OVERVIEWOFBOND SECTORSAND INSTRUMENTS
SOLUTIONS
1.Noneofthestatementsiscorrectandthereforeonemustdisagreewitheachstatement forthefollowingreasons.
a.TheforeignbondmarketsectoroftheJapanesebondmarket consistsofnonJapaneseentitiesthatissuebondsinJapan.
b.AllbutU.S.governmentbondsarerated.
c.Theguaranteeofsemi-governmentbondsvariesfromcountrytocountry.Some maycarrythefullfaithandcreditofthecentralgovernment whileothersmayhave animpliedorindirectguarantee.
d.IntheUnitedStates,federallyrelatedagencysecurities(withsomeexceptions)carry thefullfaithandcreditoftheU.S.government.Government sponsoredenterprises (withsomeexceptions)haveanimpliedguarantee.
2.Thereasonforassigningtwotypesofratingsisthathistoricallythedefaultfrequency forgovernmentissuesdenominatedinaforeigncurrencyisdifferentfromthatof governmentissuesdenominatedinthelocalcurrency.
3.a.Inasingle-priceauction,allwinningbiddersareawardedsecuritiesatthehighest yieldbid.Inamultiple-priceauction,allwinningbidders areawardedsecuritiesat theyieldtheybid.
b.Inatapsystem,agovernmentissuesadditionalbondsofapreviouslyoutstanding bondissueviaanauction.
4.a.Sincetheinflationrate(asmeasuredbytheCPI-U)is3.6%,thesemiannual inflationrateforadjustingtheprincipalis1.8%.
(i)Theinflationadjustmenttotheprincipalis
$1,000,000 × 0 018% = $18,000
(ii)Theinflation-adjustedprincipalis
$1,000,000 + theinflationadjustmenttotheprincipal = $1,000,000 + $18,000 = $1,018,000
(iii)Thecouponpaymentisequalto
inflation-adjustedprincipal × (realrate/2)
= $1,018,000 × (0.032/2) = $16,288.00
b.Sincetheinflationrateis4.0%,thesemiannualinflationrateforadjustingthe principalis2.0%.
(i)Theinflationadjustmenttotheprincipalis
$1,018,000 × 0.02% = $20,360
(ii)Theinflation-adjustedprincipalis
$1,018,000 + theinflationadjustmenttotheprincipal = $1,018,000 + $20,360 = $1,038,360
(iii)Thecouponpaymentisequalto
inflation-adjustedprincipal × (realrate/2)
= $1,038,360 × (0 032/2) = $16,613 76
5.a.Theinflationrateselectedisthenon-seasonallyadjustedU.S.CityAverageAll ItemsConsumerPriceIndexforAllUrbanConsumers(denoted CPI-U).
b.TheTreasuryhasagreedthatiftheinflation-adjustedprincipalislessthanthe initialparvalue,theparvaluewillbepaidatmaturity.
c.WhenaTIPSissueispurchasedbetweencouponpayments,thepricepaidbythe buyerhastobeadjustedfortheinflationuptothesettlement date.Thatiswhythe Treasuryreportsadailyindexratioforanissue.
6.Agencydebenturesaresecuritiesissuedbygovernmentsponsoredenterprisesthatdo nothaveanyspecificcollateralsecuringthebond.Theabilitytopaybondholders dependsontheabilityoftheissuingGSEtogeneratesufficientcashflowtosatisfythe obligation.
7.a.Monthlymortgagepayment = $1,797 66 Monthlymortgagerate = 0.00583333(0.07/12)
b.Inthelastmonth(month180),afterthefinalmonthlymortgagepaymentismade, theendingmortgagebalancewillbezero.Thatis,themortgagewillbefullypaid.
c.Thecashflowisunknowneveniftheborrowerdoesnotdefault.Thisisbecause theborrowerhastherighttoprepayinwholeorinpartthemortgagebalanceat anytime.
8.a.Aprepaymentisadditionalprincipalpaidbytheborrowerinexcessofthemonthly mortgagepayment.
b.Themonthlycashflowofamortgage-backedsecurityismade upofthreeelements: (1)netinterest(i.e.,interestlessservicingandotherfees),(2)scheduledprincipal repayments(amortization),and(3)prepayments.
c.Acurtailmentisaformofprepayment.Ratherthanprepayingtheentireoutstanding mortgagebalance,acurtailmentisapayoffofonlypartoftheoutstanding balance—itshortens(or‘‘curtails’’)thelifeoftheloan.
9.Prepaymentriskistheuncertaintyregardingthereceipt ofcashflowsduetoprepayments.Becauseofprepaymentstheinvestordoesnotknowwhenprincipalpayments willbereceivedevenifborrowersdonotdefaultontheirmortgageloan.
10.a.Inamortgagepassthroughsecurity,themonthlycashflowfromtheunderlying poolofmortgagesisdistributedonaproratabasistoallthe certificateholders.In contrast,foracollateralizedmortgageobligation,there arerulesforthedistribution oftheinterest(netinterest)andtheprincipal(scheduled andprepaid)todifferent tranches.
b.Therulesforthedistributionofinterestandrulesforthedistributionofprincipal tothedifferenttranchesinaCMOstructureeffectivelyredistributesprepayment riskamongthetranches.
