Unit 2 Series 65
The term Eurodollars refers to A) American dollars held by banks in other countries, especially in Europe. B) a worldwide currency system that is expected to someday replace existing currency systems. C) European currency held in U.S. banks. D) obsolete currency that was formerly backed by the gold standard.
A) American dollars held by banks in other countries, especially in Europe. Explanation: American dollars held in international banks, especially—but not exclusively—in Europe, are known as Eurodollars.
Which of the following expressions describes the current yield of a bond? A) Annual interest payment divided by current market price B) Yield to maturity divided by par value C) Yield to maturity divided by current market price D) Annual interest payment divided by par value
A) Annual interest payment divided by current market price Explanation: The current yield on a bond is calculated by dividing the annual interest payment by the current market price of the bond.
Which of the following regarding corporate debentures are true? I. They are certificates of indebtedness. II. They give the bondholder ownership in the corporation. III. They are unsecured bonds issued to finance capital expenditures or to raise working capital. IV. They are the most senior security a corporation can issue.
A) I and III Explanation: Debentures are debt securities that represent unsecured loans of the issuer. They are senior to common and preferred stock in claims against an issuer. They are issued to finance capital expenditures or raise working capital.
A customer asks if there are any debt instruments providing income that might at least keep pace with inflation and offer some tax advantages. What suitable recommendation could be made that would meet the customer's criteria? A) TIPS B) ADRs C) GNMAs D) U.S. T-bills
A) TIPS Explanation: Treasury Inflation-Protected Securities (TIPS) are debt instruments specifically designed to provide income that keeps pace with inflation. Issued by the U.S. Treasury, the interest is tax exempt at the state and local levels. Neither GNMAs nor Treasury bills (T-bills) meet all of these criteria, and American depositary receipts (ADRs) are not debt instruments.
Which of the following statements is true if a corporate bond is callable? A) The issuing corporation has the option to redeem the bond before it matures. B) The owner of the bond may demand that the issuing corporation redeem the bond before it matures. C) The owner of the bond may exchange it for shares of stock. D) The issuing corporation may change the coupon rate at any time by giving the owner of the bond written notice.
A) The issuing corporation has the option to redeem the bond before it matures. Explanation: A callable bond is one that may be redeemed by the issuing corporation before it matures. One reason a corporation might call a bond is to sell new bonds with a lower interest rate.
DERP Corporation has issued 5% convertible debentures maturing in 2040. The conversion price is $40 and the common is currently trading at $48 per share. One would expect the DERP debentures to be selling somewhat A) above $1,200. B) below $1,200. C) below $1,000. D) above $1,000.
A) above $1,200. Explanation: 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 $48 per share, the parity price of the convertible would be $1,200 (25 × $48). Because convertible securities generally sell at a slight premium over their parity price, the debentures should have a current market value a bit higher than $1,200.
Treasury bills are A) issued in book-entry form. B) issued in bearer form. C) callable. D) issued at par.
A) issued in book-entry form. Explanation: All Treasury securities are issued in book-entry form. Treasury bills are always issued at a discount and are never callable.
A client in the 30% tax bracket owns a 5% XYZ, Inc., debenture due to mature shortly. What yield in a municipal bond will result in the same after-tax return that now exists has with the debenture? A) 2.0% B) 3.5% C) 5.3% D) 1.5%
B) 3.5% Explanation: The client's tax rate is 30%; 70% of 5% is 3.5%. A nontaxable municipal bond with a 3.5% yield would give the client the same return.
An investor interested in investing in sovereign debt would most likely purchase A) European Central Bank debt issues. B) Sweden 2.5s of 2032. C) bonds backed by gold sovereigns. D) bonds issued by the Bank of the United States.
B) Sweden 2.5s of 2032. 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.
If a company's dividend increases by 5% but its market price remains the same, the current yield of the stock will A) decrease. B) increase. C) remain at 7%. D) remain at 5%.
