Checkpoint Exam U13

An investment adviser representative has a client who prefers the safety of securities guaranteed by the U.S. Government, yet is concerned about volatility due to uncertainties in the future direction of interest rates. Which of the following recommendations would best address these concerns? A) 5% Treasury bond, maturing in 2037 B) 8% Treasury bond maturing in 2036 C) 6% Treasury bond maturing in 2035 D) Treasury STRIPS, maturing in 2036

B) 8% Treasury bond maturing in 2036 Generally speaking, those bonds with the highest coupons have the shortest duration, therefore, are the least subject to interest rate risk. STRIPS, which are zero-coupon bonds, are the most volatile because they have the longest duration. The actual calculation of the duration of each of the other bonds given is beyond the scope of this exam. U13LO11

In general, from the choices given, the type of security offering the greatest degree of safety to an investor is A) preferred stock B) a debenture C) a mortgage bond D) common stock

C) a mortgage bond Debt securities, because they are an obligation of the issuer, are generally considered safer than equity securities. Secured debt is safer than unsecured debt. The only one of these debt obligations with pledged assets as security for the loan is the mortgage bond. Debentures are unsecured corporate debt obligations. U13LO3

As defined in the Securities Exchange Act of 1934, the term municipal security would include A) a U.S. Treasury bill B) a City of Chicago school district bond C) a Province of Ontario library construction bond D) 50-year bonds issued by the Tennessee Valley Authority

B) a City of Chicago school district bond 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. U13LO5

To secure the debt that a subsidiary is offering, a railroad holding company transfers to a trustee the common stock of another subsidiary. The offering is one of A) collateral trust certificates B) secured income notes C) equipment trust certificates D) guarantee trust bonds

A) collateral trust certificates When a company uses the securities of one subsidiary to collateralize a bond issue of another subsidiary, the bonds are known as collateral trust certificates. U13LO3

Which of the following is NOT a money market instrument? A) Treasury bills B) Commercial paper C) Banker's acceptances D) Newly issued Treasury notes

D) Newly issued Treasury notes Commercial paper, Treasury bills, and banker's acceptances are debt instruments with maturities of 1 year or less and are therefore money market instruments. A newly issued Treasury note would have a maturity of 2 to 10 years and therefore would not be a money market instrument. U13LO13

All of the following are true of government agency bonds EXCEPT A) they are considered relatively safe investments B) they trade openly C) older ones have coupons attached, new ones are book entry D) they are direct obligations of the U.S. government

D) they are direct obligations of the U.S. government The only government agency that is a direct obligation of the U.S. government is the Ginnie Mae security. All of the others are moral obligations. U13LO1

An analyst wishes to assess the value of a fixed income security by taking the income payments scheduled to be received over a given future period and adjusting that for the time value of money. This analytical tool is known as A) discounted cash flow B) yield to maturity C) duration D) future value

A) discounted cash flow The discounted cash flow (DCF) for a fixed income security (bond) is a summary of the expected interest payments that has been adjusted to reflect the time value of money. With all other things being equal, the bond with the higher DCF is the better investment. U13LO12

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) Interest payments of $40 C) 60 payment periods D) Present value of $1,100

B) Interest payments of $40 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

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

A) U.S. Treasury zero-coupon bonds with a maturity corresponding to the maturity of the individual Brady bond 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

Which of the following statements regarding convertible bonds is NOT true? A) Convertible bondholders are creditors of the corporation. B) If there is no advantage to converting the bonds into common stock, they would sell at a price based on their market value without the convertible feature. C) Coupon rates are usually higher than nonconvertible bond rates of the same issuer. D) Coupon rates are usually lower than nonconvertible bond rates of the same issuer.

