Fin 334 Ch. 10

12) Most bonds pay interest A) annually. B) semi-annually. C) quarterly. D) monthly.

Answer: B

10) When bonds are initially added to an all-equity portfolio the A) level of risk of the portfolio is impacted more than the rate of return. B) rate of return on the portfolio is impacted more than the level of risk. C) level of risk and the rate of return are equally impacted. D) rate of return is not impacted but the level of risk is lowered.

Answer: A

11) Two years ago, Mathew purchased a 10 year government bond with a yield of 4.75%. Today, the interest rate on government bonds with 8 years to maturity is 3.5%. If Mathew sells his bond today, he most likely will A) realize a capital gain. B) realize a capital loss. C) sell the bond at face value. D) sell the bond at par value.

Answer: A

14) Lee is considering buying one of two newly-issued bonds. Bond A is a twenty-year, 7.5% coupon bond that is non-callable. Bond B is a twenty-year, 8.25% bond that is callable after two years. Both bonds are comparable in all other aspects. Lee plans on holding his bond to maturity. What should Lee do if he feels that interest rates are going to decline by 2% in the near future and then remain relatively stable thereafter? A) purchase Bond A B) purchase Bond B C) purchase neither A nor B at this time D) negotiate a higher rate on Bond A

Answer: A

15) Debt securities issued by the Federal Home Loan Bank, the Student Loan Marketing Association and the Government National Mortgage Association are known as A) agency bonds. B) organizational bonds. C) municipal bonds. D) Treasury bonds.

Answer: A

16) Which one of the following is the most junior in terms of its claim on earnings and assets? A) subordinated debenture B) mortgage bond C) collateral trust bond D) equipment trust certificate

Answer: A

20) When the economy is moving toward a recession, the yield on riskier bonds will tend to A) rise. B) fall. C) stagnate. D) become volatile.

Answer: A

24) Which of the following statements concerning equipment trust certificates are correct? I. Equipment trust certificates are typically used to raise funds for purchasing airplanes and railroad engines. II. Equipment trust certificates are usually issued with a single maturity date. III. Equipment trust certificates normally mature in 20 to 30 years. IV. Equipment trust certificates generally offer above-average yields. A) I and IV only B) II and IV only C) I and III only D) I, III and IV only

Answer: A

26) Which one of the following statements correctly describes the major drawback of a zero-coupon bond? A) Unless the bond is held in a tax-sheltered account, the investor must pay taxes on the annual accrued interest even though no interest is actually received. B) The conversion feature found on most zero-coupon bonds generally requires the investor to switch to a coupon-bearing bond after a period of 5 years. C) The lack of an annual coupon basically prohibits the investor from locking in a high rate of return. D) Because there is no reinvestment of a coupon payment, large capital losses accrue when interest rates decline.

Answer: A

30) The practice of bundling mortgages or other types of loans into pools and selling pieces of the pool as bond-like instruments to investors is known as A) securitization. B) privatization. C) collateralization. D) fractionalization.

Answer: A

33) The practice of bundling mortgages or other loans into pools and selling shares of the pool as bond-like instruments is known as A) securitization. B) privatization. C) collateralization. D) fractionalization.

Answer: A

9) Liquid yield option notes or LYONS have which of the following characteristics? I. convertibility at a fixed conversion ratio II. high coupon rates III. a put feature that guarantees the right to redeem the bonds at a prespecified price. IV. convertibility at a fixed conversion price. A) I and III only B) II and IV only C) I and IV only D) II and III only

Answer: A

13) The bond market is considered bearish when A) market interest rates are low or falling. B) market interest rates are high or rising. C) the risk-free rate of return exceeds the required rate of return. D) more bonds are called than issued over a given period of time.

Answer: B

14) Under normal economic conditions, the major source of risk faced by investors who purchase investment grade bonds is A) purchasing power risk. B) interest rate risk. C) liquidity risk. D) default risk.

Answer: B

16) If you expect market interest rates to rise, you should purchase A) short term, low coupon bonds. B) short term, high coupon bonds. C) long term, low coupon bonds. D) long term, high coupon bonds.

