Unit 13

A TIPS bond is issued in the principal amount of $1,000, paying 3.5%. Over the security's 5-year term, the annual inflation rate is 6%. What is the principal value of the bond at the end of 4 years? A) $1,267 B) $1,240 C) $1,344 D) $1,300

A

An investor is considering the purchase of some bonds to diversify his portfolio. If he should decide to purchase Treasury STRIPS instead of Treasury Bonds, his major risk would be A) interest rate risk B) credit risk C) reinvestment risk D) purchasing power risk

A Treasury STRIPS are zero-coupon bonds and, as such, have a longer duration than those paying semiannual interest. The longer the duration, the greater the interest rate risk. Because both are guaranteed by the U.S. government, there is no credit risk. Both have the same purchasing power risk, and there is no reinvestment risk with a zero-coupon bond.

Which of the following is NOT a valuation method for a fixed-income security? A) Conversion parity B) Dividend discount model C) Price-to-earnings ratio D) Discounted cash flow

C The P/E ratio is only used with common stock. The parity price is a way to value a convertible bond or convertible preferred stock. DCF is one of the most popular ways to value bonds. The DDM can be used with preferred stock, which, because of its fixed dividend, is considered in the general category of fixed-income security.

A customer buys 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) has increased B) has stayed at par C) cannot be determined D) has declined

D

An analyst would use the discounted cash flow method in an attempt to find A) the fair value of a security. B) the current rate of return of a security. C) the current market price of a security. D) the cash flow from operations.

A

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 U.S. Treasury bond issued 25 years ago with a 30-year maturity C) A convertible preferred stock D) A laddered bond portfolio

A

Which of the following would be most likely to increase a bond's liquidity? A) A higher rating B) A lower rating C) A longer maturity D) No call protection

A

Which of the following statements regarding U.S. government agency securities is TRUE? A) They generally trade on the major stock exchanges. B) Interest received on agency securities is exempt from federal income tax. C) They are direct obligations of the U.S. government. D) They generally offer higher yields than direct U.S. obligations.

D

If a customer buys a 6% bond maturing in 8 years on a 7.33 basis, the price of the bond is A) at par B) inverted C) above par D) below par

D A bond with a basis, or yield to maturity, greater than its coupon is trading at a discount, or below par.

A sudden decrease in market interest rates will have the effect of increasing the trading price of an existing bond because A) lower interest rates will result in a higher rating for the bond B) a reduction in market interest rates generally signifies a stronger economy C) the future value of the bond's present cash flows increases D) the present value of the bond's future cash flows increases

D

If an investor pays 95.28 for a Treasury bond, how much did the bond cost? A) $950.28 B) $95.28 C) $9,528 D) $958.75 Explanation Treasury bonds are quoted as a percentage of par, ($1,000), plus 32nds. In this case, the price is $950 plus 28/32 (i.e., 7/8) of $10, for a total of $958.75.

D

The minimum face amount of a negotiable CD is: A) $25,000.00 B) $50,000.00 C) $10,000.00 D) $100,000.00

D

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

D 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 ratings 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.

As defined in the Securities Exchange Act of 1934, the term municipal security would include A) a City of Chicago school district bond B) a Province of Ontario library construction bond C) a U.S. Treasury bill D) 50-year bonds issued by the Tennessee Valley Authority

A

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

A

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

D

The best time for an investor seeking returns to purchase long-term, fixed-interest-rate bonds is when A) short-term interest rates are low and beginning to rise B) short-term interest rates are high and beginning to decline C) long-term interest rates are low and beginning to rise D) long-term interest rates are high and beginning to decline

D The best time to buy long-term bonds is when interest rates have peaked. In addition to providing a high initial return, as interest rates fall, the bonds will rise in value.

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

B 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.

Your client is interested in investing in preferred stocks in an effort to receive dividend income. The client's target goal is a 6% current return on investment (ROI). If the RIF Series B preferred stock is paying a quarterly dividend of $.53, your client's goal will be achieved if the RIF can be purchased at A) $50.00 B) $35.33 C) $8.83 D) $22.55

B First, take the quarterly dividend and annualize it (4 × $.53 = $2.12). Then, divide that number by 6% and you get $35.3333, which rounds down to $35.33. Or, if you wish, but it takes more time, multiply each of the choices by 6% to see which of them equals $2.12.

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

C

A client of yours owns some convertible preferred stock. She notices an article in the business section of her local newspaper that reports the company is going to pay a 20% stock dividend on their common stock. She wants to know how this will affect her? A) If there is an antidilution clause, her conversion privilege will permit her to acquire 20% more shares than before the stock dividend. B) There will be no effect. C) More than likely, the price of the preferred stock will rise. D) She will also receive 20% more shares because preferred stock has a priority claim ahead of common.

