CFA 51: Fixed Income Securities: Defining Elements

Relative to an otherwise similar option-free bond, a: putable bond will trade at a higher price. callable bond will trade at a higher price. convertible bond will trade at a lower price.

A is correct. A put feature is beneficial to the bondholders. Thus, the price of a putable bond will typically be higher than the price of an otherwise similar non-putable bond. B is incorrect because a call feature is beneficial to the issuer. Thus, the price of a callable bond will typically be lower, not higher, than the price of an otherwise similar non-callable bond. C is incorrect because a conversion feature is beneficial to the bondholders. Thus, the price of a convertible bond will typically be higher, not lower, than the price of an otherwise similar non-convertible bond.

The provision that provides bondholders the right to sell the bond back to the issuer at a predetermined price prior to the bond's maturity date is referred to as: a put provision. a make-whole call provision. an original issue discount provision.

A is correct. A put provision provides bondholders the right to sell the bond back to the issuer at a predetermined price prior to the bond's maturity date. B is incorrect because a make-whole call provision is a form of call provision; i.e., a provision that provides the issuer the right to redeem all or part of the bond before its maturity date. A make-whole call provision requires the issuer to make a lump sum payment to the bondholders based on the present value of the future coupon payments and principal repayments not paid because of the bond being redeemed early by the issuer. C is incorrect because an original issue discount provision is a tax provision relating to bonds issued at a discount to par value. The original issue discount tax provision typically requires the bondholders to include a prorated portion of the original issue discount (i.e., the difference between the par value and the original issue price) in their taxable income every tax year until the bond's maturity date.

Relative to domestic and foreign bonds, Eurobonds are most likely to be: bearer bonds. registered bonds. subject to greater regulation.

A is correct. Eurobonds are typically issued as bearer bonds, i.e., bonds for which the trustee does not keep records of ownership. In contrast, domestic and foreign bonds are typically registered bonds for which ownership is recorded by either name or serial number. B is incorrect because Eurobonds are typically issued as bearer bonds, not registered bonds. C is incorrect because Eurobonds are typically subject to lower, not greater, regulation than domestic and foreign bonds.

A 10-year bond was issued four years ago. The bond is denominated in US dollars, offers a coupon rate of 10% with interest paid semi-annually, and is currently priced at 102% of par. The bond's: tenor is six years. nominal rate is 5%. redemption value is 102% of the par value.

A is correct. The tenor of the bond is the time remaining until the bond's maturity date. Although the bond had a maturity of 10 years at issuance (original maturity), it was issued four years ago. Thus, there are six years remaining until the maturity date. B is incorrect because the nominal rate is the coupon rate, i.e., the interest rate that the issuer agrees to pay each year until the maturity date. Although interest is paid semi-annually, the nominal rate is 10%, not 5%. C is incorrect because it is the bond's price, not its redemption value (also called principal amount, principal value, par value, face value, nominal value, or maturity value), that is equal to 102% of the par value.

Which of the following provisions is a benefit to the issuer? Put provision Call provision Conversion provision

B is correct. A call provision (callable bond) gives the issuer the right to redeem all or part of the bond before the specified maturity date. If market interest rates decline or the issuer's credit quality improves, the issuer of a callable bond can redeem it and replace it by a cheaper bond. Thus, the call provision is beneficial to the issuer. A is incorrect because a put provision (putable bond) is beneficial to the bondholders. If interest rates rise, thus lowering the bond's price, the bondholders have the right to sell the bond back to the issuer at a predetermined price on specified dates. C is incorrect because a conversion provision (convertible bond) is beneficial to the bondholders. If the issuing company's share price increases, the bondholders have the right to exchange the bond for a specified number of common shares in the issuing company.

Which of the following is a type of external credit enhancement? Covenants A surety bond Overcollaterization

B is correct. A surety bond is an external credit enhancement, i.e., a guarantee received from a third party. If the issuer defaults, the guarantor who provided the surety bond will reimburse investors for any losses, usually up to a maximum amount called the penal sum. A is incorrect because covenants are legally enforceable rules that borrowers and lenders agree upon when the bond is issued. C is incorrect because overcollateralization is an internal, not external, credit enhancement. Collateral is a guarantee underlying the debt above and beyond the issuer's promise to pay, and overcollateralization refers to the process of posting more collateral than is needed to obtain or secure financing. Collateral, such as assets or securities pledged to ensure debt payments, is not provided by a third party. Thus, overcollateralization is not an external credit enhancement.

An affirmative covenant is most likely to stipulate: limits on the issuer's leverage ratio. how the proceeds of the bond issue will be used. the maximum percentage of the issuer's gross assets that can be sold.

B is correct. Affirmative (or positive) covenants enumerate what issuers are required to do and are typically administrative in nature. A common affirmative covenant describes what the issuer intends to do with the proceeds from the bond issue. A and C are incorrect because imposing a limit on the issuer's leverage ratio or on the percentage of the issuer's gross assets that can be sold are negative covenants. Negative covenants prevent the issuer from taking actions that could reduce its ability to make interest payments and repay the principal.

Which of the following best describes a negative bond covenant? The issuer is: required to pay taxes as they come due. prohibited from investing in risky projects. required to maintain its current lines of business.

B is correct. Prohibiting the issuer from investing in risky projects restricts the issuer's potential business decisions. These restrictions are referred to as negative bond covenants. A and C are incorrect because paying taxes as they come due and maintaining the current lines of business are positive covenants.

The legal contract that describes the form of the bond, the obligations of the issuer, and the rights of the bondholders can be best described as a bond's: covenant. indenture. debenture.

