Unit 2
Bond prices and yields move in... A. The same direction B. The opposite direction
B. as interest rates rise, bond prices fall, and vice versa
What is the Current Yield formula?
CY = Annual Coupon / Bond Price
Tax Equivalent Yield - Corporate bond Formula: Tax Equivalent Yield - Municipal bond Formula:
Corporate x (100% - tax bracket) = Tax-free Municipal Equivalent Municipal bond coupon divided by (100% - investors tax bracket)
Which of the following have no interest rate risk? A) Negotiable CDs B) Commercial paper C) U.S. Treasury bonds D) Time deposits at your local bank
D. Time deposits, either in the form of a savings account or a certificate of deposit, have no interest rate risk. Because these do not trade in the market, the value is not subject to changes in market interest rates. LO 2.k
_____ are written promises of the corporation to pay the principal at its due date and interest on a regular basis.
Debentures
Formula for computing tax equivalent yield (TEY)
Municipal bond coupon divided by (100% - investor's tax bracket
Are Brady bonds U.S. government guaranteed? Yes or no?
No
_____ _____ are payable from the earnings of a revenue-producing enterterm-35prise, such as a water, sewer, electric or gas system, toll bridge, airport, college dormitory, or any other income-producing facility.
Revenue bonds Note: The yield, generally, is higher for this type of bond than for a GO (taxes are more secure than revenues).
Corporations, particularly railroads and airline companies, finance the acquisition of their rolling stock, locomotives, or airplanes by issuing an _____ _____ _____.
equipment trust certificate
The advantages of investing in foreign bonds include: (3 answers)
- Potentially higher returns - Diversification - Hedging against a drop in value of the U.S. dollar
What is the liquidation priority pertaining to the capital structure of a corporation?
- Secured creditors (e.g., mortgage bonds, equipment trust certificates, collateral trust bonds) - Unsecured creditors (e.g., general creditors including debenture holders) - Subordinated debt holders - Preferred stockholders - Common stockholders
Three advantages of Eurodollar bonds to investors are:
- because they are U.S. dollar denominated, they bear no currency risk to U.S. investors; - they are rated by U.S. rating agencies, so the risk is clear; and - they may offer higher yields than domestic bonds from the same issuer.
If the rates are going from greatest to least starting with Yield to Call (YTC), Yield to Maturity (YTM), Current Yield (CY), and Coupon / Nominal Yield (NY),is this a... A. Discount bond B. Par bond C. Premium bond
Answer: A. Discount bond
A company realizes money from the sale of surplus equipment. It would like to invest this money but will need it in 4-6 months and must take that into consideration when selecting an investment. You would recommend A. preferred stock. B. Treasury bills. C. AAA rated bonds with long-term maturities. D. common stock.
Answer: B. For this client, the appropriate investment is a money market instrument, and nothing is safer than a T-bill.
If the rates are going from greatest to least starting with Coupon / Nominal Yield (NY), Current Yield (CY), Yield to Maturity (YTM), and Yield to Call (YTC) is this a... A. Discount bond B. Par bond C. Premium bond
Answer: C. Premium bond
If an investor in the 27% federal income tax bracket invests in municipal general obligation bonds selling at par with a coupon of 4.5%, what is the tax equivalent yield? A. 3.29% B. 5.72% C. 6.16% D. 16.67%
Answer: C. The formula for computing tax equivalent yield is nominal (coupon) yield divided by (1 − federal income tax rate): 0.045 ÷ (1 − 0.27) = 0.045 ÷ 0.73 = 6.16%.
A 4.67% convertible debenture is selling at 102. It is convertible into the common stock of the same corporation at $25. The common stock is currently trading at $23. If the stock were trading at parity with the debenture, the price of the stock would be A) $44.35. B) $25.00. C) $25.50. D) $25.25.
C. To determine the parity price of the common, first find the number of shares the debenture is convertible into (conversion ratio) by dividing par value by the conversion price ($1,000 / $25 = 40 shares). Next, divide the current price of the bond by the conversion ratio. The result is the parity price of the common stock (1,020 / 40 = $25.50). LO 2.d
Practice Question One would expect to have checkbook access to a CMO. DDA. GNMA. LIBOR.
Answer: B. DDA stands for demand deposit account, most often a checking account at a bank.
