Unit 7: U.S. Treasury and Government Agency Securities

All of the following statements regarding the Federal National Mortgage Association (FNMA) are true except A) FNMA is owned by the U.S. government. B) interest on FNMA certificates is taxable at all levels. C) FNMA pass-through certificates are not guaranteed by the U.S. government. D) FNMA is a publicly held corporation.

A) Explanation FNMA is a publicly held corporation; it is not owned by the federal government. The interest income on all mortgage-backed securities is fully taxable on the local, state, and federal levels. Though FNMA is a government agency, FNMA pass-through certificates are not guaranteed by the U.S. government. The only tested U.S. agency whose securities are considered direct obligations of the U.S. government is the Government National Mortgage Association (GNMA). LO 7.c

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

C) Explanation As money market instruments, the longest initial maturity of Treasury bills is 52 weeks. Those bills are auctioned once a month. T-bills of shorter maturities are auctioned weekly. The shortest initial maturity is four weeks. LO 7.b

Which of the following is not part of the Federal Farm Credit System (FFCS)? A) Bank for Cooperatives B) Federal Land Bank C) Federal Home Loan Bank D) Federal Intermediate Credit Bank

C) Explanation The Federal Land Bank, Bank for Cooperatives, and Federal Intermediate Credit Bank are all parts of the FFCS. The Federal Home Loan Bank is not. LO 7.c

A customer buys a 6% Treasury bond, maturing in 10 years, at a price of 91.07. The yield to maturity is A) same as current yield. B) less than current yield. C) less than nominal yield. D) greater than nominal yield.

D) Explanation A bond whose price is below par or at a discount has a higher yield to maturity than current yield, which in turn is higher than the nominal yield. LO 7.b

T-bills are quoted A) in 16ths. B) as a percentage of par. C) in 32nds. D) on an annualized discount yield basis.

D) Explanation T-bills do not bear interest. T-bills trade and are quoted on an annualized discount yield basis. LO 7.b

Which of the following is not part of the Federal Farm Credit System? A) The Bank for Cooperatives B) The Federal Intermediate Credit Bank C) The Federal Land Banks D) The Federal Home Loan Banks

D) Explanation The Federal Farm Credit Bank system is for farms, not homes. LO 7.c

Income from all of the following securities is fully taxable at the federal, state, and local levels except A) Treasury bonds. B) corporate bonds. C) Ginnie Maes. D) reinvested mutual fund dividends.

A) Explanation Interest on Treasury bonds is not taxed at the state or local level. LO 7.e

Which of the following is not considered a short-term investment vehicle? A) Treasury bonds B) Negotiable CDs C) Repurchase agreements D) Commercial paper

A) Explanation Treasury bonds are long-term investment vehicles having maturities of 10 years or more. LO 7.b

Treasury STRIPS and Treasury receipts are quoted based on A) amortization of premiums. B) yield to maturity. C) 0.125 (⅛ of a point in dollars). D) 0.03125 (1/32 of a point in dollars).

B) Explanation Noninterest-bearing securities, like zeroes, are quoted based on their yield to maturity. They are sold at a discount and mature at par. LO 7.a

Which of the following securities can generate phantom income? A) Treasury notes B) TIPS bonds C) Treasury bills D) Treasury bonds

B) Explanation TIPS bonds adjust the principal value each six months based on the inflation rate. If the inflation rate is positive, the value increases. Those increases are reported as income each year even though the investor does not receive the appreciation until the bonds mature (or are sold). LO 7.a

Which of the following statements regarding Treasury receipts is not true? A) Treasury receipts pay interest at maturity. B) Treasury receipts are not backed by the faith and credit of the U.S. government. C) Interest income is taxed at maturity. D) Treasury securities held in trust collateralize the receipts.

C) Explanation Unlike Treasury STRIPS, which are issued directly by the U.S. government, Treasury receipts are indirect obligations of the government. Treasury receipts are issued by investment bankers who buy Treasury securities, place them in trust at a bank, and sell separate receipts against the principal and interest payments. Like most zeroes, interest must be accreted and taxed annually even though it is not received until maturity. LO 7.a

All of the following are used to back collateralized mortgage obligations except A) Ginnie Mae. B) Fannie Mae. C) Freddie Mac. D) Sallie Mae.

D) Explanation Sallie Mae is the Student Loan Marketing Association, which purchases student loans and packages them for the secondary market. The FNMA, GNMA, and FHLMC sell mortgage-backed securities. LO 7.c

All of the following issue securities under the Federal Farm Credit System except A) Bank for Cooperatives. B) the Federal Land Bank. C) the Federal Intermediate Credit Bank. D) the Federal Home Loan Mortgage Corporation.

D) Explanation The Federal Home Loan Mortgage Corporation issues securities backed by residential mortgages. The Farm Credit System is made up of Federal Intermediate Credit Banks, cooperative banks, and Federal Land Banks. LO 7.c

Municipal securities issued by which of the following are triple tax exempt? A) U.S. territories B) New York City C) Hawaii D) Public authorities

A) Explanation Federal income taxes are not currently imposed on interest earned from bonds issued by U.S. territories and possessions (e.g., Puerto Rico, Guam, and the U.S. Virgin Islands). LO 7.e

Which of the following securities has the direct backing of the U.S. Treasury? A) Ginnie Maes B) Fannie Maes C) Treasury stock D) Freddie Macs

A) Explanation Securities issued by the Government National Mortgage Association (GNMA) are the only agency security with the direct backing of the U.S. Treasury. Other agencies are not directly backed. Treasury stock is a corporate issue and has nothing to do with the U.S. Treasury. LO 7.c

