Unit 2
The price of which of the following will fluctuate most with a change in interest rates? A) Long-term bonds B) Money market instruments C) Short-term bonds D) Common stock
Answer: A) Explanation Long-term debt prices fluctuate more than short-term debt prices as interest rates rise and fall. LO 2.e
An investor purchasing 10 corporate bonds at a price of 102¼ each will pay A) $1,022.50. B) $10,225.00. C) $1,020.25. D) $10,202.50.
Answer: B) At 102¼, each bond costs $1,022.50 (102 = 1,020 and ¼ of $10 = $2.50). There are 10 bonds, so the total is $1,022.50 × 10 = $10,225. LO 2.c
Which of the following is unlikely to be issued at a discount? A) Zero-coupon bond B) Treasury bill C) Jumbo CD D) Commercial paper
Answer: C) Explanation 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. LO 2.k
The current yield of a callable bond selling at a premium is calculated A) to its maturity date. B) as a percentage of its par value. C) as a percentage of its market value. D) as a percentage of its call price.
Answer: C) Current yield for any security is always computed on the basis of the current market value. LO 2.e
Which of the following are general characteristics of negotiable jumbo CDs? A) Typically pay interest on a monthly basis B) Always mature in one to two years with a prepayment penalty for early withdrawal C) Trade only in the primary market D) Issued in amounts of $100,000 to $1 million
Answer: D) 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 one year or less. Being negotiable in the secondary market, there is no prepayment penalty. These CDs generally pay interest on a semiannual basis, not monthly. LO 2.k
Although there are a number of risks to owning a debt security that are common to all investors, which specific risk is avoided when a U.S. resident purchases a Eurodollar bond? A) Currency risk B) Inflation risk C) Default risk D) Interest rate risk
Answer: A) Eurodollar bonds are denominated in dollars; therefore, no currency risk exists for a U.S. resident. LO 2.i
If an investor pays 95.28 for a Treasury bond, how much did the bond cost? A) $958.75 B) $95.28 C) $9,528.00 D) $950.28
Answer: A) Treasury bonds are quoted as a percentage of par ($1,000) plus 32nds. In this case, the price is $950 plus 28/32 (i.e., ⅞) of $10, for a total of $958.75. LO 2.c
A respected analyst reports that last week's T-bill rate at 6% is lower than the rate for the preceding week and lower than the average for the past month. Which of the following is true? A) Stock prices are rising. B) Investors are paying less for T-bills. C) Investors are paying more for T-bills. D) The general level of interest rates is increasing.
Answer: C) Explanation When the rate is lower, the price has gone up; this means investors are paying more as interest rates are going down. There is nothing in this question that gives us enough information to evaluate the movement of stock prices. LO 2.f
A bond purchased at $900 with a 5% coupon and a five-year maturity has a current yield of A) 5.00%. B) 7.80%. C) 7.40%. D) 5.56%.
Answer: D) 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. LO 2.e
Which of the following projects is most likely to be financed by a general obligation rather than a revenue bond? A) Expansion of an airport B) Public library C) Municipal hospital D) Public golf course
Answer: B) Hospitals, airports, and golf courses all generate revenue and can be financed with revenue bond issues. Public libraries are financed through general obligation (GO) bond sales with the backing of taxes. LO 2.h
A company currently has earnings of $4.00 and pays a $0.50 quarterly dividend. If the market price is $40, what is the current yield? A) 10.00% B) 15.00% C) 5.00% D) 1.25%
Answer: C) Explanation The quarterly dividend is $0.50, so the annual dividend is $2.00; $2 ÷ $40 (market price) = 5% annual yield (current yield). LO 2.e
Which type of risk is a mortgage-backed security most likely to experience? A) Market risk B) Business C) Exchange-rate risk D) Reinvestment risk
Answer: D) Explanation A mortgage-backed security, such as a Ginnie Mae, is most likely to experience reinvestment-rate risk. As mortgages are paid off early and refinanced in the event of declining interest rates, the interim cash flows received from the obligation must be reinvested in lower-yielding securities. This is the practical effect of prepayment risk. LO 2.f
The net asset value of an international bond fund can be expected to increase if which of these occur? I. Interest rates rise abroad. II. Interest rates fall abroad. III. The U.S. dollar strengthens. IV. The U.S. dollar weakens. A) II and IV B) II and III C) I and III D) I and IV
Answer: A) Explanation If interest rates fall, bond prices will rise, thus increasing the NAV of a bond portfolio. If the U.S. dollar weakens, the value of other currencies will rise. This would also increase the NAV for a portfolio of international bonds. LO 2.i
Bond prices are quoted as a percentage of A) par value. B) conversion value. C) stated value. D) market value.
