Series 7 Unit 4
DERF Corporation has a significant amount of cash on hand. The chief financial officer (CFO) has suggested to the chief executive officer (CEO) that it might be wise to use some of that cash to reduce the company's outstanding debt by $10 million. There are four bond issues outstanding, and your broker-dealer is approached for advice on determining which issue to repay. Which of these four issues would the firm most likely recommend? A) $15 million @8% due in 10 years, callable at 101 B) $25 million @5% due in 5 years, callable at 104 C) $10 million @6% due in 20 years, callable at par D) $30 million @12% due in 15 years, non-callable
A) $15 million @8% due in 10 years, callable at 101. - Anytime we have extra cash, it can make sense to pay off debt. - Corporations feel the same way. When it comes to deciding which debt to repay, the wisest move is to pay down the debt with the highest interest cost. - In this case, that would be the 12% bond. However, that bond is non-callable. - Based on the inverse relationship between interest rates and bond prices, the 12% bond is going to be selling at a higher price than any of the others. - Any savings in interest payments would be more than offset by the price the company would have to pay to buy the bond in the open market. - The next highest interest rate is 8% and that bond will cost us a slight premium of $10 per bond to call. - Although the 6% bond is callable at par, the company would be far better off removing an 8% debt than one at 6%. - In fact, the 1 point call premium is saved after the first semiannual interest payment. A partial call, calling in $10 million of the 8% bond, should be the recommendation.
A customer purchased a 5% bond yielding 6%. A year before the bond matures, new bonds of the same quality are being issued at 4%, and the customer sells the 5% bond. The customer probably did which of the following? Bought it at a discount Bought it at a premium Sold it at a discount Sold it at a premium A) I and IV B) II and IV C) I and III D) II and III
A) 1 and 4 - Their customer purchased the 5% bond when it was yielding 6% (discount). - The customer sold the bond when other bonds of like kind, quality, and maturity were yielding 4%. - The bond is now at a premium, therefore the customer realized a capital gain.
In the United Kingdom, they are called gilts. In Germany, they are called Bunds. In France, they are called OATS. To investors, they are known as A) sovereign debt. B) eurobonds. C) stock exchanges. D) commodities.
A) sovereign debt. - Although it is highly unlikely that you would ever see any of these terms on the exam, you might need to know what sovereign debt is. - For the United States, the sovereign debt (the debt issued by the sovereign nation) is Treasury securities. - The safety of sovereign debt depends on the economy of the specific nation. - You would probably not recommend the debt of a third-world country to a customer wishing to avoid risk.
When a corporation issues a debt security, the terms of the loan are expressed in a document known as the bond's indenture. The indenture is sometimes referred to as A) the deed of trust. B) the loan agreement. C) the debenture. D) the bond resolution.
A) the deed of trust. 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.
An investor sells 10 5% bonds at a profit and buys another 10 bonds with a 5¼% coupon rate. The investor's yearly return will increase by A) $1.00 per bond. B) $2.50 per bond. C) $2.00 per bond. D) $1.50 per bond.
B) $2.50 per bond. - The first bonds are 5% and pay $50 per year per bond. - The new bonds are 5 1/4% and pay $52.50 per year per bond, for a difference of $2.50 per bond.
The basis of a bond with a 5% nominal yield maturing in twenty years and selling at 115 is approximately A) 4.35%. B) 3.95%. C) 4.65%. D) 5.75%.
B) 3.95% Annual interest - (premium ÷ number of years to maturity) (Current market price + par) ÷ 2) Plugging in the numbers, we have: ($50 - $7.50) divided by $1,075. That is 3.95%
The basis of a bond with a 5% nominal yield maturing in twenty years and selling at 85 is approximately A) 4.59%. B) 6.22%. C) 5.75%. D) 5.88%.
