Series 65 Unit 13
If an investor buys a bond with a 15% current yield at 110 with 10 years to maturity, what is the yield to maturity?
13.33%. The formula is annual interest - (premium/years to maturity)/ average price of the bond. Average price of the bond is price paid plus the amount received at maturity, then divided by 2.
What is a Yankee bond?
A bond denominated in U.S. dollars that is publicly issued in the U.S. by foreign banks and corporations. According to the Securities Act of 1933, these bonds must first be registered with the Securities and Exchange Commission (SEC) before they can be sold. Yankee bonds are often issued in tranches and each offering can be as large as $1 billion.
Duration is identical to a bond's maturity a measure of a bond's price sensitivity with respect to a change in interest rates equivalent to the yield to maturity the deviation of a bond's returns from its average returns
B. Duration measures a bond's sensitivity to a change in interest rates. The longer the duration, the greater the change in a bond's price with respect to interest rate changes.
All of the following are true of negotiable, jumbo certificates of deposit EXCEPT they are usually issued in denominations of $100,000 to $1 million they usually have maturities of 1 year or less they are readily marketable they are secured obligations of the issuing bank
D. Negotiable CDs are general obligations of the issuing bank; they are not secured by any specific asset. They do qualify for FDIC insurance (up to $250,000), but that is not the same as stating that the bank has pledged specific assets as collateral for the loan.
True or False: The yield to maturity of a bond purchased at a premium is always lower than the current yield
The YTM of a bond bought at a premium is always lower than the coupon rate and the nominal yield.
What are GOs?
They are municipal securities that are paid by means of tax revenues. As such, they are considered quite safe.
What are collateral trust bonds?
When a company puts up securities as the collateral for a loan. These securities can be the company's own stock so long as they are marketable, i.e. liquid.
Which of the following is NOT a money market instrument? Newly issued Treasury notes Treasury bills Banker's acceptances Commercial paper
A. Commercial paper, Treasury bills, and banker's acceptances are debt instruments with maturities of 1 year or less and are therefore money market instruments. A newly issued Treasury note would have a maturity of 2 to 10 years and therefore would not be a money market instrument.
GNMA mortgage-backed securities are a direct obligation of the U.S. government available to investors through a minimum purchase of $5,000 exempt from federal income tax for the interest payments received by the bondholders backed exclusively by a pool of mortgages
A. GNMA securities are a direct obligation of the U.S. government and are backed by a pool of mortgages (which is why the choice, backed exclusively by a pool of mortgages is not the best choice). The monthly payments are partially a return of principal and partially taxable interest, which is subject to state and federal income tax. GNMA pass-through securities are available to investors with a minimum issue price of $25,000.
All of the following factors have an inverse relationship to a bond's duration except time to maturity. coupon rate. yield to maturity. current yield.
A. The relationship between the time to maturity (length) and duration is a linear one. That is, the longer the time until the bond matures, the higher (longer) the duration - it is a direct relationship. Yields, on the other hand, have an inverse relationship with duration. That is, the higher the yield, the lower (shorter) the duration. An example would be comparing a bond with an 8% coupon rate to one with a 6% coupon rate. All other things being equal, the bond with the 8% coupon rate will have a shorter duration than the one with a 6% coupon; the relationship is inverse rather than linear.
Which of the following U.S. government securities do NOT bear a stated interest rate but are sold at a discount through weekly auctions? Treasury bills Treasury bonds Treasury notes TIPS
A. Treasury bills bear no stated interest rate. They are sold at a discount through weekly auctions and are actively traded in the money market. Treasury notes and Treasury bonds both carry stated interest rates.
A bond analyst who determines the value of a debt security by adding the present value of the future coupons to the present value of the maturity value is using which of the following valuation methods? Present value Discounted cash flow Future value Dividend discount
B. This type of question sometimes appears on the exam. There is a second answer that could be correct, but is not scored as such. In this example, a case could be made for present value, but the better choice is discounted cash flow; it is more correct.
If an investor in the 27% federal income tax bracket invests in municipal general obligations bonds selling at par with a coupon of 4.5%, what is the tax equivalent yield? 3.29% 5.72% 6.16% 16.67%
C. The formula for computing tax equivalent yield is: nominal coupon yield divided by (1-federal income tax rate) .045/ (1-.27)= 6.16%
A corporation has issued a 4% $60 par convertible stock with a conversion price of $20. With the preferred stock selling at $66 per share, an investor holding 100 shares of this stock would benefit by converting if the price of the common stock was above $18.20 per share below $22 per share over $22 per share above $20 per share
C. With a conversion price of $20 and a par value of $60, this preferred stock is convertible into 3 shares of the company's common stock. We divide the current price of the preferred ($66) by the 3 shares to arrive at the parity price of $22. If the common stock is selling for more than the parity price, the investor can benefit by converting and selling the stock in the marketplace.
