S66 Unit 2 Bond Quiz

An investor purchases a Treasury note and the confirmation shows a price of 102.21. Rounded to the nearest cent, the investor's cost, excluding commissions, is A) $1,026.56. B) $1,022.10. C) $1,022.21. D) $102.21.

A) $1,026.56. Explanation Treasury notes are quoted in 32nds, where each 32nd equals $0.3125. The 102 in the quote equals $1,020 and the 21/32 is an additional $6.56, bringing the total to $1,026.56. LO 2.c

If GHI currently has earnings of $3.00 and pays an annual dividend of $1.75 and GHI's market price is $35, the current yield is A) 5.00%. B) 1.75% C) 8.60%. D) 3.00%.

A) 5.00%. Explanation The current yield is calculated by dividing the annual dividend by the current market value ($1.75 ÷ $35.00 = 5%). LO 2.e

Which of the following indicates a bond selling at a premium? A) 8% coupon yielding 7.5% B) 10% coupon yielding 11.0% C) 5% coupon yielding 5.0% D) 8% coupon yielding 8.5%

A) 8% coupon yielding 7.5% Explanation Whenever the yield is less than the coupon, the bond is selling at a premium over the par value. In our question, the coupon or nominal rate is 8%, but the bond is selling at a price that makes its current yield 7.5%. That happens only when the investor pays more than par (face) value, a premium, for the bond. LO 2.e

High-yield bonds are frequently called junk bonds. Which of the following expresses the highest rating that would apply to a junk bond? A) BB B) CCC C) BBB D) CC

A) BB Explanation Investment-grade bonds run from a highest Standard and Poor's rating of AAA (Aaa for Moody's) down to BBB (Baa for Moody's). When the rating gets to BB (or Ba), the bond is considered high yield, or a junk bond. LO 2.b

ABC's stock has paid a regular dividend every quarter for the past several years. If the price of the stock has remained the same over the past year but the dividend amount per share has increased, it may be concluded that ABC's A) current yield per share has been unaffected. B) yield to maturity has gone up. C) current yield per share has increased. D) current yield per share has decreased.

C) current yield per share has increased. Explanation The current yield would have increased because current yield is the income (dividend) divided by price. A higher dividend divided by the same price results in a higher yield. Stocks do not have a yield to maturity. LO 2.e

An investor is trying to decide whether to purchase $10,000 face amount of a U.S. Treasury bond or a highly rated corporate bond. The price of the Treasury bond is 102.20 while the price of the corporate bond is 99 3/8. If the investor decides to purchase the Treasuries, disregarding commissions, the price difference is A) $325.00. B) $32.50. C) $282.50. D) $28.25.

A) $325.00. Explanation The first step is remembering that Treasuries are quoted in 32nds. That means that 102.20 is 102 and 20/32 which is 102 5/8. Subtract 99 3/8 from 102 5/8 to get 3 2/8 or 3 1/4. On a $1,000 bond, that is $32.50. Then, note that this investor is purchasing 10 bonds, so the difference in price is $32.50 times 10 or $325. LO 2.c

ABC Corporation's 5% mortgage bond is currently trading at a premium. The bond is callable at par in 10 years and matures in 15 years. When comparing the returns available to an investor, it would be accurate to state A) the yield to maturity is higher than the yield to call. B) the current yield is higher than the nominal yield. C) the yield to maturity is higher than the current yield. D) the yield to call is higher than the current yield.

A) the yield to maturity is higher than the yield to call. Explanation Whenever a bond is selling at a premium, the return—in descending order—is nominal yield, current yield, YTM, and YTC. It is the reverse order when the bond is selling at a discount. When the bond is at par, all are the same (if the call is at par). LO 2.e

An investor buys 10M RAN 6.6s of 32 at 67. What is the total purchase price? A) $10,000 B) $6,600 C) $6,700 D) $10,200

C) $6,700 Explanation For those of you not familiar with bond listings, this means that the investor 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. LO 2.c

An investor buys 10M 6.6s of 10 at 67. The investor will receive annual interest of A) $670. B) $820. C) $660. D) $1,000.

C) $660. Explanation Interpret "10M" as "$10,000 worth of." The investor receives the nominal yield of the bonds, which is 6.6% of $10,000. The M is from the roman numeral for 1,000. LO 2.e

Which of the following are characteristics of negotiable jumbo CDs? I) Issued in amounts of $100,000 to $1 million or more II) Typically pay interest on a monthly basis III)Always mature in one to two years with a prepayment penalty for early withdrawal IV) Trade in the secondary market A) I and III B) II and IV C) I and IV D) II and III

C) I and IV Explanation Negotiable jumbo CDs are issued for $100,000 to $1 million or more 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 semiannual basis, not monthly. LO 2.f

GHI currently has earnings of $4.00 and pays a $0.50 quarterly dividend. If GHI's market price is $40.00, the current yield is A) 10.00%. B) 1.25%. C) 15.00%. D) 5.00%.

