Final Exam: Bond Basics

If interest rates are rising, which statement about discount and premium bonds is TRUE? A. Discount bonds will depreciate faster than premium bonds B. Premium bonds will depreciate faster than discount bonds C. Both bonds will depreciate equally D. The rate of depreciation depends on the credit rating of the issuer

A. Discount bonds will 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.

In 2021, a customer buys 5 GE 10% debentures, M '41 at 90. The interest payment dates are Feb 1st and Aug 1st. The bonds are callable as of 2026 at 107. The current yield on the bonds is: A. 10.00% B. 11.11% C. 11.76% D. 12.43%

B. 11.11% The formula for current yield is: Annual Income/Market Price = Current Yield $100/$900 = 11.11%

Which bond will exhibit the greatest price volatility? A. 11-year bond; 7% coupon; 8% yield; duration of 7.71 B. 9-year bond; 0% coupon; 7% yield; duration of 9.00 C. 5-year bond; 4% coupon; 3.50% yield; duration of 4.59 D. 3-year bond; 2% coupon; 1.50% yield; duration of 2.93

B. 9-year bond; 0% coupon; 7% yield; duration of 9.00 The longer the expiration, the more volatile a bond's price movements, which narrows the Choices to either A or B. The lower the coupon, the more volatile the bond's price movements, with the lowest coupon being "0." A 9-year zero coupon bond will actually be more volatile in price movements than a slightly longer maturity bond (11 years) with a fairly high coupon (7% in this case). The higher coupon means that more of the bond's value is represented by the interest stream than comes in early and this stabilizes the bond's price as market interest rates move. 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.

Which of the following Moody's MIG ratings are considered investment grade? I. MIG 1 II. MIG 2 III. MIG 3 IV. SG A. I only B. I and II C. II and III D. I, II, III, IV

B. I and II Moody's rates municipal anticipation notes under the "MIG" (Moody's Investment Grade) ratings scale, with MIG 1 and MIG 2 being investment grades; and the non-investment grades being MIG 3 and SG ("Speculative Grade").

A rising rate of inflation would lead to: I. lower bond prices II. higher bond prices III. lower bond yields IV. higher bond yields A. I and III B. I and IV C. II and III D. II and IV

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 statements are TRUE regarding market risk for bondholders? I. As interest rates rise, the price of long term bonds falls faster than that of short term bonds II. As interest rates rise, the price of short term bonds falls faster than that of long term bonds III. To avoid market risk, a customer would invest in bonds with long term maturities IV. To avoid market risk, a customer would invest in bonds with short term maturities A. I and III B. I and IV C. II and III D. II and IV

B. I and IV Market risk for a bondholder is the risk of rising interest rates forcing the price of a bond to drop. As interest rates rise, the price of a long term bond falls faster than that of a short term bond. To avoid market risk, a bondholder would want to invest in the shortest maturity possible.

A "call premium" on a bond is the: A. amount by which the purchase price of the bond exceeds par B. amount by which the redemption price prior to maturity exceeds par C. amount which the redemption price at maturity exceeds par D. maximum premium at which the bond can trade over its life

B. amount by which the redemption price prior to maturity exceeds par A call premium is the excess over par value that the issuer will pay the bondholder to call in the bonds prior to maturity.

The nominal yield of a bond will: A. increase as bond prices fall B. remain unchanged as bond prices fluctuate C. increase as bond prices rise D. decrease as bond prices rise

B. remain unchanged as bond prices fluctuate 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.

Which of the following affect the marketability of corporate bonds? I. Bond rating II. Maturity III. Block size IV. Bond denominations A. I only B. II only C. I, II, III D. II, III, IV

C. I, II, III The higher rated a bond, the more marketable it is. The shorter the maturity, the more marketable it is. 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 bond denominations have no effect on marketability.

When the yield curve is inverted, which of the following statements are TRUE? I. Short term rates are lower than long term rates II. Short term rates are higher than long term rates III. To maximize income, an investor should invest in short term maturities IV. To maintain income, an investor should invest in long term maturities A. I and III B. I and IV C. II and III D. II and IV

C. II and III When the yield curve is "inverted," short term rates are higher than long term rates. To maximize income during this period, a customer would liquidate long term (lower rate) holdings and invest in short term (higher rate) holdings.

Bonds quoted on a yield to maturity basis are generally: A. term bonds B. series bonds C. serial bonds D. short term maturities

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.

Which of the following will increase the marketability risk of a bond? I. Active trading in that security II. Inactive trading in that security III. Round lot size transaction amount IV. Large block size transaction amount A. I and III B. I and IV C. II and III D. II and IV

D. II and IV Marketability risk is the risk that a security will be difficult to sell. The easiest securities to trade are "round lots" of actively traded issues. For example, a round lot of stock is 100 shares; a round lot of bonds is 5 bonds. Large blocks are more difficult to market; and it is more difficult to sell thinly traded securities than actively traded securities.