Series 6: US Government, Municipal, Money Market Securities

Which of the following statements describe characteristics of Negotiable CDs?

Banks negotiate the terms of the CD The "negotiable" in negotiable CDs means that the holder may sell the instrument to anyone. There is no requirement to return the CD to the bank to "cash it in." Negotiable also means that the bank negotiates the rate and term with the customer. The minimum size is $100,000, not $1 million. Only banks may issue CDs; corporations may not issue them.

Which of the following U.S. Government securities are marketable? I Treasury Bonds II Treasury Notes III Treasury Bills IV Series HH Bonds

I, II, and III only Treasury Bonds, Notes, and Bills are marketable securities, but Series HH bonds are not marketable - rather, they are redeemable. Series HH bonds are bought from, and redeemed with, the Treasury.

All of the following statements concerning municipal bonds are correct EXCEPT:

Capital gains income is exempt from federal income tax Municipal interest income is exempt from Federal income tax (the big tax bite). In addition, interest income is exempt from State and Local tax if the bond is purchased by a resident of the State of issuance. While the interest income from municipals is exempt from Federal taxation, capital gains on municipals are subject to Federal income taxation.

Which of the following is an example of a derivative product?

Collateralized Mortgage Obligations (CMOs) A "derivative" product is one whose value is "derived" via a "formula" from an underlying investment. Options are the most basic derivative - option values are derived from the price movements of the underlying stock, in addition to time premiums on the contracts. Collateralized mortgage obligation values are derived from the underlying mortgage backed pass-through certificates held in trust by recutting the cash flows and applying them to the CMO tranches. Again, these are derived via a formula. Mutual fund shares are not a derivative, because Net Asset Value per share is a direct correlation to the value of total net assets divided by the number of shares outstanding.

A customer wishes to make an investment that provides minimal credit risk with monthly income. Which of the following is the best recommendation?

GNMA Pass-Through Certificates Credit risk is the risk that the issuer will be unable to pay interest and repay principal at maturity. Simply put, it is the risk of default. The U.S. government directly guarantees GNMA certificates, so they have no credit risk. As pass-through certificates they pay income on a monthly basis. While both T-Bonds and T-Notes are government guaranteed and have no credit risk, they do not make monthly payments. T-Bonds pay interest semi-annually. T-Bills do not pay "interest" until maturity. Zero-coupon bonds pay no interest until maturity and their level of credit risk depends on the issuer.

A municipal issue of a State backed by that State's income and sales taxes, is a:

General obligation bond A G.O. (general obligation) bond of a State has the full faith, credit, and unlimited taxing power of the issuer as its backing. The main sources of taxing power for States are income taxes and sales taxes. Special taxes, usually "sin taxes," back "special tax" bonds. These bonds are backed by excise taxes, such as gasoline, liquor, or tobacco taxes. Special assessment bond issues are used where a municipality wants to make an improvement to a limited area, (say put in new street lights) and then only assesses those properties that benefit from the improvement to pay for the debt service on the bonds that were issued to fund the improvement. (Exam Note: Only G.O. bonds are tested; Special tax bonds and Special assessment bond features do not need to be known - since this is a multiple choice test, they are "wrong" answers.) Moral obligation bonds morally obligate the issuer to pay, but the issuer has no legal obligation to pay (for example, a municipality exceeded its legal debt limit).

Typically, who are the parties to repurchase agreements? I Commercial banks with other commercial banks II Federal Reserve Bank with commercial banks III Federal Home Loan Bank with commercial banks IV Department of the Treasury with Federal Reserve Banks

I & II only In a Fed-Dealer Repo, the Fed buys Government and Agency securities from banks with an agreement to sell them back the next day. This gives the banks an injection of cash, increasing the amount of funds that the bank has to lend out. The Fed engages in Repos with bank dealers every day, and uses this as a means of easing credit. There can also be repos directly between 2 bank dealers, one with excess funds to lend out and another that is short of funds. The Fed, not the Treasury Department, enters into repos as part of its monetary policy. The Federal Home Loan Bank purchases mortgages and issues long term bonds to finance this.

