Lesson 2.3: Corporate and Treasury Debt Securities

A client has 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%

A)3.50% Treasury Inflation-Protected Securities (TIPS) adjust the principal value each six months to account for the inflation rate. Therefore, the real rate of return will always be the coupon.

Bright-Lite Incandescent Bulb, Inc., recently suffered significant operating losses and is planning a bankruptcy filing. Which of the following debt issues have the most junior claim? A)Debentures B)Mortgage bonds C)Common stock D)Senior notes

A)Debentures Explanation Although the most junior claim of all is that of the common stockholder (equity), this question is about the priority of debt issues. In that case, the most junior (last in line) of the creditors are the holders of the company's debentures.

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 more for T-bills. B)Investors are paying less for T-bills. C)The general level of interest rates is increasing. D)Stock prices are rising.

A)Investors are paying more for T-bills. Explanation When the rate is lower, the price has gone up; this means investors are paying more as interest rates are going down. There is nothing in this question that gives us enough information to evaluate the movement of stock prices.

In general, from the choices given, the type of security offering the greatest degree of safety to an investor is A)a mortgage bond. B)a debenture. C)preferred stock. D)common stock.

A)a mortgage bond. Explanation Debt securities, because they are an obligation of the issuer, are generally considered safer than equity securities. Secured debt is safer than unsecured debt. The only one of these debt obligations with pledged assets as security for the loan is the mortgage bond. Debentures are unsecured corporate debt obligations.

Treasury bills are A)issued in book-entry form. B)issued at par. C)issued in bearer form. D)callable.

A)issued in book-entry form. Explanation All Treasury securities are issued in book-entry form. Treasury bills are always issued at a discount and are never callable.

Ginnie Mae pass-throughs will pay back both principal and interest A)monthly. B)semiannually. C)annually. D)quarterly.

A)monthly. Explanation Ginnie Mae (GNMA) securities are called pass-through certificates because the monthly home mortgage payments, which consist of both principal and interest, pass through to the GNMA investor monthly.

A mortgage-backed security (MBS), such as a Ginnie Mae, makes a combination principal and interest payment to an investor. This payment will be A)partly taxed as ordinary income and partly a tax-free return of principal. B)taxed as a capital gain if underlying mortgage is prepaid. C)taxed as ordinary income. D)tax free.

A)partly taxed as ordinary income and partly a tax-free return of principal. Explanation All interest payments made on a mortgage-backed security (MBS) are taxed as ordinary income. MBSs may make principal and interest payments to investors, which are partly taxed as ordinary income and partly tax-free returns of principal.

All of the following are true of government agency bonds except A)they are direct obligations of the U.S. government. B)they are considered relatively safe investments. C)older ones have coupons attached, while new ones are book-entry. D)they trade openly.

A)they are direct obligations of the U.S. government. Explanation The only government agency that is a direct obligation of the U.S. government is the Ginnie Mae security. All of the others are moral obligations.

Which of the following is true of Ginnie Maes but not of other agency mortgage-backed securities? A)Are pass-through securities B)Backed by the full faith and credit of the U.S. government C)Collateralized by mortgages D)Yield more than T-bonds

B)Backed by the full faith and credit of the U.S. government Explanation Of the mortgage-backed government agency securities, only the Ginnie Maes are backed by the full faith and credit of the U.S. government. They are all collateralized by mortgages (the name MBS gives that away), and even the Ginnie Maes yield more than Treasury bonds. As an MBS, they all pass through the income and principal repayments to the investors.

Which two of the following investments would offer your clients the best chance of minimizing inflation risk? Common stock Callable preferred stock Money market mutual funds TIPS A)I and II B)I and IV C)II and III D)III and IV

B)I and IV Explanation Historically, common stock has been the best hedge against inflation. TIPS (Treasury Inflation-Protected Securities) are government-guaranteed debt issues that automatically adjust the principal based upon the inflation rate.

An unsecured long-term debt security issued by a corporation is known as A)a mortgage bond. B)a debenture. C)an equipment trust certificate. D)a collateral trust bond.

B)a debenture. Explanation A debenture is a long-term debt security issued by a corporation with no specific asset pledged as security for the loan.

The longest initial maturity for U.S. T-bills is A)13 weeks. B)2 years. C)52 weeks. D)39 weeks.

C)52 weeks. Explanation As money market instruments, the longest initial maturity of Treasury bills (T-bills) is 52 weeks. Those bills are auctioned every four weeks. T-bills of shorter maturities are auctioned weekly. The shortest initial maturity is four weeks.

Which of the following rates of return is used by investment professionals as the risk-free rate? A)Prime rate B)Discount rate C)91-day Treasury bill rate D)Federal funds rate

C)91-day Treasury bill rate Explanation The interest rate used as the basis for a risk-free rate of return is the 91-day Treasury bill rate. T-bills are U.S.-government guaranteed, the rate is short term, and the market risk is minimal.

