Unit #13: Types and Characteristics of Fixed Income (Debt) Securities and Methods Used to Determine Their Value.

A client has indicated that his primary objective is maximizing current income regardless of the risk. Which of the following mutual funds would probably be most suitable for achieving that goal? A) DEF High-Yield Bond Fund B) ABC Growth and Income Fund C) JKL Municipal Bond Fund D) GHI Index Fund

A) DEF High-Yield Bond Fund *High-yield (junk) bonds, although carrying more risk, produce higher current income than other funds.

When doing cash flow analysis on a mortgage-backed pass-through security, you would want to know A) size of the tranche being analyzed B) the average maturities C) the quality of the mortgages D) whether there is a real estate "bubble"

B) The average maturities' *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.

What would likely happen to the market value of existing bonds during an inflationary period coupled with rising interest rates? A) The price of the bonds would stay the same. B) The price of the bonds would decrease. C) The nominal yield of the bonds would increase. D) The price of the bonds would increase.

B) the price of the bonds would decrease *Bond prices fall when interest rates rise because bond prices have an inverse relationship with interest rates.

High-yield bonds are frequently called junk bonds. Which of the following expresses the highest rating that would apply to a junk bond? A) CC B) CCC C) BB D) BBB

C) BB *Investment-grade bonds run from a highest Standard and Poor's rating of AAA (Aaa − Moody's) down to BBB (Baa − Moody's). When the rating gets to BB (or Ba) the bond is considered high yield, or a junk bond.

An analyst would use the discounted cash flow method in an attempt to find A) the current rate of return of a security. B) the current market price of a security. C) the fair value of a security. D) the cash flow from operations.

C) the fair value of a security *DCF uses the present value of future cash flows, based on a specified discount (interest) rate, to evaluate the price that a security should be selling for in the market. If the current market price of the security is less than this value, it has a positive net present value (NPV) and should be a good investment. The opposite is true if there is a negative NPV (the market price is higher than that computed under the DCF method).

When an investor owns a convertible security where, upon conversion, the account value would remain the same, it is considered that the convertible and the common are selling at A) the arbitrage level B) the nominal yield C) equivalent value D) parity

D) Parity *Parity means equal. When one could convert the security and realize the same value, it is said that both are at parity.

If the coupon rate on a bond increases, the duration of the bond will A) decrease B) remain unchanged C) increase D) change in an unpredictable fashion

A) Decrease *The higher the coupon, the shorter the duration.

Market interest rates rise by 50 basis points. If each of these bonds has about the same maturity date, which of the following would decline the least? A) Treasury bond issued at par carrying a 6% coupon B) Treasury bond issued at par carrying a 7% coupon C) AAA corporate bond carrying a 6% coupon D) AA corporate bond carrying a 7% coupon

B) Treasury bond issued at par carrying a 7% coupon *All other factors being equal, bonds of higher quality experience less price volatility than do bonds of lower quality. Treasury securities have higher quality than other debt securities due to the elimination of default risk. When market interest rates rise, bonds having higher coupons will decline less than bonds having lower coupons.

Adam has a portfolio of bonds worth approximately $125,000. He is concerned that interest rates will increase in the near term. Which of the following would be the least desirable strategy for Adam? A) Sell Treasury bonds and buy Treasury bills B) Sell bonds with a short duration and buy those with a longer duration C) Sell bonds with lower coupons and buy those with higher coupons D) Sell long-term bonds and buy short-term bonds

B)Sell bonds with a short duration and buy those with a longer duration *Prices of bonds decline when interest rates rise. An investor expecting an increase in interest rates should sell more volatile bonds and purchase less volatile bonds. Bonds with higher coupons and shorter durations are less price volatile than low coupon, long-term, and long duration bonds.

One of the likely consequences of a rating downgrade on a bond is A) an increase to the coupon by the issuer. B) the call feature will be employed. C) a reduction in the market price of the bond. D) the current yield will be reduced.

