SIE - Ch. 2 - Practice Questions
Debentures [are/are not] secured by a physical asset or collateral.
"Are Not" Debentures are bonds not secured by a physical asset or collateral but simply by the "full faith and credit" of the issuer.
_____ are bonds that are secured by financial assets.
"Collateral Trust Bonds" Collateral trusts are bonds that are secured by financial assets, such as stocks and bonds. These are also called collateral trust certificates (CTCs). They are issued by companies that have few hard assets but significant amounts of securities.
_____ is a measure of a bond's sensitivity to interest rates.
"Duration" Duration is a measure of a bond's sensitivity to changes in interest rates. A bond's duration expresses the percentage change in the price of a bond that would result from a 1% change in yield. A bond with a high duration is more sensitive to interest rate changes than a bond with a low duration. If a bond has a duration of 5, its price will decrease roughly 5% with a 1% increase in interest rates; a bond with a duration of 10 will decrease 10% with a 1% increase interest rates. So, in other words, duration measures the risk of interest rate volatility. Another way of thinking about duration is to think about when the principal and interest will be paid to the investor. The more interest paid later in the life of the bond, the more sensitive the bond is to interest rate changes. Bonds with lower coupon rates pay a greater portion of their payments at the end of the bond's life than bonds with higher coupon rates, so bonds with lower coupon rates have higher durations than bonds with higher coupon rates. Zero coupon bonds have the highest duration among bonds of a comparable maturity because all the payments are made at maturity. Additionally, longer-term bonds take more time until all the interest and principal are paid, so they have higher durations than shorter-term bonds.
_____ are secured bonds that offer bondholders a first lien on corporate property.
"Mortgage Bonds" Mortgage bonds are secured bonds that offer bondholders a first lien on corporate property. Having a lien means that if a corporation defaults on its bond payments, the trustee can sell corporate property to pay the bondholders.
Convertible Bond Parity: A customer purchases a 6% XYZ convertible debenture at par for $1,000. The bond is convertible at $25. If the stock is selling at $30 per share and the bond is sold at parity, what will it be sold at?
$1,200. First, find the conversion ratio by dividing the conversion price into the par value: $1,000 / $25 = 40 shares of common stock for 1 bond. Then multiply 40 shares times $30 to find the parity value (40 x $30 = $1,200).
Put the following in order from highest to lowest priority in liquidation: subordinated debentures, secured bonds, common stock, debentures, preferred stock.
**1. Secured Bonds (Secured Debt Holders) 2. Administrative Expenses 3. Unpaid Wages 4. Unpaid contributions to Employee Benefit Plans 5. Customer Deposits 6. Taxes **7. Debentures (Unsecured Debt Holders) **7a. Subordinated Debentures **8. Preferred Stock **9. Common Stock
Convertible Bond Parity: A customer purchased a 6% XYZ convertible debenture at par for $1,000. The bond has a conversion ratio of 50. The price of the stock has risen to $25 per share. The bonds are trading 10% above parity. What can the customer sell his bond for in bond points?
137.5 bond points. First, find the conversion parity value by multiplying the conversion ratio by the stock price: 50 shares x $25 = $1,250. Then multiply the parity value by 110% ($1,250 x 1.1 = $1,375). So he could sell his bond for 137.5 bond points.
Convertible Bond Parity: A customer purchased a 6% XYZ convertible debenture at par for $1,000. The conversion price is $20. If the bond's market price increases by 10%, what is the conversion ratio?
50. Find the conversion ratio by dividing the conversion price into the par value: $1,000 / $20 = 50 shares of common stock for 1 bond. The conversion ratio is not influenced by a rise in the market price of the bond.
What is it called when new bonds are issued with the purpose of using the proceeds to pay off older bonds? A. Refunding B. Defeasement C. A sinking fund redemption D. A bond SWAP
A. A bond refunding is the replacement of existing bonds with new "refunding" bonds. The issuer of refunding bonds often seeks to lower its interest payments by paying off its previously issued (refunded) bonds with newly issued bonds that pay interest at a lower rate. Another reason to refund existing bonds may be to release the issuer from legal covenants or restrictions in the original indenture.
What is it called when an issuer regularly puts money into an escrow account in order to redeem bonds before maturity? A. A sinking fund redemption B. Advance refunding C. Defeasement D. A make-whole provision
A. A sinking fund redemption requires the issuer to set money aside regularly in a reserve account for the redemption of the bonds before maturity.
When is advance refunding most likely to occur? A. When interest rates are low and the bond issue has not reached its call date B. When interest rates are low and the bond is past its call date C. When interest rates are high and the bond issue has not reached its call date D. When interest rates are high and the bond issued has passed its call date
A. Advance refunding is most likely to occur when interest rates are low and the issuer would like to lock in the low rates but the outstanding bond issue has not reached its call date yet. The issuer cannot call the bonds, but it can issue new bonds at the low rate in anticipation of the call date.
