cff cfa l2 ss 14 Fixed Income
Fixed Income Part 1
Terms in this set (29)
Downgrade watch - down 2 levels
Upgrade watch - up 2 levels
Negative outlook - down 1 level
Stable outlook - keep current
Positive outlook - up 1 level
Using a pool of loans or receivables as collateral for a security; can be used as funding source for generating liquidity
Help companies pay for debt; strongest forms are contractually binding and do not include a provision for that permits the lender to refuse to provide funds.
Profitability Ratios to know
Return on Stockholder's Equity
Return on Total Assets
Affirmiative or postivive covenants call upon the debtor to make promises to do certain things.
Negative covenents are those which require the borrower not to take certain actions.
Convenent which requires ratio of earnings available for interest or fixed charges to be a certain minimum on each reporting date.
Debt Incurrence Test
Covenent that places restrictions on debt ratios which limits companies from taking on additional debt.
Date at which debt was issued
Factors affecting Character of company
Strategic direction, financial philosophy, conservatism, track record, succession planning, and control systems
Managers (agents) represent owners (principals). Agent should act in best interest of the principal, but sometimes act their own self interest.
1. Monitoring costs - costs incurred to monitor or restrict actions of actions.
2. Bonding costs - costs incurred by agents to assure prinicipal they are acting in their best interest.
3. Residual loss - costs incurred even after monitoring and bonding costs are implemented.
Reducing Agency problems
1. Compensation tied to performance
2. Granting significant equity interest in company
3. Internal corporate control systems that help make timely decisions (ex. timely removal of CEO)
Bank debt characteristics in analyzing credit-worthiness of high-yield issuers
1. costs are influenced by changes in interest rates
2. Bank debt is short term, and must be repaid quickly so where does money come from? operating CF, refinancing, or sale of assets.
3. Bank debt holders have priority over other debt holders
Asset backed securities
Pool of loans can reduce credit risk via diversification; if loans are concentrated, default risk is higher.
Assets (loans or receivables) are to collected and distributed to bondholders; no operating or business risks to cash flow; most important thing is quality of collateral (ex. housing bust)
"True" securitization transaction
Servicer is just there to collect cash flows; no need to actively manage the collateral to get cash flow.
S&P emphasis on domestic gov't policies for timely debt service
Stability of political institutions, income and economic structure, fiscal policy and budgetary flexibility, monetary policy and inflation pressure, public debt burden, and debt service track record.
score used to predict a corporate bankruptcy; less than 1.81 indicate serious credit problems while excess of 3.0 indicate a healthy firm.
Credit risk models - Structural models aka "firm value" models
Basically, a company defaults on its debt if the value of the assets of the company falls below a certain default point.
Credit risk models - Reduced form models
Directly models the probability of default or downgrade. Default and recovery process are modeled independently and are independent of each other.
Convention in swap market is to quote the swap spread over a benchmark rather than a certain rate at a certain maturity.
Market Segmentation Theory
Like the Preferred Habit theory except that market participants will not move between their segments
Local Expectations Form of Pure Expectations theory
Suggestion is that return will be the same over a short-term investment horizon starting today.
Elements of a Bond Valuation Model
No matter how complex model, when each on-the-run issue for a benchmark security is valued using the model, the value produced should be equal to the on-the-run market price.
Valuation Trees are Different
The prices vary because different assumptions are used for volatility, call rules may differ, or different benchmark interest rates.
Spread Measures reflect compensation for...
Nominal and Zero-Volatility (Z spread) reflect compensation for credit risk, liquidity risk, and option risk. OAS only credit and liquidity for both Treasure and Sector benchmarks. Take off credit risk on all for Issuer bench.
Valuing a Step-Up Callable Note
Note where coupon changes over the life of the bond. To value, just adjust the cash flow according to the step-up coupon rate.
Valuing a Capped Floater
The coupon rate for floaters is set at the beginning of the period but paid at the end, so the coupon interest is paid in arrears. You would have to adjust binomial model for it. Also, have to note the "cap" on interest rate and use it.
"Modified" vs. "Effective" duration and convexity
Modified assumes that when interest rates change, the cash flows do not change. For "effective", cash flows could change. Note formulas are the same.
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