Which of the following statements regarding Treasury receipts are true? I) Interest is paid annually. II) Interest is paid at maturity. III) Interest is taxed annually. IV) Interest is taxed at maturity. A) II and III B) I and III C) II and IV D) I and IV

A) Explanation Treasury receipts are zero-coupon bonds issued by broker-dealers. Zero-coupon bonds pay all of their interest at maturity. They are issued at a discount and redeemed at par, and the difference represents the interest earned. For zeroes with a maturity of more than one year, the interest (or discount) must be accreted each year—and is taxable that year as income. This is called imputed interest. LO 7.a

Securities issued by private lending institutions approved by which of the following are directly backed by the federal government? A) Federal National Mortgage Association (FNMA) B) Government National Mortgage Association (GNMA) C) Federal Home Loan Mortgage Corporation (FHLMC) D) Federal Intermediate Credit Bank (FICB)

B) Explanation The GNMA is a government agency backed by the full faith and credit of the U.S. government. The FNMA and FHLMC are government-sponsored corporations owned by public stockholders. FICB bonds are backed by the banks, not the U.S. government. LO 7.c

Investors wishing to protect the fixed-income portion of their portfolios from inflation risk would find which of the following choices most suitable? A) AAA-rated corporate bonds B) TIPS bonds C) Common stock D) Cumulative preferred stock

B) Explanation The Treasury Inflation-Protected Securities bonds (TIPS) are designed to do just that. Each six months, the principal amount of the bond adjusts based on changes to the cost of living. The interest and principal on the corporate bonds is fixed, as is the dividend on the preferred stock. Although common stock is generally the choice for inflation protection, the question is referring to the fixed-income portion of the portfolio, not the equity portion. LO 7.a

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

C) Explanation GNMA securities, which are backed by the full faith and credit of the U.S. government, are considered to be the safest of the agency issues. As is the case with most agencies, the minimum denomination is $1,000. LO 7.c

U.S. Treasury bills are issued for all of the following maturities except A) 26 weeks. B) 13 weeks. C) 4 weeks. D) 39 weeks.

D) Explanation As of the authoring date of this question, Treasury bills are issued for terms of 4, 8, 13, 26, and 52 weeks. The Treasury auctions the 52-week bill every four weeks and the 4-, 8-, 13-, and 26-week bills every week. LO 7.b

Which of the following are a direct obligation of the U.S. government? A) Government bond mutual funds B) Treasury receipts C) Fannie Maes D) Ginnie Maes

D) Explanation Direct debt is backed in full by the U.S. government. The Government National Mortgage Association is owned by the U.S. government; thus, Ginnie Maes are fully backed. Treasury receipts are zero-coupon bonds based on U.S. government debt instruments but are created and issued by broker-dealers and, as such, are not direct obligations of the U.S. government. LO 7.c

Which of the following securities is frequently offered with a 50-year maturity? A) GNMA pass-through B) U.S. Treasury bond C) Federal Home Loan Bank D) TVA bonds

D) Explanation Tennessee Valley Authority bonds are the only government security available today with a maturity as long as 50 years. Most of the agencies don't offer anything longer than 20 years, and the maximum on Treasury bonds is usually 30 years. LO 7.c

All of the following are true except A) income bonds are required to pay interest only if it is earned. B) corporate bonds are quoted in 1/8ths and as a percentage of par. C) U.S. Treasury bonds are quoted in 32nds and as a percentage of par. D) Treasury bills are quoted in 1/8ths and as a percentage of par.

D) Explanation U.S. Treasury bills are issued at a discount and are quoted on an annualized return on a discount basis, the return based on the actual amount paid. LO 7.b

Which of the following usually does not pay interest semiannually? A) Treasury bonds B) Public utility bonds C) Government National Mortgage Association (GNMA) D) Treasury notes

C) Explanation GNMA pass-through certificates pay principal and interest monthly. The others usually pay interest semiannually. LO 7.c

Which of the following statements regarding the Federal Farm Credit System securities are not true? A) They issue short-term notes and long-term bonds. B) Interest is tax exempt at the state and local levels. C) The proceeds are used to make loans to farmers. D) They are direct obligations of the U.S. government.

D) Explanation With the exception of Ginnie Mae, all agency securities are indirect obligations of the U.S. government. LO 7.c

Which of the following agencies approves private lending institutions to issue bonds that are backed by the full faith and credit of the U.S. government? A) Government National Mortgage Association (GNMA) B) Federal Home Loan Mortgage Corporation (FHLMC) C) Federal National Mortgage Association (FNMA) D) Financial Guaranty Insurance Company (FGIC)

A) Explanation GNMA bonds are issued by private lending institutions approved by GNMA and are backed by the full faith and credit of the U.S. government. They are considered to be default risk free. LO 7.c

Which of the following statements regarding the Government National Mortgage Association (GNMA) is true? A) Private lending institutions approved by GNMA originate eligible loans and sell the mortgage-backed securities to investors. B) GNMA originates loans to home buyers and sells the mortgage-backed securities to private lending institutions. C) GNMA approves residential mortgages for home buyers. D) Lending institutions apply to GNMA for funds to lend to residential home buyers.

A) Explanation GNMA is a government-owned corporation that approves private lending institutions, such as banks and mortgage companies, to originate eligible loans, pool them into securities, and sell the GNMA mortgage-backed securities to investors. GNMA does not originate loans, and it does not issue or sell securities. LO 7.c

An investor interested in monthly interest income should invest in A) Government National Mortgage Associations (GNMAs). B) Treasury bonds. C) utility company stock. D) corporate bonds.

