5.4 Fixed Income (Debt) Securities

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) $1,000. B) $1,200. C) $1,440. D) $1,219.

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

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

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 amount of the final semiannual interest check? A) $17.50. B) $35.00. C) $42.66. D) $21.33.

The semiannual interest of a TIPS bond is computed on the basis of the inflation-adjusted principal. Because the principal increases with the inflation rate, at the end of the 5-year term, it has grown to $1,219 ($1,000 × 102% ten times). Therefore, the final interest check is for $1,219 × 1.75% (remember it is a semiannual check).

Which of the following investments gives the investor the least exposure to reinvestment risk? A) Treasury notes. B) Preferred stock in a growth company. C) Common stock in an electric utility. D) Treasury STRIPS/zero-coupon bonds.

Treasury STRIPS (Separate Trading of Registered Interest and Principal of Securities) are zero-coupon bonds paying no interest. Thus, there is no income to reinvest during the holding period and therefore no reinvestment risk.

Which of the following debt instruments is unsecured? A) Aaa/AAA rated debentures. B) Junior lien mortgage bonds. C) Collateral trust certificates. D) Equipment trust certificates.

A) Aaa/AAA rated debentures. debentures= unsecured bonds *Corporate debentures are unsecured bonds backed by the credit of the issuing corporation; they are not secured by underlying collateral. Mortgage bonds are secured with real estate serving as collateral. Collateral trust bonds are secured by securities that a corporation owns in other companies or bonds. Equipment trust certificates are secured by transportation equipment owned by the corporation.

Which of the following are NOT considered money market instruments? American depositary receipts. Commercial paper. Corporate bonds. Jumbo (negotiable) certificates of deposit. A) I and III. B) I and II. C) II and IV. D) III and IV.

A) I and III. A money market instrument is a high-quality, short-term debt security with maturity of less than 1 year. American Depositary Receipts (ADRs) are equity, and corporate bonds are long-term debt instruments.

Which of the following statements about zero-coupon bonds are TRUE? Zero-coupon bonds are sold at a deep discount from face value. Zero-coupon bonds pay periodic interest payments. The owner of a zero-coupon bond receives his return only at maturity. A) I and III. B) I and II. C) II and III. D) I, II and III.

A) I and III. A zero-coupon bond is a type of debt security that pays no periodic interest payments. Instead, the investor receives his return only at maturity, when the bonds are redeemed. Zero-coupon bonds are sold at a deep discount from face value, but are redeemed at full face value when they mature.

Which of the following statements regarding corporate zero-coupon bonds are TRUE? Interest is paid semiannually. The discount is in lieu of periodic interest payments. The discount must be accreted and is taxed annually. The discount must be accreted annually with taxation deferred until maturity. A) II and III. B) I and III. C) I and IV. D) II and IV.

A) II and III. The investor in a corporate zero-coupon bond receives the return in the form of growth of the principal amount over the bond's life. The bond is purchased at a deep discount and redeemed at par at maturity. That discount from par represents the interest that will be earned at maturity date. However, the discount is accreted annually and the investor pays taxes yearly on the imputed interest.

Which of the following U.S. government securities do NOT bear a stated interest rate but are sold at a discount through weekly auctions? A) Treasury bills. B) Treasury notes. C) Treasury bonds. D) TIPS.

A) Treasury bills. Treasury bills bear no stated interest rate. They are sold at a discount through weekly auctions and are actively traded in the money market. Treasury notes and Treasury bonds as well as Treasury Inflation Protection Securities (TIPS), all carry stated interest rates.

An investor regularly reads financial blogs on the Internet and they are filled with articles suggesting that the economy is headed for a slump. Some are even saying that there will be price deflation. If these projections are accurate, the best place for the investor to place funds would probably be: A) U.S. treasury bonds. B) gold. C) commercial real estate. D) common stock.

A) U.S. treasury bonds. When the economy is headed downward, safety is the imperative and nothing is as safe as US Treasuries. Gold, and most other commodities, are a hedge against inflation, not deflation. In "down" times, real estate, both residential and commercial, usually underperforms.

A bond issued by the GEMCO Corporation has been rated AAA by a major bond rating organization. This bond would be considered: A) an investment grade corporate bond. B) a high-yield corporate bond. C) secured. D) callable.