B) increase. Explanation: The current yield of a stock is the annual dividend divided by the market price. If a company's dividend increases and its market price remains the same, its current yield will increase.
In order to compute yield to maturity, all of the following are necessary except A) the current market price. B) the call price. C) the nominal yield. D) the maturity date.
B) the call price. Explanation: Computing the yield to maturity (YTM) does not require the call price or call date—that is necessary to compute the yield to call (YTC). We do need to know the current market price, the coupon (nominal yield), and the maturity date.
An investor buys 10M 6.6s of 10 at 67. The investor will receive annual interest of A) $820. B) $670. C) $660. D) $1,000.
C) $660. Explanation: Interpret "10M" as "$10,000 worth of." The investor receives the nominal yield of the bonds, which is 6.6% of $10,000. The M is from the roman numeral for 1,000.
A corporate bond that pays interest semiannually has a par value of $1,000, matures in five years, and has a yield to maturity of 10%. What is the value of the bond today if the coupon rate is 8%? A) $1,051.23 B) $1,221.17 C) $922.78 D) $1,144.31
C) $922.78 Explanation: How did we calculate that? We used a tool that you won't have available at the test center (a financial calculator), but there is a great tool you will have—common sense. When a bond has a yield to maturity that is greater than its coupon rate, the bond must be selling at a discount, and that only leaves one possible answer. The only way to get a 10% return on an 8% bond is to buy it at a price below par.
A client of yours owns some convertible preferred stock. She notices an article in the business section of her local newspaper that reports the company is going to pay a 20% stock dividend on their common stock. How will this affect her? A) More than likely, the price of the preferred stock will rise. B) She will also receive 20% more shares because preferred stock has a priority claim ahead of common. C) If there is an antidilution clause, her conversion privilege will permit her to acquire 20% more shares than before the stock dividend. D) There will be no effect.
C) If there is an antidilution clause, her conversion privilege will permit her to acquire 20% more shares than before the stock dividend. Explanation: Most convertible securities are sold with antidilutive clauses that provide for an adjustment in the number of shares based on stock splits or stock dividends.
On the initial public offering, an investor buys a $10,000 Aa-rated, 20-year corporate bond with a 4% coupon rate. One year later, the prevailing market rate is 5% and the bond has had its rating increased to Aa1. Which of the following statements is most likely true with reference to the current market price of this bond? A) The bond would be selling at par value. B) The bond would be selling at a premium. C) The bond would be selling at a discount. D) The yield to maturity of this bond is above 4%.
C) The bond would be selling at a discount. Explanation: When interest rates go up, bond prices go down. Had interest rates remained the same, the slight improvement in rating would have probably caused the bond to sell at a very slight premium, but that rating increase is not nearly strong enough to offset a 25% increase in market interest rates. Because this bond would be selling at a discount, its YTM would be above 4%, but the question is asking about the current market price, not the yield.
An investor owns a debenture convertible into 20 shares of the issuer's common stock. After a 2-for-1 stock split, the terms of the debenture provide for conversion into 40 shares. This is because the debenture has A) preemptive rights. B) increased its par value to $2,000 to account for the split. C) an antidilution clause. D) warrants attached.
C) an antidilution clause. Explanation: Most convertible securities are sold with antidilutive clauses that provide for an adjustment in the number of shares based on stock splits or stock dividends.
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 selling at a premium. B) is nearing its maturity date. C) is selling at a discount. D) is in danger of going into default.
C) is selling at a discount. 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.
A client is trying to decide between a par value corporate bond carrying a coupon rate of 6.25% per year and a par value municipal bond that pays an annual coupon rate of 4.75%. Assuming all other factors are equal and your client is in a 28% marginal income tax bracket, which bond do you tell the client to purchase and why? A) The municipal bond because its equivalent taxable yield is 6.30% B) The corporate bond because the after-tax yield is 4.50% C) The municipal bond because its equivalent taxable yield is 6.60% D) The corporate bond because the after-tax yield is
C)The municipal bond because its equivalent taxable yield is 6.60% Explanation: If we compute the tax-equivalent yield of the muni, we see that it is 6.60%, which is a higher return than the 6.25% on the corporate bond. The formula to get this starts by taking the investor's tax bracket and subtracting it from 100%. 100% − 28% = 72%. We then divide the muni coupon of 4.75% by the 72%, and the result rounds off to 6.6%.