A) Explanation GNMAs pay monthly interest and principal, Treasury bonds pay semiannual interest, utility stocks pay quarterly dividends, and corporate bonds pay semiannual interest. LO 7.c

All of the following statements regarding the Federal National Mortgage Association (FNMA) are true except A) interest on FNMA certificates is taxable at all levels. B) FNMA is owned by the U.S. government. C) FNMA is a publicly held corporation. D) FNMA pass-through certificates are not guaranteed by the U.S. government.

B) Explanation FNMA is a publicly held corporation. The interest income on all mortgage-backed securities is fully taxable. Though a government agency, FNMA pass-through certificates are not guaranteed by the U.S. government. The only U.S. agency whose securities are considered direct obligations of the U.S. government is the Government National Mortgage Association. LO 7.c

Which of the following is a debt instrument that pays no periodic interest? A) Treasury bond B) STRIPS C) GNMA D) Treasury note

B) Explanation STRIPS are Treasury bonds with the coupons removed. STRIPS do not make regular interest payments. Instead, they are sold at a deep discount and mature at par value. LO 7.a

Pass-through securities are issued by all of these except A) the Federal Home Loan Mortgage Corporation. B) the Farm Credit System. C) the Federal National Mortgage Association. D) the Government National Mortgage Association.

B) Explanation The Farm Credit System (FCS) is a national network of lending institutions that provides agricultural financing and credit. The federal FCS issues discount notes, floating rate bonds, and fixed-rate bonds. The maturities range from one day to 30 years. Unlike the mortgage agencies, these are not pass-through investments. LO 7.d

If a customer believes interest rates have peaked, and therefore, wants to buy long-term, fixed-income securities providing semiannual interest payments, you would recommend A) Treasury STRIPS. B) bonds that do not have a call feature. C) puttable bonds. D) premium bonds with low call premiums.

B) Explanation The purchase of noncallable bonds provides the investor with a constant flow of semiannual interest income until maturity. Treasury STRIPS do not make regular interest payments. LO 7.a

Your client lives in a state with a personal income tax. To minimize that tax liability, it would probably be best for this client to purchase A) FNMAs. B) Freddie Macs. C) U.S. Treasury bonds. D) GNMAs.

C) Explanation With few exceptions, securities issued by the U.S. Treasury are the only government securities carrying an exemption from state income tax. They are, however, taxable on the federal level. The other choices here are taxed at the local, state, and federal levels. LO 7.e

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

D) Explanation A mortgage-backed security, such as a collateralized mortgage obligation, is most likely to experience reinvestment rate risk. As mortgages are paid off early and refinanced in the event of declining interest rates, the interim cash flows received from the obligation must be reinvested in lower yielding securities. This is the practical effect of prepayment risk. LO 7.c

Which of the following is not a money market instrument? A) A commercial paper issued by a finance corporation of a major automobile manufacturer B) A Federal Farm Credit Bank note maturing in one year C) A municipal construction loan note D) A newly issued Treasury notes issued to meet a specific government funding requirement

D) Explanation A newly issued Treasury note would have a maturity of at least two years and would not be considered a money market instrument at issue. When the note is within one year of maturity, it is considered a money market instrument. LO 7.a

An investor looking for income with the highest degree of safety would probably choose to purchase A) FHLMCs. B) SLMAs. C) FNMAs. D) GNMAs.

D) Explanation All of the choices are U.S. government agencies, but only those issued by the Government National Mortgage Association (GNMA) have the direct backing of the government. LO 7.c

All of the following are characteristics of Treasury receipts except A) the certificates may represent either the principal or the interest portion of the securities that were deposited with a trustee. B) they are stripped bonds. C) they are zero-coupon bonds. D) accumulated interest is not subject to federal taxation.

D) Explanation Treasury receipts are zero-coupon instruments, which are purchased at a discount and mature at face value. Although interest is not paid annually on receipts, investors receive a 1099 original issue discount that reports the amount of interest imputed for that year. This interest must be reported to the IRS as taxable income. LO 7.a

Which of the following securities is an original issue discount obligation? A) GNMA certificates B) Corporate bonds C) FNMA bonds D) 13-week U.S. Treasury bills

D) Explanation U.S. Treasury bills are always originally issued at a discount and mature at par, with the investor making the appreciation between the original discounted amount and the par value at maturity. However, this appreciation is treated as interest, not a capital gain. LO 7.b

Interest income from all of the following are exempt from state and local taxation except A) FNMA mortgage-backed issues. B) Series EE savings bonds. C) Treasury bonds. D) Treasury bills.

A) Explanation As a general rule, the interest income from U.S. government and agency securities is subject to federal taxation only; it is generally exempt from state and local taxation. However, the interest income from mortgage-backed securities is fully taxable. LO 7.e

A quote of 2.20 bid 2.18 offered would most likely be a quote on A) a T-bill. B) a T-bond. C) a Ginnie Mae bond. D) a general obligation bond.

A) Explanation Discounted instruments (such as T-bills) are quoted on a discount yield basis. Even though the number representing the bid is higher than the ask, it would be lower when converted into dollars. The greater the yield, the lower the price. LO 7.b

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

B) Explanation Agencies, with very 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. LO 7.d

If an investor keeps $100,000 invested in U.S. Treasury bills at all times during a 10-year period, she is subject to which of the following? I) Stable principal II) Unstable principal III) Stable interest IV) Unstable interest A) II and IV B) I and IV C) I and III D) II and III

B) Explanation Treasury bills are purchased at a discount and mature at face value. This feature provides principal stability to investors who own them. The discount on bills is determined by current market interest rates and fluctuates accordingly. LO 7.b

A U.S. Treasury bond is quoted at 103:24. The dollar amount represented by this quote is A) $103.24. B) $1,037.50. C) $1,032.40. D) $1,030.24.

