65- 13: Types and Characteristics of Fixed Income (Debt) Securities and Methods Used to Determine Their Value

(TIPS) Treasury Inflation Protection Securities

-**Protects investors against purchasing power risk. -Issued with fixed interest rate -Principal amt is adjusted semiannually by amount equal to CPI (inflation) -Sold at lower interest rates than conventional fixed-rate Treasury securities. -**Interest exempt from state and local income tax but subject to federal tax -**However, in any year when the principal is adjusted for inflation, that increase is reportable income for that year

FNMA Securities (Fannie Mae)

-*NOT backed by government -purchases and sells real estate mortgages -Then, fannie mae issues bonds backed by those mortgages -Issued at par, pay semiannual interest (interest is taxable at all levels: state, local, federal) -Has REINVESTMENT/PREPAYMENT risk since people move, sell their home, or refinance their mortgage because interest rates have fallen

US Treasury Notes

-direct debt obligations of U.S. Treasury -pay semi-annual interest -mature at par value -have maturities of 2, 3, 5, 7, and 10 years -they are noncallable

If a convertible bond is purchased at its $1,000 par value and is convertible at $83.33 per common share, what is the conversion ratio of common shares per bond? A) 1.2 shares for each bond B) 8 shares for each bond C) 12 shares for each bond D) 2 shares for each bond

C 1000/83.33

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

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

Some analysts use the discounted cash flow to determine the theoretical value of a debt security. Under DCF, the bond price can be summarized as the sum of the A) present value of the par value repaid at maturity plus the present value of the coupon payments B) future value of the par value repaid at maturity plus the present value of the coupon payments C) future value of the par value repaid at maturity plus the future value of the coupon payments D) present value of the par value repaid at maturity plus the future value of the coupon payments

A A bond's price can be calculated using the present value approach. As with any security or capital investment, the theoretical fair value of a bond is the present value of the stream of cash flows it is expected to generate. Therefore, the value of a bond is obtained by discounting the bond's expected cash flows to the present using an appropriate discount rate. The two choices using future value of the par value at maturity make no sense because we already know that is $1,000 (or whatever the par value might happen to be). U13LO12

Charlie Mindel is the portfolio manager for the Steady Yield Bond Fund. If Charlie was of the opinion that interest rates were going to fall, he would A) increase the average duration of the portfolio B) decrease the average duration of the portfolio. C) move more of the portfolio into cash. D) keep the average duration the same.

A As interest rates go down, prices of bonds rise. Those with the longest duration will have the greatest price increase. To benefit from this move, managers of bond portfolios will lengthen the average duration of the portfolio. The reverse action would be taken if Charlie thought that interest rates were going to rise. Of course, if interest rates move in the opposite direction of that the manager expects, the fund might start looking for a new manager. U13LO11

Bond prices are quoted as a percentage of A) par value B) market value C) conversion value D) stated value

A Bond prices are quoted as a percentage of par value. On the exam, the par value of bonds is always $1,000. U13LO2

All of the following are true of negotiable, jumbo certificates of deposit EXCEPT A) they are secured obligations of the issuing bank B) they usually have maturities of 1 year or less C) they are readily marketable D) they are usually issued in denominations of $100,000 to $1 million

A 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. U13LO13

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 6 years at 103. In the computation of the bond's yield to call, which of the following would be a factor? A) Interest payments of $30 B) 20 payment periods C) Future value of $1,200 D) Present value of $1,030

A The YTC computation involves knowing the amount of interest payments to be received, the length of time to the call, the current price, and the call price. A bond with a 6% coupon will make $30 semiannual interest payments. With a 6-year call, there are only 12 payment periods, not 20. The present value is $1,200 and the future value is $1,030, the reverse of the numbers indicated in the answer choices. U13LO10

A popular tool used by analysts is discounted cash flow (DCF). Most use this tool to evaluate A) the present value of future cash flows to determine an appropriate current value. B) the future value of present cash flows to determine an appropriate current value. C) the future value of future cash flows to determine the value at a specified date in the future. D) the present value of future cash flows to determine the value at a specified date in the future.

