ABS. The principal payments Irom
credit card receivables are not paid to the investor but are retained by the trustee
to reinvest in additional receivables. The indenture speciIies (1) the intended
maturity Ior the security; (2)the "lockout period" during which no principal will
be paid; and (3) the structure Ior repaying the principal aIter the lockout period.
The accumulated principal can be paid in a single lump sum at maturity, or
amortized monthly over a speciIied period.

See Section C Ior international bonds.

b. describe the important characteristics of the corporate bond markets in 1apan,
Cermany, the United Kingdom, and the U.S.

In the US corporate bond market:
There are Iour major segments: utilities, industrials, transportation, and Iinancial
companies.
Industrials typically have the lowest average yield, Iollowed by utilities, Iinancial
issues, and Iinally transportation issues.
Maturities oI corporate bonds range Irom 25 to 40 years. Corporate bonds with
maturities oI 5 to 7 years are typically noncallable.
Most bonds have semiannual interest payments, a single maturity date, sinking
Iunds, and 5 - 10 year deIerred calls.

The corporate bond market in 1apan is made up oI two components: (1) pure corporation
bonds, which are bonds issued by industrial Iirms or utilities and (2) bank bonds, which
are bonds issued by banks to Iinance loans to corporations. They are regulated by the
Kisaikai, a council composed oI 22 bond-related banks and seven major securities
companies. Samurai bonds are yen-denominated bonds sold by non-Japanese issuers and
mainly sold in Japan. Euroyen bonds are yen-denominated bonds sold in market outside
Japan by international syndicates.

In Germany nonbank corporate bonds are almost nonexistent. All deutschemark bonds
oI Ioreign issuers can be considered Eurobonds.

Corporate bonds in the UK are available in three Iorms: debentures, unsecured loans and
convertible bonds. They are issued through both public oIIerings and private placements.
UK Ioreign bonds, reIerred to as bulldog bonds, are sterling-denominated bonds issued
by non-English Iirms and sold in London.

Cfa L1 Session15

Uploaded by

Document Information

Original Description:

Copyright

Available Formats

Share this document

Share or Embed Document

Sharing Options

Did you find this document useful?

Is this content inappropriate?

Copyright:

Available Formats

Cfa L1 Session15

Uploaded by

Copyright:

Available Formats

Study Session 15 Debt Investments: Basic Concepts

You might also like