B) Explanation Treasury bonds are quoted in fractions of 32nds. In fractions, this translates to 103¾ (24/32). That is $1,030 plus ¾ of $10 ($7.50). LO 7.b

U.S. government securities that are deposited with a trustee against which certificates are sold representing principal payments only on the securities are I) clipped bonds. II) stripped bonds. III) subject to annual taxation on the per-year accreted amount. IV) subject to taxation at maturity. A) I and III B) I and IV C) II and III D) II and IV

C) Explanation U.S. government securities that are deposited with a trustee and against which certificates are sold representing principal payments only on the securities are referred to as Treasury STRIPS. These are zero-coupon bonds issued by the U.S. government and are subject to annual taxation on the per-year accreted amount. LO 7.a

United States Treasury notes are intermediate length securities. Treasury notes are not issued with maturities of A) 2 years. B) 5 years. C) 7 years. D) 4 years.

D) Explanation U.S. Treasury notes are issued with maturities of 2, 3, 5, 7, and 10 years. LO 7.b

Which of the following statements regarding U.S. government agency obligations are true? I) They are direct obligations of the U.S. government. II) They generally have higher yields than direct U.S. obligations. III) The Federal National Mortgage Association (FNMA) is a publicly IV) traded corporation. Securities issued by the Government National Mortgage Association (GNMA) trade on the NYSE floor. A) II and IV B) I and II C) I and III D) II and III

D) Explanation U.S. government agency debt is an obligation of the issuing agency. This obligation causes agency debt to trade at slightly higher yields that reflect this greater risk. FNMA securities and GNMA pass-through certificates trade over the counter. GNMA is the only agency whose securities are direct U.S. government obligations. LO 7.c

Which of the following statements regarding Government National Mortgage Association (GNMA) securities are true? I) Interest is subject to federal income tax. II) Interest is exempt from federal income tax. III) They are backed by farm mortgages. IV) They are backed by residential mortgages. A) I and IV B) I and III C) II and IV D) II and III

A) Explanation GNMA securities are subject to both state and federal income tax and are backed by residential mortgages. LO 7.c

High-tax-bracket investors are likely to receive the most favorable tax treatment from investing in A) municipal bonds issued by a political subdivision of their state. B) bonds issued by the U.S. Treasury. C) preferred stock. D) GNMA pass-through securities.

A) Explanation Municipal bonds issued by a political subdivision of the investor's state are free of federal, state, and local income taxes. Treasury securities are taxed on the federal level, but not the state and local levels. GNMAs are taxed at every level. Qualifying dividends on preferred stock are taxed on all levels, although generally at a rate not exceeding 20%. LO 7.e

A) Which of the following statements regarding Treasury bills T-bills are true? I) The government auctions T-bills at a discount. II) The difference between the cost of a T-bill and its value at maturity is treated as a capital gain. III) T-bills have longer maturities than T-notes. IV) The minimum denomination of a T-bill is $100 face amount. A) I and IV B) II and III C) I and III D) II and IV

A) Explanation T-bills are sold at a discount and can be purchased in minimum denominations of $100. The difference between the purchase price and the maturity value is taxed as interest income, not as a capital gain. Treasury bills are short-term investments maturing in 1 year or less. T-notes have maturities of 2 to 10 years. T-bonds have maturities of longer than 10 years. LO 7.b

A TIPS bond has a coupon of 3%. Over a two-year period, the annual inflation rate has been 4.5%. At the end of that time, the principal value of the TIPS would be A) $1,093.08. B) $1,061.36. C) $1,060.00. D) $1,090.00.

A) Explanation TIPS bonds have the special feature of adjusting the principal value every six months by the inflation rate. With an annual rate of 4.5%, the adjustment is 2.25% semiannually. There are two ways to solve this. One is to take the calculator given to you at the test center and multiply $1,000 × 102.25%. Take the result and multiply that times 102.25%. Do that two more times (there are four adjustments in two years), and the ending number will be 1,093.08. A faster way is to take the simple interest of 4.5% per year. That is $45 per year or $90 for the two years. Add that to the original principal to get $1,090. That is not the correct answer, but the next highest number in the answer choices is. LO 7.a

One respect in which TIPS bonds differ from all other U.S. Treasury securities issued at par value is that they A) subject the investor to phantom income. B) pay interest annually. C) are quoted in 1/8 increments. D) have a variable coupon rate.

A) Explanation The inflation protection of a TIPS bond comes from the semiannual adjustment to the principal value. Those increases are reported to the IRS as ordinary income to the investor. It is called phantom income because the investor does not "see" that money currently, but still must pay taxes on it. Like other Treasuries issued at par (T-notes and T-bonds), interest is paid semiannually at the fixed coupon rate. The actual interest will vary based on the principal adjustment, but the coupon is fixed. As with the other two mentioned, quotes are in 32nds. LO 7.e

A resident of Minnesota is in the 28% federal tax bracket and the 4% state tax bracket. This person must pay both federal and state taxes on A) Federal National Mortgage Association (FNMA) pass-throughs. B) Treasury bills. C) Minneapolis Housing Authority bonds. D) federal home loan bank notes.

