1.2 Fixed Income - Debt Securities
Which of the following is NOT a risk to a U.S. resident owning a eurodollar bond? A) Currency risk. B) Interest rate risk. C) Inflation risk. D) Default risk.
Answer: A Eurodollar bonds are denominated in dollars; therefore, no currency risk exists for a U.S. resident.
Mr. Beale buys 10M RAN 6.6s of 32 at 67. What is his total purchase price? A) $6,700 B) $6,600 C) $10,000 D) $10,200
Answer: A For those of you not familiar with bond listings, this means that Mr. Beale bought $10,000 (10M) of the RAN Corporation bonds with a 6.6% coupon (interest rate stated on the face of the bond) that mature in 2032 (32). The price is 67, which represents 67% of $10,000, or $6,700. Reference: 1.2.7 in the License Exam Manual.
GNMA mortgage-backed securities are: A) a direct obligation of the US government. B) backed exclusively by a pool of mortgages. C) exempt from federal income tax for the interest payments received by the bondholders. D) available to investors through a minimum purchase of $5,000.
Answer: A GNMA securities are a direct obligation of the U.S. government and are backed by a pool of mortgages. The monthly payments are partially a return of principal and partially taxable interest, which is subject to state and federal income tax. GNMA pass-through securities are available to investors with a minimum issue price of $25,000.
Mr. Beale buys 10M 6.6s of 10 at 67. What will his annual interest be? A) $660.00 B) $670.00 C) $820.00 D) $1,000.00
Answer: A Interpret "10M" as "$10,000 worth of." Mr. Beale receives the nominal yield of the bonds, which is 6.6% of $10,000. Reference: 1.2.6 in the License Exam Manual.
All of the following statements regarding government and agency securities are true EXCEPT: A) they are always directly backed by the federal government. B) they are considered safer than corporate debt securities. C) interest paid is always subject to federal income tax. D) they are authorized by Congress.
Answer: A Only GNMAs are directly backed by the federal government. FNMAs and FHLMCs are only indirectly backed but are still considered less risky than corporate debt. All are subject to federal taxation, and all were authorized by Congress. Reference: 1.2.4.5 in the License Exam Manual.
The best time for an investor seeking returns to purchase long-term, fixed-interest-rate bonds is when: A) long-term interest rates are high and beginning to decline. B) short-term interest rates are high and beginning to decline. C) short-term interest rates are low and beginning to rise. D) long-term interest rates are low and beginning to rise.
Answer: A The best time to buy long-term bonds is when interest rates have peaked. In addition to providing a high initial return, as interest rates fall, the bonds will rise in value. Reference: 1.2.7.3 in the License Exam Manual.
A client in the 28% marginal federal income tax bracket invests in a corporate bond with an 8% coupon. To calculate the client's after-tax rate of return: A) multiply .08 by .72. B) divide .08 by .28. C) divide .08 by .72. D) multiply .08 by .28.
Answer: A To determine a taxable bond's after-tax rate of return, multiply the coupon rate by the compliment of the client's marginal federal income tax bracket. The client's tax bracket is .28, so the compliment is 100 − .28 = .72. Reference: 1.2.6.4 in the License Exam Manual.
One would look at the average maturities when doing a cash flow analysis for A) revenue bonds B) mortgage-backed pass-through securities C) Brady bonds D) subordinated debentures
Answer: B Mortgage-backed pass-through securities pass through interest and principal payments to their investors. The rate at which the cash flows are generated depends, among other things, on the rate at which the mortgages mature. Reference: 1.2.10.5 in the License Exam Manual.
One of your clients approaches you looking for an investment that will provide ready marketability and income. Which of the following would be the most appropriate recommendation? A) limited partnership in rental real estate. B) U.S. treasury notes. C) bank insured CDs. D) NYSE listed common stock.
Answer: B The key is meeting both needs - marketability and income and only the treasury notes supply both. A CD will provide income, but they are non-marketable - they can only be redeemed at the bank and, if done prior to maturity, will invariably suffer a penalty to interest, principal, or both. NYSE common stock will be marketable, but there are no guarantees as to the income and the limited partnership will almost always have limited to no marketability. Reference: 1.2.4.2 in the License Exam Manual.
To secure the debt that a subsidiary is offering, a railroad holding company transfers to a trustee the common stock of another subsidiary. The offering is one of: A) secured income notes. B) collateral trust certificates. C) guarantee trust bonds. D) equipment trust certificates.
Answer: B When a company uses the securities of one subsidiary to collateralize a bond issue of another subsidiary, the bonds are known as collateral trust certificates.
The term" eurodollars "refers to: A) a worldwide currency system that is expected to someday replace existing currency systems. B) European currency held in U.S. banks. C) American dollars held by banks in other countries, especially in Europe. D) obsolete currency that was formerly backed by the gold standard.
Answer: C American dollars held in international banks, especially, but not exclusively, in Europe, are known as eurodollars.
