Fixed Income Analysis Workbook. Barbara S. Petitt

reduces the bond's outstanding principal amount to zero by the maturity date is best described as a:

      A. bullet bond.

      B. plain vanilla bond.

      C. fully amortized bond.

      12. If interest rates are expected to increase, the coupon payment structure most likely to benefit the issuer is a:

      A. step-up coupon.

      B. inflation-linked coupon.

      C. cap in a floating-rate note.

      13. Investors who believe that interest rates will rise most likely prefer to invest in:

      A. inverse floaters.

      B. fixed-rate bonds.

      C. floating-rate notes.

      14. A 10-year, capital-indexed bond linked to the Consumer Price Index (CPI) is issued with a coupon rate of 6 % and a par value of 1,000. The bond pays interest semi-annually. During the first six months after the bond's issuance, the CPI increases by 2 %. On the first coupon payment date, the bond's:

      A. coupon rate increases to 8 %.

      B. coupon payment is equal to 40.

      C. principal amount increases to 1,020.

      15. The provision that provides bondholders the right to sell the bond back to the issuer at a predetermined price prior to the bond's maturity date is referred to as:

      A. a put provision.

      B. a make-whole call provision.

      C. an original issue discount provision.

      16. Which of the following provisions is a benefit to the issuer?

      A. Put provision

      B. Call provision

      C. Conversion provision

      17. Relative to an otherwise similar option-free bond, a:

      A. putable bond will trade at a higher price.

      B. callable bond will trade at a higher price.

      C. convertible bond will trade at a lower price.

      CHAPTER 2

      FIXED-INCOME MARKETS: ISSUANCE, TRADING, AND FUNDING

      LEARNING OUTCOMES

      After completing this chapter, you will be able to do the following:

      ● describe classifications of global fixed-income markets;

      ● describe the use of interbank offered rates as reference rates in floating-rate debt;

      ● describe mechanisms available for issuing bonds in primary markets;

      ● describe secondary markets for bonds;

      ● describe securities issued by sovereign governments, non-sovereign governments, government agencies, and supranational entities;

      ● describe types of debt issued by corporations;

      ● describe short-term funding alternatives available to banks;

      ● describe repurchase agreements (repos) and their importance to investors who borrow short term.

      SUMMARY OVERVIEW

      Debt financing is an important source of funds for governments, government-related entities, financial institutions, and non-financial companies. Well-functioning fixed-income markets help ensure that capital is allocated efficiently to its highest and best use globally. Important points include the following:

      ● The most widely used ways of classifying fixed-income markets include the type of issuer; the bonds' credit quality, maturity, currency denomination, and type of coupon; and where the bonds are issued and traded.

      ● Based on the type of issuer, the three major bond market sectors are the government and government-related sector, the corporate sector, and the structured finance sector. The major issuers of bonds globally are governments and financial institutions.

      ● Investors make a distinction between investment-grade and high-yield bond markets based on the issuer's credit quality.

      ● Money markets are where securities with original maturities ranging from overnight to one year are issued and traded, whereas capital markets are where securities with original maturities longer than one year are issued and traded.

      ● The majority of bonds are denominated in either euros or US dollars.

      ● Investors make a distinction between bonds that pay a fixed rate versus a floating rate of interest. The coupon rate of floating-rate bonds is expressed as a reference rate plus a spread. Interbank offered rates, such as Libor, are the most commonly used reference rates for floating-rate debt and other financial instruments.

      ● Interbank offered rates are sets of rates that reflect the rates at which banks believe they could borrow unsecured funds from other banks in the interbank market for different currencies and different maturities.

      ● Based on where the bonds are issued and traded, a distinction is made between domestic and international bond markets. The latter includes the Eurobond market, which falls outside the jurisdiction of any single country and is characterized by less reporting, regulatory, and tax constraints. Investors also make a distinction between developed and emerging bond markets.

      ● Fixed-income indices are used by investors and investment managers to describe bond markets or sectors and to evaluate performance of investments and investment managers.

      ● The largest investors in bonds include central banks; institutional investors, such as pension funds, some hedge funds, charitable foundations and endowments, insurance companies, and banks; and retail investors.

      ● Primary markets are markets in which issuers first sell bonds to investors to raise capital. Secondary markets are markets in which existing bonds are subsequently traded among investors.

      ● There are two mechanisms for issuing a bond in primary markets: a public offering, in which any member of the public may buy the bonds, or a private placement, in which only an investor or small group of investors may buy the bonds either directly from the issuer or through an investment bank.

      ● Public bond issuing mechanisms include underwritten offerings, best effort offerings, shelf registrations, and auctions.

      ● When an investment bank underwrites a bond issue, it buys the entire issue and takes the risk of reselling it to investors or dealers. In contrast, in a best efforts offering, the investment bank serves only as a broker and sells the bond issue only if it is able to do so. Underwritten and best effort offerings are frequently used in the issuance of corporate bonds.

      ● The underwriting process typically includes six phases: the determination of the funding needs, the selection of the underwriter, the structuring and announcement of the bond offering, pricing, issuance, and closing.

      ● A shelf registration is a method for issuing securities in which the issuer files a single document with regulators that describes a range of future issuances.

      ● An auction is a public offering method that involves bidding, and that is helpful in providing price discovery and in allocating securities. It is frequently used in the issuance of sovereign bonds.

      ● Most bonds are traded in over-the-counter (OTC) markets, and institutional investors are the major buyers and sellers of bonds in secondary markets.

      ● Sovereign bonds are issued by national governments primarily for fiscal reasons. They take different names and forms depending on where they are issued, their maturities, and their coupon types. Most sovereign bonds are fixed-rate bonds, although some national governments also issue floating-rate bonds and inflation-linked bonds.

      ● Local governments, quasi-government entities, and supranational agencies issue bonds, which are named non-sovereign, quasi-government, and supranational bonds, respectively.

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