Bond Basics
All of the following affect the marketability of corporate bonds EXCEPT:
A Bond denominations For corporate bonds, the most marketable blocks are 5 bonds up to 100 bonds. Under 5 is an odd lot; over 100 is a large block which is more difficult to trade. The shorter the maturity, the more marketable the bond. The higher the rating, the more marketable the bond. The bond denominations have no effect on marketability.
Which of the following are considered to be creditors of a corporation?
A Convertible Bondholders Bondholders are creditors of a company. Convertible bondholders are creditors of a company as long as they keep their bonds and do not convert to common shares. Common and preferred shareholders have an equity position. Warrant holders have a long term option to buy the stock. Warrants are considered equity-related securities, but they have neither an equity nor creditor stake in the corporation.
If interest rates are rising, which statement about discount and premium bonds is TRUE?
A Discount bondswill depreciate faster than premium bonds As a general rule, the longer the maturity on a debt issue, the greater the issue's price volatility in response to interest rate movements. Another general rule is that the lower the price of the issue (which would result from having a lower coupon), the greater the issue's price volatility in response to interest rate movements. As interest rates rise, bonds that are selling at a discount will fall proportionately more than bonds trading at an equivalent premium. This is true since the change in price as a percentage of the bond's cost is greater for a discount bond than for a premium bond.
Which of the following ratings applies to short term municipal issues? I MIG 1 II MIG 2 III P1 IV NP
A I and II only MIG ratings stand for "Moody's Investment Grade," with MIG 1 being highest and SG ("Speculative Grade") being the lowest ratings. These are the ratings used for short term municipal notes. The "P" (Prime) ratings are used to grade corporate commercial paper.
When bonds are trading at a large discount, which of the following statements are TRUE? I The deeper the discount, the more volatile the bond's price movement in response to interest rate changes II The deeper the discount, the less volatile the bond's price movement in response to interest rate changes III Discount bonds with long maturities are more volatile than ones with short maturities IV Discount bonds with short maturities are more volatile than ones with long maturities
A I and III As a general rule, the deeper the discount, the more volatile the bond's price movements in response to market interest rate changes. The deepest discount bond that can be purchased is a "zero coupon" bond. Such a bond has the most volatile price movements. Also, the longer the maturity, the more volatile the bond's price movements in response to market interest rate changes.
When a bond trades at a premium, which bond yield will be the highest?
A Nominal When bonds are trading at a premium, the stated yield or nominal yield will be the highest, since it is the annual income divided by par value. Current yield is lower because it is annual income divided by the current market price (which is at a premium to par). Basis (or yield to maturity) is even lower because it not only considers that the current market price is at a premium to par; it also pro-rates the loss of the premium over the life of the bond, reducing the annual yield below the current yield.
For bonds trading at a discount, rank the yield measures from lowest to highest?
A Nominal; Current; Yield to Maturity; Yield to Call When bonds are trading at a discount, the stated (nominal) yield will be lowest. The current yield will be higher, since it is based on the discounted market price - not par value. The yield to maturity will be the next highest, since it includes the portion of the discount earned annually as part of the annual return in addition to the interest received. Finally, yield to call will be highest, since the discount would be earned over a shorter period of time, increasing the annual yield on the security.
In 2020, a customer buys 5 GE 10% debentures, M '29, at 85. The interest payment dates are Feb 1st and Aug 1st. The bonds are callable as of 2022 at 103. If the bonds are called prior to maturity, which statement is TRUE?
A The yield to callwill be higher than the yield to maturity Note for the exam that you do not have to compute yield to call; but you must know that yield to call will be higher than yield to maturity if the bond is trading at a discount; and yield to call will be lower than yield to maturity if the bond is trading at a premium.
Under the "market expectations" theory of yield curves, when investors expect interest rates to rise in the future, the yield curve should be:
A ascending Under the "market expectations" theory of yield curves, when investors expect interest rates to rise in the future, the yield curve will have an upward slope. Conversely, when investors expect interest rates to fall in the future, the yield curve will have a downward slope. If investors are uncertain as to the future direction of market interest rates, then the yield curve will be flat.
Moody's ratings measure:
A default risk of debt issues Moody's measures default risk of debt issues. Moody's only rates bonds, not equity securities.
