Practice Exam Questions - *Chapter 2*
Corporate bonds are normally issued in denominations of __________.
*$1,000.00* - Reasoning: The par value of principal amount of a corporate bond is normally $1,000.00*
A corporate bond called at 108 1/8 would pay the bondholder: A) $1,084.50 B) $1,081.25 plus accrued interest C) $1,081.25 minus accrued interest D) $1000 plus accrued interest of $1.25
*$1,081.25 plus accrued interest* - Reasoning: The premium price of 108 1/8 would represent $1,081.25 (108 = $1,080 1/8 x $10 = 1.25 / $1,081.25), and further the investor would be entitled to the accrued interest. [Chapter 2.3]
Assume your customer has 300 shares of common stock with a current market value of $21.25 and 20 first mortgage bonds at par. Both increase 3/4 of a point. What is the increase in the value of his holdings?
*$375* Reasoning: - 1 point on a stock = $1.00 - 1 point on a bond = $10.00 3/4 point on a stock = $0.75 p/share 3/4 point on a bond = $7.50 p/bond $0.75 x 300 shares = $225 increase on Stock $7.50 x 20 bonds = $150 increase on Bonds $225 + $150 = $375 (overall increase in value) [Chapter 2.1]
Mr. Jones purchased $1,000 par value of 8% bonds to yield 5%. On the normal interest payment date, he will receive: A) $250 B) $400 C) $500 D) $800
*$400* - Reasoning: "Nominal" interest payment date is semi-annual and based on the coupon rate, not yield. Mr. Jones has purchased $10,000 worth of bonds, or ten (10) $1,000 bonds. So we can multiply the overall par value of the bonds by the coupon rate to find the annual interest, then divide by 2 to find the semi-annual payment. $10,000 x .08 = $800 (annual interest) $800 / 2 = $400 (semi-annual payment) [Chapter 2.1]
What is the amount of interest payable per year on a $1,000 par value 5% bond selling at 80 and redeemable at par in 10 years? A) $10 B) $40 C) $45 D) $50
*$50* - Reasoning: Annual interest is the coupon rate (5%) x par ($1,000), or in this case $50. [Chapter 2.1]
A corporate bond priced at 88 5/8 has a dollar value of: A) $88.625 B) $886.25 C) $885.80 D) $8,862.50
*$886.25* - Reasoning: Corporate and municipal bonds are quoted in points worth $10 each (or 1 point). Each bond has a par value of $1,000 (or 100 points). Here, you are told that the bond is priced at 88 5/8. Multiplying this price by $10 per point gives a dollar price for the bond of $886.25. [Chapter 2.3]
Bobby is currently in the 25% tax bracket. He owns a municipal bond yielding 4%. He has also been looking for a few corporate bonds to add to his portfolio, but he wants to make sure that the yield after taxes is at least equal to what he is receiving on his munis. What is the corporate equivalent yield of Bobby's municipal bond?
*5.33%* - Reasoning: In order to find the taxable equivalent yield, you would divide the yield on the municipal bond (4%) by 100%, minus the investor's tax bracket (25%). 0.04 / (1.00-.25) = 0.04 / 0.75 = 0.05333 or *5.33%* So the corporate equivalent yield would be 5.33% and any corporate bond in Bobby's portfolio would have to have a yield equal to or higher than 5.33%. [Chapter 2.8]
An issuer of bonds sees that interest rates have gone down. The issuer wishes to redeem an existing bond issue and refund it with new bonds that have a lower coupon rate. What bond feature is necessary in order for the issuer to effectively complete their desired refunding? a) A conversion feature b) An anti-dilution feature c) A call feature d) A put feature
*A call feature* - Reasoning: Conversion features allow investors to exchange debt securities for equity securities. Anti-dilution features or clauses require adjustments to conversion features when new issues of stock or stock dividends are paid. Put features allow the investor to "put" or tender their bond back to the issuer on specified dates throughout the lifetime of the bond. [Chapter 2.5]
Which of the following is NOT permitted in a CMO advertisement? a) A comparison of the risks of investing in CDs vs. CMOs. b) A description of the initial issue tranche. c) The maturity date must be prominently displayed. d) The risks of investing in CMOs.
