Series 66 -- Fixed Income Basics

Rule of 72

A simplistic rule that states that if one takes the interest rate being earned and divides it into 72, the result is the number of years it takes to double one's money.

The cost of money is known as the: A. marginal rate B. consumption rate C. interest rate D. opportunity cost

The best answer is C. The interest rate charged on loans is the "cost" of money. The higher the interest rate, the higher the "cost" of borrowing money, and vice-versa.

Inertial inflation is:

The best answer is C. Inertial inflation is inflation that is contractually embedded in the economy. For example, COLAs (Cost of Living Adjustments) in union and government employment contracts are tied to increases in the inflation rate. Inertial inflation can be "self-fulfilling" because as wages rise due to COLAs, this creates inflationary pressure on prices of goods and services, so their prices rise, which triggers another COLA increase, etc. In periods of sustained inflation, bonds do terribly because interest rates rise, and stocks don't fare well either. Tangible assets such as real estate are the best investments in periods of sustained inflation.

Future Value (also known as Compound value)

The original principal amount of an investment plus any interest accrued during a specific time period. The Future Value is dependent upon the amount of time the investment is held and the interest rate earned over the investment's life.

Duration

Duration is a measure of a bond's price volatility in response to changes in market interest rates. The bonds that are least volatile are those with short maturities and higher coupons; the bonds that are most volatile are those with long maturities and low coupons.

Net Present Value vs. Internal Rate of Return

Net present value (NPV) is the difference between the present value of cash inflows and the present value of cash outflows over a period of time. By contrast, the internal rate of return (IRR) is a calculation used to estimate the profitability of potential

If the U.S. dollar goes up in value, what type of investment would be least affected?

Small and mid-cap companies would be lest affected because they tend to operate only in the U.S., so they are not subject to exchange rate risk. If the U.S. dollar appreciates, then any foreign holdings which are denominated in a foreign currency, when converted back to U.S. dollars, "buy" fewer U.S. dollars. Therefore, those investments are worth a lower amount, when converted back into U.S. dollars. This is called "exchange rate risk." If an investment is made in a company that only operates in the U.S., this is not an issue. Large cap companies tend to be multi-national, so these are subject to exchange rate risk.

A retired individual invests $75,000 in a 5-year bank Certificate of Deposit. This investor will be susceptible to: A. unsystematic risk and interest rate risk B. purchasing power risk and reinvestment risk C. market risk and business risk D. opportunity cost risk and credit risk

The best answer is B. Purchasing power risk is the risk of inflation. At the CD's maturity, the customer will get back his or her principal, plus interest, but there is no growth in investment value to compensate for inflation. In addition, if interest rates have dropped over the 5 year investment time horizon, when the CD matures, the proceeds would be reinvested at a lower rate - this is a version of reinvestment risk.

Which of the following is NOT a benefit of making an investment in an emerging markets fund? A. Diversification B. Liquidity C. Higher investment yield D. Reduced investment risk

The best answer is C. An emerging markets fund is a type of growth fund (growth investing) that invests in companies in rapidly growing countries (e.g., a "BRIC" Fund - Brazil-Russia-India-China). Investing via a mutual fund structure provides diversification (which reduces investment risk) and provides liquidity, since the fund shares can be redeemed daily at NAV, or if the fund is closed-end, the shares can be sold in the market. What is not a benefit is a higher investment yield - the yield may be higher than making direct investments in these foreign stocks or it may be lower. Furthermore, the expenses of running the fund (which include a high management fee for these types of funds) can be a real drag on returns. So, while the investment return may be better than direct investing, it might also be worse. This is the best of the choices offered.

A corporation has issued 10% AA rated sinking fund debentures at par. Three years later, similar issues are being offered in the primary market at 8%. Which are TRUE statements about the outstanding 10% issue? I The current yield will be higher than the nominal yieldII The current yield will be lower than the nominal yieldIII The dollar price of the bond will be at a premium to parIV The dollar price of the bond will be at a discount to par A. I and III B. I and IV C. II and III D. II and IV

The best answer is C. The bond was issued with a coupon of 10%. Currently, the yield for a similar issue is 8%. Therefore, interest rates have dropped. When interest rates drop, yields on bonds already trading must also drop. What causes this is a rise in the dollar price of the issue - the bond now trades at a premium.