C) Coupon rates are usually higher than nonconvertible bond rates of the same issuer. The bondholders are creditors. Coupon rates are not higher; they are lower because of the value of the conversion feature. If the stock price falls, the conversion feature will not influence the bond's price. U13LO8

GNMA mortgage-backed securities are A) exempt from federal income tax for the interest payments received by the bondholders B) available to investors through a minimum purchase of $5,000 C) a direct obligation of the U.S. government D) backed exclusively by a pool of mortgages

C) a direct obligation of the U.S. government GNMA securities are a direct obligation of the U.S. government and are backed by a pool of mortgages. The monthly payments are partially a return of principal and partially taxable interest, which is subject to state and federal income tax. GNMA pass-through securities are available to investors with a minimum issue price of $25,000. U13LO1

A method of assessing the value of a fixed-income security by looking at the future expected free cash flow and discounting it to arrive at a present value is known as A) future value B) internal rate of return C) discounted cash flow D) current yield

C) discounted cash flow The discounted cash flow, DCF, is used to assess the value of a fixed-income security by looking at the future expected free cash flow and discounting it to arrive at a present value. This is basically nothing more than taking the income payments you are scheduled to receive over a given future period and adjusting that for the time value of money. U13LO12

Which of the following is TRUE of a zero-coupon bond? The rate of return is locked in. There is no reinvestment risk. The imputed interest is taxed as ordinary income on an annual basis. A check for the interest is paid at maturity. A) I only B) I and IV C) I, III, and IV D) I, II, and III

D) I, II, and III Zero-coupon bonds pay no periodic interest and are always issued at a discount from par. The appreciation of the zero from its discounted purchase price to its face value is thought of as interest to the bondholder, but this annual "phantom income," so named because you don't receive it, is taxed as ordinary income on an annual basis. When the bond is purchased, the investor locks in that yield, and with nothing to reinvest, there is no reinvestment risk. U13LO8

One would look at the average maturities when doing a cash flow analysis for A) Brady bonds B) subordinated debentures C) revenue bonds D) mortgage-backed pass-through securities

D) mortgage-backed pass-through securities Mortgage-backed pass-through securities pass-through interest and principal payments to their investors. The rate at which the cash flows are generated depends, among other things, on the rate at which the mortgages mature. U13LO12

Which of the following municipal bonds would be most subject to interest rate risk? A) 7.8s '35 on a 7.4% basis B) 8s '40 on a 7.8% basis C) 7.5s '29 on a 7.2% basis D) 7s '28 on a 7½% basis

B) 8s '40 on a 7.8% basis The longer the duration of a bond, the greater the interest rate risk. The 8s '40 on a 7.8% basis, (YTM), is a bond with a 2040 maturity, which is the longest maturity (without a substantially higher coupon) of the choices available. Remember, duration is a function of coupon and length to maturity. If the coupons are relatively close, the longest maturity is the one with the longest duration (and greatest sensitivity to changes in interest rates). There is a giveaway to this answer if you look carefully. The greater the risk, the greater the reward and the 8s '40 have the highest yield, indicating that investors are demanding a higher return for the greater risk. U13LO11

Rank the following bonds in order of shortest to longest duration. ABC 8s of 2040 DEF 9s of 2041 GHI 5s of 2039 JKL zeros of 2035 A) I, II, IV, III B) IV, II, I, III C) II, I, III, IV D) III, I, II, IV

C) II, I, III, IV A bond's duration consists of two interrelated components; the coupon and the length to maturity. When the coupon rates are approximately the same, the bond with the nearest maturity will have the shortest duration and that with the latest maturity, the longest duration. When the maturities are approximately the same, the bond with the highest coupon will have the shortest duration and the one with the lowest coupon (and you can't get lower than zero) will have the longest duration. Unless maturing very soon, zero coupon bonds (certainly on the exam) will always have the longest duration because they receive no interest payments over the life of the bond. In this example, the maturity dates for the interest bearing bonds are very close (a 2 year spread on bonds maturing in about 25 years) and the zero's maturity is not nearly soon enough to be a factor. Therefore, the bond with the 9% coupon will have the shortest duration, followed closely by the 8% and a good bit behind, the 5%, with the zero bringing up the rear. U13LO11