*A comparison of the risks of investing in CDs vs. CMOs* - Reasoning: CMO advertisements must NOT contain comparisons between CMOs and any other investments, including CDs (CMOs are not as safe as CDs). [Chapter 2.6]
A customer interested in call protection on a bond would NOT purchase which of the following? a) A discount bond callable at premium b) A deep discount bond callable at par c) A premium bond callable at par d) A discount bound callable at par
*A premium bond callable at par* - Reasoning: There are two things you want to evaluate here - premium or discount, and callable price at par or at a premium. A bond that is selling at a *premium* is likely to be paying an interest rate that is *higher* than the standard rate for this time period (in other words, we might have a bond that is paying 10% when all other bonds of similar risk are paying only 5%). This will drive the price of the bond up (premium). The bond at a premium is an indication that the company is paying a higher interest rate, which makes it more likely to be called in and refunded with new, lower-interest bonds. The company wants to get rid of the 10% bond and issue a new one at the lower rate of 5%. As an investor, you would want call protection on a premium bond because it is likely to get called. Second, you want a callable bond at par. The company will always want to call the bond back at the lowest price. Callable at a premium or callable at par. Par value will be the lower price so that will most likely be called. [Chapter 2.5]
An RR makes the following statements about private CMOs to his customers. Which statement is FALSE? a) A private CMO is backed jointly by the issuer and the federal government. b) Private CMOs can include letters of credit. c) Home builders can issue CMOs. d) Credit agencies rate private CMOs.
*A private CMO is backed jointly by the issuer and the federal government* - Reasoning: Private CMO's are backed by the issuer. [Chapter 2.6]
If a corporation is in liquidation, the holder of a subordinated debenture would be paid at what time? a) Before bank loans and before general creditors. b) Before bank loans and after general creditors. c) After bank loans and before general creditors. d) After bank loans and after general creditors.
*After bank loans and after general creditors* - Reasoning: A subordinated debenture is one that is paid after any senior lien debt. If a corporation was in liquidation, bank loans and general creditors including accounts payable would be paid before the holder of a subordinated debenture would receive any money. [Chapter 2.4]
If an issuer of bonds decides to call in an outstanding bond issuer and redeem those bonds, which of the following is normally TRUE? a) The issuer will typically pay face value during the redemption. b) Because bonds are being called ahead of maturity, the issuer normally pays a discounted amount below face value during redemption. c) The issuer will typically pay market value at the time of redemption. d) Because bonds are being called ahead of maturity, the issuer normally pays a call premium above face value during redemption.
*Because bonds are being called ahead of maturity, the issuer normally pays a call premium above face value during redemption* - Reasoning: When an issuer uses a call feature and redeems bonds ahead of maturity, the issuer will normally pay a call premium above face value to bondholders. This is one way for the bond issuer to compensate the bondholder for the early payout and loss of interest revenue after the call takes place. Bonds can be called at face value, but that is not typical. Bonds are not normally called at a discount or at the market price. [Chapter 2.5]
Which of the following statements regarding Collateralized Debt Obligations (CDOs) is correct? a) CDOs are divided into tranches, generally based on risk. b) CDOs are backed only by mortgages. c) CDOs are considered equity securities. d) CDOs are unsecured debt obligations.
*CDOs are divided into tranches, generally based on risk* - Reasoning: CDO's are asset-backed debt securities. They can be backed by various assets such as mortgages, auto loans, corporate debt, and credit card debt. They are structured into tranches, similar to CMOs, and tranches are generally determined based upon risk. [Chapter 2.6]
A change of 10 basis points would produce the greatest change in the dollar price on which of the following bonds? a) Coupon Rate: 5%; Maturity: 2018; YTM: 5% b) Coupon Rate 5%; Maturity: 2021; YTM: 6% c) Coupon Rate: 5%; Maturity: 2025; YTM: 6.75% d) Coupon Rate: 5%; Maturity: 2030: YTM: 7.2%
*Coupon Rate: 5%; Maturity: 2030: YTM: 7.2%* - Reasoning: Short-term bonds are affected the quickest and *long-term bonds are affected the greatest* when there is a change in interest rates. Therefore, the bond with the latest maturity (2030) would produce the greatest price change.