Answer: B

16) Which of the following statements concerning agency bonds are correct? I. Agency issues are normally noncallable or carry lengthy call deferment features. II. Agency issues usually provide yields that are somewhat below the market yields for Treasuries. III. All agency issues are backed by the full faith and credit of the U.S. government. IV. New agency bonds are all issued in book entry form. A) I and III only B) I and IV only C) II, III and IV only D) I, II and III only

Answer: B

17) Bonds are least likely to be called if A) they are selling at a substantial premium. B) they are selling at a substantial discount. C) the price is close to par value. D) if they do not mature for at least 5 years.

Answer: B

17) Municipal bonds can be either general obligation bonds or revenue bonds. Of these two types of municipal bonds, only general obligation bonds A) are specifically serviced by the income generated from particular projects. B) are backed by the full faith and credit of the issuer. C) repay the principal only if a sufficient level of revenue is generated. D) have the principal and interest guaranteed by a third party.

Answer: B

18) Which of the following statements are correct concerning municipal bonds? I. Yields on municipal bonds are usually lower than yields on Treasury bonds. II. Municipal bonds are most appealing to individuals with high incomes. III. Interest on a municipal bond is exempt from federal income tax. IV. Municipal bonds are less risky than Treasury bonds. A) I, II, III and IV B) I, II and III only C) II, III and IV only D) II and III only

Answer: B

19) Bonds with one of the top four ratings (Aaa through Baa, or AAA through BBB) are designated as A) split bonds. B) investment grade bonds. C) illiquid bonds. D) high-yield bonds.

Answer: B

19) Jennifer is in the 25% federal income tax bracket and the 3% state income tax bracket. If Jennifer purchases a municipal bond yielding 4.25%, what is her after-tax equivalent yield if the bond income is exempt from both federal and state taxes? A) 5.67% B) 5.84% C) 5.90% D) 6.01%

Answer: B

23) Bond ratings are an important element of the bond market. Explain what bond ratings are, who issues the ratings, and what the ratings mean to the average investor.

Answer: B

25 to 40 years

Answer: B

27) Treasury strip bonds are popular because I. they are high-quality bonds. II. they have a wide range of maturities. III. they are very liquid. IV. their income is not taxed until the bonds mature. A) I and III only B) I, II and III only C) I, II and IV only D) I, II, III and IV

Answer: B

36) PIK-bonds A) are relatively safe investments. B) initially pay interest payments in the form of additional debt. C) are collateralized by home mortgages. D) pay monthly interest payments.

Answer: B

8) Which one of the following variables has the greatest effect on bond prices? A) economic growth B) interest rates C) inflation D) stock market returns

Answer: B

9) Which of the following are advantages of owning bonds? I. diversification properties II. higher long-term returns than equity holdings III. current income IV. relatively low risk A) I and II only B) I, III and IV only C) I, II and III only D) I, II, III and IV

Answer: B

negative

Answer: B

premium

Answer: B

10) A note is generally defined as debt with an initial term to maturity of A) zero to two years. B) one year or less. C) two to ten years. D) ten to thirty years.

Answer: C

11) the phenomenon known as "flight to quality" causes yields on government bond and corporate bonds A) to rise in tandem. B) to fall in tandem. C) to move in opposite directions. D) to become less volatile.

Answer: C

13) A bond which has a deferred call A) does not have to be redeemed when it reaches maturity. B) can be retired at any time prior to maturity provided six months notice is given. C) cannot be retired for a specific period of time after which it can be retired at any time. D) can be retired at any time during the initial call period but after that time can not be redeemed prior to maturity.

Answer: C

14) Which one of the following combination of features causes bond prices to be the most volatile? A) low coupon, short maturity B) high coupon, short maturity C) low coupon, long maturity D) high coupon, long maturity

Answer: C

15) Bob expects to retire in a few years and his primary goal is to avoid major losses in his 401-K account. Which of the following bond characteristics should he be seeking? I. Long maturities II. High ratings III High yields IV. Short maturities A) I and III only. B) I, III, and III only C) II and IV only D) II, III, and IV only.