One popular method of determining the value of certain securities is discounted cash flow. Using the DCF with the current discount rate at 3%, which of the following would be expected to have the highest market value? A) Bay Area Rapid Transit Authority 4% revenue bond maturing in 15 years B) ABC Corporation debenture maturing in 25 years with a 5% coupon C) XYZ Corporation mortgage bond maturing in 10 years with a coupon of 4.5% D) U.S. Treasury bond maturing in 20 years with a 4% coupon

B) ABC Corporation debenture maturing in 25 years with a 5% coupon The current discount rate represents market interest rates. At 3%, each of these bonds should sell at a premium (their coupon rates are higher than 3%). When a bond is paying interest at a rate higher than the current market rate, the longer the investor will be receiving that higher rate, the higher the premium. Therefore, the 5% bond with 25 years to maturity will have the highest present value using the DCF. U13LO12

A TIPS bond with a par value of $1,000 has a coupon rate of 6%. During year 1, the inflation rate is 8%. How does this affect the TIPS in year 2? A) There is no effect until the 3rd year. B) The market price increases to approximately $1,080. C) The interest payment will be approximately $65. D) The coupon increases to 8%.

C) The interest payment will be approximately $65. On a semiannual basis, the principal value of a TIPS is increased by that year's inflation rate. A TIPS bond adjusts principal every 6 months based on the inflation rate. With an annual rate of 8%, the first semiannual adjustment is half of that, or 4%. That increased the principal value to $1,040. The next 6 months adds 4% to the $1,040 bringing the end-of-year value to $1,081.60. The 6% coupon rate will be applied to the new principal giving us approximately $65 in interest paid during the 2nd year. Technically, we would also have to know the inflation rate for the first 6 months of year 2 because that will impact the amount of interest paid on the 2nd semiannual payment date. If that information is not given, just go with it as we have it here. As noted in the solution, the principal value has increased to a bit over $1,081, but the market price is determined by supply and demand and could be higher or lower. U13LO1

Which of the following would be most likely to increase a bond's liquidity? A) No call protection B) A higher rating C) A lower rating D) A longer maturity

B) A higher rating 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. The absence of call protection is negative to many investors thus limiting the number of potential investors. U13LO4

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) future value of the par value repaid at maturity plus the future value of the coupon payments B) present value of the par value repaid at maturity plus the present value of the coupon payments C) present value of the par value repaid at maturity plus the future value of the coupon payments D) future value of the par value repaid at maturity plus the present value of the coupon payments

B) present value of the par value repaid at maturity plus the present value of the coupon payments 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

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

B) II and III 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. U13LO10

You are meeting with a relatively unsophisticated investor who doesn't understand very much about stocks and bonds. When asked, "can you list the advantages of owning common stock as compared to bonds?" among other reasons, you could reply A) there is limited liability B) bonds must be surrendered at maturity or at a call while the owner of common stock can hold the investment as long as desired C) bonds have priority over any equity security in the event of liquidation D) income payments are more reliable

B) bonds must be surrendered at maturity or at a call while the owner of common stock can hold the investment as long as desired One negative of owning bonds is that the bond will ultimately mature or be called and the bondholder has no choice but to surrender the security. With common stock, the investor has total control over the length of the holding period. Although there are many positive benefits to owning bonds compared to common stock, among them is priority in the event of liquidation and regular payment of interest. Yes, common stock has limited liability, but the same is true of the bondholder—if the company goes under, the bondholder's maximum loss is the investment. Even then, because of its seniority, it is less likely that the entire investment will be lost. U13LO8

Your client in the 35% federal income tax bracket currently owns some corporate bonds with a coupon yield of 7%. In order to receive the same income after taxes, he would need to buy municipal bonds with a coupon of A) 4.55% B) 2.45% C) 9.45% D) 7.00%

