SIE Ch. 3
The value of a municipal bond will rise if credit rating agencies: A Affirm their original opinion of creditworthiness B Change their ratings from BBB to A C Change their ratings from BBB to BB D Change their ratings from AA to A
A Affirm their original opinion of creditworthiness When credit rating agencies change their ratings in a positive direction it will have a positive impact on the value of the bond. The less risk the more value the lower the yield.
What index is a TIP linked to? A CPI B S&P 500 C Barclays Capital Aggregate Bond Index D Dow 30
A CPI Treasury Inflation Protected Securities (TIPS) are a type of U.S. Government debt where the principal amount is adjusted every 6 months based on changes in the Consumer Price Index. They are issued at $1000 par value, pay interest semiannually and the interest rate is fixed. It is the principal amount that is adjusted for inflation. So, every 6 months there could be a larger amount of principal that is earning interest. Unlike most debt securities, TIPS have no inflation risk because of the semiannual principal adjustment.
The U.S. Government awards bids on what basis? A Highest dollar amount lowest yield B Lowest dollar amount highest yield C Highest dollar amount highest yield D Lowest dollar amount lowest yield
A Highest dollar amount lowest yield The U.S. Government sells their debt at weekly and monthly auctions, depending on the length of maturity. Weekly auctions are held for all T-Bills except for the 52 week T-Bill. All other Government debt, which includes T-Notes, Bonds, Tips, and the 52 week T-Bills, are auctioned monthly. These auctions use a type of competitive bid system called a Dutch Auction. Bids, that specify a dollar amount and the yield that is wanted, are submitted and filled from lowest to highest yield until the Treasury has sold the required amount of securities. The last yield accepted will be the yield that all accepted bids are awarded, even if it's larger than the bid they entered. The government wants the lowest possible yields because that equals lower interest costs. The higher yield bids are not filled.
What is the current yield of 8% coupon bond when the bond is trading for $800? A 4% B 10% C 5% D 8%
B 10% $1,000 x 8% = $80; $80/$800 = 10%. Current yield is annual cash flow divided by current price.
Your customer bought a General Electronics 10% bond at 105. The bond matures in 10 years. What is the current yield? A 9.27% B 9.52% C 9.76% D 11.22%
B 9.52% The current yield is calculated by dividing the annual interest payment by the current market price. In this case, the current yield would be 9.52%, which is $100 divided by $1,050. Notice that the maturity date is irrelevant to the current yield.
Which of the following bonds is NOT subject to reinvestment risk? A A 3% coupon bond purchased at a discount B A zero coupon bond purchased at a discount C An 9% coupon bond purchased at a premium D A 6% coupon bond purchased at par
B A zero coupon bond purchased at a discount Since they do not pay semiannual interest, zero coupon bonds have no reinvestment risk regardless of their purchase price.
How is a CMO different from other mortgage-backed securities? A Increased liquidity B Separated into maturity classes C Backed by government guarantees D Higher yield
B Separated into maturity classes CMOs are mortgage-backed securities in which the mortgage pools are separated into different maturity classes, known as tranches. CMOs may have higher or lower yields and/or liquidities than other mortgage-backed securities and they are NOT backed by the full faith and credit of the U.S. government.
General Microsystem's 9% bonds mature in 10 years and are trading at 92. What is the approximate yield to maturity? A 9.80% B 9.00% C 10.20% D 10.7%
C 10.20% The YTM (basis) calculation must consider the difference between the purchase price and par value, plus the interest earned during the entire time from purchase to maturity. The bond is trading at 92, or $920 and will mature at par ($1,000). The customer will have an $80 gain over 10 years, which is a gain of $8 per year. The adjusted interest is the $90 annual interest payment plus the $8 per year gain on the bond, a total of $98. The average price is the $1,000 par value, plus the $920 purchase price, divided by 2, or $960. The $98 adjusted interest divided by the $960 average price gives an approximate yield to maturity of 10.2%.