B is correct. The indenture, also referred to as trust deed, is the legal contract that describes the form of the bond, the obligations of the issuer, and the rights of the bondholders. A is incorrect because covenants are only one element of a bond's indenture. Covenants are clauses that specify the rights of the bondholders and any actions that the issuer is obligated to perform or prohibited from performing. C is incorrect because a debenture is a type of bond. In many jurisdictions, debentures are unsecured bonds.

If interest rates are expected to increase, the coupon payment structure most likely to benefit the issuer is a: step-up coupon. inflation-linked coupon. cap in a floating-rate note.

C is correct. A cap in a floating-rate note (capped FRN) prevents the coupon rate from increasing above a specified maximum rate. This feature benefits the issuer in a rising interest rate environment because it sets a limit to the interest rate paid on the debt. A is incorrect because a bond with a step-up coupon is one in which the coupon, which may be fixed or floating, increases by specified margins at specified dates. This feature benefits the bondholders, not the issuer, in a rising interest rate environment because it allows bondholders to receive a higher coupon in line with the higher market interest rates. B is incorrect because inflation-linked bonds have their coupon payments and/or principal repayment linked to an index of consumer prices. If interest rates increase as a result of inflation, this feature is a benefit for the bondholders, not the issuer.

A sovereign bond has a maturity of 15 years. The bond is best described as a: perpetual bond. pure discount bond. capital market security.

C is correct. A capital market security has an original maturity longer than one year. A is incorrect because a perpetual bond does not have a stated maturity date. Thus, the sovereign bond, which has a maturity of 15 years, cannot be a perpetual bond. B is incorrect because a pure discount bond is a bond issued at a discount to par value and redeemed at par. Some sovereign bonds (e.g., Treasury bills) are pure discount bonds, but others are not.

A bond that is characterized by a fixed periodic payment schedule that reduces the bond's outstanding principal amount to zero by the maturity date is best described as a: bullet bond. plain vanilla bond. fully amortized bond.

C is correct. A fully amortized bond calls for equal cash payments by the bond's issuer prior to maturity. Each fixed payment includes both an interest payment component and a principal repayment component such that the bond's outstanding principal amount is reduced to zero by the maturity date. A and B are incorrect because a bullet bond or plain vanilla bond only make interest payments prior to maturity. The entire principal repayment occurs at maturity.

A South African company issues bonds denominated in pound sterling that are sold to investors in the United Kingdom. These bonds can be best described as: Eurobonds. global bonds. foreign bonds.

C is correct. Bonds sold in a country and denominated in that country's currency by an entity from another country are referred to as foreign bonds. A is incorrect because Eurobonds are bonds issued outside the jurisdiction of any single country. B is incorrect because global bonds are bonds issued in the Eurobond market and at least one domestic country simultaneously.

A 10-year, capital-indexed bond linked to the Consumer Price Index (CPI) is issued with a coupon rate of 6% and a par value of 1,000. The bond pays interest semi-annually. During the first six months after the bond's issuance, the CPI increases by 2%. On the first coupon payment date, the bond's: coupon rate increases to 8%. coupon payment is equal to 40. principal amount increases to 1,020.

C is correct. Capital-indexed bonds pay a fixed coupon rate that is applied to a principal amount that increases in line with increases in the index during the bond's life. If the consumer price index increases by 2%, the coupon rate remains unchanged at 6%, but the principal amount increases by 2% and the coupon payment is based on the inflation-adjusted principal amount. On the first coupon payment date, the inflation-adjusted principal amount is 1,000 × (1 + 0.02) = 1,020 and the semi-annual coupon payment is equal to (0.06 × 1,020) ÷ 2 = 30.60.

Investors who believe that interest rates will rise most likely prefer to invest in: inverse floaters. fixed-rate bonds. floating-rate notes.

C is correct. In contrast to fixed-rate bonds that decline in value in a rising interest rate environment, floating-rate notes (FRNs) are less affected when interest rates increase because their coupon rates vary with market interest rates and are reset at regular, short-term intervals. Consequently, FRNs are favored by investors who believe that interest rates will rise. A is incorrect because an inverse floater is a bond whose coupon rate has an inverse relationship to the reference rate, so when interest rates rise, the coupon rate on an inverse floater decreases. Thus, inverse floaters are favored by investors who believe that interest rates will decline, not rise. B is incorrect because fixed rate-bonds decline in value in a rising interest rate environment. Consequently, investors who expect interest rates to rise will likely avoid investing in fixed-rate bonds.

A company has issued a floating-rate note with a coupon rate equal to the three-month Libor + 65 basis points. Interest payments are made quarterly on 31 March, 30 June, 30 September, and 31 December. On 31 March and 30 June, the three-month Libor is 1.55% and 1.35%, respectively. The coupon rate for the interest payment made on 30 June is: 2.00%. 2.10%. 2.20%.

C is correct. The coupon rate that applies to the interest payment due on 30 June is based on the three-month Libor rate prevailing on 31 March. Thus, the coupon rate is 1.55% + 0.65% = 2.20%.

An investor in a country with an original issue discount tax provision purchases a 20-year zero-coupon bond at a deep discount to par value. The investor plans to hold the bond until the maturity date. The investor will most likely report: a capital gain at maturity. a tax deduction in the year the bond is purchased. taxable income from the bond every year until maturity.

C is correct. The original issue discount tax provision requires the investor to include a prorated portion of the original issue discount in his taxable income every tax year until maturity. The original issue discount is equal to the difference between the bond's par value and its original issue price. A is incorrect because the original issue discount tax provision allows the investor to increase his cost basis in the bond so that when the bond matures, he faces no capital gain or loss. B is incorrect because the original issue discount tax provision does not require any tax deduction in the year the bond is purchased or afterwards.