Debt Securities
A) I, II, IV, III Explanation The lowest of all yields for a discount bond is the nominal yield (coupon rate), which is a fixed percentage of par. The highest possible return to the owner of a bond purchased at a discount would occur if the bond were called before maturity because less time must elapse for the investor to receive the discount.
A 10-year bond, callable in five years at par, is sold at a discount. Rank the following yields from lowest to highest. Nominal yield Current yield Yield to call Yield to maturity A) I, II, IV, III B) I, II, III, IV C) II, I, IV, III D) IV, II, III, I
B) high and expected to decline. Explanation This is about the inverse relationship between interest rates and bond prices. As interest rates rise, bond prices fall. Conversely, when interest rates decline, bond prices increase. If an investor buys bonds when the current interest rates are high, a future decline in those interest rates will cause the price of the bonds to increase.
A bond investor who is looking for capital gains should invest in bonds when interest rates are A) low and expected to rise. B) high and expected to decline. C) high and expected to rise. D) low and expected to decline.
A) It is the number of years into the issue before the issuer may exercise the call privilege. Explanation The definition of call protection is the length of time an investor is protected against the issuer exercising the right to call the bonds in. What is the maximum possible call protection? A noncallable bond. In many cases, the issuer sets up a sinking fund to use for the call, but that is not the definition of call protection.
A bond you are recommending to a customer has call protection. What does that mean? A) It is the number of years into the issue before the issuer may exercise the call privilege. B) It is the number of years into the issue before the investor may exercise the call privilege. C) The issuer records the phone number of investors and puts it on the do-not-call list. D) The issuer has set up a sinking fund to provide funds for the call.
B) I and IV Explanation 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.
A customer purchased a 5% bond yielding 6%. A year before the bond matures, new bonds of the same quality are being issued at 4%, and the customer sells the 5% bond. The customer probably did which of the following? Bought it at a discount Bought it at a premium Sold it at a discount Sold it at a premium A) II and IV B) I and IV C) I and III D) II and III
A) Investors are paying more for T-bills. Explanation When the rate is lower, the price has gone up. This means investors are paying more as interest rates are going down.
A respected analyst reports that last week's T-bill rate at 1% 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) Investors are paying more for T-bills. B) Prices are descending. C) The general level of interest rates is increasing. D) Investors are paying less for T-bills.
B) they are fully insured in any denomination by the FDIC. Explanation The FDIC insures only up to $250,000
All of the following statements regarding negotiable jumbo certificates of deposit are true except A) they usually have maturities of less than one year. B) they are fully insured in any denomination by the FDIC. C) they are usually issued in denominations of $100,000 to $1,000,000. D) they are readily marketable.
A) the credit spread. Explanation You should understand that the greater the risk, the higher the yield on the bond. Many analysts compare the difference between yields on bonds with the same maturity but different quality (rating) to get a sense of the market sentiment. One common measurement is the difference in yields between Treasuries and corporate bonds. This difference is called the yield or credit spread and tends to widen when economic conditions sour and narrow when they get better. ** This question deals with material not covered in your LEM, but it relates to recent rule changes and/or student feedback.
An economist is comparing the yields on 20-year U.S. Treasury bonds and AAA-rated corporate bonds with the same maturity. The economist is analyzing A) the credit spread. B) the value spread. C) the duration spread. D) the risk spread.
C) long-term bonds when interest rates are high.Explanation If an investor purchases bonds when market interest rates are high, a drop in interest rates will lead to a corresponding increase in bond value. Long-term debt instruments will fluctuate to a greater degree than those with short-term interest rates. Thus, long-term debt offers the greater chance of gain.
An investor might expect to receive the greatest gain on an investment in a corporate bond by purchasing A) short-term bonds when interest rates are low. B) long-term bonds when interest rates are low. C) long-term bonds when interest rates are high. D) short-term bonds when interest rates are high
C) $2.50 per bond. Explanation The first bonds are 5% and pay $50 per year per bond. The new bonds are 5¼% and pay $52.50 per year per bond, for a difference of $2.50 per bond.
