Series 7 Questions Unit 4

Which of the following would be considered an equity security? A) Preemptive rights B) Equity-linked notes C) Exchange-traded notes D) Negotiable CDs

A) Preemptive rights Rights (and warrants) are included in the term equity security. Confusingly, equity-linked notes are debt securities, even though the term equity is in the name. On this exam, notes always represent a form of debt security.

Which of the following is not considered a debt security? A) Prior lien preferred stock B) Promissory note C) Debenture D) Equipment trust certificate

A) Prior lien preferred stock Stock, whether preferred or common, represents equity (ownership) and is never considered a debt security. The most common example of a promissory note on the exam is commercial paper, a money market instrument. Debentures represent an unsecured debt of the issuer. Equipment trust certificates represent debt secured by specific equipment, typically rolling stock.

Two bonds currently quoted at a 5.50 basis mature in exactly 15 years. Their coupons are 6% and 7%, respectively. Which bond would experience the greatest appreciation in value if the yields dropped to a 5.20 basis? A) The 7% bond B) Neither because both would decline in value C) The 6% bond D) Both would appreciate the same amount

A) The 7% bond These bonds are selling at a premium (their coupons are above their yield to maturity, or basis). If the YTM declines to 5.20, it means that the prices of the bonds went up. Without getting too deep into the mathematics, in order for both bonds to have the same basis (5.20), the one with the 7% coupon must have a higher price because the $10 per year additional interest has to be offset by a larger annual "loss." Here is a general rule that will apply to your exam questions. When interest rates are falling, bonds with higher coupon rates are going to appreciate in price at a greater rate than bonds with lower coupon rates. Conversely, when interest rates are rising, those bonds with higher coupons will decrease in price at a slower rate than bonds with lower coupons. In our specific question, the 7% bond will have a greater price increase than the 6% bond. If, however, our question showed the bond selling at a discount, e.g., the basis (YTM) is 8%, the 7% bond would be selling closer to par value than the 6% bond.

If a fund has a fixed portfolio of municipal bonds with long maturities, how will substantial changes in general interest rates affect the fund's portfolio? A) The current value will fluctuate significantly, but the investment income will remain relatively unchanged. B) Both the income and the current value will fluctuate significantly. C) Both the income and the current value will remain unchanged. D) The current value will not change, but the investment income will fluctuate significantly.

A) The current value will fluctuate significantly, but the investment income will remain relatively unchanged. For a fund with a fixed portfolio of long-term municipal bonds, the market value of the portfolio will fluctuate with changing interest rates, but the income will remain unchanged.

In a scenario of falling interest rates and a positive yield curve, assuming all to be of equal face value, which of the following bonds will appreciate the most? A) 1-year bond selling at a premium B) 20-year bond selling at a discount C) 1-year bond selling at a discount D) 20-year bond selling at a premium

B) 20-year bond selling at a discount In general, prices of long-term bonds are more volatile than prices of short-term bonds. Therefore, the 20-year bonds will appreciate more than the 1-year bonds when interest rates fall. Also, prices of bonds with low coupon rates tend to be more volatile than prices of bonds with high coupon rates. A bond sells at a discount when its coupon is lower than prevailing interest rates. Because of its lower coupon, the 20-year discount bond tends to appreciate more than the 20-year premium bond.

A bond with a 9% coupon, maturing in 18 years and 6 months, is selling at 120. The yield to maturity is closest to A) 7.50%. B) 7.05%. C) 9.00%. D) 11.66%.

B) 7.05%. Don't waste time trying to do the yield to maturity computation. This bond is selling at a premium (120% of par). Therefore, all of the computed returns must be lower than the 9% nominal (coupon) yield. Only two of them are. The 7.50% represents the current yield ($90 ÷ $1,200). We know from our charts that, just like a seesaw, the farther from the center you go, the bigger the move at the end. That means the nominal yield is the highest, followed by the current yield (CY), the yield to maturity (YTM), and finally the yield to call (YTC) as the lowest. Because only one choice is lower than the CY, you get the correct answer with minimal effort.