A) 4.55% Because the 7% on the corporate bond is fully taxable, the client receives a net of 4.55% ($70 per bond less 35% in taxes {$24.50}, or $45.50 per year). Interest on municipal bonds is tax free, so a 4.55% coupon will result in the same amount of after-tax income. U13LO6

Which of the following choices offers the highest tax-equivalent yield? A) 6.2% municipal bond to a corporation in the 21% tax bracket B) 5% municipal bond to an individual in the 35% tax bracket C) 5.8% municipal bond to an individual in the 25% tax bracket D) 5.5% municipal bond to an individual in the 28% tax bracket

A) 6.2% municipal bond to a corporation in the 21% tax bracket 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%. U13LO6

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) $22.55 B) $35.33 C) $50.00 D) $8.83

B) $35.33 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

Of the following bonds, which has the greatest price volatility? A) AA corporate bond with 7 years to maturity B) Zero-coupon bond with 15 years to maturity C) Corporate bond fund D) Zero-coupon bond with 5 years to maturity

B) Zero-coupon bond with 15 years to maturity The longer the duration of a bond, the greater the volatility will be of its market price when interest rates change. Because zero-coupon bonds do not make interest payments but are priced at a deep discount to par value, they are more volatile than coupon-bearing bonds. U13LO11

A TIPS bond is issued in the principal amount of $1,000, paying 3.5%. Over the security's 5-year term, the inflation rate is 4%. What is the amount of the final semiannual interest check? A) $42.66 B) $17.50 C) $21.33 D) $35.00

C) $21.33 The semiannual interest of a TIPS bond is computed on the basis of the inflation-adjusted principal. Because the principal increases with the inflation rate, at the end of the 5-year term, it has grown to $1,219 ($1,000 × 102% ten times). Therefore, the final interest check is for $1,219 × 1.75% (remember that it is a semiannual check). The License Exam Manual (LEM) contains a step by step example of how this computation works. U13LO1

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) Coupon rate C) Rating of the bond D) Time until maturity

C) Rating of the bond 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

Which of the following statements regarding U.S. government agency securities is TRUE? A) They are the direct obligations of the U.S. government. B) Interest received on agency securities is exempt from federal income tax. C) They generally trade on the major stock exchanges. D) They generally offer higher yields than direct U.S. obligations.

D) They generally offer higher yields than direct U.S. obligations. In most cases, securities issued by U.S. government agencies are obligations of that agency rather than the U.S. government. As such, they carry slightly higher risk and that means investors demand a higher return. The do not trade on any exchange and their interest, like that of all U.S. government securities, is taxable on the federal level. U13LO1

One of the advantages of owning a corporation's debentures is that you have prior claim over A) employees B) secured creditors C) general creditors D) preferred stockholders

D) preferred stockholders Holders of a company's debentures are general creditors and, as such, only have prior claim over equity holders. U13LO3

Which of the following projects is most likely to be financed by a general obligation rather than a revenue bond? A) Public golf course B) Expansion of an airport C) Municipal hospital D) Public library

D) Public library Hospitals, airports, and golf courses all generate revenue and can be financed with revenue bond issues. Public libraries are financed through GO bond sales with the backing of taxes. U13LO5

An investor purchasing 10 corporate bonds at a price of 102¼ each will pay A) $10,225.00 B) $1,022.50 C) $10,202.50 D) $1,020.25

A) $10,225.00 At 102¼, each bond cost $1,022.50 (102 = 1,020 and ¼ of $10 = $2.50). There are 10 bonds so the total is $1,022.50 × 10 = $10,225. U13LO2

If an investor pays 95.28 for a Treasury bond, how much did the bond cost? A) $95.28 B) $950.28 C) $9,528 D) $958.75

D) $958.75 Treasury bonds are quoted as a percentage of par, ($1,000), plus 32nds. In this case, the price is $950 plus 28/32 (i.e., 7/8) of $10, for a total of $958.75. U13LO2

MNO is planning to raise capital through an offering of 30-year bonds. Which call price would be most beneficial to MNO? A) 104 B) 106 C) 110 D) 102