Answer: A) Explanation Bond prices are quoted as a percentage of par value. On the exam, the par value of bonds is always $1,000. LO 2.c
Which of the following is not a money market instrument? A) Banker's acceptances B) Treasury bills C) Newly issued Treasury notes D) Commercial paper
Answer: C) Commercial paper, Treasury bills, and banker's acceptances are debt instruments with maturities of one year or less and are therefore money market instruments. A newly issued Treasury note would have a maturity of two to 10 years and therefore would not be a money market instrument. LO 2.k
A client has indicated that his primary objective is maximizing current income regardless of the risk. Which of the following mutual funds would probably be most suitable for achieving that goal? A) DEF High-Yield Bond Fund B) JKL Municipal Bond Fund C) ABC Growth and Income Fund D) GHI Index Fund
Answer: A) High-yield (junk) bonds, although carrying more risk, produce higher current income than other funds. LO 2.b
MNO is planning to raise capital through an offering of 30-year bonds. Which call price would be most beneficial to MNO? A) 110 B) 102 C) 106 D) 104
Answer: B) 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. LO 2.j
An investor purchased a 20-year bond with a duration of 11 years for $1,323.18. Which of these statements is correct? A) The coupon rate is higher than the YTM, and the YTM is higher than the current yield. B) The current yield is higher than both the coupon rate and the YTM. C) The yield to maturity (YTM) is less than both the current yield and the coupon rate. D) The coupon rate is lower than the YTM, and the current yield should be higher than the coupon rate.
Answer: C) Explanation CR = coupon rate CY = current yield YTM = yield to maturity Premium bonds: CR > CY > YTM Par bonds: CR = CY = YTM Discount bonds: CR < CY < YTM Because the bond was purchased at a premium, the yield to maturity is less than both the current yield and the coupon rate. The duration has nothing to do with the question. LO 2.e
Which of the following would be most likely to increase a bond's liquidity? A) A higher rating B) No call protection C) A longer maturity D) A lower rating
Answer: A) 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 is, the greater the chance is 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. The absence of call protection is negative to many investors, thus limiting the number of potential investors. LO 2.b
Municipal bonds are often called tax-exempts. This refers to the exemption of their income from A) federal income taxes. B) federal estate taxes. C) state income taxes. D) state, federal, and inheritance taxes.
Answer: A) Municipal bonds are often called tax-exempts. This refers to the exemption of their income from A) federal income taxes. B) federal estate taxes. C) state income taxes. D) state, federal, and inheritance taxes.
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? A) Bond C, CCC rated corporate debenture with an 8.00% coupon rate B) Bond A, A-rated corporate debenture with a 6.50% coupon rate C) Bond B, BBB rated municipal bond with a 3.75% coupon rate D) Bond D, AAA rated Treasury note with a 2.55% coupon rate
Answer: B) Explanation 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% LO 2.h
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 A) the coupon return. B) the yield to maturity. C) the price return. D) the income return.
Answer: B) Explanation 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. LO 2.e
All of the following are true of negotiable, jumbo certificates of deposit except A) they are usually issued in denominations of $100,000 to $1 million or more. B) they are secured obligations of the issuing bank. C) they are readily marketable. D) they usually have maturities of one year or less.
Answer: B) Explanation 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. LO 2.k
Money market investments consistently fulfill all these roles within a client's portfolio except A) serve as an alternative to bonds and equities in a multi-asset class portfolio to lower the overall volatility. B) serve as a short-term home for cash balances. C) outperform the stock market. D) earn higher returns than cash.
Answer: C Money market investments can fulfill a number of roles within a client's portfolio, including short-term allocation for cash balances; serving as an alternative to bonds and equities in a multi-asset class portfolio to lower the overall volatility of the portfolio; and serving as part of the asset allocation strategy to get higher returns than they would receive on cash. LO 2.k
A money market mutual fund would be least likely to invest in which of the following assets? A) Jumbo CDs B) Newly issued U.S. Treasury bills C) Newly issued U.S. Treasury notes D) Repurchase agreements
Answer: C) Explanation A money market mutual fund typically invests in money market instruments—those with a maturity date not exceeding 397 days. Treasury notes are issued with maturity dates of 2-10 years. LO 2.k
All of the following statements regarding Government National Mortgage Association (GNMA) pass-through securities are true except A) the minimum initial investment is $1,000. B) investors receive a monthly check representing both interest and a return of principal. C) GNMAs are considered to be the riskiest of the agency issues. D) investors own an undivided interest in a pool of mortgages.
