Series 65: Unit 2 Quiz 1

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 market value of corporate bonds selling at a premium and yielding 6% to maturity C. $100,000 of zero-coupon bonds with a yield to maturity of 6% D. $100,000 AA rated corporate bonds trading at par with a 6% coupon rate

$100k market value of corporate bonds selling at a premium and yielding 6% to maturity When you read the full question, including the answer choices, you can immediately disregard two of the four options. With $100,000 to invest, the answer cannot be to purchase $200,000 of anything. Maximizing current income excludes zero-coupon bonds because there is no current income. Now, to the correct choice. Why does a bond sell at a premium over par? Although there are exceptions, primarily it is because the coupon rate on that bond is higher than the current market interest rate. Therefore, with a higher coupon rate, the current income on the same amount of principal invested ($100,000 in our question) will always be higher for a bond selling at a premium. That is the KISS (Keep It Simple Student) answer. For those who want to delve further, here we go. For example, if current market interest rates are 6% (likely the case here because the AA rated bonds with a 6% coupon are trading at par), t

A client approaches the investment adviser representative handling the advisory account with a request to find a preferred stock that will offer a 6% income return. The investment adviser representative suggests a stock paying a $0.28 quarterly dividend. That stock will exactly meet the income objective if it has a current market price of A. $6.72. B. $4.67. C. $11.91. D. $18.67.

$18.67 The first thing to do is annualize the dividend by multiplying the $0.28 by 4. Once we have the annual dividend of $1.12, divide by 6% and the result is $18.6666, or $18.67 properly rounded. If you left your math skills at home, all you have to do is multiply each of the choices by 6% to see which one is closest to $1.12.

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

A debenture

The price of which of the following will fluctuate most with a change in interest rates? A. Short-term bonds B. Long-term bonds C. Common stock D. Money market instruments

Long-term bonds

The minimum face amount of a negotiable CD is A. $10,000. B. $50,000. C. $100,000. D. $25,000.

$100k Negotiable CDs are issued in the minimum face amount of $100,000. These are called jumbo CDs and are usually traded in blocks of $1 million or more

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. $28.25. B. $325.00. C. $32.50. D. $282.50.

$325

BFJ Corp.'s 5% convertible bond is trading at 120. The bond is convertible at $50. An investor buying the bond now and immediately converting into common stock would receive A. 2.4 shares. B. 20 shares. C. 24 shares. D. 20 shares plus cash for fractional shares.

20 shares ($1,000/ $50)

A client in the 30% tax bracket owns a 5% XYZ, Inc., debenture due to mature shortly. What yield in a municipal bond will result in the same after-tax return that now exists has with the debenture? A. 5.3% B. 2.0% C. 3.5% D. 1.5%

3.5% 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.

Your client in the 28% federal income tax bracket currently owns some U.S. government bonds with a coupon yield of 6%. In order to receive the same income after taxes, she would need to buy municipal bonds with a coupon of A. 6.00%. B. 4.32%. C. 1.68%. D. 7.68%.

4.32% Because the 6% on the government bond is fully taxable on a federal basis, the client receives a net of 4.32% ($60 per bond less 28% in taxes [$16.80], or $43.20 per year). Interest on municipal bonds is tax free, so a 4.32% coupon will result in the same amount of after-tax income.

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. 5%. B. not determinable from the information given. C. 2%. D. 10%.

5% 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%.

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%.

5% The current yield is calculated by dividing the annual dividend by the current market value ($1.75 ÷ $35.00 = 5%).

Although bonds are issued by many different entities, most of their features are the same. With few exceptions, included in that list of similarities would be all of these except A. a stated interest date. B. a stated maturity date. C. safety of principal. D. price movement that is inverse to interest rates.

A safety of principal

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

A bank CD maturing in 5 yrs 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 th

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

A stated maturity date 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.

In the event of a company's insolvency, which of the following has first claim on assets? A. Members of the board of directors B. Common stockholders C. Preferred stockholders D. Bondholders

Bondholders Bondholders have contractual rights to the assets of a business that must be honored on insolvency before claims of stockholders or directors.

A customer bought a 10-year 6% AAA bond at par when it was issued. Two years later, if the CPI has increased from 2% to 4%, the price of the bond most likely A. cannot be determined. B. has declined. C. has stayed at par. D. has increased.

Has declined When inflation is on the rise, interest rates often rise. When interest rates increase, bond prices may be expected to decline.

A bond with a par value of $1,000 and a coupon rate of 5%, paid semiannually, is currently selling for $1,200. The bond matures in 10 years and is callable in six years at 103. In the computation of the bond's yield to call, which of the following would be a factor? A. Interest payments of $25 B. 20 payment periods C. Future value of $1,200 D. Present value of $1,030

Interest payments of $25

Which of the following usually does not pay interest semiannually? A. Public utility bond B. Treasury note C. Treasury bond D. GNMA

GNMA GNMA pass-through certificates pay principal and the interest monthly. All other choices usually pay interest semiannually.