The yield curve shows the yields of:
A different maturities of the same type of security The yield curve compares the yields of all maturities for the same type of security (e.g., the yields for all maturities of U.S. Government securities; the yields for all maturities of AAA rated corporate securities, etc.)
When short term interest rates are the same as long term interest rates, the yield curve is said to be:
A flat When short term rates are the same as long term rates, this is a flat yield curve. If the Federal Reserve tightens credit to a limited extent, the effect is felt mainly on short term rates, which can then rise to the same level as long term rates.
Exchange rate risk exists when making an investment in a:
A foreign security when the U.S. dollar strengthens When an investment is made outside the U.S. that is denominated in a foreign currency, the investor assumes exchange rate risk. This is the risk that the foreign currency weakens against the U.S. dollar (which is the same as the U.S. dollar strengthening).
A customer who has taken his portfolio and invested it only in money market instruments is most likely concerned with:
A purchasing power risk If there a high level of inflation (purchasing power risk), then interest rates start to rise. This causes bond prices to fall. It also causes stock prices to fall, because companies have to pay higher interest rates on bonds that they issue, depressing profits, and companies have a hard time raising prices as fast as their input costs rise, also depressing profits. Because interest rates rise when there is substantial inflation, money market rates go up as well. However, these securities do not lose value because their maturity is short, and when they mature, the proceeds are reinvested in other money market instruments offering high yields. These are one of the best investments during inflationary times.
During periods when the yield curve is inverted, investors wishing to maximize current income would buy:
A short term maturities When the yield curve is inverted, short term rates are higher than long term rates. To maximize income, invest in short term securities. This curve is typical during periods of tight credit.
During a period when the yield curve is inverted:
A short term rates are more volatile than long term rates Whether the yield curve is ascending (normal), flat or inverted, the true statement always is that short term rates are more volatile than long term rates. Short term rates are susceptible to Federal Reserve influence, and move much faster than do long term rates. Long term rates respond more slowly; and reflect longer term expectations for inflation and economic growth, among other factors.
10 basis points equals:
B .1% One basis point equals .01% movement in interest rates, so 10 basis points equals a .1% movement in interest rates.
A corporate bond was issued on Jan 1, 2010, that matures on Jan 1, 2030. The trust indenture allows the corporation to call the bond starting in 2020 at a price equaling 100 plus an additional 1/2 point premium for every 6 month period remaining until maturity. If the bond is called on Jan 1, 2028, the redemption price will be:
B 102 If the bond is called on Jan 1, 2028, it has 2 years left to maturity. This is the same as 4 - six month periods. For each six month period prior to maturity that the bond is called, 1/2 point is added to the call premium (total equals 2 points). Since the call price is 100 plus the additional premium of 2 points, the total call price is 102.
A 6% corporate bond with 15 years left to maturity is currently trading at 115. The bond is callable in 5 years at 105. If a client buys the bond and then the issuer calls it in 5 years, the yield to call will be:
B 3.64% YTC is Net Annual Return / Average Value. The annual income is 6% of $1,000 par = $60 per year. The bond can be purchased at 115, but it will be called in 5 years at 105, so there will be a 10 point ($100) loss over 5 years = 2 point loss ($20) per year. The Net Annual Return is: Annual Income ($60) - Annual Loss ($20) = $40 The Average Value is: $1,150 Purchase Price + $1,050 Redemption Price / 2 = $2,200 / 2 = $1,100 YTC is: $40 / $1,100 = 3.636%
Which bond will exhibit the greatest price volatility?
B 8-year bond; 0% coupon; 7% yield; duration of 8.00 Duration is a concept that is tested as a "basic" idea on Series 7. It represents the amount of time that it will take for an investor to recoup his or her purchase price. The longer the duration, the longer it will take for an investor to get his or her money back and longer term bonds are more volatile. So the higher the duration number, the greater the bond volatility, and duration is often used as a measure of bond price volatility.
In 2020, a customer buys 1 PDQ 10%, $1,000 par debenture, M '35, at 115. The interest payment dates are Jan 1st and Jul 1st. The current yield on the bond is:
B 8.70% The current yield is the stated rate of interest on the bond, based on market value. $100$1,150= 8.70%
Which of the following would be a quote for a U.S. Government bond?
B 99-16
What is NOT a characteristic of investing in preferred stock?
