Series 7 - Progress Exam 3A/3B
Which of the following would increase most in price if interest rates decline? Short-term bonds selling at a discount Long-term bonds selling at a discount Short-term bonds selling at a premium Long-term bonds selling at a premium
*Long-term bonds selling at a discount* When interest rates decline, bond prices rise. The longer maturities rise more in price than the shorter maturities due to market risk. Bonds selling at a discount rise more sharply in price than those selling at a premium. A bond with a high coupon would tend to trade at a premium and a bond with a low coupon would tend to trade at a discount. The bond with the high coupon will repay an investor sooner than a bond with a low coupon since the investor will be earning more money from the coupon on a bond selling at a premium. Therefore, bonds that have longer maturities and/or lower coupon rates will have a higher degree of interest rate risk. Due to this fact, if interest rates decline, the long-term bond selling at a discount will increase (in percentage terms) more than the long-term bond selling at a premium. Another way of looking at this is a $50 price change to a long-term bond selling at $900 is equal to a 5.55% change in price whereas a $50 price change in a long-term bond selling at $1,200 is equal to a 4.17% change in price.
A corporation has issued a bond with a 5% coupon that is convertible into common stock at $40. The stock is selling at $43.50 and the bond is selling at 109. The number of shares that will be received on conversion is:
25 The conversion price is $40. To find the conversion ratio (the number of shares of common stock received if the bond is converted), divide the par value of the bond ($1,000) by the conversion price ($40). This is equal to 25 ($1,000 divided by $40 equals 25). For every bond that is converted, the investor will receive 25 shares of common stock. The current price of the stock and bond are not relevant when calculating the conversion ratio.
An individual owns an ARF corporation 8% convertible debenture. The debenture is convertible at 20 and is currently selling in the market at 97 1/2. If ARF common stock is trading in the market at 18, at what price should the debenture sell to be at a 10% premium to parity with the common?
990.00 Since the conversion price is $20 per share, the debenture can be converted into 50 shares ($1,000 par divided by $20 per share). If converted, the stock will have a total value of $900 (50 shares x $18 per share market price). To be at a 10% premium to parity, the debenture should be trading at $990 ($900 parity plus 10% of $900).
A bond secured by other bonds and securities is referred to as a:
A bond issued by a corporation that is secured by other bonds and securities is called a collateral trust bond. A CMO is backed by mortgages that were purchased from banks and other lenders who originated loans to homeowners.
An indenture of a bond has a closed-end provision. This means that:
A closed-end provision in a bond indenture means that additional borrowing against a particular source of revenue is prohibited. An open-end provision means additional borrowing against a revenue source is permitted.
A corporate bond that has no specific collateral backing it and is guaranteed by the full faith and credit of the issuing corporation is called a(n):
A corporate bond that has no specific collateral backing it and is guaranteed by the full faith and credit of the issuing corporation is called a debenture. Most corporate debt issued falls into this category.
An investor purchased T-bonds that mature January 1, 2020. He purchased the T-bonds on Friday, February 20, for regular-way settlement. How many days of accrued interest did the investor owe?
Accrued interest is calculated from the last interest payment date up to, but not including, the settlement date. The last interest payment was made January 1. (Since maturity is January 1, 2020, interest payments are every January 1 and July 1.) The settlement date is Monday, February 23. (A transaction for government securities settles on the next business day.) Government securities accrue interest on actual days elapsed. The investor, therefore, owes 31 days for January and 22 days for February (not including settlement date), for a total of 53 days.
When comparing long-term bonds to short-term bonds, all of the following statements about long-term bonds are TRUE, EXCEPT: They usually have higher yields than short-term bonds They usually provide greater liquidity than short-term bonds They usually are more often callable than short-term bonds Their market prices are more sensitive to interest-rate changes than short-term bonds
All of the statements about long-term bonds compared to short-term bonds are true except that they usually provide greater liquidity than short-term bonds.
Which of the following statements BEST describes an indenture? It is a written agreement between the issuer of a bond and an underwriter It is a written agreement between the underwriter and investors when a new bond is issued It is a contract between the issuer of a bond and the trustee for the benefit of the holder of the bonds It is a contract between the issuer of stock and shareholders of a corporation
An indenture is a written contract between the issuer of bonds and the trustee under which bonds and debentures are issued. Listed in the indenture are the maturity date, the coupon rate, other terms for the benefit of the bondholder, and obligations of an issuer of a bond.
An outstanding municipal bond would most likely be called when interest rates:
Bonds may contain a provision that allows the issuer, at its option, to redeem the bonds before they mature. Call provisions usually benefit the issuer, which has the option of calling in the bonds when interest rates decline. The issuer may then refinance the debt at a lower rate of interest. For instance, if an issuer's outstanding bond is paying a coupon rate (nominal yield) of 9% at a time when similar bonds are paying only 5%, the issuer can reduce its interest costs by calling in the 9% bonds and issuing new ones at 5%. As interest rates decline, a bond's yield to maturity or yield to call would also decline.