A

A risk-averse investor, who had only invested funds in bank certificates of deposits, was informed by his investment adviser representative that higher returns with safety could be achieved by investing in U. S. Treasury notes with a 10-year maturity. The adviser representative assured his client that investment in federal government-backed securities is riskless. In this situation, the representative acted A) unethically, because the agent failed to disclose that the customer retains interest rate risk B) properly because Treasury notes are suitable for a risk-averse customer C) unethically, because Treasury notes are unsuitable for a risk-averse customer D) properly, because Treasury notes carry no risk of principal default

A

An investor owns a TIPS bond with an initial par value of $1,000. The coupon rate is 6%, and during the first year, the inflation rate is 9%. How much interest would be paid for the year? A) $64.11 B) $90.00 C) $60.00 D) $65.40

A

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) $1,022.21. C) $102.21. D) $1,022.10.

A

Which of the following would you NOT expect to see issued at a discount? A) Bank jumbo CD B) Commercial paper C) Treasury Bill D) Zero-coupon bond

A

Managers of bond portfolios who anticipate an increase in interest rates should A) decrease the portfolio duration B) assume higher risk in the secondary market C) invest in high-yield or junk bonds D) increase the portfolio duration

A A bond portfolio manager who anticipates periods of rising interest rates should decrease the duration of a bond portfolio to minimize the price decline. Duration is inversely related to changes in market and coupon interest rates.

Which of the following projects is most likely to be financed by a general obligation rather than a revenue bond? A) Municipal hospital B) Public golf course C) Public library D) Expansion of an airport

A Hospitals, airports, and golf courses all generate revenue and can be financed with revenue bond issues. Public libraries are financed through GO bond sales with the backing of taxes.

The Straitened Corporation has filed for bankruptcy. One of your clients held a mortgage secured by the corporation's building. When the building was sold, the proceeds were less than the mortgage balance creating a deficiency balance. Where does this investor's claim stand? A) As a general creditor on a pro rata basis B) After the unsecured creditors C) There is no further claim once the building has been sold D) After the secured creditors

A Secured creditors, such as those holding mortgage bonds, always have priority in a liquidation. If it happens, as in this question, that the asset(s) securing the debt are insufficient to satisfy the claim, the balance is considered to be an unsecured debt. In that case, those bondholders are considered general creditors and share in any remaining assets proportionate to the amount of the deficiency. The Latin legal term for this is pari passu, but we don't expect you'd see that on the exam.

One popular method of determining the value of certain securities is discounted cash flow. Using the DCF with the current discount rate at 3%, which of the following would be expected to have the highest market value? A) ABC Corporation debenture maturing in 25 years with a 5% coupon B) U.S. Treasury bond maturing in 20 years with a 4% coupon C) Bay Area Rapid Transit Authority 4% revenue bond maturing in 15 years D) XYZ Corporation mortgage bond maturing in 10 years with a coupon of 4.5%

A The current discount rate represents market interest rates. At 3%, each of these bonds should sell at a premium (their coupon rates are higher than 3%). When a bond is paying interest at a rate higher than the current market rate, the longer the investor will be receiving that higher rate, the higher the premium. Therefore, the 5% bond with 25 years to maturity will have the highest present value using the DCF.

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) slightly less than 5.33% B) approximately 12.90% C) 4% D) slightly more than 5.33%

A 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.

In general, among the advantages to investing in Brady bonds over those issued by countries classified as emerging economies is A) greater risk B) increased liquidity C) higher yields D) shorter maturities

B

When comparing a time deposit account and a demand deposit account, you would expect A) FDIC insurance on the time deposit account but not on the demand deposit account B) a higher rate of interest paid on the time deposit account C) lower penalties for withdrawing funds from a time deposit account D) easier access to the funds in a time deposit account

B

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

B For those of you not familiar with bond listings, this means that Beale 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

A client has a 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) 4.00% B) 3.50% C) -0.50% D) 7.50%

B Treasury Inflation Protected Securities (TIPS) adjust the principal value each 6 months to account for the inflation rate. Therefore, the real rate of return will always be the coupon.

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) 20 shares plus cash for fractional shares D) 24 shares

B (same amount of shares)

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

C

All the following securities are issued at a discount EXCEPT A) commercial paper B) zero-coupon bonds C) CDs D) Treasury bills

C

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) Purchasing power risk C) Default risk D) Interest rate risk

C

Currently, a company issues 5% Aaa/AAA debentures at par. Two years ago, the corporation issued 4% AAA-rated debentures at par. Which of the following statements regarding the outstanding 4% issue are TRUE? The dollar price per bond will be higher than par. The dollar price per bond will be lower than par. The current yield on the issue will be higher than the coupon. The current yield on the issue will be lower than the coupon. A) I and IV B) II and IV C) II and III D) I and III

C

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

C

Several years ago, an investor purchased an investment-grade bond with a 6% coupon. Today that bond is priced to yield 4.6% to maturity in 5 years. If the bond is called at par in one year, the bond's yield would be A) the coupon rate of 6% because it is called at par value. B) 4.6%. C) less than 4.6%. D) more than 4.6%

C

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

C

Which of the following is unlikely to be issued at a discount? A) Treasury bill B) Commercial paper C) Jumbo CD D) Zero-coupon bond