A bond with a par value of $1,000 and a nominal yield of 6% paid semiannually is currently selling for $1,300. The bond matures in 25 years and is callable in 15 years at $1,080. In the computation of the bond's yield to call, which of these would be a factor? A. Future value of $1,300 B. Interest payments of $30 C. Present value of $1,080 D. 50 payment periods

Interest payments of $30 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. With a 15-year call, there are only 30 semiannual interest payment periods, not 50. The present value is $1,300 and the future value is $1,080, the reverse of the numbers indicated in the answer choices.

A money market mutual fund would be least likely to invest in which of the following assets? A. Newly issued ​U.S. Treasury notes B. Repurchase agreements C. Jumbo CDs D. Newly issued ​U.S. Treasury bills

Newly issued U.S. Treasury notes A money market mutual fund typically invests in money market instruments—those with a maturity date not exceeding 397 days. Treasury notes are issued with maturity dates of 2-10 years.

Bond prices are quoted as a percentage of A. par value. B. market value. C. conversion value. D. stated value.

Par value Bond prices are quoted as a percentage of par value. On the exam, the par value of bonds is always $1,000.

Which of the following debt instruments does not make periodic interest payments? A. TIPS B. T-bonds C. T-bills D. T-notes

T-bills Treasury bills are always issued at a discount from their face value. At maturity, the investor receives the face value. The other choices pay interest semiannually. What makes TIPS different from the others is that the principal adjusts for inflation every six months. That means the fixed interest rate is paid on a varying principal.

In order to compute yield to maturity, all of the following are necessary except A. the maturity date. B. the nominal yield. C. the call price. D. the current market price.

The call price Computing the yield to maturity (YTM) does not require the call price or call date—that is necessary to compute the yield to call (YTC). We do need to know the current market price, the coupon (nominal yield), and the maturity date.

A customer purchased new issue bonds at par two years ago. Since then, the cost of living as measured by the consumer price index (CPI) has declined by almost half and the current yield on the bonds has also declined. Which of the following best describes the value of the bonds purchased? A. Their market price has increased. B. Their market price has remained unchanged. C. Their market price has declined. D. It cannot be determined from the information presented.

Their market price has increased The annual coupon interest payment on the bonds has not changed, but the current yield has. If the yield has decreased, it means the market price of the bonds must have increased. For example, if the bond has a 5% coupon but the current yield is now 4%, the bond's price must be 125 ($1,250) because $50 annual interest on $1,250 is a current return of 4%. Remember the inverse relationship: if interest rates decline, bond price rise (and vice versa).

Of the following securities, which is most commonly recommended to fund a child's college education? A. Treasury bills B. Zero-coupon Treasury bonds C. Investment-grade corporate bonds D. Municipal bonds

Zero-coupon Treasury bonds Zero-coupon bonds, particularly those carrying the guarantee of the U.S. Treasury, are a favored investment vehicle for saving for a child's higher education. They have the advantage of providing a certain, quantifiable sum at a certain date in the future.

A bond selling for $20 above par would be quoted A. 120. B. 1,020. C. 1,200. D. 102.

102 Bonds are quoted in percentages of $1,000 (par) (1% of $1,000 = $10). The proper quote would be 102; 102 is 102% of $1,000.

GHI common stock has a $10 par value and is selling in the market for $60 per share. If the current quarterly dividend is $1, the current yield is A. 10%. B. 1%. C. 1.7%. D. 6.7%.

6.7% 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 two of the following investments would offer your clients the best chance of minimizing inflation risk? 1. Common stock 2. Callable preferred stock 3. Money market mutual funds 4. TIPS

Common stock and TIPS 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.

When an income-oriented investor wishes to compute the current yield of a specific investment, which one of these items would not be considered? A. Dividends paid B. Current market price C. Interest coupon D. Net present value

Net present value The current yield of any investment is the income return (dividends on equity; interest on debt) divided by the current market price. The NPV is a tool that evaluates the reasonableness of the price of an investment.

When referring to municipal bonds, the formula of (1 − tax bracket) is found in the computation of A. yield to maturity. B. return on investment. C. current yield. D. tax-equivalent yield.

Tax-equivalent yield

The bond document that states the issuer's obligation to pay the investor a specific rate of interest for the use of the funds as well as any collateral pledged as security for the loan and all other pertinent details might be referred to by all of these terms except A. the bond contract. B. the deed of trust. C. the debenture. D. the indenture.

The debenture

Which of the following statements is true if a corporate bond is callable? A. The owner of the bond may demand that the issuing corporation redeem the bond before it matures. B. The owner of the bond may exchange it for shares of stock. C. The issuing corporation may change the coupon rate at any time by giving the owner of the bond written notice. D. The issuing corporation has the option to redeem the bond before it matures.

