Series 7 Unit 4

Two conservative customers in their 50s are interested in preserving principal and high-current income from their investments. From first to last, in which order are the following bonds ranked in meeting your customer's needs? I. Fort Worth Gas 5¼s of 35, rated A1 II. San Antonio Transit 5¼s of 35, rated AA+ III. Texas Telecom 5¼s of 35, rated AAA IV. Dallas Electric 5¼s of 35, rated AA-

A) III, II, IV, I Because the maturity and coupon rates are all the same, we can rank the bonds by rating. Based on the ratings given, the highest-quality bond is the Texas Telecom, rated AAA, followed in order by the bonds rated AA+, AA-, and A1. LO 4.f

The price of which of the following will fluctuate most with fluctuating interest rates? A) Long-term bonds B) Money market instruments C) Common stock D) Short-term bonds

A) Long-term bonds Long-term debt prices will fluctuate more than short-term debt prices as interest rates rise and fall. When buying a debt instrument, a person is really buying the interest payments and final principal payment. Money has a time value: the longer it takes to receive the money, the less it is worth today. LO 4.e

The XYZ Corporation has issued some 4% callable bonds maturing in 20 years. The bonds are callable at 102 commencing in 10 years. Regarding these bonds, which of the following statements is not correct? A) These bonds will appreciate faster in declining interest rate markets than comparable bonds without a call feature. B) The bonds will likely be called in a declining interest rate market, forcing the bondholders to reinvest at lower rates. C) XYZ will most probably call these bonds when it can refund the issuer at a lower interest rate. D) The call premium generally will not compensate the bondholder for the loss of interest if the bond is called.

A) These bonds will appreciate faster in declining interest rate markets than comparable bonds without a call feature. All things being equal, callable bonds will not show as much appreciation in a declining interest rate market as bonds without a call feature. Logically, as interest rates fall, those bonds will be called making them less attractive than bonds where the higher interest rate payments will continue until maturity. It is correct that the premium ($20 in this question) is generally not going to equal the amount of interest that the investor would have been able to earn on the bond. It is some compensation, but not full. The bonds will be called when interest rates have declined, and the investor will now have the cash but faces the reinvestment risk of having to put the money to work at those lower interest rates. LO 4.b

All of the following statements regarding commercial paper are correct except A) it is quoted as a percentage of par. B) it is quoted on a discount yield basis. C) it is unsecured. D) interest is received at maturity.

A) it is quoted as a percentage of par. Commercial paper is short-term, unsecured corporate debt. It is issued and traded at a discount of face value and does not pay periodic interest. Like all zeroes, it is quoted on a discounted yield basis. LO 4.c

A callable municipal bond maturing in 30 years is purchased at 102. The bond is callable at par in 15 years. If the bond is called at the first call date, the effective yield earned on the bond is A) lower than the yield to maturity. B) the same as the yield to maturity. C) higher than the yield to maturity. D) not determinable.

A) lower than the yield to maturity. When a bond is purchased at a premium ($1,020) and called for redemption, the investor's effective yield is the yield to that call date. That will be lower than the bond's yield to maturity because the premium is lost sooner. LO 4.e

All of the following statements regarding negotiable jumbo certificates of deposit are true except A) they are fully insured in any denomination by the FDIC. B) they are usually issued in denominations of $100,000 to $1,000,000. C) they usually have maturities of less than one year. D) they are readily marketable.

A) they are fully insured in any denomination by the FDIC. The FDIC insures only up to $250,000. LO 4.c

Which of the following money market instruments is most often used by those in the import/export business? A) Commercial paper B) Bankers' acceptances C) Variable rate demand notes D) Negotiable CDs

B) Bankers' acceptances Bankers' acceptances are loans guaranteed by a commercial bank that are typically used to finance international transactions. Although all of the choices are money market instruments, it is the BAs that are primarily used by those engaged in international business. LO 4.c

Which of the following is a money market instrument? A) Common stock B) Short-term debt C) Preferred stock D) Long-term debt

B) Short-term debt A money market instrument is short-term debt with one year or less to maturity. LO 4.a

An issuer of a bond will apply to the rating services for a rating for the purpose of A) reducing interest rate risk. B) reducing credit risk. C) reducing the bond's duration. D) reducing liquidity risk.

B) reducing credit risk. What does the bond rating measure? It is a measurement of the credit risk. The higher the rating, the lower the credit risk and the reverse. With lower credit risk, the issuer will be able to borrow at a lower interest cost. Does the rating have an effect on the bond's liquidity? Possibly, but as is so often on the exam, you must select the answer that best fits the question. LO 4.f

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.

C) I and III Commercial paper instruments are debt securities; they represent loans to the issuing corporation by the holder. They are commonly issued to raise working capital and, as debt obligation, are senior in preference to preferred stock in claims against an issuer. LO 4.c

When part of an issue of speculative bonds with a 25-year maturity are called, the effect on the remaining bonds will be to A) decrease their quality. B) increase their coupon rate. C) improve their quality. D) decrease their coupon rate.