C) reduction in the market price of the bond *If the rating agencies downgrade the quality of a bond, potential investors will look to compensate for the increased risk by demanding a greater yield on the issuer's bonds. This will inevitably result in a lower bond price. A change in ratings is unlikely to lead to a call. In fact, with the reduction in the market price, the bond may be selling below par giving the issuer the opportunity to retire the debt at a discount. Bonds are fixed-income securities because the coupon rate is fixed when the bond is issued and does not change.

A customer buys a 10-year 6% AAA bond at par when it was issued. Two years later, if the CPI has increased from 2% to 4%, the price of the bond most likely A) has increased B) has stayed at par C) cannot be determined D) has declined

D) Has declined *When inflation is on the rise, interest rates often rise. When interest rates increase, bond prices may be expected to decline.

The price of which of the following will fluctuate most with fluctuating interest rates? A) Money market instruments B) Common stock C) Short-term bonds D) Long-term bonds

D) Long-term bonds *Because of its longer duration, long-term debt prices will fluctuate more than short-term debt prices as interest rates rise and fall. When buying a debt instrument, one is really buying the interest payments and final principal payment. Money has a time value: the longer it takes to receive the money, the less it is worth today.

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.

Which of the following is a discounted cash flow computation? A) Net present value B) Current yield C) Standard deviation D) Holding period return

A) Net Present Value *A key component of a DCF computation is using the time value of money. None of these, other than NPV, consider the time value of money.

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

The Wall Street pundits are predicting a substantial increase in interest rates. If they are correct, which of the following bonds would be most sensitive to that increase? A) 5s of 2035 B) 4s of 2020 C) 5s of 2040 D) 5s of 2045

D) 5s of 2045 *The bond with the longest duration will have the greatest sensitivity to change in interest rates. We examine two factors: the coupon rate and the length to maturity. When the coupon rates are the same, as they are for three of these bonds, the one with the maturity date farthest into the future will have the longest duration. Even though the 4% coupon is lower than the others, the maturity date is so much closer making it have the shortest duration (least sensitivity to change) of this group

A corporation has issued a 4% $60 par convertible stock with a conversion price of $20. With the preferred stock selling at $66 per share, an investor holding 100 shares of this stock would benefit by converting if the price of the common stock was A) above $22 per share B) below $22 per share C) above $18.20 per share D) above $20 per share

A) Above $22 per share *With a conversion price of $20 and a par value of $60, this preferred stock is convertible into 3 shares of the company's common stock. We divide the current price of the preferred ($66) by the 3 shares to arrive at the parity price of $22. If the common stock is selling for more than the parity price, the investor can benefit by converting and selling the stock in the marketplace.

On the initial public offering, an investor buys a $10,000 Aa-rated, 20-year corporate bond with a 4% coupon rate. One year later, the prevailing market rate is 5% and the bond has had its rating increased to Aa1. Which of the following is most likely TRUE with reference to the current market price of this bond? A) Discount B) Cannot be determined from the information given C) Par value D) Premium

A) Discount *When interest rates go up, bond prices go down. Had interest rates remained the same, the slight improvement in rating would have probably caused the bond to sell at a very slight premium, but that rating increase is not nearly strong enough to offset a 25% increase in market interest rates.

A bond with a par value of $1,000 and a nominal yield of 6% paid semiannually is currently selling for $1,300. The bond matures in 25 years and is callable in 15 years at $1,080. In the computation of the bond's yield to call, which of these would be a factor? A) Interest payments of $30 B) Future value of $1,300 C) 50 payment periods D) Present value of $1,080

A) Interest payments of $30 *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. With a 15-year call, there are only 30 semiannual interest payment periods, not 50. The present value is $1,300 and the future value is $1,080; the reverse of the numbers indicated in the answer choices.

Knowing the average maturities would be most important when doing a cash flow analysis on A) common stock B) mortgage-backed securities C) REITs D) preferred stock

B) Mortgage Backed 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.

