Series 65 Unit 3

Many fixed-income investors are looking to avoid loss of principal. Which of the following would likely have the lowest degree of exposure to credit risk? A) Aa-rated corporate debenture B) Ba-rated corporate mortgage bond C) A-rated general obligation municipal bond D) Baa-rated municipal revenue bond

A A bond's rating takes into consideration all factors, including collateral and tax base. The higher the rating, the lower the credit risk.

Which of the following statements regarding convertible debentures is true? A) When compared with similar nonconvertible debentures, convertible debentures are issued with a lower coupon rate. B) The issuer pays a higher rate of interest compared with a comparable nonconvertible debenture. C) The debenture holders receive a variable rate of interest. D) The issuer has the right to convert the debentures during the time period specified in the indenture.

A A conversion feature is a benefit to the debtholder. It allows the debtholder a choice to either continue holding the debt represented by the debenture or to convert it into shares of common stock of the underlying issuer. Everything that is done in the securities industry has to be a win-win situation. The win for the debtholder in this instance is the ability to take advantage of the capital appreciation potential the common stock may offer, and the win for the issuer is that by offering something extra to the debenture purchaser, that purchaser is willing to accept a lower interest rate on the debt (as compared to a nonconvertible debenture), therefore giving the issuer a lower cost of capital. It is the debtholder, not the issuer, who determines when and if to convert.

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

A Agencies, with only a 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.

Treasury bills are A) issued in book-entry form. B) callable. C) issued in bearer form. D) issued at par.

A All Treasury securities are issued in book-entry form. Treasury bills are always issued at a discount and are never callable.

An investor purchased a 20-year bond with a duration of 11 years for $1,323.18. Which of these statements is correct? A) The yield to maturity (YTM) is less than both the current yield and the coupon rate. B) The coupon rate is higher than the YTM, and the YTM is higher than the current yield. C) The coupon rate is lower than the YTM, and the current yield should be higher than the coupon rate. D) The current yield is higher than both the coupon rate and the YTM.

A CR = coupon rate CY = current yield YTM = yield to maturity Premium bonds: CR > CY > YTM Par bonds: CR = CY = YTM Discount bonds: CR < CY < YTM Because the bond was purchased at a premium, the yield to maturity is less than both the current yield and the coupon rate. The duration has nothing to do with the question.

A new convertible debt security has a provision that it cannot be called for five years after the issue date. This call protection is most valuable to a recent purchaser of the security if A) the market price of the underlying common stock is increasing. B) interest rates are stable. C) interest rates are falling. D) interest rates are rising.

A Convertible debt securities are more sensitive to the price of the underlying common stock than they are to interest rates. Call protection would enable this investor to hold on to the debt security while the stock rises in value rather than having it called away. Although it is true that call protection protects against a potential call when interest rates decline, the protection against a call when the underlying stock is rising is considered to be more valuable.

An investor is analyzing various risks related to corporate and government bonds. She is interested in finding a risk that is more specific to corporate bonds than to government bonds. Which of the following options correctly defines that risk? A) Default risk B) Liquidity risk C) Interest rate risk D) Purchasing power risk

A Default risk is avoided with U.S. government bonds. There is no chance (at least for test purposes) that timely payment of interest and principal will not be made on them. All bonds have interest rate and purchasing power risk. Although it is true that government bonds are generally more liquid than corporate bonds, many corporate bonds are exchange listed. That ensures good liquidity. More important is the test-taking skill. If you have to choose between lack of credit risk and lack of liquidity, it should be clear where the government bond comes out ahead.

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

A GNMAs pay monthly interest and principal, treasury bonds pay semiannual interest, utility stocks pay quarterly dividends, and corporate bonds pay semiannual interest.

A customer buys a 5% bond at par. The bond is callable in 5 years at par and matures in 10 years. Which of the following statements is true? A) YTC is the same as YTM. B) YTC is lower than YTM. C) YTC is higher than YTM. D) Nominal yield is higher than either YTM or YTC.

A If a bond is trading at par, the nominal yield (coupon rate) = current yield = yield to maturity = yield to call (unless the call price is at a premium, in which case the YTC would be higher). YTC is higher than YTM if the bond is trading at a discount to par. YTC is lower than YTM if the bond is trading at a premium over par. Nominal yield is higher than either YTM or YTC if the bond is trading at a premium over par.

Which of the following statements about municipal bonds is not true? A) Municipal bonds are generally considered riskier than corporate bonds. B) The interest on municipal bonds is usually not subject to federal income tax. C) Municipal bonds are bonds issued by governmental units at levels other than the federal. D) Municipal bonds generally carry lower coupon rates than corporate bonds of the same quality.

A Municipal bonds are generally considered second only to Treasury instruments in relative safety.

Mitch purchased a 30-year bond for 97¾ with a stated coupon rate of 8.5%. What is the approximate yield to maturity for this investment if Mitch receives semiannual coupon payments and expects to hold the bond to maturity? A) 8.67% B) 4.36% C) 5.68% D) 8.50%

A No calculation is necessary here. Why not? Because anytime a bond is purchased at a discount from par (97¾% is a discount), the YTM must be greater than the nominal (coupon) rate. There is only one choice greater than 8.5%. It isn't about your computational skills; it is about your understanding of the relationship between prices and yields.

Which of the following would be least likely for an investment adviser representative to consider before recommending a municipal security to a customer? A) The customer's highest education level B) The municipal security's rating C) The customer's state of residence D) The customer's tax status

A The customer's state of residence and tax status are essential when determining suitability for a municipal security because the higher the tax bracket, the more attractive the tax-free yield, especially if there is a state income tax. The security's rating is also critical because it measures the safety and quality of the bond. The investor's education level rarely enters into the suitability equation.

Which of the following rates of return is used by investment professionals as the risk-free rate? A) 91-day Treasury bill rate B) Discount rate C) Prime rate D) Federal funds rate

A The interest rate used as the basis for a risk-free rate of return is the 91-day Treasury bill rate. T-bills are U.S.-government guaranteed, the rate is short term, and the market risk is minimal.