B) 6.22% - A bond's basis is its yield to maturity (YTM). It is not necessary to do the YTM calculation because it could only be one choice. -We can easily compute the current yield by dividing the $50 annual interest by the $850 current market price. That is about 5.88%. -The YTM must be higher than that because it includes the eventual profit realized when the bond matures at par. -There is only one selection that is higher than 5.88%. The calculation would follow our formula of: Annual interest + (discount ÷ number of years to maturity) ÷ (Current market price + par) ÷ 2) Plugging in the numbers, we have: ($50 + [$150 ÷ 20 years]) = ($50 + $7.50) divided by ([$850 + $1,000] ÷ 2]) = $57.50 ÷ ($1,850 ÷ 2) = $57.50 ÷ $925= 6.22%
Which of the following bonds is most affected by interest rate risk? A) 7.3s of '37 B) 7.6s of '45 C) 7.8s of '42 D) 7.5s of '39
B) 7.6s of '45 - To begin with, let's be sure you understand the nomenclature used here. Each of the choices has two numbers. - The first is the coupon rate of the bond and the second is the year the bond matures. For example, the 7.3s of '37 pay interest at a rate of 7.3% of the $1,000 par value per year and mature in 2037. - The s is just to separate the two numbers. - Interest rate risk is the loss in value due to a rise in interest rates. - Because there is little difference in coupon rates, the bond with the longest maturity (highest duration) will experience the greatest fall in a rising interest rate market.
If a fund has a fixed portfolio of municipal bonds with long maturities, how will substantial changes in general interest rates affect the fund's portfolio? A) The current value will not change, but the investment income will fluctuate significantly. B) The current value will fluctuate significantly, but the investment income will remain relatively unchanged. C) Both the income and the current value will remain unchanged. D) Both the income and the current value will fluctuate significantly.
B) The current value will fluctuate significantly, but the investment income will remain relatively unchanged. For a fund with a fixed portfolio of LT municipal bonds, the market value of the portfolio will fluctuate with changing interest rates, but the income will remain unchanged.
Two bonds currently quoted at a 5.50 basis mature in exactly 15 years. Their coupons are 6% and 7%, respectively. Which bond would experience the greatest appreciation in value if the yields dropped to a 5.20 basis? A) The 6% bond B) Neither because both would decline in value C) The 7% bond D) Both would appreciate the same amount
C) The 7% bond - These bonds are selling at a premium (their coupons are above their yield to maturity, or basis). - If the YTM declines to 5.20, it means that the prices of the bonds went up. - Without getting too deep into the mathematics, in order for both bonds to have the same basis (5.20), the one with the 7% coupon must have a higher price because the $10 per year additional interest has to be offset by a larger annual "loss." - Here is a general rule that will apply to your exam questions. When interest rates are falling, bonds with higher coupon rates are going to appreciate in price at a greater rate than bonds with lower coupon rates. - Conversely, when interest rates are rising, those bonds with higher coupons will decrease in price at a slower rate than bonds with lower coupons. - In our specific question, the 7% bond will have a greater price increase than the 6% bond. If, however, our question showed the bond selling at a discount, e.g., the basis (YTM) is 8%, the 7% bond would be selling closer to par value than the 6% bond.
Nickelplate Manufacturing Corporation (NMC) is capitalized with 1 million shares of a 6% $50 par callable preferred stock and 10 million shares of $1 par common stock. With the preferred stock currently selling at $75 per share and the common stock at $60 per share, the current yield of the preferred stock is closest to A) 6%. B) 5%. C) 8%. D) 4%.
D) 4% - Current yield on any security, stock or bond, is the annual income (dividend on stock, interest on bond) divided by the current market price per share (or per bond). - The math in this question is the dividend of $3 (a 6% $50 par preferred stock is paying an annual dividend of 6% of $50, or $3 per share) divided by the current market price of the preferred stock ($75). - The quotient is .04 or 4%. - What about the common stock? All of that information is just to distract you! - We cannot compute the current yield of the common stock because we do not have any information about its dividend.
Which of the following is not a characteristic of certificates of deposit (CDs)? A) A CD may be payable to the bearer or registered in the name of the investor. B) A CD is often issued by a bank. C) A CD can be negotiable or nonnegotiable. D) The Federal Deposit Insurance Corporation (FDIC) provides insurance for CDs to $500,000.