11.Twogovernment-sponsoredenterprisesthatissuemortgage-backedsecuritiesare FannieMaeandFreddieMac.
12.Anunlimitedtaxgeneralobligationbondisastrongerformofageneralobligation bondthanalimitedtaxgeneralobligationbond.Theformerissecuredbytheissuer’s unlimitedtaxingpower.Thelatterisalimitedtaxpledgebecauseforsuchdebtthere isastatutorylimitontaxratesthattheissuermaylevytoservicethedebt.
13.Amoralobligationbondisamunicipalbondthatinthecaseofdefaultofanissuer allowsthestatewheretheissuerislocatedtoappropriatefundsthatarescheduled tobepaidtothedefaultedissuerandusethosefundstomeetthedefaultedissuer’s obligation.Thisisanonbindingobligationthatdependson thebesteffortsofthestate toappropriatethefundstosatisfythedefaultedissuer’sobligation.
14.Aninsuredmunicipalbondisanissuethatisbackedbyaninsurancepolicywrittenby acommercialinsurancecompanysuchthattheinsureragrees topaybondholdersany principaland/orcouponinterestthatthemunicipalissuer failstopay.
15.a.Aprerefundedbondisamunicipalbondthatmayhaveoriginallybeenageneral obligationbondorarevenuebondthatiseffectivelyrefundedbycreatingaportfolio ofTreasurysecuritiesthatgeneratesacashflowequaltothe debtservicepayments ontheissue.
b.Regardlessofthecreditratingoftheissuepriortoprerefunding,afterprerefunding theissueiseffectivelycollateralizedbyaportfolioofTreasuryobligationssuchthat thecashflowoftheTreasuryportfoliomatchesthepaymentsontheissuewhen theyaredue.Hence,aprerefundedissuehasnocreditriskif properlystructured.
16.a.Inaliquidation,alltheassetsofacorporationwillbedistributedtotheholdersof claimsandnocorporateentitywillsurvive.Inareorganization,anewcorporate entitywillbecreatedandsomesecurityholderswillreceiveinexchangefortheir claimscashand/ornewsecuritiesinthenewcorporation.
b.Theabsolutepriorityprincipleisthatseniorcreditors arepaidinfullbeforejunior creditorsarepaidanything.
c.Thestatementistrueinaliquidation;however,thisisnotnecessarilythecaseina reorganization.Infact,studiessuggestthattheprincipleofabsolutepriorityisthe exceptionratherthantheruleinareorganization.
17.a.Anunsecuredbondiscalledadebenture.Subordinated debenturebondsareissues thatrankaftersecureddebt,afterdebenturebonds,andoftenaftersomegeneral creditorsintheirclaimonassetsandearnings.
b.Anegativepledgeclauseprohibitsacorporationfromcreatingorassumingany lientosecureadebtissueattheexpenseofexistingcreditors.Thisisanimportant provisionforunsecuredcreditors.
18.a.Theperformanceofcorporatebondswilldependnotonlyonthedefaultrate,but therecoveryrateaswellasthespreadoverTreasurysecurities.
b.Thereasonforthediscrepancyisthatthesestudiesaremeasuringdefaultsover differentperiods.Studiesthatfindthatone-thirddefault lookatcumulativedefault ratesoveraperiodoftime.The2.15%to2.4%figureisanannualdefaultrate.
c.Thecommentiswrongfortworeasons.First,studieshavefoundthattherecovery rateisabout38%ofthetradingpriceatthetimeofdefault.Secondstudieshave foundthatthehigherthelevelofseniority,thegreaterthe recoveryrate.
19.a.Amedium-termnoteandcorporatebonddifferastohowtheyaredistributedto investorswhentheyareinitiallysold.ForaMTN,anissuerofferssecuritiesona continuousbasisviaaninvestmentbankingfirmorabroker/dealeractingasan agentbypostingratesdailyastotherateitiswillingtopay forspecificmaturities. Incontrast,acorporatebondisissuedonadiscretebasis—itisissuedatagiven pointintimebyaninvestmentbanker.
b.Anissuercancoupleamedium-termnoteofferingwithoneormorepositionsin derivativeinstrumentstocreateaninstrumentthathasacouponratecustomized withrespecttorisk-returncharacteristicsforaninstitutionalinvestor.Suchmediumtermnotesarecalledstructurednotes.
c.Withanindexamortizingnote(IAN),thecouponrateisfixedandtheprincipal paymentsaremadepriortothestatedmaturitydatebasedontheprevailingvaluefor somereferenceinterestrate.Specifically,theprincipalpaymentsdecreasewhenthe referenceinterestrateincreases(hencethematurityincreases)andincreaseswhen thereferenceinterestratedecreases(hencethematuritydecreases).Theriskfaced bytheinvestoristhatanIANwillbeoutstandingforalonger periodwheninterest ratesrise,justwhentheinvestorwouldlikeproceedstoreinvestatahigherinterest rate;thereisreinvestmentriskwheninterestratesfallbecausemoreprincipalispaid asratesdecline,justwhentheinvestorwouldnotwanttoreceiveprincipal.