An investor is concerned about safety. When consulting the ratings, which of the following securities would appear to be least likely to default on its obligation to make timely payment of interest and principal? A) AAA rated common stock B) AA rated debenture C) BB rated sovereign debt D) A rated mortgage bond

B) AA rated debenture When it comes to reducing default risk, "the As have it." That is, the more As in the rating, the lower the default risk. True, the common stock is rated triple A, but stock has no obligation to pay interest and repay principal. Why isn't the mortgage bond a safer bet than the debenture? Aren't secured bonds the safest? These are good questions, but the rating services take that into consideration when giving a rating. In their eyes, the debenture, an unsecured debt, merits a double A rating while the mortgage bond, even with the pledged collateral, can only be awarded a single A rating. Sovereign debt, the debt of a country's government, is usually quite safe, but history has shown us that governments can, and do, default. The BB rating here indicates a certain question as to the safety.

It would be most unusual to see which of the following issued at a discount? A) Banker's acceptance B) Jumbo CD C) Treasury bill D) Commercial paper

B) Jumbo CD Jumbo (negotiable) CDs are one of the few money market instruments issued at face value. Unlike those issued at a discount, they are interest bearing.

Moody's Investment Grade (MIG) ratings are applied to: A) corporate bonds. B) municipal notes. C) money market instruments. D) municipal bonds.

B) municipal notes. Moody's Investment Grade ratings are applied to municipal notes, which are short-term municipal debts such as bond anticipation notes (BANs) and tax anticipation notes (TANs). Aren't these short term notes considered money market instruments? Yes they are, but as is so often the case on the exam, the correct answer is the one that is most specific. That is, MIG ratings apply only to muncipal notes. There are many other kinds of money market instruments that Moody's rates, but not using the MIG description.

When a corporation issues a debt security, the terms of the loan are expressed in a document known as the bond's deed of trust. The deed of trust is sometimes referred to as A) the bond resolution. B) the indenture. C) the debenture. D) the loan agreement.

B) the indenture. The indenture, sometimes also referred to as the deed of trust, states the issuer's obligation to pay back a specific amount of money on a specific date. A debenture is a debt security containing an indenture. Bond resolution is a term used for municipal bonds, not corporate debt.

Which of the following is an example of sovereign debt? A) Bank of England notes B) Sony Corporation debentures C) U.S. Treasury bonds D) Royal Bank of Canada CDs

C) U.S. Treasury bonds Sovereign debt represents loans to governments. On the exam, it is likely that the examples will be foreign governments, not U.S. Treasury securities. The Royal Bank of Canada is a privately owned corporation and its debts are not those of the Canadian government. Bank of England notes are the paper currency issued (e.g., the ₤10 and ₤20 notes).

When part of an issue of speculative bonds with a 25-year maturity are called, the effect on the remaining bonds will be to A) decrease their quality. B) decrease their coupon rate. C) improve their quality. D) increase their coupon rate.

C) improve their quality. Speculative bonds are those with lower ratings. They are considered to be of lower quality because the risk of timely payment and principal are higher than investment-grade bonds. When a company shows its determination to honor its debt by paying off some of it in advance, the rating associations take note of that and invariably increase the rating. Compare this to your personal credit score. Your score might be relatively low because you have a lot of outstanding debt. As you pay down that debt, your credit score is likely to increase. It is the same logic here.

A corporate bond is quoted in the Wall Street Journal as follows: Bid: 100½ Asked: 100¾ Bid Chg.: -⅛ YTM: 5.75% From this information, you know the nominal yield is A) less than 5.75%. B) 5.625%. C) 5.75%. D) greater than 5.75%.

D) greater than 5.75%. The bid and asked prices show that the bond is being quoted at a premium (above par), with a yield to maturity of 5.75%. When bonds are trading at a premium, the nominal yield (coupon rate) is greater than the yield to maturity.