exam 2 fixed income

expected loss

Which of the following is the best measure of credit risk?

A) the severity of loss

B) the probability of default

C) expected loss

D) pari passu principal

interest rate risk

Which of the following is not credit or credit related risk?

A) interest rate risk

B) default risk

C) downgrade or credit migration risk

D) severity of loss

issuer credit rating and an issue credit rating

“Notching” is best described as a difference between:

A) company credit rating and an industry average credit rating

B) issuer credit rating and an issue credit rating

C) investment grade credit rating and a non-investment grade credit rating

economy improves

Credit spreads tend to narrow when:
A) economy improves

B) the credit cycle worsens

C) broker-dealers become less willing to provide less capital

the various classes of claimants agree to it

Under which circumstance is a subordinated bondholder most likely to recover some value in a bankruptcy without a senior creditor getting paid in full:

A) the various classes of claimants agree to it

B) the company is liquidated rather than reorganized

C) absolute priority rules are enforced

credit ratings adjust quickly to changes in bond prices

Which of the following statements is least likely a limitation of relying on credit ratings?

A) credit ratings are dynamic

B) credit ratings adjust quickly to changes in bond prices

C) firm-specific risks are difficult to rate

recovery rate

Expected loss can decrease with an increase in a bond’s:

A) default risk

B) loss severity

C) recovery rate

creditors negotiate a different outcome

Absolute priority of claims in a bankruptcy might be violated because:
A) of the pari passu principal

B) creditors negotiate a different outcome

C) available funds must be distributed equally among creditors

can print money

One key difference between sovereign bonds and municipal bonds is that:

A) have government taxing powers

B) are affected by economic conditions

C) can print money

interest rates would go down and bond prices would go up

If GDP comes out and it is a lot worse than expected, what will happen to the bond market?

Since the increase in productivity is deflationary, bond prices would go up once the information is released.

Ceteris paribus, if productivity numbers come out better than expected, what will happen to bonds?

This would spark inflation fears, causing interest rates to go up and bond prices to go down.

If the unemployment numbers come out and they are a lot better (less people unemployed) than expected, what will happen to the bond market, ceteris paribus?

credit risk

the risk that the borrower will fail to make principal and or interest payments on time

default risk and loss severity given default. Expected Loss

What are the 2 components of credit risk? What do these 2 components combine into?

default probability multiplied by loss severity given default

How do you calculate expected loss?

downgrade risk

the risk of decline in an issuer’s creditworthiness which results in a widening of the spread.

market liquidity risk

the risk that the price that investors can buy or sell at may differ from the market price

Size of the issuer and credit quality of the issuer

What 2 factors affect market liquidity risk?

capital structure

the way a firm finances its assets across operating units

seniority ranking

What determines who gets paid first?

debentures

What’s another name for unsecured bonds?

secured bondholders

Who has the first claim on cash flows in the event of a default?

“on equal footing” All creditors at the same level of capital structure fall under the same class and they will have the same recovery rates

What does pari passu mean? (literally and the definition)

low

If an industry is on the decline, the recovery rates will be ——

No

Is the priority of claims always absolute?

Moody’s, S&P, and Fitch

What are the 3 main rating agencies?

issuer rating

rating based on the credit worthiness of the issuer

issue rating

the rating assigned to a specific debt/financial obligation

cross-default provision

the probability of default on one issue is linked to other issues of the same issuer

• credit ratings can be very dynamic

• rating agencies aren’t infallible

• events risks are difficult to capture in ratings

• ratings tend to lag market pricing of credit

What are some risks in relying on agency ratings?

credit analysis

What kind of analysis focuses on downside risk?

equity analysis

What kind of analysis focuses on the growth potential of a company?