A) Explanation The interest income from most U.S. government and agency securities is exempt from state and local—but not federal—taxes. Mortgage-backed securities (such as FNMA and GNMA obligations) are subject to federal, state, and local taxes. The interest on municipal issues (like the Minneapolis Housing Authority bonds) is exempt from federal taxes and, because this investor is a Minnesota resident, state taxes as well. LO 7.e

If an investor watches the latest T-bill auction fall to 4.71% from 4.82%, the best interpretation is that A) investors who purchased bills at this auction paid more for them than purchasers last week. B) the decline in yields indicates the Federal Reserve Board has raised the discount rate. C) the federal funds rate and other short-term interest rate indicators are probably rising. D) investors who purchased T-bills 12 weeks ago paid less than subsequent purchasers.

A) Explanation The rates on the T-bills fell, so prices rose, and the investor paid more for the bills this week than last week. The decline in yields indicates there was good demand for the securities because the price rose, driving the yields down. The question does not indicate the price of T-bills 12 weeks ago; it is unclear if the investor paid less for the T-bills then. The federal funds rate and other short-term interest rates would decline—not rise—in line with those of T-bills. LO 7.b

A customer purchases 10 8% Treasury notes at 101-16. What is the dollar amount of this purchase? A) $10,150 B) $10,015 C) $10,812 D) $10,116

A) Explanation Though the denomination of the T-notes purchased is not given, always assume par ($1,000) unless told differently in the question. Remember that government notes and bonds are quoted in 32nds. Therefore, a quote of 101-16 means 101 plus 16/32. 101 + 1/2 = $1,015; $1,015 × 10 bonds = $10,150. LO 7.b

A customer purchases ten 8% Treasury notes at 101-16. What is the dollar amount of this purchase? A) $10,150 B) $10,015 C) $10,812 D) $10,116

A) Explanation Though the denomination of the T-notes purchased is not given, always assume par ($1,000) unless told differently in the question. Remember that government notes and bonds are quoted in 32nds. Therefore, a quote of 101-16 means 101 plus 16/32. 101 plus 1/2 = $1,015; $1,015 × 10 bonds = $10,150. LO 7.b

A dealer in U.S. government securities quotes a 5-year Treasury note at 89.12-89.16. In dollars, that represents a spread of A) $1.25. B) $4.00. C) $0.04. D) $0.125.

A) Explanation Treasury notes and bonds are quoted in fractions of 32nds. The spread between the bid and the ask is 4/32nds. In simpler terms, that is 1/8th. Each point is $10.00, so this 1/8th of $10.00 is equal to $1.25. LO 7.b

Other than the 52-week bills, the U.S. Treasury conducts auctions for Treasury bills A) weekly. B) bimonthly. C) monthly. D) only when the U.S. Treasury Department deems it necessary.

A) Explanation With the exception of the 52-week bills, T-bills are auctioned by the U.S. Treasury weekly. The 52-week T-bills are auctioned every four weeks (which is not the same as monthly). LO 7.b

An individual with $100,000 to invest will require these funds in six months for the purchase of a house. In which of the following circumstances did the registered representative act correctly? A) The registered representative convinced the client to purchase a $100,000 lump sum fixed annuity on the basis of its backing by an insurance company. B) The registered representative convinced the client to invest in a Treasury bill on the basis of its safety. C) The registered representative convinced the client to invest in an IPO on the basis of its high-growth prospects. D) The registered representative convinced the client to invest in a REIT as a hedge against the rise of real estate values until the client purchases the house.

B) Explanation Investment in a Treasury bill is the only suitable investment among the choices listed. Purchase of annuities and a REIT are long-term investments not suitable to an individual who wants to invest funds on a short-term basis. Although an IPO may be liquid, it is not suitable for short-term funds earmarked for the purchase of a house because there is too much risk to the principal. LO 7.a

Which of the following statements regarding Ginnie Maes are true? I) They are quoted in 1/8ths. II) They are quoted in 1/32nds. III) They are traded with an accrued interest computed on an actual-day basis. IV) They are traded with an accrued interest computed on a 30/360 basis. A) I and IV B) II and IV C) I and III D) II and III

B) Explanation Like governments, Ginnie Maes are quoted in 1/32nds, but, like corporates, Ginnie Maes compute accrued interest on a 30/360-day basis. LO 7.c

Which of the following securities is sold at auction? A) Corporate bonds B) T-bills C) Freddie Macs D) Ginnie Maes

B) Explanation T-bills, T-notes, and T-bonds are sold through auction. These auctions award securities to the most competitive bids. Agency securities are sold through selling groups appointed by the agency. LO 7.b

Treasury Inflation Protection Securities (TIPS) offer which of the following benefits to an investor? I) Semiannual adjustments to principal based on the Consumer Price Index (CPI) II) A guarantee of profit upon sale III) Interest payments that keep pace with inflation IV) Provide investors with an income they can't outlive A) II and III B) I and III C) I and II D) III and IV

B) Explanation TIPS are issued by the government and designed to offer investors inflation protection by adjusting the principal of the TIPS semiannually based on the CPI. In times of inflation, the interest payments increase, and they decrease during times of deflation. No security guarantees a profit upon sale, and only an annuity can guarantee an income for life. LO 7.a

Because money market instruments are designed to meet the short-term cash needs of issuing institutions, which of the following is not a money market instrument? A) Commercial paper issued by the finance corporation of a major automobile manufacturer B) Federal Farm Credit Bank note maturing in one year or less C) Newly issued Treasury notes issued to meet a specific government funding requirement D) Municipal construction loan note

C) Explanation A newly issued Treasury note would have a maturity of 2-10 years and would not be considered a money market instrument. A Federal Farm Credit Bank note maturing in one year or less is a money market instrument, as is commercial paper issued by the finance corporation of a major automobile manufacturer with a maturity of less than one year. Municipal construction loans issued to provide short-term financing for a construction project are money market securities. LO 7.a

A customer purchases five 6.25% U.S. Treasury notes at 98.24. How much will the customer receive on each interest payment date? A) $312.50 B) $154.30 C) $156.25 D) $153.50

C) Explanation Although minimum purchase denominations can be less, always use par value ($1,000) for these calculations. A 6.25% bond pays $62.50 annually (6.25% × $1,000 = $62.50). Therefore, a customer purchasing five bonds receives $312.50 each year. Because Treasury notes pay semiannually, each interest payment equals $156.25. LO 7.b

One of the popular mortgage-back issues are those issued by the Government National Mortgage Association (GNMA). One of the reasons for their popularity is the elimination of A) extension risk. B) interest-rate risk. C) credit risk. D) prepayment risk.