Which one of the following bonds is selling for a premium? A An investor owns a bond with a 5% coupon when a similar new bond can be issued with one at 7% B An investor owns a bond with a 6% coupon when a similar new bond can be issued with one at 6.5% C An investor owns a bond with a 5% coupon when a similar new bond can be issued with one at 5% D An investor owns a bond with a 7% coupon when a similar new bond can be issued with one at 5%
D. An investor owns a bond with a 7% coupon when a similar new bond can be issued with one at 5% An existing bond's market price will increase in value when current interest rates decline in the market. When interest rates go down, new bonds are issued with coupon rates lower than the coupon rates on existing bonds trading in the market, driving existing bond prices upward.
nominal yield
Even if a bond's price changed, the coupon is always paid on the original $1,000 principal balance
Maturities of treasury securities ranging from shortest to longest:
T-Bills, T-Notes, and T-Bonds.
Put provisions
allow the bondholder to sell the bond back to the issuer at par value on specific dates that occur before maturity. This provision protects the bondholders from declining values of the bonds due to lower credit ratings or rising interest rates in the market.
T-STRIPS (Separate Trading of Registered Interest and Principal Securities)
are U.S. Treasury zero coupon instruments backed by the U.S. Government. T-STRIPS are issued at a discount and mature at face value, with a maturity of up to 30 years. Like other zero coupon bonds, T-STRIPS earn phantom income. Phantom income is taxable in the year it is added to the investor's cost basis (accreted) and taxable in the year accreted at ordinary income rates. Accretion is the process used to determine the amount of annual income that discount bonds have earned, but have not yet received. These T-STRIPS are often purchased by investors looking to fund retirement, since the interest rate is fixed for a long term.
Treasury Inflation Protected Securities(TIPS)
are a type of U.S. Government debt where the principal amount is adjusted every 6 months based on changes in the Consumer Price Index. They are issued at $1000 par value, pay interest semiannually, and the interest rate is fixed. It is the principal amount that is adjusted for inflation. Every 6 months there is a larger amount of principal that is earning interest. Unlike most debt securities, TIPS have no inflation risk because of the semiannual adjustment to the principal.
Secured bonds
are backed by specific collateral to reduce the risks associated with lending. If the issuer defaults, the assets used as collateral will be liquidated to pay the issuer's debt (bond). Secured bonds are not risk-free. If the market value of the collateral is insufficient, the lender on a defaulted issue may still suffer consequences.
Mortgage bonds
are backed by the corporation's real estate, such as office buildings, apartment complexes, shopping malls, or other tangible property owned by the issuer. If the bond defaults, the property will be sold to compensate bondholders for the default.
Debentures
are bond issues that are not secured by any form of collateral. They are backed by the general creditworthiness and reputation of the issuer. In other words, the issuer's full faith, credit, and promise to pay.
Collateral trust certificates
are bonds backed by the securities of another company. These bonds are typically issued by subsidiary companies and backed by the parent company's stock. If the issuer cannot pay off the collateral trust certificate, the parent company's underlying stock will be liquidated to pay off the bond.
Treasury notes
are intermediate-term government securities that mature in 2-10 years. T-Notes can be issued in denominations of $100 to $5,000,000, however assume par value for a T-Note is $1,000. T-Notes are issued at par value and pay semiannual interest income that is federally taxable at ordinary income rates.
Treasury bonds
are long-term instruments ranging in maturity from 10-30 years. Like T-Notes, T-Bonds can be issued in denominations of $100 to $5,000,000, however assume par value for a T-Bond is $1,000. T-Bonds are issued at par value and pay semiannual interest income that is federally taxable at ordinary income rates. 30 year bonds are no longer issued but, some may still be in the hands of investors and not yet mature.
Equipment trust certificates
are secured bonds backed by equipment; traditionally, these bonds are issued by large transportation companies. The title of the equipment is held in trust for the debt holders until the equipment is paid off. Since equipment depreciates in value over time, the issue is originally secured by equipment with a market value more than the original borrowing.
Treasury bills
are short-term securities with maturities of 1 year or less. T-bills do not pay interest; instead, they are issued at a discount, and the investor earns interest as the security grows from its discounted purchase price to the face amount (par value), which it pays at maturity. T-Bills have the shortest maturity of all government debt and mature in 4, 13, 26, or 52 weeks. They are issued in increments of $1,000 up to $1,000,000. T-Bills are very safe and highly liquid. These instruments are often purchased by conservative investors with short-time horizons. T-Bills are short term debt instruments that mature in 1 year or less. The U.S. government does not issue a 9-month T-Bill.