Which best describes municipal bonds priced at par? a) All coupons yield the same return. b) Bonds will be issued with a face value of $100. c) Coupon rate for any given year equals the yield to maturity. d) Bonds are offered net of accrued interest.
*Coupon rate for any given year equals the yield to maturity* - Reasoning: all yields (Nominal, Current, and YTM) are equal when a bond is trading at par value. [Chapter 2.2]
Which of the following statements is FALSE regarding equipment trust certificates? a) Default is common due to financial problems. b) They are typically serial issues. c) They are most often issued by transportation companies. d) They are secured by specific corporate assets.
*Default is common due to financial problems* - Reasoning: Equipment Trust Certificates rarely default because companies do not want to lose their equipment. [Chapter 2.4]
Of the securities listed below, which one is subject to Federal, State, and local tax? a) Treasury Notes b) Equipment Trust Certificates c) Federal Farm Credit notes d) Federal Land Bank Bonds
*Equipment Trust Certificates* - Reasoning: Equipment Trust certificates are issued by corporations and are fully taxable. [Chapter 2.4]
When a conversion takes place, what occurs? a) Existing bonds are traded into the issuer for new bonds. b) The issuer performs a second issue of bonds to retire an existing issue with the proceeds. c) The issuer uses excess cash on hand to retire bonds prior to their original maturity date. d) Existing bonds are tendered to the issuer for equity securities, most frequently common stock.
*Existing bonds are tendered to the issuer for equity securities, most frequently common stock* - Reasoning: A conversion feature on a bond or preferred stock allows the holder to "tender" or turn in the bond on preferred stock in exchange for shares of common stock. Each of the other items listed applies to early retirement of existing bonds (or refunding of existing bond issues). [Chapter 2.5]
Collateralized Mortgage Obligations (CMOs) may be collateralized by which of the following? a) Fannie Mae b) Sallie Maes c) Federal Land Banks d) Equipment
*Fannie Mae* - Reasoning: In the CMO, the collateral is a pool or group of mortgages. The mortgages may be guaranteed or insured by a government agency (e.g., Fannie Mae). Sallie Mae deals with student loans and not mortgages, therefore would not be included in the portfolio of a CMO. [Chapter 2.6]
List the yields from lowest to highest, if a corporate bond is trading at a *discount*: I. Nominal Yield II. Current Yield III. Basis A) II, III, I B) I, II, III C) III, I, II D) III, II, I
*I, II, III* - Nominal Yield = Coupon Rate - Current Yield = Annual Interest - Market Price Basis = Yield to Maturity [Chapter 2.2]
List the yields from lowest to highest, if a corporate bond is trading at a premium. I. Nominal Yield II. Current Yield III. Basis A) I, II, III B) II, III, I C) III, II, I D) III, I, II
*III, II, I* - Reasoning: Because the price is high, the current yield and basis will be less than the nominal yield. Remember that *Basis always has the greatest reaction*. [Chapter 2.2]
Municipal securities which have interest and principal payments dependent on rental income from corporate facilities built to improve local environments are ______________.
