Unit 2: Types and Characteristics of Fixed-Income (debt) Securities

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) 1.25% C) 15.00% D) 10.00%

A) 5.00% The quarterly dividend is $0.50, so the annual dividend is $2.00; $2 ÷ $40 (market price) = 5% annual yield (current yield).

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

A) II and IV Commercial paper represents the unsecured debt obligations of corporations needing short-term financing. Both yield and maturity are open to negotiation. Because commercial paper is issued with maturities of no more than 270 days, it is exempt from registration under the Securities Act of 1933.

Your client in the 25% federal income tax bracket lives in a state where his earnings place him in the 6% bracket for state income tax purposes. If he were to purchase a 4% bond issued by a political subdivision of his state, his total tax-equivalent yield would be A) slightly more than 5.33%. B) approximately 12.90%. C) 4.00%. D) slightly less than 5.33%.

A) slightly more than 5.33%. When an individual owns a municipal bond issued in his state of residence, not only is the interest tax free on a federal basis but (at least in all cases on the exam) also it is nontaxed in that state. Therefore, the tax-equivalent yield here is slightly higher than it would be if we only computed using the federal tax rate. Because that would be 4.0% divided by 0.75 (100% minus the 25% tax bracket) or 5.33%, saving on state income taxes would increase the yield slightly.

If a customer buys a 6% bond maturing in eight years on a 7.33 basis, the price of the bond is A) at par. B) inverted. C) below par. D) above par.

C) below par. A bond with a basis, or yield to maturity, greater than its coupon is trading at a discount, or below par.

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) 7.50% B) 4.00% C) 3.50% D) -0.50%

C) 3.50% 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.

The net asset value of an international bond fund can be expected to increase if which of these occur? Interest rates rise abroad. Interest rates fall abroad. The U.S. dollar strengthens. The U.S. dollar weakens. A) I and III B) II and III C) II and IV D) I and IV

C) II and IV If interest rates fall, bond prices will rise, thus increasing the NAV of a bond portfolio. If the U.S. dollar weakens, the value of other currencies will rise. This would also increase the NAV for a portfolio of international bonds.

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) tax free. C) partly taxed as ordinary income and partly a tax-free return of principal. D) taxed as a capital gain if underlying mortgage is prepaid.

C) partly taxed as ordinary income and partly a tax-free return of principal. 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.

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

D) income payments are more reliable. 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 would make a corporate bond more subject to liquidity risk? Short-term maturity Long-term maturity High credit rating Low credit rating A) II and III B) II and IV C) I and III D) I and IV

B) II and IV Liquidity risk is the risk that when an investor wishes to dispose of an investment, no one will be willing to buy it, or that a very large purchase or sale will not be possible at the current price. The available pool of purchasers for bonds with a low credit rating is much smaller than for those with investment-grade ratings (many institutions are only able to purchase bonds with higher credit ratings). As a result, the lower the credit rating, the greater chance of the bond having liquidity issues. Similarly, bonds with short-term maturities attract many more investors than those with long-term maturities, causing the long-term bonds to be less liquid.

GNMA mortgage-backed securities are A) exempt from federal income tax for the interest payments received by the bondholders. B) a direct obligation of the U.S. government. C) backed exclusively by a pool of mortgages. D) available to investors through a minimum purchase of $5,000.

B) a direct obligation of the U.S. government. GNMA securities are a direct obligation of the U.S. government and are backed by a pool of mortgages (which is why the choice "backed exclusively by a pool of mortgages" is not the best choice). The monthly payments are partially a return of principal and partially taxable interest, which is subject to state and federal income tax. GNMA pass-through securities are available to investors with a minimum issue price of $1,000.

A bond with a par value of $1,000 and a coupon rate of 5%, paid semiannually, is currently selling for $1,200. The bond matures in 10 years and is callable in six years at 103. In the computation of the bond's yield to call, which of the following would be a factor? A) Future value of $1,200 B) Present value of $1,030 C) Interest payments of $25 D) 20 payment periods

C) Interest payments of $25 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. A bond with a 5% coupon will make $25 semiannual interest payments. With a six-year call, there are only 12 payment periods, not 20. The present value is $1,200 and the future value is $1,030, the reverse of the numbers indicated in the answer choices.

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

D) II and III 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.

Your customer owns $100 par 5½% callable convertible preferred stock convertible into four shares of 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 common stock is trading at $25.50? A) Place irrevocable instructions to convert the preferred stock into common stock and sell short the common stock immediately. B) Hold the preferred stock to continue the 5½% yield. C) Convert her preferred stock into common stock because it is selling above parity. D) Present the preferred stock for the call because the call price is $4 above the parity price.

D) Present the preferred stock for the call because the call price is $4 above the parity price. If the preferred stock is called, the client will receive $106. 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. The dividends will cease on the call date if the preferred stock is held beyond the call date.

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

A) 5.0%. 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%.

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) 8.50% C) 5.68% D) 4.36%

A) 8.67% 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 are characteristics of negotiable jumbo CDs? Issued in amounts of $100,000 to $1 million or more Typically pay interest on a monthly basis Always mature in one to two years with a prepayment penalty for early withdrawal Trade in the secondary market A) I and IV B) II and III C) I and III D) II and IV

A) I and IV Negotiable jumbo CDs are issued for $100,000 to $1 million or more and trade in the secondary market. Most jumbo CDs are issued with maturities of one year or less. Being negotiable, there is no prepayment penalty. These CDs generally pay interest on a semiannual basis, not monthly.

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

A) II and IV Commercial paper represents the unsecured debt obligations of corporations needing short-term financing. Both yield and maturity are open to negotiation. Because commercial paper is issued with maturities of no more than 270 days, it is exempt from registration under the Securities Act of 1933. LO

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 has the right to convert the debentures during the time period specified in the indenture. C) The issuer pays a higher rate of interest compared with a comparable nonconvertible debenture. D) The debenture holders receive a variable rate of interest.

A) When compared with similar nonconvertible debentures, convertible debentures are issued with a lower coupon rate. 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.

When an investor divides the coupon rate of a municipal bond by the complement of her tax rate, she is computing the bond's A) after-tax rate of return. B) tax-equivalent yield. C) inflation-adjusted return. D) discounted cash flow.

B) tax-equivalent yield. The computation for the tax-equivalent yield of a municipal bond is performed by dividing the bond's coupon rate by the complement of the investor's tax rate (1 - the investor's tax bracket). If the bond has a coupon of 4% and the investor is in the 20% bracket, the tax-equivalent yield is 4% divided by (1 - 0.20), or 4% divided by 0.80 = 5%.

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

B) they are more likely to be called than comparable bonds selling at a premium. 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.