Guarantee bonds
are unsecured bonds backed not only by the promise of the issuer to pay, but also a parent company. If the issuer defaults on the bond, the parent company must step in and make payments, similar to a co-signer on an automobile.
Yield to call
computes the investor's expected return upon the bond being called. must consider the difference between purchase price and par value, plus the interest earned during the entire period from purchase to the call date. The bond is called at the call value. The call value is either the bond's par value or par value plus a call premium. Discount bonds are not normally called because of the inverse relationship between current interest rates and bond prices. A lower yielding bond in the market usually will not be called.
Corporate bonds
debt instruments issued by a corporation (issuer) and sold to investors. Bonds are a major source of capital for many larger businesses. Generally, a corporation needs to have consistent earnings to offer debt securities to the public at a favorable interest rate. The higher the credit rating of the corporation, the lower the bond's coupon rate will be.
treasury receipt
is a zero coupon security, similar to a Treasury STRIP, that was created and issued by broker-dealers. These receipts are backed by the interest and principal of treasury securities (T-Notes or T-Bonds), owned by the broker-dealer, and held in escrow. A treasury receipt, however, is not a direct obligation of the U.S. Government because it is issued by a broker-dealer. These are no longer issued, but may still be held by investors.
yield
is the benefit received from holding a bond. Yields are always quoted in percentage terms and are further broken down into basis points
Current yield
is the return that an investor buying a bond at the current market value can expect to receive on an annual basis CURRENT YIELD = ANNUAL INTEREST ÷ CURRENT MARKET PRICE
accreted value
is the value, at any given time, of a debt instrument that accrues interest over multiple years.
call risk
loss of income due to early retirement In a low interest rate environment, the bondholder might be forced to accept a lower coupon on a new investment.
yield to maturity
must consider the difference between purchase price and par value, plus the interest earned during the entire period from purchase to maturity. At maturity, the bond will be redeemed only for its par value, and the owner will have a gain if the bond was purchased at a discount, or suffer a loss if the bond was purchased at a premium. (annual interest + annualized gain OR - annualized loss)/ ([purchase price + redemption price]/2)
par value
or face value, for a bond is $1,000 Issuers pay the investor interest semi-annually and the principal at maturity.
A 9% corporate bond is quoted at 120. What is the current yield? A 108% B $90 C 9% D 7.5%
D 7.5% A 9% bond pays annual interest of 9% of its par value of $1,000, or $90. A bond quoted at 120 is selling at 120% of par, or $1,200. The current yield is annual interest divided by current market price, or $90 / $1200 = 7.5%.
If a $1,000 par value 6% bond is selling at $500, the current yield is: A 8% B 10% C 12% D 6%
C 12% Current Yield = annual interest of $60 divided by market price of $500 = 12%. Par value has no bearing on current market price. The nominal yield (stated or coupon rate) is 6%, regardless of the bond's market price.
Callable Bonds:
-Subject to early retirement at the issuer's discretion -Often pay more than $1,000 if called -Are typically called when interest rates fall -Carry higher coupons when compared with non-callable issues
Income Bonds
AKA Adjustment Bond is issued by a corporation that is under reorganization and coming out of bankruptcy. These bonds have no legal obligation to make interest payments and will only pay interest when the corporation earns enough income to do so. These bonds carry a high default risk and are not recommended for investors looking for a stable income stream, despite the name of the bond.
Which T-Bill is not auctioned off weekly? A 26 week B 4 week C 52 week D 13 week
C 52 week The U.S. Government sells their debt at weekly and monthly auctions, depending on the length of maturity. Weekly auctions are held for all T-Bills except for the 52 week T-Bill. All other Government debt, which includes T-Notes, Bonds, Tips, and the 52 week T-Bills, are auctioned monthly. These auctions use a type of competitive bid system called a Dutch Auction. Bids, that specify a dollar amount and the yield that is wanted, are submitted and filled from lowest to highest yield until the Treasury has sold the required amount of securities. The last yield accepted will be the yield that all accepted bids are awarded, even if it's larger than the bid they entered. The government wants the lowest possible yields because that equals lower interest costs. The higher yield bids are not filled.