C

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

C

f your customer wants to set aside $40,000 for when his child starts college, but does not want to endanger the principal, you should recommend A) corporate bonds with high rates of interest B) municipal bonds for their tax benefits C) zero-coupon bonds backed by the U.S. Treasury D) common stock

C

An investor purchasing 10 corporate bonds at a price of 102¼ each will pay A) $10,202.50 B) $1,022.50 C) $10,225.00 D) $1,020.25

C At 102¼, each bond cost $1,022.50 (102 = 1,020 and ¼ of $10 = $2.50). There are 10 bonds so the total is $1,022.50 × 10 = $10,225

The XYZ 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) $22.50 per share B) $44 per share C) $36 per share D) $40 per share

C 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? 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

Question ID: 1179423 The most common collateral securing a Brady bond is A) the credit standing of the banking institution acquiring the Brady bond B) an asset, or group of assets, pledged by the borrowing entity C) the credit standing of the sovereign nation issuing the Brady bond D) U.S. Treasury zero-coupon bonds with a maturity corresponding to the maturity of the individual Brady bond

D

Rank the following bonds in order of shortest to longest duration. ABC 8s of 2040 DEF 9s of 2041 GHI 5s of 2039 JKL zeros of 2035 A) I, II, IV, III B) IV, II, I, III C) III, I, II, IV D) II, I, III, IV

D

Securities issued by which of the following issuers have the direct backing of the U.S Treasury? A) Federal Home Loan Mortgage (Freddie Mac) B) Federal National Mortgage Association (Fannie Mae) C) Federal Agricultural Mortgage Corporation (Farmer Mac) D) Government National Mortgage Association (Ginnie Mae)

D

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

D

Which of the following is TRUE of a zero-coupon bond? The rate of return is locked in. There is no reinvestment risk. The imputed interest is taxed as ordinary income on an annual basis. A check for the interest is paid at maturity. A) I and IV B) I, III, and IV C) I only D) I, II, and III

D

The current yield on a bond with a coupon rate of 7.5% currently selling at 105½ is approximately A) 6.50% B) 7.50% C) 8.00% D) 7.11%

D A bond with a coupon rate of 7.5% pays $75 of interest annually. Current yield equals annual interest amount divided by bond market price, or $75 ÷ $1,055 = 7.109%, or approximately 7.11%.

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 6.25% B) The corporate bond because the after-tax yield is 4.5% C) The municipal bond because its equivalent taxable yield is 6.3% D) The municipal bond because its equivalent taxable yield is 6.6%

D If we compute the tax-equivalent yield of the muni, we see that it is 6.6%, 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 that 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%.

A TIPS bond is issued in the principal amount of $1,000, paying 3.5%. Over the security's 5-year term, the inflation rate is 4%. What is the principal value of the bond at the end of 5 years? A) $1,440 B) $1,200 C) $1,000 D) $1,219

D In addition to paying interest, a TIPS bond increases its principal value semiannually by the amount of inflation. If the inflation rate is 4% for 5 years, the principal value of the bond increases semiannually by that inflation rate. Allowing for compounding, the best choice would be the $1,219. This is computed by multiplying $1,000 by 102% 10 times. The License Exam Manual (LEM) contains a step by step example of how this computation works

Which of the following bonds would appreciate the most if interest rates fell? A) 15-year maturity, selling at a discount B) 15-year maturity, selling at a premium C) 30-year maturity, selling at a premium D) 30-year maturity, selling at a discount

D The general rule of thumb is that bonds with long-term maturities will have greater fluctuations in price than will short-term maturities, given the same move in interest rates. Furthermore, discounted bonds, with their lower coupon rates, have a longer duration than a bond selling at a premium and will respond more favorably to falling rates than will those premium bonds. Thus, the 30-year discounted bond will move faster than the others.

An investor is looking to add some bonds to her portfolio. One of the bonds she is analyzing has a 3% coupon and the other a 6% coupon. Assuming both bonds have the same maturity date, a change in interest rates will have a more profound effect upon the market price of which bond? A) The bond with the lower rating B) Changes in interest rates affect both bonds equally C) The 6% coupon D) The 3% coupon

D The longer a bond's duration, the more its price is affected by changes to interest rate. When bonds have the same maturity, the one with the lowest coupon has the longest duration. Ratings have little or nothing to do with price changes caused by interest rate changes

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

D 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.

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

D ebenture is a long-term debt security issued by a corporation with no specific asset pledged as security for the loan

DERP 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 $30 per share D) somewhat below $48 per share

D he 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.

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

D. 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.

An investment in which of the following would expose the investor to the greatest capital risk? A) Mortgage bonds B) Debentures C) Common stock D) Preferred stock

c

To secure the debt that a subsidiary is offering, a railroad holding company transfers to a trustee the common stock of another subsidiary. The offering is one of A) secured income notes B) equipment trust certificates C) collateral trust certificates D) guarantee trust bonds

c When a company uses the securities of one subsidiary to collateralize a bond issue of another subsidiary, the bonds are known as collateral trust certificates.