*Industrial Revenue Bonds* - Reasoning: The key word in the question is *"corporate facilities"*; Municipal bonds issued on behalf of corporations are also called Industrial Revenue Bonds. [Chapter 2.8]
CMO tranches that pay a variable rate of interest which is usually measured against the: a) T-bill rate b) Federal funds rate c) LIBOR (London Interbank Offered Rate) d) Prime rate
*LIBOR (London Interbank Offered Rate)* - Reasoning: Returns on variable CMO's are compared to the LIBOR. [Chapter 2.6]
Which of the following is issued by state and local governments and pays interest, typically semi-annually? a) Subscription Rights b) Subscription Warrants c) Corporate Bonds d) Municipal Bonds
*Municipal Bonds* [Chapter 2.8]
Principal payments of a collateralized mortgage obligation (CMO) are: a) Paid in full as a lump sum at maturity b) Paid in equal installments over the life of the CMO c) Paid in varying amounts over the life of the CMO d) Paid in full when the CMO is refunded
*Paid in varying amounts over the life of the CMO* - Reasoning: CMO payments are received monthly by the investor as homeowners pay their mortgage payments. Part of the payments is interest and part is principal. At the beginning, the principal part of every payment is small, but as the mortgages are almost paid off, the principal payments are larger. [Chapter 2.6]
If a bond has a Coupon Rate of 7%, and a Basis of 6%, the bond is trading at a __________.
*Premium* - Reasoning: Whenever a bond's coupon rate is *higher than the basis*, the bond is trading at a *premium*. [Chapter 2.2]
Which of the following statements related to Collateralized Mortgage Obligations (CMOs) is FALSE? a) CMOs can be created from FHA mortgage loans and conventional mortgages. b) Private mortgage issuers are prohibited from pooling and collateralizing mortgages to create CMOs. c) Entities such as Ginnie Mae (GNMA) and Fannie Mae (FNMA) pool mortgages and create collateralized products. d) Credit card debt and student loan debt is not included in CMO products.
*Private mortgage issuers are prohibited from pooling and collateralizing mortgages to create CMOs* - Reasoning: Each of the statement is true except for the statement about private mortgage issuers. Private mortgage issuers can pool and collateralize mortgage debt to sell CMO products. [Chapter 2.6]
Which statement is correct if a sinking fun provision is included in a corporate bond indenture? a) Such provision requires a mandatory retirement of debt by the issuer. b) Such provision allows the voluntary retirement of debt by the issuer. c) Such provision makes the bond issue less attractive to investors by removing safety from the issuance. d) Such provision makes the bond issue more volatile once it trades in the secondary market.
*Such provision requires a mandatory retirement of debt by the issuer* - Reasoning: Not all bonds have sinking fund provisions, but if they do, the *sinking fund provisions are attractive* to investors because they *require mandatory retirement of debt* by the issuer on a specified date or at specified dates. This adds to the safety of the bond issuance because the issuer is required to have money on hand and available to retire the securities at the times specified. A sinking fund does not make a bond more volatile. [Chapter 2.1]
Which of the following best describes the "Call Premium" of a bond? a) The amount by which the bond trades above par value b) The amount above par value which the issuer must pay to call the bond in for redemption c) The amount above par which the investor must pay to purchase the bond d) The amount the investor would receive upon sale of the bond in the secondary market
*The amount above par value which the issuer must pay to call the bond in for redemption* - Reasoning: A call premium is the amount over par that an issuer has to pay to an investor for redeeming the security early. [Chapter 2.5]
All of the following are true of a *corporate bond with a call feature* EXCEPT: a) Interest payments cease after the bond is called. b) It limits the upside potential on the bond. c) If the bond has a call premium, it normally declines in later years. d) The bond will be sold for a higher price because of the call feature.
*The bond will be sold for a higher price because of the call feature* - Reasoning: Call features are *less desirable* to the investor (so the bonds usually sell for a *lower* price) [Chapter 2.5]
An investor who purchases a CMO (Collateralized Mortgage Obligation) can expect distributions of cash how frequently?
*The investor can expect distributions on a monthly basis* - Reasoning: Since CMO's are backed by mortgages, and home owners make mortgage payments monthly, investors owning CMO's would also receive monthly payments. [Chapter 2.6]
A guaranteed bond is a bond in which? a) Principal and interest are always paid promptly. b) The payment of interest and principal of a subsidiary corporation is guaranteed by a parent corporation. c) There is absolutely no risk associated with the bond. d) Interest and principal is only paid if earnings by the parent corporation exceed a specified level.