Answer: C

16) Which type of risk is based on the financial integrity of a bond issuer? A) liquidity risk B) call risk C) business risk D) interest rate risk

Answer: C

18) Which of the following will tend to improve a bond's rating? I. an improvement in the firm's cash flow II. an increase in corporate debt III. an increase in net profits IV. an increase in net working capital A) I, II and III only B) II, III and IV only C) I, III and IV only D) I, II, III and IV

Answer: C

20) What is the tax-equivalent yield of a double tax-free 5% municipal bond if the investor is in the 28% federal and 7% state tax brackets? A) 6.94% B) 7.14% C) 7.47% D) 7.69%

Answer: C

21) Which one of the following statements concerning the tax treatment of municipal bonds is correct? A) The interest income on municipal bonds is subject to federal income tax. B) The capital gain realized on the sale of a municipal bond is tax-free income. C) Interest income on a municipal bond is usually exempt from state and local income taxes if the bond is issued by the state or locality in which the investor resides. D) Municipal bonds receive no special income tax treatment.

Answer: C

22) Martin is trying to decide which one of the following bonds he should purchase. All the bonds have the same maturity date and all have approximately the same level of risk. The general level of interest rates is declining. Martin is in the 33 percent federal income tax bracket and the 8 percent state income tax bracket. The municipal bonds are from his home state. Which bond should Martin purchase if he wishes to hold it for the long term? A) Bond A B) Bond B C) Bond C D) Bond D

Answer: C

28) One of the major problems associated with mortgage-backed securities is that A) the principal portion of each payment is considered taxable income. B) they are refundable. C) they are self-liquidating. D) they are serial issues.

Answer: C

29) Which of the following characteristics apply to collateralized mortgage obligations? I. All bondholders receive a pro-rata share of all interest payments. II. CMOs are derivative securities created from mortgage-backed bonds. III. All principal payments are paid to the shortest remaining tranche. IV. CMOs have definite maturity dates for each tranche. A) I and II only B) I and III only C) I, II and III only D) II, III and IV only

Answer: C

31) Collateralized mortgage obligations are relatively safe investments except A) when interest rates rise. B) when inflation is high. C) when home prices decline. D) when mortgage holders refinance frequently.

Answer: C

32) Pass-through securities backed by pools of auto loans, credit card bills, and computer leases are known as A) PIK bonds. B) REIMCs. C) ABSs. D) Fannie Maes.

Answer: C

34) The first tranche of a collateralized mortgage obligation has A) the greatest default risk. B) the greatest interest rate risk. C) the greatest prepayment risk. D) the greatest total risk.

Answer: C

6) When convertible bonds are first issued: I. the conversion price of the stock is higher than the market price. II. the market price of the stock is higher than the conversion price. III. the coupon rate is higher than if the bond were not convertible. IV. the coupon rate is lower than if the bond were not convertible. A) I and III only B) II and IV only C) I and IV only D) II and III only

Answer: C

7) Which of the following is most likely to happen with a convertible bond when the market price of the stock exceeds the conversion price. The stock does not pay a dividend. A) The bondholders will immediately convert their bonds to stock. B) The issuing company will call the bonds and the bondholders will redeem them for the call price. C) The issuing company will call the bonds and bondholders will convert them to common shares. D) Both the issuing company and the bondholders will wait for the bonds to reach their maturity date.

Answer: C

8) When convertible bonds are first issued I. the conversion price of the stock is higher than the market price. II. the market price of the stock is higher than the conversion price. III. the coupon rate is higher than if the bond were not convertible. IV. the coupon rate is lower than if the bond were not convertible. A) I and III only B) II and IV only C) I and IV only D) II and III only

Answer: C

9) A single bond issue with multiple maturity dates is called a A) callable bond. B) premium bond. C) serial bond. D) term bond.

Answer: C

9) Which of the following statements are correct concerning Eurodollar bonds? I. Initial offerings of Eurodollar bonds are sold in U.S. bond markets. II. Eurodollar bonds are denominated in dollars. III. The Eurodollar market is dominated by foreign-based investors. IV. Eurodollar bonds originate outside the United States. A) II and III only B) I and IV only C) II, III and IV only D) I, II and IV only

Answer: C

10) Eurodollar bonds are A) purchased with dollars but redeemed in euros. B) purchased with dollars but redeemed in euros. C) purchased with dollars, but redeemable in either euros or dollars. D) purchased and redeemed in dollars but issued by entities outside the U.S.A.