An investor purchased $10,000 of a 15 year AA rated corporate bond with a 6% coupon in the secondary market 3 years ago at par. The bond matured last week and the investor has just received a check for $10,300. Which of the following is a true statement? A) The investors cost basis has been reduced to $9,700. B) $300 is considered a return of principal. C) $300 is taxed as ordinary income. D) $300 is taxed as long-term capital gain.
Answer: C At maturity, the bondholder receives both the principal ($10,000) and the final interest check (6% of $10,000 = $600 per year/paid semi-annually) of $300. This interest, like all corporate bond interest, is ordinary income. Reference: 1.2 in the License Exam Manual.
A new convertible bond has a provision that it cannot be called for five years after the issue date. This call protection is most valuable to a recent purchaser of the bond if: A) interest rates are rising. B) interest rates are stable. C) the market price of the underlying common stock is increasing. D) interest rates are falling.
Answer: C Convertible bonds are more sensitive to the price of the underlying common stock than they are to interest rates. Call protection would enable this investor to hold onto the bond while the stock rises in value rather than having the bond called away. Reference: 1.2.8.1.3 in the License Exam Manual.
An investor interested in monthly interest income should invest in: A) utility company stock. B) corporate bonds. C) GNMAs. D) Treasury bonds.
Answer: C GNMAs pay monthly interest and principal, treasury bonds pay semiannual interest, utility stocks pay quarterly dividends, and corporate bonds pay semiannual interest. Reference: 1.2.4.5.6 in the License Exam Manual.
The price of which of the following will fluctuate most with a change in interest rates? A) Money-market instruments. B) Short-term bonds. C) Long-term bonds. D) Common stock.
Answer: C Long-term debt prices fluctuate more than short-term debt prices as interest rates rise and fall. Reference: 1.2.7.3 in the License Exam Manual.
he interest from which of the following bonds is exempt from federal income tax? State of California bonds. City of Anchorage bonds. Treasury bonds. GNMA bonds. A) II and IV. B) III and IV. C) I and II. D) I and III.
Answer: C Municipal bonds are exempt from federal income tax. Treasury bonds are exempt from state tax but not federal tax. GNMAs are subject to federal, state, and local income tax. Reference: 1.2.6.4 in the License Exam Manual.
Which of the following would you NOT expect to see issued at a discount? A) Treasury Bill B) Zero-coupon bond C) Bank jumbo CD D) Commercial paper
Answer: C Of these securities, only the bank jumbo (negotiable) CDs are always interest bearing and issued at par or face value. Reference: 1.2.9.3 in the License Exam Manual.
U.S. Treasury bills are issued for all of the following maturities EXCEPT: A) 13 weeks. B) 26 weeks. C) 8 weeks. D) 4 weeks.
Answer: C U.S. Treasury bills are issued with 4-, 13-, 26-week, and 52-week maturities. There are no 8-week T-bills. Reference: 1.2.4.1 in the License Exam Manual.
An 8% corporate bond is offered on a 8.25 basis. Which of the following statements are TRUE? Nominal yield is higher than YTM. Current yield is higher than nominal yield. Nominal yield is lower than YTM. Current yield is lower than nominal yield. A) I and III. B) I and IV. C) II and IV. D) II and III.
Answer: D A bond offered on an 8.25 basis is the same as at a YTM of 8.25%. Because the yield quoted is higher than the 8% coupon, the bond is trading at discount to par. For discount bonds, the nominal yield is lower than both the current yield and the yield to maturity. Reference: 1.2.6.3 in the License Exam Manual.
A bond issued by the GEMCO Corporation has been rated BBB by a major bond rating organization. This bond would be considered: A) a high-yield corporate bond. B) secured. C) callable. D) an investment grade corporate bond.
Answer: D An investment-grade bond has a bond rating between AAA and BBB. Lower-rated bonds are considered high-yield bonds and are often referred to as junk bonds The bond may or may not be secured: the rating does not indicate that fact. Reference: 1.2.5.1 in the License Exam Manual.
Which of the following are characteristics of commercial paper? It represents a loan by the holder to the issuer. It is a certificate of ownership in the corporation. It is commonly issued to raise working capital for a corporation. It is junior in preference to convertible preferred stock. A) I and IV. B) II and III. C) II and IV. D) I and III.
Answer: D Commercial paper instruments are debt securities; they represent loans to the issuing corporation by the holder. They are commonly issued to raise working capital and, as debt obligation, are senior in preference to preferred stock in claims against an issuer. Reference: 1.2.9.3 in the License Exam Manual.
All of the following statements regarding Government National Mortgage Association (GNMA) pass-through securities are true EXCEPT: A) investors receive a monthly check representing both interest and a return of principal. B) the minimum initial investment is $25,000. C) investors own an undivided interest in a pool of mortgages. D) GNMAs are considered to be the riskiest of the agency issues.
Answer: D GNMA securities, which are backed by the full faith and credit of the U.S. government, are considered to be the safest of the agency issues. Reference: 1.2.4.5.6 in the License Exam Manual.
A TIPS bond is issued in the principal amount of $1,000, paying 3.5%. Over the security's 5-year term, the inflation rate is 4%. What is the principal value of the bond at the end of 5 years? A) $1,000. B) $1,200. C) $1,440. D) $1,219.