One year ago, ABC Widgets, Inc., funded an expansion to its manufacturing facilities by issuing a 20-year first mortgage bond. The bond is secured by the new building and land. The bond was issued with a 5.5% coupon and is currently rated Aa. The current market price of the bond is 105 resulting in a current yield of approximately A) 5.61%. B) 5.50%. C) 5.24%. D) 4.99%.

C) 5.24% *Corporate bonds are quoted as a percentage of the $1,000 par value. A market price of 105 is equal to $1,050 (105% × $1,000). Each $1,000 5.5% bond pays $55 of interest annually ($1,000 × 5.5% = $55.00). Current yield equals the annual interest divided by the current price of $1,050. The calculation is $55 ÷ $1,050, which is equal to approximately 5.24%. Because the bond is at a premium, the current yield must be below the nominal yield, which removes two of the choices from consideration.

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) internal rate of return B) current yield C) discounted cash flow D) future value

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.

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

D) $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.

What would likely happen to the market value of existing bonds during an inflationary period coupled with rising interest rates? A) The price of the bonds would increase. B) The nominal yield of the bonds would increase. C) The price of the bonds would stay the same. D) The price of the bonds would decrease.

D) The price of the bonds would decrease *Bond prices fall when interest rates rise because bond prices have an inverse relationship with interest rates.

If a bond has a long duration, it will A) be less sensitive to small changes in interest rates than a bond with a shorter duration B) be relatively unaffected by small changes in interest rates C) continue paying interest into perpetuity D) be more sensitive to small changes in interest rates than a bond with a shorter duration

D) be more sensitive to small changes in interest rates than a bond with a shorter duration *Duration measures how sensitive a bond will be to a small change in interest rates. The longer the duration of a bond, the more volatile (sensitive to interest rate changes) it will be.

Which of the following factors has an inverse relationship to a bond's duration? A) Yield to maturity B) Rating C) Time to maturity D) Par value

A) Yield to maturity *Yield to maturity has an inverse relationship to duration. That is, the higher the YTM, the lower (shorter) the duration. The longer the time to maturity, the higher (longer) the duration; it is a direct relationship. The bond's rating and par value are irrelevant.

Which of the following bonds would most likely be exposed to the greatest amount of interest rate risk? A) GHI 7s of 2042 B) ABC 5s of 2040 C) JKL 4s of 2020 D) DEF 6s of 2041

B) ABC 5s of 2040 *The bond with the longest duration is generally going to have the greatest exposure to interest rate risk. Because there is very little difference between maturity dates of 2040 through 2042, the bond with the lowest coupon will have the longest duration. The 4s of 2020 have a relatively short duration, even though their coupon is low.

A company has two outstanding bond issues, both with a coupon rate of 8%. Bond A will mature in 2 years, while Bond B will mature in 15 years. If market interest rates were to increase to 10%, which of the following statements is CORRECT? A) Both bonds will be selling at a premium. B) The company will attempt to postpone the maturity of Bond A. C) Bond B will be selling at a greater discount than Bond A. D) Bond B will be selling at a greater premium than Bond A.

C) Bond B will be selling at a greater discount than Bond A *An increase in interest rates in the marketplace will cause the price of a debt security to fall. The nearer the maturity, the shorter the duration, hence the less impact. Therefore, Bond B with a much longer maturity (and longer duration) will see its market price fall far more than Bond A.

Which of the following bonds has the shortest duration? A bond with A) a 20-year maturity, 10% coupon rate. B) a 10-year maturity, 10% coupon rate. C) a 10-year maturity, 6% coupon rate. D) a 20-year maturity, 6% coupon rate.

D) 10-year maturity, 10% coupon rate *Two factors go into the computation of a bond's duration - the length to maturity and the coupon rate. When the maturities are the same, the bond with the highest coupon has the shortest duration. When the coupons are the same, the bond with the nearest maturity has the shortest duration. The 10% bond maturing in 10 years "wins" on both counts. It has the nearest maturity with the highest coupon. All else being equal, a bond with a longer duration will be more sensitive to changes in interest rates.

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

D) 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).