A) an investment grade corporate bond. An investment-grade bond has a bond rating between AAA and BBB. Lower-rated bonds are considered high-yield bonds and are often referred to as junk bonds The bond may or may not be secured: the rating does not indicate that fact.

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

A) short-term debt. Money market instruments are high-quality debt securities with maturities that do not exceed 1 year.

An investor purchased $10,000 of a 15 year AA rated corporate bond with a 6% coupon in the secondary market 3 years ago at par. The bond matured last week and the investor has just received a check for $10,300. Which of the following is a true statement? A) $300 is considered a return of principal. B) $300 is taxed as ordinary income. C) $300 is taxed as long-term capital gain. D) The investors cost basis has been reduced to $9,700.

B) $300 is taxed as ordinary income. At maturity, the bondholder receives both the principal ($10,000) and the final interest check (6% of $10,000 = $600 per year/paid semi-annually) of $300. This interest, like all corporate bond interest, is ordinary income.

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

B) Bank CD. Of these securities, only the bank CDs are always interest bearing and issued at par or face value

A client has indicated that his primary objective is maximizing current income regardless of the risk. Which of the following mutual funds would probably be most suitable for achieving that goal? A) JKL Municipal Bond Fund. B) DEF High Yield Bond Fund. C) ABC Growth and Income Fund. D) GHI Index Fund.

B) DEF High Yield Bond Fund. High yield (junk) bonds, although carrying more risk, produce higher current income than other funds.

Which of the following regarding corporate debentures are TRUE? They are certificates of indebtedness. They give the bondholder ownership in the corporation. They are unsecured bonds issued to finance capital expenditures or to raise working capital. They are the most senior security a corporation can issue. A) III and IV. B) I and III. C) I and II. D) II and IV.

B) I and III. Debentures are debt securities that represent unsecured loans of the issuer. They are senior to common and preferred stock in claims against an issuer. They are issued to finance capital expenditures or raise working capital.

**Which of the following are characteristics of negotiable jumbo CDs? I. Issued in amounts of $100,000 to $1 million. II. Typically pay interest on a monthly basis. III. Always mature in 1 to 2 years. IV. Trade in the secondary market. A) II and IV. B) I and IV. C) I and III. D) II and III.

B) I and IV. Negotiable jumbo CDs are issued for $100,000 to $1 million and trade in the secondary market. Most jumbo CDs are issued with maturities of less than a year. These CDs generally pay interest on a semi-annual basis, not monthly.

Your client has been saving for the purchase of a home. She calls to tell you that her bank CD matured and she is not pleased with the renewal rate offered by the bank. The client plans to purchase the home within the next 9-12 months and will probably need these funds for the down payment. Which of the following would be the most suitable recommendation? A) Public utility stock paying liberal dividends. B) Treasury bills. C) Large-cap stock. D) Growth stock.

B) Treasury bills. When customers need access to funds within a short period of time, their primary consideration is liquidity. The most suitable investment recommendation for this client is US Treasury bills, which are highly liquid and safe. In addition, recommending investments in stocks that carry market risk to a client who traditionally purchases bank CDs may not meet the client's nonfinancial considerations.

One of your clients approaches you looking for an investment that will provide ready marketability and income. Which of the following would be the most appropriate recommendation? A) limited partnership in rental real estate. B) U.S. treasury notes. C) bank insured CDs. D) NYSE listed common stock.

B) U.S. treasury notes. The key is meeting both needs - marketability and income and only the treasury notes supply both. A CD will provide income, but they are non-marketable - they can only be redeemed at the bank and, if done prior to maturity, will invariably suffer a penalty to interest, principal, or both. NYSE common stock will be marketable, but there are no guarantees as to the income and the limited partnership will almost always have limited to no marketability.

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

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

**Which of the following issues is most affected by credit risk? A) preferred stock. B) corporate zero-coupon bonds. C) common stock. D) debentures.

B) corporate zero-coupon bonds. Credit risk is the risk of default, found only with debt instruments. Although debentures are issued strictly on the issuer's credit rating, they have the advantage over any zero-coupon bond in that interest payments begin approximately six months after issuance while in a zero-coupon bond, nothing is paid until maturity date.

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

B) 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.

If interest rates decline sharply, which of the following bonds is likely to appreciate the most? A) 15-year 8% bond trading on an 8.10 basis. B) 15-year 7% bond trading at par. C) 15-year zero coupon bond trading on a 7.60 basis. D) 15-year 8% bond trading on a 7.90 basis.