For a corporate bond with a par value of $1,000, how much is 60 basis points? I. 0.6% II. $6 III. $60 IV. 6% A. I and II B. I and III C. II and III D. II and IV
A. Basis points refer to one-hundredths of a percent on a yield quote. So 60 basis points would be equivalent to 0.6%. On a $1,000 par bond, 0.06% would be equivalent to $6 (0.6% x $1,000).
Rank the following yields for a premium bond held to maturity from highest to lowest. I. Yield to call II. Coupon rate III. Yield to maturity IV. Current yield A. II, IV, III, I B. IV, I, III, II C. II, IV, I, III D. III, I, IV, II
A. For a premium bond held to maturity, the nominal coupon rate will always be the highest, followed by the current yield, the yield to maturity, and the yield to call. Discount bonds are ranked in the exact opposite order.
Which of the following statements are accurate? I. Moody's highest rating is AAA. II. S&P's highest rating is AAA. III. Any bond with a grade lower than Baa on the Moody scale is considered a junk investment. IV. A bond rated BBB on the S&P scale is less risky than a bond rated Baa on the Moody scale. A. II and III B. I and IV C. I and III D. II and IV
A. II and III S&P's highest rating is AAA, while Moody's highest rating is Aaa. BBB is S&P's equivalent rating to Moody's Baa; both are considered investment-grade ratings, and anything with a lower grade is considered junk. Both S&P and Moody's have subcategories within each grade level called notches. The notches for S&P are expressed as plusses and minuses so that within the lowest investment grade, there is a BBB+, BBB, and BBB-. The notches for Moody's are numbers, so that within the lowest investment grade, there is Baa1, Baa2, and Baa3.
Calculating accrued interest on bond sales: Sheila has just sold her XYZ 5% bond. The bond last paid interest on February 1st and she sold it on Monday, May 15. How much accrued interest should Sheila receive?
Answer: $14.72 Explanation: Sheila's bond will settle on May 17. The bond last paid interest on February 1, so she will receive 30 days for February, 30 days for March, 30 days for April, and 16 days for May. This is 106 days total. Divide 106 by 360 days to calculate the fraction of annual interest Sheila is due: 106/ 360 = 0.2944. Then calculate the amount of annual interest: $1,000 x 5% = $50. The fraction Sheila is due times the annual interest = 0.2944 x $50 = $14.72. This amount will be added to the price she receives for the bond.
Which of the following bonds could have a coupon payment that comes in the mail? I. Fully registered bonds II. Partially registered bonds III. Book-entry bonds IV. Bearer bonds A. I and II B. II and III C. II and IV D. III and IV
B. A bondholder of a bearer bond or a partially registered bond will have to present the coupons to the issuer to receive payment because the coupons are not registered in the bondholder's name. Owners of fully registered and book-entry bonds could have their coupon payments sent to them through the mail because the issuer has the bondholder's name and address on file.
A bond will be more likely to be called when: A. Interest rates rise B. Interest rates fall C. Interest rates are flat D. There is no relation between interest rates and when a bond is called
B. An issuer will be more likely to call an issue of bonds when interest rates fall because it can reissue new bonds at a lower rate.
Which of the following is not a type of corporate money market security? A. Bankers' acceptances B. Debentures C. Commercial paper D. Repurchase agreements
B. Bankers' acceptances, commercial paper, and repurchase agreements are all types of corporate money market securities (short-term and highly liquid). Debentures are bonds not backed by any collateral and, because they are longer term, are typically two to five years. Because they are not highly liquid, they are not considered money market securities.
Which of the following two statements are true? I. The prices of short-term bonds fluctuate more than the prices of long-term bonds, due to changes in interest rates. II. The prices of long-term bonds fluctuate more than the prices of short-term bonds, due to changes in interest rates. III. Long-term bonds tend to be more liquid than short-term bonds. IV. Short-term bonds tend to be more liquid than long-term bonds. A. I and III B. II and IV C. I and IV D. II and III
B. Because there is more time for interest rates to move in an undesirable way, the prices of long-term bonds are more sensitive to changes in interest rates than the prices of short-term bonds. Another way to say this is that long-term bonds have a higher duration than short-term bonds. Duration is a measure of a bond's sensitivity to changes in interest rates. Short-term bonds also tend to be more liquid than long-term bonds because investors don't have to tie their money up for as long.