C) Explanation Among mortgage-back securities, GNMAs have the unique distinction of direct backing of the government. At least for testing purposes, that eliminates credit risk (the U.S. government cannot go bankrupt). Extension risk is the uncertainly that mortgages will not be paid off as quickly as estimated and prepayment risk is just the opposite. Common to virtually all debt securities is interest-rate risk: as interest rates go up, the price of the security goes down. LO 7.c

Which of the following statements regarding Sallie Mae debentures are true? I) Interest is generally paid monthly. II) Interest is generally paid semiannually. III) Interest is exempt from state and local taxation. IV) Interest is not exempt from state and local taxation. A) II and IV B) I and IV C) II and III D) I and III

C) Explanation As a general rule, debentures pay interest every six months. Further, interest on nonmortgage-backed government securities is taxable at the federal level and exempt from state and local taxation. LO 7.c

Which of the following is not a money market instrument? A) Banker's acceptances B) Commercial paper C) Newly issued Treasury notes D) Treasury bills

C) Explanation Commercial paper, Treasury bills, and banker's acceptances are debt instruments with maturities of one year or less, and therefore, are money market instruments. A newly issued Treasury note would have a maturity of 2-10 years, and therefore, would not be a money market instrument. LO 7.a

For an investor who needs regular income, a GNMA pass-through certificate would be attractive because A) each check is for the same amount. B) the security has the direct backing of the U.S. government. C) the investor would receive a monthly check. D) the income is not taxable on the state or local level.

C) Explanation GMNAs pass through the mortgage payments collected on the pool. Because home mortgages are paid monthly, distributions are made to investors monthly. The fact that GNMAs have the ultimate in security—government backing—does not represent a unique benefit for receiving regular income. Treasury bonds or notes have that backing but only pay interest semiannually. The income from a GNMA is taxable at all levels. Because the mortgage payments, which contain principal as well as interest, include mortgage prepayments, the monthly checks will vary. LO 7.d

Which of the following agency securities has the strongest backing of timely payment of principal and interest? A) FHLMCs B) FNMA C) GNMAs D) Treasury notes

C) Explanation Of the agency securities listed here, the only one that is a direct obligation of the U.S. government is the GNMA. The others are quite safe but are only a moral obligation. Please do not be fooled by the Treasury note - that is not an agency security. This is a perfect example of why it is so important to carefully read the question. This is a perfect example of why it is so important to carefully read the question. LO 7.c

The terminology guaranteed full faith and credit is most applicable to A) interest only on a U.S. government-issued bond. B) interest and principal on a municipal revenue bond. C) interest and principal on a U.S. government-issued bond. D) interest and principal on a corporate bond.

C) Explanation Of the choices given, the terminology would be most applicable to both interest and principal on a U.S. government bond. Remember that the U.S. government's guarantee is backed by their authority to tax and print money. While corporate bonds can be backed by the issuer's full faith and credit, the guarantee is only as good as the corporation's ability to pay. Municipal revenue bonds are backed by the expected revenue generated from the project being financed. LO 7.a

All of the following statements regarding government and agency securities are true except A) interest paid is always subject to federal income tax. B) they are considered safer than corporate debt securities. C) they are always directly backed by the federal government. D) they are authorized by Congress.

C) Explanation Only GNMAs are directly backed by the federal government. FNMAs and FHLMCs are only indirectly backed but are still considered less risky than corporate debt. All are subject to federal taxation, and all were authorized by Congress. LO 7.c

Disregarding commissions, and investor purchasing $10,000 face amount of Treasury notes at a price of 98.12 would expect to pay A) $9,812.00. B) $983.75. C) $9,837.50. D) $981.20.

C) Explanation Please note that the purchase is not for $1,000, but for $10,000. Treasury notes (and bonds) are quoted in 32nds. This quote of 98.12 is 98 12/32 or 98 3/8% of $10,000. LO 7.b

All of the following issue mortgage-backed securities except A) Fannie Mae. B) Freddie Mac. C) Sallie Mae. D) Ginnie Mae.

C) Explanation Sallie Mae is the name for the Student Loan Marketing Association, which does not issue mortgage-backed securities. Ginnie Mae, Fannie Mae, and Freddie Mac do issue mortgage-backed securities. LO 7.c

Which of the following regarding T-bills are true? T-bills trade at a discount to par. T-bills have maturities of 1 to 10 years. Most T-bill issues are callable. T-bills are a direct obligation of the U.S. government. A) I and III B) II and IV C) I and IV D) II and III

C) Explanation T-bills trade at a discount to par, are six months or less to maturity, and are a direct obligation of the U.S. government. T-bills are also noncallable. LO 7.b

The income from all of the following securities is taxable on the federal, state, and local income tax levels except A) GNMA certificates. B) reinvested mutual fund dividends. C) Treasury bonds. D) corporate BBB bonds.

