Series 65 Important Defs
An investor purchases a Treasury note and the confirmation shows a price of $102.25. Rounded to the nearest cent, the investor's cost, excluding commissions, is
$1,027.81. Treasury notes are quoted in 32nds, where each 32nd equals $0.3125. The 102 in the quote equals $1,020 and the 25/32 is an additional $7.81, bringing the total to $1,027.81.
The DERP Corporation has an outstanding convertible bond issue that is convertible into eight shares of stock. If the current market price of the bond is 80, the parity price of the stock is
$100 per share. Parity means equal. With a conversion ratio of eight shares per bond, the investor can convert the bond into eight shares. If the bond is currently selling for $800, then, to be of equal value (parity), the eight shares must be selling at $100 each.
If a convertible bond is purchased at its $1,000 par value and is convertible at $83.33 per common share, what is the conversion ratio of common shares per bond?
12 shares for each bond The conversion ratio is determined by dividing the par value of the bond, or $1,000, by its conversion price of $83.33 per common share. This results in a conversion ratio of 12 shares for each bond.
BFJ Corp.'s 5% convertible bond is trading at 120. The bond is convertible at $50. An investor buying the bond now and immediately converting into common stock would receive
20 shares. The conversion ratio always uses the par value ($1,000), never the current market price. With a par value of $1,000 and a conversion price of $50 per share, this bond is convertible into 20 shares ($1,000 / $50). Remember, the number of shares in a conversion never changes. When the market price changes, the parity price changes, but that isn't relevant to this question.
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?
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 current yield on a bond with a coupon rate of 5.5% selling at 110 is
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%.
The longest initial maturity for U.S. T-bills is
52 weeks. As money market instruments, the longest initial maturity of Treasury bills (T-bills) is 52 weeks. Those bills are auctioned every four weeks. T-bills of shorter maturities are auctioned weekly. The shortest initial maturity is four weeks.
Which of the following choices offers the highest tax-equivalent yield?
6.2% municipal bond to a corporation in the 21% tax bracket Corporations receive the same tax break on municipal bonds as do individuals. Therefore, receiving a 6.2% return in the 21% tax bracket is equivalent to 7.85% before tax. A 5% bond to someone in the 35% bracket is equivalent to 7.69%; a 5.5% coupon to someone in the 28% bracket is equivalent to 7.64%; and a 5.8% coupon to someone in the 25% bracket is equivalent to 7.73%.
Which of the following rates of return is used by investment professionals as the risk-free rate?
91-day Treasury bill rate The interest rate used as the basis for a risk-free rate of return is the 91-day Treasury bill rate. T-bills are U.S.-government guaranteed, the rate is short term, and the market risk is minimal.
Which of the following statements represents an advantage of a municipal general obligation (GO) bond over a revenue bond?
A GO bond generally involves less risk to the investor. GO bonds are generally less risky than revenue bonds because they are backed by taxes rather than revenues. GO debt is charged against the borrowing limits (similar to the credit limit on your credit cards). That is a benefit to the investor because that limit protects against the municipality getting into debt over its head. It is the revenue bond that needs a feasibility study and collects user fees.
The value of which of the following would be least likely to be impacted by changes in interest rates?
A bank CD maturing in 5 years This question is dealing with interest rate (or money-rate) risk. That risk refers to the inverse relationship between the price of fixed-income investments and interest rates. That is, when interest rates go up, the price of fixed-income securities falls (and vice versa). However, this risk only affects investments that are marketable (those with a fluctuating market price). Bank CDs are nonnegotiable (we're not referring to the negotiable jumbo CDs with a maturity of one year or less) and, as a result, will not fluctuate in price, regardless of changes to interest rates. In this case, interest rate risk is eliminated. That is one of the reasons why the exam's first choice for capital preservation is insured bank CDs. Will a laddered bond portfolio reduce interest rate risk? Yes, but it will not eliminate it. Is a convertible preferred (or bond) less subject to changes in interest rates than one without the conversion feature? Yes, but the risk is still there. Does a 30-year T-bond with 5 years remaining to maturity have a short duration and, therefore, a reduced interest rate risk? Yes, but the price of the bond will still be affected by changes in the market interest rates.
A company has two outstanding bond issues, both with a coupon rate of 10%. Bond A will mature in 3 years while Bond B will mature in 20 years. If interest rates were to decrease to 8%, which of the following statements is correct?
Bond B will be selling at a greater premium than Bond A. When interest rates go down, bond prices will go up. As far as which bond will sell at the higher premium using the discounted cash flow method, it is clear that the bond with the longer duration will be worth more.
A bond is selling at a premium over par value. Therefore,
its current yield is less than its nominal yield. Any bond selling at a premium will yield less than the coupon rate (nominal yield). Conversely, of course, a bond trading at a discount will certainly yield more. Remember, there is an inverse relationship between bond prices and bond yields.
An investor interested in monthly interest income should invest in
GNMAs. GNMAs pay monthly interest and principal, treasury bonds pay semiannual interest, utility stocks pay quarterly dividends, and corporate bonds pay semiannual interest.
Which of the following is a direct obligation of the U.S. government?
Ginnie Maes Ginnie Maes are backed by the full faith and credit of the United States. Other agencies have a moral, but not direct, government backing. Government bond mutual funds are not backed by the U.S. government.
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
Issued in amounts of $100,000 to $1 million or more Trade in the secondary market 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.
Your customer owns 1,000 shares of the XYZ $100 par 5½% callable convertible preferred stock convertible into four shares of XYZ 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 XYZ common stock is trading at $25.50?
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 per share or $106,000. 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. On the 1,000 shares, this is a $4,000 difference. The dividends will cease on the call date if the preferred stock is held beyond the call date.