Which of the following statements concerning Series HH bonds is correct? I HH bonds pay interest semi-annually II HH bonds are sold at a discount to face value III HH bonds earn a stated rate of interest throughout the life of the bond IV HH bonds are marketable and trade in the over-the counter market

I & III only Series HH bonds are issued at face value and earn a stated rate of interest that is paid semi-annually throughout the bond's life. The annual interest received is taxable each year. Both Series HH and Series EE bonds are non-negotiable.

Interest from which of the following securities is subject to income tax at the federal, state, and local levels? I Fannie Mae Pass Through Certificates II Ginnie Mae Pass Through Certificates III Treasury Bonds IV Agency bonds

I and II only Interest income from mortgage backed pass-through certificates is taxable at both the Federal and States levels (because the homeowner that paid the interest got to deduct it both the Federal and State level). In contrast, interest income received from Treasury and Agency issues is subject to Federal income tax, but is exempt from State and local income taxes (because the States cannot tax Federal obligations and vice-versa).

Which of the following municipal bonds will generate interest that is free of federal income tax? I Revenue bonds II General obligation bonds III Industrial revenue bonds IV Private purpose bonds

I and II only The interest on revenue bonds and general obligation bonds is exempt from federal income tax. These bonds are issued to fund public improvements such as new schools, roads, sewers, airports, etc. In contrast, so-called "non-essential use, private purpose revenue bond issues" are subject to Federal income tax (because they do not benefit the general public). These include industrial revenue bond issues where a municipal authority builds a manufacturing plant that is leased to a corporation. The source of the bond's revenue is the corporation's lease payments and the corporation brings jobs to the area. Convention center and ball stadium bond issues also fall into the taxable municipal bond category.

A mortgage-backed pass-through certificate offers which of the following features? I Monthly payment of principal and interest II Semi-annual repayment of interest and repayment of principal at maturity III A maturity date that is known with certainty IV A maturity date that will vary depending on market interest rate movements

I and IV A mortgage-backed pass-through security represents an undivided interest in a pool of mortgages. With a pass-through security, the pro-rata share of the monthly mortgage payments are "passed-through" to the certificate holder. Each monthly payment is a combined payment of principal and interest, just like the underlying mortgages. Homeowners have the right to prepay their mortgages, so if interest rates fall, the homeowners in the mortgage pool will pay off their "old" mortgages early - and these prepayments will be passed through to the certificate holders. Thus, the maturity of the issue is not known with certainty - it depends on future interest rate movements.

Which of the following are issuers of mortgage backed pass through certificates? I Fannie Mae II Federal Home Loan Banks III Federal Intermediate Credit Bank IV Ginnie Mae

I and IV Fannie Mae and Ginnie Mae buy mortgages from originating lenders, place them into mortgage pools, and then sell mortgage backed pass through certificates that represent an ownership interest in the underlying mortgage pool. The Federal Home Loan Banks buys mortgages from savings and loans, but funds this activity by issuing conventional bonds. The Federal Intermediate Credit Bank makes short term farmer loans, and borrows conventionally to fund this activity.

Which of the following statements concerning T-bills are correct? I 6-month T-bills can be issued by the Treasury II 10-year T-bills can be issued by the Treasury III They are issued with a stated rate of interest IV They are issued at a discount

I and IV T-Bills are issued with maturities of 1, 3, 6 or 12 months. T-Bills are sold at a discount and pay face value at maturity, so they do not pay interest periodically and are not issued with a stated rate of interest.

Which of the following may issue municipal bonds? I State of Illinois II City of Seattle III New York Port Authority IV Cass County, Nebraska

I, II, III and IV A state, county, or city as well as a non-profit authority, such as a port authority or airport authority, may all issue municipal bonds.

Michael, a resident of Pennsylvania, a state that imposes a state income tax, owns the following list of securities. Interest income received from which of the following is EXEMPT from Pennsylvania income tax? I Treasury Bonds II Treasury Notes III Treasury Bills IV Series HH Bonds

I, II, III, and IV Interest income received from any Treasury obligation is subject to Federal income tax, but is exempt from State and local income taxes. The basic idea is that one level of government cannot tax the obligations of another level of government. Thus, the Federal government cannot tax the interest income received from municipal (State) obligations; and the State cannot tax the interest income received from Federal obligations.