Current market interest rates are 6%. A bond with an 8% coupon would be most likely to have a net present value of zero when the bond is A) called for redemption. B) selling at par. C) selling at a discount. D) selling at a premium.

D) selling at a premium *A bond's NPV is most likely to be zero when its IRR is equal to the current market interest rate. In this case, that would be 6%. The only way for a bond with an 8% coupon to have a yield to maturity of 6% is if the bond is selling at a premium.

Duration is A) the deviation of a bond's returns from its average returns B) equivalent to the yield to maturity C) a measure of a bond's volatility with respect to a change in interest rates D) identical to a bond's maturity

C) a measure of a bond's volatility with respect to a change in interest rates *Duration measures a bond's volatility with respect to a change in interest rates. The higher the duration, the greater the change in a bond's price with respect to interest rate changes.

Which of the following factors has a direct relationship to a bond's duration? A) Time to maturity B) Coupon rate C) Rating D) Yield to maturity

A) Time to maturity *The longer the time to maturity, the higher (longer) the duration. Yield to maturity and coupon rate have an inverse relationship. That is, the higher the YTM and the coupon, the lower (shorter) the duration. The bond's rating is irrelevant.

Assume that a corporation issues a 5% Aaa/AAA-rated debenture at par. Two years later, similarly rated debt issues are being offered in the primary market at 5.5%. Which of the following statements regarding the outstanding 5% debenture are TRUE? 1. The current yield on the debenture will be higher than 5%. 2. The current yield on the debenture will be lower than 5%. 3. The dollar price per bond will be higher than par. 4. The dollar price per bond will be lower than par. A) II and IV B) II and III C) I and IV D) I and III

C) 1 & 4 *Because interest rates have risen after the issue of the 5% debenture, the bond's price will be discounted to result in a higher current yield (computed as annual income divided by current market price). Accordingly, the discounting of the issue will make the 5% debenture competitive with new issues offered with a 5.5% coupon.

Richard purchased a 30-year bond for 103½ with a stated coupon rate of 8.5%. What is the approximate yield to maturity for this investment if Richard receives semiannual coupon payments and expects to hold the bond to maturity? A) 9.36% B) 8.50% C) 8.68% D) 8.24%

D) 8.24% *No calculation is necessary here. Why not? Because anytime a bond is purchased at a premium over par (103½% is a premium), the YTM must be less than the nominal (coupon) rate. There is only one choice lower than 8.5%. It isn't about your computational skills; it is about your understanding the relationship between prices and yields.

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

D) 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.

Current market interest rates are 6%. A bond with an 8% coupon would be most likely to have a net present value of zero when the bond is A) called for redemption. B) selling at par. C) selling at a discount. D) selling at a premium.

D) Selling at a premium *A bond's NPV is most likely to be zero when its IRR is equal to the current market interest rate. In this case, that would be 6%. The only way for a bond with an 8% coupon to have a yield to maturity of 6% is if the bond is selling at a premium.

The best time for an investor seeking returns to purchase long-term, fixed-interest-rate bonds is when A) short-term interest rates are low and beginning to rise B) short-term interest rates are high and beginning to decline C) long-term interest rates are high and beginning to decline D) long-term interest rates are low and beginning to rise

C) long-term interest rates are high and beginning to decline *The best time to buy long-term bonds is when interest rates have peaked. In addition to providing a high initial return, as interest rates fall, the bonds will rise in value.

A bond with a par value of $1,000 and a coupon rate of 6% paid semi-annually, is currently selling for $1,200. The bond is callable in 15 years at 105. In the computation of the bond's yield to call, which of these would be a factor? A) Interest payments of $30 B) Present value of $1,050 C) Future value of $1,200 D) 15 payment periods

A) Interest payments of $30 *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 a 6% coupon will make $30 semi-annual interest payments. With a 15-year call, there are 30 semi-annual payment periods, not 15. The present value is $1,200 and the future value is $1,050, the reverse of the numbers indicated in the answer choices.