An investor sells 10 5% bonds at a profit and buys another 10 bonds with a 5¼% coupon rate. The investor's yearly return will increase by A) $1.50 per bond. B) $2.00 per bond. C) $2.50 per bond. D) $1.00 per bond.
A) reducing credit risk. Explanation 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.
An issuer of a bond will apply to the rating services for a rating for the purpose of A) reducing credit risk. B) reducing liquidity risk. C) reducing interest rate risk. D) reducing the bond's duration
D) $15 million @8% due in 10 years, callable at 101 Explanation Anytime we have extra cash, it can make sense to pay off debt. Corporations feel the same way. When it comes to deciding which debt to repay, the wisest move is to pay down the debt with the highest interest cost. In this case, that would be the 12% bond. However, that bond is non-callable. Based on the inverse relationship between interest rates and bond prices, the 12% bond is going to be selling at a higher price than any of the others. Any savings in interest payments would be more than offset by the price the company would have to pay to buy the bond in the open market. The next highest interest rate is 8% and that bond will cost us a slight premium of $10 per bond to call. Although the 6% bond is callable at par, the company would be far better off removing an 8% debt than one at 6%. In fact, the 1 point call premium is saved after the first semiannual interest payment. A partial call, calling in $10 million of the 8% bond, should be the recommendation.
DERF Corporation has a significant amount of cash on hand. The chief financial officer (CFO) has suggested to the chief executive officer (CEO) that it might be wise to pay off $10 million of the company's outstanding debt. There are four bond issues outstanding, and your broker-dealer is approached for advice on determining which issue to repay. Which of these four issues would the firm recommend? A) $25 million @5% due in 5 years, callable at 104 B) $10 million @6% due in 20 years, callable at par C) $30 million @12% due in 15 years, non-callable D) $15 million @8% due in 10 years, callable at 101
A) II and IV Explanation Because eurodollar bonds are denominated in U.S. dollars, a U.S. corporate issuer will not be subject to foreign exchange risk, regardless of the country of issuance. In addition, because the bonds are issued outside the United States, the issue is not registered with the SEC.
If a U.S. corporation wishes to issue eurodollar bonds, which of the following statements are true? The corporation will be subject to currency risk. The corporation will not be subject to currency risk. The issue must be filed with the SEC. The issue need not be filed with the SEC. A) II and IV B) I and IV C) II and III D) I and III
B) equity-linked notes. Explanation An ELN is an equity-linked note. That is a strange name for a debt product. The equity refers to the specific stock, a basket of stocks, or an equity index upon which the return is based. Therefore, the return is not fixed and can be higher or lower than anticipated depending on the selected equity's performance. There are foreign exchange-linked notes where the performance is based on currency rates, but that is unlikely to ever be a topic covered on the exam. There are no such products as exchange or equity-leveraged notes.
In a discussion with one of your customers, the topic of alternative debt instruments is brought up. It seems that the customer was competing in a duplicate bridge tournament in town and one of the other competitors mentioned that they have been obtaining higher income returns from ELNs. When the customer asks you for the meaning of that abbreviation, you would reply A) exchange-leveraged notes. B) equity-linked notes. C) exchange-linked notes. D) equity-leveraged notes.
C) mezzanine debt Explanation Just as the mezzanine in a theater is between the balcony and the orchestra levels, mezzanine debt represents financing supplied at the intermediate point in a new company's development. The funds are provided on a private basis and the investment carries a high degree of risk. As an alternative investment, it will be suitable for a very narrow range of customers. **This question deals with material not covered in your LEM, but it relates to recent rule changes and/or student feedback. LO 4.g
In recent years, much publicity has surrounded the rapid growth of start-up businesses. In most cases, the early financing was done privately. When private debt is used at the intermediate stage of a company's development, it is called A) intermediate debt. B) middle-risk debt. C) mezzanine debt. D) mid-term debt.