The issuing corporation has the option to redeem the bond before it matures A callable bond is one that may be redeemed by the issuing corporation before it matures. One reason a corporation might call a bond is to sell new bonds with a lower interest rate.

A municipal bond has a coupon of 6.25%, and at the present time, its yield to maturity is 6.75%. From this information, it can be determined that the municipal bond is trading A. at a discount. B. flat. C. at par. D. at a premium.

At a discount The YTM is greater than the nominal yield, or coupon yield. Therefore, the bond is trading at a discount.

During the past year, the market price of Kapco common stock has increased from $47 to $50 per share. Over that period, Kapco's earnings per share (EPS) have increased from $2.00 to $2.50 per share, and their dividend payout ratio has decreased from 50% to 40%. Based on this information, the current yield on Kapco common stock is A. 2.13%. B. 2.00%. C. 6.34%. D. 4.26%.

2% The current yield on a stock is computed by dividing the annual dividend rate by the current market price. With EPS of $2.50 and a 40% payout ratio (multiply them), the annual dividend is $1.00. This dollar divided by the current market price of $50.00 results in a current return of 2%.

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

52 weeks 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.

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. 7% Ba rated corporate bond C. 5% U.S. Treasury bond D. 6% FDIC-insured CD

7% Ba rated corporate bond 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. Because 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.

Which of the following indicates a bond selling at a discount? A. 10% coupon yielding 9% B. 5% coupon yielding 5% C. 7% coupon yielding 6.5% D. 7% coupon yielding 7.5%

7% coupon yielding 7.5% Whenever the yield is higher than the coupon, the bond is selling at a discount from the par value. When the question says "yielding," it is generally referring to the yield to maturity. However, whether referring to the YTM or the current yield, the answer here is the same: the yield is higher than the coupon.

Which of the following investments would provide the highest after-tax income to your client in the 35% federal income tax bracket? A. 8% debenture issued by the LMN Corporation B. 6% U.S. Treasury bond C. 7% bond issued by Canadian Province M D. 5% general obligation municipal bond issued by State H

8% debenture issued by the LMN Corporation Only the State H bond is exempt from federal income tax. Using the tax-equivalent yield formula of the muni coupon divided by (100% minus the investor's tax bracket %), we get 5% divided by 65%, or 7.7%. That's a better deal than receiving 6% on the Treasury and paying taxes as well as 7% on the Canadian bond (although you learned that securities issued by Canadian provinces were exempt from registration under the Uniform Securities Act, that has nothing to do with U.S. income taxes). However, with a TEY of 7.7%, your client would take home more with the 8% taxable corporate security. You can also work backward to get the correct answer. Simply subtract 35% tax from each of the choices (other than the muni) and see which is the highest. In this case, 8% minus a 35% tax equals 5.2%—just a bit higher than the 5% coupon on the municipal bond.

Mitch purchased a 30-year bond for 97¾ with a stated coupon rate of 8.5%. What is the approximate yield to maturity for this investment if Mitch receives semiannual coupon payments and expects to hold the bond to maturity? A. 8.67% B. 4.36% C. 8.50% D. 5.68%

8.67% No calculation is necessary here. Why not? Because anytime a bond is purchased at a discount from par (97¾% is a discount), the YTM must be greater than the nominal (coupon) rate. There is only one choice greater than 8.5%. It isn't about your computational skills; it is about your understanding of the relationship between prices and yields.

Which of the following best describes a Yankee bond? A. A U.S. dollar-denominated bond issued by a U.S. entity outside the United States B. A U.S. dollar-denominated bond issued by a non-U.S. entity inside the United States C. A U.S. dollar-denominated bond issued by a U.S. entity inside the United States D. A U.S. dollar-denominated bond issued by a non-U.S. entity outside the United States

A U.S. dollar-denominated bond issued by a non-U.S. entity inside the United States Yankee bonds are issued by non-U.S. entities in marketplaces inside the United States. The bonds are issued in U.S. dollars, meaning these foreign issuers will have currency risk if the dollar drops in value against their local currency.

A bond, preferred stock, or debenture exchangeable at the option of the holder (for common stock of the issuing corporation) is A. a synthetic security. B. a nondilutive stock. C. a convertible security. D. a collateral-backed equity security.

A convertible security A bond, preferred stock, or debenture exchangeable at the option of the holder for common stock of the issuing corporation is a convertible security.

GNMA mortgage-backed securities are A. backed exclusively by a pool of mortgages. B. a direct obligation of the U.S. government. 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.

A direct obligation of the U.S. government 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.

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. common stock. C. a debenture. D. preferred stock.

A mortgage bond 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.

One of the likely consequences of a rating downgrade on a bond is A. the current yield will be reduced. B. an increase to the coupon by the issuer. C. a reduction in the market price of the bond. D. the call feature will be employed.