An investor sells ten 5% bonds at a profit and buys another 10 bonds with a 5¼% coupon rate. The investor's yearly return will increase by A) $1.50 per bond. B) $1.00 per bond. C) $2.00 per bond. D) $2.50 per bond.
D) $2.50 per bond. Explanation: The first bonds are 5% and pay $50 per year per bond. The new bonds are 5¼% and pay $52.50 per year per bond. A 5% coupon rate × $1,000 face value = $50 per year per bond; a 5¼% coupon rate × $1,000 face value = $52.50 per year per bond.
An investor buys 10M RAN 6.6s of 32 at 67. What is the total purchase price? A) $6,600 B) $10,000 C) $10,200 D) $6,700
D) $6,700 Explanation: For those of you not familiar with bond listings, this means that the investor bought $10,000 (10M) of the RAN Corporation bonds with a 6.6% coupon (interest rate stated on the face of the bond) that mature in 2032 (32). The price is 67, which represents 67% of $10,000, or $6,700.
Which of the following indicates a bond selling at a discount? A) 7% coupon yielding 6.5% B) 10% coupon yielding 9% C) 5% coupon yielding 5% D) 7% coupon yielding 7.5%
D) 7% coupon yielding 7.5% Explanation: Whenever the yield is higher than the coupon, the bond is selling at a discount from the par value. When the question says "yielding," it is generally referring to the yield to maturity. However, whether referring to the YTM or the current yield, the answer here is the same: the yield is higher than the coupon.
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 stay the same. B) The price of the bonds would increase. C) The nominal yield of the bonds would increase. D) The price of the bonds would decrease.
D) The price of the bonds would decrease. Explanation: Bond prices fall when interest rates rise because bond prices have an inverse relationship with interest rates
Of the following securities, which is most commonly recommended to fund a child's college education? A) Treasury bills B) Investment-grade corporate bonds C) Municipal bonds D) Zero-coupon Treasury bonds
D) Zero-coupon Treasury bonds Explanation: Zero-coupon bonds, particularly those carrying the guarantee of the U.S. Treasury, are a favored investment vehicle for saving for a child's higher education. They have the advantage of providing a certain, quantifiable sum at a certain date in the future.
A client in the 28% marginal federal income tax bracket invests in a corporate bond with an 8% coupon. To calculate the client's after-tax rate of return, A) multiply 0.08 by 0.72. B) multiply 0.08 by 0.28. C) divide 0.08 by 0.72. D) divide 0.08 by 0.28.
A) multiply 0.08 by 0.72. Explanation: To determine a taxable bond's after-tax rate of return, multiply the coupon rate by the complement of the client's marginal federal income tax bracket. The client's tax bracket is 28% (0.28), so the complement is 100% − 28% (1.00 − 0.28) = 0.72.
The yield to maturity is A) the annualized return of a bond if it is held to call date. B) the annualized return of a bond if it is held to maturity. C) set at issuance and printed on the face of the bond. D) determined by dividing the coupon rate by the current market price of the bond.
B) the annualized return of a bond if it is held to maturity. Explanation: The yield to maturity reflects the annualized return of a bond if it is held to its maturity. The computation reflects the internal rate of return and is frequently referred to as the market required rate of return for a debt security. The rate set at issuance and printed on the face of the bond is the nominal or coupon rate. Dividing the coupon rate by the current market price of the bond provides the current yield. The return of a bond if it is held to the call date is the yield to call.
The longest initial maturity for U.S. T-bills is A) 39 weeks. B) 13 weeks. C) 52 weeks. D) 2 years.