20.a.SincenegotiablecertificatesofdepositissuedbyU.S.bankstypicallyexceedthe federallyinsuredamountof$100,000,thereiscreditriskfortheamountinvested inexcessof$100,000.
b.LIBORreferstotheLondoninterbankofferedrateanditis theinterestratepaid onEurodollarcertificatesofdeposit.‘‘1-monthLIBOR’’is theinterestratethat majorinternationalbanksareofferingtopaytootheronaEurodollarCDthat maturesinonemonth.
21.Investinginbankersacceptancesexposestheinvestortotheriskthatneitherthe borrowernortheacceptingbankwillbeabletopaytheprincipaldueatthematurity date;thatis,theinvestorfacescreditrisk.Onthesurface, thereisliquidityriskbecause
therearefewdealerswhomakeamarketinbankersacceptances.However,investors typicallypurchasebankersacceptanceswiththeintentofholdingthemtomaturity. Consequently,inpractice,liquidityriskisnotaconcerntosuchinvestors.
22.Theadvantageisthatdependingonthequalityoftheconsumerloanportfolio,this BBBratedissuermaybeabletoissueanasset-backedsecuritywithahigherratingthan BBBandtherebyreduceitsborrowingcosts,netofthecostof creditenhancement.
23.Aspecialpurposevehicleallowsacorporationseekingfundstoissueasecuritybacked bycollateralsuchthatthesecuritywillberatedbasedonthecreditqualityofthe collateralratherthantheentityseekingfunds.Effectively,thespecialpurposevehicle istheownerofthecollateralsothatthecreditorsoftheentityseekingfundscannot claimthecollateralshouldtheentitydefault.
24.a.Externalcreditenhancementincludescorporateguarantees,aletterofcredit,and bondinsurance.
b.Adisadvantageofanexternalcreditenhancementisthatitexposestheasset-backed securitystructuretoacreditdowngradingshouldthethird-partyguarantorbe downgraded.
25.a.Acollateralizeddebtobligationisastructurebackedbyaportfolioofoneormore fixedincomeproducts—corporatebonds,asset-backedsecurities,mortgage-backed securities,bankloans,andotherCDOs.Fundsareraisedtopurchasetheassetsby thesaleoftheCDO.Anassetmanagermanagestheassets.
b.Thestatementisincorrect.WhenaCDOisissued,thenotes arerated.Restrictions areimposedontheassetmanagerinordertoavoidadowngradingofthetranches orthepossibilitythatthetrusteemustbeginpayingoffthe principaltothesenior tranches.
c.Thedistinctionbetweenanarbitragetransactionfromabalancesheettransaction isbasedonthemotivationofthesponsoroftheCDO.Arbitragetransactionsare motivatedbytheobjectivetocapturethespreadbetweenthe yieldofferedonthe poolofassetsunderlyingtheCDOandthecostofborrowingwhichistheyield offeredtoselltheCDO.Inbalancesheettransactions,typicallyundertakenby financialinstitutionssuchasbanksandinsurancecompanies,themotivationisto removeassetsfromthebalancesheettherebyobtainingcapitalreliefintheformof lowerrisk-basedcapitalrequirements.
26.Aboughtdealisaformofabondunderwriting.Theunderwritingfirmorgroupof underwritingfirmsoffersanissuerafirmbidtopurchaseaspecifiedamountofthe bondswithacertaincouponrateandmaturity.Theissuerisgivenashorttimeperiod toacceptorrejectthebid.Ifthebidisaccepted,theunderwritingfirmhasboughtthe deal.
27.IntheUnitedStates,SECRule144Aeliminatesthetwo-yearholdingperiodrequirementforprivatelyplacedsecuritiesbypermittinglargeinstitutionstotradesecurities acquiredinaprivateplacementamongthemselveswithouthavingtoregisterthese securitieswiththeSEC.Asaresult,privateplacementsare classifiedintwotypes.The firsttypeareRule144Aofferingswhichareunderwrittensecurities.Thesecondtype arethetraditionalprivateplacementswhicharereferredtoasnon-Rule144Aofferings.
28.Thetwomajortypesofelectronicbondtradingsystemsarethedealer-to-customer systemsandexchangesystems.Theformerarefurtherdividedintosingle-dealersystems andmultiple-dealersystems.Single-dealersystemsarebasedonacustomerdealing withasingle,identifieddealeroverthecomputer.Inmulti-dealersystemsacustomer
canselectfromanyofseveralidentifieddealerswhosebidsandoffersareprovidedon acomputerscreen.
Thesecondtypeofelectronicsystemforbondsistheexchangesystem.Inthis system,dealerandcustomerbidsandoffersareenteredinto thesystemonan anonymousbasis,andtheclearingoftheexecutedtradesisdonethroughacommon process.Exchangesystemscanbefurtherdividedintocontinuoustradingandcall auctionsystems.Continuoustradingpermitstradingatcontinuouslychangingmarket determinedpricesthroughouttheday.Callauctionsprovideforfixedpriceauctions atspecifictimesduringtheday.