Answer: C) Explanation GNMA securities, which are backed by the full faith and credit of the U.S. government, are considered to be the safest, not riskiest, of the agency issues. The minimum denomination is $1,000 and payments to investors are made monthly. Because the asset is a pool of mortgages, just like a personal home mortgage, each payment consists of interest and principal. LO 2.f
The GHIJ Corporation has a 3% convertible debenture outstanding with a conversion price of $40. The bond's current market price is 126. The most probable reason for this is A) interest rates have risen since the debenture was issued. B) the current market price of the GHIJ common stock is approximately $35 per share. C) the current market price of the GHIJ common stock is approximately $50 per share. D) GHIJ's earnings have risen since the debenture was issued.
Answer: C) With a conversion price of $40, the bond is convertible into 25 shares. Convertible securities generally sell at a slight premium to their parity price, which—at $1,260—would be $50.40 per share. LO 2.d
Richard purchased a 30-year bond for 103½ with a stated coupon rate of 8.5%. What is the approximate yield to maturity for this investment if Richard receives semiannual coupon payments and expects to hold the bond to maturity? A) 9.36% B) 8.50% C) 8.68% D) 8.19%
Answer: D) Explanation No calculation is necessary here. Why not? Because anytime a bond is purchased at a premium over par (103½% is a premium), the YTM must be less than the nominal (coupon) rate. There is only one choice lower than 8.5%. It isn't about your computational skills; it is about your understanding of the relationship between prices and yields. LO 2.e
An investor interested in investing in sovereign debt would most likely purchase A) bonds backed by gold sovereigns. B) bonds issued by the Bank of the United States. C) European Central Bank debt issues. D) Sweden 2.5s of 2032.
Answer: D) Explanation Sovereign debt refers to bonds and other debt instruments issued by a specific country. The European Central Bank manages the currency of the many countries that have adopted the euro. There is no such thing as the Bank of the United States, and gold sovereigns are coins—they are not used to back debt. LO 2.i
An investor is analyzing various risks related to corporate and government bonds. She is interested in finding a risk that is more specific to corporate bonds than to government bonds. Which of the following options correctly defines that risk? A) Default risk B) Interest rate risk C) Liquidity risk D) Purchasing power risk
Answers: A) Explanation Default risk is avoided with U.S. government bonds. There is no chance (at least for test purposes) that timely payment of interest and principal will not be made on them. All bonds have interest rate and purchasing power risk. Although it is true that government bonds are generally more liquid than corporate bonds, many corporate bonds are exchange listed. That ensures good liquidity. More important is the test-taking skill. If you have to choose between lack of credit risk and lack of liquidity, it should be clear where the government bond comes out ahead. LO 2.g
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) 8.67% B) 8.50% C) 5.68% D) 4.36%
Answer: A) Explanation 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 of the relationship between prices and yields. LO 2.e
A TIPS bond is issued in the principal amount of $1,000, paying 3.5%. Over the security's 5-year term, the annual inflation rate is 6%. What is the principal value of the bond at the end of 4 years? A) $1,240 B) $1,344 C) $1,300 D) $1,267
Answer: D) The unique feature of a TIPS bonds is its semiannual adjustment to principal based on the inflation rate. With an annual inflation rate of 6%, there is a 3% increase to the principal value every 6 months. The arithmetic is $1,000 multiplied by 103% consecutively 8 times (there are 8 semiannual periods in 4 years). Be sure to stop at 4 years—the question doesn't ask for the ending value for the 5th year. If this math is too challenging, there is a simple method that always works. That simple method has you take the annual inflation rate (6% = $60) for 4 years ($240) and add that to the original $1,000 face value. That is $1,240, and the correct answer on the exam will always be the next higher number ($1,267 in this case). This simple step means you are calculating the simple interest while the bond's principal growth is actually compounding.
One of the advantages of owning a corporation's debentures is that you have prior claim over A) general creditors. B) employees. C) secured creditors. D) preferred stockholders.
Answer: D) Holders of a company's debentures are general creditors and, as such, have prior claim only over equity holders. LO 2.g
When discussing convertible debt securities, it would be incorrect to state that A) the issuer pays a lower interest rate. B) holders receive a higher interest rate. C) holders may share in the growth of the common stock. D) holders have a fixed interest rate.