Answer: D In addition to paying interest, a TIPS bond increases its principal value semiannually by the amount of inflation. If the inflation rate is 4% for 5 years, the principal value of the bond increases semiannually by that inflation rate. Allowing for compounding, the best choice would be the $1,219. This is computed by multiplying $1,000 by 102% 10 times. Reference: 1.2.4.4 in the License Exam Manual.
In the secondary market, Treasury bond prices are most influenced by the: A) Treasury department. B) primary dealers. C) prime rate. D) inflation rate.
Answer: D In the secondary market, the rate of inflation has the greatest influence on all bond prices. Reference: 1.2.5.2 in the License Exam Manual.
MNO is planning to raise capital through an offering of 30-year bonds. Which call price would be most beneficial to MNO? A) 102 B) 104 C) 106 D) 110
Answer: A MNO would benefit most from the ability to call bonds at the lowest possible price. The call feature enables MNO to buy the bonds before maturity to reduce their fixed interest costs. A call price of 102 requires the lowest call premium of the options shown. Reference: 1.2.8.1.1 in the License Exam Manual.
A client in the 30% tax bracket owns a 5% XYZ, Inc., debenture due to mature shortly. What yield in a municipal will give him the same after-tax return that he now has with his debenture? A) 3.50%. B) 1.50%. C) 2%. D) 5.30%.
Answer: A The client's tax rate is 30%; 70% of 5% is 3.5%. A nontaxable municipal bond with a 3.5% yield would give the client the same return. Reference: 1.2.6.4 in the License Exam Manual.
In general, advantages to investing in Brady Bonds over those issued by countries classified as emerging economies are: Greater safety. Higher yields. Increased liquidity. Shorter maturities. A) II and IV. B) I and III. C) I and II. D) II and III.
Answer: B Brady bonds are issued to take over the debt of failing commercial loans in emerging economies. They are secured by collateral, often US Treasury zero-coupon bonds thereby making them more secure than direct issues of that country. This backing also increases the liquidity as there is a larger pool of potential investors. These benefits cause the yields to be lower - less risk, less reward. Reference: 1.2.11.3 in the License Exam Manual.
A corporate bond valued at $1,012.50 is shown in the Standard & Poor's Bond Guide as: A) 101-4/16. B) 101-¼. C) 101.25. D) 101-8/32.
Answer: B Corporate bonds are quoted as a percentage of par in eighths. The quote of 101-¼ = $1,012.50 is correct. This represents $1,010 (101% of par) + $2.50 (¼ of $10). Each point in a corporate bond is equal to $10. Reference: 1.2.7 in the License Exam Manual.
All of the following are money market instruments EXCEPT: A) commercial paper. B) newly issued Treasury notes. C) Treasury bills. D) jumbo (negotiable) CDs.
Answer: B Money market securities have a maximum maturity of 1 year. Treasury notes are issued with maturities of 2 to 10 years. Treasury bills are money market instruments with maturities of 52 weeks or less. Jumbo CDs are issued by banks and have maturities of 1 year or less. Commercial paper (issued by corporations) is unsecured short-term debt with maturities of 270 days or less. Reference: 1.2.9 in the License Exam Manual.
A company with 20 million shares outstanding paid $36 million in dividends. If the current market value of the company's shares is $36, the current yield is: A) not determinable from the information given. B) 5%. C) 2%. D) 10%.
Answer: B The current yield formula is annual dividends per share divided by current market price. The dividends per share are $36 million ÷ 20 million shares = $1.80 per share. Current yield is $1.80 ÷ $36.00 = 5% Reference: 1.2.6.1 in the License Exam Manual.
An investor purchases zero-coupon bonds issued by the U.S. Treasury due to mature in 18 years at $100,000. Which of the following might describe the primary reason for selecting that investment vehicle? The investor is 65 years old and needs the reliability of current income. The investor is 45 years old and has purchased these in an IRA rollover account and wants the assurance of funds for retirement. The investor is 30 years old and has a newborn child and wishes to assure funds for a college education. The investor is 20 years old, has just received an inheritance, and wishes to shelter income for as long as possible. A) III and IV. B) II and III. C) I and II. D) I and IV.
Answer: B Zero-coupon bonds maturing in 18 years would assure the 45-year-old of the face value at age 63. Being in an IRA, there would be no current taxation and, upon maturity, if desired, the funds could be distributed without the 10% penalty. Zero-coupon bonds are one way to guarantee funds for college education. However, with no current income, they would not be suitable for the 65-year-old and would not offer any tax shelter to the 20-year-old. Reference: 1.2.7.4 in the License Exam Manual.
Which of the following is not included in adjusted gross income on an individual's federal income tax return? A) Salary and commissions B) Unemployment compensation C) Municipal bond interest D) Dividends paid on preferred stock
Answer: C Although tax-exempt interest is reported on the Form 1040 (line 8b), it is not included in adjusted gross income. Reference: 1.2.6.4 in the License Exam Manual.