*The payment of interest and principal of a subsidiary corporation is guaranteed by a parent corporation* - Reasoning: Guaranteed bonds are issued by a subsidiary corporation, but the parent corporation guarantees payment if the subsidiary is unable to meet their obligation. [Chapter 2.4]
If yields on all marketable fixed-income bonds increase approximately 1%, which of the following is correct concerning changes in bond prices? a) There will be no changes in bond prices b) The prices of short-term and long-term bonds will decrease by exactly the same amount c) The prices of short-term bonds will decrease more than the prices of long-term bonds d) The prices of long-term bonds will decrease more than the prices of short-term bonds
*The prices of long-term bonds will decrease more than the prices of short-term bonds* - Reasoning: When interest rates change, prices of short-term bonds reach the quickest but long-term bond prices react the greatest. [Chapter 2.2]
Concerning the taxation of Collateralized Mortgage Obligations (CMO's), which of the following decreases the yield of the bond? a) The return is tax exempt b) The return is taxable by the Federal Government only c) The return is taxable by state governments only d) The return is taxable at the Federal, state, and local levels
*The return is taxable at the Federal, state, and local levels* - Reasoning: Since the income would be subject to Federal, State and local tax the net yield to the investor would be less. [Chapter 2.6]
The Trust Indenture Act of 1939 regulates corporate debt issues and requires the designation of a trustee. What duty does this trustee have? a) The trustee is charged with ensuring that the proper filing procedures take place with relation to the issue and SEC registration. b) The trustee is charged with allocating any remaining bonds that may not have been sold in the initial issuance. c) The trustee is charged with acting on behalf of bondholders and ensuring that the rights of these bondholders are not infringed upon. d) The trustee is charged with being the liaison to the SEC in relation to all matters associated with the bond issue.
*The trustee is charged with acting on behalf of bondholders and ensuring that the rights of these bondholders are not infringed upon* - Reasoning: The Trust Indenture Act of 1939 pertains to corporate debt issues and requires that each corporate debt issue has an indenture and a trustee. The trustee's main function is the representation of bondholders and ensuring the safeguarding of bondholder rights. [Chapter 2.3]
Which of the following is a characteristic of corporate "junk bonds"? a) They are issued by corporations with questionable credit strength. b) They are also called specialty bonds. c) They are often issued to finance corporate stock buybacks. d) They are never assigned a rating by a bond rating service.
*They are issued by corporations with questionable credit strength* - Reasoning: Junk bonds are also referred to as high yield bonds, not specialty bonds. They are often issued to finance corporate takeovers, but not stock buybacks. Junk bonds can be assigned a rating of BB or lower, or can be unrated. [Chapter 2.4]
Which statement is correct regarding Negotiable CDs? a) They can be issued as long-term CDs. b) Minimum deposit is $10,000. c) No penalties incurred if CD is cashed in prior to maturity. d) They are guaranteed by the U.S. Treasury.
*They can be issued as long-term CDs* - Reasoning: CDs could have maturities of 3, 5, or even 10 years. The other statements are incorrect: Minimum deposit is $100,000; penalties will be incurred if cashed in prior to maturity; and they are not guaranteed by the U.S. Treasury (but they are by the banks that issue them). [Chapter 2.9]
A collateralized mortgage obligation (CMO) has 4 tranches. Interest rates have dropped significantly recently and mortgage holders are starting to prepay their loans because they are refinancing at lower rates. Which of the following tranches would be most affected by these prepayments? a) Tranche 4 b) Tranche 3 c) Tranche 2 d) Tranche 1
*Tranche 1* - Reasoning: Principal payments and pre-payments from the mortgage loans in the CMO pool pay off one tranche at a time in order of maturity (Tranche 1, 2, 3, etc.) [Chapter 2.6]
Which of the following most frequently issue *Equipment Trust Certificates*? a) High tech companies. b) Aircraft construction companies. c) Utility companies. d) Transportation companies.