Answer: B) Explanation Because of the possibility of participating in the growth of the common stock through an increase in the market price of the common, the convertible can be issued with a lower interest rate. LO 2.j
To secure the debt that a subsidiary is offering, a railroad holding company transfers to a trustee the common stock of another subsidiary. The offering is one of A) equipment trust certificates. B) collateral trust certificates. C) guarantee trust bonds. D) secured income notes.
Answer: B) When a company uses the securities of one subsidiary to collateralize a bond issue of another subsidiary, the bonds are known as collateral trust certificates. LO 2.g
Which of the following debt instruments generally presents the least amount of default risk? A) Convertible senior debentures B) Municipal revenue bonds C) High-yield corporate bonds D) Municipal general obligation bonds
Answer: D) Because the full taxing power of the municipality backs a general obligation municipal bond, it will exhibit the least amount of default risk. A corporate debenture is an unsecured bond with a potentially greater degree of risk, as is a junk or high-yield corporate bond. LO 2.h
One year ago, ABC Widgets, Inc., funded an expansion to its manufacturing facilities by issuing a 20-year first mortgage bond. The bond is secured by the new building and land and is callable at par 15 years after the issue date. The bond was issued with a 5.5% coupon and is currently rated Aa. If the current market price of the bond is 105, A) the yield to call is lower than the yield to maturity. B) the nominal yield is lower than the current yield. C) the yield to call is higher than the current yield. D) the yield to maturity is higher than the current yield.
Answer: A) Explanation When a bond is selling at a premium (105 means 105% of $1,000, or $1,050), the order—from highest to lowest yield—is nominal (coupon) yield, current yield, YTM, and YTC. If the bond is callable at a premium, the order could be changed, but it is highly unlikely that the exam will present that situation in a question. LO 2.e
A client approaches the investment adviser representative handling the advisory account with a request to find a preferred stock that will offer a 6% income return. The investment adviser representative suggests a stock paying a $0.28 quarterly dividend. That stock will exactly meet the income objective if it has a current market price of A) $4.67. B) $18.67. C) $11.91. D) $6.72.
Answer: B) Explanation The first thing to do is annualize the dividend by multiplying the $0.28 by 4. Once we have the annual dividend of $1.12, divide by 6% and the result is $18.6666, or $18.67 properly rounded. If you left your math skills at home, all you have to do is multiply each of the choices by 6% to see which one is closest to $1.12. LO 2.e
When a U.S. resident investor purchases foreign bonds, A) appreciation of both the bonds and the foreign currency benefits the domestic investor. B) appreciation of the bonds and depreciation of the foreign currency benefit the domestic investor. C) depreciation of both the bonds and the foreign currency benefits the domestic investor. D) depreciation of the bonds and appreciation of the foreign currency benefit the domestic investor.
Answer: A) Explanation In the same manner that purchasing foreign equities adds diversification to a portfolio, purchasing foreign bonds does as well. As with any security, if the value goes up (it appreciates), that is a benefit to the investor. When foreign securities are involved, there is another concern—currency risk. Because the foreign bond is denominated in the local currency, an increase in that currency's value versus the U.S. dollar means the semiannual interest payments will translate into more dollars. At maturity, the return of principal will be higher as well. Of course, it can go the other way if the market value or the foreign currency depreciates against the dollar. LO 2.i
The term Eurodollars refers to A) obsolete currency that was formerly backed by the gold standard. B) a worldwide currency system that is expected to someday replace existing currency systems. C) American dollars held by banks in other countries, especially in Europe. D) European currency held in U.S. banks.
Answer: C) Explanation American dollars held in international banks, especially—but not exclusively—in Europe, are known as Eurodollars. LO 2.i
One of the benefits of adding foreign debt securities to an investor's portfolio is A) receiving income in foreign currency. B) potentially higher risk. C) reduced taxation. D) potentially higher yields.
Answer: D) The interest rates paid on debt in many foreign countries, especially those in emerging economies, is higher than that available domestically. The tradeoff is higher risk. Receiving interest payments in foreign currency involves not only currency risk but the added expense of conversion into U.S. dollars. (ADRs are for equity, not debt securities.) In many cases, investors pay both foreign and U.S. tax on the interest. LO 2.i
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? A) Both bonds will be selling at a discount. B) Bond B will be selling at a greater premium than Bond A. C) The issuer will attempt to call in Bond A. D) Bond B will be selling at a greater discount than Bond A.
Answer: B) Explanation 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. LO 2.e
A bond with a par value of $1,000 and a coupon rate of 6% paid semiannually is currently selling for $1,200. The bond is callable in 15 years at 105. In the computation of the bond's yield to call, which of these would be a factor? A) Interest payments of $30 B) Future value of $1,200 C) Present value of $1,050 D) 15 payment periods
Answer: A) The yield to call (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 a 6% coupon will make $30 semiannual interest payments. With a 15-year call, there are 30 semiannual payment periods, not 15. The present value is $1,200 and the future value is $1,050, which is the reverse of the numbers indicated in the answer choices.