Your client with $100,000 to invest is looking for maximum current income. Which of the following would offer the highest current return? A) $200,000 of utility common stock paying a current dividend of 3.5%. B) $100,000 of zero-coupon bonds with a yield to maturity of 6%. C) $100,000 market value of corporate bonds selling at a premium and yielding 6% to maturity. D) $100,000 AA rated corporate bonds trading at par with a 6% coupon rate.
Answer: C Bonds selling at a premium have higher coupons than those selling at par. Therefore, the current yield on those bonds is higher than the ones at par, even though they would have the same yield to maturity. The zero-coupon bonds offer no current income and the investor only has $100,000 to invest so the utility stock is not a viable option.
Which of the following are characteristics of commercial paper? Backed by money market deposits. Negotiated maturities and yields. Issued by insurance companies. Not registered with the SEC. A) I and III. B) III and IV. C) II and IV. D) I and II.
Answer: C Commercial paper represents the unsecured debt obligations of corporations needing short-term financing. Both yield and maturity are open to negotiation. Because commercial paper is issued with maturities of no more than 270 days, it is exempt from registration under the Securities Act of 1933. Reference: 1.2.9.3 in the License Exam Manual.
A client of yours owns some convertible preferred stock. She notices an article in the business section of her local newspaper that reports the company is going to pay a 20% stock dividend on their common stock. She wants to know how this will affect her? A) she will also receive 20% more shares because preferred stock has a priority claim ahead of common. B) there will be no effect. C) if there is an anti-dilution clause, her conversion privilege will permit her to acquire 20% more shares than before the stock dividend. D) more than likely, the price of the preferred stock will rise.
Answer: C Most convertible securities are sold with anti-dilutive clauses that provide for an adjustment in the number of shares based upon stock splits or stock dividends. Reference: 1.2.8.2.4 in the License Exam Manual.
Which of the following are characteristics of negotiable jumbo CDs? Issued in amounts of $100,000 to $1 million. Typically pay interest on a monthly basis. Always mature in 1 to 2 years with a prepayment penalty for early withdrawal. Trade in the secondary market.
Answer: C Negotiable jumbo CDs are issued for $100,000 to $1 million and trade in the secondary market. Most jumbo CDs are issued with maturities of one year or less. Being negotiable, there is no prepayment penalty. These CDs generally pay interest on a semi-annual basis, not monthly.
If a group of money managers were having a discussion and the term LIBOR was mentioned, the topic would most likely be: A) current economic conditions in Liberia. B) long-term borrowing rates. C) short-term borrowing rates. D) contract negotiations with the employee's union.
Answer: C The British Banker's Association LIBOR is the most widely used benchmark or reference rate for short-term interest rates world-wide. The acronym stands for London Interbank Offered Rate. Reference: 1.2.11.1 in the License Exam Manual.
With respect to safety of principal, of the following investments, the least risky is: A) equity options. B) exchange-listed warrants. C) corporate AA debentures. D) common stock.
Answer: C The least risky investment listed is the corporate debenture because, as a debt instrument, it has priority over the others.
All of the following statements regarding bonds selling at a discount are correct EXCEPT: A) they can indicate that interest rates have risen. B) they can indicate that the issuer's credit rating has fallen. C) they are more likely to be called than comparable bonds selling at a premium. D) they will appreciate more than comparable bonds selling at a premium if interest rates fall.
Answer: C The longer the duration, the more volatile the bond's price. Lower coupon rates mean a longer duration. If rates rise, prices fall. If a bond's rating falls, so does its price. Issuers tend to call bonds with higher coupons. Bonds trading at a premium have higher coupons than those trading at a discount (and are more likely to be called). Reference: 1.2.8.1.1 in the License Exam Manual.
Ms. Libby Ralph sees a tombstone advertisement for a new issue of Southwest Barge subordinated convertible debentures. The bonds will carry an 11-¼% coupon, are convertible into common stock at $10.50, and are being issued to the public at 100. The proceeds of the issue will be used specifically for purchasing new Southwest barges. Ms. Ralph's concerns about the issue could include: A) the company might demand that she accept common stock for her bond. B) nothing, because the bonds will be first in liquidation. C) the issue may be junior-in-lien to another security issue. D) the new barges might sink, and the collateral would be gone.
Answer: C The word "subordinated" is the key to the question. A subordinated bond has other debt holders ahead of it in the event of liquidation. The barges do not serve as collateral because the bonds are identified as debentures, and having to convert to common stock is not a threat because she is the one that will exercise the conversion privilege if she desires. Reference: 1.2.2.7 in the License Exam Manual.
The current yield on a bond with a coupon rate of 7.5% currently selling at 105-½ is approximately: A) 6.50%. B) 7.50%. C) 8%. D) 7.10%.
Answer: D A bond with a coupon rate of 7.5% pays $75 of interest annually. Current yield equals annual interest amount divided by bond market price, or $75 ÷ $1,055 = 7.109%, or approximately 7.1%. Reference: 1.2.6.1 in the License Exam Manual.