*Transportation companies* - Reasoning: Transportation companies are the most frequent issuers of Equipment Trust Certificates, where the debt is secured by the rolling stock of the company (e.g., such as airplanes, trucks, and cargo ships). [Chapter 2.4]
Which of the following bonds pay all of their interest at maturity? a) Defaulted Bonds b) Zero-Coupon Bonds c) Corporate Bonds d) Government Bonds
*Zero-Coupon Bonds* - Reasoning: Zero-Coupon Bonds do not pay semiannual interest (all interest is paid at maturity with the principal payment). [Chapter 2.4]
If a customer believes that interest rates will decline substantially, she should invest in: A) a 1 year Certificate of Deposit @ 10%. B) a long-term variable rate Corporate Bond yielding 12 1/2%. C) a long-term Corporate Bond with a coupon rate of 10%, callable in 3 years at par, at a 9% basis. D} a long-term Corporate Bond with a coupon rate of 10% at a 12% basis, non-callable.
*a long-term Corporate Bond with a coupon rate of 10% at a 12% basis, non-callable* - Reasoning: Bonds have an inverse reaction to interest rate movements. In addition, long-term bonds react the greatest to interest rate changes compared with bonds with shorter maturities. The non-callable feature stated in the correct answer is also appealing because it gives the investor some protection against her bond being called by the issuer when interest rates fall. [Chapter 2.2]
A structured debt security backed by a pool of assets such as mortgages and auto loans where the securities are generally traded based on the Average Life of the security rather than a set maturity date is known as ____________.
*an asset-backed security* - Reasoning: Asset-Backed Securities (ABS) or Collateral Debt Obligations (CDOs) are structured debt securities backed by a pool of mortgages, auto loans, corporate debt, and credit card debt. They are generally traded based on the Average Life of the security (rather than a set maturity date). [Chapter 2.9]
The Trust Indenture Act of 1939 is a federal law that requires a qualified trustee to A) represent the issuer. B) be appointed by an independent auditor. C) be elected by the bondholders. D) be appointed by the issuer.
*be appointed by the issuer* - Reasoning: The Trust Indenture Act of 1939 is a federal law that requires all corporate debt securities to be issued under an indenture agreement providing for the appointment of a qualified trustee by the issuer to represent the bondholders and to be free of any conflict of interest with the issuer. [Chapter 2.3]
If the basis price of a bond is 5.25 and the coupon rate is 4.75, the bond is selling __________.
*below par* - Reasoning: If the basis (YTM) is *higher than the coupon*, that tells you that the bond's price is below par. *Lower price equals higher yield (Basis)* [Chapter 2.2]
The "Call Protection" period on an outstanding callable bond would be most advantageous to __________.
*bondholders* [Chapter 2.5]
A customer has a portfolio of various corporate and Treasury bonds. She tells her registered representative that she believes interest rates are going lower and she wants to maintain a portfolio of bonds. Given the customer's concern, the RR should recommend that the client: A) begin swapping her existing bonds for bonds selling at a premium. B) extend the overall maturity and increase the call protection on her bond portfolio. C) attempt to shorten the overall maturity on her bond portfolio. D) sell corporate bonds and buy Treasury bonds.
*extend the overall maturity and increase the call protection on her bond portfolio* - Reasoning: The customer feels that interest rates are going to go down, so she should attempt to lock in the longest maturities possible in her portfolio. This calls for extending the overall maturity of the bond portfolio. The customer should also attempt to eliminate the possibility of early calls of her bonds, so she should increase the call protection for her portfolio. In order to achieve this, the customer should make changes to her portfolio by selling bonds with the shortest maturities and buying bonds with longer maturities. Also, she should sell bonds that are callable now or soon to be callable and buy new ones with callable dates that are much further out. [Chapter 2.5]
A bond's par value represents the bond's: A) market price and guaranteed payout on the bond. B) face value and the amount of principal that the issuer is expected to repay at maturity of the bond. C) value as a sum of all interest payments that will be made on the bond over its lifetime. D) total impact as a liability on the balance sheet of the issuing entity.