C) 52 weeks. EAs money market instruments, the longest initial maturity of Treasury bills (T-bills) is 52 weeks. Those bills are auctioned every four weeks. T-bills of shorter maturities are auctioned weekly. The shortest initial maturity is four weeks.
Which of the following expressions describes the current yield of a bond? A) Yield to maturity divided by current market price B) Annual interest payment divided by par value C) Annual interest payment divided by current market price D) Yield to maturity divided by par value
C) Annual interest payment divided by current market price Explanation: The current yield on a bond is calculated by dividing the annual interest payment by the current market price of the bond.
If a customer buys a 6% bond maturing in eight years on a 7.33 basis, the price of the bond is A) above par. B) inverted. C) below par. D) at par.
C) below par. Explanation: A bond with a basis, or yield to maturity, greater than its coupon is trading at a discount, or below par.
An investor purchases a Treasury note and the confirmation shows a price of $102.25. Rounded to the nearest cent, the investor's cost, excluding commissions, is A) $102.25. B) $1,022.50. C) $1,020.25. D) $1,027.81.
D) $1,027.81 Explanation: Treasury notes are quoted in 32nds, where each 32nd equals $0.3125. The 102 in the quote equals $1,020 and the 25/32 is an additional $7.81, bringing the total to $1,027.81.
The current yield on a bond with a coupon rate of 5.5% selling at 110 is A) 5.0%. B) 6.0%. C) 5.5%. D) 2.0%.
A) 5.0%. Explanation: 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 × 5.5%) divided by $1,100, and that equals 5%.
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) 4.00%. B) slightly less than 5.33%. C) approximately 12.90%. D) slightly more than 5.33%.
B) slightly less than 5.33% Explanation: 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.
Your client in the 28% federal income tax bracket currently owns some U.S. government bonds with a coupon yield of 6%. In order to receive the same income after taxes, she would need to buy municipal bonds with a coupon of A) 6.00%. B) 1.68%. C) 4.32%. D) 7.68%.
C) 4.32% Explanation:Because the 6% on the government bond is fully taxable on a federal basis, the client receives a net of 4.32% ($60 per bond less 28% in taxes [$16.80], or $43.20 per year). Interest on municipal bonds is tax free, so a 4.32% coupon will result in the same amount of after-tax income.
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) Future value of $1,150 B) Present value of $1,100 C) Interest payments of $40 D) 60 payment periods
C) Interest payments of $40 Explanation: 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.
The term Eurodollars refers to A) European currency held in U.S. banks. B) a worldwide currency system that is expected to someday replace existing currency systems. C) obsolete currency that was formerly backed by the gold standard. D) American dollars held by banks in other countries, especially in Europe
D) American dollars held by banks in other countries, especially in Europe. Explanation: American dollars held in international banks, especially—but not exclusively—in Europe, are known as Eurodollars.
Which of the following debt instruments does not make periodic interest payments? A) TIPS B) T-notes C) T-bonds D) T-bills
D) T-bills Explanation: 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.
Treasury bills are A) issued in bearer form. B) callable. C) issued at par. D) issued in book-entry form.
D) issued in book-entry form. Explanation: All Treasury securities are issued in book-entry form. Treasury bills are always issued at a discount and are never callable.