B Guaranteed dividend rate
A rising rate of inflation would lead to: I lower bond prices II higher bond prices III lower bond yields IV higher bond yields
B I and IV A rising rate of inflation will lead to higher interest rates. If interest rates rise, then bond prices will drop.
Which of the following statements are TRUE regarding the effect of market interest rate movements on callable and puttable bond prices? I When interest rates fall, the call price tends to set a ceiling on the market price of the bond II When interest rates fall, the call price tends to set a floor on the market price of the bond III When interest rates rise, the put price tends to set a ceiling on the market price of the bond IV When interest rates rise, the put price tends to set a floor on the market price of the bond
B I and IV If interest rates drop, it is more likely that an issuer will call its bonds. As interest rates drop, bond prices in the market will rise. The price will not rise by as much for a callable issue as that for a non-callable issue. The reason: why would someone pay a premium for an issue that is likely to be called off the market? The price for a puttable bond sets a floor under the market price of the bond during periods of rising interest rates. The price will never drop much below par once the option is exercisable, because if it did, customers would buy as many of the bonds as possible and "put" them to the issuer at par for a capital gain.
Which characteristics make a security least subject to liquidity risk? I Short term maturity II Long term maturity III Low credit rating IV High credit rating
B I and IV Liquidity risk is the risk that a security can only be sold by incurring large transaction costs. The easiest securities to sell (meaning the most readily marketable) are those with high credit ratings and short term maturities.
The price of which of the following bonds would be MOST affected by rising interest rates? I Low coupon bond II High coupon bond III Short maturity bond IV Long maturity bond
B I and IV The deeper the discount on a bond (the same as the lower the coupon rate), the greater the price will move for a given change in interest rates. The longer the maturity, the greater the price will move for a given change in interest rates.
As interest rates rise, which of the following statements are TRUE? I Bonds trading at large discounts fall faster in price than bonds trading at small discounts. II Bonds trading at small discounts fall faster in price than bonds trading at large discounts. III Bonds trading at large premiums fall faster in price than bonds trading at small premiums. IV Bonds trading at small premiums fall faster in price than bonds trading at large premiums.
B I and IV The general rule is the lower the price of the bond, the faster that bond's price will move as market interest rates change. Deep discount bonds have a lower price than small discount bonds, hence their prices move faster. Small premium bonds have a lower price than large premium bonds, hence their prices move faster as well.
When it is expected that a recession will occur, which of the following statements are TRUE? I Investors sell corporate bonds II Investors buy corporate bonds III Investors sell government bonds IV Investors buy government bonds
B I and IV When a recession is expected, investors sell corporate bonds (pushing corporate bond prices down, and thus raising their yields) and buy government bonds (pushing government bond prices up and thus decreasing their yields). Thus, the spread between corporate and government bond yields will widen.
All of the following are true statements about discount bonds EXCEPT:
B bonds trading at a discount are more likely to be called than bonds trading at a premium
Issuers will call their bonds when interest rates:
B have declined Issuers call in bonds when interest rates have declined. The issuer can retire the "old" high interest rate debt; and issue new bonds at lower current market rates; reducing its interest cost.
A decreasing market rate of interest would lead to:
B higher bond prices and lower bond yields A declining market rate of interest means that interest rates are dropping. If market interest rates drop, then bond prices will rise, and the yields on those bonds will fall.
During a period when the yield curve is normal:
B long term bond prices are more volatile than short term bond prices Whether the yield curve is ascending (normal), flat or descending, long term bond prices always move faster than short term bond prices, as interest rates change. This is due to the compounding effect on the bond's price that occurs, which increases with longer maturities.
Most of the value of a bond is established by the:
B present value of the last payment The actual dollar price of a bond is computed by taking the yearly income stream and principal repayment at maturity and discounting it back to today's "present value" based on the current market interest rate. Most of the value of the bond comes not from the yearly interest payments, but rather from the final payment when the principal is being returned.
The current yield on a bond is:
B stated interest rate / bond market value The current yield is the stated rate of interest on the bond, based on current market value.
A serial bond issue is one in which the bonds are issued on:
B the same date and mature on different dates Serial bonds are ones where all of the bonds are issued on the same date, but portions of the issue mature on different dates, "serially" over the upcoming years. It allows issuers to schedule principal repayment as an annual budget item.
