Series 6: Debt Securities
Which one of the following corporate debt instruments is unsecured? A Debenture B Equipment trust certificate C Collateral trust certificate D Mortgage bond
A Debentures are not secured by any collateral. A debenture is backed by the good faith and credit of the issuer, or the issuer's good will. Mortgage bonds are secured by the corporation's real estate or property owned by the issuer, such as an office building. A collateral trust certificate is backed by securities of another company. Equipment trust certificates are secured issues backed by leased or purchased equipment, such as vehicles or other machinery by debtors, such as railroads, trucking companies, and airlines.
A debt instrument backed by equipment such as vehicles or other machinery is a(n): A Equipment trust certificate B Mortgage bond C Collateral trust certificate D Debenture
A Mortgage bonds are secured by the corporation's real estate or property owned by the issuer, such as an office building. A debenture is an unsecured bond issue backed only by the creditworthiness of the issuer. A collateral trust certificate is backed by securities of another company. Equipment trust certificates are secured issues backed by leased or purchased equipment, such as vehicles or other machinery, by debtors, such as railroads, trucking companies, and airlines.
How often is bond interest paid? A Monthly B Semiannually C Annually D Quarterly
B Bond interest is paid semiannually, while cash dividends on common stock are paid quarterly.
In considering investor suitability, GNMA pass-through certificates would be most appropriate for which investor? A An investor in the 37% tax bracket, seeking tax-free income with a goal of capital preservation B An investor with a large portfolio seeking income and safety of principal C An investor seeking capital appreciation with a high risk tolerance D An investor seeking growth and income with a moderate risk tolerance
B GNMA pass-through certificates are guaranteed by the full faith, credit, and taxing power of the U.S. government. They are often purchased by conservative income investors drawn to the product's safety, as well as their higher return versus traditional Treasurys.
Which of the following bonds is backed by the full faith, credit and taxing power of the issuer? A Industrial development revenue B General obligation C Revenue obligation D General revenue
B General obligation bonds are backed by the full faith, credit and taxing power of the issuer. Only issuers with authority to levy taxes may sell GO bonds.
A Treasury bill does not have which of the following characteristics? A It is a marketable issue that trades in the secondary market B It is sold at face value and pays interest semiannually C It is issued weekly on a competitive bidding basis D It has a maturity date of up to 1 year
B T-bills are issued in maturities ranging from 4 weeks to one year. They do NOT have a coupon rate and do NOT pay periodic interest. They are purchased at a discount and mature at face amount. They are issued by the U.S. government through a weekly auction and trade in the secondary market.
All the following statements are true regarding T-bonds, except: A They have interest-rate risk B They are purchased at a discount and mature at par C The maximum maturity is 30 years D They pay semiannual interest
B Treasury bonds are issued at par and mature at face value. They pay semiannual interest at a stated coupon rate. The maximum maturity is 30 years. At maturity, the investor receives the par value plus the last semiannuals interest rate payment. U.S. government securities are virtually free of default (credit) risk but are still subject to interest-rate risk.
Which statement about U.S. government securities is true? A Income from U.S. government securities is always subject to state tax B All U.S. government securities are backed by the full faith and credit of the U.S. government C Capital gains generated by the sale of U.S. government securities are exempt from federal income tax D In case of default, the extent of coverage is determined by authorizing legislation
B U.S. government securities are unconditionally backed by the federal government. Their interest is exempt at the state level. Only interest is exempt; trading profits are always taxable.
Under what circumstances would it make sense to recommend a lower yielding bond to an investor over a higher yielding bond? A When the lower yielding bond is taxable, and the higher yielding bond is tax-free B When the higher yielding bond has a lower after-tax return than the lower yielding bond C When the higher yielding bond has a higher after-tax return than the lower yielding bond D When the lower yielding bond is subject to AMT
B When the higher yielding bond has a lower after-tax return (e.g. 5%) than the lower yielding bond (e.g. 5.5%) due to the income tax bracket of the investor.
General Obligation Bonds
Backed by the full faith, credit and taxing power of the issuer
Bankers' Acceptances
Bankers' acceptances (BAs) are debt securities used to finance foreign trade. When money is due from a foreign company, the U.S. corporation may sell this debt to the bank as a letter of credit at a discounted price. The U.S. company is effectively paid sooner, and the bank earns the difference between the purchase price and the face value of the money owed.