Which of the following are municipal securities? I General obligation bonds II Revenue bonds III Series EE bonds IV Industrial development bonds

I, II, IV Series EE bonds are savings bonds issued by the U.S. Government. Types of municipal issues include general obligation bonds backed by tax collections at the state and local level; revenue bonds issued by "municipal authorities" to build toll road, bridges, etc., where the revenues from the facility pay off the bonds; and industrial development bonds, which are issued by "municipal authorities" to build manufacturing facilities that will be leased to a corporation to bring jobs to a depressed area.

Which of the following securities are money market instruments? I Treasury bills II Commercial paper III Treasury bond maturing in 6 months IV Warrants expiring in 6 months

I, II, and III only A money market instrument is a debt that will mature in 1 year or less. Treasury Bills have a maximum 12 month maturity, so they are a money market instrument. Commercial paper has a maximum maturity of 9 months, and so it is a money market instrument. Any U.S. Government debt maturing within 1 year is a money market instrument. A warrant is an equity security. Since it is not a debt, it is not a money market instrument.

A "Reverse Repo" is a debt instrument that evidences that the Federal Reserve has: I lent funds to banks II borrowed funds from banks III taken government securities from banks as collateral IV given government securities to banks as collateral

II and IV In a Fed-Dealer Reverse Repo, the Fed sells Government and Agency securities to banks with an agreement to buy them back the next day. This drains the banks of cash, decreasing the amount of funds that the bank has to lend out. The Fed engages in Reverse Repos with bank dealers every day, and uses this as a means of tightening credit.

Arrange the following money market interest rates from highest to lowest? I Federal Funds Rate II Call Loan Rate III Prime Rate

III, II, I The Fed Funds rate is the rate at which Fed member banks will lend each other reserves overnight. Because of the short duration and the fact that both banks are Fed members, this is the lowest rate of the 3 choices offered. The call money rate is the interest rate that banks charge brokers on "call loans" where margin securities are collateral. This rate is higher than the Fed Funds rate, since one counter-party to the loan is a brokerage firm, instead of a Fed member bank. The Prime rate is the interest rate that banks charge their best commercial customers for an unsecured loan. It is higher than the call money rate because it is unsecured.

Which investor will likely be subject to the AMT on interest income received? A high-income investor with large tax deductions that purchases a(n):

Industrial Revenue bond While the general rule is that municipal interest income is exempt from Federal income tax, any revenue bonds that are "private activity" issues such as Industrial Development Bonds, are subject to a form of Federal income tax called the "AMT" - Alternative Minimum Tax. The idea behind the AMT is that "creative" taxpayers with high incomes can take advantage of "tax preferences" included in the tax code to reduce their taxable income, often to almost nothing. The AMT tax takes these "tax preferences" and adds them back to that person's reported taxable income and then taxes the whole amount at a flat rate of 26-28%. Congress felt that municipal bonds that are not benefitting the public should be taxable; but they included their interest as an "AMT" tax preference item. Thus, the interest becomes taxable only to high-income taxpayers that use tax preferences to reduce taxable income and thus, that become subject to AMT.

Which of the following statements concerning Series HH bonds is correct?

Interest is paid semi-annually Series HH bonds are issued at face value and earn a stated rate of interest that is paid semi-annually throughout the bond's life. The annual interest received is taxable each year. Both Series HH and Series EE bonds are non-negotiable. Series HH Bonds replaced the older Series H bonds $500 was the smallest face amount Investors purchased HH bonds at face They receive interest semi-annually This interest does not accumulate It is reportable each year for federal income tax as received The bonds earn interest for up to 20 years Since 2004 investors may not redeem EE bonds for HH bonds

Which of the following statements concerning federal income taxation of Series HH bond interest is correct?

Interest must be reported annually Series HH bonds are issued at face value and earn a stated rate of interest that is paid semi-annually throughout the bond's life. The annual interest received is taxable each year. Both Series HH and Series EE bonds are non-negotiable.

Which of the following statements concerning commercial paper is correct?

It is unsecured Only companies with good credit quality can issue commercial paper because the debt is unsecured. Banks and insurance companies may buy commercial paper as an investment, but they do not issue it. The maximum maturity found on commercial paper is 9 months, because if its maturity were longer, it would have to be registered with the SEC and sold with a prospectus under the requirements of the securities laws.