C) Explanation The interest on U.S. government securities (such as Treasury bonds) is exempt from state and local income taxes but not federal income taxes. Dividends (whether reinvested or not), Ginnie Maes, and corporate bonds of all types and/or ratings are taxable on all levels. LO 7.e

Which of the following choices lists Treasury bills, Treasury bonds, and Treasury notes in ascending order of maturity? A) Bills, bonds, notes. B) Bonds, notes, bills. C) Bills, notes, bonds. D) Notes, bills, bonds.

C) Explanation Treasury bills have a maturity of less than one year, Treasury notes mature in 1 to 10 years, and Treasury bonds mature in 10 years or more. LO 7.b

A customer, currently finding the income offered from a money market fund quite low, asks if there might be any debt instruments providing income that could be expected to at least keep pace with inflation, as well as offer some tax relief. What suitable recommendation could be made that meets the investor's investment objectives? A) GNMAs B) ADRs C) U.S. Treasury bills D) Treasury Inflation Protection Securities (TIPS) Explanation Provide income, keep pace with inflation, and offer tax relief are the three criteria. TIPS are specifically designed to provide income that keeps pace with inflation. In addition, the interest is tax exempt at the state and local level, providing some tax relief. None of the remaining choices meet all three. LO 7.

D) A customer, currently finding the income offered from a money market fund quite low, asks if there might be any debt instruments providing income that could be expected to at least keep pace with inflation, as well as offer some tax relief. What suitable recommendation could be made that meets the investor's investment objectives? A) GNMAs B) ADRs C) U.S. Treasury bills D) Treasury Inflation Protection Securities (TIPS) Explanation Provide income, keep pace with inflation, and offer tax relief are the three criteria. TIPS are specifically designed to provide income that keeps pace with inflation. In addition, the interest is tax exempt at the state and local level, providing some tax relief. None of the remaining choices meet all three. LO 7.a

Freddie Mac does which of the following? Issues pass-through securities Purchases student loans Purchases conventional residential mortgages from financial institutions Issues securities backed directly by the full faith and credit of the U.S. government A) II and III B) II and IV C) I and IV D) I and III

D) Explanation Freddie Mac is a publicly owned and traded U.S. government agency that issues pass-through securities based on a pool of conventional residential mortgages purchased from financial institutions. Ginnie Mae is the only U.S. agency that issues securities backed by the full faith and credit of the U.S. government. LO 7.c

Government agency bonds issued by which of the following carry a minimum denomination of $1,000 with $1 increments? A) Freddie Mac B) Sallie Mae C) Federal Home Loan Bank D) Ginnie Mae

D) Explanation GNMA securities are available with a minimum denomination of $1,000 and in increments of $1.00. That means, for example, that a client can purchase one for $1,003.00 or $1,337.00 if desired. The only other agency with that type of pricing is the FNMA. LO 7.d

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

D) Explanation Ginnie Maes pay interest on a monthly basis, not semiannually. LO 7.c

For both U.S. Treasury notes and Ginnie Maes, A) interest is computed on an actual-day basis. B) interest income is taxed at the federal level only. C) settlement is next business day. D) quotes are as a percentage of par in 32nds.

D) Explanation Interest from U.S. T-notes is taxed at the federal level only, while interest on Ginnie Maes is taxed at all levels. GNMA bonds are treated like corporate bonds in many ways. T-notes settle next day, while Ginnie Maes normally settle T+2. Interest on T-notes is computed on an actual-day basis, and Ginnie Mae interest is computed on a 30-day month/360-day year basis. Both Ginnie Maes and T-notes are quoted in 32nds. LO 7.c

An investor purchases $10,000 worth of Treasury bills on November 27 and holds them until they mature on March 30 of the following year. For purposes of taxation, the interest from those Treasury bills is treated as A) tax-free income. B) a short-term gain. C) partially ordinary income and partially capital gain. D) ordinary income subject to federal income tax.

D) Explanation Interest on Treasury bills, notes, and bonds is taxable as ordinary income at the federal level. It is exempt from state and local taxation. LO 7.e

If a customer owns a $10,000 8% U.S. Treasury Bond, and she is in the 28% federal tax bracket and a 2.5% state tax bracket, what amount of tax will she pay on the income received from the bond? A) $80 B) $100 C) $20 D) $224

D) Explanation Interest on U.S. Treasury bonds is taxable at the federal level only; $800 of interest taxed at 28% equals $224. LO 7.e

Which of the following statements regarding Sallie Mae debentures are true? A) They are backed by the taxing power of the U.S. government. B) Interest is paid monthly. C) Sallie Mae securities finance building public schools across the country. D) Interest is tax exempt at the state and local levels.

D) Explanation Interest on nonmortgage-backed government securities is taxable at the federal level and exempt from state and local taxation. As a general rule, debentures pay interest every six months. Sallie Mae is not backed by the taxing power of the U.S. government, and money is used for student loans for higher education. LO 7.c

One of your customers would like to purchase a government agency security for the UTMA account of her daughter. The daughter worked in construction over the summer and would like to use $1,275 of her savings for the purchase. Securities issued by which of these agencies could be purchased for this account? A) Student Loan Marketing Association B) Federal Home Loan Mortgage Corporation C) Federal Farm Credit System D) Federal National Mortgage Association

D) Explanation Of this group, the only agency that would be able to sell $1,275 of securities is Fannie Mae. Their securities are available with a minimum denomination of $1,000 and then increments of $1. FHLMC also has the $1,000 initial minimum, but with $1,000 increments. The same numbers apply to the FCS, and Sallie Mae's minimum is $10,000. Another agency that would have met the investor's need is GNMA. LO 7.d