Which of the following debt instruments does not make periodic interest payments?
T-bills Treasury bills are always issued at a discount from their face value. At maturity, the investor receives the face value. The other choices pay interest semiannually. What makes TIPS different from the others is that the principal adjusts for inflation every six months. That means the fixed interest rate is paid on a varying principal.
Which of the following statements regarding corporate zero-coupon bonds is true?
The discount is in lieu of periodic interest payments. The investor in a corporate zero-coupon bond receives the return in the form of growth of the principal amount over the bond's life. The bond is purchased at a deep discount and redeemed at par at maturity. That discount from par represents the interest that will be earned at maturity date. However, the discount is accreted annually and the investor pays taxes yearly on the imputed interest creating "phantom income." Zero-coupon bonds have greater, not lower, price volatility.
Which of the following regarding corporate debentures are true? They are certificates of indebtedness. They give the bondholder ownership in the corporation. They are unsecured bonds issued to finance capital expenditures or to raise working capital. They are the most senior security a corporation can issue.
They are certificates of indebtedness. They are unsecured bonds issued to finance capital expenditures or to raise working capital. Debentures are debt securities that represent unsecured loans of the issuer. They are senior to common and preferred stock in claims against an issuer. They are issued to finance capital expenditures or raise working capital.
Which of the following investments gives the investor the least exposure to reinvestment risk?
Treasury STRIPS/zero-coupon bonds Treasury STRIPS (Separate Trading of Registered Interest and Principal of Securities) are zero-coupon bonds paying no interest. Thus, there is no income to reinvest during the holding period and therefore no reinvestment risk.
An unsecured long-term debt security issued by a corporation is known as
a debenture. A debenture is a long-term debt security issued by a corporation with no specific asset pledged as security for the loan.
When comparing a time deposit account and a demand deposit account, you would expect
a higher rate of interest paid on the time deposit account. The best example of a time deposit account is a CD. Money is deposited for a fixed length of time, generally at a fixed interest rate. Demand deposit accounts are checking accounts. Because the bank expects to have longer use of time deposit funds, interest rates are generally higher. DDAs offer the instant access of check-writing (or online payments). Typically CDs, have penalties for early withdrawal; there is no such charge on a checking account. Both are covered by FDIC up to the applicable limit.
DERP Corporation has issued 5% convertible debentures maturing in 2040. The conversion price is $40 and the common is currently trading at $48 per share. One would expect the DERP debentures to be selling somewhat
above $1,200. The first step here is to compute the parity price. A conversion price of $40 means the debenture is convertible into 25 shares of the common stock (par of $1,000 divided by $40 = 25 shares). With a current market price of $48 per share, the parity price of the convertible would be $1,200 (25 × $48). Because convertible securities generally sell at a slight premium over their parity price, the debentures should have a current market value a bit higher than $1,200.
A bank is advertising a no-cost DDA. Your client asks you to describe what that is. You would respond that DDA stands for
demand deposit account. In the banking industry, the most common definition of a DDA is demand deposit account, better known as a checking account.
Municipal bonds are often called tax-exempts. This refers to the exemption of their income from
federal income taxes. Although municipal bonds are sometimes exempt from state income tax (if issued in the state of residence of the taxpayer), all references to tax exemption refer to their exemption from federal income taxes.
Several years ago, an investor purchased an investment-grade bond with a 6% coupon. Today, that bond is priced to yield 4.6% to maturity in five years. If the bond is called at par in one year, the bond's yield will be
less than 4.6%. Let's take things in order. If a bond with a 6% coupon is showing a YTM below 6%, the bond must be selling at a premium. When bonds selling at a premium are called in advance of the maturity date, the loss (the difference between the premium and the par value) is recognized sooner than expected. This results in a yield to call (YTC) that is less than the YTM.
A mortgage-backed security (MBS), such as a Ginnie Mae, makes a combination principal and interest payment to an investor. This payment will be
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 agent is discussing a specific bond that would be a good addition to the client's portfolio. The client comments that the nominal yield is lower than its current yield. The agent would explain that the bond is
selling at discount Anytime the current yield on a bond is higher than its nominal or coupon rate, the bond must be selling at a discount.
A European corporation seeking a short-term loan would probably be most concerned about an increase to
the SOFR. For more than 40 years, the London Interbank Offered Rate—commonly known as LIBOR—was a key benchmark for setting the interest rates charged on adjustable-rate loans, mortgages, and corporate debt. Over the last decade, LIBOR has been burdened by scandals and crises. Effective January 2022, LIBOR is no longer being used to issue new short-term loans in the U.S. It was replaced by the Secured Overnight Financing Rate (SOFR) which many experts consider a more accurate and more secure pricing benchmark. As is always the case with NASAA, we do not know when the exam questions will be updated. One thing we can promise you is that any question relating to this topic will not have both LIBOR and SOFR as choices, so you should choose whichever one appears.
A company has paid a dividend every quarter for the past 20 years. If the stock's price has fallen dramatically over the past quarter but the dividend has remained the same, it may be concluded that
the current dividend yield has increased. The current dividend yield is income dividend divided by price. If the price of a stock decreases and the dividend remains the same, the dividend yield will increase.
If a corporate bond is convertible, this means that
the owner of the bond may exchange it for a set number of shares of stock. A convertible bond is usually a debenture that allows the owner to exchange it for a set number of shares of stock.
If investors hold bonds until maturity, their realized rate of return, assuming all interim cash flows are reinvested at that same rate, would be equal to
the yield to maturity. The yield to maturity is an investor's total return if they purchase the bond at any point and then hold it until maturity, assuming all interim cash flows are reinvested at that same YTM. This takes into consideration any capital gain or loss; therefore, the yield to maturity will fluctuate with the bond's price.