When doing cash flow analysis on a mortgage-backed pass-through security, you would want to know: A) the quality of the mortgages. B) whether there is a real estate "bubble." C) size of the tranche being analyzed. D) the average maturities.
Answer: D Mortgage-backed pass-through securities pass through interest and principal payments to their investors. The rate at which the cash flows are generated depends, among other things, on the rate at which the mortgages mature. Reference: 1.2.10.5 in the License Exam Manual.
A TIPS bond is issued in the principal amount of $1,000, paying 3.5%. Over the security's 5-year term, the inflation rate is 4%. What is the amount of the final semiannual interest check? A) $17.50. B) $35.00. C) $42.66. D) $21.33.
Answer: D The semiannual interest of a TIPS bond is computed on the basis of the inflation-adjusted principal. Because the principal increases with the inflation rate, at the end of the 5-year term, it has grown to $1,219 ($1,000 × 102% ten times). Therefore, the final interest check is for $1,219 × 1.75% (remember it is a semiannual check). Reference: 1.2.4.4 in the License Exam Manual.
While listening to a commentator on cable TV, you hear the statement, "the flight to quality has ended." What would you expect the effect of this to be? A) yield spreads are narrowing B) yield spreads are widening C) airline stocks are in for a beating D) pessimism is spreading
Answer: A The term yield spread refers to the difference in yield between very high quality debt instruments, such as US government bonds, and those with lower ratings. The spread compensates for the additional risk. When investors perceive that the risk has lessened, they won't demand as much in return from the lower rated instruments. Reference: 1.2.5.3 in the License Exam Manual.
A client has a TIPS with a coupon rate of 3.5%. The inflation rate has been 4% for the last year. What is the inflation-adjusted return? A) 3.50%. B) -0.50%. C) 4.00%. D) 7.50%.
Answer: A Treasury Inflation Protected Securities (TIPS) adjust the principal value each 6 months to account for the inflation rate. Therefore, the real rate of return will always be the coupon. Reference: 1.2.4.4 in the License Exam Manual.
Which of the following would make a corporate bond more subject to liquidity risk? Short-term maturity Long-term maturity High credit rating Low credit rating A) II and III B) II and IV C) I and III D) I and IV
Answer: B Liquidity risk is the risk that when an investor wishes to dispose of an investment, no one will be willing to buy it, or that a very large purchase or sale would not be possible at the current price The available pool of purchasers for bonds with a low credit rating is much smaller than for those with investment grade ratings (many institutions are only able to purchase bonds with higher credit ratings). As a result, the lower the credit rating, the greater chance of the bond having liquidity issues. Similarly, bonds with short-term maturities attract many more investors than those with long-term maturities causing the long-term bonds to be less liquid. Reference: 1.2.5.1 in the License Exam Manual.
A respected analyst reports that last week's T-bill rate at 6% is lower than the rate for the preceding week and lower than the average for the past month. Which of the following is TRUE? A) Investors are paying less for T-bills. B) Investors are paying more for T-bills. C) The yield curve is inverted. D) The general level of interest rates is increasing.
Answer: B When the rate is lower, the price has gone up; this means investors are paying more as interest rates are going down. Reference: 1.2.7.3 in the License Exam Manual.
If a company's dividend increases by 5% but its market price remains the same, the current yield of the stock will: A) remain at 5%. B) remain at 7%. C) increase. D) decrease.
Answer: C The current yield of a stock is the annual dividend divided by the market price. If a company's dividend increases and its market price remains the same, its current yield will increase.
All of the following statements regarding bonds with both a convertible and callable feature are correct EXCEPT: A) after the call redemption date, interest payments will cease. B) dilution of company stock will occur on conversion of the bonds. C) the coupon rate on a convertible bond would be less than the rate for comparable nonconvertible debt. D) if called, the owners have the option of retaining the bonds and will continue to receive interest.
Answer: D After bonds are called, the issuer no longer pays interest. Conversion of convertible bonds causes more shares outstanding, resulting in a reduced proportionate ownership interest (dilution) for current shareholders. The coupon rate paid on convertible bonds is lower than the coupon for nonconvertible bonds. There is a trade-off in the amount of interest for the ability to convert the bonds into common stock.
A company has paid a dividend every quarter for the past 20 years. If the stock's price has fallen dramatically over the past quarter, but the dividend has remained the same, it may be concluded that: A) current dividend yield has decreased. B) current dividend yield has remained the same. C) dividend yield to maturity has decreased. D) current dividend yield has increased.
Answer: D Current dividend yield is income dividend divided by price. If the price of a stock decreases and the dividend remains the same, dividend yield will increase. Reference: 1.2.6.1 in the License Exam Manual.
Which of the following best describes that which secures a debenture issued by an industrial corporation? A) The securities of the issuing company. B) The mortgages and real estate of the issuing company. C) The assets of a company other than the issuing company. D) The assets of the issuing company.
Answer: D Debentures are general obligations of the issuing company. They are actually backed by the assets of the company. Prior claims to those specific assets by secured debt issues take precedence over the debentures. Reference: 1.2.2.4 in the License Exam Manual.
