Unit 13 -

A corporation is likely to call eligible debt when interest rates are A) declining B) stable C) volatile D) rising

A A corporation generally calls in its debt when interest rates are declining, in order to replace old, higher interest rate debt with new, lower interest rate issues. U13LO8

When an investor divides the coupon rate of a municipal bond by the reciprocal of her tax rate, she is computing the bond's A) tax-equivalent yield. B) discounted cash flow. C) after-tax rate of return. D) inflation-adjusted return.

A The computation for the tax-equivalent yield of a municipal bond is performed by dividing the bond's coupon rate by the reciprocal of the investor's tax rate (1 - the investor's tax bracket). If the bond has a coupon of 4% and the investor is in the 20% bracket, the tax-equivalent yield is 4% divided by (1 - .20) or 4% divided by .80 = 5%. U13LO6

Which of the following is TRUE of a zero-coupon bond? I. The rate of return is locked in. II. There is no reinvestment risk. III. The imputed interest is taxed as ordinary income on an annual basis. IV. A check for the interest is paid at maturity. A) I, II, and III B) I, III, and IV C) I and IV D) I only

A Zero-coupon bonds pay no periodic interest and are always issued at a discount from par. The appreciation of the zero from its discounted purchase price to its face value is thought of as interest to the bondholder, but this annual "phantom income," so named because you don't receive it, is taxed as ordinary income on an annual basis. When the bond is purchased, the investor locks in that yield, and with nothing to reinvest, there is no reinvestment risk. U13LO8

Which two of the following investments would offer your clients the best chance of minimizing inflation risk? I. Common stock II. Callable preferred stock III. Money market mutual funds IV. TIPS A) II and III B) I and IV C) III and IV D) I and II

B Historically, common stock has been the best hedge against inflation. TIPS (Treasury Inflation Protection Securities) are government-guaranteed debt issues that automatically adjust the principal based upon the inflation rate. U13LO1

Market interest rates rise by 50 basis points. If each of these bonds has about the same maturity date, which of the following would decline the least? A) Treasury bond issued at par carrying a 6% coupon B) AA corporate bond carrying a 7% coupon C) Treasury bond issued at par carrying a 7% coupon D) AAA corporate bond carrying a 6% coupon

C All other factors being equal, bonds of higher quality experience less price volatility than do bonds of lower quality. Treasury securities have higher quality than other debt securities due to the elimination of default risk. When market interest rates rise, bonds having higher coupons will decline less than bonds having lower coupons. U13LO11

In general, from the choices given, the type of security offering the greatest degree of safety to an investor is A) a debenture B) preferred stock C) a mortgage bond D) common stock

C Debt securities, because they are an obligation of the issuer, are generally considered safer than equity securities. Secured debt is safer than unsecured debt. The only one of these debt obligations with pledged assets as security for the loan is the mortgage bond. Debentures are unsecured corporate debt obligations. U13LO3

Which of the following statements represents an advantage of a municipal general obligation bond over a revenue bond? A) A GO bond issuer is required to conduct a feasibility study. B) A GO bond is not charged against the municipality's borrowing limits. C) A GO bond generally involves less risk to the investor. D) Only a facility's users pay for a GO bond.

C GO bonds are generally less risky than revenue bonds because they are backed by taxes rather than revenues. U13LO5

The current yield on a bond with a coupon rate of 5.5% selling at 110 is A) 5.5% B) 6% C) 5% D) 2%

C 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 x 5.5%) divided by $1,100 and that equals 5%. U13LO10

A TIPS bond is issued in the principal amount of $1,000, paying 3.5%. Over the security's 5-year term, the inflation rate is 4%. What is the amount of the final semiannual interest check? A) $35.00 B) $42.66 C) $21.33 D) $17.50

C The semiannual interest of a TIPS bond is computed on the basis of the inflation-adjusted principal. Because the principal increases with the inflation rate, at the end of the 5-year term, it has grown to $1,219 ($1,000 × 102% ten times). Therefore, the final interest check is for $1,219 × 1.75% (remember that it is a semiannual check). The License Exam Manual (LEM) contains a step by step example of how this computation works. U13LO1