D) 5.00%. Explanation The quarterly dividend is $0.50, so the annual dividend is $2.00; $2 ÷ $40 market price = 5% current yield. LO 2.e

Which of the following expressions describes the current yield of a bond? A) Yield to maturity divided by par value B) Annual interest payment divided by par value C) Yield to maturity divided by current market price D) Annual interest payment divided by current market price

D) Annual interest payment divided by current market price Explanation The current yield on a bond is calculated by dividing the annual interest payment by the current market price of the bond. LO 2.e

Which of the following are characteristics of commercial paper? I) Backed by money market deposits II) Negotiated maturities and yields III) Issued by insurance companies IV) Not registered with the SEC A) I and II B) III and IV C) I and III D) II and IV

D) II and IV Explanation Commercial paper represents the unsecured debt obligations of corporations needing short-term financing. Most commercial paper is sold to institutions, and the borrower and lender negotiate the terms. Those terms include the interest rate (the yield because they're discounted) and whether these are overnight, 30-day, or longer maturities. Because commercial paper is issued with maturities of no more than 270 days, it is exempt from registration under the Securities Act of 1933. LO 2.f

With respect to safety of principal, of the following investments, the least risky is A) common stock. B) corporate AA debentures. C) equity options. D) exchange-listed warrants.

B) corporate AA debentures. Explanation The least risky investment listed is the corporate debenture because, as a debt instrument, it has priority over the others. LO 2.b

A bond with a par value of $1,000 and a coupon rate of 8% paid semiannually is currently selling for $1,150. The bond is callable in 10 years at $1,100. In the computation of the bond's yield to call, which of these would be a factor? A) Future value of $1,150 B) 60 payment periods C) Present value of $1,100 D) Interest payments of $40

D) Interest payments of $40 Explanation The YTC computation involves knowing the amount of interest payments to be received, the length of time to the call, the current price, and the call price. A bond with an 8% coupon will make $40 semiannual interest payments. With a 10-year call, there are only 20 payment periods, not 60. The present value is $1,150 and the future value is $1,100, the reverse of the numbers indicated in the answer choices. LO 2.e

YZ Corporation's A-rated convertible debenture is currently selling for 90. If the bond's conversion price is $40, what is the parity price of the stock? A) $40.00 per share B) $36.00 per share C) $22.50 per share D) $44.00 per share

B) $36.00 per share Explanation If the bond's conversion price is $40, it means the bond is convertible into 25 shares ($1,000 par value divided by the $40 conversion price). Parity means equal, so what does each share have to be worth so that 25 of them are equal to $900? Remember, bonds are quoted as a percentage of the $1,000 par value, so a price of 90 means $900. Dividing $900 by 25 shares results in a parity price of $36. That does not mean the stock is selling for $36 per share (probably a bit less), but at $36, holding the bond, or converting into the stock, gives the investor equal value. Some students quickly see that the bond is 10% below its par value, so the stock—to be equal—must be 10% below the conversion price. Take 10% off $40 and the result is $36. Either way works. LO 2.d

Which of the following are characteristics of commercial paper? I) It represents a loan by the holder to the issuer. II) It is a certificate of ownership in the corporation. III) It is commonly issued to raise working capital for a corporation. IV) It is junior in preference to convertible preferred stock. A) I and IV B) I and III C) II and IV D) II and III

B) I and III Explanation 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. LO 2.f

Regardless of the nature of the issuer, one thing an investor in debt securities can expect is A) priority in payout second only to stock with a prior lien. B) physical coupons that are clipped every six months for interest payments. C) an interest rate that varies with changes to market interest rates. D) a stated maturity date.

D) a stated maturity date. Explanation It would be very rare to find a debt security without a stated date indicating when the debt will be paid off (the maturity date). In the majority of cases, debt securities have a fixed interest rate (which is why they are called fixed-income securities). There are some with variable rates, but the question would have to indicate that exception. No stock of any kind has priority over a debt security. Prior to 1986, you would have physical coupons on the bond, but none of them have been issued since then. LO 2.a

The current yield of a callable bond selling at a premium is calculated A) as a percentage of its par value. B) as a percentage of its call price. C) to its maturity date. D) as a percentage of its market value.

D) as a percentage of its market value. Explanation Current yield for any security is always computed on the basis of the current market value. LO 2.e

An agent is discussing a specific bond that would be a good addition to the client's portfolio. The client comments that the nominal yield is lower than its current yield. The agent would explain that the bond is A) a high-yield bond B) selling at a premium C) issued by an unseasoned company, and the market hasn't yet realized how well secured the debt is D) selling at discount

D) selling at discount Explanation Anytime the current yield on a bond is higher than its nominal or coupon rate, the bond must be selling at a discount. LO 2.e

Which of the following statements regarding credit risk is not true? A) Credit risk is the probability of the issuer defaulting on their payment obligations. B) An A-rated mortgage bond has less credit risk than a AA rated debenture. C) A rating downgrade may or may not result in a lower market price for a bond. D) Credit risk can be assessed by referring to the independent credit rating agencies.