In 2020, a customer buys 1 PDQ 10%, $1,000 par debenture, M '35, at 115. The interest payment dates are Jan 1st and Jul 1st. The nominal yield on the bond is:
C 10.00% The nominal yield is the stated rate of interest on the bond, based on par value. $100/$1,000= 10%
A customer has purchased three different bonds, each yielding 9%, with 5 year, 10 year, and 15 year maturities. If prevailing interest rates drop by 20 basis points, which will show the greatest percentage price change?
C 15 year maturity As interest rates move, long term maturities will change in price at a faster rate than will short term obligations. This is due to the fact that the "compounding effect" is more acute as maturities lengthen. As interest rates move up, long term maturities fall faster in price than do short term maturities.
All of the following callable municipal bonds are trading at an 8% basis. Which is MOST likely to be called?
C 8 3/4% coupon rate callable at 100 in 2020 An issuer is most likely to call bonds which have high interest rates (high financing cost to the issuer) and low call premiums (the least expensive for the issuer to call in these bonds).
Which of the following would be a quote for a manufacturing company bond?
C 99 1/2
Which of the following are TRUE statements about discount bonds? I Discount bonds will appreciate more rapidly as interest rates fall than will similar premium bonds II A bond trading at a discount can indicate that market interest rates have risen III A bond trading at a discount can indicate that the issuer's credit rating has deteriorated IV Bonds trading at a discount are more likely to be called than bonds trading at a premium
C I, II, III As interest rates fall, discount bonds will appreciate at a faster rate than will premium bonds. The change in value of the bond's price is a result of an increased "present value" of the remaining interest payments to be received. This increase in the "value" of the remaining interest payments is a larger percentage of a discount bond's price than of a premium bond's price. Thus, as interest rates drop, discount bond prices rise faster than premium bond prices. Similarly, as interest rates rise, discount bond prices fall faster than premium bond prices. If a bond is trading at a discount, it can indicate that interest rates have risen after the issuance of the bond. One reason why bonds trade at a discount is because the interest rate that the bond is paying is less than the "market" rate of interest. A bond may be trading at a discount because the issuer's credit rating has slipped, forcing prices down and subsequently, yields up. Bonds trading at a premium are most likely to be called. An issuer calls debt when interest rates have fallen so it can refund at a lower interest cost.
A call premium on a bond is the amount: I by which the bond's redemption price at maturity exceeds par II by which the bond's redemption price prior to maturity exceeds par III the bondholder will pay the issuer to call in bonds prior to maturity IV the issuer will pay the bondholder to call in bonds prior to maturity
D II and IV A call premium is the excess over par value that the issuer will pay the bondholder to call in the bonds prior to maturity.
Which statements are TRUE regarding bonds? I Short term bonds fluctuate more in value than long term bonds due to interest rate movements II Long term bonds fluctuate more in value than short term bonds due to interest rate movements III Short term maturities are more liquid than long term maturities IV Long term maturities are more liquid than short term maturities
C II and III Long term bonds fluctuate more in value than do short term bonds in response to market interest rate changes. Short term bonds do not fluctuate much in value as interest rates move since they will be redeemed shortly at par. There is more active trading of short term debt than long term debt, so short term debt is more liquid.
A bond is rated BBB by Standard and Poor's. The bond is:
C Lowest Quality Investment Grade A BBB rating is the lowest investment grade rating for a bond. The investment grade ratings are AAA, AA, A, and BBB.
Which bond portfolio with a 20-year life would be expected to give the highest long-term return?
C Portfolio #3 with an expected rate of return of 10% and a default risk of 20% over the portfolio life The "default risk" represents the loss of return that is likely due to making higher risk investments. If Portfolio #1 has an expected annual rate of return of 6% over 20 years; but there is the probability that 5% of those bonds will default, so the net return will be 95% of 6% = 5.7%. If Portfolio #2 has an expected annual rate of return of 8% over 20 years; but there is the probability that 10% of those bonds will default, so the net return will be 90% of 8% = 7.2%. If Portfolio #3 has an expected annual rate of return of 10% over 20 years; but there is the probability that 20% of those bonds will default, so the net return will be 80% of 10% = 8.0%. If Portfolio #4 has an expected annual rate of return of 12% over 20 years; but there is the probability that 40% of those bonds will default, so the net return will be 60% of 12% = 7.2%.
Which bond does NOT have interest rate risk?