Negotiable Certificates of Deposit (CDs)
Banks issue negotiable CDs (Jumbo CDs) to attract deposits outside of their traditional client bases. These CDs are usually purchased by large institutional investors. The minimum denomination is $100,000, which is guaranteed by the issuing bank, and the maturity is one year or less. Because these securities are negotiable, they may be traded in the secondary market and carry a very low risk due to the short-term maturity.
A portfolio composed entirely of convertible securities does not provide which of the following? A The potential for capital appreciation B Greater downside protection than holding only common stocks C A higher rate of return than one composed of nonconvertible bonds D Current income
C A convertible bond has the potential to share stock appreciation while nonconvertible bonds do not. Because of this attractive feature, convertibles provide lower returns than nonconvertible bonds. Convertible bonds receive higher income than common stock and tend to be less volatile. Because of their greater safety and more assured income, their prices generally fall less than common stocks.
Last year, a client purchased an 8% G.O. bond at par. The current yield on the bond stands at 9.5%. Which of the following statements is true? A The market value of the bond has fallen since the purchase and the investor will receive $95 per year in interest over the coming year B The market value of the bond has risen since the purchase and the investor will receive $95 per year in interest over the coming year C The market value of the bond has fallen since the purchase, and the investor will receive $80 per year in interest over the coming year D The market value of the bond has risen since the purchase and the investor will receive $80 per year in interest over the coming year
C An investor who owns an 8% bond will receive $80 per year in interest (8% x $1,000 par), regardless of the current market price of the bond. However, the current price of the bond will affect the bond's current yield, which is the bond's coupon payment divided by its current market value. Since this bond pays an $80 annual coupon, the only way for it to show a current yield of more than 8% is to have a price of less than $1,000 par. Since most bonds are originally issued at par, this means the bond's price must have fallen since it was issued.
Which of the following debt issues is considered a money market security? A A newly issued 20-year corporate debenture B A 30-year municipal general obligation bond that is 5 years old C A 10-year U.S. treasury note 9 months prior to maturity D A 30-year U.S. treasury bond that is 2 years prior to maturity
C Any debt issue that is within one-year of maturity is considered a money market instrument at that time regardless of what it was at time of issuance.
Which of the following bonds will generate interest that is completely exempt from federal income tax? A An industrial revenue bond B A general obligation bond that does not contain a legal opinion C A revenue bond that contains a legal opinion D A private activity bond
C Municipal bonds are generally exempt from federal income tax. To be federally tax-exempt, municipal bond issues must contain the opinion of legal counsel that the bond qualifies as a municipal issue—and all interest is exempt from federal income tax. Private activity bonds, such as IDRs, may be subject to federal AMT.
What would be happening in the interest-rate market to expose an investor in mortgage or asset-backed securities to extension risk? A Interest rates would be declining B Interest rates would be stable C Interest rates would be increasing D Interest rates would be the same as when the investor first purchased the security
C One drawback of mortgage-backed securities and asset-backed securities is that the principal may be paid back by the borrower ahead of schedule. Although many of the loans backing these pools have a 30-year life, home sales, voluntary early payoffs, and refinancing by homeowners will all accelerate the payment of principal. This prepayment risk occurs when interest rates decline in the market. Extension risk is the risk that the principal will be paid back at a slower rate than expected. This occurs when interest rates in the market rise.
An investor that purchases corporate bonds should be advised that bonds have what type of risk? A Currency risk B Legislative risk C Default risk D Marketability risk
C Since the investors of a corporate bond are considered creditors, the interest payments are a legal obligation owed to the bondholders. Failure to pay the semiannual interest means the corporation is in default and can be forced into liquidation by the investors. This risk is called default or credit risk.
All the following securities are guaranteed by the U.S. government, except: A GNMA certificates B T-notes C FNMA issues D T-STRIPS
C The Federal National Mortgage Association (FNMA or Fannie Mae) mortgage-backed pass-through securities are comprised of conventional and insured mortgages from other agencies. Fannie Mae is a publicly traded corporation that is not backed by the U.S. government, but it is sponsored by the government.
What is both a government security and a money market instrument? A Treasury stock B Certificate of deposit C Treasury bill D Treasury bond
C The best answer is T-bills, which are issued by the federal government. They are short term, high quality, and safe. A jumbo (negotiable) CD is a money market instrument issued by a bank and is not a government security. Treasury stock is not a money market instrument. It is common stock of the issuer, which was purchased from investors by the issuer.
Commercial Paper
Commercial paper is a short-term unsecured debt instrument issued by a corporation as a promissory note to help finance accounts receivable and seasonal inventory overages. It is issued at a discount and must have a maturity of less than 270 days. Additionally, they must have a minimum face amount of $50,000 and be in one of the top three highest ratings by Moody's or S&P.