What would the offer quote be on a $1,000 52-week T-Bill that an investor purchases at $970. A. 97.0 B. 3.0% C. $1,000 D. 1.03%
B. Offers for T-bills are given in yields. This is the yield at which the dealer is willing to sell the bond to an investor. If an investor is willing to buy a $1,000 52-week T-bill for $970, the investor is receiving a $30 discount. The yield for this T-bill would be calculated as follows: $30 / $1,000 = 3.0%. So the offer could be stated as 3.0%.
Which of the following is not true of pre-refunded bonds? A. They are typically AAA rated. B. They are not defeased. C. They no longer count as debt on the issuer's balance sheet. D. The funds that will be used to refund the bonds are held in escrow.
B. When a company issues a set of new bonds and puts the proceeds in an escrow fund to pay off a set of older bonds, it is called pre-refunding or advance refunding. The pre-refunded bonds are typically AAA rated. The funds that will be used in advance refunding must be kept in an escrow account. The pre-refunded bonds will no longer count as debt on the issuer's balance sheet, and when this occurs, the bonds are considered defeased.
Your local Convention Center non-callable revenue bond will mature in four years. Its face value is $1,000 and it has a 4.5% coupon rate. You just bought the bond at par minus 4 points. Which of the following statements is true? A. This is a premium bond. B. Yield to maturity exceeds 4.69%. C. Current yield exceeds at 4.69%. D. After-tax yield equals 4.50%.
B. You bought this bond at a discount, 96% of par. Current yield is its coupon payment/market price, which in this case is just under 4.69%. Since yield to maturity for a discount bond is always greater than current yield, YTM must exceed 4.69%. This bond has the potential to be triple tax-free (meaning tax-free at the federal, state, and local levels). But whether it actually is depends on where the bondholder lives. The holder of a municipal bond pays no state or municipal taxes if she lives in the state or municipality that issued the bond.
What typically happens when a credit agency downgrades a bond? I. Its price goes up. II. Its price goes down. III. Its yield to maturity goes up. IV. Its yield to maturity goes down. A. I and III B. II and III C. I and IV D. II and IV
B. II and III When a credit agency downgrades a security, its price goes down because fewer people want it. Because its price goes down, the inverse relationship between price and yield dictates that its yield to maturity must go up.
A bond is selling at a discount when its: A. Coupon rate is higher than its yield to maturity. B. Current yield is lower than its coupon rate. C. Yield to maturity is higher than its coupon rate. D. Yield to maturity is lower than its current yield.
C. The yield to maturity is higher than the coupon rate and the current yield when a bond is selling at a discount. A discounted bond also has a current yield that is higher than its coupon rate.
Which of the following are types of cash equivalents? I. Money market funds II. Bank certificates of deposit III. U.S. Treasury bills IV. Bonds A. I and II B. II and III C. I, II, and III D. I, II, III, and IV
C. Cash equivalents are the most liquid investment vehicles with very short-term maturities. While cash equivalents tend to be very safe investments, it is possible in extreme cases for cash equivalents to have negative returns. Examples of cash equivalents include money market funds, bank CDs, T-bills, commercial paper, and bankers' acceptances.
A corporate bond selling on the secondary market is quoted at 96 and has a coupon rate of 4.25%. What is the current yield for this bond? A. 4.08% B. 4.25% C. 4.43% D. 4.29%
C. Current yield equals the annual interest divided by the bond price. Remember that corporate bonds are quoted in bond points and each bond point is worth $10. So this bond will cost $960 (96 x $10). Annual interest is calculated by multiplying the coupon rate by the bond's par value. Corporate bonds typically have a par value of $1,000, so the annual interest rate would be 0.0425 x $1,000 = $42.50. So the current yield is $42.50 / 960 = 0.04427, or 4.43%.
Company A has issued a 5% convertible bond with a conversion price of $25. Its current share price is $45. At what price would the bond be trading at parity? A. $1,000 B. $1,125 C. $1,800 D. $1,050
C. In order for a bond to be trading at parity, it needs to be trading at the conversion value. To calculate this value, first find the conversion ratio by dividing the conversion price into $1,000 ($1,000 / $25 = 40 shares per bond). Then take the ratio times the share price, which is equal to $1,800 ($45 x 40). Parity is the price of the bond that is equal to the bond's value if converted to common stock.
What is the price of a $1,000 10-year Treasury bond quoted at 101.08 (excluding accrued interest)? A. $1,010.80 B. $10,108.00 C. $1,012.50 D. $1,010.25
C. Treasury bonds are typically priced in percentage points of par and in fractions of 32nds of percentage points. For example the ".08" of the quote should be understood as 8/32 of a percentage point, or 0.25%. Thus, 101.08 is equivalent to 101.25% of par, which is $1,000 x 101.25, which is $1,012.50.
Company A has issued four different types of bonds. They are all callable bonds. Which bond will Company A be most likely to call? A. 5% bond, callable at 102. B. 5% bond, callable at par. C. 8% bond, callable at 102. D. 8% bond, callable at par.