A $1,000 bond with a nominal yield of 8% will pay how much interest each year? A) $80 B) $800 C) $160 D) $40

A The nominal yield (or coupon rate) is the interest rate stated on the bond and is the rate the bondholder promises to pay on the bond until the bond matures. A $1,000 bond with an 8% nominal yield will pay $80 per year in interest.

A company currently has earnings of $4.00 and pays a $0.50 quarterly dividend. If the market price is $40, what is the current yield? A) 5.00% B) 15.00% C) 1.25% D) 10.00%

A The quarterly dividend is $0.50, so the annual dividend is $2.00; $2 ÷ $40 (market price) = 5% annual yield (current yield).

A U.S. dollar-denominated bond that is sold outside the United States and the issuer's country but for which the principal and interest are stated and paid in U.S. dollars is best described as A) a Eurodollar bond. B) a Yankee bond. C) a Brady bond. D) a eurobond.

A This is the definition of a Eurodollar bond. Yes, it is also a eurobond, but because the question specifies U.S. dollars, the more accurate choice is Eurodollar bond. A Yankee bond is U.S. dollar-denominated but is issued in the United States; Eurodollar bonds are not. Brady bonds are issued only by foreign governments, usually—but not always—are U.S. dollar-denominated, and are available for purchase in the United States.

Which of the following debt instruments does not make periodic interest payments? A) T-bills B) TIPS C) T-bonds D) T-notes

A Treasury bills are always issued at a discount from their face value. At maturity, the investor receives the face value. The other choices pay interest semiannually. What makes TIPS different from the others is that the principal adjusts for inflation every six months. That means the fixed interest rate is paid on a varying principal.

Which of the following indicates a bond selling at a premium? A) 8% coupon yielding 7.5% B) 8% coupon yielding 8.5% C) 5% coupon yielding 5.0% D) 10% coupon yielding 11.0%

A Whenever the yield is less than the coupon, the bond is selling at a premium over the par value. In our question, the coupon or nominal rate is 8%, but the bond is selling at a price that makes its current yield 7.5%. That happens only when the investor pays more than par (face) value, a premium, for the bond.

When current interest rates are at 6%, you would expect a bond with a nominal yield of 4% to be A) selling at a discount. B) selling at a premium. C) selling at par. D) in danger of default.

A With the market rate of return at 6%, a 4% bond just isn't as valuable, so the only way investors will be interested is if they can acquire it at a discount. That discount works out to be a figure that will result in a 6% return for the purchaser. Remember, as interest rates go up, bond prices go down, and vice versa.

An 8% corporate bond is offered on an 8.25 basis. Which of the following statements are true? I. Nominal yield is higher than YTM. II. Current yield is higher than nominal yield. III. Nominal yield is lower than YTM. IV. Current yield is lower than nominal yield. A) II and IV B) II and III C) I and III D) I and IV

B A bond offered on an 8.25 basis is the same as at a YTM of 8.25%. Because the yield quoted is higher than the 8% coupon, the bond is trading at a discount to par. For discount bonds, the nominal yield is lower than both the current yield and the yield to maturity.

When a bond is selling at a premium, a bond callable at par will A) have a YTM that is more than the coupon. B) have a YTC that is less than the YTM. C) have a current yield that is less than the YTM. D) have a YTC that is more than the coupon.

B A bond selling at a premium will always have a yield that is lower than the coupon. The highest of the computed yields will be the current yield because, unlike the YTM or the YTC, the loss at payoff of the principal is not included. Comparing YTM and YTC, because in both cases the investor is getting back the same par value, the YTC is lower because the loss is occurring sooner (bonds are always called prior to maturity).

A bond, preferred stock, or debenture exchangeable at the option of the holder (for common stock of the issuing corporation) is A) a collateral-backed equity security. B) a convertible security. C) a synthetic security. D) a nondilutive stock.

B A bond, preferred stock, or debenture exchangeable at the option of the holder for common stock of the issuing corporation is a convertible security.

An unsecured long-term debt security issued by a corporation is known as A) a mortgage bond. B) a debenture. C) an equipment trust certificate. D) a collateral trust bond.

B A debenture is a long-term debt security issued by a corporation with no specific asset pledged as security for the loan.

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

B A money market instrument is a high-quality, short-term debt security with maturity of one year or less. American depositary receipts (ADRs) are equity, and corporate bonds are long-term debt instruments.

Assume that a corporation issued a 5% Aaa/AAA rated debenture at par. Two years later, similarly rated debt issues are being offered in the primary market at 5.5%. Which of the following statements regarding the outstanding 5% debenture are true? I. The current yield on the debenture will be higher than 5%. II. The current yield on the debenture will be lower than 5%. III. The dollar price per bond will be higher than par. IV. The dollar price per bond will be lower than par. A) II and III B) I and IV C) I and III D) II and IV

B Because interest rates have risen after the issue of the 5% debenture, the bond's price will be discounted to result in a higher current yield (computed as annual income divided by current market price). Accordingly, the discounting of the issue will make the 5% debenture competitive with new issues offered with a 5.5% coupon.

When discussing convertible debt securities, it would be incorrect to state that A) the issuer pays a lower interest rate. B) holders receive a higher interest rate. C) holders have a fixed interest rate. D) holders may share in the growth of the common stock.

B Because of the possibility of participating in the growth of the common stock through an increase in the market price of the common, the convertible can be issued with a lower interest rate.

Your client in the 28% federal income tax bracket currently owns some U.S. government bonds with a coupon yield of 6%. In order to receive the same income after taxes, she would need to buy municipal bonds with a coupon of A) 7.68%. B) 4.32%. C) 6.00%. D) 1.68%.

B Because the 6% on the government bond is fully taxable on a federal basis, the client receives a net of 4.32% ($60 per bond less 28% in taxes [$16.80], or $43.20 per year). Interest on municipal bonds is tax free, so a 4.32% coupon will result in the same amount of after-tax income.

In the event of a company's insolvency, which of the following has first claim on assets? A) Members of the board of directors B) Bondholders C) Preferred stockholders D) Common stockholders

B Bondholders have contractual rights to the assets of a business that must be honored on insolvency before claims of stockholders or directors.