What is the difference between eurobonds and eurodollar bonds?
Eurobonds are any bonds issued outside the country of the currency in which they denominated. Eurodollar bonds are specifically denominated in US dollars. For example, a bond in Yen issued in the United States is a eurobond but not a eurodollar bond.
What is an equipment trust certificate? How is the certificate paid?
It functions much like a loan on a car, with the debtholder having a lien against the equipment. The company pays off an annual portion of the loan.
An investor purchases a Treasury note and the confirmation shows a price of $102.21. Rounded to the nearest cent, the investor's cost, excluding commissions, is $1,026.56. $1,022.10. $1,022.21. $102.21.
A. Treasury notes are quoted in 32nds where each 32nd equals $.3125. The 102 in the quote equals $1,020 and the 21/32 is an additional $6.56 bringing the total to $1,026.56.
Kate, age 59, has an investment portfolio exceeding $250,000. She considers herself a moderate to conservative investor. To generate additional income, she is anticipating adding bonds to her portfolio. She lives in a state that does not have an income tax and she is in the 28% federal income tax bracket. Which of the following bonds would be the best recommendation for her portfolio? Bond D, AAA-rated Treasury note with a 2.55% coupon rate Bond A, A-rated corporate debenture with a 6.5% coupon rate Bond B, BBB-rated municipal bond with a 3.75% coupon rate Bond C, CCC-rated corporate debenture with an 8% coupon rate
B. Even though Bond C has the highest after-tax rate of return, this bond would not be appropriate for Kate based on her risk tolerance. Therefore, Bond A would be the best choice. Calculations: Bond A: 6.5 × (1 - 0.28) = 4.68% Bond B: 3.75% Bond C: 8% × (1 - 0.28) = 5.76% Bond D: 2.55% × (1 - 0.28) = 1.84%
A new convertible bond has a provision that it cannot be called for 5 years after the issue date. This call protection is most valuable to a recent purchaser of the bond if interest rates are rising interest rates are stable the market price of the underlying common stock is increasing interest rates are falling
C. Convertible bonds are more sensitive to the price of the underlying common stock than they are to interest rates. Call protection would enable this investor to hold on to the bond while the stock rises in value rather than having the bond called away.
Which of the following choices offers the highest tax-equivalent yield? 5.5% municipal bond to an individual in the 28% tax bracket 5% municipal bond to an individual in the 35% tax bracket 6.2% municipal bond to a corporation in the 21% tax bracket 5.8% municipal bond to an individual in the 25% tax bracket
C. 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%.
What is debt capital?
Money loaned to an issuer by investors purchasing the issuer's bonds
Your client in the 25% federal income tax bracket lives in a state where his earnings place him in the 6% bracket for state income tax purposes. If he were to purchase a 4% bond issued by a political subdivision of his state, his total tax-equivalent yield would be approximately 12.90% 4% slightly less than 5.33% slightly more than 5.33%
D. When an individual owns a municipal bond issued in his state of residence, not only is the interest tax free on a federal basis, but (at least in all cases on the exam) it is nontaxed in that state. Therefore, the tax-equivalent yield here is slightly higher than it would be if we only computed using the federal tax rate. Because that would be 4.0% divided by 0.75 (100% minus the 25% tax bracket) or 5.33%, saving on state income taxes would increase the yield slightly.
Which of the following are characteristics of commercial paper? Backed by money market deposits Negotiated maturities and yields Issued by insurance companies Not registered with the SEC II and IV I and III I and II III and IV
A. Commercial paper represents the unsecured debt obligations of corporations needing short-term financing. Both yield and maturity are open to negotiation. Because commercial paper is issued with maturities of no more than 270 days, it is exempt from registration under the Securities Act of 1933.
Which of the following projects is most likely to be financed by a general obligation rather than a revenue bond? Public golf course Public library Expansion of an airport Municipal hospital
B. Hospitals, airports, and golf courses all generate revenue and can be financed with revenue bond issues. Public libraries are financed through GO bond sales with the backing of taxes.
How does taxation work on TIPS?