Your client with $100,000 to invest is looking for maximum current income. Which of the following would offer the highest current return? A) $100,000 market value of corporate bonds selling at a premium and yielding 6% to maturity B) $100,000 AA rated corporate bonds trading at par with a 6% coupon rate C) $200,000 of utility common stock paying a current dividend of 3.5% D) $100,000 of zero-coupon bonds with a yield to maturity of 6%
A) $100,000 market value of corporate bonds selling at a premium and yielding 6% to maturity Explanation: When you read the full question, including the answer choices, you can immediately disregard two of the four options. With $100,000 to invest, the answer cannot be to purchase $200,000 of anything. Maximizing current income excludes zero-coupon bonds because there is no current income. Now, to the correct choice. Why does a bond sell at a premium over par? Although there are exceptions, primarily it is because the coupon rate on that bond is higher than the current market interest rate. Therefore, with a higher coupon rate, the current income on the same amount of principal invested ($100,000 in our question) will always be higher for a bond selling at a premium. That is the KISS (Keep It Simple Student) answer. For those who want to delve further, here we go. For example, if current market interest rates are 6% (likely the case here because the AA rated bonds with a 6% coupon are trading at par), then a bond with a 7% coupon will be selling at a premium. The current yield on $100,000 of the 6% bonds would be $6,000 per year. If a bond's yield to maturity is 6% and it is selling at a premium, it must be that the coupon is higher than 6%. For example (and we're doing the math that you won't have to do), $93,000 par (93 times $1,000) value of bonds with a 7% coupon, selling at $100,000 (a premium over the $93,000), and maturing in 10 years has a YTM of 6%. Investing $100,000 into these bonds will result in current income of $6,510 per year ($93,000 par times the 7% coupon).
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) 7% Ba rated corporate bond B) 4.8% AAA rated insured municipal bond C) 6% FDIC-insured CD D) 5% U.S. Treasury bond
A) 7% Ba rated corporate bond 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.
All of the following statements regarding Government National Mortgage Association (GNMA) pass-through securities are true except A) GNMAs are considered to be the riskiest of the agency issues. B) the minimum initial investment is $1,000. C) investors receive a monthly check representing both interest and a return of principal. D) investors own an undivided interest in a pool of mortgages.
A) GNMAs are considered to be the riskiest of the agency issues. 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.
Which of the following are not considered money market instruments? I. American depositary receipts II. Commercial paper III. Corporate bonds IV. Jumbo (negotiable) certificates of deposit
A) I and III Explanation: A money market instrument is a high-quality, short-term debt security with maturity of one year or less. American depositary receipts (ADRs) are equity, and corporate bonds are long-term debt instruments.
Which of the following statements about zero-coupon bonds are true? I. Zero-coupon bonds are sold at a deep discount from face value. II. Zero-coupon bonds pay periodic interest payments. III. The owner of a zero-coupon bond receives his return only at maturity.
A) I and III Explanation: A zero-coupon bond is a type of debt security that pays no periodic interest payments. Instead, the investor receives his return only at maturity, when the bonds are redeemed. Zero-coupon bonds are sold at a deep discount from face value, but they are redeemed at full face value when they mature.
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 yield to maturity (YTM) is less than both the current yield and the coupon rate. B) The coupon rate is higher than the YTM, and the YTM is higher than the current yield. C) The coupon rate is lower than the YTM, and the current yield should be higher than the coupon rate. D) The current yield is higher than both the coupon rate and the YTM.
A) The yield to maturity (YTM) is less than both the current yield and the coupon rate. 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.
Which of the following best describes a Yankee bond? A) U.S. dollar-denominated bond issued by a non-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 U.S. entity inside the United States
A) U.S. dollar-denominated bond issued by a non-U.S. entity inside the United States 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.
As defined in the Securities Exchange Act of 1934, the term municipal security would include A) a City of Chicago school district bond. B) 50-year bonds issued by the Tennessee Valley Authority. C) a Province of Ontario library construction bond. D) a U.S. Treasury bill.
A) a City of Chicago school district bond. Explanation: Under federal law, municipal bonds are those issued by any domestic political body or subdivision from the state level on down. Treasury bills and TVA issues are defined as government securities, not municipal securities. Under federal law, Canadian cities (or provinces) are not municipal securities.
One of the likely consequences of a rating downgrade on a bond is A) a reduction in the market price of the bond. B) an increase to the coupon by the issuer. C) the current yield will be reduced. D) the call feature will be employed.
A) a reduction in the market price of the bond. Explanation: If the rating agencies downgrade the quality of a bond, potential investors will look to compensate for the increased risk by demanding a greater yield on the issuer's bonds. This will inevitably result in a lower bond price. A change in rating is unlikely to lead to a call. In fact, with the reduction in the market price, the bond may be selling below par, giving the issuer the opportunity to retire the debt at a discount. Bonds are fixed-income securities because the coupon rate is fixed when the bond is issued and does not change.