D. A corporation would be most likely to call the issue of bonds with the highest interest payments. It would also prefer to call the issue without a call premium.
Which of the following is not a secured bond? A. Collateral trust bond B. Equipment trust certificates C. Mortgage bond D. Debenture
D. Debentures are bonds not secured by a physical asset or collateral but rather by the full faith and credit of the issuer. Collateral trust bonds are secured by financial assets, such as stocks and bonds. Equipment trust certificates are secured by equipment, such as a fleet of planes. Mortgage bonds are secured by a lien on the corporation's property.
All of the following are advantages to the issuer of debt financing over equity financing except: A. No ownership dilution B. No loss of control C. Interest payments are a deductible business expense D. Fixed repayment schedule
D. Issuing debt securities allows a business to get financing without diluting ownership and control, which are the downsides of equity financing (selling stock). Additionally, interest on debt is generally a tax-deductible expense on the corporation's taxes. This means that it costs a company more to pay dividends to stockholders than interest to debt-holders, since dividends are paid out of after-tax profits. However, the firm timeline of a loan repayment schedule can be challenging for a business, particularly if the business doesn't generate free cash flow. Selling stock (equity financing) imposes no fixed requirement to repay or compensate the investor.
Which of the following would be considered a money market instrument at issuance? I. Commercial paper II. Repurchase agreements III. T-notes IV. Six-month T-bills A. I, II, and III B. II, III, and IV C. I and III D. I, II, and IV
D. Money market instruments have maturities of one year or less. All of the listed debt instruments meet this characteristic at issuance except for T-notes, which have maturities of 2 to 10 years.
John bought a debt security at par that was issued on 1 Jan 2018. The debt security has a nominal yield of 5% and will mature on 5 Aug 2018. Which of the following statements are true? I. John's debt security is a money market security. II. The bond's coupon rate is 10%. III. John's debt security is a zero coupon bond. IV. The debt security's coupon rate will not be affected if interest rates fluctuate. A. II and IV B. II and III C. I and III D. I and IV
D. The terms "nominal yield" and "coupon rate" mean the same thing. Therefore, the security's coupon rate is 5%. Additionally, nominal yields, or coupon rates, are fixed, so they are not affected by interest rate fluctuations. Since this debt security will mature less than one year from the issue date, it is a money market security. It is not a zero coupon bond, as those bonds don't have nominal yields or coupon rates attached to them. Instead, zero coupon bonds are issued at a discount to par value, and then the interest payments are added up and paid together at maturity.
What two types of risk are callable bonds most susceptible to? I. Call risk II. Default risk III. Reinvestment risk IV. Market risk A. I and IV B. II and III C. III and IV D. I and III
D. While callable bonds are susceptible to all these types of risk, they are especially susceptible to call risk and reinvestment risk. Call risk is the risk that the bonds may be called before maturity, and reinvestment risk is the risk that the bondholder will get back his money early and have to reinvest it at a lower rate.
As the price of the underlying stock of a convertible debenture goes up: I. The parity value of the bond increases. II. The current yield of the bond goes up. III. The parity value of the bond decreases. IV. The current yield of the bond goes down. A. I and III B. III and IV C. II and III D. I and IV
D. With a fixed conversion schedule, the parity value of the bond increases along with the price of the underlying stock. Since the nominal yield of the bond is fixed, the current yield, expressed as a percent of the bond's price, goes down.
Q. #56271 Tom has a bond with a YTM of 5.7%. He bought the bond for $950. Which of the following is true? I. His current yield is greater than 5.7% II. His current yield is less than 5.7% III. His nominal yield is greater than 5.7% IV. His nominal yield is less than 5.7% A. I and IV B. I and III C. II and III D. II and IV
D. II and IV For bonds that are purchased at a premium and held to maturity, the order of the yields from highest to lowest is: Nominal Yield, Current Yield, YTM, and YTC. For bonds that are purchased at a discount, the opposite is true. The bond is selling at a discount so both Nominal and Current Yield must be less than YTM.
Order the following premium bond interest rates from highest to lowest: yield to maturity, current yield, nominal yield.
Nominal Yield, Current Yield, Yield to Maturity
Bonds with a credit rating of _____ or lower are known as junk bonds.
Under the following rating agencies: Standard & Poor's: BB+ Moody's Investors Services: Ba1 Fitch Ratings: BB+ The bonds are interchangeably referred to as 'junk,' 'high-yield,' or 'speculative.'
Order the following discount bond interest rates from highest to lowest: yield to maturity, current yield, nominal yield, yield to call.
Yield to Call, Yield to Maturity, Current Yield, Nominal Yield