Reading 63: Overview of Bond Sectors and Instruments-LOS b 习 2011, protection, between, center, style

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Session 15: Fixed Income: Basic Concepts
Reading 63: Overview of Bond Sectors and Instruments

LOS b: Describe the types of securities issued by the U.S. Department of the Treasury (e.g. bills, notes, bonds, and inflation protection securities), and differentiate between on-the-run and off-the-run Treasury securities.

 

 

U.S. Treasury Inflation Protection Securities (TIPS):

A) make annual inflation adjustments.

B) have coupon rates that are fixed for the life of the issue.

C) will be repaid at maturity for less than their initial face value if deflation has occurred.

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The coupon rate is fixed for a TIPS. The principal adjusts semi-annually and then the fixed coupon is multiplied by the new principal value to get the inflation adjusted interest payment. If deflation occurs over the life of a TIPS, the Treasury will redeem the security for its initial face value of $1,000 at maturity.

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If an investor purchases a 9 ?s 2001 Feb. $10,000 par Treasury Note at 101:11 and holds it for exactly one year, what is the rate of return if the selling price is 101:17?

A) 9.75%.

B) 8.75%.

C) 9.81%.

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Purchase price = [(101 + 11 / 32) / 100] × 10,000 = $10,134.375

Selling price = [(101 + 17 / 32) / 100] × 10,000 = $10,153.125

Interest = 9?% of 10,000 = $975.00

Return = (P_end ? P_beg + Interest) / P_beg = (10,153.125 ? 10,134.375 + 975.00) / 10134.375 = 9.81%

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Given that a Treasury bond has a par value of $50,000 and is currently offered at a quoted price of 98:5, what is the dollar amount that an investor must pay in order to purchase the bond?

A) $98.16.

B) $49,078.13.

C) $4,907,812.50.

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If the quoted price is 98:5 this equals 98 5/32 which equals 98.15625% and means that the dollar amount is:

0.9815625 × $50,000 = $49,078.13

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Which of the following is a difference between an on-the-run and an off-the-run issue? An on-the-run issue:

A) is publicly traded whereas an off-the-run issue is not.

B) is the most recently issued security of that type.

C) tends to sell at a lower price.

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An on-the-run issue is the most recently auctioned Treasury issue. An off-the-run issue older issues, when more current issues are brought to market.

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Which of the following statements concerning U.S. Treasury securities is least accurate?

A) Treasury bonds have original maturities of 20 to 30 years.

B) Treasury Inflation Protected Securities pay a fixed coupon rate.

C) Treasury notes carry no coupon.

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T-notes are coupon-bearing instruments. TIPS pay a fixed coupon rate on a par value that is adjusted for inflation.

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U.S. Treasury bonds that provide some protection from inflation by periodic adjustments of the principal value are called:

A) CPI Adjustable Bonds.

B) Inflation Linked Treasury Securities.

C) Treasury Inflation Protected Securities.

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Beginning in 1997, the U.S. Treasury began to offer Treasury Inflation Protected Securities, which are commonly known as TIPS. The principal value is periodically adjusted for changes in CPI. The periodic coupon payment, based upon the adjusted principal amount, reflects any changes in inflation.

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The annual payment of a 20-year, semi-annual pay bond with a $5,000 par value and a 6.875% coupon rate currently trading at 89.28 is closest to:

A) $171.88.

B) $153.45.

C) $343.75.

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$5,000 × 0.06875 = $343.75.

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Which of the following statements about U.S. Treasury Inflation Protection Securities (TIPS) is most accurate?

A) Adjustments to principal values are made annually.

B) The inflation-adjusted principal value cannot be less than par.

C) The coupon rate is fixed for the life of the issue.

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The coupon rate is set at a fixed rate determined via auction. This is called the real rate. The principal that serves as the basis of the coupon payment and the maturity value is adjusted semiannually. Because of the possibility of deflation, the adjusted principal value may be less than par (however, at maturity the Treasury redeems the bonds at the greater of the inflation-adjusted principal and the initial par value).

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If a U.S. Treasury bond is quoted at 92-16, the price of the bond is:

A) $925.00.

B) $92.50.

C) $92.16.

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92 ? 16 = 92 16/32 = 92.5% of par value

0.925 × $1,000 = $925

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U.S. Treasury securities face several risks to varying degrees. Generally speaking, rank the following risks that an investor in a 5% coupon, 25-year, off-the-run U.S. Treasury bond, issued after 1984, would face. Order them from left to right with the least likely risk first through the most likely risk faced by the investor last.

• 1 = liquidity risk.
• 2 = prepayment risk.
• 3 = default risk.
• 4 = interest rate risk.

A) 1, 2, 3, 4.

B) 3, 4, 2, 1.

C) 2, 3, 1, 4.

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All U.S. Treasuries issued after 1984 are non-callable, so there is no prepayment risk. Treasuries are default risk free although one might argue that a long-term Treasury might have a minute level of default risk. Off-the-run Treasuries face more liquidity risk than on-the-run issues. Finally, given the long-term nature of the bond, the investor is definitely exposed to interest rate risk. Given the available alternatives, we conclude that the answer is prepayment risk, default risk, liquidity risk, and interest rate risk.