Capacity, collateral, covenants, and character

What are the Four C’s of Credit Analysis?

credit cycle, broader economic conditions, funding availability in the financial sector, general market supply and demand, and financial performance of the issuer

What factors affect the spread on corporate bonds?

modified duration and magnitude of the spread change

What 2 factors affect the price and return on a bond?

positive (higher)

A narrower spread change causes what kind of bond return/price?

non-investment grade, junk bonds

What are other names for high-yield corporate bonds?

to finance public projects

What do governments issue sovereign debt for?

general obligation bonds

bonds that are unsecured and issued with the full faith and credit of the issuing government

revenue bonds

bonds that are issued for specific project but higher risk than GO bonds

First Bank of the United States

What was the first federally chartered bank in the United States?

backed up by gold and silver

What is the bimetallic dollar standard?

if state banks are having trouble with bank runs, can come to the central bank for a loan.

What does Lender of Last Resort mean?

1837-1859

When was the Free Banking System used?

1861-1872

When was the first income tax introduced in the US?

1863-1913

When was the National Banking System used?

Gold Standard Act of 1900

Who won the battle between gold and silver and what act implemented this?

Jekyll Island in 1910. Federal Reserve Act of 1913

Where and when was the Federal Reserve planned? What Act started it?

1913

In what year was the income tax reintroduced?

1923

What year did open market operations begin?

-separated investment banking from commercial banking

-created the FDIC (every deposit you have is insured)

-created the FOMC (all the power is now in D.C.)

What did the Banking Act of 1933 (Glass-Steagal) do?

1971

When did we get off the gold standard?

CPI, core CPI, PCE, core PCE. Fed prefers PCE

What are the different measurements for inflation? What does the Fed prefer?

personal consumption expenditure index

What does PCE stand for?

-they are 1 year or less in maturity

-also called money market instruments

-new issuances come in 1,2,3,4,6, or 12 months

-T-bills are OID (original issue discount)

Name 4 facts about T-bills.

buying T-bills at less than par and when it matures it’s par

What does original issue discount mean?

plain vanilla bonds; they are a classic bond with a fixed coupon at fixed intervals and it’s at par value

What kind of bonds are T-notes and T-bonds?

10 year T-note

What specific financial instrument is considered The Bond Market?

-2 year maturities, newest of all US treasuries

-not plain vanilla; they pay coupon interest quarterly so 8 total coupon payments plus the $1000 par value

-coupon rate you get is adjusted weekly and is based on the index rate plus a spread.

once the bond is issued the spread doesn’t change

the index rate is based on the 3 year T-bill rate

Give 5 facts about Floating Rate Notes (FRNs)

Treasury Inflation Protection Securities

What does TIPS stand for?

r = r* + IP +MRP

What is the Treasury yield equation?

the expected inflation over the life of the bond. Based on CPI

What is the inflation premium and what is it based on?

increase in purchasing power OR your reward for delaying consumption

What is the real rate of return?

More

Do long term bonds have more or less interest rate risk than short term bonds?

nominal interest rate minus real interest rate

How doo you calculate IP?

clean price + accrued interest

How to calculate dirty price?

everything from BBB- and above

What bond ratings are considered investment grade bonds?

everything from BB+ and below

What bond ratings are considered non-investment grade?

fallen angel

going from investment grade to junk bond

needing 2/3 of Moody’s, S&P, Fitch downgrading you to actually downgrade you

What is the two agency rule?

rising star

going from junk bond to investment grade

1.5%

What is the historical average return for investment grade bonds?

5.5%

What is the historical average return for junk bonds?

-inflationary measures coming out higher than expected

-unemployment numbers coming out better than expected (good news but inflationary)

-GDP comes out greater than expected (good news but inflationary)W

-productivity numbers worse than expected

-when oil goes up → inflationary

What makes IP go up? (potential inflationary news)

-CPI or PCE or any inflationary measure is less than expected

-unemployment numbers worse than expected (bad news but deflationary)

-GDP less than expected (bad news but deflationary)

-productivity better than expected

-oil prices go down

What makes IP go down? (potential deflationary news)

inverse relationship

What is the relationship between bond prices and interest rates?

“pull to par”

if a yield stays constant, bond prices change and come closer to par as time passes and as they near maturity date. What is this called?