Your client is interested in investing in preferred stocks in an effort to receive dividend income. The client's target goal is a 6% current return on investment (ROI). If the RIF Series B preferred stock is paying a quarterly dividend of $0.53, your client's goal will be achieved if the RIF can be purchased at A) $22.55. B) $35.33. C) $8.83. D) $50.00.
Answer: B) First, take the quarterly dividend and annualize it (4 × $0.53 = $2.12). Dividing that number by 6% gets you $35.3333, which rounds down to $35.33. Alternatively if you wish (but which takes more time), multiply each of the choices by 6% to see which of them equals $2.12. LO 2.e
Which of the following statements regarding U.S. government agency securities is true? A) They are direct obligations of the U.S. government. B) They generally offer higher yields than direct U.S. obligations. C) Interest received on agency securities is exempt from federal income tax. D) They generally trade on the major stock exchanges.
Answer: B) In most cases, securities issued by U.S. government agencies are obligations of that agency rather than the U.S. government. As such, they carry slightly higher risk, and that means investors demand a higher return. They do not trade on any exchange. Their interest, like that of all U.S. government securities, is taxable on the federal level while being tax exempt on the state level. LO 2.f
DERP Corporation's 5% convertible debentures maturing in 2030 are currently selling for 120. The conversion price is $40. One would expect the DERP common stock to be selling A) somewhat above $48 per share. B) somewhat above $30 per share. C) somewhat below $30 per share. D) somewhat below $48 per share.
Answer: D) 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 $1,200, the parity price of the stock would be $48. Because convertible securities generally sell at a slight premium over their parity price, the stock should have a current market value a bit less than $48 per share. LO 2.d
What is the name of the bond document that states the issuer's obligation to pay back a specific amount of money on a specific date? A) The bond coupon B) The bond agreement C) The debenture D) The indenture
Answer: D) The indenture is the contract that sets forth the promises of the issuer of the bond and the rights of the lenders (the investors). A debenture is an unsecured long-term debt security (that has an indenture). One of the details in the indenture is the coupon (interest) rate that will be paid on the loan. LO 2.a
When an investor notices that a bond's coupon yield is lower than its current yield, this is an indication that the bond A) is in danger of going into default. B) is nearing its maturity date. C) is selling at a discount. D) is selling at a premium.
Answer: C) Explanation A bond's current yield is the coupon (nominal) yield divided by the current market price. When those two are the same, the bond is selling at its par (face) value. When selling below par (at a discount), the coupon yield will be lower than the current yield (if you pay less, you get more). Although a bond's market price will generally get closer to par as the maturity date approaches, anytime the price of the bond is below par (selling at a discount), its current yield will be higher than the coupon. LO 2.e
A corporation is capitalized with common stock, senior preferred stock, mortgage bonds, and subordinated debentures. Your client, who holds $10,000 of the debentures, is concerned about the future viability of the enterprise. You can inform the client that the debentures have a claim A) behind the bonds, the preferred stock, and the common stock. B) ahead of the common stock but after the preferred stock and the bonds. C) ahead of the common stock and the preferred stock but after the bonds. D) ahead of the common stock, the preferred stock, and the bonds.