The interest generated by TIPS is exempt from state and local income taxes but subject to federal income taxation. HOWEVER, the principal adjustment for inflation is considered reportable income for the year and therefore taxable.
Which of the following are general characteristics of negotiable jumbo CDs? Always mature in 1 to 2 years with a prepayment penalty for early withdrawal Typically pay interest on a monthly basis Issued in amounts of $100,000 to $1 million Only trade in the primary market
C. Negotiable jumbo CDs are issued for $100,000 to $1 million and trade in the secondary market. Most jumbo CDs are issued with maturities of 1 year or less. Being negotiable in the secondary market, there is no prepayment penalty. These CDs generally pay interest on a semi-annual basis, not monthly.
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 1 to 2 years with a prepayment penalty for early withdrawal Trade in the secondary market II and IV I and III I and IV II and III
C. 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 1 year or less. Being negotiable, there is no prepayment penalty. These CDs generally pay interest on a semiannual basis, not monthly.
A bond with a par value of $1,000 and a nominal yield of 6% paid semiannually is currently selling for $1,300. The bond matures in 25 years and is callable in 15 years at $1,080. In the computation of the bond's yield to call, which of these would be a factor? Present value of $1,080 50 payment periods Future value of $1,300 Interest payments of $30
D. The YTC computation involves knowing the amount of interest payments to be received, the length of time to the call, the current price, and the call price. With a 15-year call, there are only 30 semiannual interest payment periods, not 50. The present value is $1,300 and the future value is $1,080; the reverse of the numbers indicated in the answer choices.
A bond purchased at $900 with a 5% coupon and a 5-year maturity has a current yield of 5.56% 7.80% 5.00% 7.40%
A. Current yield is determined by dividing the annual interest payment by the current market price of the bond ($50 ÷ $900 = 5.56%). Years to maturity is not a factor in calculating current yield.
A client interested in fixed income is viewing different bonds with the same rating and a coupon of 6%. Using the DCF method, which bond should have the highest market value? 5 yr maturity when the discount rate is 4% 5 yr maturity when the discount rate is 8% 10 yr maturity when the discount rate is 4% 10 yr maturity when the discount rate is 8%
C. When interest rates change, the longer the time to maturity, the greater the effect on the market price of a bond.
Some analysts use the discounted cash flow to determine the theoretical value of a debt security. Under DCF, the bond price can be summarized as the sum of the future value of the par value repaid at maturity plus the present value of the coupon payments future value of the par value repaid at maturity plus the future value of the coupon payments present value of the par value repaid at maturity plus the future value of the coupon payments present value of the par value repaid at maturity plus the present value of the coupon payments
D. A bond's price can be calculated using the present value approach. As with any security or capital investment, the theoretical fair value of a bond is the present value of the stream of cash flows it is expected to generate. Therefore, the value of a bond is obtained by discounting the bond's expected cash flows to the present using an appropriate discount rate. The two choices using future value of the par value at maturity make no sense because we already know that is $1,000 (or whatever the par value might happen to be).
All of the following statements regarding Government National Mortgage Association (GNMA) pass-through securities are true EXCEPT GNMAs are considered to be the riskiest of the agency issues investors own an undivided interest in a pool of mortgages investors receive a monthly check representing both interest and a return of principal the minimum initial investment is $25,000
A. GNMA securities, which are backed by the full faith and credit of the U.S. government, are considered to be the safest of the agency issues.
One of the ways in which U.S. government agency issues differ from those offered directly by the U.S. Treasury is that agency issues are more likely to be issued in larger amounts agency issues are taxable on the federal level while Treasury issues are not agency issues typically carry higher returns than Treasury issues because of the lack of direct government backing agency issues frequently trade on the NYSE while Treasuries never do
C. Agencies, with only a very few exceptions, GNMA being one, do not carry the direct backing of the U.S. Treasury. While they are quite safe, that lack of direct backing causes their yields to be somewhat higher. Agencies are never traded on the stock exchanges and their float is almost always smaller than Treasuries. Both are taxable on the federal level.
MNO is planning to raise capital through an offering of 30-year bonds. Which call price would be most beneficial to MNO? 110 106 102 104
C. MNO would benefit most from the ability to call bonds at the lowest possible price. The call feature enables MNO to buy the bonds before maturity to reduce their fixed interest costs. A call price of 102 requires the lowest call premium of the options shown. U13LO8
Your customer owns $100 par 5½% callable convertible preferred stock convertible into 4 shares of 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 common stock is trading at $25.50? Hold the preferred stock to continue the 5½% yield. Convert her preferred stock into common stock because it is selling above parity. Place irrevocable instructions to convert the preferred stock into common stock and sell short the common stock immediately. Present the preferred stock for the call because the call price is $4 above the parity price.