Which of the following is unlikely to be issued at a discount? A) Treasury bill B) Zero-coupon bond C) Commercial paper D) Jumbo CD

D Jumbo (negotiable) CDs are one of the few money market instruments issued at face value. Unlike those issued at a discount, they are interest bearing. U13LO13

Securities issued by which of the following agencies offer direct government backing? A) Federal Home Loan Mortgage Corporation (Freddie Mac) B) Government National Mortgage Association C) Federal National Mortgage Association D) Federal Intermediate Credit Bank

FNMA, FHLMC, and FICB are considered GSEs (government-sponsored enterprises), and although their securities are quite safe, they do not have the direct backing of the Treasury. It is important to remember for the exam that the only security without the word Treasury in its name that is backed by the U.S. government is a GNMA. U13LO1

One of the more popular money market instruments is the negotiable CD. These normally are found in minimum denominations of A) $100,000 B) $500,000 C) $25,000 D) $1,000,000

A Negotiable CDs, sometimes referred to as jumbo CDs, have a minimum denomination of $100,000. They are unsecured, interest-bearing obligations of banks. U13LO14

The most common collateral securing a Brady bond is A) the credit standing of the banking institution acquiring the Brady bond B) U.S. Treasury zero-coupon bonds with a maturity corresponding to the maturity of the individual Brady bond C) an asset, or group of assets, pledged by the borrowing entity D) the credit standing of the sovereign nation issuing the Brady bond

B Although other securities may be pledged, the most common is zero-coupon U.S. Treasuries, selected to mature at roughly the same time as the specific Brady bond. An investor purchasing a Brady with collateralized principal knows that, at maturity, a third-party paying agent will receive a payment from the U.S. Treasury that will be used to repay the principal on the Brady issue. In the event of default, the bondholder will receive the principal collateral on the maturity date. U13LO7

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 another state, his total tax-equivalent yield would be A) slightly more than 5.33% B) slightly less than 5.33% C) approximately 12.90% D) 4%

B When an individual owns a municipal bond issued in a state other than his state of residence, although the interest is tax free on a federal basis, it is taxable (at least in all cases on the exam) in that state. Therefore, the tax-equivalent yield here is slightly lower 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%, paying the state income taxes would decrease the yield slightly. U13LO6

Partners with the United States in the creation of Brady bonds were I. the International Monetary Fund (IMF) II. the Import/Export Bank III. the United Nations IV. the World Bank A) III and IV B) II and III C) I and IV D) I and II

C Joining in with the United States in creating Brady bonds were the IMF and the World Bank. U13LO7

When an investor owns a convertible security where, upon conversion, the account value would remain the same, it is considered that the convertible and the common are selling at A) the arbitrage level B) equivalent value C) parity D) the nominal yield

C Parity means equal. When one could convert the security and realize the same value, it is said that both are at parity. U13LO9

The market price of a convertible bond depends on all of the following EXCEPT A) the rating of the bond B) the value of the underlying stock into which the bond can be converted C) the conversion prices of bonds from similar companies D) current interest rates

C There are two factors that impact the current market price of all bonds: current interest rates and the rating of the bond. A third factor is unique to convertible bonds and that is the conversion value. The conversion value is based on the price of the underlying stock into which the bond can be converted. Comparing the conversion price of one issuer's bond to another's tells us nothing about the value of a specific bond. U13LO8

A $1,000 bond with a nominal yield of 8% will pay how much interest each year? A) $40.00 B) $160.00 C) $800.00 D) $80.00

D The nominal yield (or coupon rate) is the interest rate stated on the bond and is the rate the bondholder promises to pay on the bond until the bond matures. A $1,000 bond with an 8% nominal yield will pay $80 per year in interest. U13LO10

Which of the following debt instruments does not make periodic interest payments? A) TIPS B) T-bonds C) T-notes D) T-bills