Which of the following statements regarding callable bonds is correct? A) They are only issued by government entities. B) They usually provide a call risk premium. C) They are unaffected by changes in market yields. D) They offer lower yields than comparable noncallable bonds.

B Callable bonds are normally called only when interest rates fall. The call premium (a percentage above par value that the issuer will pay when called) helps to compensate bondholders for the lower interest rate at which they will be able to reinvest the proceeds. Callable bonds have greater risk for investors (call risk) and therefore offer higher yields than noncallable bonds.

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

B Commercial paper represents the unsecured debt obligations of corporations needing short-term financing. Most commercial paper is sold to institutions, and the borrower and lender negotiate the terms. Those terms include the interest rate (the yield because they're discounted) and whether these are overnight, 30-day, or longer maturities. Because commercial paper is issued with maturities of no more than 270 days, it is exempt from registration under the Securities Act of 1933.

A client plans to purchase a home within the next three months and will require $100,000 for the down payment. The client has the money in her DDA and asks you for your recommendation as to the best place to put the money. Your recommendation would probably be for the client to A) purchase a GNMA for the monthly income. B) keep the money where it is. C) move the money into a 1-year CD. D) use the money to buy IPOs until the home is purchased.

B DDA stands for demand deposit account, usually a checking account at a bank. Because this client cannot afford any risk to principal, and the bank account is covered by FDIC insurance, this is the most attractive option. The 1-year CD would offer more income, but there would likely be a penalty for early withdrawal. Even though the GNMA is directly backed by the U.S. government, it is subject to market fluctuation, a risk this client cannot take.

A corporate bond that pays interest semiannually has a par value of $1,000, matures in five years, and has a yield to maturity of 10%. What is the value of the bond today if the coupon rate is 8%? A) $1,144.31 B) $922.78 C) $1,221.17 D) $1,051.23

B How did we calculate that? We used a tool that you won't have available at the test center (a financial calculator), but there is a great tool you will have—common sense. When a bond has a yield to maturity that is greater than its coupon rate, the bond must be selling at a discount, and that only leaves one possible answer. The only way to get a 10% return on an 8% bond is to buy it at a price below par.

An investor buys 10M 6.6s of 10 at 67. The investor will receive annual interest of A) $1,000. B) $660. C) $670. D) $820.

B Interpret "10M" as "$10,000 worth of." The investor receives the nominal yield of the bonds, which is 6.6% of $10,000. The M is from the roman numeral for 1,000.

High-yield bonds are frequently called junk bonds. Which of the following expresses the highest rating that would apply to a junk bond? A) CC B) BB C) BBB D) CCC

B Investment-grade bonds run from a highest Standard and Poor's rating of AAA (Aaa for Moody's) down to BBB (Baa for Moody's). When the rating gets to BB (or Ba), the bond is considered high yield, or a junk bond.

Which of the following is true of Ginnie Maes but not of other agency mortgage-backed securities? A) Yield more than T-bonds B) Backed by the full faith and credit of the U.S. government C) Are pass-through securities D) Collateralized by mortgages

B Of the mortgage-backed government agency securities, only the Ginnie Maes are backed by the full faith and credit of the U.S. government. They are all collateralized by mortgages (the name MBS gives that away), and even the Ginnie Maes yield more than Treasury bonds. As an MBS, they all pass through the income and principal repayments to the investors.

Which of the following investments would provide the highest after-tax income to your client in the 35% federal income tax bracket? A) 5% general obligation municipal bond issued by State H B) 8% debenture issued by the LMN Corporation C) 6% U.S. Treasury bond D) 7% bond issued by Canadian Province M

B Only the State H bond is exempt from federal income tax. Using the tax-equivalent yield formula of the muni coupon divided by (100% minus the investor's tax bracket %), we get 5% divided by 65%, or 7.7%. That's a better deal than receiving 6% on the Treasury and paying taxes as well as 7% on the Canadian bond (although you learned that securities issued by Canadian provinces were exempt from registration under the Uniform Securities Act, that has nothing to do with U.S. income taxes). However, with a TEY of 7.7%, your client would take home more with the 8% taxable corporate security. You can also work backward to get the correct answer. Simply subtract 35% tax from each of the choices (other than the muni) and see which is the highest. In this case, 8% minus a 35% tax equals 5.2%—just a bit higher than the 5% coupon on the municipal bond.

A bond with a par value of $1,000 and a nominal yield of 6% paid semiannually is currently selling for $1,300. The bond matures in 25 years and is callable in 15 years at $1,080. In the computation of the bond's yield to call, which of these would be a factor? A) Present value of $1,080 B) Interest payments of $30 C) 50 payment periods D) Future value of $1,300

B The YTC computation involves knowing the amount of interest payments to be received, the length of time to the call, the current price, and the call price. With a 15-year call, there are only 30 semiannual interest payment periods, not 50. The present value is $1,300 and the future value is $1,080, the reverse of the numbers indicated in the answer choices.

If a convertible bond is purchased at its $1,000 par value and is convertible at $83.33 per common share, what is the conversion ratio of common shares per bond? A) 1.2 shares for each bond B) 12 shares for each bond C) 2 shares for each bond D) 8 shares for each bond

B The conversion ratio is determined by dividing the par value of the bond, or $1,000, by its conversion price of $83.33 per common share. This results in a conversion ratio of 12 shares for each bond.

A company with 20 million shares outstanding paid $36 million in dividends. If the current market value of the company's shares is $36, the current yield is A) not determinable from the information given. B) 5%. C) 2%. D) 10%.

B The current yield formula is annual dividends per share divided by current market price. The dividends per share are $36 million ÷ 20 million shares = $1.80 per share. Current yield is $1.80 ÷ $36.00 = 5%.

The current yield on a bond with a coupon rate of 5.5% selling at 110 is A) 2.0%. B) 5.0%. C) 5.5%. D) 6.0%.

B The current yield of any security, equity, or debt is always the income return (dividend or interest) divided by the current market price. In this case, it is the annual interest of $55 ($1,000 × 5.5%) divided by $1,100, and that equals 5%.