A reduction in the market price of the bond If the rating agencies downgrade the quality of a bond, potential investors will look to compensate for the increased risk by demanding a greater yield on the issuer's bonds. This will inevitably result in a lower bond price. A change in rating is unlikely to lead to a call. In fact, with the reduction in the market price, the bond may be selling below par, giving the issuer the opportunity to retire the debt at a discount. Bonds are fixed-income securities because the coupon rate is fixed when the bond is issued and does not change.

Many fixed-income investors are looking to avoid loss of principal. Which of the following would likely have the lowest degree of exposure to credit risk? A. A-rated general obligation municipal bond B. Ba-rated corporate mortgage bond C. Baa-rated municipal revenue bond D. Aa-rated corporate debenture

Aa-rated corporate debenture A bond's rating takes into consideration all factors, including collateral and tax base. The higher the rating, the lower the credit risk.

DERP Corporation has issued 5% convertible debentures maturing in 2040. The conversion price is $40 and the common is currently trading at $48 per share. One would expect the DERP debentures to be selling somewhat A. below $1,200. B. above $1,200. C. above $1,000. D. below $1,000.

Above $1,200 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 $48 per share, the parity price of the convertible would be $1,200 (25 × $48). Because convertible securities generally sell at a slight premium over their parity price, the debentures should have a current market value a bit higher than $1,200.

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. Credit risk can be assessed by referring to the independent credit rating agencies. D. A rating downgrade may or may not result in a lower market price for a bond.

An A-rated mortgage bond has less credit risk than a AA rated debenture 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.

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

As a percentage of its market value Current yield for any security is always computed on the basis of the current market value.

A company has two outstanding bond issues, both with a coupon rate of 10%. Bond A will mature in 3 years while Bond B will mature in 20 years. If interest rates were to decrease to 8%, which of the following statements is correct? A. Both bonds will be selling at a discount. B. Bond B will be selling at a greater discount than Bond A. C. The issuer will attempt to call in Bond A. D. Bond B will be selling at a greater premium than Bond A.

Bond B will be selling at a greater premium than Bond A When interest rates go down, bond prices will go up. As far as which bond will sell at the higher premium using the discounted cash flow method, it is clear that the bond with the longer duration will be worth more.

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? 1. Bought it at a discount 2. Bought it at a premium 3. Sold it at a discount 4. Sold it at a premium

Bought it at a discount and sold it at a premium 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.

When it comes to issuing a debt security, which of the following features will generally enable the issuing corporation to borrow at the lowest interest rate? A. Convertible B. Zero-coupon C. Cumulative D. Callable

Convertible Because the convertible feature offers potential growth through the exercise of the conversion option, the interest rate on these securities is generally lower than other debt issues of the same corporation. The call feature increases the reinvestment risk and that is compensated for with a higher coupon. The descriptive adjective cumulative refers to dividend payments on preferred stock but not to bonds. Because zero-coupon bonds pay nothing until maturity, that added risk requires a higher yield to attract investors.

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

Monthly 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.

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. Senior notes B. Mortgage bonds C. Common stock D. Debentures

Debentures 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.

Corporate long-term debt securities that are issued on the general credit of the issuer and are not otherwise secured are called A. general obligation bonds. B. debentures. C. preferred stock. D. prior lien bonds.

Debentures Debentures are corporate long-term debt securities issued on the general credit of the corporation and are not backed by any specific assets. The term prior lien means there is a secured claim against a specific asset. Preferred stock is not a debt security, and general obligation bonds are municipal, not corporate, securities.

A corporation is likely to call eligible debt when interest rates are A. rising. B. stable. C. volatile. D. declining.

Declining A corporation generally calls in its debt when interest rates are declining, in order to replace old, higher interest rate debt with new, lower interest rate issues.

An investor is considering the purchase of $100,000 maturity value of zero-coupon AAA rated corporate bonds scheduled to mature in 20 years. Which of these are among the risks that this investor will be assuming? 1. Default risk 2. Interest rate risk 3. Prepayment risk 4. Reinvestment risk

Default and interest rate risk Even though these bonds are rated AAA, 20 years is a long time and it is possible that this corporation may not even exist when the maturity date arrives. Adding to the risk is the fact that there are no interest payments in the interim. That is why the most commonly recommended zero-coupon bonds are those issued or guaranteed by the U.S. Treasury. Because zero-coupon bonds have the longest duration for their maturity of any bonds, they have the greatest exposure to interest rate changes. Prepayment risk is only found with mortgage-backed securities, and one of the benefits of zeroes is that there is no reinvestment risk.

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. Liquidity risk B. Interest rate risk C. Purchasing power risk D. Default risk

Default risk 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.

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

Government National Mortgage Association 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.

For a bond selling at a discount, the yield to maturity will be A. higher than the yield to call. B. equal to the nominal yield. C. higher than the nominal yield. D. lower than the nominal yield.