D) 102 MNO would benefit most from the ability to call bonds at the lowest possible price. The call feature enables MNO to buy the bonds before maturity to reduce their fixed interest costs. A call price of 102 requires the lowest call premium of the options shown. U13LO8

A TIPS bond is issued in the principal amount of $1,000, paying 3.5%. Over the security's 5-year term, the annual inflation rate is 6%. What is the principal value of the bond at the end of 4 years? A) $1,344 B) $1,240 C) $1,300 D) $1,267

D) $1,267 The unique feature of a TIPS bonds is its semi-annual adjustment to principal based on the inflation rate. With an annual inflation rate of 6%, there is a 3% increase to the principal value every 6 months. The arithmetic is $1,000 multiplied by 103% consecutively 8 times (there are 8 semi-annual periods in 4 years). Be sure to stop at 4 years—the question doesn't ask for the ending value for the 5th year. U13LO1

All the following securities are issued at a discount EXCEPT A) CDs B) Treasury bills C) commercial paper D) zero-coupon bonds

A) CDs CDs are interest-bearing debt instruments issued by banks at their face value. All of the others are issued at a discount. In truth, only about 85% of commercial paper is, but that's good enough for NASAA. U13LO13

Although there are a number of risks to owning a debt security that are common to all investors, which specific risk is avoided when a U.S. resident purchases a Eurodollar bond? A) Currency risk B) Inflation risk C) Default risk D) Interest rate risk

A) Currency risk Eurodollar bonds are denominated in dollars; therefore, no currency risk exists for a U.S. resident. U13LO7

A TIPS bond is issued in the principal amount of $1,000, paying 3.5%. Over the security's 5-year term, the inflation rate is 4%. What is the principal value of the bond at the end of 5 years? A) $1,200 B) $1,219 C) $1,000 D) $1,440

B) $1,219 In addition to paying interest, a TIPS bond increases its principal value semiannually by the amount of inflation. If the inflation rate is 4% for 5 years, the principal value of the bond increases semiannually by that inflation rate. Allowing for compounding, the best choice would be the $1,219. This is computed by multiplying $1,000 by 102% 10 times. The License Exam Manual (LEM) contains a step by step example of how this computation works. U13LO1

When an investor notices that a bond's coupon yield is lower than its current yield, that is an indication that the bond A) is probably rated investment grade B) is selling at a discount C) is in danger of going into default D) is selling at a premium

B) is selling at a discount The coupon yield, or nominal yield, is the rate stated on the face of the bond. It never changes. However, because the current yield is computed by dividing the coupon rate by the current market price, this return will constantly be in flux. Anytime the price of the bond is below par (selling at a discount), its current yield will be higher than the coupon. U13LO10

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 $30 per share B) somewhat above $48 per share C) somewhat below $48 per share D) somewhat above $30 per share

C) somewhat below $48 per share 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. U13LO9

If interest rates were to decline sharply, which of the following securities is likely to appreciate the most? A) 20-year municipal bond currently trading at par B) 20-year mortgage-backed security currently trading at a small discount C) 20-year corporate bond currently trading at a small premium D) 20-year zero-coupon Treasury bond currently trading at a deep discount

D) 20-year zero-coupon Treasury bond currently trading at a deep discount As a rule, the longer the duration, the greater the price appreciation. In this case, all the fixed-income securities have 20-year maturities. Another general rule is that the lower the coupon on the bond, the longer the duration. The zero-coupon bond has the lowest coupon and would likely appreciate the most. U13LO11

Which of the following is TRUE of GNMA securities? Interest is subject to federal income tax. Interest is exempt from federal income tax. They are backed by farm mortgages. They are backed by residential mortgages. A) I and III B) II and IV C) II and III D) I and IV

D) I and IV Income received by investors in Government National Mortgage Association (GNMA) securities is subject to both state and federal income tax, and the asset backing them is residential mortgages. U13LO1