During the past year, the market price of Kapco common stock has increased from $47 to $50 per share. Over that period, Kapco's earnings per share (EPS) have increased from $2.00 to $2.50 per share, and their dividend payout ratio has decreased from 50% to 40%. Based on this information, the current yield on Kapco common stock is A) 2.13%. B) 2.00%. C) 6.34%. D) 4.26%.

B The current yield on a stock is computed by dividing the annual dividend rate by the current market price. With EPS of $2.50 and a 40% payout ratio, the annual dividend is $1.00. This dollar divided by the current market price of $50.00 results in a current return of 2%.

ABC's stock has paid a regular dividend every quarter for the past several years. If the price of the stock has remained the same over the past year but the dividend amount per share has increased, it may be concluded that ABC's A) yield to maturity has gone up. B) current yield per share has increased. C) current yield per share has decreased. D) current yield per share has been unaffected.

B The current yield would have increased because current yield is the income (dividend) divided by price. A higher dividend divided by the same price results in a higher yield. Stocks do not have a yield to maturity.

An investor purchases a Treasury note and the confirmation shows a price of $102.25. Rounded to the nearest cent, the investor's cost, excluding commissions, is A) $102.25. B) $1,027.81. C) $1,020.25. D) $1,022.50.

B Treasury notes are quoted in 32nds, where each 32nd equals $0.3125. The 102 in the quote equals $1,020 and the 25/32 is an additional $7.81, bringing the total to $1,027.81.

Which of the following statements regarding a $1,000 corporate 8.50% bond offered at 110 is true? A) The bond's current yield is lower than its yield to maturity. B) To determine the bond's current yield, its stated rate must be compared against other fixed-rate investments in the client's portfolio. C) The bond's current yield is calculated by dividing its annual interest by its current market price. D) The bond is a discount bond.

C A bond's current yield is calculated by dividing its annual interest by its current (market) price. In this case, it would be $85 ÷ $1,100. The current yield will be higher than its yield to maturity, which takes into consideration the $100 difference between the purchase price and the par value (a loss of $100). The determination of a bond's yield is unrelated to other bonds. In addition, this bond is selling at a premium (more than $1,000), not at a discount (less than $1,000).

When an investor notices that a bond's coupon yield is lower than its current yield, this is an indication that the bond A) is selling at a premium. B) is nearing its maturity date. C) is selling at a discount. D) is in danger of going into default.

C A bond's current yield is the coupon (nominal) yield divided by the current market price. When those two are the same, the bond is selling at its par (face) value. When selling below par (at a discount), the coupon yield will be lower than the current yield (if you pay less, you get more). Although a bond's market price will generally get closer to par as the maturity date approaches, anytime the price of the bond is below par (selling at a discount), its current yield will be higher than the coupon.

A mortgage-backed security (MBS), such as a Ginnie Mae, makes a combination principal and interest payment to an investor. This payment will be A) taxed as ordinary income. B) taxed as a capital gain if underlying mortgage is prepaid. C) partly taxed as ordinary income and partly a tax-free return of principal. D) tax free.

C All interest payments made on a mortgage-backed security (MBS) are taxed as ordinary income. MBSs may make principal and interest payments to investors, which are partly taxed as ordinary income and partly tax-free returns of principal.

A risk-averse investor, who had only invested funds in bank certificates of deposits, was informed by his investment adviser representative that higher returns with safety could be achieved by investing in U.S. Treasury notes with a 10-year maturity. The adviser representative assured the client that investment in federal government-backed securities is riskless. In this situation, the representative acted A) properly because Treasury notes carry no risk of principal default. B) properly because Treasury notes are suitable for a risk-averse customer. C) unethically because the agent failed to disclose that the customer retains interest rate risk. D) unethically because Treasury notes are unsuitable for a risk-averse customer.

C Although Treasury securities do not carry default risk (principal and interest are guaranteed by the federal government), they are subject to interest rate risk. The prices of Treasury securities will decline if interest rates rise, subjecting the client to loss of principal if he sells them prior to maturity.

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

C As money market instruments, the longest initial maturity of Treasury bills (T-bills) is 52 weeks. Those bills are auctioned every four weeks. T-bills of shorter maturities are auctioned weekly. The shortest initial maturity is four weeks.

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

C 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.

Kate, age 59, has an investment portfolio exceeding $250,000. She considers herself a moderate to conservative investor. To generate additional income, she is anticipating adding bonds to her portfolio. She lives in a state that does not have an income tax and she is in the 28% federal income tax bracket. Which of the following bonds would be the best recommendation for her portfolio? A) Bond D, AAA rated Treasury note with a 2.55% coupon rate B) Bond B, BBB rated municipal bond with a 3.75% coupon rate C) Bond A, A-rated corporate debenture with a 6.50% coupon rate D) Bond C, CCC rated corporate debenture with an 8.00% coupon rate

C Even though Bond C has the highest after-tax rate of return, this bond would not be appropriate for Kate based on her risk tolerance. Therefore, Bond A would be the best choice. Calculations: Bond A: 6.5 × (1 - 0.28) = 4.68% Bond B: 3.75% Bond C: 8% × (1 - 0.28) = 5.76% Bond D: 2.55% × (1 - 0.28) = 1.84%

Securities issued by which of the following agencies offer direct government backing? A) Federal Home Loan Mortgage Corporation (Freddie Mac) B) Federal National Mortgage Association C) Government National Mortgage Association D) Federal Intermediate Credit Bank

C FNMA, FHLMC, and FICB are considered GSEs (government-sponsored enterprises), and although their securities are quite safe, they do not have the direct backing of the Treasury. It is important to remember for the exam that the only security without the word Treasury in its name that is backed by the U.S. government is a GNMA.

If a group of money managers was having a discussion and the term SOFR was mentioned, the topic would most likely be A) long-term borrowing rates. B) current economic conditions in Liberia. C) short-term borrowing rates. D) contract negotiations with the employee's union.