Answer: D

10) Which of the following is a good reason to invest in convertible bonds? A) They often have higher than normal coupon rates. B) They offer protection against rising interest rates. C) They tend to be issued by stable, low-risk companies. D) They offer predictable income and a chance to profit from an increase in the stock price.

Answer: D

11) Under which bond provision is the issuer required to retire portions of the bond issue prior to maturity? A) call feature B) refunding provision C) subordination clause D) sinking fund feature

Answer: D

12) At the time you purchase a bond, you know the exact holding period return you will earn if A) the bond is called at any time prior to maturity. B) you resell the bond in exactly one year from the date of purchase. C) the market rate of interest declines within the next year. D) you hold the bond to maturity.

Answer: D

12) Which of the following types of risk affect bonds? I. call risk II. business risk III. purchasing power risk IV. liquidity risk A) III and IV only B) II, III and IV only C) I, III and IV only D) I, II, III and IV

Answer: D

13) When the market rate of return exceeds the coupon rate, a bond will sell at A) par. B) face value. C) a premium. D) a discount.

Answer: D

13) Which one of the following statements concerning Treasury bonds is correct? A) The coupon rate of a TIPS is adjusted periodically in response to changes in the rate of inflation. B) Treasury bonds have maturity dates ranging from two to ten years. C) Interest earned on Treasury bonds is tax-exempt at the federal level. D) All Treasury securities are backed by the "full faith and credit" of the U.S. government.

Answer: D

14) Which of the following statements about U.S. Treasury bonds are true? I. They are backed by the "full faith and credit" of the U.S. government. II. They are all indexed and adjusted for inflation. III. They trade in a very thin market. IV. They are traded in both U.S. and foreign markets. A) I, II and IV only B) I, III and IV only C) II and III only D) I and IV only

Answer: D

15) In a severe recession, the major source of risk faced by investors who purchase corporate bonds is A) purchasing power risk. B) interest rate risk. C) liquidity risk. D) default risk.

Answer: D

15) Which of the following is(are) senior bonds? I. equipment trust certificates II. mortgage bonds III. debentures IV. collateral trust bonds A) I and II only B) II and IV only C) III only D) I, II and IV only

Answer: D

17) A bond quoted at a price of 101.2 A) is a deep discount bond. B) yields 10.12%. C) yields 12%. D) has a coupon rate that exceeds the market rate.

Answer: D

21) If a bond rating moves from a BB to a BBB rating A) the bond will still be classified as junk. B) it must also move from a Ba to a Baa rating. C) the market yield on the bond will rise. D) the market price of the bond will rise.

Answer: D

22) Which of the following factors are included in the rating analysis of a corporate bond? I. the issue's indenture provisions II. the liquidity position of the issuing company III. the issuing company's relative debt burden IV. the stability of the company's earnings A) I and II only B) I, II and III only C) II, III and IV only D) I, II, III and IV

Answer: D

25) Which one of the following statements correctly describes the unique feature of GNMA pass-through securities? A) The interest income on a GNMA is exempt from state and federal tax. B) GNMAs consistently have lives of 25-30 years. C) GNMAs are backed by the full faith and credit of the issuing state. D) GNMAs pay income to holders on a monthly basis.

Answer: D

35) Which of the following statements are correct in respect to high-yield bonds? I. They are junk bonds with highly unpredictable rates of return. II. The issuing corporation usually has an excessive amount of debt. III. They possess a high level of default and market risk. IV. They are often subordinated debentures. A) I, II and III only B) II, III and IV only C) I and III only D) I, II, III and IV

Answer: D

6) One type of foreign bond that carries no currency exchange rate risk for a U.S. investor is a A) Eurodollar bond. B) foreign-pay bond. C) PIK bond. D) Yankee bond.

Answer: D

7) Which one of the following statements concerning a global view of the bond market is correct? A) The United States today accounts for about seventy-five percent of the available fixed-income securities worldwide. B) U.S. pay bonds distribute both interest and principal payments in euros. C) Foreign bonds, like junk bonds, have high default risk. D) Exchange rate fluctuations influence the returns earned on foreign-pay bond holdings.