Answer: C) Explanation Any debt security, even a subordinated debenture, has a claim ahead of all equity. However, it is subordinated to all other debt. LO 2.g
A client is in the 28% marginal federal income tax bracket and the 3% state income tax bracket. Which of the following investments would produce the highest after-tax yield for the client? A) A public-purpose municipal bond yielding 6% B) A AAA rated debenture yielding 7.75% C) An A-rated corporate mortgage bond yielding 8% D) A U.S. Treasury note yielding 7%
Answer: A) Explanation Because your client is in the 28% tax bracket, she has to earn more than the 6% on a taxable bond for the yield to be equal to, or higher than, the tax-free bond. That number can easily be calculated because 72% of the taxable amount must be equal to or greater than the 6% return (6% ÷ 72% = 8.33%). The 8.33% is higher than the return on the other bonds listed, so the public-purpose municipal bond would produce the highest retained return. This would be even more appropriate if the issue was tax exempt in the client's state. LO 2.h
What rate of interest would a bank in England charge another British bank for a short-term loan? A) SOFR B) Prime rate C) Fed funds rate D) Discount rate
Answer: A) SOFR Explanation 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. LO 2.k
Which of the following best describes a Yankee bond? A) U.S. dollar-denominated bond issued by a U.S. entity inside the United States B) U.S. dollar-denominated bond issued by a non-U.S. entity outside the United States C) U.S. dollar-denominated bond issued by a U.S. entity outside the United States D) U.S. dollar-denominated bond issued by a non-U.S. entity inside the United States
Answer: D) Explanation Yankee bonds are issued by non-U.S. entities in marketplaces inside the United States. The bonds are issued in U.S. dollars, meaning these foreign issuers will have currency risk if the dollar drops in value against their local currency. LO 2.i
Probably the most significant characteristic of municipal bonds for investors is A) their safety. B) their exemption from federal income tax. C) their exemption from registration on the state and federal level. D) that their coupon yields are higher than comparably rated corporate issues
Answer: B) Municipal bonds are unique in that their interest is not subject to federal income tax. As a result, their coupon yields are generally lower than corporate bonds with a similar rating; you get to keep all of the interest instead of paying taxes on it. The fact that they are exempt from registration with state and federal agencies is of little, if any, consequence to the typical investor. Although they tend to be quite safe, if safety is the primary concern, the investor would turn to U.S. Treasuries or government agency securities. LO 2.h
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 A) 4.00%. B) slightly more than 5.33%. C) approximately 12.90%. D) slightly less than 5.33%.
Answer: B) Explanation 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) also 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. LO 2.h
When a bond is selling at a premium, a bond callable at par will A) have a YTC that is more than the coupon. B) have a YTM that is more than the coupon. C) have a current yield that is less than the YTM. D) have a YTC that is less than the YTM.
Answer: D) Explanation A bond selling at a premium will always have a yield that is lower than the coupon. The highest of the computed yields will be the current yield because, unlike the YTM or the YTC, the loss at payoff of the principal is not included. Comparing YTM and YTC, because in both cases the investor is getting back the same par value, the YTC is lower because the loss is occurring sooner (bonds are always called prior to maturity). LO 2.e
ABC's stock has paid a regular dividend every quarter for the past several years. If the price of the stock has remained the same over the past year but the dividend amount per share has increased, it may be concluded that ABC's A) current yield per share has decreased. B) current yield per share has been unaffected. C) current yield per share has increased. D) yield to maturity has gone up
Answer: C) Explanation The current yield would have increased because current yield is the income (dividend) divided by price. A higher dividend divided by the same price results in a higher yield. Stocks do not have a yield to maturity. LO 2.e
Securities issued by which of the following agencies offer direct government backing? A) Federal Home Loan Mortgage Corporation (Freddie Mac) B) Federal National Mortgage Association C) Government National Mortgage Association D) Federal Intermediate Credit Bank
Answer: C) Explanation 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. LO 2.f
Securities issued by which of the following issuers have the direct backing of the U.S Treasury? A) Federal National Mortgage Association (Fannie Mae) B) Federal Agricultural Mortgage Corporation (Farmer Mac) C) Government National Mortgage Association (Ginnie Mae) D) Federal Home Loan Mortgage Corporation (Freddie Mac)
Answer: C) Bonds issued or guaranteed by the Government National Mortgage Association (Ginnie Mae) are backed by the "full faith and credit of the U.S. government," just like U.S. Treasuries. Bonds issued by government-sponsored enterprises (GSE), such as the Federal National Mortgage Association (Fannie Mae), the Federal Home Loan Mortgage Corporation (Freddie Mac), and the Federal Agricultural Mortgage Corporation (Farmer Mac), are not backed by the same guarantee those issued by federal government agencies. Bonds issued by GSEs carry credit risk. The GSEs are publicly traded companies whose shares are registered with the SEC. LO 2.f
The value of which of the following would be least likely to be impacted by changes in interest rates? A) A U.S. Treasury bond issued 25 years ago with a 30-year maturity B) A bank CD maturing in 5 years C) A laddered bond portfolio D) A convertible preferred stock
Answer: B) Explanation 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.
Which of the following statements regarding convertible bonds is not true? A) The conversion rate is set at issuance and does not change. B) If there is no advantage to converting the bonds into common stock, they would sell at a price based on their market value without the convertible feature. C) Coupon rates are usually higher than nonconvertible bond rates of the same issuer. D) Convertible bondholders are creditors of the corporation.