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 below $48 per share. B) somewhat above $48 per share. C) somewhat above $30 per share. D) somewhat below $30 per share.
A) somewhat below $48 per share. Explanation: 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.
A European corporation seeking a short-term loan would probably be most concerned about an increase to A) the SOFR. B) the eurobond rate. C) the U.S. Treasury bill rate. D) the Fed funds rate.
A) the 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.
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) 6% FDIC-insured CD B) 7% Ba rated corporate bond C) 4.8% AAA rated insured municipal bond D) 5% U.S. Treasury bond
B) 7% Ba rated corporate bond 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.
Which of the following statements represents an advantage of a municipal general obligation (GO) bond over a revenue bond? A) Only a facility's users pay for a GO bond. B) A GO bond generally involves less risk to the investor. C) A GO bond is not charged against the municipality's borrowing limits. D) A GO bond issuer is required to conduct a feasibility study.
B) A GO bond generally involves less risk to the investor. Explanation: GO bonds are generally less risky than revenue bonds because they are backed by taxes rather than revenues. GO debt is charged against the borrowing limits (similar to the credit limit on your credit cards). That is a benefit to the investor because that limit protects against the municipality getting into debt over its head. It is the revenue bond that needs a feasibility study and collects user fees.
An investor is considering the purchase of $100,000 maturity value of zero-coupon AAA rated corporate bonds scheduled to mature in 20 years. Which of these are among the risks that this investor will be assuming? I. Default risk II. Interest rate risk III. Prepayment risk IV. Reinvestment risk
B) I and II Explanation: Even though these bonds are rated AAA, 20 years is a long time and it is possible that this corporation may not even exist when the maturity date arrives. Adding to the risk is the fact that there are no interest payments in the interim. That is why the most commonly recommended zero-coupon bonds are those issued or guaranteed by the U.S. Treasury. Because zero-coupon bonds have the longest duration for their maturity of any bonds, they have the greatest exposure to interest rate changes. Prepayment risk is only found with mortgage-backed securities, and one of the benefits of zeroes is that there is no reinvestment risk.
The call feature available on some bonds A) allows bond issuers to extend the life of the bond. B) allows the issuer the option to escape high interest rates if market rates decline. C) allows the issuer to refinance the debt if interest rates rise above the call rate. D) may be used to convert the bond into preferred shares.
B) allows the issuer the option to escape high interest rates if market rates decline. Explanation: Many bonds have a call feature that allows the issuer to call in the bonds, assuming the issuer has the cash available to pay them off, and escape high interest rates if market interest rates decline. If the company does not have the cash, it may issue a new bond at the lower prevailing interest rate and use that money to pay off the old bonds. This is known as refunding and, in essence, is no different from refinancing the mortgage on a home.
An investor purchases a 30-year zero-coupon corporate bond. The bond was issued by a Fortune 500 company. Her investment is subject to all of the following risks except A) interest rate risk. B) reinvestment risk. C) default risk. D) purchasing power risk.
B) reinvestment risk. Explanation: Zero-coupon bonds are not subject to reinvestment risk because there is nothing to reinvest. However, they are subject to purchasing power, interest rate, and default risk.
Issuing callable bonds is advantageous to the issuer because it allows the company to A) call in the bonds at less than par value and capture the difference as income. B) replace a high, fixed-rate issue with a lower issue after the call date. C) take advantage of high interest rates. D) issue fixed-income securities at a yield lower than usual.
B) replace a high, fixed-rate issue with a lower issue after the call date. Explanation: Callable bonds allow the company to take advantage of reduced interest rates by calling in high bonds with high interest rates and replacing them with lower ones. The marketplace requires that the company pay a higher coupon rate on callable bonds compared to ones that are not callable. This compensates the investor for taking the risk of a future call. The call price would never be less than the par value.