A 5% $1,000 par value bond sells at $900 and matures in 10 years. What is the amount of each interest payment?
Bonds pay interest every six months (semiannually). The dollar amount of interest payments is computed as a percentage of the par value. In this example, the coupon rate is 5%. The annual interest payment is $50 (5% of $1,000 par value). Each interest payment is one-half of that amount, or $25.00.
Which of the following statements is NOT TRUE regarding commercial paper? It is issued by a corporation for cash flow purposes It is usually not backed by any of the corporation's specific assets It is considered an exempt security if it matures in more than 270 days It may be sold to the public by a broker-dealer or the issuer
Commercial paper is unsecured corporate debt with a *maximum maturity of 270 days. * Commercial paper is usually marketed through certain dealers but some corporations market their paper directly. Some issues are interest bearing (have a stated interest rate) but most are discount instruments. Corporations issue commercial paper to satisfy a short-term need for cash.
Private label CMOs are more likely than government-sponsored CMOs to be subject to which of the following risks? Extension Prepayment Credit Interest-rate
Credit Private label CMOs include mortgages that are issued by banks and are subject to the creditworthiness of the issuer. By contrast, government-sponsored CMOs are supported by the government agency that backs them.
Duration measures
Duration measures price sensitivity for fixed-income securities given changes in interest rates. For example, a bond with a 7-year duration would experience a 7 percent change in price for every one percent change in market interest rates.
Which of the following statements is TRUE concerning bonds issued by FNMA (Fannie Mae)? They have yields that are lower than comparable Treasury securities They are a direct obligation of the U.S. government The value of these securities is highly dependent on current interest rates They are generally not considered suitable for investors seeking income
Government-Sponsored Enterprise (GSE) bonds, such as those issued by FNMA (Fannie Mae) or FHLMC (Freddie Mac) are not direct obligations of the U.S. government. They are able to borrow funds from the government, which makes their yield slightly higher than Treasury securities with the same maturities. As with most fixed-income securities, their value is highly dependent on current interest rates, and they are suitable for investors seeking income.
A client is seeking a safe investment that pays interest on a monthly basis. Which of the following securities would be an appropriate recommendation? STRIPS Preferred stock Treasury notes GNMA modified pass-through certificates
Interest (and principal) payments on GNMA pass-through certificates are made monthly. Treasury notes and bonds pay interest semiannually. Preferred stock dividends are paid to shareholders only when declared by the corporation's board of directors. STRIPS are a zero-coupon Treasury security (non-interest-bearing).
The real interest rate is best defined as the: Interest earned by an investor after taxes Interest earned that is less than the rate of inflation Interest earned that exceeds the inflation rate Amount that LIBOR exceeds the fed funds rate
Interest earned that exceeds the inflation rate
Which of the following statements describes the greatest risk associated with mortgage-backed securities? Borrowers might default on their mortgage payments The market for mortgage-backed securities is illiquid The market price of the bonds might fall due to a rating downgrade Falling interest rates might accelerate early repayment of principal
Mortgage-backed securities are subject to prepayment risk. The early return of principal would then need to be reinvested when rates are low. Many mortgages that underlie mortgage-backed securities are backed by government guarantees or private mortgage insurance, which insulates many holders from defaults on the underlying mortgages.
Which of the following securities is NOT guaranteed by the U.S. government? Treasury notes Treasury bills Government National Mortgage Association (Ginnie Mae) certificates Federal National Mortgage Association (Fannie Mae) bonds
Of the choices given, the only obligations that are not guaranteed by the U.S. government are FNMA (Fannie Mae) bonds. FNMA was created as a government-chartered private corporation. It borrows funds and uses the proceeds to purchase conventional residential mortgages. Although FNMA can borrow funds from the U.S. government, the securities it issues are not directly backed by the U.S. government.
Private label CMOs are more likely than government-sponsored CMOs to be subject to which of the following risks?
Private label CMOs include mortgages that are issued by banks and are subject to the creditworthiness of the issuer. By contrast, government-sponsored CMOs are supported by the government agency that backs them.