Answer: C) Because convertible debentures offer investors the opportunity to gain from increases in the issuer's common stock, those investors are willing to accept a lower coupon (interest rate) than debt securities without the convertible feature. Debentures are debt securities, making their holders creditors of the issuer. At the time the debenture is issued, the bond indenture indicates the conversion rate. That rate is fixed and does not change over the life of the security. In general, the conversion feature will be exercised only if the market price of the underlying stock has risen to the point where the investor is better off owning the stock than the debenture. One of the benefits of owning this security is that, as a debt instrument, if the stock price falls below the conversion price, the debenture will trade in the market like a comparable nonconvertible issue. That is, it will trade at a market price offering a yield similar to nonconvertible debt securities of the same quality and maturity. LO 2.j
In general, among the advantages to investing in Brady bonds over those issued by countries classified as emerging economies is A) higher yields. B) shorter maturities. C) increased liquidity. D) greater risk.
Answer: C) Brady bonds are issued to take over the debt of failing commercial loans in emerging economies. They are secured by collateral—often U.S. Treasury zero-coupon bonds—thereby making them more secure than direct issues of that country. This backing also increases the liquidity as there is a larger pool of potential investors. These benefits cause the yields to be lower—less risk, less reward. There is nothing unique about the maturities of Brady bonds. LO 2.i
You are meeting with a relatively unsophisticated investor who doesn't understand very much about stocks and bonds. The investor asks, "Can you list the advantages of owning common stock as compared to bonds?" Among other reasons, you could reply that A) bonds have priority over any equity security in the event of liquidation. B) there is limited liability. C) bonds must be surrendered at maturity or at a call while the owner of common stock can hold the investment as long as desired. D) income payments are more reliable.
Answer: C) One negative of owning bonds is that the bond will ultimately mature or be called and the bondholder has no choice but to surrender the security. With common stock, the investor has total control over the length of the holding period. Although there are many benefits to owning bonds compared to common stock, among them is priority in the event of liquidation and regular payment of interest. Yes, common stock has limited liability, but the same is true of bonds; if the company goes under, the bondholder's maximum loss is the investment. Even then, because of the seniority of bonds, it is less likely that the entire investment will be lost. LO 2.j
A European corporation seeking a short-term loan would probably be most concerned about an increase to A) the Fed funds rate. B) the eurobond rate. C) the U.S. Treasury bill rate. D) the SOFR.
Answer: D) Explanation 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. LO 2.k
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 A) $156.25 per share. B) $125.00 per share. C) $64.00 per share. D) $100.00 per share.
Answer: D) What does parity mean? It means that two things have equal value. What two 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. However, that conversion is not based on a market price, which can fluctuate every day; it is based on the amount of 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). LO 2.d
Which of the following statements regarding a $1,000 corporate 8.50% bond offered at 110 is true? A) The bond is a discount bond. B) The bond's current yield is calculated by dividing its annual interest by its current market price. C) The bond's current yield is lower than its yield to maturity. D) To determine the bond's current yield, its stated rate must be compared against other fixed-rate investments in the client's portfolio.
Answer B) Explanation 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). LO 2.e
What would likely happen to the market value of existing bonds during an inflationary period coupled with rising interest rates? A) The price of the bonds would decrease. B) The nominal yield of the bonds would increase. C) The price of the bonds would increase. D) The price of the bonds would stay the same.
Answer: A) Bond prices fall when interest rates rise because bond prices have an inverse relationship with interest rates. LO 2.e
Which of the following would you not expect to see issued at a discount? A) Bank jumbo CD B) Commercial paper C) Treasury bill D) Zero-coupon bond
Answer: A) Of these securities, only the bank jumbo (negotiable) CDs are always interest bearing and issued at par or face value. LO 2.k
The owner of a convertible debt issue A) is a creditor of the issuer. B) has the choice of receiving the bond's interest or dividends on the underlying stock, whichever is higher. C) is generally in a senior position to other bondholders. D) generally expects a higher current return than with a nonconvertible bond of the same quality and maturity.
Answer: A) The owner of any bond is a creditor of the issuer. Dividends are paid only on stock, and the investor will have to convert in order to be a stockholder. Because of the growth potential of the common stock, holders of convertible securities invariably accept a lower coupon rate resulting in a lower current yield (return). In almost all cases, convertible debt securities are debentures and, therefore, junior to secured bonds. LO 2.g
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 A) 2.4 shares. B) 20 shares. C) 24 shares. D) 20 shares plus cash for fractional shares.