A The principle behind a DCF computation is that an investment made currently is worth an amount equal to the sum of all the future cash flows expected to be received. These future cash flows are discounted to arrive at a fair value. U13LO12

Advantages and disadvantages of eurodollar bonds

Advantages -No currency risk since they are US dollar denominated -They are rated by US rating agencies so the risk is clear -may offer higher yields than domestic bonds from the same issuer Disadvantages -lack of transparency because they are NOT registered with the SEC -political and country risk (taken into consideration by the rating agencies -currency risk (if denominated in a currency other than one's home country)

Advantages and Disadvantages of investing in foreign bonds

Advantages -potentially higher returns -diversification -hedging against a drop in value of the US dollar Disadvantages -currency risk (if foreign currency falls in value against the dollar) -potentially higher risk of default -generally less liquidity -generally higher trading costs

High-yield bonds are frequently called junk bonds. Which of the following expresses the highest rating that would apply to a junk bond? A) CCC B) BB C) CC D) BBB

B Investment-grade bonds run from a highest Standard and Poor's rating of AAA (Aaa − Moody's) down to BBB (Baa − Moody's). When the rating gets to BB (or Ba) the bond is considered high yield, or a junk bond. U13LO4

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) ahead of the common stock, the preferred stock, and the bonds B) ahead of the common stock and the preferred stock, but after the bonds C) behind the bonds, the preferred stock, and the common stock D) ahead of the common stock, but after the preferred stock and the bonds

B Any debt security, even a subordinated debenture, has a claim ahead of all equity. However, it is subordinated to all other debt. U13LO3

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

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

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

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

Q: Client has a TIPS with coupon rate 4.5%. Inflation rate has been 7% for last year. What is inflation adjusted return? A. -2.5% B. 4.5% C. 7% D. 11.5%

B TIPS adjust the principal value every 6 months to account for inflation rate. Therefore, the real rate of return will always be the coupon

Benefits and Risks to mortgage-backed securities:

Benefits: -pay a higher rate of return compared to other debt securities Risks -complicated instruments and hard to understand -prepayment risk due to mortgages being refinanced when interest rates drop -default risk if mortgages are subprime -reinvestment risk -liquidity risk

Which of the following would you NOT expect to see issued at a discount? A) Zero-coupon bond B) Treasury Bill C) Bank jumbo CD D) Commercial paper

C

Being concerned about price volatility, a bond investor wishes to compute the duration of a bond being considered for her portfolio. Which of the following is NOT a necessary component of that calculation? A) Current market price B) Time until maturity C) Rating of the bond D) Coupon rate

C Although it is true that lower-rated bonds tend to have greater price volatility than high-rated ones, the rating has nothing to do with the calculation of the bond's duration. Duration is simply the weighted average of the cash flows an investor will receive over time, discounted to the bond's present value. Those cash flows come from the coupon and the return of the par value at maturity. The market price represents the present value of those future cash flows. U13LO11

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

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

Your client 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 $.53, your client's goal will be achieved if the RIF can be purchased at A) $50.00 B) $8.83 C) $35.33 D) $22.55

C First, take the quarterly dividend and annualize it (4 × $.53 = $2.12). Then, divide that number by 6% and you get $35.3333, which rounds down to $35.33. Or, if you wish, but it takes more time, multiply each of the choices by 6% to see which of them equals $2.12. U13LO10

All of the following debt instruments pay interest semiannually EXCEPT A) municipal general obligation bonds B) industrial development bonds C) Ginnie Mae pass-through certificates D) municipal revenue bonds

C Ginnie Maes pay interest on monthly, not semiannually. U13LO1

Bond Pricing

Corp/Muni -each bond point represents $10, fractions are in eights -Bond quoted @ 90 1/4= $902.5 -Bond quoted @ 101 3/4= $1,017.50 Goverments -Each point is $10, and each .1 represents 1/32 of $10 -Gov bond quoted @ 90.8 = $902.50 -Gov bond quoted @ 101.24= $1017.50 Ex: When you see a corporate bond quoted at 103 1/2, it represents a market price of $1035. The 103 is 103% of $1000, or $1030, and the 1/2 is half of a $10 point, or $5. On a treasury bond, that same price would be shown as 103.16 where the .16 is 16/32s or 1/2

Taxation of the different types of bonds

Corporate bonds: -interest taxed as ordinary income on both state and federal tax returns Treasury bonds: -interest taxed only on federal level Municipal bonds: -interest is free of federal income tax -IF investor resides in the same state as the issuer of the bond, it is also exempt from state income tax as well

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 LIBOR

D LIBOR stands for London Interbank Offered Rate and, for the rest of the world outside of the U.S., is the standard upon which short-term rates are based. U13LO13

An investor owns a TIPS bond with an initial par value of $1,000. The coupon rate is 6%, and during the first year, the inflation rate is 9%. How much interest would be paid for the year? A) $65.40 B) $60.00 C) $90.00 D) $64.11