Exchange rate risk exists when :

an investment is made outside the U.S. that is denominated in a foreign currency, the investor assumes exchange rate risk. This is the risk that the foreign currency weakens against the U.S. dollar (which is the same as the U.S. dollar strengthening).

The "Present Value" of a fixed income security is based on the:

discounting of all expected future payments to be made by the issuer of the security. It takes all of the future payments to be made by that security and discounts them at the current market rate of interest (compounded yearly) to arrive at the security's "present value." This is the actual market price of the security at that moment.

The measure that is closest to IRR is: A. YTM B. YTC C. ROI D. AIR

The best answer is A. IRR is the Internal Rate of Return. This is the rate of return that discounts all of the cash flows from an investment to a present value of "0." For a bond, it is the same as the YTM (Yield to Maturity) given by that investment.YTC stands for Yield to Call; ROI stands for Return on Investment; and AIR stands for Assumed interest Rate - the estimated conservative rate of return used in a variable annuity return illustration.

Years ago, a bond was issued at par with a 7% coupon. This year, new issue bonds of similar credit quality are being issued at 10%. Which statement is TRUE? A. The new bonds will be issued at a premium to the current price of the 7% bonds B. The new bonds will be issued at a discount to the current price of the 7% bonds C. The new bonds will be issued at the same price as the current price of the 7% bonds D. There is no relationship between the prices of the 2 bond issues

The best answer is A. Because interest rates have risen from 7% to 10%, any new issue bonds will come out at par with a 10% coupon; while the prices of outstanding bonds with lower coupons will drop in the market. Thus, new bonds will be selling at a premium to the current price of existing bonds that have lower coupons.

An investment of $1,000 is projected to give an annual return of $100 for 5 years, at which point the $1,000 invested will be returned. The comparable market rate of return for 5-year investments is 5%. Based on this information, the Net Present Value of the investment: A. will be positive B. will be negative C. will be zero D. cannot be determined

The best answer is A. Net Present Value of an investment takes the projected cash flows from an investment and discounts them back to today's present value, using the market rate of return as the discount factor. Since this investment is generating a 10% annual rate of return; but these returns are discounted by a 5% market rate of return, the NPV, in percentage terms, will be 5%. As long as the NPV is positive, the investment is projected to generate a better than market rate of return and should be made.

A 20-year, 5% bond is quoted by a dealer on a 6% basis. The bond is callable in 10 years at par. To calculate the dollar price for the bond, the dealer would use the: A .redemption date to find the number of years over which the discount would be earned B. call date to find the number of years over which the discount would be earned C. redemption date to find the number of years over which the premium would be lost D. call date to find the number of years over which the premium would be lost

The best answer is A. This is a discount bond. To approximate the price for a long-term bond, divide the coupon by the basis = 5/6 x $1,000 par = $833. A discount bond is one that the issuer would not call - because market interest rates have risen. To bring a 5% coupon up to a 6% yield implies that 1% will be earned each year = 1% of $1,000 = $10 annual earning of discount. If the bond were called early (not likely), the discount would be earned faster and the customer would get a higher yield than the 6% promised. The worst case scenario for the customer is the bond being held to maturity. If it were called early, the yield would actually improve. For bonds quoted on a yield basis, dealers must use "yield to worst" pricing. For discount bonds, this is the case if the bond is held to maturity - this is where the discount would be earned at the slowest rate.

If Congress decides to lower income tax rates, municipal bond yields will: A. fall B. rise C. be unaffected D. become volatile

The best answer is B. Municipal bond interest income is exempt from Federal income taxes, while the interest income from other bonds (Treasuries, Agencies and Corporates) is subject to Federal income tax. Because of this exemption, municipal bonds trade at lower "tax-free" yields than other bonds that offer taxable yields. If Congress lowers Federal tax rates, then municipal yields must rise, since the value of the Federal tax exemption is diminished. This will cause municipal bond prices to fall.

If an individual sells the shares of a stock included in the Standard and Poor's 500 Index and uses the proceeds to buy SPDRs, then the individual has: A.increased business risk B.decreased business risk C.increased regulatory risk D.decreased regulatory risk

The best answer is B. Since this customer is liquidating a single stock position, and investing the proceeds in an index ETF (which is diversified), the customer is reducing the unsystematic risk or business risk inherent in a single stock position.