Answer: D

8) A type of bond that is issued and traded outside the United States and which is denominated in U.S. dollars but is not registered with the SEC is A) a Yankee bond. B) an issue of the World Bank. C) an issue of the InterAmerican Bank. D) a Eurodollar bond.

Answer: D

9) An increase in the market rate of return on an outstanding bond will A) increase the coupon rate. B) decrease the coupon rate. C) increase the bond price. D) decrease the bond price.

Answer: D

12) From the viewpoint of a U.S. resident, describe the merits of investing in foreign bonds. Answer: The merits include the (a) potential for higher average annual returns on a portfolio. (b) potential for capital appreciation due to exchange rate movements. (c) ability to purchase either U.S.-pay or foreign-pay bonds. (d) probability of low default risk. (e) benefits of portfolio diversification. 10.6 Learning Goal 6 1) When the call price of a convertible bond stock exceeds the conversion value of the bond, the issuing company is likely to force conversion by calling the bonds.

Answer: FALSE

17) Discuss at least three differences between investing in stocks and investing in bonds. Answer: Students may discuss any of the following: Bonds provide a predictable stream of income that will not change until the bonds mature, while stock dividends can be reduced or even eliminated. Corporations have a legal obligation to pay interest and principle, but there is no legal obligation to pay dividends. Stocks can lose value permanently, but the value of bonds will always rise (or fall) to face value when they mature unless the corporation fails and the bonds default. Because bond prices depend primarily on interest rates, they move within a much narrower range and change less quickly than stock prices. On the negative side, bonds values do not share in the growth of a company and over the long term, average returns on bonds are lower than on stocks. 10.2 Learning Goal 2 1) Each interest payment on a 6%, semi-annual bond is $60.

Answer: FALSE

2) Interest rates and bond prices are directly related.

Answer: FALSE

2) The coupon rate on convertible bonds is usually higher than the coupon rate on equivalent bonds that are not convertible.

Answer: FALSE

2) The par value of a Treasury inflation-indexed obligation is established as $1,000 over the life of the bond.

Answer: FALSE

3) From 1996 through 2005, the bond market outperformed the stock market by a slim margin.

Answer: FALSE

37) Define zero-coupon bonds and list some advantages and some disadvantages of these instruments. Answer: Zero-coupon bonds have no coupons. They are bonds sold at a deep discount from par and pay face value at maturity. Advantages: (a) Zeros pay nothing to investors until maturity. Therefore investors do not have to worry about reinvesting the interest income. (b) The rate of return on a zero-coupon bond is locked in over the life of the issue if the bond is held to maturity. (c) Zero-coupon bonds offer high capital gains potential if market interest rates decline. Disadvantages: (a) If interest rates move up over the life of the issue, zero-coupon bond price growth will be diminished or even negative (b) A zero-coupon bond is subject to extreme price volatility. (c) A zero-coupon bondholder must report the interest as taxable income as it is accrued even though no interest is actually received. 10.5 Learning Goal 5 1) The biggest risk with foreign bonds is the risk of default.

Answer: FALSE

4) Convertible bonds are especially attractive when stock prices are falling.

Answer: FALSE

4) The holder of a serial bond receives both semi-annual interest and principal payments over the life of the bond.

Answer: FALSE

4) Yankee bonds are issued by the U.S. government, but sold only to foreign investors.

Answer: FALSE

5) An American investor who holds euro-denominated bonds will profit if the euro weakens against the dollar.

Answer: FALSE

6) Bond prices are stable over any five- to ten-year period.

Answer: FALSE

6) Most bonds pay interest quarterly.

Answer: FALSE

6) Zero coupon bonds have very limited price volatility.

Answer: FALSE

8) Corporate bonds are actively traded in the secondary markets.

Answer: FALSE

8) Mortgage-backed bonds are issued primarily by state governments and are secured by home mortgages.