D TIPS bonds have a fixed coupon rate with a principal that varies each 6 months based on the inflation rate. With an annual inflation rate of 9%, each 6 months, the principal increases by 4.5% (half of the annual rate). Each semiannual coupon is half of the 6% rate times the new principal. The arithmetic is: $1,000 × 104.5% = $1,045 × 3% = $31.35 plus, $1,045 × 104.5% = $1,092 × 3% = $32.76. Adding the 2 interest payments together results in a total of $64.11 for the year. U13LO1

The best time for an investor seeking returns to purchase long-term, fixed-interest-rate bonds is when A) short-term interest rates are high and beginning to decline B) long-term interest rates are low and beginning to rise C) short-term interest rates are low and beginning to rise D) long-term interest rates are high and beginning to decline

D The best time to buy long-term bonds is when interest rates have peaked. In addition to providing a high initial return, as interest rates fall, the bonds will rise in value. U13LO11

Q: when T bills are issued, they are quoted at: A. premium over par B. 100% of par value C. par value with interest coupons attached D. a discount from principal with no coupons attached

D always issued at discount, pay no interest

Bond Listings

DEF 5s35 @ 106 -DEF= the issuer -5= the coupon rate -35= the maturity date of 2035 -106= the price of $1,060

Investment-Grade Debt

Debt obligation with a credit rating of AAA, AA, A, or BBB -greater liquidity and less risk than junk/high yield bonds

TIPS example: you have a TIPS bond of 3% coupon and annual inflation rate is 4% for the next 2 years:

Each six months, you will receive 1.5% (half of the annual 3% coupon) of the principal value as adjusted for the inflation rate. If inflation rate is 4% per year, that is 2% every 6 months. After the first semiannual period, the principal value of the bond is now $1,020 ($1000 + 2%). Therefore, the first interest check will be 1.5% of $1020, or $15.30. Six months later, the adjusted principal is $1040 ($1020 + 2%), so that interest check will be $15.61

Eurobonds and Eurodollar Bonds

Eurobonds: pay in foreign currency Eurodollar bonds: Pay in US dollars

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 II B) I and III C) II and IV D) III and IV

I and III A money market instrument is a high-quality, short-term debt security with maturity of 1 year or less. American depositary receipts (ADRs) are equity, and corporate bonds are long-term debt instruments. U13LO13

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

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

Differentiate between secured (collateralized) and unsecured debt

Secured: Things like mortgage bonds, equipment trust certificates, and collateral trust bonds. These have collateral on their bonds (pledge of property like mortgages, equipment, and securities) that can pay off their debtors if they cannot pay them back Unsecured: Debentures. Backed only by a corporation's word and creditworthiness. Written promises of the corporation to pay the principal at its due date and interest on a regular basis -NOT secured by any pledge of property

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

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

An investor is looking to add some bonds to her portfolio. One of the bonds she is analyzing has a 3% coupon and the other a 6% coupon. Assuming both bonds have the same maturity date, a change in interest rates will have a more profound effect upon the market price of which bond? A) Changes in interest rates affect both bonds equally B) The 3% coupon C) The 6% coupon D) The bond with the lower rating

The longer a bond's duration, the more its price is affected by changes to interest rate. When bonds have the same maturity, the one with the lowest coupon has the longest duration. Ratings have little or nothing to do with price changes caused by interest rate changes. U13LO11

High Yield Bonds

corporate bonds that pay higher interest, but also have a higher risk of default -aka junk bonds

Tax Equivalent Yield

the rate of return that a taxable bond must offer to equal the tax-exempt yield on a municipal bond. Tax equivalent yield= coupon rate of tax free municipal bond/ (100%-tax bracket) Alternatively, we might know the taxable security's coupon and the investor's tax bracket and we want to know what the tax free bond must yield to give us an equivalent yield. Ex: taxable bond is paying 8% interest and the investor is in the 30% tax bracket. Therefore, investor will pay taxes equal to 2.4% (30% of 8%). After paying taxes, the investor will keep the other 5.6% (8%-2.4%). So, a tax free bond paying 5.6% will offer a TEY equal to the 8% one

GNMA Securities (Ginnie Mae)

-Backed by federal gov** (unlike FNMA) -Payments are received monthly (since the security is a pool of home mortgages that are paid monthly) -Each monthly payment the investor receives consists partly of interest and partly of principal -*Portion of each monthly payment representing interest is subject to state/local taxation AND federal income tax

US Treasury bonds

-direct debt obligations of the U.S. Treasury -pay semi-annual interest as a % of the stated par value -long term maturities between 10-30 years -mature at par value