Debentures are backed by: A Parent company of a subsidiary B Tangible property owned by the issuer C Transportation equipment D Issuer's full faith, credit, and promise to pay
D A debenture is an unsecured debt instrument. It is backed solely by the issuer's full faith, credit, and promise to pay.
The legal agreement that outlines the terms of the bond issue is called: A Loan closing document B Lending pledge C Bond agreement D Trust indenture
D An indenture, or trust indenture, is a legal agreement outlining the terms of the loan between the corporation and the bondholders. A trustee is appointed to represent the bondholders and protect their interests.
An investor purchases a 7% bond at par, how much will the investor receive at redemption? A $1,700 B $1,000 C $1,070 D $1,035
D At redemption the investor will receive the repayment of principal plus the final coupon payment. A 7% bond will pay the investor 7% annually, and the investor will receive semiannual payments of $35 each. At redemption, this investor will receive $1,035.
Investors can find information on municipal securities and municipal fund securities on an electronic website called: A ECN B PORTAL C NASAA D EMMA
D EMMA, the Electronic Municipal Market Access System, is the electronic website where issuers file almost all important documents, such as the final official statement and any offering documents. PORTAL is a trading platform for qualified institutional buyers. An ECN is an electronic communication network used in the Fourth Market of trading in the secondary market, and the NASAA is the North American Securities Administrators Association, the organization made up of state administrators that create model law for the states regarding securities business.
Which of the following entities are not permitted to issue municipal bonds? A New York City B The state of New Jersey C The Broward County FL school district D The federal government
D Municipal bonds are issued by states and their political subdivisions, such as counties, cities, and taxing districts. Bonds issued by the federal government are not municipal bonds.
Which investment vehicle is appropriate for a client who seeks current income and preservation of capital? A Preferred stocks B Common stocks C Lower rated zero-coupon bonds D Investment quality corporate bonds
D Zero-coupon bonds do not pay income but do pay an amount at maturity equal to the par value. High-grade corporate bonds provide a blend of income and principal safety. Stocks are generally for long-term appreciation and income from dividends but do not provide preservation of principal.
Why buy a mutual fund?
Diversification at an low cost, professional management and record keeping, no 'brokers' fee. -easy liquidity -cant really trade -theyre long term investments
Treasury Bills (T-bills)
In addition to T-bills (which have a maturity of one year or less when issued), T-notes and T-bonds with one year or less remaining to maturity are also considered money market instruments.
Revenue Bonds
Issued by municipal authorities to finance specific projects being constructed, such as toll roads, parking structures, or local sports stadiums
Industrial Development Revenue Bonds
Issued to finance the construction or acquisition of a commercial facility that will be leased to a private entity
Double-barreled Bond
Secured by the revenues generated from an income-producing facility and the full taxing power of the issuing state or municipality
Which statement best describes an industrial revenue bond? A A bond issued by a municipality to fund a specific project, such as a bridge B A bond issued by a corporation and backed by the general revenue of the firm C A bond issued by a municipality to finance an asset that is leased to a private firm D A bond issued by a municipality and repaid from the general revenue and borrowings of the governing body
c An industrial revenue bond is issued by a municipality to finance an asset that is leased to a private firm. The corporation's lease payments repay the bonds. The other choices refer to a debenture, a general obligation bond and a traditional revenue bond.
An investor has 3 ABC 6% bonds and 3 XYZ 6.4% bonds. What is the difference in annual interest between the 2 positions? A $4 B $24 C $12 D $48
c The investor has 3 ABC bonds with a 6% coupon. Each bond will earn $60 per year (or $180 total for all three bonds per year). Additionally, the investor has 3 XYZ bonds earning 6.4%, or $64, per year (or $192 total for all 3 bonds per year). The difference between the $192 earning on the XYZ bonds and the $180 earning on the ABC bonds equals a $12 difference in annual interest between the 2 positions.
An investor is in the 32% tax bracket and considering the purchase of a 7.5% municipal bond, a corporate bond paying 9%, or an 8% Treasury note. Which bond offers the greatest after-tax yield? A The corporate bond B The after-tax yield is virtually the same on all three C The Treasury note D The municipal bond
d Tax-Equivalent Yield = Interest on Municipal Bond divided by (100% - Tax Bracket%). 7.5% divided by (100% - 32%) = 7.5% divided by 68% = 11.02% This is better than the 8% Treasury or the 9% corporate bond.