C) 15-year zero coupon bond trading on a 7.60 basis. Prices of zero-coupon bonds tend to be more volatile than prices of interest-bearing bonds because of their longer duration.

All of the following statements regarding Government National Mortgage Association (GNMA) pass-through securities are true EXCEPT: A) the minimum initial investment is $25,000. B) investors own an undivided interest in a pool of mortgages. 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) GNMAs are considered to be the riskiest of the agency issues. 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.

One of the advantages of owning a corporation's debentures is that you have: prior claim over common stockholders. prior claim over preferred stockholders. prior claim over general creditors. prior claim over secured creditors. A) II and IV. B) III and IV. C) I and II. D) I and III.

C) I and II. Holders of a company's debentures are general creditors and, as such, only have prior claim over equity holders.

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

C) I and III. 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.

Which two of the following investments would offer your clients the best chance of minimizing inflation risk? Common stock. Cumulative preferred stock. Money market mutual funds. TIPS. A) II and III. B) III and IV. C) I and IV. D) I and II.

C) I and IV. Historically, common stock has been the best hedge against inflation. TIPS (Treasury Inflation Protection Securities) are Government guaranteed debt issues that automatically adjust the principal based upon the inflation rate.

**Which of the following are characteristics of negotiable certificates of deposit? Minimum face value of $100,000. Maturities rarely extend beyond 360 days. May be sold on the secondary market. A) I and III. B) II and III. C) I, II and III. D) I and II.

C) I, II and III. Negotiable certificates of deposit usually have a minimum face value of $100,000. It is rare to find one with a maturity that exceeds 360 days. Unlike nonnegotiable certificates of deposit, they may be bought and sold on the secondary market.

An investor purchases zero-coupon bonds issued by the U.S. Treasury due to mature in 18 years at $100,000. Which of the following might describe the primary reason for selecting that investment vehicle? The investor is 65 years old and needs the reliability of current income. The investor is 45 years old and has purchased these in an IRA rollover account and wants the assurance of funds for retirement. The investor is 30 years old and has a newborn child and wishes to assure funds for a college education. The investor is 20 years old, has just received an inheritance, and wishes to shelter income for as long as possible. A) I and IV. B) III and IV. C) II and III. D) I and II.

C) II and III. Zero-coupon bonds maturing in 18 years would assure the 45-year-old of the face value at age 63. Being in an IRA, there would be no current taxation and, upon maturity, if desired, the funds could be distributed without the 10% penalty. Zero-coupon bonds are one way to guarantee funds for college education. However, with no current income, they would not be suitable for the 65-year-old and would not offer any tax shelter to the 20-year-old.

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 generally carry lower coupon rates than corporate bonds of the same quality. C) Municipal bonds are generally considered riskier than corporate bonds. D) Municipal bonds are bonds issued by governmental units at levels other than the federal.

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

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

C) Zero-coupon Treasury bonds. Zero-coupon bonds, particularly those carrying the guaranteed of the US 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.

Of the following bonds, which has the greatest price volatility? A) Corporate bond fund. B) AA corporate bond with 7 years to maturity. C) Zero-coupon bond with 15 years to maturity. D) Zero-coupon bond with 5 years to maturity.

C) Zero-coupon bond with 15 years to maturity. The longer the duration of a bond, the greater the volatility will be of its market price when interest rates change. Because zero-coupon bonds do not make interest payments but are priced at a deep discount to par value, they are more volatile than coupon-bearing bonds.

Corporate bonds that are issued on the general credit of the issuer and are NOT otherwise secured are called: A) consolidated mortgages. B) convertible. C) debentures. D) participating.

C) debentures. Debentures are corporate bonds issued on the general credit of the corporation and are not backed by any specific assets.

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

C) 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.

Which of the following statements are NOT true concerning revenue bonds? They are secured by a specific pledge of property. They are a type of general obligation bond. Generally, their interest is tax-exempt at the federal level. They are analyzed primarily on the project's ability to generate earnings. A) I and III. B) II and IV. C) III and IV. D) I and II.

D) I and II. Revenue bonds are not secured by a specific pledge of property and are not a type of general obligation bond. They are secured by user fees, such as tolls.

