Questions
One of your customers is in the 37% federal income tax bracket. The customer prefers purchasing corporate bonds over municipal bonds because the corporation's financials are much easier to understand. On the customer's next purchase, the instructions are to find a corporate bond that will yield the same after-tax return as would be received from a municipal bond with a 3.20 coupon. The bond you suggest must have a coupon of A) 8.65%. B) 3.20%. C) 5.08%. D) 4.38%.
5.08%. This is a tax-equivalent yield question. The interest paid on a corporate bond is taxable, while that of the municipal bond is tax free. The formula is: The coupon of the municipal bond divided by (100% − tax bracket). In our question, that would be 3.20% divided by 63%, or 5.08%
If interest rates increase, the interest payable on outstanding corporate bonds will A) remain unchanged. B) increase. C) change according to the inverse payout theory. D) decrease.
A) remain unchanged The interest payable is the nominal yield, which is stated on the face of the bond. It is the percentage of face value the bond will pay each year regardless of the prevailing interest rates in the market. It is the market price of bonds, not the interest payable, that responds inversely to changes in interest rates.
When a corporation issues a debt security, the terms of the loan are expressed in a document known as the bond's deed of trust. The deed of trust is sometimes referred to as A) the indenture. B) the bond resolution. C) the loan agreement. D) the debenture.
A) the indenture The indenture, sometimes also referred to as the deed of trust, states the issuer's obligation to pay back a specific amount of money on a specific date. A debenture is a debt security containing an indenture. Bond resolution is a term used for municipal bonds, not corporate debt.
Which of the following is an example of sovereign debt? A) Royal Bank of Canada CDs B) U.S. Treasury bonds C) Bank of England notes D) Sony Corporation debentures
B) U.S. treasury bonds Sovereign debt represents loans to governments. On the exam, it is likely that the examples will be foreign governments, not U.S. Treasury securities. The Royal Bank of Canada is a privately owned corporation and its debts are not those of the Canadian government. Bank of England notes are the paper currency issued (e.g., the ₤10 and ₤20 notes).
Which of the following debt securities would be most likely to offer a conversion feature into common stock? A) A mortgage bond B) A debenture C) Commercial paper D) Preferred stock
B) debenture Invariably, when it comes to convertible debt securities, they are debentures rather than secured bonds. The conversion concept makes no sense with money market securities—they mature in one year or less. Preferred stock is often convertible, but it is an equity security, not a debt security.
Which of the following is not a type of corporate debt instrument? A) Income bond B) Revenue bond C) Mortgage bond D) Subordinated debenture
B) revenue bond A revenue bond is a type of municipal bond. Income bonds are usually issued by companies coming out of a bankruptcy where the company is obligated to pay the semiannual interest only if there are sufficient earnings. Mortgage bonds are secured by real property, such as the company's physical facilities, and subordinated debentures are unsecured debt and come last in line among the creditors. The course will not describe municipal revenue bonds until the next unit. How were you supposed to know what they are? You might have a question where the correct response is something you never heard of—what do you do? Eliminating the choices you know are incorrect is an important test-taking technique. Look at this question. We covered the other three choices in our text on corporate debt issues; that should have made the correct answer obvious.
An investor purchases a bond on its initial public offering. Even though the bond has a maturity value of $1,000 in 10 years, the offering price is only $600. If the bond is held to maturity, A) there is a $400 long-term capital gain. B) there are no tax consequences to report. C) $400 is reported as ordinary income. D) there is a $360 long-term capital gain and $40 in ordinary income.
B) there are no tax consequences to report A bond issued at a significant discount from its maturity value is known as an original issue discount bond (OID). In the case of a corporate bond, the computation is more complex than can be tested, but there are two things you need to know: 1. A portion of the discount is taxed as ordinary income each year until maturity, even though it is not actually received. This is called phantom income. Each year's taxable amount is reported on Form 1099-OID. 2. Because a portion of the discount has been taxed each year, at maturity there are no tax consequences—no gain, no interest.
Moody's Investment Grade (MIG) ratings are applied to A) money market instruments. B) municipal bonds. C) municipal notes. D) corporate bonds.
C) municipal notes Moody's Investment Grade ratings are applied to municipal notes, which are short-term municipal debts such as bond anticipation notes (BANs).
A bond with a 9% coupon, maturing in 18 years and 6 months, is selling at 120. The yield to maturity is closest to A) 7.50%. B) 9.00%. C) 11.66%. D) 7.05%.
D) 7.05%. Don't waste time trying to do the yield to maturity computation. This bond is selling at a premium (120% of par). Therefore, all of the computed returns must be lower than the 9% nominal (coupon) yield. Only two of them are. The 7.50% represents the current yield ($90 ÷ $1,200). We know from our charts that, just like a seesaw, the farther from the center you go, the bigger the move at the end. That means the nominal yield is the highest, followed by the current yield (CY), the yield to maturity (YTM), and finally the yield to call (YTC) as the lowest. Because only one choice is lower than the CY, you get the correct answer with minimal effort.
An investor is concerned about safety. When consulting the ratings, which of the following securities would appear to be least likely to default on its obligation to make timely payment of interest and principal? A)AAA rated common stock B)BB rated sovereign debt C)A rated mortgage bond D)AA rated debenture
D) AA rated debenture When it comes to reducing default risk, "the As have it." That is, the more As in the rating, the lower the default risk. True, the common stock is rated triple A, but stock has no obligation to pay interest and repay principal. Why isn't the mortgage bond a safer bet than the debenture? Aren't secured bonds the safest? These are good questions, but the rating services take that into consideration when giving a rating. In their eyes, the debenture, an unsecured debt, merits a double A rating while the mortgage bond, even with the pledged collateral, can only be awarded a single A rating. Sovereign debt, the debt of a country's government, is usually quite safe, but history has shown us that governments can, and do, default. The BB rating here indicates a certain question as to the safety.
A corporate bond is quoted in the Wall Street Journal as follows: Bid: 100½ Asked: 100¾ Bid Chg.: -⅛ Yield: 5.75 From this information, you know the nominal yield is A) less than 5.75%. B) 5.75%. C) 5.625%. D) greater than 5.75%.
D) greater than 5.75% The bid and asked prices show that the bond is being quoted at a premium (above par), with a yield to maturity of 5.75%. When bonds are trading at a premium, the nominal yield (coupon rate) is greater than the yield to maturity.
An investor whose primary objective is a steady income flow would probably be best served by building a portfolio of A) preferred stock. B) cumulative common stock. C) income bonds. D) investment-grade debentures.
D) investment-grade debentures The "trick" here is to remember that income bonds are issued during a corporate reorganization and only pay interest when and if the company has sufficient earnings. When a bond or debenture is investment grade, the likelihood of receiving timely interest payment is high. Preferred stock is generally a good source of income, but, because the dividends are not an obligation in the way that interest is, the stability of the income is less assured. There is no such thing as cumulative common stock, only preferred.
A customer purchases an ABC 6½% convertible preferred stock at $80. The conversion price is $20. If the common stock is trading 2 points below parity, the price of ABC common is A) $12. B) $14. C) $18. D) $16.
The correct answer was: $14. The conversion ratio is computed by dividing par value by the conversion price ($100 par / $20 = 5). Parity price of the common stock is computed by dividing the market price of the convertible by the conversion ratio ($80 / 5 = $16). $16 − 2 = $14.Reference: 1.3.2.3 in the License Exam Manual.