The city of Grand Aire issued municipal bonds to finance a major upgrade of its water treatment plant. Grand Aire plans to pay the interest and principal for the bonds by installing new water meters in all properties that use the water supply and sending out water bills to these users. These bonds are:

Revenue bonds The pledge of revenues from an income-producing project backs revenue bonds. The city is charging the users for the water, so these are revenue bonds. In contrast, general obligation bonds are backed by taxing power. The full faith and credit of the U.S. government backs U.S. government bonds. Finally, there is no such thing as a "single-purpose" bond.

Which of the following statements about revenue bonds is FALSE?

Revenue bonds require voter approval to issue True: Revenue bonds are repaid from monies generated by the projects they finance Revenue bonds are municipal bonds Revenue bonds are generally considered riskier than general obligation bonds Although general obligation bonds must receive voter approval, revenue bonds do not. Revenue bonds are municipal issues with interest and principal paid from the revenue generated by the projects funded. Revenue bonds have a higher level of risk than G.O. bonds because they are backed by the revenues from a specific project - and that project may be an economic failure. In contrast, G.O. bonds are backed by broad-based taxing power.

On their federal income tax returns, investors must report interest annually on all of the following securities EXCEPT:

Series EE bonds Series EE savings bonds and Treasury STRIPS are long term "zero-coupon" obligations sold at a discount and are redeemed at face value. The difference is the interest earned. A major benefit of Series EE bonds is that the interest is not taxed until redemption. In contrast, with Treasury STRIPS, the pro-rata annual accrual of the discount must be reported each year and is taxable. Series HH bonds, T-Bonds, and T-Notes pay interest semi-annually and the interest is taxable annually at the Federal level.

All of the following U.S. government debt instruments are marketable, EXCEPT:

Series HH Bonds Series EE and Series HH bonds are not marketable - they are savings bonds that are bought from Treasury and can be redeemed with the Treasury. These are redeemable securities that are "non-negotiable" - that is, they cannot be traded. Treasury bills and Treasury bonds are marketable (negotiable) and the trading market for these is the largest and most liquid in the world.

Which statement is TRUE about interest income received from private activity revenue bonds?

The interest income is a tax preference item included in the AMT While the general rule is that municipal interest income is exempt from Federal income tax, any revenue bonds that are "private activity" issues such as Industrial Development Bonds, are subject to a form of Federal income tax called the "AMT" - Alternative Minimum Tax. The idea behind the AMT is that "creative" taxpayers with high incomes can take advantage of "tax preferences" included in the tax code to reduce their taxable income, often to almost nothing. The AMT tax takes these "tax preferences" and adds them back to that person's reported taxable income and then taxes the whole amount at a flat rate of 26-28%. Congress felt that municipal bonds that are not benefitting the public should be taxable; but they included their interest as an "AMT" tax preference item. Thus, the interest becomes taxable only to high-income taxpayers that use tax preferences to reduce taxable income and thus, that become subject to AMT.

Which of the following statements concerning municipal securities is correct?

The interest income is lower than U.S. Government bonds The nominal yield on municipal bonds is lower than that for both corporate bonds and U.S. Government bonds, because the interest income earned on municipals is exempt from Federal income tax (the big tax bite), while the interest income earned from both corporate and U.S. Government bonds is subject to Federal income tax. Because of this Federal tax exemption, municipal bonds are generally only suitable for customers in high Federal tax brackets. Note that while the interest income from municipal bonds is exempt from Federal income tax, capital gains on municipal bonds are subject to Federal income tax.

Which of the following is a disadvantage of collateralized mortgage obligations?

The proceeds need to be continually reinvested Because the underlying mortgage backed pass through certificates pay monthly, CMOs created from the certificates also pay monthly. These monthly payments must be continually reinvested in order to maintain the best portfolio return. In contrast, conventional bonds pay interest 2 times a year that must be reinvested; and zero-coupon bonds only pay interest and principal at maturity that must be reinvested. CMOs offer a variety of maturities, are very safe because the underlying collateral is Ginnie, Fannie or Freddie pass-through certificates.

Which of the following statements concerning U.S. agency debt is correct?