Higher than the nominal yield Yield to maturity is a measure of the total return on a long-term bond, including capital appreciation and interest, while nominal yield measures the interest rate stated on the face of the bond. An investor who buys a $1,000 bond at a discount (for less than $1,000) will receive the interest payments on the bond at the nominal rate and will still receive $1,000 for the bond when it matures. As a result, the total return will be higher than the nominal yield. When a bond is selling at a discount, the YTC will always be higher than the YTM.

An advantage of being a bondholder compared with owning common stock in the same corporation is that A. income payments are more reliable. B. common stock has priority over the bond in the event of liquidation. C. there is limited liability. D. the bondholder can select the optimum time to have the issuer redeem the bond.

Income payments are more reliable Even though bond interest is semiannual, while dividends are typically paid quarterly, the payment of interest is an obligation that comes ahead of the payment of any dividend. Companies can elect to skip or reduce their dividends but not their interest payments.

An individual purchases a $10,000 CD with a 5-year maturity from her local bank branch. In doing so, she is eliminating A. opportunity cost. B. inflation risk. C. interest rate risk. D. purchasing power risk.

Interest rate risk Interest rate risk is the uncertainty that changes to market interest rates will cause the price of an investment to fluctuate in value. Because this type of bank CD is nonnegotiable (it doesn't trade), changes to interest rates do not impact the principal value of the investment—she can always redeem the CD for $10,000 (although there could be a penalty for early withdrawal). As a fixed-income investment, though, it does suffer from purchasing power risk, also known as inflation risk, and the investor has the opportunity cost of settling for a lower rate of return than could potentially be obtained with equities.

Partners with the United States in the creation of Brady bonds were which of these? 1. International Monetary Fund (IMF) 2. Import/Export Bank 3. United Nations 4. World Bank

International Monetary Fund (IMF) and World Bank Joining the United States in creating Brady bonds were the IMF and the World Bank.

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

Investors are paying more for T-bills

When an investor notices that a bond's coupon yield is lower than its current yield, this is an indication that the bond A. is selling at a premium. B. is in danger of going into default. C. is nearing its maturity date. D. is selling at a discount.

Is selling at a discount

Which of the following are characteristics of commercial paper? 1. It represents a loan by the holder to the issuer. 2. It is a certificate of ownership in the corporation. 3. It is commonly issued to raise working capital for a corporation. 4. It is junior in preference to convertible preferred stock.

It represents a loan by the holder to the issuer and it is commonly issued to raise working capital for a corporation 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.

If a resident of New York City purchases an Albany, New York, general obligation bond that yields $600 of interest during the course of the year, how is the interest taxed? A. It is subject to federal income tax at ordinary rates. B. It is subject to state income tax at ordinary rates. C. Taxation is deferred until the bond matures. D. It is not subject to federal income tax.

It's not subject to federal income tax

A bond is selling at a premium over par value. Therefore, A. none of these are correct. B. its current yield is less than its nominal yield. C. its nominal yield is less than its current yield. D. its yield to maturity is greater than its current yield.

Its current yield is less than its nominal yield Any bond selling at a premium will yield less than the coupon rate (nominal yield). Conversely, of course, a bond trading at a discount will certainly yield more. Remember, there is an inverse relationship between bond prices and bond yields.

A client plans to purchase a home within the next three months and will require $100,000 for the down payment. The client has the money in her DDA and asks you for your recommendation as to the best place to put the money. Your recommendation would probably be for the client to A. purchase a GNMA for the monthly income. B. use the money to buy IPOs until the home is purchased. C. move the money into a 1-year CD. D. keep the money where it is.

Keep the money where it is DDA stands for demand deposit account, usually a checking account at a bank. Because this client cannot afford any risk to principal, and the bank account is covered by FDIC insurance, this is the most attractive option. The 1-year CD would offer more income, but there would likely be a penalty for early withdrawal. Even though the GNMA is directly backed by the U.S. government, it is subject to market fluctuation, a risk this client cannot take.

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. divide 0.08 by 0.72. B. multiply 0.08 by 0.72. C. multiply 0.08 by 0.28. D. divide 0.08 by 0.28.

Multiply .08 by .72 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% (.28), so the complement is 100% - 28% (1.00 - .28) = .72.

Which of the following statements about municipal bonds is not true? A. Municipal bonds are generally considered riskier than corporate bonds. B. Municipal bonds generally carry lower coupon rates than corporate bonds of the same quality. C. Municipal bonds are bonds issued by governmental units at levels other than the federal. D. The interest on municipal bonds is usually not subject to federal income tax.

Municipal bonds are generally considered riskier than corporate bonds Municipal bonds are generally considered second only to Treasury instruments in relative safety.

Which of the following are characteristics of commercial paper? 1. Backed by money market deposits 2. Negotiated maturities and yields 3. Issued by insurance companies 4. Not registered with the SEC

Negotiated maturities and yields and not registered w/ the SEC 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.

Issuing callable bonds is advantageous to the issuer because it allows the company to A. issue fixed-income securities at a yield lower than usual. B. replace a high, fixed-rate issue with a lower issue after the call date. C. take advantage of high interest rates. D. call in the bonds at less than par value and capture the difference as income.