An investor is analyzing various risks related to corporate and government bonds. She is interested in finding a risk that is more specific to corporate bonds than to government bonds. Which of the following options correctly defines that risk? A)Interest rate risk B)Liquidity risk C)Default risk D)Purchasing power risk

C)Default risk Explanation Default risk is avoided with U.S. government bonds. There is no chance (at least for test purposes) that timely payment of interest and principal will not be made on them. All bonds have interest rate and purchasing power risk. Although it is true that government bonds are generally more liquid than corporate bonds, many corporate bonds are exchange listed. That ensures good liquidity. More important is the test-taking skill. If you have to choose between lack of credit risk and lack of liquidity, it should be clear where the government bond comes out ahead.

All of the following statements regarding Government National Mortgage Association (GNMA) pass-through securities are true except A)investors own an undivided interest in a pool of mortgages. B)investors receive a monthly check representing both interest and a return of principal. C)GNMAs are considered to be the riskiest of the agency issues. D)the minimum initial investment is $1,000.

C)GNMAs are considered to be the riskiest of the agency issues. Explanation GNMA securities, which are backed by the full faith and credit of the U.S. government, are considered to be the safest, not riskiest, of the agency issues. The minimum denomination is $1,000 and payments to investors are made monthly. Because the asset is a pool of mortgages, just like a personal home mortgage, each payment consists of interest and principal.

Which of the following agency securities is guaranteed by the U.S. government? A)Freddie Mac B)Fannie Mae C)Ginnie Mae D)Federal Home Loan Bank

C)Ginnie Mae Explanation Only Ginnie Mae securities are backed by the full faith and credit of the U.S. government. Other agency securities have lines of credit at the Treasury, but this credit does not constitute a full guarantee.

Which of the following is a direct obligation of the U.S. government? A)Government bond mutual funds B)Bank for cooperatives bonds C)Ginnie Maes D)Fannie Maes

C)Ginnie Maes Explanation Ginnie Maes are backed by the full faith and credit of the United States. Other agencies have a moral, but not direct, government backing. Government bond mutual funds are not backed by the U.S. government.

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. A)II and IV B)I and II C)I and III D)III and IV

C)I and III Explanation 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.

Which type of risk is a mortgage-backed security most likely to experience? A)Market risk B)Business C)Reinvestment risk D)Exchange-rate risk

C)Reinvestment risk Explanation A mortgage-backed security, such as a Ginnie Mae, is most likely to experience reinvestment-rate risk. As mortgages are paid off early and refinanced in the event of declining interest rates, the interim cash flows received from the obligation must be reinvested in lower-yielding securities. This is the practical effect of prepayment risk.

GNMA mortgage-backed securities are A)available to investors through a minimum purchase of $5,000. B)backed exclusively by a pool of mortgages. C)a direct obligation of the U.S. government. D)exempt from federal income tax for the interest payments received by the bondholders.

C)a direct obligation of the U.S. government. Explanation GNMA securities are a direct obligation of the U.S. government and are backed by a pool of mortgages (which is why the choice "backed exclusively by a pool of mortgages" is not the best choice). 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 $1,000.

All of the following are true about GNMAs except A)interest on GNMAs is not exempt from state and local taxes. B)they are backed by the U.S. government. C)interest is paid semiannually. D)they provide funds for residential mortgages.

C)interest is paid semiannually. Explanation GMNAs make payments monthly, unlike virtually all other debt securities, which make payments semiannually.

One of the ways in which U.S. government agency issues differ from those offered directly by the U.S. Treasury is that agency issues A)are taxable on the federal level while Treasury issues are not. B)frequently trade on the NYSE while Treasuries never do. C)typically carry higher returns than Treasury issues because of the lack of direct government backing. D)are more likely to be issued in larger amounts.

C)typically carry higher returns than Treasury issues because of the lack of direct government backing. Explanation Agencies, with only a few exceptions (GNMA being one), do not carry the direct backing of the U.S. Treasury. While they are quite safe, that lack of direct backing causes their yields to be somewhat higher. Agencies are never traded on the stock exchanges and their float is almost always smaller than Treasuries. Both are taxable on the federal level.

All of the following debt instruments pay interest semiannually except A)industrial development bonds. B)municipal revenue bonds. C)municipal general obligation bonds. D)Ginnie Mae pass-through certificates.

D)Ginnie Mae pass-through certificates. Explanation Ginnie Maes pay interest monthly, not semiannually.

Securities issued by which of the following agencies offer direct government backing? A)Federal Home Loan Mortgage Corporation (Freddie Mac) B)Federal Intermediate Credit Bank C)Federal National Mortgage Association D)Government National Mortgage Association

D)Government National Mortgage Association Explanation FNMA, FHLMC, and FICB are considered GSEs (government-sponsored enterprises), and although their securities are quite safe, they do not have the direct backing of the Treasury. It is important to remember for the exam that the only security without the word Treasury in its name that is backed by the U.S. government is a GNMA.

A customer asks if there are any debt instruments providing income that might at least keep pace with inflation and offer some tax advantages. What suitable recommendation could be made that would meet the customer's criteria? A)GNMAs B)ADRs C)U.S. T-bills D)TIPS

D)TIPS Explanation Treasury Inflation-Protected Securities (TIPS) are debt instruments specifically designed to provide income that keeps pace with inflation. Issued by the U.S. Treasury, the interest is tax exempt at the state and local levels. Neither GNMAs nor Treasury bills (T-bills) meet all of these criteria, and American depositary receipts (ADRs) are not debt instruments.