A) in U.S. dollars. Explanation It is always the final part of the word that describes the currency of a eurobond. A Eurodollar bond pays in U.S. dollars, while a Euroyen bond would pay in Japanese yen.
Interest and principal on a Eurodollar bond issued in Germany are paid A) in U.S. dollars. B) in German deutsche marks. C) in German euros. D) in European Union euros.
C) a eurobond.
Many investors, especially institutions, diversify their fixed-income portfolios by purchasing bonds issued outside of the United States. When a French corporation issues a bond denominated in Swiss francs, it is known as A) sovereign debt. B) a euroswiss bond. C) a eurobond. D) a eurodollar bond.
C) A municipal note Explanation The three major rating services each have their own rating system for short-term municipal debt (notes). In the case of Standard and Poor's, the ratings are SP-1, SP-2, and SP-3 in declining order of quality. Regulation S-P (with the hyphen between the S and P) deals with privacy notices. Although it is unlikely to be tested, commercial paper is rated A-1, A-2, A-3, and then into the "Bs."
One of your customers calls and asks you about a security with an S&P rating of SP-2. The customer is most likely asking about which of the following? A) Commercial paper B) Your firm's privacy notice C) A municipal note D) A municipal bond
D) 5.67%. Explanation The first point to notice is that the bond is trading at a discount. When bonds trade at a discount, our yield chart and example tells us that the yields, in ascending order, are nominal yield, current yield, yield to maturity, and yield to call. That last one is of no relevance to this question because a call feature is not mentioned anywhere. Therefore, we know that the yield to maturity must be greater than the nominal (coupon) yield of 5%. There are only two choices that are, so if you are running out of time or do not remember how to do this, at least you have a 50% chance. However, 50% doesn't pass the exam, so let's make that 100%. The yield to maturity computation is tricky, but current yield is not. It is simply the coupon divided by the current market price. In our question, that is 5% divided by 94 equals 5.32% (or $50 divided by $940). We know the yield to maturity for a bond selling at a discount is higher than its current yield. That means the correct answer must be greater than 5.32%. If you have a question like this on the actual exam, there will be only one choice higher than the current yield. As shown in the LEM, the YTM calculation goes like this: [annual interest + (discount divided by the number of years to maturity)] divided by the average price of the bond Plugging in the numbers, we get a numerator of $50 + ($60 divided by 12 years) = $50 + $5 = $55. The denominator is ($940 + $1,000) divided by 2 = $1,940 divided by 2 = $970. Solve by dividing $55 by $970 and the answer is 5.67%.
The ELLA Distributing Company issued a bond with a nominal yield of 5%. The bond matures in 12 years and is currently trading at 94. The bond's yield to maturity is closest to A) 4.64%. B) 5.32%. C) 5.00%. D) 5.67%.
C) Ba Explanation High-yield bonds are those whose ratings fall below investment grade. Investment grade is the top four. Using Moody's descriptions, ratings run from Aaa to Aa to A to Baa to Ba to B and then below. The first rating below the top four is Ba. That is equivalent to a BB rating from Standard & Poor's (but the question asks specifically about Moody's).
The term high-yield bond would apply to a bond with a Moody's rating of A) Baa. B) BB. C) Ba. D) BBB.
D) municipal revenue bonds. Explanation The money market is the marketplace for short-term (less than one year) debt obligations. The capital market is where long-term capital is raised. Municipal bonds, being long term, are a part of the capital market.
Transactions in all of the following are affected in the money market, as opposed to the capital market, except A) commercial paper. B) U.S. Treasury bills. C) jumbo CDs. D) municipal revenue bonds.