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) yield to maturity B) future value C) discounted cash flow D) duration

C) 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.

Adam has a portfolio of bonds worth approximately $125,000. He is concerned that interest rates will increase in the near term. Which of the following would be the least desirable strategy for Adam? A) Sell bonds with lower coupons and buy those with higher coupons B) Sell Treasury bonds and buy Treasury bills C) Sell bonds with a short duration and buy those with a longer duration D) Sell long-term bonds and buy short-term bonds

C) Sell bonds with a short duration and buy those with a longer duration *Prices of bonds decline when interest rates rise. An investor expecting an increase in interest rates should sell more volatile bonds and purchase less volatile bonds. Bonds with higher coupons and shorter durations are less price volatile than low coupon, long-term, and long duration bonds.

As a bond's duration changes, A) its sensitivity to changes in interest rates changes. B) its maturity date changes. C) the income received by the bondholder changes. D) its rating might be affected.

A) It's sensitivity to changes in interest rates changes *A bond's duration measures its sensitivity to changes in market interest rates. The longer the duration, the greater the sensitivity (bigger the price swings). As a bond approaches its maturity date, its duration gets shorter and shorter. The rate of income on a bond is set at issuance. The nominal (coupon) yield never changes - that is why bonds are known as fixed-income investments. Duration has nothing to do with a bond's rating and, as is the case with the coupon, a bond's maturity date is set when the bond is issued.

In order to perform a discounted cash flow estimation of the value of a bond, it would be necessary to know all of the following EXCEPT A) the parity price of the bond B) the future cash flow C) the number of interest payments D) the discount rate

A) The parity price of the bond *In its simplest iteration, discounted cash flow is nothing more than taking all the money you are scheduled to receive over a given future period and adjusting that for the time value of money (the discount rate). Parity price is only relevant to convertible bonds.

A bond issued by the GEMCO Corporation has been rated BBB by a major bond rating organization. This bond would be considered A) an investment-grade corporate bond B) secured C) callable D) a high-yield corporate bond

A) an investment-grade corporate bond *An investment-grade bond has a bond rating between AAA and BBB. Lower-rated bonds are considered high-yield bonds and are often referred to as junk bonds. The bond may or may not be secured—the rating does not indicate that fact.

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) Time until maturity B) Coupon rate C) Rating of the bond D) Current market price

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.

A client of yours owns some convertible preferred stock. She notices an article in the business section of her local newspaper that reports the company is going to pay a 20% stock dividend on their common stock. She wants to know how this will affect her? A) More than likely, the price of the preferred stock will rise. B) She will also receive 20% more shares because preferred stock has a priority claim ahead of common. C) There will be no effect. D) If there is an antidilution clause, her conversion privilege will permit her to acquire 20% more shares than before the stock dividend.

D) If there is an antidilution clause, her conversion privilege will permit her to acquire 20% more shares than before the stock dividend. *Most convertible securities are sold with antidilutive clauses that provide for an adjustment in the number of shares based on stock splits or stock dividends.

On the initial public offering, an investor buys a $10,000 Aa-rated, 20-year corporate bond with a 4% coupon rate. One year later, the prevailing market rate is 5% and the bond has had its rating increased to Aa1. Which of the following statements is most likely TRUE with reference to the current market price of this bond? A) The yield to maturity of this bond is above 4%. B) The bond would be selling at a premium. C) The bond would be selling at par value. D) The bond would be selling at a discount.

D) The bond would be selling at a discount *When interest rates go up, bond prices go down. Had interest rates remained the same, the slight improvement in rating would have probably caused the bond to sell at a very slight premium, but that rating increase is not nearly strong enough to offset a 25% increase in market interest rates. Because this bond would be selling at a discount, its YTM would be above 4%, but the question is asking about the current market price, not the yield.

Which of the following statements regarding the properties of duration is NOT true? A) Duration measures the effect of an interest rate change on the price of a bond or bond portfolio. B) Duration measures a bond's price volatility by weighting the length of time it takes for a bond to pay for itself. C) Duration measures the holding period return on a bond. D) Duration is a weighted-average term to maturity of a bond's cash flows.