Replace a high, fixed-rate issue w/ a lower issue after the call date Callable bonds allow the company to take advantage of reduced interest rates by calling in high bonds with high interest rates and replacing them with lower ones. The marketplace requires that the company pay a higher coupon rate on callable bonds compared to ones that are not callable. This compensates the investor for taking the risk of a future call. The call price would never be less than the par value.

Which of the following should be considered a liquid asset for emergency fund purposes? A. Stock mutual funds B. Savings account C. A personal residence D. Life insurance cash values

Savings account A savings account can be accessed immediately if funds are needed right now. The redemption period for mutual funds is seven days. That is quick but not same day as the savings account is. Another factor is that there could be a redemption or back-end load to cash in the fund shares, while there is no fee to draw on a savings account. Life insurance cash values can take 30 days or longer, and selling a house is not the way to meet an emergency. LO 2.k

Which of the following best describes the liquidation order when a company files for bankruptcy? 1. Common stockholders 2. Debenture holders 3. Preferred stockholders 4. Secured creditors

Secured creditors, debenture holders, preferred stockholders, and common stockholders Secured creditors, including secured bondholders, have the first claim on assets. They are followed by general creditors, including debenture holders. The final claim is that of stockholders (equity), with preferred coming ahead of common.

Money market instruments are A. long-term debt. B. short-term debt. C. long-term equity. D. intermediate debt.

Short-term debt Money market instruments are high-quality debt securities with maturities that do not exceed one year.

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. approximately 12.90%. B. slightly more than 5.33%. C. 4.00%. D. slightly less than 5.33%.

Slightly less than 5.33% 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. Because that would be 4.0% divided by 0.75 (100% minus the 25% tax bracket) or 5.33%, paying the state income taxes would decrease the yield slightly.

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 his state, his total tax-equivalent yield would be A. approximately 12.90%. B. slightly less than 5.33%. C. slightly more than 5.33%. D. 4.00%.

Slightly more than 5.33% When an individual owns a municipal bond issued in his state of residence, not only is the interest tax free on a federal basis but (at least in all cases on the exam) also it is nontaxed in that state. Therefore, the tax-equivalent yield here is slightly higher than it would be if we only computed using the federal tax rate. Because that would be 4.0% divided by 0.75 (100% minus the 25% tax bracket) or 5.33%, saving on state income taxes would increase the yield slightly.

When investing in a foreign bond fund, a customer will profit if which of these occur? 1. The U.S. dollar strengthens. 2. The U.S. dollar weakens. 3. Foreign currencies strengthen. 4. Foreign currencies weaken.

The U.S. dollar weakens and foreign currencies strengthen Because the fund is purchasing bonds denominated in foreign currencies, a weakening of the U.S. dollar or strengthening of foreign currencies will be beneficial.

The yield to maturity is A. the annualized return of a bond if it is held to maturity. B. set at issuance and printed on the face of the bond. C. determined by dividing the coupon rate by the current market price of the bond. D. the annualized return of a bond if it is held to call date.

The annualized return of a bond if it is held to maturity The yield to maturity reflects the annualized return of a bond if it is held to its 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 yield to call.

On the initial public offering, an investor buys a $10,000 Aa-rated, 20-year corporate bond with a 4% coupon rate. One year later, the prevailing market rate is 5% and the bond has had its rating increased to Aa1. Which of the following statements is most likely true with reference to the current market price of this bond? A. The yield to maturity of this bond is above 4%. B. The bond would be selling at a premium. C. The bond would be selling at a discount. D. The bond would be selling at par

The bond would be selling at a discount When interest rates go up, bond prices go down. Had interest rates remained the same, the slight improvement in rating would have probably caused the bond to sell at a very slight premium, but that rating increase is not nearly strong enough to offset a 25% increase in market interest rates. Because this bond would be selling at a discount, its YTM would be above 4%, but the question is asking about the current market price, not the yield.

Which of the following statements regarding a $1,000 corporate 8.50% bond offered at 110 is true? A. The bond's current yield is lower than its yield to maturity. B. The bond is a discount bond. C. To determine the bond's current yield, its stated rate must be compared against other fixed-rate investments in the client's portfolio. D. The bond's current yield is calculated by dividing its annual interest by its current market price.

The bond's current yield is calculated by dividing its annual interest by its current market price A bond's current yield is calculated by dividing its annual interest by its current (market) price. In this case, it would be $85 ÷ $1,100. The current yield will be higher than its yield to maturity, which takes into consideration the $100 difference between the purchase price and the par value (a loss of $100). The determination of a bond's yield is unrelated to other bonds. In addition, this bond is selling at a premium (more than $1,000), not at a discount (less than $1,000).