If a customer buys 1 US Treasury 7-½% due Dec 2019 at 102, which of the following statements regarding this bond is TRUE? A) It has a yield to maturity of more than 7-½%. B) It has a nominal yield of less than 7-½%. C) Interest paid on it is subject to state and local taxes. D) Interest paid on it is subject to federal income tax.
Answer: D Interest earned on U.S. government obligations is subject to federal tax. This bond is trading at a premium ($1,020), so its yield to maturity is lower than the nominal yield of 7-½%. The nominal yield is the same as the coupon rate (7-½%). Interest on U.S. government obligations is exempt from state and local taxes. Reference: 1.2.4.5.4 in the License Exam Manual.
The DERP Corporation has an outstanding convertible bond issue with a conversion price of $125 per share. If the current market price of the bond is 80, the parity price of the stock is: A) $64 per share. B) $156.25 per share. C) $125 per share. D) $100 per share.
Answer: D Parity means equal. With a conversion price of $125, the bond is convertible into 8 shares (Par of $1,000 divided by $125). If the bond is currently selling for $800, then, to be of equal value (parity), the 8 shares must be selling at $100 each. Reference: 1.2.8.2.1 in the License Exam Manual.
An investor in the 25% federal income tax bracket is considering the purchase of some fixed-income instruments. Which of the following would provide the investor with the greatest after-tax return? A) 4.8% AAA rated insured municipal bond. B) 5% U.S. Treasury bond. C) 6% FDIC insured CD. D) 7% Ba rated corporate bond.
Answer: D The greatest after-tax return is provided by the instrument listed that, after subtracting 25% for income tax, leaves the investor with the greatest amount. Since the Treasury bond, the CD, and the corporate bond are all taxable at the same rate, the 7% bond must be the best deal. Even though the municipal bond is not taxed, its 4.8% net yield is far lower than the 5.25% ($70 − 25% tax) return on the corporate bond. Reference: 1.2.6.4 in the License Exam Manual.
An investor who chooses to use preferred stock as an income source instead of bonds would potentially incur which of the following risks? Loss of principal Price volatility of preferred stock is closely related to interest rates Preferred stock cannot be traded as readily as bonds If the stock is callable, the client's income can be suddenly lowered A) I, II, III, and IV B) I and II C) III and IV D) I, II, and IV
Answer: D Because bonds have seniority over any equity security, there is a greater risk of loss of principal with preferred stock than with bonds. The price volatility of preferred stocks, like bonds, is impacted by interest rate changes. Unlike bonds, however, preferred stock does not have a maturity date. This means that preferred shares may never return to their par value as bonds do at maturity date. Because the preferred stock may have a callable feature, the company can redeem its shares at any time after the call protection period (if any) is over. This usually happens when interest rates have declined so the client whose stock was called will not be able to reinvest the proceeds at the same rate and could, therefore, suffer an unexpected drop in income. Preferred shares, particularly those listed on the exchanges, are generally easier to trade than corporate bonds (and certainly no worse). Reference: 1.2.2.7 in the License Exam Manual.
From first to last, in what order would claimants receive payment in the event of bankruptcy? Holders of secured debt. Holders of subordinated debentures. General creditors. Preferred stockholders. A) I, II, III and IV. B) III, I, II and IV. C) IV, I, II and III. D) I, III, II and IV.
Answer: D The liquidation order is as follows: wages, taxes, secured debt holders, unsecured debt holders (including general creditors), holders of subordinated bonds, preferred stockholders, and common stockholders.
Of the following bonds, which has the greatest price volatility? A) Zero-coupon bond with 5 years to maturity. B) Corporate bond fund. C) AA corporate bond with 7 years to maturity. D) Zero-coupon bond with 15 years to maturity.
Answer: D The longer the duration of a bond, the greater the volatility will be of its market price when interest rates change. Because zero-coupon bonds do not make interest payments but are priced at a deep discount to par value, they are more volatile than coupon-bearing bonds. Reference: 1.2.7.4 in the License Exam Manual.
A bond's yield to maturity is: A) set at issuance and printed on the face of the bond. B) determined by dividing the coupon rate by the bond's current market price. C) the annualized return of a bond if it is held to call date. D) the annualized return of a bond if it is held to maturity.
Answer: D The yield to maturity is the annualized return of a bond if it is held to maturity. The computation reflects the internal rate of return and is frequently referred to as the market required rate of return for a debt security. The rate set at issuance and printed on the face of the bond is the nominal or coupon rate. Dividing the coupon rate by the current market price of the bond provides the current yield. The return of a bond if it is held to the call date is the YTC. Reference: 1.2.6.3 in the License Exam Manual.
Although there may be some slight differences in methodology, when S&P or Moody's evaluate a security in order to assign a rating, they would be least likely to consider the issuer's A) asset turnover ratio B) cash flow to debt ratio C) liquidity ratio D) profitability ratio
Answer: A The rate at which assets are turned over is not nearly as important to determining a rating as the other three. Reference: 1.2.5* in the License Exam Manual.