Although bonds are issued by many different entities, most of their features are the same. With few exceptions, included in that list of similarities would be all of these except A) price movement that is inverse to interest rates. B) safety of principal. C) a stated maturity date. D) a stated interest date
B) safety of principal Explanation: The safety of principal largely depends on the issuer. For example, there are no bonds as safe as U.S. Treasury bonds. On the other hand, there are some corporate bonds that are quite speculative. In general, all bonds have a stated maturity date , interest rate, and interest payment date, and they are exposed to interest rate risk. That is the risk that as interest rates rise, the price of the bonds will decline.
Which of the following investments would provide the highest after-tax income to your client in the 35% federal income tax bracket? A) 6% U.S. Treasury bond B) 5% general obligation municipal bond issued by State H C) 8% debenture issued by the LMN Corporation D) 7% bond issued by Canadian Province M
C) 8% debenture issued by the LMN Corporation Explanation: Only the State H bond is exempt from federal income tax. Using the tax-equivalent yield formula of the muni coupon divided by (100% minus the investor's tax bracket %), we get 5% divided by 65%, or 7.7%. That's a better deal than receiving 6% on the Treasury and paying taxes as well as 7% on the Canadian bond (although you learned that securities issued by Canadian provinces were exempt from registration under the Uniform Securities Act, that has nothing to do with U.S. income taxes). However, with a TEY of 7.7%, your client would take home more with the 8% taxable corporate security. You can also work backward to get the correct answer. Simply subtract 35% tax from each of the choices (other than the muni) and see which is the highest. In this case, 8% minus a 35% tax equals 5.2%—just a bit higher than the 5% coupon on the municipal bond.
Which of the following best describes a Yankee bond? A) A U.S. dollar-denominated bond issued by a U.S. entity inside the United States B) A U.S. dollar-denominated bond issued by a non-U.S. entity outside the United States C) A U.S. dollar-denominated bond issued by a non-U.S. entity inside the United States D) A U.S. dollar-denominated bond issued by a U.S. entity outside the United States
C) A U.S. dollar-denominated bond issued by a non-U.S. entity inside the United States 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
Which of the following choices offers the highest tax-equivalent yield? A) 5.0% municipal bond to an individual in the 35% tax bracket B) 5.8% municipal bond to an individual in the 25% tax bracket C) 5.5% municipal bond to an individual in the 28% tax bracket D) 6.2% municipal bond to a corporation in the 21% tax bracket
D) 6.2% municipal bond to a corporation in the 21% tax bracket Explanation: Corporations receive the same tax break on municipal bonds as do individuals. Therefore, receiving a 6.2% return in the 21% tax bracket is equivalent to 7.85% before tax. A 5% bond to someone in the 35% bracket is equivalent to 7.69%; a 5.5% coupon to someone in the 28% bracket is equivalent to 7.64%; and a 5.8% coupon to someone in the 25% bracket is equivalent to 7.73%.
Which of the following statements represents an advantage of a municipal general obligation (GO) bond over a revenue bond? A) A GO bond is not charged against the municipality's borrowing limits. B) A GO bond issuer is required to conduct a feasibility study. C) Only a facility's users pay for a GO bond. D) A GO bond generally involves less risk to the investor.