C) Duration measures the holding period return on a bond *Duration does not measure the holding period return on a bond; it measures the effect of an interest rate change on the price of a bond or bond portfolio. Duration measures a bond's price volatility by weighting the length of time it takes for a bond to pay for itself. Duration is also a weighted-average term to maturity of a bond's cash flows.

A bond's duration is A) identical to its maturity for an interest-bearing bond B) expressed as a percentage C) longer for a 10-year bond with a 5% coupon than it is for a 10-year bond with a 10% coupon D) an indication of a bond's yield that ignores its price volatility

C)longer for a 10-year bond with a 5% coupon than it is for a 10-year bond with a 10% coupon *Duration measures a bond's price volatility by weighting the length of time it takes for a bond's cash flow to pay for itself. If 2 bonds with differing coupon rates have identical maturities, the one with the lower coupon has the longer duration. The cash flow from an interest-bearing bond makes its duration shorter than its maturity. Bonds with longer duration carry greater price volatility. Duration is expressed in years (time) rather than in percentage.

The DERP Corporation has an outstanding convertible bond issue with a conversion price of $125 per share. If the current market price of the bond is 80, the parity price of the stock is A) $64.00 per share B) $125.00 per share C) $156.25 per share D) $100.00 per share

D) $100 per share *What does parity mean? It means that 2 things have equal value. What 2 things do we have here? We have the convertible bond and, because it is convertible, it can be "converted" into common stock. There is a number where the value of the bond and the value of the stock are the same—this price is the parity price. The bond is currently valued at $800 (80% of par). Anytime the investor wishes, he can exchange (convert) that bond into DERP's stock at $125 per share. But, that conversion is based not on a market price, which can fluctuate every day—it is based on the amount of the money initially borrowed—the $1,000 par value of the bond. DERP is saying that it will allow you to exchange the $1,000 they owe you for stock at $125 per share. Simple division results in the ability to convert into 8 shares. Now we have everything we need to compute the parity (equal) price. If the bond is currently valued at $800 and we can convert it into 8 shares, what does each of those shares have to be worth so that the stock is also valued at $800? Dividing 800 / 8 = $100 per share. That means that if the stock is selling for $100 per share, and we decide to convert the bond, we'll have the same $800 in value. Some students find the answer a quicker way. If the bond is selling at 80% of its par value, then, to be equal, the stock must be selling at 80% of the conversion value (80% × $125 = $100).

The portfolio manager of a bond fund believes that interest rates are going to increase in the near future. As such, it would be wise for that manager to A) increase the equity portion of the portfolio. B) lengthen the average duration of the portfolio. C) shift into higher-rated bonds. D) shorten the average duration of the portfolio.

D) Shorten the average duration of the portfolio *Increasing interest rates lead to declining bond prices, regardless of the ratings. This is interest rate risk. Those bonds with the longest duration have the most sensitivity to that risk, while short-term maturities are only slightly affected. Reducing the average duration of the portfolio means that the average maturities will be shortened, thus reducing the effects of an increase to interest rates.

Which of the following bonds would be the least price sensitive to changes in market interest rates? A) 6% AA bond due in 18 years with a YTM of 6.8% B) 4.5% Treasury bond due in 20 years with a YTM of 4.1% C) 10% BB bond due in 21 years with a YTM of 8.7% D) Zero due in one year with a YTM of 6%

D) Zero due in one year with a YTM of 6% *In almost every question like this, the zero will have the longest duration and the greatest price sensitivity to interest rate changes. This is the odd case where the zero is due so soon that its duration is by far the shortest of any of the choices. Shorter duration means less price sensitivity.

The current yield on a bond with a coupon rate of 7.5% currently selling at 105½ is approximately A) 6.50% B) 7.11% C) 8.00% D) 7.50%

B) 7.11 *A bond with a coupon rate of 7.5% pays $75 of interest annually. Current yield equals annual interest amount divided by bond market price, or $75 ÷ $1,055 = 7.109%, or approximately 7.11%.