2 years ago a woman leased a new car by putting $2,000 down and signing a 48 month lease at $500 per month. She has received a letter from the lease company saying that she can complete the lease right now by making a single $10,000 payment and keep the car for 2 more years; or she can finish the lease by making the remaining 24 monthly payments of $500. Assuming that this customer can earn 6% by investing in Treasury securities, and ignoring any tax consequences, to determine the best option, the method to be used is: A. Rule of 72 B. Internal Rate of Return C. Expected Return D. Future Value

The best answer is B. This customer can get out of the lease by making a $10,000 payment now; or can continue to make $500 per month payments for the next 24 months, paying a total of $12,000 to complete the lease. One method to compute the best option (lowest cost) would be to use net present value - but this is not given as a choice! The customer can pay off the lease now by paying $10,000 now - this is the present value of this payment. Using NPV and a 6% risk-free rate of return, the present value of continuing the lease payments is: $6,000 paid in 1 year1.06= $5,660 NPV for year 1 payments$6,000 paid in 2 years1.06(2)= $5,340 NPV for year 2 paymentsTotal NPV = $5,660 + $5,340 = $11,000 Paying off the lease in one payment costs $10,000; while the net present cost of continuing the lease is $11,000. The up-front $10,000 payment is the best alternative (assuming that the customer has the $10,000 on hand!). Since NPV is not given as a choice, we have to evaluate the cost of each option by another method. The customer can either pay $10,000 now; or can make 24 more monthly payments of $500. If we can find the interest rate that discounts these monthly payments to $10,000; then we know the true interest cost implicit in continuing to make the monthly payments (this is the Internal Rate of Return). This is done using a financial calculator or by interpolation. Just as an example, assume that we try a 12% interest rate to discount the payments: $6,000 paid in 1 year1.12= $5,357 NPV for year 1 payments$6,000 paid in 2 years1.12(2)= $4,783 NPV for year 2 payments This gives us a Net Present Value of $5,357 + $4,783 = $10,140, which is darn close to the $10,000 we must pay now to terminate the lease. Thus, the interest cost of continuing to make the $500 payments is about 12%. If we can borrow money somewhere else at a cheaper interest rate than 12%; or if we are not earning at least 12% on our investments; then we should pay off this lease with the single $10,000 payment now!

A U.S. investor purchasing foreign securities trading on the LSE (London Stock Exchange) will benefit when the: I U.S. Dollar weakens II U.S. Dollar strengthens III British Pound weakens IV British Pound strengthens A. I and III B. I and IV C. II and III D. II and IV

The best answer is B. U.S. Dollar weakens, British Pound strengthens If the U.S. Dollar weakens; or if the British Pound strengthens; then when the investment made in British Pounds is converted back into U.S. Dollars, it buys "more" U.S. Dollars. Thus, the value of the holding in U.S. Dollars will go up.

A customer who lives in Minnesota buys a Florida General Obligation bond with a 4.5% coupon at par. The customer is in the 30% federal tax bracket and the 5% Minnesota state tax bracket. What is the customer's equivalent taxable yield? A. 2.93% B. 3.15% C. 6.577% D . 6.92%

The best answer is C. This bond is not fully tax-free. The customer must pay 5% state tax on the 4.50% yield, so the customer keeps 95% of the return after tax = .95 x 4.50% = 4.275%. This is the customer's return on the municipal bond after taxes are paid. If the customer bought a taxable bond, 35% of the return would go to tax (interest income would be taxable at both the federal and state level), and 65% would be kept after tax. Therefore, to find the equivalent taxable yield, you would take the municipal yield after all taxes - 4.275% - and divide by .65 = 6.577% If the customer bought a 6.577% taxable bond, 30% of the return would go to federal tax and 5% of the return would go to state tax, leaving the customer with 65% of 6.577% after tax = 4.275%. This is a VERY nasty question! But, hey, you can always get it down to 50/50 by knowing that the taxable yield must always be higher than the tax-free yield!

To compute the interest rate that will discount the present value of cash flows to be received in upcoming years to "0," the method to be used is called: A. Black-Scholes B. Monte Carlo Simulation C.Internal Rate of Return D. Macaulay Duration

The best answer is C. The present value method that finds the interest rate that discounts the value of cash flows to be received in the future to "0" is the Internal Rate of Return. This is the true yield to maturity of an investment. Black-Scholes is a sophisticated options pricing model. Monte Carlo simulation tests expected outcomes by varying the assumptions used to find best/worst case scenarios for likely investment outcomes; and Macaulay duration measures bond price volatility as market interest rates move.