A customer owns 10M of 7% U.S. Treasury bonds. He is in the 28% federal tax bracket and the 10% state tax bracket. What is his annual tax liability on these bonds? A) $98 B) $266 C) $70 D) $196

D) Explanation The 10M means $10,000. (Remember your Roman numerals? M equals 1,000). His tax liability is as follows: $1,000 times 7% equals $70 annual interest per bond; $70 times 10 equals $700 annual interest, which is taxable only by the federal government; and $700 times 28% equals a $196 tax liability. LO 7.e

A Treasury bond is quoted in The Wall Street Journal as follows: Bid 100:15 Asked 100:17 Bid Chg. -1 Yield 7.9 From this information, you know that the nominal yield is A) less than 7.90%. B) 7.89%. C) 7.90%. D) greater than 7.90%.

D) Explanation The Bid and Asked prices show that the Treasury bond is being quoted at a premium (above par), with a yield to maturity of 7.9%. When bonds are trading at a premium, the nominal yield (coupon rate) is greater than the yield to maturity. LO 7.b

The function of the Federal National Mortgage Association (FNMA) is to A) guarantee the timely payment of interest and principal on FHA and VA mortgages. B) issue conventional mortgages. C) provide financing for government-assisted housing. D) purchase FHA-insured, VA-guaranteed, and conventional mortgages.

D) Explanation The FNMA buys FHA, VA, and conventional mortgages and uses them to back the issuance of debt securities. FNMA currently issues debentures, mortgage-backed securities, and certificates. LO 7.c

Your customer wishes to lock in a long-term yield with minimal risk and is not interested in regular income. Which of the following securities should you recommend? A) Treasury bond B) Corporate A-rated zero-coupon bond C) Treasury bill D) Treasury STRIPS

D) Explanation The Treasury STRIPS is long-term, no-interim income security and has a locked-in yield because it is purchased at a discount from par. The Treasury bill is short term, the Treasury bond provides semiannual interest, and the corporate zero is riskier than the STRIPS. LO 7.a

A customer, currently finding the income offered from a money market fund quite low, asks if there might be any debt instruments providing income that one could expect to at least keep pace with inflation as well as offer some tax relief. What suitable recommendation could be made that meets the investor's investment objectives? A) GNMAs B) U.S. T-bills C) Participating preferred D) TIPS

D) Explanation The investor has requested a debt security that can meet three criteria: provide income, keep pace with inflation, and offer tax relief. Treasury Inflation Protection Securities (TIPS) are specifically designed to provide income that keeps pace with inflation. In addition, the interest is tax exempt at the state and local level, providing some tax relief. GMNAs will provide income, but they are fully taxable on a state and federal level and offer no inflation protection. T-bills provide income that is probably lower than the money market fund the investor was unhappy with, and participating preferred stock is not a debt security. LO 7.a

A registered representative calls a dealer for a quote and is given the following quote: Maturity | Bid | Asked | Chg. | Asked yield | 5/28/2019 | 2.273 | 2.263 | 0.015 | 2.301 What type of security did the registered representative ask for? A) An exchange-traded note B) A municipal note C) A Treasury note D) A Treasury bill

D) Explanation This represents a quote for a T-bill. The quote represents a percentage discount from 100%. It is easy to identify because it looks like the bid price is greater than the ask price. This is the only quote you will see on the Series 7 that looks like this. If you subtract 0.02273 % from 100%, the result is 99.97727% of par, and if you subtract 0.02263% from 100%, the result is 99.97737%. Therefore, the quote is bid $999.7727, ask $999.7737. Note that the ask price is slightly higher. For the exam, it is only important to identify the quote as a T-bill quote; you do not need to do the calculation. LO 7.b

Which of the following statements regarding Treasury bills are true? I) They are sold in minimum denominations of $10,000. II) They are offered with maturities ranging up to 52 weeks. III) Their interest is exempt from taxation at the state level. IV) They are callable by the U.S. Treasury at any time before maturity. A) I and III B) II and IV C) I and II D) II and III

D) Explanation Treasury bills are sold in minimum denominations of $100 and are not callable before maturity. T-bills are regularly offered with maturities from four weeks to as long as 52 weeks from issuance and are issued at a discount. Interest on Treasury bills is taxable at the federal level only. LO 7.b

All of the following statements regarding Treasury bills are correct except A) Treasury bills trade at a discount to par. B) Treasury bills are a direct obligation of the U.S. government. C) 4-, 13-, and 26-week maturities are typical with the maximum sometimes changing. D) most Treasury bill issues are callable.

D) Explanation Treasury bills trade at a discount to par and are 4, 13, or 26 weeks in original maturity. (Maximum maturities are subject to change.) They are a direct obligation of the U.S. government and are noncallable. LO 7.b

Debt instruments put up for auction by the U.S. Treasury that offer intermediate maturities best describes A) Treasury bonds. B) anticipation notes. C) Treasury bills. D) Treasury notes.

D) Explanation Treasury notes are the intermediate maturity (2 to 10 years). Treasury bills are short term (less than one year), anticipation notes are short-term revenue notes, and Treasury bonds are long term (10 years or more). LO 7.b

Interest on direct debt issued by the U.S. government is taxable at A) the federal level and exempt at the state level. B) the federal and state level. C) the state level only. D) different levels in different states.

A) Explanation Interest on direct debt (T-bills, T-notes, T-bonds, and STRIPS) is taxable by the federal government but not by state or local governments. LO 7.e