B) An A-rated mortgage bond has less credit risk than a AA rated debenture. Explanation The rating agencies split bonds into two distinct classes: investment grade and noninvestment grade. The highest investment-grade rating is AAA (Aaa) and the lowest is BBB (Baa). The more As the bond has, the lower the credit risk. That is why the AA debenture has less credit risk than the A-rated mortgage bond. The rating agencies take into consideration any collateral, such as a mortgage, when giving the rating. LO 2.b

ERP 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 above $30 per share. B) somewhat above $48 per share. C) somewhat below $48 per share. D) somewhat below $30 per share.

C) somewhat below $48 per share. Explanation 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. Because 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. LO 2.d

One year ago, ABC Widgets, Inc., funded an expansion to its manufacturing facilities by issuing a 20-year first mortgage bond. The bond is secured by the new building and land and is callable at par 15 years after the issue date. The bond was issued with a 5.5% coupon and is currently rated Aa. If the current market price of the bond is 105, A) the nominal yield is lower than the current yield. B) the yield to call is higher than the current yield. C) the yield to call is lower than the yield to maturity. D) the yield to maturity is higher than the current yield.

C) the yield to call is lower than the yield to maturity. Explanation When a bond is selling at a premium (105 means 105% of $1,000, or $1,050), the order—from highest to lowest yield—is nominal (coupon) yield, current yield, YTM, and YTC. If the bond is callable at a premium, the order could be changed, but it is highly unlikely that the exam will present that situation in a question. LO 2.e

An investor purchased a bond with a 6% coupon rate exactly three months after its most recent interest payment. As a result, I) the buyer will pay $15 accrued interest. II) the buyer will receive $15 accrued interest. III) the seller will pay $15 accrued interest. IV) the seller will receive $15 accrued interest. A) II and III B) I and IV C) II and IV D) I and III

B) I and IV Explanation First of all, a 6% bond pays $30 semiannually (half of $60 per year). Therefore, the accrued interest on this bond purchased halfway between interest payments is half of $30 or $15. That $15 dollars is added to the purchaser's cost and will be paid to the seller as it represents the interest the seller earned for holding the bond for three months. At the next interest payment date, the purchaser will receive the full $30 payment representing the accrued interest paid to the seller plus the interest earned for the three months the purchaser held the bond. LO 2.a

A corporation issued a bond with a coupon of 6%, callable at 103. The bond matures in 2059. Current interest rates are 8%. It is most likely that A) the coupon will be increased. B) the bond will be called. C) the bond will go into default. D) the bond is selling at a discount.

D) the bond is selling at a discount. Explanation There is excess information in this question (a favorite trick of the test authors). We don't need to know the call price or the maturity date. We have a 6% bond when current market interest rates are 8%. The inverse relationship between interest rates and bond prices teaches us that this bond is going to be selling at a discount. Bonds are called when interest rates go down, not when they rise. The coupon on a bond is fixed. LO 2.e

The value of which of the following would be least likely to be impacted by changes in interest rates? A) A U.S. Treasury bond issued 25 years ago with a 30-year maturity B) A bank CD maturing in 5 years C) A convertible preferred stock D) A laddered bond portfolio

B) A bank CD maturing in 5 years Explanation This question is dealing with interest rate (or money-rate) risk. That risk refers to the inverse relationship between the price of fixed-income investments and interest rates. That is, when interest rates go up, the price of fixed-income securities falls (and vice versa). However, this risk only affects investments that are marketable (those with a fluctuating market price). Bank CDs are nonnegotiable (we're not referring to the negotiable jumbo CDs with a maturity of one year or less) and, as a result, will not fluctuate in price, regardless of changes to interest rates. In this case, interest rate risk is eliminated. That is one of the reasons why the exam's first choice for capital preservation is insured bank CDs. Will a laddered bond portfolio reduce interest rate risk? Yes, but it will not eliminate it. Is a convertible preferred (or bond) less subject to changes in interest rates than one without the conversion feature? Yes, but the risk is still there. Does a 30-year T-bond with 5 years remaining to maturity have a short duration and, therefore, a reduced interest rate risk? Yes, but the price of the bond will still be affected by changes in the market interest rates. LO 2.f

A European corporation seeking a short-term loan would probably be most concerned about an increase to A) the Fed funds rate. B) the eurobond rate. C) the SOFR. D) the U.S. Treasury bill rate.

C) the SOFR. Explanation For more than 40 years, the London Interbank Offered Rate—commonly known as LIBOR—was a key benchmark for setting the interest rates charged on adjustable-rate loans, mortgages, and corporate debt. Over the last decade, LIBOR has been burdened by scandals and crises. Effective January 2022, LIBOR is no longer being used to issue new short-term loans in the U.S. It was replaced by the Secured Overnight Financing Rate (SOFR) which many experts consider a more accurate and more secure pricing benchmark. As is always the case with NASAA, we do not know when the exam questions will be updated. One thing we can promise you is that any question relating to this topic will not have both LIBOR and SOFR as choices, so you should choose whichever one appears. LO 2.f