Which two of the following investments would offer your clients the best chance of minimizing inflation risk? Common stock. Cumulative preferred stock. Money market mutual funds. TIPS. A) I and II. B) II and III. C) III and IV. D) I and IV.

D) I and IV. Historically, common stock has been the best hedge against inflation. TIPS (Treasury Inflation Protection Securities) are Government guaranteed debt issues that automatically adjust the principal based upon the inflation rate.

From first to last, in what order would claimants receive payment in the event of bankruptcy? Holders of secured debt. Holders of subordinated debentures. General creditors. Preferred stockholders. A) I, II, III, IV. B) III, I, II, IV. C) IV, I, II, III. D) I, III, II, IV.

D) I, III, II, IV. The liquidation order is as follows: wages, taxes, secured debt holders, unsecured debt holders (including general creditors), holders of subordinated bonds, preferred stockholders, and common stockholders.

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

D) II and IV. Negotiated maturities and yields. Not registered with the SEC. Commercial paper represents the unsecured debt obligations of corporations needing short-term financing. Both yield and maturity are open to negotiation. Because commercial paper is issued with maturities of less than 270 days, it is exempt from registration under the Act of 1933.

Which of the following best describes the liquidation order when a company files for bankruptcy? common stockholders. debenture holders. preferred stockholders. secured creditors. A) III, IV, II, I. B) IV, III, II, I. C) I, II, III, IV. D) IV, II, III, I.

D) IV, II, III, I. 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.

Which of the following debt instruments generally present the least amount of default risk? A) High-yield corporate bonds. B) Convertible senior debentures. C) Municipal revenue bonds. D) Municipal general obligation bonds.

D) Municipal general obligation bonds. Because the full taxing power of the municipality backs a general obligation municipal bond, it will exhibit the least amount of default risk. A corporate debenture is an unsecured bond with a greater degree of risk, as is a junk or high-yield corporate bond.

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

D) Newly issued Treasury notes. Commercial paper, Treasury bills, and banker's acceptances are debt instruments with maturities of 1 year or less and are therefore money market instruments. A newly issued Treasury note would have a maturity of 2 to 10 years and therefore would not be a money market instrument.

Which of the following best describes that which secures a debenture issued by an industrial corporation? A) The securities of the issuing company. B) The mortgages and real estate of the issuing company. C) The assets of a company other than the issuing company. D) The assets of the issuing company.

D) The assets of the issuing company. Debentures are general obligations of the issuing company. They are actually backed by the assets of the company. Prior claims to those specific assets by secured debt issues take precedence over the debentures.

Bondholders are paid interest: A) after the preferred stockholders receive their dividends, but before the common stockholders are paid. B) after the common stockholders are paid, but before the preferred stockholders are paid. C) at any time determined by the board of directors. D) before both the preferred and the common stockholders are paid.

D) before both the preferred and the common stockholders are paid. Dividends are paid to both preferred and common stockholders only after interest has been paid on all of the corporation's outstanding debts and debt securities.

Corporate bonds are considered safer than common stock issued by the same company because: A) bonds and similar fixed-rate securities are guaranteed by SIPC. B) the par value of bonds is generally higher than that of stock. C) if there is a shortage of cash, dividends are paid before interest. D) bonds place the issuer under an obligation but stock does not.

D) bonds place the issuer under an obligation but stock does not. A bond represents a legal obligation to repay principal and interest by the company. Common stock carries no such obligation, and is therefore considered riskier.

All of the following are money market instruments EXCEPT: A) Treasury bills. B) jumbo (negotiable) CDs. C) commercial paper. D) newly issued Treasury notes.

D) newly issued Treasury notes. Money market securities have a maximum maturity of 1 year. Treasury notes are issued with maturities of 2 to 10 years. Treasury bills are money market instruments with maturities of 6 months or less. Jumbo CDs are issued by banks and have maturities of 1 year or less. Commercial paper (issued by corporations) is unsecured short-term debt with maturities of 270 days or less.

Investors seeking higher income may be interested in mortgage-back securities. To prepare a cash flow analysis on these, the most important of the following factors is: A) the quality of the mortgages. B) whether there is a real estate "bubble." C) current tax rates. D) the average maturities.

D) the average maturities. Mortgage-backed pass-through securities pass through interest and principal payments to their investors. The rate at which the cash flows are generated depends, among other things, on the rate at which the mortgages mature.