Answer: FALSE

ond ratings are letter grades that designate a bond's investment quality. They are issued by agencies such as Moody's, Standard & Poor's, Fitch Investor Services and Duff & Phelps. Bond analysts study each bond issue for factors such as the bond's provisions and the issuing company's financial stability and then issue the rating. "A" ratings are highest, then "B" ratings, followed by "C" ratings for bonds that are at or near default and finally "D" ratings for bonds that are in default. For investors, ratings measure an issue's default risk. Other things being equal, the higher the rating, the higher the bond price and the lower the yield. 24) Every bond is issued with a call feature. Explain what it means for a bond to be "called," then briefly describe the three most common types of call features. Also explain why investors suffer when bonds are called. Answer: If a bond is called, it is retired before its maturity date. The 3 types of call features are 1. freely callable (the bond can be retired at any time) 2. noncallable (the bond cannot be called) 3. deferred call (can be called, but only after a certain specified period). Investors suffer because high-yielding bonds are called and replaced with low-yielding bonds. Thus the investor is left with a lower rate of return than anticipated. 10.3 Learning Goal 3 1) When interest rates change, the prices of short-term bonds will change more than those of long-term bonds.

Answer: FALSE

1) Bondholders can earn income both from interest and from capital gains.

Answer: TRUE

10) One disadvantage of mortgage backed securities is their uncertain maturity date.

Answer: TRUE

10.4 Learning Goal 4 1) A debenture is secured only by the issuer's promise to repay the debt.

Answer: TRUE

11) Junk bond prices tend to be volatile just like common stock prices.

Answer: TRUE

12) The various CMO tranches can have significantly different degrees of prepayment risk.

Answer: TRUE

2) Each interest payment on a 6%, semi-annual bond is $30.

Answer: TRUE

2) Foreign companies sometimes issue bonds which pay interest and principal in U. S. dollars.

Answer: TRUE

2) The primary reasons for owning bonds are the income they provide and also the stability they bring to an investment portfolio.

Answer: TRUE

3) After the U. S. dollar, bonds denominated in euros are the largest segment of the global bond market.

Answer: TRUE

3) An increase in the market rate of interest can cause a bondholder to realize a capital loss on the sale of their bonds.

Answer: TRUE

3) In an inflationary environment, the interest payments on Treasury inflation-indexed obligations increase over time.

Answer: TRUE

3) The conversion ratio denotes the number of shares for which a convertible bond can be exchanged.

Answer: TRUE

3) When a bond is called, the bondholder generally faces a rate of return that is lower than expected.

Answer: TRUE

4) As investors approach retirement age, they should hold more bonds and less stock.

Answer: TRUE

4) Fixed coupon rates cause bond yields to lag inflation rates when inflation rates begin to increase significantly.

Answer: TRUE

4) If the inflation rate is 2%, the principal of a Treasury inflation protection security will from $1,000 to $1,020.

Answer: TRUE

5) If you hold a zero-coupon bond to maturity, the fully compounded rate of return is virtually guaranteed to be equal to the rate stated at the time the bond was purchased.

Answer: TRUE

5) If you want to reduce the price volatility of your bond portfolio, you should shorten the time-to-maturity of your portfolio.

Answer: TRUE

5) In 2006 and 2007, low yielding government bonds outperformed stocks by a significant margin.

Answer: TRUE

5) LYON's or liquid yield option notes are a type of convertible security.

Answer: TRUE

5) The risk premium component of a bond's market interest rate is related to the characteristics of the particular bond and its issuer.

Answer: TRUE

6) If you feel interest rates are going to drop significantly, you could potentially realize large capital gains by purchasing long-term zero coupon bonds prior to the rates decreasing.

Answer: TRUE

7) A bond which is noncallable for a period of time after which it is freely callable is called a deferred call bond.

Answer: TRUE

7) Bonds are typically a good investment choice for an individual who is seeking long-term preservation of capital.

Answer: TRUE

7) Investment-grade bonds are more interest rate sensitive than junk bonds.

Answer: TRUE

7) Municipal bonds are most attractive to residents of states with high income tax rates.

Answer: TRUE

8) The initial call price of an 8% bond could be as high as $1,080.

Answer: TRUE

9) Mortgage-backed securities are self-liquidating.

Answer: TRUE

11) What are the major factors that affect the price of convertible bonds?

Answer: When the stock's market price is at or above its conversion price, the value of a convertible is driven by the price behavior of the underlying common stock. When the stock's price is well below the conversion price, convertibles behave more like conventional bonds and the price is driven by market interest rates.