An investor purchased a 6% corporate bond selling at par. Because the next interest payment date is not for another two months, the bond carries accrued interest of $20. Disregarding commissions, which of the following statements is correct? A. The buyer will pay $1,020, and the seller will receive $980. B. The buyer will pay $1,000, and the seller will receive $1,020. C. The buyer will pay $1,020, and the seller will receive $1,020. D. The buyer will pay $1,020, and the seller will receive $1,

The buyer will pay $1,020, and the seller will receive $1,020 When a bond is purchased or sold in between semiannual interest payment dates, the interest that has accrued since the previous payment is added to the purchaser's price. In our question, $1,000 plus $20 equals $1,020. That interest belongs to the seller who has held that bond since the previous interest payment. Therefore, the seller receives the selling price ($1,000) plus the accrued interest of $20 for a total of $1,020. Remember, the buyer will be getting the full six months interest of $30 (6% of $1,000 is $30 semiannually) in two months. That represents $10 for the two months the bond was held plus reimbursement for the four months of interest paid to the seller. You will not need to know how to calculate the accrued interest; it will be given in the question as is the case here.

The market price of a convertible bond depends on all of the following except A. the conversion prices of bonds from similar companies. B. the rating of the bond. C. the value of the underlying stock into which the bond can be converted. D. current interest rates.

The conversion prices of bonds from similar companies

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. the current dividend yield has remained the same. B. the current dividend yield has increased. C. the current dividend yield has decreased. D. the dividend yield to maturity has decreased.

The current dividend yield has increased The current dividend yield is income dividend divided by price. If the price of a stock decreases and the dividend remains the same, the dividend yield will increase.

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 call is higher than the current yield. B. the yield to maturity is higher than the current yield. C. the current yield is higher than the nominal yield. D. the yield to maturity is higher than the yield to call.

The yield to maturity is higher than the yield to call 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).

Assume that a corporation issued a 5% Aaa/AAA rated debenture at par. Two years later, similarly rated debt issues are being offered in the primary market at 5.5%. Which of the following statements regarding the outstanding 5% debenture are true? 1. The current yield on the debenture will be higher than 5%. 2. The current yield on the debenture will be lower than 5%. 3. The dollar price per bond will be higher than par. 4. The dollar price per bond will be lower than par.

The current yield on the debenture will be higher than 5% and the dollar price per bond will be lower than par Because interest rates have risen after the issue of the 5% debenture, the bond's price will be discounted to result in a higher current yield (computed as annual income divided by current market price). Accordingly, the discounting of the issue will make the 5% debenture competitive with new issues offered with a 5.5% coupon.

What is the name of the bond document that states the issuer's obligation to pay back a specific amount of money on a specific date? A. The indenture B. The bond agreement C. The bond coupon D. The debenture

The indenture The indenture is the contract that sets forth the promises of the issuer of the bond and the rights of the lenders (the investors). A debenture is an unsecured long-term debt security (that has an indenture). One of the details in the indenture is the coupon (interest) rate that will be paid on the loan.

Which of the following statements regarding a zero-coupon corporate bond is true? A. These bonds have higher reinvestment risk as to interest than bonds paying semiannual interest. B. The investor reports the difference between the purchase price and maturity value as ordinary income at maturity. C. Bonds selling at a premium have a yield lower than the coupon rate. D. The investor has phantom income, which must be reported on an annual basis.

The investor has phantom income, which must be reported on an annual basis On a taxable zero-coupon bond, the annual imputed interest is reported for tax purposes. Because this income is not actually received annually, it is referred to as phantom income. Zero-coupon bonds always sell at a discount from their maturity value—never at a premium—and one risk that zero-coupon bonds avoid is reinvestment risk because there are no interest payments to reinvest.

It is not uncommon to find a fixed-income security issued with a call feature. The feature is usually of most benefit to A. the investor. B. the underwriter. C. the issuer. D. the transfer agent.

The issuer The call feature enables the issuer to redeem (call in or buy back) the security at a specified price, usually beginning with a specified number of years after the security is issued. How does this benefit the issuer? If the cost of money (interest rates) has declined since the fixed-income security was issued, the issuer can float a new issue with interest (or dividends in the case of preferred stock) based on that lower cost of funds and use the money raised to call in the existing securities currently paying a higher return. It is the same concept as refinancing a mortgage when interest rates go down.

A new convertible debt security 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 security if A. interest rates are rising. B. interest rates are falling. C. the market price of the underlying common stock is increasing. D. interest rates are stable.

The market price of the underlying common stock is increasing

A client is trying to decide between a par value corporate bond carrying a coupon rate of 6.25% per year and a par value municipal bond that pays an annual coupon rate of 4.75%. Assuming all other factors are equal and your client is in a 28% marginal income tax bracket, which bond do you tell the client to purchase and why? A. The corporate bond because the after-tax yield is 4.50% B. The municipal bond because its equivalent taxable yield is 6.30% C. The corporate bond because the after-tax y

The municipal bond b/c its equivalent taxable yield is 6.6% If we compute the tax-equivalent yield of the muni, we see that it is 6.60%, which is a higher return than the 6.25% on the corporate bond. The formula to get this starts by taking the investor's tax bracket and subtracting it from 100%. 100% − 28% = 72%. We then divide the muni coupon of 4.75% by the 72%, and the result rounds off to 6.6%.