A) $25 Explanation The interest is based on the par value of $1,000. The current market price is irrelevant. With a coupon rate of 5%, this bond pays $50 per year. That would be $25 semiannually
What is the amount of interest payable semiannually on a $1,000 par value, 5% corporate bond currently selling at 80 and redeemable at par in 20 years? A) $25 B) $50 C) $20 D) $40
A) the current yield will always be higher than the yield to maturity. Explanation When a bond is selling at a premium, all of the yields are lower than the nominal (coupon) yield. The sequence in descending order of yield is NY, CY, YTM, YTC.
When a bond is selling at a premium A) the current yield will always be higher than the yield to maturity. B) the yield maturity will always be higher than the nominal yield. C) the current yield will always be higher than the nominal yield. D) the nominal yield will always be lower than the yield to call.
C) I and IV Explanation Commercial paper and negotiable certificates of deposit are short-term debt securities and are considered money market securities.
Which of the following are money market securities? Commercial paper Treasury bonds American depositary receipts Negotiable certificates of deposit A) II and III B) I and III C) I and IV D) II and IV
A)7.6s of '45 Explanation To begin with, let's be sure you understand the nomenclature used here. Each of the choices has two numbers. The first is the coupon rate of the bond and the second is the year the bond matures. For example, the 7.3s of '37 pay interest at a rate of 7.3% of the $1,000 par value per year and mature in 2037. The s is just to separate the two numbers. Interest rate risk is the loss in value due to a rise in interest rates. Because there is little difference in coupon rates, the bond with the longest maturity (highest duration) will experience the greatest fall in a rising interest rate market.
Which of the following bonds is most affected by interest rate risk? A) 7.6s of '45 B) 7.8s of '42 C) 7.5s of '39 D) 7.3s of '37
D) Negotiable CDs Explanation To trade with accrued interest, the security must pay interest. Of the choices, the only one that is interest bearing is the negotiable (jumbo) CD. All of the others are issued at a discount and return the face value at maturity.
Which of the following debt instruments trades with accrued interest? A) Zero-coupon issues B) Treasury bills C) Bankers acceptances D) Negotiable CDs
D) The Federal Deposit Insurance Corporation (FDIC) provides insurance for CDs to $500,000. Explanation The FDIC provides insurance for CDs up to $250,000. All of the other characteristics are applicable to CDs.
Which of the following is not a characteristic of certificates of deposit (CDs)? A) A CD is often issued by a bank. B) A CD may be payable to the bearer or registered in the name of the investor. C) A CD can be negotiable or nonnegotiable. D) The Federal Deposit Insurance Corporation (FDIC) provides insurance for CDs to $500,000.
C) I and II Explanation Moody's, Standard & Poor's, and Fitch's are all recognized as rating companies that would rate commercial paper issued by corporations. The SEC is a federal government regulatory body.
Which of the following rate commercial paper issued by corporations? Moody's Standard & Poor's Municipal Securities Rulemaking Board Securities Exchange Commission (SEC)
A) The bond's current yield is calculated by dividing its annual interest by its market price. Explanation 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.
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 calculated by dividing its annual interest by its market price. 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 lower than its yield to maturity. D) The bond is a discount bond.
A) I and IV Explanation Negotiable CDs are issued primarily by banks and backed by the issuing bank. The minimum denomination is $100,000. These are sometimes referred to as jumbo CDs.
Which of the following statements regarding negotiable certificates of deposit (CDs) are true? The issuing bank guarantees them. They are callable. Minimum denominations are $1,000. They can be traded in the secondary market. A) I and IV B) II and III C) II and IV D) I and III
B) A prior lien preferred stock Explanation Stock means equity. Prior lien means that this preferred has priority over other preferred stock the company has issued. The other three are alternative forms of debt financing. Do not fall into the equity-linked note trap; it is a debt security.
Which of the following would be considered an equity security? A) An exchange-traded note B) A prior lien preferred stock C) An equity-linked note D) A collateralized mortgage obligation