If the rates for the Coupon / Nominal Yield (NY)Current Yield (CY), Yield to Maturity (YTM), and Yield to Call (YTC) are all the same is this a... A. Discount bond B. Par bond C. Premium bond
Answer: B. Par Bond
What is the primary advantage of investing in mortgage-backed securities?
Compared with other debt securities with similar ratings, they pay a higher rate of return.
Purchasing a bond issued in a foreign currency subjects you to what kind of risk?
Currency risk
What we normally refer to as cash in the bank is, in banking terms, known as a _____ _____.
demand deposit.
Interest Payments from Treasury Inflation Protected Securities (TIPS), and increases in the principal of TIPS, are subject to ______ tax but exempt from ______ and _____ tax
federal state and local
Prepayment risk is a form of _____ risk.
reinvestment
Risks of investing in foreign bonds include: (4 answers)
- Currency risk (if the foreign currency falls in value against the dollar) - Potentially higher risk of default - Generally less liquidity - Generally higher trading costs
If we have a taxable security, for example, a taxable bond is paying 8% interest and the investor is in the 30% tax bracket, the investor would pay 2.4% in taxes (30% of 8%), so after paying taxes, the investor will keep the other 5.6%. So, a tax-free bond paying ___% will over a tax equivalent yield.
5.6%
A bond indenture states that payment of interest and principal will come from the collection of ad valorem taxes. This is most likely A) a municipal general obligation bond. B) a corporate bond backed by property taxes. C) a U.S. Treasury bond. D) a municipal revenue bond.
A. Explanation Ad valorem taxes, most often taxes on real property, are the backing for municipal GO bonds. Corporations and the U.S. government do not collect property taxes. LO 2.h
A a debt obligation of the corporation backed only by its word and general creditworthiness is called a _____.
Debenture
What is a legal term for checking account?
Demand deposit
A ______ is any long-term debt instrument issued and sold outside the country of the currency in which it is denominated.
Eurobond
What is one of the replacement options for LIBOR?
SOFR Secured Overnight Financing Rate
What is the difference between secured and unsecured corporate debt?
Secured debt securities - are backed by by various kinds of assets of the issuing corporation Unsecured debt securities - are backed only by the reputation, credit record, and financial stability of the corporation.
Which rate is the world's most widely used benchmark for short-term interest rates?
The LIBOR rate (London Interbank Offered Rate)
Whenever the term municipal security is used on the exam, it is referring to a _____ _____ issued by a state or political subdivision, e.g., city, county, or school district.
debt security
What is a Yankee bond?
it is a U.S. dollar-denominated bond issued by a non-U.S. entity in the U.S. market
The term _____ _____ means bonds and preferred stock, because they have a claim senior to common stock.
senior securities Note: If an exam question described a corporation as having issued senior bonds, the answer would have to state that there were mortgage bonds and/or collateral trust bonds and/or equipment trust certificates issued by that corporation with priority claim ahead of unsecured creditors.
What is used when a corporation wants to borrow money and has neither real estate (for a mortgage) nor equipment (for an equipment trust) to use as collateral?
It deposits securities it owns into a trust to serve as collateral for the lenders.
If each of the following bonds matures in 10 years and has the same rating, which is the most volatile? A) Corporate bond priced at par with 6% yield B) Zero coupon bond priced to yield 6% C) Corporate bond priced at par with 8% yield D) Zero coupon bond priced to yield 8% Explanation
B. Explanation Zero coupon bonds are more volatile than bonds with coupon payments. All other things being equal, the most volatile bonds are the bonds with the lowest yield or coupon rate and the longest time to maturity. Because the bonds have the same maturity and the same rating the zero coupon bond with 6% yield will have the longest duration and be the most volatile. LO 2.j
Janeece, who is in the 37% marginal income tax bracket, would like to purchase a bond for her investment portfolio. Assuming all of the bonds are of similar investment quality, which would produce the highest after-tax yield? A) 5.25% corporate bond B) 3.55% municipal bond C) 3.75% U.S. Treasury bond D) 2.25% U.S. Treasury note
B. Janeece should purchase the municipal bond based on the following after-tax yield calculations: U.S. Treasury bond [3.75% × (1 − 0.37)]: 2.36% Corporate bond [5.25% × (1 − 0.37)]: 3.31% Municipal bond (tax-free): 3.55% U.S. Treasury note [2.25% × (1 - 0.37)]: 1.42%.