C For more than 40 years, the London Interbank Offered Rate—commonly known as LIBOR—was a key benchmark for setting the interest rates charged on adjustable-rate loans, mortgages, and corporate debt. Over the last decade, LIBOR has been burdened by scandals and crises. Effective January 2022, LIBOR is no longer being used to issue new short-term loans in the U.S. It was replaced by the Secured Overnight Financing Rate (SOFR) which many experts consider a more accurate and more secure pricing benchmark. As is always the case with NASAA, we do not know when the exam questions will be updated. One thing we can promise you is that any question relating to this topic will not have both LIBOR and SOFR as choices, so you should choose whichever one appears.

A bank is advertising a no-cost DDA. Your client asks you to describe what that is. You would respond that DDA stands for A) direct deposit account. B) deferred deposit account. C) demand deposit account. D) digital deposit account.

C In the banking industry, the most common definition of a DDA is demand deposit account, better known as a checking account.

When a U.S. resident investor purchases foreign bonds, A) depreciation of both the bonds and the foreign currency benefits the domestic investor. B) appreciation of the bonds and depreciation of the foreign currency benefit the domestic investor. C) appreciation of both the bonds and the foreign currency benefits the domestic investor. D) depreciation of the bonds and appreciation of the foreign currency benefit the domestic investor.

C In the same manner that purchasing foreign equities adds diversification to a portfolio, purchasing foreign bonds does as well. As with any security, if the value goes up (it appreciates), that is a benefit to the investor. When foreign securities are involved, there is another concern—currency risk. Because the foreign bond is denominated in the local currency, an increase in that currency's value versus the U.S. dollar means the semiannual interest payments will translate into more dollars. At maturity, the return of principal will be higher as well. Of course, it can go the other way if the market value or the foreign currency depreciates against the dollar.

Which of the following is true of GNMA securities? 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 III B) II and III C) I and IV D) II and IV

C Income received by investors in Government National Mortgage Association (GNMA) securities is subject to both state and federal income tax, and the asset backing them is residential mortgages.

Investors interested in acquiring convertible debentures as part of their investment portfolio would A) be interested in tax advantages available to convertible debt securities. B) want the assurance of a guaranteed dividend on the underlying common stock. C) want the safety of a fixed-income investment along with potential capital appreciation. D) seek to minimize changes in the bond price during periods of steady interest rates.

C Investors who want the safety of a fixed-income investment with the potential for capital gains would be most interested in purchasing a convertible debenture. However, because convertible debentures can be exchanged for common stock, their market price tends to be more volatile during times of steady interest rates than other fixed-income securities.

A client of yours owns some convertible preferred stock. She notices an article in the business section of her local newspaper that reports the company is going to pay a 20% stock dividend on their common stock. How will this affect her? A) More than likely, the price of the preferred stock will rise. B) There will be no effect. C) If there is an antidilution clause, her conversion privilege will permit her to acquire 20% more shares than before the stock dividend. D) She will also receive 20% more shares because preferred stock has a priority claim ahead of common.

C Most convertible securities are sold with antidilutive clauses that provide for an adjustment in the number of shares based on stock splits or stock dividends.

The interest from which of the following bonds is exempt from federal income tax? I. State of California bonds II. City of Anchorage bonds III. Treasury bonds IV. GNMA bonds A) III and IV B) I and III C) I and II D) II and IV

C Municipal bonds are exempt from federal income tax. Treasury bonds are exempt from state tax but not federal tax. GNMAs are subject to federal, state, and local income tax.

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

C Negotiable CDs are general obligations of the issuing bank; they are not secured by any specific asset. They do qualify for FDIC insurance (up to $250,000), but that is not the same as stating that the bank has pledged specific assets as collateral for the loan.

The Straitened Corporation filed for bankruptcy. One of your clients held a mortgage secured by the corporation's building. When the building was sold, the proceeds were less than the mortgage balance, creating a deficiency balance. Where does this investor's claim stand? A) After the unsecured creditors B) After the secured creditors C) As a general creditor on a pro rata basis D) There is no further claim once the building has been sold

C Secured creditors, such as those holding mortgage bonds, always have priority in a liquidation. If it happens, as in this question, that the assets securing the debt are insufficient to satisfy the claim, the balance is considered to be an unsecured debt. In that case, those bondholders are considered general creditors and share in any remaining assets proportionate to the amount of the deficiency. The Latin legal term for this is pari passu, but we don't expect you'd see that on the exam.

A company has paid a dividend every quarter for the past 20 years. If the stock's price has fallen dramatically over the past quarter but the dividend has remained the same, it may be concluded that A) the dividend yield to maturity has decreased. B) the current dividend yield has decreased. C) the current dividend yield has increased. D) the current dividend yield has remained the same.

C The current dividend yield is income dividend divided by price. If the price of a stock decreases and the dividend remains the same, the dividend yield will increase.

What is the name of the bond document that states the issuer's obligation to pay back a specific amount of money on a specific date? A) The bond coupon B) The debenture C) The indenture D) The bond agreement

C The indenture is the contract that sets forth the promises of the issuer of the bond and the rights of the lenders (the investors). A debenture is an unsecured long-term debt security (that has an indenture). One of the details in the indenture is the coupon (interest) rate that will be paid on the loan.

All of the following are true of government agency bonds except A) older ones have coupons attached, while new ones are book-entry. B) they trade openly. C) they are direct obligations of the U.S. government. D) they are considered relatively safe investments.

C The only government agency that is a direct obligation of the U.S. government is the Ginnie Mae security. All of the others are moral obligations.

Which of the following statements regarding credit risk is not true? A) Credit risk can be assessed by referring to the independent credit rating agencies. B) A rating downgrade may or may not result in a lower market price for a bond. C) An A-rated mortgage bond has less credit risk than a AA rated debenture. D) Credit risk is the probability of the issuer defaulting on their payment obligations.

C The rating agencies split bonds into two distinct classes: investment grade and noninvestment grade. The highest investment-grade rating is AAA (Aaa) and the lowest is BBB (Baa). The more As the bond has, the lower the credit risk. That is why the AA debenture has less credit risk than the A-rated mortgage bond. The rating agencies take into consideration any collateral, such as a mortgage, when giving the rating.