C Variable Rate Bond A variable rate bond has an interest rate that resets periodically to the market rate of interest (weekly, monthly, quarterly, semi-annually). Because the interest rate moves to the current market rate, the price stays right around par. Any variable rate security has no interest rate (market) risk. A high coupon bond has lower market risk than a low coupon bond, but the risk still exists for this bond. Finally, long maturity bonds are more susceptible to market risk than short maturity bonds.
A 65-year old customer wishes to invest part of his retirement funds with the dual objectives of enhanced income and safety of principal. The customer notices that "C" rated corporate bonds yield significantly more than equivalent maturity Treasury issues and asks you, the registered representative, whether these would be an appropriate investment. The best response is to tell the customer that this is a:
C bad idea because "C" rated corporate bonds have a much higher risk of default than Treasury issues "C" rated bonds are true "junk" with a high risk of default. This is a totally inappropriate investment for a retiree who needs income.
The nominal yield of a bond:
C is unaffected by changes in market interest rates The nominal yield is the stated rate of interest as a percentage of par value. It does not change as bond prices move. However, the current yield and yield to maturity will be affected by changes in bond prices.
An investor believes that interest rates are peaking and wishes to buy long term fixed income securities that will assure the investor of receiving periodic payments at today's rates. The best recommendation is high grade:
C non-callable bonds The investor wishes to receive periodic interest payments, so zero coupon obligations are not appropriate. Furthermore, if interest rates are currently high and the investor wants to "lock-in" these high rates, he or she will want a non-callable issue. If rates drop, the issuer cannot call these bonds. Puttable bonds are of no value unless interest rates rise, devaluing the bond. Then, the holder could exercise the put option and "put" the bond back to the issuer - usually at par.
The amount by which the purchase price of a municipal bond exceeds the par value of the bond is termed the:
C premium If the purchase price of a bond is higher than par, then the bond is selling for more than par. This is the bond's premium.
Bonds quoted on a yield to maturity basis are generally:
C serial bonds Bonds quoted in basis points (yield quotes) are serial bonds - this is the usual case for municipal bonds. Bonds quoted on a percentage of par basis are term bonds.
Serial bonds are quoted on a:
C yield to maturity basis Municipal serial bonds are quoted on a yield to maturity basis. Term bonds are quoted on a dollar basis.
Regarding bonds with put options, all of the following statements are true EXCEPT:
C yields on bonds with put options are higher than similar bonds without this feature Put options are exercisable at the option of the bondholder; once the option is exercisable, the bond price cannot fall below the option price, since the bondholder can always "put" the bond to the issuer for this amount. The put price represents a floor on the market price of the bond. Because the put option removes some of the market risk from the bond, this feature is valued by bondholders, who will accept lower yields on bonds having this option.
In 2020, a customer buys 5 GE 10% debentures, M '30, at 85. The interest payment dates are Feb 1st and Aug 1st. The bonds are callable as of 2025 at 103. The yield to maturity on the bonds is:
D 12.43%
When the price of a bond increases, which of the following statements regarding yields are TRUE? I Current yield increases II Current yield decreases III Yield to maturity increases IV Yield to maturity decreases
D II and IV When the price of a bond increases, yield to maturity, yield to call, and current yield all decrease. The only yield that never changes is the nominal yield or stated interest rate.
The risk that rising interest rates will cause bond prices to fall is:
D Interest Rate Risk Interest Rate Risk is the risk that rising interest rates will cause fixed income securities' prices to fall.
Term corporate bonds are quoted on a:
D percentage of par basis Corporate bonds are usually term bonds - all bonds of an issue having the same interest rate and maturity. Term bonds are quoted on a percentage of par basis in 1/8ths, which is the same as a "dollar" quote.
A municipal dealer quotes a 9 year, 6% term revenue bond at 92. The yield to maturity is:
The formula for yield to maturity is: This bond has a coupon rate of 6% = 6% of $1,000 par = $60 of annual income. The bond is purchased at 92% of $1,000 par = $920; and will mature at $1,000 in 9 years, Thus, the $80 capital gain is earned over 9 years for an annual gain of $80 / 9 = $8.88 per year. The bond is purchased at $920 and matures at $1,000, for an average value of $920 + $1,000 / 2 = $960. The YTM is: $60 + $8.88 / $960 = 7.175% = 7.18%
