Series 65 - Unit 13

A client interested in fixed income is viewing different bonds with the same rating and a coupon of 6%. Using the DCF method, which bond should have the highest market value?

10-year maturity when the discount rate is 4%

A client has a TIPS with a coupon rate of 4.5%. The inflation rate has been 7% for the last year. What is the inflation-adjusted return?

4.5%

If an investor in the 27% federal income tax bracket invests in municipal general obligation bonds selling at par with a coupon of 4.5%, what is the tax equivalent yield?

6.16%

Which of the following statements is NOT true?

A resident of France purchasing Eurodollar bonds does not incur currency risk

According to Standard and Poor's rating system, the four highest grades of bonds (from best to lowest grade) are

AAA, AA, A, and BBB

All of the following debt instruments pay interest semiannually EXCEPT

Ginnie Mae pass-through certificates

Here is something that may help. The current rate of interest (the discount rate) on new AA-rated bonds with a 20-year maturity is 4%. If you have an older AA bond with 20 years until it matures and a coupon of 6%, how does all of this apply?

If your bond is priced so the yield to maturity (YTM) on your bond is 4.4%, it has a positive NPV (its yield is above the market rate of 4% so this bond is selling at a price below its present value). If your bond is priced so the yield to maturity (YTM) on your bond is 3.6%, it has a negative NPV (its yield is below the market rate of 4% so this bond is selling at a price above its present value). If your bond is priced so the yield to maturity (YTM) on your bond is 4%, it has a zero NPV (its yield is equal to the market rate of 4% so this bond is selling at its present value).

The LIBOR rate is established on a daily basis in

London

On the Series 65 exam, there may be questions on parity. Here are two methods to help you solve the problem: RST's 6% debenture is convertible to common at $50. If the debenture is currently trading for $1,200, what is the parity price of the common?

Method One: Parity means equal. Solve for the conversion ratio as follows: Par value: $1,000 Conversion price: $50 Conversion ratio: 20 The parity stock price is found by dividing $1,200 by 20. The parity price of the common is $60 because 20 shares of the stock at $60 each equals the value of one bond trading at $1,200.

When you see a corporate bond quoted at 103 1/2, it represents a market price of $1,035. The 103 is 103% of $1,000, or $1,030, and the 1/2 is half pf a $10 point, or $5.

On a Treasury bond, that same price would be shown as 103.16 where the .16 is 16/32s or 1/2.

Being concerned about price volatility, a bond investor wishes to compute the duration of a bond being considered for her portfolio. Which of the following is NOT a necessary component of that calculation?

Rating of the bond

A customer wishes to buy a security providing periodic interest payments, safety of principal, and protection from purchasing power risk. The customer should purchase

TIPS

An investor who buys a 10% coupon bond at 105 ($1,050 per bond) with 10 years remaining to maturity can expect $100 in interest per year. If the bond is held to maturity, the bondholder loses $50, the amount of the premium. This loss is included in the YTM approximation. The actual YTM calculation for this bond selling at a premium follows: annual interest - (premium / years to maturity) / average price of the bond A bond's average price is the price paid plus the amount received at maturity (par) divided by two. Alternatively, the average price is that price midway between 100 - (50 / 10) / 1025 = 95 / 1025 = 0.093, or 9.3% The YTM of a bond bought at a premium is always lower than both the coupon rate (nominal yield) and the current yield. In this example, the nominal yield is 10%, and the current yield is 9.52% (100 / 1,050). If an investor buys a 10-year bond with a 10% coupon for 95 ($950 per bond), $100 per year in coupon interest payments is received and a gain of $50 (the amount of the discount) at maturity. This gain is included in the YTM approximation.

The actual YTM calculation for this bond selling at a discount follows: Annual interest + (discount / years to maturity) / Average price of the bond 100 + (50 / 10) / 975 = 105 / 975 = 0.1077, or 10.77% The YTM of a bond bought at a discount is always higher than both the coupon rate (nominal yield) and the current yield. In this example, the nominal yield is 10%, and the current yield is 10.53% (100 / 950). If these calculations seem complicated, do not worry. You will have at most one question requiring a YTM calculation. Focus on the relationship between YTM and CY based on the price of the bond.

Here is another style of parity question. RST's 6% debenture is convertible to common at $50. If the common is trading for $45, what is the parity price of the debenture? Start by solving for the conversion ratio. Par value: $1,000 Conversion price: $50 Conversion ratio: 20

The debenture's parity price if found by multiplying 20 * 45 which is $900. Using the percentage method, you can determine that the market price of the common stock is 10% below that of the conversion price (5 / 50 = 10%). Reducing the debenture's price of $1,000 by 10% results in a parity price of the debenture of $900.

A company realizes money from the sale of surplus equipment. It would like to invest this money but will need it in 4-6 months and must take that into consideration when selecting an investment. You would recommend

Treasury bills

If you have a TIPS bond with a 10% coupon and the annual inflation rate is 4% for the next two years, here is what happens: Each six months, you will receive 1.5% (half of the annual 3% coupon) of the principal value as adjusted for the inflation rate. If the inflation rate is 4% per year, that is 2% each six months. So, after the first semiannual period, the principal value of the bond is now $1,020 ($1,000 + 2% of $1,000, or 102% * $1,000). Therefore, the first interest check will be 1.5% * $1,020, or $15.30. Six months later, the adjusted principal value is $1,040.40 (102% * $1,020), so that interest check will be for $15.61 ($1,040.40 *1.5%). As we continue into the next year, the principal will increase to $1,061.21 ($1,040.40 * 102%) and the interest check will be for $15.92. Because we're only looking at 2 years, the ending principal value will be $1,082.43 with the final interest check of $16.24. As you can see, both the income from the TIPS and its principal value are increasing at a compounded rate based upon inflation.

We know that some of you may be mathematically challenged so here is a shortcut that will always work. The key to the increased principal value of the TIPS is that the interest is compounding. But, you don't have to do that. In this example, the inflation rate is 4%. Using just simple interest would mean that the principal would increase by $40 (4% of $1,000) per year. After two years, that would be $80 or a new principal amount of $1,080. However, we know that compounding will give us more so we choose the first number given in the answers that is above $1,080. The same trick can be used to determine the final interest payment. We take 1.5% of $1,080 ($16.20) and look for an answer choice that is slightly higher.

Which of the following statements about zero-coupon bonds is NOT true?

Zero-coupon bonds pay periodic interest payments.

One would expect to have checkbook access to

a DDA

A bond issue that may be retired in advance of maturity at the option of the issuer is said to have

a callable feature

When Treasury bills are issued they are quoted at

a discount from principal with no coupons attached

If a bond has a YTM greater than its coupon, the bond is trading at

discount

If the bond has a YTM less than its YTC, the bond is trading at

discount

If the bond has a YTM and CY that are equal, the bond is trading at

par

If the bond has a YTC lower than its CY, it is trading at

premium

Money market instruments are

short-term debt

Advantages of Brady bonds to an American investor include all of the following EXCEPT

tax-free interest

When a bond with a 6% coupon is selling for 90, each of the following statements is correct, EXCEPT

the bondholder will receive two semiannual interest payments of $27 each

An analyst would use the discounted cash flow method in an attempt to find

the fair value of a security

A debenture is issued based on

the general credit of the corporation