A client is in the 28% marginal federal income tax bracket. Which of the following investments would produce the highest after-tax yield for the client? A) A AAA-rated debenture yielding 7.75% B) An A-rated corporate mortgage bond yielding 8% C) A public-purpose municipal bond yielding 6% D) A U.S. Treasury note yielding 7%

C This question is testing your knowledge and ability to compare the after-tax return on tax exempt municipal bonds (interest is not subject to federal income tax) with other securities whose interest is subject to federal income tax. The first thing you need to recognize is that the interest on the public-purpose municipal bond is exempt from federal taxes. The interest on all of the other securities is subject to federal income tax. Therefore, to compare the municipal bond with the other answer choices to determine which security will have the highest after-tax yield, you will have to calculate the tax-equivalent yield on the 6% municipal bond. Here is how it looks for this question: = municipal rate ÷ (100% − tax bracket) = 6% ÷ (100% − 28%) = 6% ÷ 0.72 = 8.33% Now you can compare all four securities on a tax-equivalent yield basis. In this question, the municipal bond on a tax-equivalent yield basis will have a yield of 8.33%, and that is higher than any of the other choices. Alternatively, we know that the investor keeps all of the 6% return on the municipal bond while on the others, federal income tax at the investor's rate of 28% will be deducted from the actual interest received. Therefore, we can take each of the other choices, subtract 28%, and determine if any of them will have an after-tax return greater than 6%. The 7% Treasury note, after a 28% tax bite ($19.60), results in a net return to the investor of 5.04%. The 8% corporate bond nets 5.76% after subtracting the 2.24% in tax, and the 7.75% debenture's after-tax yield is 5.58%. This is proof that the 6% municipal bond with no tax on the interest has the highest after-tax return of all of the choices shown.

A client has TIPS with a coupon rate of 3.5%. The inflation rate has been 4% for the last year. What is the inflation-adjusted return? A) -0.50% B) 4.00% C) 3.50% D) 7.50%

C Treasury Inflation-Protected Securities (TIPS) adjust the principal value each six months to account for the inflation rate. Therefore, the real rate of return will always be the coupon.

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 bonds B) Treasury notes C) Treasury bills D) TIPS

C 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 both carry stated interest rates.

As defined in the Securities Exchange Act of 1934, the term municipal security would include A) a Province of Ontario library construction bond. B) a U.S. Treasury bill. C) a City of Chicago school district bond. D) 50-year bonds issued by the Tennessee Valley Authority.

C Under federal law, municipal bonds are those issued by any domestic political body or subdivision from the state level on down. Treasury bills and TVA issues are defined as government securities, not municipal securities. Under federal law, Canadian cities (or provinces) are not municipal securities.

A customer bought a 10-year 6% AAA bond at par when it was issued. Two years later, if the CPI has increased from 2% to 4%, the price of the bond most likely A) cannot be determined. B) has stayed at par. C) has declined. D) has increased.

C When inflation is on the rise, interest rates often rise. When interest rates increase, bond prices may be expected to decline.

What happens to outstanding fixed-income securities when interest rates decline? A) Coupon rates increase B) Yields increase C) Prices increase D) No change

C When interest rates drop, prices rise, decreasing effective yield. Thus, there is an inverse relationship between interest rates and bond prices.

If a corporate bond is convertible, this means that A) the owner of the bond may exchange it for a bond paying a higher coupon rate. B) the corporation may redeem the bond before its maturity date. C) the owner of the bond may exchange it for a debenture. D) the owner of the bond may exchange it for a set number of shares of stock.

D A convertible bond is usually a debenture that allows the owner to exchange it for a set number of shares of stock.

Bright-Lite Incandescent Bulb, Inc., recently suffered significant operating losses and is planning a bankruptcy filing. Which of the following debt issues have the most junior claim? A) Senior notes B) Mortgage bonds C) Common stock D) Debentures

D Although the most junior claim of all is that of the common stockholder (equity), this question is about the priority of debt issues. In that case, the most junior (last in line) of the creditors are the holders of the company's debentures.

A bond is selling at a premium over par value. Therefore, A) its yield to maturity is greater than its current yield. B) none of these are correct. C) its nominal yield is less than its current yield. D) its current yield is less than its nominal yield.

D Any bond selling at a premium will yield less than the coupon rate (nominal yield). Conversely, of course, a bond trading at a discount will certainly yield more. Remember, there is an inverse relationship between bond prices and bond yields.

Your client in the 35% federal income tax bracket currently owns some corporate bonds with a coupon yield of 7%. In order to receive the same income after taxes, he would need to buy municipal bonds with a coupon of A) 7.00%. B) 9.45%. C) 2.45%. D) 4.55%.

D Because the 7% on the corporate bond is fully taxable, the client receives a net of 4.55% ($70 per bond less 35% in taxes [$24.50], or $45.50 per year). Interest on municipal bonds is tax free, so a 4.55% coupon will result in the same amount of after-tax income.

When it comes to issuing a debt security, which of the following features will generally enable the issuing corporation to borrow at the lowest interest rate? A) Zero-coupon B) Callable C) Cumulative D) Convertible

D Because the convertible feature offers potential growth through the exercise of the conversion option, the interest rate on these securities is generally lower than other debt issues of the same corporation. The call feature increases the reinvestment risk and that is compensated for with a higher coupon. The descriptive adjective cumulative refers to dividend payments on preferred stock but not to bonds. Because zero-coupon bonds pay nothing until maturity, that added risk requires a higher yield to attract investors.

Corporate long-term debt securities that are issued on the general credit of the issuer and are not otherwise secured are called A) general obligation bonds. B) preferred stock. C) prior lien bonds. D) debentures.

D Debentures are corporate long-term debt securities issued on the general credit of the corporation and are not backed by any specific assets. The term prior lien means there is a secured claim against a specific asset. Preferred stock is not a debt security, and general obligation bonds are municipal, not corporate, securities.

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

D 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.