D. If the preferred stock is called, the client will receive $106. Tendering the preferred stock will provide the highest value. The value of converting the preferred stock into 4 shares of common is worth $102 (4 × $25.50 = $102), which is less than the call value of $106. The dividends will cease on the call date if the preferred stock is held beyond the call date.
One of your clients owns 2 different 6% corporate bonds maturing in 15 years. The first bond is callable in 5 years, while the second has 10 years of call protection. If interest rates begin to fall, which bond is likely to show a greater change in price? Both will increase by the same amount Bond with the 10-year call Bond with the 5-year call Both will decrease by the same amount
B. As interest rates fall, the investor benefits from having the highest interest rate for as long as possible. The price change will not be the same for both bonds. The greater the call protection, the more likely a bond will appreciate if rates fall. That additional call protection in essence lengthens the duration of the bond and, as we know, the longer the duration, the greater sensitivity to interest rate changes. In this case, with declining rates, bond prices will rise.
A bond investor's portfolio consists of the following 3 bonds: ABC First Mortgage bond, current market value of $4 million with a duration of 5 years. DEF Debenture, current market value of $5 million with a duration of 8 years. U.S. Treasury bond, current market value of $1 million with a duration of 10 years. What is the average duration of the portfolio? 6.54 years 7.67 years 3.04 years 7 years
D. It is unlikely that you will have a question this complicated on the exam, but, just in case, we wanted to show you the way to do it. Computing average duration of a bond portfolio involves taking each bond and figuring the proportion of the portfolio its duration represents. In this question, ABC is 40% of the portfolio so we take 40% of its 5-year duration (2). Then, we do the same with the other two bonds. DEF is 50% of 8 (4) and the Treasury bond is 10% of 10 (1). When we add the 3 numbers together, it results in an average duration of 7 years.
The DERP Corporation has an outstanding convertible bond issue with a conversion price of $125 per share. If the current market price of the bond is 80, the parity price of the stock is $64.00 per share $100.00 per share $156.25 per share $125.00 per share
B. What does parity mean? It means that 2 things have equal value. What 2 things do we have here? We have the convertible bond and, because it is convertible, it can be "converted" into common stock. There is a number where the value of the bond and the value of the stock are the same—this price is the parity price. The bond is currently valued at $800 (80% of par). Anytime the investor wishes, he can exchange (convert) that bond into DERP's stock at $125 per share. But, that conversion is based not on a market price, which can fluctuate every day—it is based on the amount of the money initially borrowed—the $1,000 par value of the bond. DERP is saying that it will allow you to exchange the $1,000 they owe you for stock at $125 per share. Simple division results in the ability to convert into 8 shares. Now we have everything we need to compute the parity (equal) price. If the bond is currently valued at $800 and we can convert it into 8 shares, what does each of those shares have to be worth so that the stock is also valued at $800? Dividing 800 / 8 = $100 per share. That means that if the stock is selling for $100 per share, and we decide to convert the bond, we'll have the same $800 in value. Some students find the answer a quicker way. If the bond is selling at 80% of its par value, then, to be equal, the stock must be selling at 80% of the conversion value (80% × $125 = $100).
An investor owns a TIPS bond with an initial par value of $1,000. The coupon rate is 6% and, during the first year, the inflation rate is 9%. How much interest would be paid for the year? $90.00 $65.40 $64.11 $60.00
C. TIPS bonds have a fixed coupon rate with a principal that varies each 6 months based on the inflation rate. With an annual inflation rate of 9%, each 6 months, the principal increases by 4.5% (half of the annual rate). Each semiannual coupon is half of the 6% rate times the new principal. The arithmetic is: $1,000 x 104.5% = $1,045 x 3% = $31.35 plus, $1,045 x 104.5% = $1,092 x 3% = $32.76. Adding the 2 interest payments together results in a total of $64.11 for the year. You should be able to "eyeball" this. Any bond with a 6% coupon will pay $60 in one year ($30 x 2). Because the TIPS bond increases the principal after the first 6 months, the second interest payment will be slightly higher than $30. There is only one choice slightly higher than $60.00 and it would be that way on the real exam.