D 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. U13LO1

Which of the following is TRUE of GNMA securities? I. Interest is subject to federal income tax. II. Interest is exempt from federal income tax. III. They are backed by farm mortgages. IV. They are backed by residential mortgages. A) I and IV B) II and III C) I and III D) II and IV

A Income received by investors in Government National Mortgage Association (GNMA) securities is subject to both state and federal income tax, and the asset backing them is residential mortgages. U13LO1

The portfolio manager of the Insatiate Bond Fund, an open-end investment company, believes that interest rates are going to increase in the near future. As such, it would be wise for that manager to A) shorten the average duration of the portfolio. B) shift into higher-rated bonds. C) lengthen the average duration of the portfolio. D) increase the equity portion of the portfolio.

A Increasing interest rates lead to declining bond prices, regardless of the ratings. This is interest-rate risk. Those bonds with the longest duration have the most sensitivity to that risk while short-term maturities are only slightly affected. Reducing the average duration of the portfolio means that the average maturities will be shortened, thus reducing the effects of an increase to interest rates. U13LO11

Mitch purchased a 30-year bond for 97¾ with a stated coupon rate of 8.5%. What is the approximate yield to maturity for this investment if Mitch receives semiannual coupon payments and expects to hold the bond to maturity? A) 8.50% B) 8.67% C) 4.36% D) 5.68%

B No calculation is necessary here. Why not? Because anytime a bond is purchased at a discount from par (97¾% is a discount), the YTM must be greater than the nominal (coupon) rate. There is only one choice greater than 8.5%. It isn't about your computational skills; it is about your understanding the relationship between prices and yields. U13LO10

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? A) 50 payment periods B) Present value of $1,080 C) Interest payments of $30 D) Future value of $1,300

C 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. U13LO10

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? A) Both will increase by the same amount B) Bond with the 5-year call C) Both will decrease by the same amount D) Bond with the 10-year call

D 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. U13LO11

Which of the following statements regarding corporate zero-coupon bonds is TRUE? A) They have lower price volatility than other bonds B) They are beneficial for investors in higher tax brackets C) Interest is paid semiannually. D) The discount is in lieu of periodic interest payments.

D 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. U13LO8

Which of the following bonds has the shortest duration? A bond with A) a 10-year maturity, 10% coupon rate. B) a 20-year maturity, 10% coupon rate. C) a 20-year maturity, 6% coupon rate. D) a 10-year maturity, 6% coupon rate.

A Two factors go into the computation of a bond's duration - the length to maturity and the coupon rate. When the maturities are the same, the bond with the highest coupon has the shortest duration. When the coupons are the same, the bond with the nearest maturity has the shortest duration. The 10% bond maturing in 10 years "wins" on both counts. It has the nearest maturity with the highest coupon. All else being equal, a bond with a longer duration will be more sensitive to changes in interest rates. U13LO11

When it comes to issuing a debt security, which of the following features will generally enable the issuing corporation to borrow at the lowest interest rate? A) Cumulative B) Convertible C) Callable D) Zero-coupon

B Because the convertible feature offers potential growth through the exercise of the conversion option, the interest rate on these securities is generally lower than other debt issues of the same corporation. The call feature increases the reinvestment risk and that is compensated for with a higher coupon. The descriptive adjective, cumulative, refers to dividend payments on preferred stock, but not to bonds. Because zero-coupon bonds pay nothing until maturity, that added risk requires a higher yield to attract investors. U13LO8

Corporate long-term debt securities that are issued on the general credit of the issuer and are NOT otherwise secured are called A) general obligation bonds B) debentures C) preferred stock D) prior lien bonds

B Debentures are corporate long-term debt securities issued on the general credit of the corporation and are not backed by any specific assets. The term prior lien means there is a secured claim against a specific asset. Preferred stock is not a debt security, and general obligation bonds are municipal, not corporate, securities. U13LO3

Which of the following would make a corporate bond more subject to liquidity risk? I. Short-term maturity II. Long-term maturity III. High credit rating IV. Low credit rating A) II and III B) I and III C) II and IV D) I and IV