An advantage of being a bondholder compared with owning common stock in the same corporation is that A) there is limited liability. B) the bondholder can select the optimum time to have the issuer redeem the bond. C) common stock has priority over the bond in the event of liquidation. D) income payments are more reliable.

D Even though bond interest is semiannual, while dividends are typically paid quarterly, the payment of interest is an obligation that comes ahead of the payment of any dividend. Companies can elect to skip or reduce their dividends but not their interest payments.

Which of the following is a direct obligation of the U.S. government? A) Bank for cooperatives bonds B) Government bond mutual funds C) Fannie Maes D) Ginnie Maes

D Ginnie Maes are backed by the full faith and credit of the United States. Other agencies have a moral, but not direct, government backing. Government bond mutual funds are not backed by the U.S. government.

Your customer owns 1,000 shares of the XYZ $100 par 5½% callable convertible preferred stock convertible into four shares of XYZ common stock at $25. What should she be advised to do if the board of directors were to call all the preferred at 106 when the XYZ common stock is trading at $25.50? A) Hold the preferred stock to continue the 5½% yield. B) Convert her preferred stock into common stock because it is selling above parity. C) Place irrevocable instructions to convert the preferred stock into common stock and sell short the common stock immediately. D) Present the preferred stock for the call because the call price is $4 above the parity price.

D If the preferred stock is called, the client will receive $106 per share or $106,000. Tendering the preferred stock will provide the highest value. The value of converting the preferred stock into four shares of common is worth $102 (4 × $25.50 = $102), which is less than the call value of $106. On the 1,000 shares, this is a $4,000 difference. The dividends will cease on the call date if the preferred stock is held beyond the call date.

A client is trying to decide between a par value corporate bond carrying a coupon rate of 6.25% per year and a par value municipal bond that pays an annual coupon rate of 4.75%. Assuming all other factors are equal and your client is in a 28% marginal income tax bracket, which bond do you tell the client to purchase and why? A) The municipal bond because its equivalent taxable yield is 6.30% B) The corporate bond because the after-tax yield is 6.25% C) The corporate bond because the after-tax yield is 4.50% D) The municipal bond because its equivalent taxable yield is 6.60%

D If we compute the tax-equivalent yield of the muni, we see that it is 6.60%, which is a higher return than the 6.25% on the corporate bond. The formula to get this starts by taking the investor's tax bracket and subtracting it from 100%. 100% − 28% = 72%. We then divide the muni coupon of 4.75% by the 72%, and the result rounds off to 6.6%.

An individual purchases a $10,000 CD with a 5-year maturity from her local bank branch. In doing so, she is eliminating A) opportunity cost. B) purchasing power risk. C) inflation risk. D) interest rate risk.

D Interest rate risk is the uncertainty that changes to market interest rates will cause the price of an investment to fluctuate in value. Because this type of bank CD is nonnegotiable (it doesn't trade), changes to interest rates do not impact the principal value of the investment—she can always redeem the CD for $10,000 (although there could be a penalty for early withdrawal). As a fixed-income investment, though, it does suffer from purchasing power risk, also known as inflation risk, and the investor has the opportunity cost of settling for a lower rate of return than could potentially be obtained with equities.

An investor in the 28% income tax bracket is considering purchasing either an 8% municipal bond or a 10% corporate bond. Which of the following regarding the bonds is true? A) The corporate bond yield is higher than the municipal yield after taxes. B) The yield difference cannot be determined. C) The yields of the bonds are equivalent on an after-tax basis. D) The municipal yield is higher than the corporate yield on an after-tax basis.

D Investors are interested in their return after taxes (what they get to keep). The two bonds must be compared on a tax-equivalent basis. For example, the tax-equivalent yield of a municipal bond equals tax-free yield divided by 100% minus tax rate. The tax-equivalent rate in this case is 0.08 ÷ 0.72 (100% − 28%) = 11.11%. In other words, a client in the 28% tax bracket would have to invest in a taxable bond that yields 11.11% to get the same after-tax return that the 8% tax-free bond offers.

All of the following statements regarding bonds selling at a discount are correct except A) they can indicate that the issuer's credit rating has fallen. B) they can indicate that interest rates have risen. C) they will appreciate more than comparable bonds selling at a premium if interest rates fall. D) they are more likely to be called than comparable bonds selling at a premium.

D Issuers tend to call bonds with higher coupons. Bonds trading at a premium have higher coupons than those trading at a discount (and are more likely to be called—wouldn't you pay off your high-interest debt before the low-interest debt?). The longer the duration, the more volatile the bond's price. Lower coupon rates mean a longer duration. If rates rise, prices fall. If a bond's rating falls, so does its price.

The call feature available on some bonds A) allows bond issuers to extend the life of the bond. B) allows the issuer to refinance the debt if interest rates rise above the call rate. C) may be used to convert the bond into preferred shares. D) allows the issuer the option to escape high interest rates if market rates decline.

D Many bonds have a call feature that allows the issuer to call in the bonds, assuming the issuer has the cash available to pay them off, and escape high interest rates if market interest rates decline. If the company does not have the cash, it may issue a new bond at the lower prevailing interest rate and use that money to pay off the old bonds. This is known as refunding and, in essence, is no different from refinancing the mortgage on a home.

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

D Money market instruments are high-quality debt securities with maturities that do not exceed one year.

The minimum face amount of a negotiable CD is A) $10,000. B) $50,000. C) $25,000. D) $100,000.

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

BFJ Corp.'s 5% convertible bond is trading at 120. The bond is convertible at $50. An investor buying the bond now and immediately converting into common stock would receive A) 24 shares. B) 20 shares plus cash for fractional shares. C) 2.4 shares. D) 20 shares.

D The conversion ratio always uses the par value ($1,000), never the current market price. With a par value of $1,000 and a conversion price of $50 per share, this bond is convertible into 20 shares ($1,000 / $50). Remember, the number of shares in a conversion never changes. When the market price changes, the parity price changes, but that isn't relevant to this question.