D) The FDIC provides insurance for CDs up to $500,000. The FDIC provides insurance for CDs up to $250,000. All of the other characteristics are applicable to CDs
When a well-established corporation needs short-term borrowing for working capital needs, it will most likely issue A) a jumbo CD. B) preemptive rights. C) a letter of credit. D) commercial paper.
D) commercial paper. - Commercial paper is the most common tool for corporations to raise short-term funds. - A letter of credit is issued by a bank. - On the exam, this would usually take the form of bankers' acceptances for those in the import/export business. - Bank issue CDs, and preemptive rights are used for the sale of common stock. Stock is LT capital.
One of your individual customers would like to add some foreign debt securities to their portfolio. When told that the investment would be $2,500, the best suggestion would be to A) tell the customer that $2,500 is below the minimum purchase quantity of foreign bonds. B) use one of the overseas branches of your firm to suggest the appropriate issues. C) contact a broker-dealer in the foreign country of choice and open an account there. D) invest in a mutual fund concentrating in foreign debt securities.
D) invest in a mentual fund concentrating in foreign debt securities. - For small investments, a mutual fund or ETF is usually going to be the most suitable choice. - Most countries do not allow nonresident noncitizens to open local brokerage accounts, and that is a pretty impractical idea anyway. - If your firm has an overseas office, it could be a source of information, but when only $2,500 is involved, purchasing individual bonds issued by a foreign nation is usually not reasonable.
Which of the following statements regarding negotiable certificates of deposit (CDs) are true? 1. The issuing bank guarantees them. 2. They are callable. 3. Minimum denominations are $1,000. 4. They can be traded in the secondary market. A) II and III B) I and IV C) I and III D) II and IV
1 and 4 Negotiable CDs are issued primarily by banks and backed by the issuing bank. The minimum denomination is $100,000.
When part of an issue of speculative bonds with a 25-year maturity are called, the effect on the remaining bonds will be to A) improve their quality. B) decrease their quality. C) decrease their coupon rate. D) increase their coupon rate.
A) improve their quality. - Speculative bonds are those with lower ratings. - They are considered to be of lower quality because the risk of timely payment and principal are higher than investment-grade bonds. - When a company shows its determination to honor its debt by paying off some of it in advance, the rating associations take note of that and invariably increase the rating. - Compare this to your personal credit score. Your score might be relatively low because you have a lot of outstanding debt. - As you pay down that debt, your credit score is likely to increase. It is the same logic here.
Your customer is interested in long-term corporate bonds. Which of the following interest rate environments makes a call protection feature most valuable to your customer? A) Stable interest rates B) Declining interest rates C) Rising interest rates D) Volatile interest rates
B) Declining interest rates - A call protection feature is an advantage to bondholders in periods of declining interest rates. - When interest rates are falling, issuers are more likely to call in bonds previously issued at higher interest rates. - For bondholders, calling bonds creates reinvestment risk, as they are unlikely to be able to reinvest at the rate they had been earning. - Call protection gives the bond holder a specified length of time during which the bond cannot be called.
A registered representative mentions a particular 6% municipal bond quoted on a 6.5% basis. Which of the following is correct? Six percent is the bond's coupon. Six percent is the bond's current yield. Six-and-a-half percent% is the bond's yield to maturity. Six-and-a-half percent% is the bond's current yield. A) II and IV B) II and III C) I and III D) I and IV
C) 1 and 3 When a bond is referred to by a yield percentage, it is the coupon (nominal or stated) yield being referenced. Basis yield refers to YTM. Hence, a 6% bond currently trading with a 6.5% YTM is correct.
All of the following statements regarding commercial paper are correct except A) it is quoted on a discount yield basis. B) it is unsecured. C) it is quoted as a percentage of par. D) interest is received at maturity.
C) It is quoted as a % of par. Commercial paper is short-term, unsecured corporate debt. It is issued and traded at a discount of face value and does not pay periodic interest. Like all zeroes, it is quoted on a discounted yield basis.