D) A GO bond generally involves less risk to the investor. Explanation: GO bonds are generally less risky than revenue bonds because they are backed by taxes rather than revenues. GO debt is charged against the borrowing limits (similar to the credit limit on your credit cards). That is a benefit to the investor because that limit protects against the municipality getting into debt over its head. It is the revenue bond that needs a feasibility study and collects user fees
Which of the following is true of Ginnie Maes but not of other agency mortgage-backed securities? A) Yield more than T-bonds B) Are pass-through securities C) Collateralized by mortgages D) Backed by the full faith and credit of the U.S. government
D) Backed by the full faith and credit of the U.S. government Explanation: Of the mortgage-backed government agency securities, only the Ginnie Maes are backed by the full faith and credit of the U.S. government. They are all collateralized by mortgages (the name MBS gives that away), and even the Ginnie Maes yield more than Treasury bonds. As an MBS, they all pass through the income and principal repayments to the investors
Which of the following is true of Ginnie Maes but not of other agency mortgage-backed securities? A) Are pass-through securities B) Collateralized by mortgages C) Yield more than T-bonds D) Backed by the full faith and credit of the U.S. government
D) Backed by the full faith and credit of the U.S. government Explanation: Of the mortgage-backed government agency securities, only the Ginnie Maes are backed by the full faith and credit of the U.S. government. They are all collateralized by mortgages (the name MBS gives that away), and even the Ginnie Maes yield more than Treasury bonds. As an MBS, they all pass through the income and principal repayments to the investors.
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? I. The dollar price per bond will be higher than par. II. The dollar price per bond will be lower than par. III. The current yield on the issue will be higher than the coupon. IV. The current yield on the issue will be lower than the coupon.
D) II and III 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.
Which of the following statements best describes the risk-free rate of interest? A) The rate of interest required to produce a net present value (NPV) of zero B) The arithmetic mean of the CPI over the past 12 months C) The rate of interest in excess of the pure time value of money D) The rate of interest earned on the 91-day U.S. Treasury bill
D) The rate of interest earned on the 91-day U.S. Treasury bill Explanation: The rate of interest earned on short-term U.S. Treasury securities, generally the 91-day T-bill (might be called the 13-week or 3-month bill on the exam), is referred to as the risk-free rate. The rate of interest in excess of the pure time value of money is called the risk premium, not the risk-free rate. CPI and NPV have nothing to do with the risk-free interest rate.
A U.S. dollar-denominated bond that is sold outside the United States and the issuer's country but for which the principal and interest are stated and paid in U.S. dollars is best described as A) a Brady bond. B) a eurobond. C) a Yankee bond. D) a Eurodollar bond.
D) a Eurodollar bond. Explanation: This is the definition of a Eurodollar bond. Yes, it is also a eurobond, but because the question specifies U.S. dollars, the more accurate choice is Eurodollar bond. A Yankee bond is U.S. dollar-denominated but is issued in the United States; Eurodollar bonds are not. Brady bonds are issued only by foreign governments, usually—but not always—are U.S. dollar-denominated, and are available for purchase in the United States.
A municipal bond has a coupon of 6.25%, and at the present time, its yield to maturity is 6.75%. From this information, it can be determined that the municipal bond is trading A) at a premium. B) flat. C) at par. D) at a discount.
D) at a discount. Explanation: The YTM is greater than the nominal yield, or coupon yield. Therefore, the bond is trading at a discount.
An advantage of being a bondholder compared with owning common stock in the same corporation is that A) common stock has priority over the bond in the event of liquidation. B) the bondholder can select the optimum time to have the issuer redeem the bond. C) there is limited liability. D) income payments are more reliable.
D) income payments are more reliable. Explanation: Even though bond interest is semiannual, while dividends are typically paid quarterly, the payment of interest is an obligation that comes ahead of the payment of any dividend. Companies can elect to skip or reduce their dividends but not their interest payments.
A bond of standard size has a nominal yield of 6%, paid in the customary fashion. The bond matures in 10 years, is callable at $105 in 5 years, and is currently priced at $110. An investor calculating the bond's yield to call would include A) 20 payment periods. B) the loss of $100 at maturity. C) the gain of $50 when called. D) the semiannual interest payments of $30.
D) the semiannual interest payments of $30. Explanation: The yield to call 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 (nominal yield) will make $30 interest payments twice each year. Remember, unless otherwise stated, bonds have a par value of $1,000 and customarily pay interest semiannually. With a 5-year call, there are only 10 payment periods, not 20. The loss at call is $50 ($1,100 - $1,050); there is no gain, and the loss at maturity of $100 is only relevant for YTM, not YTC.