A customer purchased a 5% U.S. government bond yielding 6%. A year before the bond matures, new U.S. government bonds are being issued at 4%, and the customer sells the 5% bond. The customer probably did which of the following? I. Bought it at a discount II. Bought it at a premium III. Sold it at a discount IV. Sold it at a premium A) II and III B) I and III C) II and IV D) I and IV

D The customer purchased the 5% bond when it was yielding 6% (at a discount). The customer sold the bond when other bonds of like kind, quality, and maturity were yielding 4%. The bond is now at a premium. Therefore, the customer realized a capital gain.

An investor is trying to decide whether to purchase $10,000 face amount of a U.S. Treasury bond or a highly rated corporate bond. The price of the Treasury bond is 102.20 while the price of the corporate bond is 99 3/8. If the investor decides to purchase the Treasuries, disregarding commissions, the price difference is A) $282.50. B) $28.25. C) $32.50. D) $325.00.

D The first step is remembering that Treasuries are quoted in 32nds. That means that 102.20 is 102 and 20/32 which is 102 5/8. Subtract 99 3/8 from 102 5/8 to get 3 2/8 or 3 1/4. On a $1,000 bond, that is $32.50. Then, note that this investor is purchasing 10 bonds, so the difference in price is $32.50 times 10 or $325.

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

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

Regarding convertible debentures, one characteristic of which your clients should be aware of is that A) they generally pay a higher interest rate than nonconvertible debentures. B) it is generally best to convert when the common stock is selling below its parity price. C) the conversion feature protects against an early call. D) they trade in line with the issuer's common stock once the conversion price is reached.

D The lower volatility of a convertible debenture stems from the fact that it has fixed interest payments and will be redeemed at maturity as any other bond or debenture would. No such guarantees apply to common stock.

If investors hold bonds until maturity, their realized rate of return, assuming all interim cash flows are reinvested at that same rate, would be equal to A) the income return. B) the price return. C) the coupon return. D) the yield to maturity.

D The yield to maturity is an investor's total return if they purchase the bond at any point and then hold it until maturity, assuming all interim cash flows are reinvested at that same YTM. This takes into consideration any capital gain or loss; therefore, the yield to maturity will fluctuate with the bond's price.

A bond's yield to maturity is A) set at issuance and printed on the face of the bond. B) determined by dividing the coupon rate by the bond's current market price. C) the annualized return of a bond if it is held to call date. D) the annualized return of a bond if it is held to maturity.

D The yield to maturity is the annualized return of a bond if it is held to maturity. The computation reflects the internal rate of return and is frequently referred to as the market required rate of return for a debt security. The rate set at issuance and printed on the face of the bond is the nominal or coupon rate. Dividing the coupon rate by the current market price of the bond provides the current yield. The return of a bond if it is held to the call date is the YTC.

A client in the 28% marginal federal income tax bracket invests in a corporate bond with an 8% coupon. To calculate the client's after-tax rate of return, A) divide 0.08 by 0.72. B) multiply 0.08 by 0.28. C) divide 0.08 by 0.28. D) multiply 0.08 by 0.72.

D To determine a taxable bond's after-tax rate of return, multiply the coupon rate by the complement of the client's marginal federal income tax bracket. The client's tax bracket is 28% (0.28), so the complement is 100% − 28% (1.00 − 0.28) = 0.72.

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

D 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.

If your customer wants to set aside $40,000 for when his child starts college but does not want to endanger the principal, you should recommend A) corporate bonds with high rates of interest. B) common stock. C) municipal bonds for their tax benefits. D) zero-coupon bonds backed by the U.S. Treasury.

D Treasury STRIPS are guaranteed by the U.S. government, so there is no chance of default. They are zero-coupon bonds and offer no current income, which is appropriate for a client who wants a 100% return paid at a future date for college expenses.

A respected analyst reports that last week's T-bill rate at 6% is lower than the rate for the preceding week and lower than the average for the past month. Which of the following is true? A) Stock prices are rising. B) The general level of interest rates is increasing. C) Investors are paying less for T-bills. D) Investors are paying more for T-bills.

D When the rate is lower, the price has gone up; this means investors are paying more as interest rates are going down. There is nothing in this question that gives us enough information to evaluate the movement of stock prices.

Your client with $100,000 to invest is looking for maximum current income. Which of the following would offer the highest current return? A) $200,000 of utility common stock paying a current dividend of 3.5% B) $100,000 of zero-coupon bonds with a yield to maturity of 6% C) $100,000 AA rated corporate bonds trading at par with a 6% coupon rate D) $100,000 market value of corporate bonds selling at a premium and yielding 6% to maturity

D When you read the full question, including the answer choices, you can immediately disregard two of the four options. With $100,000 to invest, the answer cannot be to purchase $200,000 of anything. Maximizing current income excludes zero-coupon bonds because there is no current income. Now, to the correct choice. Why does a bond sell at a premium over par? Although there are exceptions, primarily it is because the coupon rate on that bond is higher than the current market interest rate. Therefore, with a higher coupon rate, the current income on the same amount of principal invested ($100,000 in our question) will always be higher for a bond selling at a premium. That is the KISS (Keep It Simple Student) answer. For those who want to delve further, here we go. For example, if current market interest rates are 6% (likely the case here because the AA rated bonds with a 6% coupon are trading at par), then a bond with a 7% coupon will be selling at a premium. The current yield on $100,000 of the 6% bonds would be $6,000 per year. If a bond's yield to maturity is 6% and it is selling at a premium, it must be that the coupon is higher than 6%. For example (and we're doing the math that you won't have to do), $93,000 par (93 times $1,000) value of bonds with a 7% coupon, selling at $100,000 (a premium over the $93,000), and maturing in 10 years has a YTM of 6%. Investing $100,000 into these bonds will result in current income of $6,510 per year ($93,000 par times the 7% coupon).

Which of the following indicates a bond selling at a discount? A) 7% coupon yielding 6.5% B) 5% coupon yielding 5% C) 10% coupon yielding 9% D) 7% coupon yielding 7.5%

D Whenever the yield is higher than the coupon, the bond is selling at a discount from the par value. When the question says "yielding," it is generally referring to the yield to maturity. However, whether referring to the YTM or the current yield, the answer here is the same: the yield is higher than the coupon.