Nick Forrester owns a 6% corporate bond, which he purchased on a 6.75% basis. Which of the following could be the bond's market price on the date of purchase? A 106 B 100 C 94 D 106.75
C 94 Since the basis (YTM) of Nick's bond is greater than the coupon (nominal) rate, we conclude that this is a discount bond (a price less than par). Since each bond point is $10, 94 = $940. This is the only answer choice below par ($1,000). Yield comes from semiannual interest payments and price appreciation at maturity. If the interest payments are 6%, the other .75% (75 basis points) has to come from some price appreciation at maturity. Upon maturity, the investor receives par value, which is greater than the purchase price resulting in a capital gain for the investor.
Why would an investor buy an asset backed security (ABS)? A For principal protection B For inflation protection C For a higher interest rate D For capital appreciation
C For a higher interest rate Asset Backed Securities (ABS) are a form of pooled fixed income investment. They were created to take advantage of higher interest rates of other types of debt. Often auto loans, credit card debt and home equity loans are used in the pool. Often, a bundle of loans is divided into separate securities with different levels of risk and returns. Payments on the loans are distributed to the holders of the lower-risk, lower-interest securities first, and then to the holders of the higher-risk securities.
A corporate bond is being sold in the market for 140 and has a nominal yield of 6%. The yield-to-maturity on this bond will be: A Higher than the nominal yield B Equal the nominal yield C Lower than the nominal yield D Higher than the current yield
C Lower than the nominal yield Since the bond is trading at a premium, the yield-to-maturity will be lower than both the nominal and the current yield.
How often does a zero coupon bond pay interest to its holder? A Annually B Quarterly C Only at maturity D Semi-annually
C Only at maturity
An investor has three ABC 6% bonds and three XYZ 6.4% bonds. What is the difference in annual interest between the two positions? A $24 B $48 C $4 D $12
D $12 The investor has three 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 three XYZ bonds earning 6.4% or $64 per year (or $192 total for all three 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 two positions.
A Treasury bond which sold at a discount for 98.20 is now selling at 101.24. What is the amount of increase reflected in the current price of the bond? A $26.50 B $30.00 C $30.12 D $31.25
D $31.25 Treasury notes and bonds are quoted in points (one point =$10) and 32nds of points. The period is a place marker for 32nds. So the difference in the quotes is 101 24/32 - 98 20/32 = 3 4/32, or 3 1/8. 3 1/8% of $1,000 is $31.25.
ABC Inc. has 7% convertible debentures outstanding, offered at 96. What term is used to describe this bond? A A premium bond B A high quality bond C A par bond D A discount bond
D A discount bond Any bond that has a price less than 100 (par) is termed a discount bond. A bond trading in the market at 96 is trading at 96% of par value. 96% x $1,000 = $960.
What is the bondholder's primary objective when investing in corporate bonds? A Dividend payments B Capital appreciation C Tax-free interest payments D Interest payments
D Interest payments Corporate bondholders are income-oriented investors looking to fully receive timely interest income payments along with a repayment of bond principal when the bond matures. Municipal bonds do pay interest that is exempt from federal income taxation in most cases.
Which is NOT a direct obligation of the U.S. government? A Treasury Bonds B Treasury Bills C GNMA pass-through certificates D Securities issued by the Federal Farm Credit Consolidated System- Wide Banks
D Securities issued by the Federal Farm Credit Consolidated System- Wide Banks Securities issued by the Federal Farm Credit Consolidated System-Wide Banks have a line of credit with the federal government, but are not backed by the full faith, credit, and taxing power of the U.S. Government.
Which of the following bond return calculations does not take into account the par value received at maturity? A Total return B Yield to maturity C Internal rate of return D Yield to call
D Yield to call The yield to call is the yield assuming the investor receives the call price at the call date, and does not include consideration of the principal return at maturity.
subordinated debentures
In the event of bankruptcy, a subordinated debentures holder's claim will come after secured bondholders and straight debenture holders, but prior to preferred and common stockholders. These bonds carry a higher default risk and have to pay a higher interest rate to investors.
principal
The amount of money borrowed, or amount still owed by the issuer
coupon rate
The bond's annual interest rate
Speculative (High Yield, Junk) Bonds
The issuer has an adequate to highly vulnerable capacity to meet its financial commitments.
Investment Grade Bonds
The issuer has an extremely strong, very strong, or strong capacity to meet its financial commitments.