Lesson 2.1: Bonds as Fixed Income Securities

High-yield bonds are frequently called junk bonds. Which of the following expresses the highest rating that would apply to a junk bond? A)BB B)CC C)CCC D)BBB

A)BB. Investment-grade bonds run from a highest Standard and Poor's rating of AAA (Aaa for Moody's) down to BBB (Baa for Moody's). When the rating gets to BB (or Ba), the bond is considered high yield, or a junk bond.

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)I and III B)II and IV C)II 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.

An investor purchased a 6% corporate bond selling at par. Because the next interest payment date is not for another two months, the bond carries accrued interest of $20. Disregarding commissions, which of the following statements is correct? A)The buyer will pay $1,020, and the seller will receive $980. B)The buyer will pay $1,020, and the seller will receive $1,020. C)The buyer will pay $1,000, and the seller will receive $1,020. D)The buyer will pay $1,020, and the seller will receive $1,000.

B)The buyer will pay $1,020, and the seller will receive $1,020.-> When a bond is purchased or sold in between semiannual interest payment dates, the interest that has accrued since the previous payment is added to the purchaser's price. In our question, $1,000 plus $20 equals $1,020. That interest belongs to the seller who has held that bond since the previous interest payment. Therefore, the seller receives the selling price ($1,000) plus the accrued interest of $20 for a total of $1,020. Remember, the buyer will be getting the full six months interest of $30 (6% of $1,000 is $30 semiannually) in two months. That represents $10 for the two months the bond was held plus reimbursement for the four months of interest paid to the seller. You will not need to know how to calculate the accrued interest; it will be given in the question as is the case here.

One of the likely consequences of a rating downgrade on a bond is A)an increase to the coupon by the issuer. B)a reduction in the market price of the bond. C)the call feature will be employed. D)the current yield will be reduced.

B)a reduction in the market price of the bond. -> If the rating agencies downgrade the quality of a bond, potential investors will look to compensate for the increased risk by demanding a greater yield on the issuer's bonds. This will inevitably result in a lower bond price. A change in rating is unlikely to lead to a call. In fact, with the reduction in the market price, the bond may be selling below par, giving the issuer the opportunity to retire the debt at a discount. Bonds are fixed-income securities because the coupon rate is fixed when the bond is issued and does not change.

With respect to safety of principal, of the following investments, the least risky is A)equity options. B)common stock. C)exchange-listed warrants. D)corporate AA debentures.

D)corporate AA debentures. -> The least risky investment listed is the corporate debenture because, as a debt instrument, it has priority over the others.

Many fixed-income investors are looking to avoid loss of principal. Which of the following would likely have the lowest degree of exposure to credit risk? A)Aa-rated corporate debenture B)Baa-rated municipal revenue bond C)A-rated general obligation municipal bond D)Ba-rated corporate mortgage bond

A)Aa-rated corporate debenture. A rating takes into consideration all factors, including collateral and tax base. The higher the rating, the lower the credit risk.

Regardless of the nature of the issuer, one thing an investor in debt securities can expect is A)a stated maturity date. B)priority in payout second only to stock with a prior lien. C)an interest rate that varies with changes to market interest rates. D)physical coupons that are clipped every six months for interest payments.

A)a stated maturity date. -> would be very rare to find a debt security without a stated date indicating when the debt will be paid off (the maturity date). In the majority of cases, debt securities have a fixed interest rate (which is why they are called fixed-income securities). There are some with variable rates, but the question would have to indicate that exception. No stock of any kind has priority over a debt security. Prior to 1986, you would have physical coupons on the bond, but none of them have been issued since then.

An investor purchased a bond with a 6% coupon rate exactly three months after its most recent interest payment. As a result, the buyer will pay $15 accrued interest. the buyer will receive $15 accrued interest. the seller will pay $15 accrued interest. the seller will receive $15 accrued interest.

C)I and IV. -> First of all, a 6% bond pays $30 semiannually (half of $60 per year). Therefore, the accrued interest on this bond purchased halfway between interest payments is half of $30 or $15. That $15 dollars is added to the purchaser's cost and will be paid to the seller as it represents the interest the seller earned for holding the bond for three months. At the next interest payment date, the purchaser will receive the full $30 payment representing the accrued interest paid to the seller plus the interest earned for the three months the purchaser held the bond.

What is the name of the bond document that states the issuer's obligation to pay back a specific amount of money on a specific date? A)The bond coupon B)The debenture C)The indenture D)The bond agreement

C)The indenture. -> The indenture is the contract that sets forth the promises of the issuer of the bond and the rights of the lenders (the investors). A debenture is an unsecured long-term debt security (that has an indenture). One of the details in the indenture is the coupon (interest) rate that will be paid on the loan.

Although bonds are issued by many different entities, most of their features are the same. With few exceptions, included in that list of similarities would be all of these except A)a stated maturity date. B)price movement that is inverse to interest rates. C)a stated interest date. D)safety of principal.

D)safety of principal. -> The safety of principal largely depends on the issuer. For example, there are no bonds as safe as U.S. Treasury bonds. On the other hand, there are some corporate bonds that are quite speculative. In general, all bonds have a stated maturity date , interest rate, and interest payment date, and they are exposed to interest rate risk. That is the risk that as interest rates rise, the price of the bonds will decline.

Which of the following statements regarding credit risk is not true? A)An A-rated mortgage bond has less credit risk than a AA rated debenture. B)Credit risk can be assessed by referring to the independent credit rating agencies. C)A rating downgrade may or may not result in a lower market price for a bond. D)Credit risk is the probability of the issuer defaulting on their payment obligations.

A)An A-rated mortgage bond has less credit risk than a AA rated debenture. -> The rating agencies split bonds into two distinct classes: investment grade and noninvestment grade. The highest investment-grade rating is AAA (Aaa) and the lowest is BBB (Baa). The more As the bond has, the lower the credit risk. That is why the AA debenture has less credit risk than the A-rated mortgage bond. The rating agencies take into consideration any collateral, such as a mortgage, when giving the rating.

The bond document that states the issuer's obligation to pay the investor a specific rate of interest for the use of the funds as well as any collateral pledged as security for the loan and all other pertinent details might be referred to by all of these terms except A)the bond contract. B)the indenture. C)the debenture. D)the deed of trust.

C)the debenture. -> A debenture is an unsecured long-term debt security. Whether it is a debenture or a secured bond (such as a mortgage bond) there is, in essence, a contract between the borrower (the issuer) and the lender (the investor). The terms of the loan are expressed in a document known as the bond's indenture. The indenture (sometimes also referred to as the deed of trust) states the issuer's obligation to pay back a specific amount of money on a specific date. The indenture also states the issuer's obligation to pay the investor a specific rate of interest for the use of the funds as well as any collateral pledged as security for the loan and all other pertinent details. LO 2.a