*face value and the amount of principal that the issuer is expected to repay at maturity of the bond* - Reasoning: A bond's par value represents the bond's face or principal value, normally $1,000. This is the amount that the issue is expected to repay at maturity of the bond. It is also the amount from which the coupon payments are based. It is not the bond's market price (though the two numbers can be the same). Principal on a bond is never a "guaranteed payout". Though par value must be returned at maturity, the total impact of the bond as a liability will also include interest payments. [Chapter 2.1]
When an investment grade bond is downgraded to a Junk bond, it is referred to as a: A) sleeper B) fallen angel c) debenture d) general obligation
*fallen angel* [Chapter 2.4]
If a municipal bond *decreases* in price, its *yield to maturity will __________*.
*increase* - Reasoning: When a bond decreases in price, the yield to maturity will go up (see *seesaw diagram* in study material). [Chapter 2.8]
Higher quality debt issues of the same face value, maturity, and coupon (when compared to low quality debt issues) typically exhibit: A) lower yields and lower market prices. B) lower yields and higher market prices. C) higher yields and lower market prices. D) higher yields and higher market prices.
*lower yields and higher market prices* - Reasoning: Higher quality debt issues usually exhibit lower yields and higher market prices. The safety provided by a high quality debt instrument often allows the issuer to pay a lower coupon rate. Also because of the safety, pricing tends to be higher. With higher pricing and lower coupons, the yields tend to be lower. [Chapter 2.4]
An investor wishing to "lock-in" interest payments for the next several years would be best advised to purchase: A) a debt issue with a high call premium B) bonds trading at a high premium C) zero coupon bonds D) non-callable bonds
*non-callable bonds* - Reasoning: The best way to "lock in" interest payments is to purchase the non-callable issue. [Chapter 2.5]
An XYZ Corporation Debenture pays annual interest to its bondholders. The interest is taxable to the bondholders as: A) ordinary income subject to federal and state taxes. B) a long-term capital gain. C) ordinary income subject to federal tax only. D) ordinary income subject to state tax only.
*ordinary income subject to federal and state taxes* - Reasoning: Although corporations enjoy a 50% tax exemption on dividend income, all interest income is *fully taxable*. [Chapter 2.3]
A long-term Corporate Bond trading in the secondary market has a Nominal Yield of 10%, and a Basis of 7%. The Current Yield is 9% and the Par Value is $1,000. The bond is trading at a __________.
*premium* - Reasoning: Bonds are trading at a premium when the Yield to Maturity (or Basis) is less than the Coupon Rate/Nominal Yield. Parity is a consideration when discussing convertible securities and comparing market value to the market value of the common stock to which the securities convert. [Chapter 2.2]
Which of the following best describes the nominal yield on a bond? A) annual interest divided by the market price of the bond B) annual interest divided by the original issue price of the bond C) the compound rate of return equating the present value of the bond to the future payments of interest and principal D) the interest stated on the face of the bond
*the interest stated on the face of the bond* - Reasoning: The interest rate (or coupon rate) of a bond is defined as the bond's Nominal Yield. [Chapter 2.2]
It is TRUE to state that junk bonds: A) are required to be rated but fall into the BB category or lower. B) will normally have a lower coupon rate and lower market price when compared to investment grade bonds. C) always begin and remain in the category of "junk bond" until maturity. D) typically have higher price volatility when compared to investment grade bonds.
*typically have higher price volatility when compared to investment grade bonds* - Reasoning: Junk bonds have greater price fluctuations than investment grade bonds. Junk Bonds: - can be rated as BB or lower, or can be unrated (there is no requirement of rating). - normally will have higher coupon rates and lower market prices when compared to investment grade bonds (leading to higher yields). - can start as investment grade and be downgraded (fallen angels) or can be upgraded from junk bond status to investment grade status. [Chapter 2.4]
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