A municipality will refund a revenue bond issue for all of the following reasons, EXCEPT to: Reduce interest charges Issue new bonds at lower interest rates Reduce the market value of outstanding bonds that are not refunded Eliminate restrictions in the bond resolution
Reduce the market value of outstanding bonds that are not refunded
Which of the following statements is NOT a feature of GNMA pass-through certificates? They are backed by the U.S. government Interest is subject to federal tax but is exempt from state tax Interest and principal payments are made on a monthly basis Pools consist of fixed-rate residential mortgages
The Government National Mortgage Association (Ginnie Mae) is an agency of the United States government. It guarantees a pool of mortgages purchased by investors through Ginnie Mae pass-through certificates. These instruments pay interest and principal monthly at a stated rate on the remaining principal. The repayment of principal and interest is guaranteed by the United States government. Ginnie Mae pass-through certificates are purchased in $25,000 minimums. *Interest received from Ginnie Mae pass-through certificates is subject to federal, state, and local taxes.*
The Trust Indenture Act of 1939 establishes:
The Trust Indenture Act relates to the issuance of corporate debt instruments. It requires that a trustee be appointed to act in the bondholders' interest.
A bond is selling at a premium. This indicates that:
The amount that the market price exceeds the par value is known as a premium. One reason for selling at a premium is a decrease in interest rates after the bonds were issued. When looking at the yields for premium bonds, the nominal yield is the highest, followed by the current yield, with the yield to maturity being the lowest yield of the three.
American Utility Company of Ohio is offering $750,000,000 worth of 8% bonds at a price of 99.25% of par value. An investor buying the bonds will receive yearly interest of:
The bonds have a coupon rate of 8%. The bonds pay 8% of their par value of $1,000 each year or $80 (8% of $1,000 = $80) in interest payments.
When a bond is selling at a premium:
The market price is greater than the par value
Which of the following CMOs has the MOST prepayment risk? Sequential pay tranches Accrual or Z tranches Planned amortization class (PAC) tranches Support or companion tranches
The planned amortization class (PAC) is a type of CMO that is designed for more risk-averse investors and provides a predetermined schedule of principal repayment, as long as mortgage prepayment speeds are within a certain range. This greater predictability of maturity is accomplished by establishing a sinking-fund type of schedule. The PAC tranche has top priority and receives principal payments up to a specified amount. Any excess principal goes to a companion or support tranche that has lower priority. Holders of the companion tranche are generally compensated for this risk with higher yields.
A company has $50,000,000 par value convertible bonds outstanding. The coupon rate is 8%. The bonds are currently selling at 96. What is the current yield?
To find the current yield of the bonds, divide the yearly interest paid on the bonds by the current market value of the bonds. The yearly interest is $80. The market value of a bond is $960. Therefore, the current yield equals 8.3% ($80 divided by $960 equals 8.3%). The fact that these are convertible bonds is not relevant.
Which TWO of the following securities may be included in the STRIPS program to create zero-coupon securities? Treasury bills Treasury notes TIPS Treasury bonds
Treasury bills Treasury bonds Treasury STRIPS are created when Treasury notes and Treasury bonds are separated (stripped) of their coupons. Treasury bills and Treasury Inflation-Protected Securities (TIPS) are not permitted to be stripped.
A quote of 5.90 - 5.75 is a quote for which of the following securities?
Treasury bills are quoted on a discount yield basis while the other choices are quoted at a price. Since yield is inversely related (moves opposite) to price, the higher yield (5.90) represents the lower price and is the bid. The lower yield (5.75) represents the higher price and is the ask (offer). The other securities are all quoted as a percentage of par in 32nds
A U.S. government bond is selling in the market at 95.28. The dollar value of this bond is:
U.S. government notes and bonds (Treasury securities) are quoted in 32nds. 95.28 is equivalent to 95 28/32nds (28/32 = .875). This is equivalent to 95.875 percent of the par value of $1,000, which equals $958.75.
Three-month and six-month Treasury bills are auctioned by the Federal Reserve Board:
Weekly
Four municipal bonds have the same maturity date. Which of the following bonds will cost an investor the greatest dollar amount when purchased? A 4 3/4% coupon bond offered on a 5.10 basis A 5 1/4% coupon bond offered on a 5.00 basis A 5 3/4% coupon bond offered on a 6.00 basis A 6 1/4% coupon bond offered on a 6.50 basis
When bonds are purchased at a discount (below the $1,000 par value) the yield to maturity (basis) will be greater than the coupon rate (nominal yield). This is the case in all of the choices listed except where the coupon rate of 5 1/4% is greater than the yield to maturity of 5%. This would mean that an investor purchased the bond at a premium (above the $1,000 par value) and paid the greatest dollar amount.
A type of security that is issued by foreign governments and corporations, trades in U.S. markets, and is denominated in U.S. dollars is called a: Global mutual fund Eurodollar bond Yankee bond Repurchase agreement
Yankee bonds are issued by foreign corporations and governments, are dollar-denominated securities, and trade in U.S. markets. Yankee bonds are normally issued by foreign entities when conditions in the U.S. are better than in the foreign country. Eurodollar bonds are issued by U.S. companies and sold to investors overseas and pay their interest in Eurodollars (dollars on deposit in banks outside the U.S.). Since Eurodollar bonds are not initially offered to investors in the U.S., they are exempt from SEC registration.