Which of the following statements best describes the risk-free rate of interest? A. The rate of interest required to produce a net present value (NPV) of zero B. The rate of interest in excess of the pure time value of money C. The arithmetic mean of the CPI over the past 12 months D. The rate of interest earned on the 91-day U.S. Treasury bill

The rate of interest earned on the 91-day U.S. Treasury bill The rate of interest earned on short-term U.S. Treasury securities, generally the 91-day T-bill (might be called the 13-week or 3-month bill on the exam), is referred to as the risk-free rate. The rate of interest in excess of the pure time value of money is called the risk premium, not the risk-free rate. CPI and NPV have nothing to do with the risk-free interest rate.

Which of the following is a characteristic of an investment-grade general obligation municipal bond? A. The bond retains a direct claim on specific property. B. The taxing authority of the issuing government or municipality backs the issue's repayment. C. The bond's periodic interest is paid to investors only when sufficient revenue is collected by the municipality. D. The bond's main source of investment risk is financial risk.

The taxing authority of the issuing government or municipality backs the issue's repayment General obligation bonds are backed by the full faith and credit of the government issuing the debt and are repaid through taxes collected by the government body. The main source of investment risk for a municipal security is interest rate risk. General obligation bonds do not retain a claim on specific property. The government issuing the bonds uses its taxing authority to pay the interest and repay the principal. Revenue bonds, not general obligation bonds, are dependent on revenue collected from the financed project.

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

They are direct obligations of the U.S. government 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.

All of the following are true of negotiable, jumbo certificates of deposit except A. they are readily marketable. B. they usually have maturities of one year or less. C. they are usually issued in denominations of $100,000 to $1 million or more. D. they are secured obligations of the issuing bank.

They are secured obligations of the issuing bank Negotiable CDs are general obligations of the issuing bank; they are not secured by any specific asset. They do qualify for FDIC insurance (up to $250,000), but that is not the same as stating that the bank has pledged specific assets as collateral for the loan.

Which of the following is correct regarding zero-coupon bonds? A. They have low interest rate risk. B. They sell at a premium. C. They offer minimum price volatility. D. They eliminate reinvestment rate risk.

They eliminate reinvestment rate risk Zero-coupon bonds are sold at a deep discount from par value and have no coupon payments. Because there is nothing to reinvest, there is no reinvestment risk. That is why many investors prefer zero-coupon bonds for specific goals, such as college education for children. The tradeoff is that no coupon also means higher interest rate risk. These bonds have maximum price volatility and respond sharply to interest rate changes.

Regarding convertible debentures, one characteristic of which your clients should be aware of is that A. the conversion feature protects against an early call. B. it is generally best to convert when the common stock is selling below its parity price. C. they generally pay a higher interest rate than nonconvertible debentures. D. they trade in line with the issuer's common stock once the conversion price is reached.

They trade in line w/ the issuer's common stock once the conversion price is reached The lower volatility of a convertible debenture stems from the fact that it has fixed interest payments and will be redeemed at maturity as any other bond or debenture would. No such guarantees apply to common stock.

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. typically carry higher returns than Treasury issues because of the lack of direct government backing. B. frequently trade on the NYSE while Treasuries never do. C. are more likely to be issued in larger amounts. D. are taxable on the federal level while Treasury issues are not.

Typically carry higher returns than Treasury issues b/c of the lack of direct government backing 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.

The most common collateral securing a Brady bond is A. U.S. Treasury zero-coupon bonds with a maturity corresponding to the maturity of the individual Brady bond. B. the credit standing of the banking institution acquiring the Brady bond. C. an asset, or group of assets, pledged by the borrowing entity. D. the credit standing of the sovereign nation issuing the Brady bond.

U.S. Treasury zero-coupon bonds w/ a maturity corresponding to the maturity of the individual Brady bond Although other securities may be pledged, the most common is zero-coupon U.S. Treasuries, selected to mature at roughly the same time as the specific Brady bond. An investor purchasing a Brady with collateralized principal knows that, at maturity, a third-party paying agent will receive a payment from the U.S. Treasury that will be used to repay the principal on the Brady issue. In the event of default, the bondholder will receive the principal collateral on the maturity date.

Which of the following statements regarding convertible debentures is true? A. The debenture holders receive a variable rate of interest. B. When compared with similar nonconvertible debentures, convertible debentures are issued with a lower coupon rate. C. The issuer has the right to convert the debentures during the time period specified in the indenture. D. The issuer pays a higher rate of interest compared with a comparable nonconvertible debenture.

When compared w/ similar nonconvertible debentures, convertible debentures are issued w/ a lower coupon rate