A _____ _____ has a claim that is behind (junior to) that of any other creditor. However, no matter how subordinated the _____, it is still senior to any stockholder.
subordinated debenture subordinated
Which of the following statements about jumbo CDs is not correct? A) Negotiable CDs do not have a prepayment penalty. B) Jumbo CDs pay interest semiannually. C) They are secured by pledged assets of the issuing bank. D) FDIC insurance applies up to $250,000.
C. The jumbo (negotiable) CDs traded in the money market are unsecured debt of the issuer. LO 2.k
A debenture is issued based on... A. the general credit of the corporation. B. a pledge of real estate. C. a pledge of equipment. D. the ability to levy taxes.
Answer: A. There are no pledged assets behind a debenture, merely the credit standing of the corporation. It is a corporate IOU.
Advantages of Brady bonds to an American investor include all of the following except A) higher yields than on U.S. Treasury securities. B) greater safety than most emerging market debt because of the collateral. C) greater liquidity than found in most emerging market securities. D) tax-free interest.
D. The interest on Brady bonds is fully taxable to a U.S. investor. All of the other statements are true. LO 2.i
A _____ _____ is a bond that is guaranteed as to payment of interest, or both principal and interest, by a corporate entity other than the issuer.
guaranteed bond
If an investor watches the latest T-bill auction fall to 0.71% from 0.82%, the best interpretation is that A) investors who purchased bills at this auction paid less for them than purchasers at last week's auction. B) these are 52-week T-bills. C) investors who purchased T-bills 12 weeks ago paid less than subsequent purchasers. D) investors who purchased bills at this auction paid more for them than purchasers at last week's auction.
D. Explanation The rates on the T-bills fell, so prices rose, and the investor paid more for the bills this week than last week. The decline in yields indicates there was good demand for the securities because the price rose, driving the yields down. The question does not indicate the price of T-bills 12 weeks ago; it is unclear if the investor paid less for the T-bills then. The 52-week (one-year T-bills) are the only ones auctioned monthly instead of weekly. LO 2.f
Calculating the Tax Equivalent Yield (TEY) when given the coupon on a municipal bond and the investor's tax bracket, what do you do?
Divide that coupon by / (100 - tax bracket) to determine what a taxable security would have to pay to give the same after tax return. TEY = coupon / (100 - x% for tax bracket)
Who can issue Eurodollar bonds?
Foreign corporations, foreign governments, domestic corporations, and domestic governments (including municipalities).
_____ _____ bonds are backed by a pledge of the issuer's full faith and credit for prompt payment of principal and interest.
General obligation
What is an unusual risk for investors owning mortgage backed securities?
pre-payment risk (or reinvestment risk)
Eurodollar bonds pay in 1. _____ _____ ; Eurobonds pay in 2. _____ _____. Hint: The name of the instrument tells you how principal and interest are paid.
1. U.S. dollars 2. foreign currency Note: These instruments must be issued outside of the United States.
All of the following are advantages of Eurodollar bonds except A) they may offer higher yields than domestic bonds from the same issuer. B) they are rated by U.S. rating agencies, so the risk is clear. C) because they are U.S. dollar denominated, they bear no currency risk to U.S. investors. D) greater transparency.
D. Eurodollar bonds are not registered with any regulatory agency. As a result, there is a certain lack of transparency. LO 2.i
What does DDA stand for?
Demand deposit account, which is most often a checking account at the bank.
Five percent XYZ debentures are trading for $1,250. Other similarly rated bonds are being offered at 4.25%. What is the current yield on the 5% XYZ debentures? A) 4.0% B) 1.5% C) 5.0% D) 6.25%
A. Explanation Current yield is defined as the annual income (or coupon rate) from a bond divided by the bond's current market price. Accordingly, $50 / $1,250 = .04 × 100 = 4%. The current yield will be lower than the coupon rate when the bond is trading at a premium. Please note that there is unnecessary information given in this question. You do not need to know anything about other bonds. LO 2.e
Which of the following corporate securities has a specific corporate asset pledged as security for the debt? A) An equipment trust certificate B) A debenture C) A subordinated loan D) A guaranteed bond
A. Explanation There are three primary examples of secured corporate debt instruments on the exam. Those are Equipment trust certificates (secured by the pledged equipment); Collateral trust bonds or certificates (secured by the securities pledged); and Mortgages bonds (secured by real property pledged). A guaranteed bond is secured by a pledge made by a third party—no asset of the issuing corporation is pledged. LO 2.g
One of your customers is a new parent. The customer wishes to deposit a lump sum into an investment offering a guaranteed return in 18 years, just in time for college. Which of the following bonds maturing in 18 years would offer the greatest safety? A) An unrated Treasury STRIP B) A high-yield corporate bond C) A corporate zero coupon bond with a AAA rating D) A municipal zero coupon bond with a AAA rating
A. Explanation Treasury securities are not rated because the backing of the U.S. Treasury implies no default risk. Even with AAA ratings, a lot can happen to a corporation or a municipality in 18 years, making the STRIP the best choice for safety. LO 2.j
Which of the following statements regarding bond interest is true? A) Bond prices have an inverse relationship to interest rates. B) The par value of a bond will increase as market interest rates fall. C) Bond prices have a direct relationship to interest rates. D) The par value of a bond will decrease as market interest rates fall.