A customer buys a 5% bond at par. The bond is callable in 5 years at par and matures in 10 years. Which of the following statements is TRUE? A) Nominal yield is higher than either YTM or YTC. B) YTC is the same as YTM. C) YTC is higher than YTM. D) YTC is lower than YTM.
Answer: B If a bond is trading at par, the nominal yield (coupon rate) = current yield = yield to maturity = yield to call. YTC is higher than YTM if the bond is trading at a discount to par. YTC is lower than YTM if the bond is trading at a premium over par. Nominal yield is higher than either YTM or YTC if the bond is trading at a premium over par. Reference: 1.2.6.3 in the License Exam Manual.
Which of the following regarding U.S. government agency obligations are TRUE? They are direct obligations of the U.S. government. They generally have higher yields than direct U.S. obligations. The Federal National Mortgage Association is a publicly traded corporation. Securities issued by GNMA trade on the NYSE floor. A) I and III. B) II and IV. C) II and III. D) I and II.
Answer: C U.S. government agency debt is an obligation of the issuing agency. This causes agency debt to trade at slightly higher yields reflecting this greater risk. FNMA was created as a government agency but was spun off in 1968 and is now (because of the problems it had during mortgage meltdown of 2008-9), traded on the OTC Bulletin Board rather than the NYSE. GNMA pass-through certificates trade OTC. GNMAs are the only agency whose securities are direct US government obligations.
A category of bonds were created in the late 1980's in an attempt to "bail-out" defaulted commercial loans issued by banks from developing countries. These are commonly known as: A) Greenspan Bonds. B) Resolution Trust Bonds. C) Series BB Bonds. D) Brady Bonds.
Answer: D Named after U.S. Secretary of the Treasury Nicholas Brady, these bonds were created in 1989 to exchange defaulted commercial bank loans issued in less-developed countries, particularly Latin America. Reference: 1.2.11.3 in the License Exam Manual.
Which of the following debt securities does not have a fixed maturity date? A) Treasury STRIPS. B) Subordinated debenture. C) Collateralized mortgage obligation (CMO). D) General obligation bond.
Answer: C Collateralized mortgage obligations (CMOs) are mortgage-backed securities which are often paid off ahead of the scheduled maturity so the maturity date remains uncertain. The operative word is "fixed"; as opposed to "scheduled". Reference: 1.2.10.2 in the License Exam Manual.
The current yield of a 6% bond offered at 95 is: A) the nominal yield. B) the yield to maturity. C) 6%. D) 6.3%.
Answer: D The current yield of 6.3% is computed by dividing the annual interest payment ($60) by the current market price ($950). Reference: 1.2.6.1 in the License Exam Manual.
A customer purchased a 5% U.S. government bond yielding 6%. A year before the bond matures, new U.S. government bonds are being issued at 4%, and the customer sells the 5% bond. The customer probably did which of the following? Bought it at a discount. Bought it at a premium. Sold it at a discount. Sold it at a premium. A) I and IV. B) I and III. C) II and III. D) II and IV.
Answer: A The customer purchased the 5% bond when it was yielding 6% (at a discount). The customer sold the bond when other bonds of like kind, quality, and maturity were yielding 4%. The bond is now at a premium. Therefore, the customer realized a capital gain. Reference: 1.2.7.3 in the License Exam Manual.
Currently, a company issues 5% Aaa/AAA debentures at par. Two years ago, the corporation issued 4% AAA-rated debentures at par. Which of the following statements regarding the outstanding 4% issue are TRUE? The dollar price per bond will be higher than par. The dollar price per bond will be lower than par. The current yield on the issue will be higher than the coupon. The current yield on the issue will be lower than the coupon. A) II and III. B) I and III. C) I and IV. D) II and IV.
Answer: A Interest rates in general have risen since the issuance of the 4% bonds, so the bond's price will be discounted to produce a higher current yield on the bonds. Remember that as interest rates go up, the price of outstanding debt securities goes down. Reference: 1.2.6.2 in the License Exam Manual.
DERP Corporation's 5% convertible debentures maturing in 2030 are currently selling for 120. The conversion price is $40. One would expect the DERP common stock to be selling: A) somewhat below $48 per share. B) somewhat above $48 per share. C) somewhat above $30 per share. D) somewhat below $30 per share.
Answer: A The first step here is to compute the parity price. A conversion price of $40 means the debenture is convertible into 25 shares of the common stock (Par of $1,000 divided by $40 = 25 shares). With a current market price of $1,200, the parity price of the stock would be $48. Since convertible securities generally sell at a slight premium over their parity price, the stock should have a current market value a bit less than $48 per share. Reference: 1.2.8.2.1 in the License Exam Manual.
Your client in the 25% federal income tax bracket lives in a state where his earnings place him in the 6% bracket for state income tax purposes. If he were to purchase a 4% bond issued by a political subdivision of another state, his total tax equivalent yield would be: A) Slightly less than 5.33%. B) 4%. C) Slightly more than 5.33%. D) Approximately 12.90%.