C Liquidity risk is the risk that when an investor wishes to dispose of an investment, no one will be willing to buy it, or that a very large purchase or sale would not be possible at the current price. The available pool of purchasers for bonds with a low credit rating is much smaller than for those with investment-grade ratings (many institutions are only able to purchase bonds with higher credit ratings). As a result, the lower the credit rating, the greater chance of the bond having liquidity issues. Similarly, bonds with short-term maturities attract many more investors than those with long-term maturities, causing the long-term bonds to be less liquid. U13LO4

A method of assessing the value of a fixed-income security by looking at the future expected free cash flow and discounting it to arrive at a present value is known as A) current yield B) future value C) internal rate of return D) discounted cash flow

D The discounted cash flow, DCF, is used to assess the value of a fixed-income security by looking at the future expected free cash flow and discounting it to arrive at a present value. This is basically nothing more than taking the income payments you are scheduled to receive over a given future period and adjusting that for the time value of money. U13LO12

Which of the following statements regarding a $1,000 corporate 8.50% bond offered at 110 is true? A) The bond's current yield is calculated by dividing its annual interest by its current market price. B) To determine the bond's current yield, its stated rate must be compared against other fixed-rate investments in the client's portfolio. C) The bond is a discount bond. D) The bond's current yield is lower than its yield to maturity.

A A bond's current yield is calculated by dividing its annual interest by its current (market) price. In this case, it would be $85 ÷ $1,100. The current yield will be higher than its yield to maturity, which takes into consideration the $100 difference between the purchase price and the par value (a loss of $100). The determination of a bond's yield is unrelated to other bonds. In addition, this bond is selling at a premium (more than $1,000), not at a discount (less than $1,000). U13LO10

Which of the following are characteristics of commercial paper? I. It represents a loan by the holder to the issuer. II. It is a certificate of ownership in the corporation. III. It is commonly issued to raise working capital for a corporation. IV. It is junior in preference to convertible preferred stock. A) I and III B) II and IV C) I and IV D) II and III

A Commercial paper instruments are debt securities; they represent loans to the issuing corporation by the holder. They are commonly issued to raise working capital and, as debt obligation, are senior in preference to preferred stock in claims against an issuer. U13LO13

A bond with a par value of $1,000 and a coupon rate of 8% paid semiannually, is currently selling for $1,150. The bond is callable in 10 years at $1,100. In the computation of the bond's yield to call, which of these would be a factor? A) Interest payments of $40 B) 60 payment periods C) Present value of $1,100 D) Future value of $1,150

A 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. A bond with an 8% coupon will make $40 semiannual interest payments. With a 10-year call, there are only 20 payment periods, not 60. The present value is $1,150 and the future value is $1,100, the reverse of the numbers indicated in the answer choices. U13LO10

Current market interest rates are 6%. A bond with an 8% coupon would be most likely to have a net present value of zero when the bond's internal rate of return is A) 6%. B) 4%. C) 0%. D) 8%.

A The internal rate of return of a bond is the interest rate that makes the NPV of the investment equal to zero. When a bond is selling at its present value, the NPV is zero. A bond's present value should be equal to a market price giving a yield to maturity equal to the current market interest rates. Therefore, when current market interest rates are 6%, a bond with an 8% coupon should be selling at a price producing a YTM, or IRR of approximately 6%. U13LO10

Which of the following is not a component of the discounted cash flow method of determining the value of a fixed-income security? A) The discount rate B) The security's coupon C) The security's rating D) The security's maturity date

C The discounted cash flow method of valuing a fixed-income security discounts the investment's future cash flows to arrive at a present value. Those cash flows come from two sources. The first is the semiannual interest payments and the second is the final maturity payoff. Each of these is discounted using the required rate of return (usually the current market interest rate) and the result is the present value of those cash flows. The security's rating is not a factor in this computation although it may affect what investors are willing to pay for the security. U13LO12