An investor would most likely purchase money market instruments for their A) yields. B) inflation protection. C) liquidity. D) appreciation potential.
C) Liquidity - Money market instruments are frequently referred to as cash equivalents. - That is largely due to their high liquidity. - Yields on these instruments are very low, and as fixed-income instruments, they offer no appreciation potential or inflation protection.
If interest rates increase, the interest payable on outstanding corporate bonds will A) decrease. B) change according to the inverse payout theory. C) remain unchanged. D) increase.
C) remain unchanged. The interest payable is the nominal yield, which is stated on the face of the bond. - It is the % of face value the bond will pay each year, regardless of the prevailing interest rates in the market. - It is the market price of bonds - not the interest payable - that responds inversely to changes in interest rates.
A bond analyst plots the yields of AAA corporate bonds and compares them to the yields of U.S. Treasury bonds with similar maturities. This is known as A) yield comparison analysis. B) yield plot analysis. C) yield curve analysis. D) inverse yield analysis.
C) yield curve analysis. - The plotting of bond yield results in a curve, usually one where the longer the time to maturity, the higher the yield. - The term yield curve anaylsis is the proper way to describe comparing the yields of highly-rated corporate bonds to those of Treasury bonds. - When the spread between the yields is narrow, economic conditions in the U.S. are generally favorable. - If the spread widens, it is generally a sign of a worsening economy.
Which of the following are characteristics of commercial paper? It is registered with the SEC. It is a short-term debt instrument. It is issued by commercial banks. It is unsecured debt. A) I and II B) I and III C) III and IV D) II and IV
D) 2 and 4 - Commercial paper represents the unsecured debt obligations of corporations needing short-term financing. - Because commercial paper is issued with maturities of less than 270 days, it is exempt from SEC registration under the Securities Act of 1933.
The market price of fixed-income securities, especially bonds, is highly sensitive to changes in market interest rates. Based on that knowledge, which of the following bonds will have the greatest price change when market interest rates increase? A) 10-year maturity, 4% coupon B) 10-year maturity, 6% coupon C) 20-year maturity, 6% coupon D) 20-year maturity, 4% coupon
D) 20-year maturity, 4% coupon - The longer the duration, the greater the decrease in price when interest rates go up. - The bond with the longest duration will have the longest term to maturity and lowest coupon.
Which of the following callable municipal bonds trading on a 7% basis is most likely to be called? A) 6.5% coupon, callable at 100 in 2030 B) 7.5% coupon, callable at 105 in 2030 C) 6.5% coupon, callable at 105 in 2030 D) 7.5% coupon, callable at 100 in 2030
D) 7.5% coupon, callable at 100 in 2030 - An issuer will call the higher coupon bonds before calling the lower coupons. - Of the two bonds with coupons of 7.5%, the one with the lower call price will likely be called first.
A bond investor who is looking for capital gains should invest in bonds when interest rates are A) low and expected to rise. B) low and expected to decline. C) high and expected to rise. D) high and expected to decline.
D) high and expected to decline. - This is about the inverse relationship between interest rates and bond prices. - As interest rates rise, bond prices fall. Conversely, when interest rates decline, bond prices increase. - If an investor buys bonds when the current interest rates are high, a future decline in those interest rates will cause the price of the bonds to increase. *PRICES AND INTEREST RATES HAVE INVERSE RELATIONSHIP!!!!!*
An economist is comparing the yields on 20-year U.S. Treasury bonds and AAA-rated corporate bonds with the same maturity. The economist is analyzing A) the risk spread. B) the value spread. C) the duration spread. D) the credit spread.
D) the credit spread - You should understand that the greater the risk, the higher the yield on the bond. - Many analysts compare the difference between yields on bonds with the same maturity but different quality (rating) to get a sense of the market sentiment. - One common measurement is the difference in yields between Treasuries and corporate bonds. - This difference is called the yield or credit spread and tends to widen when economic conditions sour and narrow when they get better.