Answer: A When an individual owns a municipal bond issued in a state other than his state of residence, although the interest is tax-free on a federal basis, it is taxable, (at least in all cases on the exam), in that state. Therefore, the tax equivalent yield here is slightly lower than it would be if we only computed using the federal tax rate. Since that would be 4.0% divided by .75 (100% minus the 25% tax bracket) or 5.33%, paying the state income taxes would decrease the yield slightly. Reference: 1.2.6.4 in the License Exam Manual.
Which of the following debt instruments generally present the least amount of default risk? A) Convertible senior debentures. B) Municipal revenue bonds. C) Municipal general obligation bonds. D) High-yield corporate bonds.
Answer: C Because the full taxing power of the municipality backs a general obligation municipal bond, it will exhibit the least amount of default risk. A corporate debenture is an unsecured bond with a greater degree of risk, as is a junk or high-yield corporate bond. **TAXES ARE MORE SECURE THAN REVENUE Reference: 1.2.3.1 in the License Exam Manual.
If a client who holds a convertible preferred stock believes the company may go bankrupt within the next 3 years, what would you advise the client to do with the stock? A) Sell calls on the preferred stock. B) Sell the security. C) Immediately convert to common stock because the preferred dividends may no longer be paid. D) Buy puts on the common stock as a hedge.
Answer: B In the event of bankruptcy, all debt holders have priority over equity holders in claims on the assets of the corporation in liquidation. The safest alternative is to sell the stock. Buying puts on the underlying common stock would be an effective hedge, but with a 3-year wait, the position would have to be renewed several times as the usual option only has a life of 9 months; this would lead to increased transaction costs.
Which of the following statements regarding U.S. government agency issues is NOT true? A) Government National Mortgage Association (GNMA) obligations are mortgage-backed securities that pass through principal and interest free of federal, but not state income tax. B) Government National Mortgage certificates carry higher interest rates than U.S. Treasury securities because of prepayment risk. C) Federal National Mortgage Association (FNMA) is a publicly held corporation that provides mortgage capital in much the same fashion as GNMA, except that Fannie Maes are backed by the general credit of the FNMA, and not by the full faith and credit of the U.S. government, as is the case with GNMAs. D) The Federal Intermediate Credit Banks (FICBs) lend money to credit companies, agricultural institutions, and commercial banks which in turn lend the money to farmers.
Answer: A Government National Mortgage Association (GNMA) obligations are mortgage-backed securities that pass-through principal and interest and are backed by the U.S. government. However, the interest is taxed on all levels; federal, state and local. Government National Mortgage certificates carry higher interest rates than U.S. Treasury securities because of prepayment or reinvestment risk. The Federal National Mortgage Association (FNMA) is a publicly held corporation that provides mortgage capital in much the same fashion as GNMA. However, Fannie Maes are backed by the general credit of the FNMA and not by the full faith and credit of the U.S. government, as is the case with GNMAs. The Federal Intermediate Credit Banks (FICBs) lend money to credit companies, agricultural institutions, and commercial banks which in turn lend the money to farmers.
Partners with the U.S. in the creation of Brady Bonds were the: International Monetary Fund (IMF). Import/Export Bank. United Nations. World Bank. A) I and IV. B) I and II. C) II and III. D) III and IV.
Click for Answer and Explanation Answer: A Joining in with the United States in creating Brady Bonds were the IMF and the World Bank.
An analyst is comparing two discounted 8% AA bonds. Both have 20 years to maturity. One of the bonds is callable in 4 years and the other is callable in 9 years. If interest rates fall, which will have the greatest increase in price? A) The bond with the 4-year call. B) Both will increase the same. C) Both will decrease the same. D) The bond with the 9-year call.
Answer: D When interest rates fall, bond prices move inversely (they go up). All other things being equal, the longer the maturity, the greater the movement. In this case, both bonds have the same 20-year maturity, but one is callable much sooner than the other. This makes the bond less attractive because an investor may have this bond called away in as little as 4 years. Reference: 1.2.8.1.3 in the License Exam Manual.
All the following securities are bought at a discount EXCEPT A) CDs B) Treasury bills C) zero coupon bonds D) commercial paper
Answer: A CDs are interest-bearing debt instruments issued by banks at their face value. All of the others are issued at a discount. In truth, only about 85% of commercial paper is, but that's good enough for NASAA. Reference: 1.2.9.3 in the License Exam Manual.
GHI stock is at $10 par value and is selling in the market for $60 per share. If the current quarterly dividend is $1, the current yield is:
Answer: A Current yield is determined by dividing the annual dividend of $4 ($1 per quarter × 4 = $4) by the current stock price of $60 ($4 ÷ $60 = 6.7%).
Which of the following regarding corporate debentures are TRUE? They are certificates of indebtedness. They give the bondholder ownership in the corporation. They are unsecured bonds issued to finance capital expenditures or to raise working capital. They are the most senior security a corporation can issue.
Click for Answer and Explanation Answer: D Debentures are debt securities that represent unsecured loans of the issuer. They are senior to common and preferred stock in claims against an issuer. They are issued to finance capital expenditures or raise working capital. Reference: 1.2.2.4 in the License Exam Manual.