Charlie Mindel is the portfolio manager for the Steady Yield Bond Fund. If Charlie was of the opinion that interest rates were going to fall, he would A) increase the average duration of the portfolio B) keep the average duration the same. C) move more of the portfolio into cash. D) decrease the average duration of the portfolio.

A) increase the average duration of the portfolio *As interest rates go down, prices of bonds rise. Those with the longest duration will have the greatest price increase. To benefit from this move, managers of bond portfolios will lengthen the average duration of the portfolio. The reverse action would be taken if Charlie thought that interest rates were going to rise. Of course, if interest rates move in the opposite direction of that the manager expects, the fund might start looking for a new manager.

A bond fund owns $100 million each of a number of different corporate bonds. The duration of those individual bonds is 3, 4, 5, 6, 8, and 10 years. From this information, you would estimate the average duration of the bond fund to be A) 4 years B) 6 years C) 8 years D) 5.5 years

B) 6 years *The approximate average duration of bonds in a bond mutual fund can be estimated by finding the mean (average) of the individual bonds. In this case, the total is 36 divided by 6 or an average of 6 years.

A bond offered at par has a coupon rate A) greater than its yield to maturity B) equal to its current yield C) less than its yield to maturity D) less than its current yield

B) Equal to its current yield *When a bond is selling at par, its coupon or nominal rate, current yield, and yield to maturity are all the same.

If yields should change by 75 basis points, which of the following bonds would have the greatest price change? A) GHI 4s 2030 B) ABC 4s 2040 C) DEF 4s 2035 D) JKL 4s 2020

B) ABC 4s of 2040 *When all coupons are the same, the bond with the longest maturity will have the longest duration and, therefore, will be subject to the greatest price fluctuations.

Mitch purchased a 30-year bond for 97¾ with a stated coupon rate of 8.5%. What is the approximate yield to maturity for this investment if Mitch receives semiannual coupon payments and expects to hold the bond to maturity? A) 4.36% B) 5.68% C) 8.50% D) 8.67%

D) 8.67% *No calculation is necessary here. Why not? Because anytime a bond is purchased at a discount from par (97¾% is a discount), the YTM must be greater than the nominal (coupon) rate. There is only one choice greater than 8.5%. It isn't about your computational skills; it is about your understanding the relationship between prices and yields.

A bond purchased at $900 with a 5% coupon and a 5-year maturity has a current yield of A) 5.56% B) 5.00% C) 7.40% D) 7.80%

A) 5.56% *Current yield is determined by dividing the annual interest payment by the current market price of the bond ($50 ÷ $900 = 5.56%). Years to maturity is not a factor in calculating current yield.

A bond's yield to maturity is A) the annualized return of a bond if it is held to maturity B) set at issuance and printed on the face of the bond C) determined by dividing the coupon rate by the bond's current market price D) the annualized return of a bond if it is held to call date

A) The annualized return of a bond if it is held to maturity *The yield to maturity is the annualized return of a bond if it is held to maturity. The computation reflects the internal rate of return and is frequently referred to as the market required rate of return for a debt security. The rate set at issuance and printed on the face of the bond is the nominal or coupon rate. Dividing the coupon rate by the current market price of the bond provides the current yield. The return of a bond if it is held to the call date is the YTC.

Current market interest rates are 6%. A bond with an 8% coupon would be most likely to have a net present value of zero when the bond's internal rate of return is A) 8%. B) 6%. C) 4%. D) 0%.

B) 6% *The internal rate of return of a bond is the interest rate that makes the NPV of the investment equal to zero. When a bond is selling at its present value, the NPV is zero. A bond's present value should be equal to a market price giving a yield to maturity equal to the current market interest rates. Therefore, when current market interest rates are 6%, a bond with an 8% coupon should be selling at a price producing a YTM, or IRR of approximately 6%.