2 types of municipal bonds

-interest earned from both is free from federal income tax and they are considered to be safe 1. General Obligation Bonds -backed by pledge of issuer's full faith and credit for prompt payment of principal and interest 2. Revenue Bonds -payable from the earnings of a revenue-producing enterprise like water, sewer, electric, gas, toll bridge, airport, etc. -Yield/interest is typically higher for these than GO bonds

Tennessee Valley Authority (TVA)

-nations largest public power provider -their bonds are NOT backed by US gov -backed by the revenues generated by their projects

Liquidation priority

-secured creditors (mortgage bonds, equipment trust certificates, collateral bonds) -unsecured creditors (debenture holders) -subordinated debt holders -preferred stockholders -common stockholders

U.S. Treasury Bills

-short term debt obligations of the US gov -Pay no interest** --ONLY treasury security issued without stated interest -Issued at discount from their par value** -Highly liquid -91 day (13 week) T bills are used in market analysis as the stereotypical "risk free" investment Ex: Investor might purchase a $10,000, 26-week T-bill at a price of $9,800. No interest is received, but at maturity, the Treasury sends investor a check for $10k. The difference between what was paid and what was received would be considered interest income even though a separate interest check was never received

When comparing a time deposit account and a demand deposit account, you would expect A) lower penalties for withdrawing funds from a time deposit account B) a higher rate of interest paid on the time deposit account C) easier access to the funds in a time deposit account D) FDIC insurance on the time deposit account but not on the demand deposit account

B The best example of a time deposit accounts is a CD. Money is deposited for a fixed length of time, generally at a fixed interest rate. Demand deposit accounts are checking accounts. Because the bank expects to have longer use of time deposit funds, interest rates are generally higher. DDAs offer the instant access of check-writing (or online payments). Typically CDs, have penalties for early withdrawal; there is no such charge on a checking account. Both are covered by FDIC up to the applicable limit. U13LO14

Five years ago, an investor purchased an ABC Corporation BBB-rated debenture with a coupon of 6% maturing in 2037. Currently, new BBB-rated debentures maturing in 2037 are being issued with coupons of 7%. Based on the discounted cash flow method, one could say that the present value of the investor's security is A) negative B) less than the par value C) equal to the par value D) more than the par value

B The discounted cash flow method is just a technical way of computing the value of a security that demonstrates the inverse relationship between interest rates and bond prices. The discount rate here is the current market rate of 7%. Because this investor's debenture is paying at a rate of 6%, its cash flow is less valuable than a 7% bond; therefore, it will sell at a discount (below par). U13LO12

A bond analyst who determines the value of a debt security by adding the present value of the future coupons to the present value of the maturity value is using which of the following valuation methods? A) Dividend discount B) Discounted cash flow C) Present value D) Future value

B This type of question sometimes appears on the exam. There is a second answer that could be correct, but is not scored as such. In this example, a case could be made for present value, but the better choice is discounted cash flow; it is more correct. U13LO12

Mr. Beale buys 10M RAN 6.6s of 32 at 67. What is his total purchase price? A) $10,000 B) $10,200 C) $6,700 D) $6,600

C this means that Beale 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. U13LO2

Which of the following bonds would appreciate the most if interest rates fell? A) 30-year maturity, selling at a premium B) 15-year maturity, selling at a premium C) 30-year maturity, selling at a discount D) 15-year maturity, selling at a discount

C The general rule of thumb is that bonds with long-term maturities will have greater fluctuations in price than will short-term maturities, given the same move in interest rates. Furthermore, discounted bonds, with their lower coupon rates, have a longer duration than a bond selling at a premium and will respond more favorably to falling rates than will those premium bonds. Thus, the 30-year discounted bond will move faster than the others. U13LO11

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

C The investor in a corporate zero-coupon bond receives the return in the form of growth of the principal amount over the bond's life. The bond is purchased at a deep discount and redeemed at par at maturity. That discount from par represents the interest that will be earned at maturity date. However, the discount is accreted annually and the investor pays taxes yearly on the imputed interest creating "phantom income." Zero-coupon bonds have greater, not lower price, volatility. U13LO8

An 8% corporate bond is offered on a 8.25 basis. Which of the following statements are TRUE? I. Nominal yield is higher than YTM. II. Current yield is higher than nominal yield. III. Nominal yield is lower than YTM. IV. Current yield is lower than nominal yield.

II and III A bond offered on an 8.25 basis is the same as at a YTM of 8.25%. Because the yield quoted is higher than the 8% coupon, the bond is trading at discount to par. For discount bonds, the nominal yield is lower than both the current yield and the yield to maturity. U13LO10