There is a moral, not legal, obligation on the part of the U.S. government to support the U.S. agency debt instruments Because there is only a moral and not a legal obligation on the part of the U.S. government to pay agency debt, the yields available to investors are slightly higher. In general, yield varies directly with risk. Higher risk means higher yield and lower risk means lower yields.

Which statement best describes bankers' acceptances?

They are a means for financing transactions in foreign goods and services Bankers' acceptances are a means for financing transactions in foreign goods and services. The bankers' acceptance is a draft presented by an exporter to a bank, and the bank has stamped it as accepted. The exporter can immediately "cash out" the draft by selling it in the "money market."

Which statement concerning T-Bonds is correct?

They are sold at par T-Notes and T-Bonds are highly liquid and marketable, since the Treasury market is the largest, most active trading market in the world. T-Notes have 2-10 year maturities, while Treasury Bonds have 30 year maturities. They are sold at par and pay interest semi-annually.

All of the following are originally sold at a discount from face EXCEPT:

Treasury Bonds Treasury Bonds are sold at par and pay interest semi-annually. Treasury Bills are very short term instruments that are sold at a discount from face and mature at par, with the difference being the interest earned. Treasury Receipts and Treasury STRIPs are long term zero-coupon Treasury obligations. They, too, are sold at a discount from face and mature at par, with the difference being the interest earned.

When are Series EE bonds subject to U.S. federal income tax?

Upon redemption Interest on Series EE bonds is subject to reporting for income tax in the year the bondholder redeems the bonds. That is when the bond actually "pays" the interest.

The yield on a private activity revenue bond is likely to be less for a(n):

person that is subject to the AMT While the general rule is that municipal interest income is exempt from Federal income tax, any revenue bonds that are "private activity" issues such as Industrial Development Bonds, are subject to a form of Federal income tax called the "AMT" - Alternative Minimum Tax. The idea behind the AMT is that "creative" taxpayers with high incomes can take advantage of "tax preferences" included in the tax code to reduce their taxable income, often to almost nothing. The AMT tax takes these "tax preferences" and adds them back to that person's reported taxable income and then taxes the whole amount at a flat rate of 26-28%. Congress felt that municipal bonds that are not benefitting the public should be taxable; but they included their interest as an "AMT" tax preference item. Thus, the interest becomes taxable only to high-income taxpayers that use tax preferences to reduce taxable income and thus, that become subject to AMT.

The city of Des Moines has proposed a bond issue to build a football stadium in which a new football team will be the primary tenant. This bond issue is a(n):

private purpose bond, and interest is subject to federal income tax So-called "non-essential use, private purpose revenue bond issues" are subject to Federal income tax (because they do not benefit the general public). These include industrial revenue bond issues where a municipal authority builds a manufacturing plant that is leased to a corporation. The source of the bond's revenue is the corporation's lease payments and the corporation brings jobs to the area. Convention center and ball stadium bond issues also fall into the taxable municipal bond category because the facilities that are built with the bond issue do not benefit the general public.

Negotiable CDs are money market instruments having all of the following characteristics EXCEPT:

they cannot be resold to other investors and may only be redeemed with the issuer Banks issue negotiable CDs, in denominations of $100,000 or more. Banks and their customers negotiate the length and rate of these CDs. These CDs are negotiable, meaning customers purchasing them may sell them to others before they mature.

Which of the following securities is a money market instrument?

A corporate bond maturing in 6 months Money market instruments are a debt that will mature in one year or less. Common stock is equity, not debt. A 5-year debenture is a funded corporate debt - a source of long term funding. A Treasury Bond with 20 years to maturity is a long-term debt, not a money market instrument.

Which of the following is a money market instrument?

T-Bond with 9 months remaining to maturity Any debt that will mature within 1 year is a money market instrument.

Commercial paper has all of the following characteristics EXCEPT:

it can be purchased in $100 notes The money market is aimed at institutional investors, not the small investor, so the minimum purchase is typically $10,000 (not $100). Only companies with good credit quality can issue commercial paper because the debt is unsecured. The maximum maturity found on commercial paper is 9 months, because if its maturity were longer, it would have to be registered with the SEC and sold with a prospectus under the requirements of the securities laws.