C) improve their quality. Speculative bonds are those with lower ratings. They are considered to be of lower quality because the risk of timely payment and principal are higher than investment-grade bonds. When a company shows its determination to honor its debt by paying off some of it in advance, the rating associations take note of that and invariably increase the rating. Compare this to your personal credit score. Your score might be relatively low because you have a lot of outstanding debt. As you pay down that debt, your credit score is likely to increase. It is the same logic here. LO 4.f

During a period of sustained low interest rates, many investors, particularly institutions, look to increase their return through alternative debt investments. Examples of those would include all of the following except A) exchange-traded notes. B) private placement debt. C) leveraged ETFs. D) equity-linked notes.

C) leveraged ETFs. Although leveraged ETFs (exchange-traded funds) are certainly an alternative investment, they represent an equity investment rather than debt. Despite the misleading name, equity-linked notes are, in fact, debt instruments. LO 4.g

An investor would most likely purchase money market instruments for their A) yields. B) appreciation potential. C) liquidity. D) inflation protection.

C) liquidity. Money market instruments are frequently referred to as cash equivalents. That is largely due to their high liquidity. Yields on these instruments are very low, and as fixed-income instruments, they offer no appreciation potential or inflation protection. LO 4.a

All of the following are money market instruments except A) reverse repurchase agreements. B) commercial paper. C) options. D) bankers' acceptances.

C) options. Money market instruments are short-term (one year or less to maturity) liquid debt instruments. Reverse repurchase agreements, repurchase agreements, commercial paper, CDs, and bankers' acceptances are examples. Options are not money market instruments. LO 4.c

When a bond is issued by a national government, it is called A) high-quality debt. B) national debt. C) sovereign debt. D) treasury debt.

C) sovereign debt. The term sovereign debt applies to securities issued by national governments. U.S. Treasuries are an example of sovereign debt issued here. Other countries have their versions. Not all are considered high quality, especially those issued by emerging economies. LO 4.d

It would be expected that your firm would employ heightened suitability standards when evaluating recommendations for A) nonvoting common stock. B) cumulative preferred stock. C) structured products. D) sovereign debt.

C) structured products. The higher the risk of the investment, the greater the need for checking suitability. Structured products, such as equity-linked notes and exchange-traded notes, are considered complex products. In many cases, FINRA has discovered that registered representatives had inadequate understanding of the investment, leading to their making unsuitable recommendations. LO 4.g

The market price of fixed-income securities, especially bonds, are highly sensitive to changes in market interest rates. Based on that knowledge, assuming all of these bonds were purchased at par value, which of the following will have the greatest price change when market interest rates decrease? A) 10-year maturity, 4% coupon B) 10-year maturity, 6% coupon C) 20-year maturity, 4% coupon D) 20-year maturity, 6% coupon

D) 20-year maturity, 6% coupon Without getting into complicated math, assume that market interest rates fell to 2%. Those investors holding a bond with a 4% coupon are going to be earning twice the going rate while those with the 6% coupon are earning three times the going rate of 2%. Presented with that information, what would be worth more to an investor: the 4% bond or the 6% bond? I think most would rather earn 6% and would pay a higher price for that bond. The next step is thinking about how long the investor will be receiving that higher-than-market rate. Would you rather receive three times the going rate for 10 years or for 20 years? Clearly, the longer you can get those higher interest payments, the more attractive the bond. That makes the 6% bond with a 20-year maturity the most attractive investment, and its price will increase more than the others. Remember, there is an inverse relationship between bond market prices and changes to market interest rates. As interest rates decrease, the value of older bonds (with their higher coupons) increases. The higher the coupon, the greater the increase. When their coupons are the same, the longer the time to maturity, the more valuable that higher coupon rate. LO 4.e

A bond would be considered speculative below which of the following Standard & Poor's (S&P) ratings? A) A B) BB C) B D) BBB

D) BBB A rating of BBB is the lowest investment-grade rating assigned by S&P. Any rating beneath this is considered speculative. LO 4.f

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 is a discount bond. D) The bond's current yield is calculated by dividing its annual interest by its market price.

D) The bond's current yield is calculated by dividing its annual interest by its market price. A bond's current yield is calculated by dividing its annual interest by its current (market) price. The current yield will be higher than its yield to maturity, which will include the premium return. The determination of a bond's yield is unrelated to other bonds. In addition, this is a premium bond, not a discount bond. LO 4.e

When a bond is selling at a discount A) the current yield will always be higher than the yield to call. B) the yield to call will always be lower than the yield to maturity. C) the yield to maturity will always be lower than the current yield. D) the nominal yield will always be lower than the current yield.

D) the nominal yield will always be lower than the current yield. When a bond is selling at a discount, all of the yields are higher than the nominal (coupon) yield. The sequence in ascending order of yield is NY, CY, YTM, YTC.