Answer: B) Explanation 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. LO 2.d
A new client is looking for a recommendation. The client is 72 years old, has sufficient income from Social Security, and has a pension plan to cover all of her living expenses. She has just inherited $100,000. She wants to invest this money to have a bit more income so she can spoil her grandchildren. Which of the following would be antipodal to her wishes? A) Jumbo CDs B) Treasury STRIPS C) Public utility stock D) Treasury bonds
Answer: B) If she wants additional income, she cannot get that from Treasury STRIPS. They are zero-coupon bonds and pay nothing until maturity. LO 2.j
Which two of the following investments would offer your clients the best chance of minimizing inflation risk? Common stock Callable preferred stock Money market mutual funds TIPS A) III and IV B) I and IV C) II and III D) I and II
Answer: B) Explanation Historically, common stock has been the best hedge against inflation. TIPS (Treasury Inflation-Protected Securities) are government-guaranteed debt issues that automatically adjust the principal based upon the inflation rate. LO 2.f
If a customer buys a 6% bond maturing in eight years on a 7.33 basis, the price of the bond is A) inverted. B) below par. C) at par. D) above par.
Answer: B) A bond with a basis, or yield to maturity, greater than its coupon is trading at a discount, or below par. LO 2.e
The current yield on a bond with a coupon rate of 7.5% currently selling at 105½ is approximately A) 7.50%. B) 7.11%. C) 6.50%. D) 8.00%.
Answer: B) A bond with a coupon rate of 7.5% pays $75 of interest annually. Current yield equals annual interest amount divided by bond market price, or $75 ÷ $1,055 = 7.109%, or approximately 7.11%. LO 2.e
A bond is selling at a premium over par value. Therefore, A) its yield to maturity is greater than its current yield. B) its current yield is less than its nominal yield. C) none of these are correct. D) its nominal yield is less than its current yield.
Answer: B) Explanation 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. LO 2.e
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 A) $80 per share. B) $125 per share. C) $100 per share. D) $64 per share.
Answer: C Explanation 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. LO 2.d
An investor in the 25% federal income tax bracket is considering the purchase of some fixed-income instruments. Which of the following would provide the investor with the greatest after-tax return? A) 5% U.S. Treasury bond B) 6% FDIC-insured CD C) 7% Ba rated corporate bond D) 4.8% AAA rated insured municipal bond
Answer: C) Explanation The greatest after-tax return is provided by the instrument listed that, after subtracting 25% for income tax, leaves the investor with the greatest amount. Because the Treasury bond, the CD, and the corporate bond are all taxable at the same rate, the 7% bond must be the best deal. Even though the municipal bond is not taxed, its 4.8% net yield is far lower than the 5.25% ($70 − 25% tax) return on the corporate bond. LO 2.h
Currently, a company issues 5% Aaa/AAA debentures at par. Two years ago, the corporation issued 4% AAA rated debentures at par. Which of the following statements regarding the outstanding 4% issue are true? The dollar price per bond will be higher than par. The dollar price per bond will be lower than par. The current yield on the issue will be higher than the coupon. The current yield on the issue will be lower than the coupon. A) II and IV B) I and IV C) I and III D) II and III
Answer: D) Explanation Interest rates in general have risen since the issuance of the 4% bonds, so the bond's price will be discounted to produce a higher current yield on the bonds. Remember that as interest rates go up, the price of outstanding debt securities goes down. LO 2.e
A mortgage-backed security (MBS), such as a Ginnie Mae, makes a combination principal and interest payment to an investor. This payment will be A) taxed as a capital gain if underlying mortgage is prepaid. B) tax free. C) taxed as ordinary income. D) partly taxed as ordinary income and partly a tax-free return of principal.
Answer: D) Explanation 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. LO 2.f
Regardless of the nature of the issuer, one thing an investor in debt securities can expect is A) physical coupons that are clipped every six months for interest payments. B) an interest rate that varies with changes to market interest rates. C) priority in payout second only to stock with a prior lien. D) a stated maturity date.
Answer: D) Explanation It would be very rare to find a debt security without a stated date indicating when the debt will be paid off (the maturity date). In the majority of cases, debt securities have a fixed interest rate (which is why they are called fixed-income securities). There are some with variable rates, but the question would have to indicate that exception. No stock of any kind has priority over a debt security. Prior to 1986, you would have physical coupons on the bond, but none of them have been issued since then. LO 2.a
A bond issued by the GEMCO Corporation has been rated BBB by a major bond-rating organization. This bond would be considered A) callable. B) a high-yield corporate bond. C) secured. D) an investment-grade corporate bond.
Answer: D) An investment-grade bond has a bond rating between AAA and BBB. Lower-rated bonds are considered high-yield bonds and are often referred to as junk bonds. The bond may or may not be secured; the rating does not indicate that fact. LO 2.b