A. Explanation Bond prices have an inverse relationship to interest rates. If interest rates go up, prices for those bonds trading in the secondary markets will go down. Conversely, if interest rates decline, bond prices rise. Par value is a fixed number for the life of the bond. LO 2.a
What is a Maple bond?
a Canadian dollar-denominated bond issued by a non-Canadian entity in the Canadian market.
Four disadvantages of Eurodollar bonds (as with foreign bonds in general) are:
- because they are not registered with the SEC, there may be a lack of transparency; - they have political and country risks (taken into consideration by the rating agencies); - they have less liquidity than domestic issues; and - they have currency risk (if denominated in a currency other than one's home country).
Disregarding commissions, an investor selling a U.S. Treasury bond for a price of 104:16 will receive A) $104.50. B) $1,045.00. C) $1,041.60. D) $104.16.
B. Explanation Treasury bonds are quoted in 32nds and as a percentage of par. A quote of 104.16 is 104 16/32 or 104 1/2% of par. With par always being $1,000, the proceeds of the sale are $1,045. LO 2.c
A bond issue that may be retired in advance of maturity at the option of the issuer is said to have a callable feature. an optional reserve. a conversion feature. a cumulative feature.
Answer: A. A bond that is callable has a provision that the issuer, at its option, may redeem that bond at a specified price known as the call or redemption price. As we will see below, the conversion feature may be exercised by the investor, not the issuer.
All of the following debt instruments pay interest semiannually except a. Ginnie Mae pass-through certificates. b. U.S. Treasury notes. c. U.S. Treasury bonds. d. TIPS.
Answer: A. A unique feature of Ginnie Maes is that they pay interest on a monthly basis, not semiannually. In addition to the interest, investors receive their share of that portion of the mortgage payments that represented principal repayment.
Which of the following statements is not true? A. A country wishing to restructure its debt using Brady bonds would do so to save on debt servicing costs. B. One of the benefits of holding convertible debentures is the option to convert into the corporation's common stock. C. U.S. Treasury securities are backed by the full faith and credit of the United States of America. D. A resident of France purchasing Eurodollar bonds does not incur currency risk.
Answer: D. As the name implies, Eurodollar bonds are denominated in U.S. dollars. That means that someone in France will have the risk that the euro, the home currency in France, will rise against the dollar and, as a result, interest payments will be worth less as will the ultimate payback at maturity. Only U.S. residents have no currency risk with Eurodollar bonds. One of the benefits of Brady bonds is the ability of the sovereign government to borrow at a lower cost because of the collateral behind the bond. At least for exam purposes, there are no securities with a stronger guarantee of timely payment of interest and principal than those issued by the U.S. Treasury. Convertible debentures are convertible into the issuer's common stock, which is a benefit if the stock rises in price.
What are the risks faced by investing in mortgage backed securities?
1. difficult to understand because of complexity 2. Prepayment risk 3. Default risk 4. Reinvestment risk 5. Liquidity risk
A customer wishes to buy a security providing periodic interest payments, safety of principal, and protection from purchasing power risk. The customer should purchase TIPS. TIGRS. CMOs. STRIPS.
Answer: A. TIPS offer inflation protection and safety of principal because they are backed by the U.S. government
A bond would be considered speculative below which of the following Moody's ratings? A) BBB B) Baa C) Ba D) A
B. Explanation A rating of Baa is the lowest investment-grade rating assigned by Moody's. Any rating beneath this is considered speculative. If the question asked about Standard & Poor's, then the correct choice would be BBB. LO 2.b