Mr. Beale buys 10M 6.6s of 10 at 67. What will his annual interest be? A) $1,000.00 B) $670.00 C) $660.00 D) $820.00

C) $660 *Interpret "10M" as "$10,000 worth of." Beale receives the nominal yield of the bonds, which is 6.6% of $10,000. The M is from the roman numeral for 1,000.

A bond with a par value of $1,000 and a coupon rate of 6%, paid semiannually, is currently selling for $1,200. The bond is callable in 6 years at 103. In the computation of the bond's yield to call, which of the following would be a factor? A) Present value of $1,030 B) Future value of $1,200 C) Interest payments of $30 D) 20 payment periods

C) Interest payments of $30 *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 a 6% coupon will make $30 semiannual interest payments. With a 6-year call, there are only 12 payment periods, not 20. The present value is $1,200 and the future value is $1,030, the reverse of the numbers indicated in the answer choices.

An 8% corporate bond is offered on a 8.25 basis. Which of the following statements are TRUE? Nominal yield is higher than YTM. Current yield is higher than nominal yield. Nominal yield is lower than YTM. Current yield is lower than nominal yield. A) II and IV B) I and III C) I and IV D) II and III

D) 2 & 3 *A bond offered on an 8.25 basis is the same as at a YTM of 8.25%. Because the yield quoted is higher than the 8% coupon, the bond is trading at discount to par. For discount bonds, the nominal yield is lower than both the current yield and the yield to maturity.

A customer purchased a 5% U.S. government bond yielding 6%. A year before the bond matures, new U.S. government bonds are being issued at 4%, and the customer sells the 5% bond. The customer probably did which of the following? 1. Bought it at a discount 2. Bought it at a premium 3. Sold it at a discount 4. Sold it at a premium A) I and IV B) II and IV C) II and III D) I and III

A) 1 & 4 *The customer purchased the 5% bond when it was yielding 6% (at a discount). The customer sold the bond when other bonds of like kind, quality, and maturity were yielding 4%. The bond is now at a premium. Therefore, the customer realized a capital gain.

Which of the following bonds would most likely be exposed to the greatest amount of interest rate risk? A) DEF 6s of 2041 B) JKL 4s of 2020 C) ABC 5s of 2040 D) GHI 7s of 2042

C) ABC 5s of 2040 *The bond with the longest duration is generally going to have the greatest exposure to interest rate risk. Because there is very little difference between maturity dates of 2040 through 2042, the bond with the lowest coupon will have the longest duration. The 4s of 2020 have a relatively short duration, even though their coupon is low.

An investor sells ten 5% bonds at a profit and buys another 10 bonds with a 5¼% coupon rate. The investor's yearly return will increase by A) $1.00 per bond B) $2.50 per bond C) $1.50 per bond D) $2.00 per bond

B) $2.50 per bond *The first bonds are 5% and pay $50 per year per bond. The new bonds are 5¼% and pay $52.50 per year per bond. 5% coupon rate × $1,000 face value = $50 per year per bond; 5¼% coupon rate × $1,000 face value = $52.50 per year per bond.

An investor is looking to add some bonds to her portfolio. One of the bonds she is analyzing has a 3% coupon and the other a 6% coupon. Assuming both bonds have the same maturity date, a change in interest rates will have a more profound effect upon the market price of which bond? A) The bond with the lower rating B) Changes in interest rates affect both bonds equally C) The 3% coupon D) The 6% coupon

C) The 3% coupon *The longer a bond's duration, the more its price is affected by changes to interest rate. When bonds have the same maturity, the one with the lowest coupon has the longest duration. Ratings have little or nothing to do with price changes caused by interest rate changes.

A $1,000 bond with a nominal yield of 8% will pay how much interest each year? A) $40.00 B) $160.00 C) $800.00 D) $80.00

D) $80 *The nominal yield (or coupon rate) is the interest rate stated on the bond and is the rate the bondholder promises to pay on the bond until the bond matures. A $1,000 bond with an 8% nominal yield will pay $80 per year in interest.

All of the following factors have an inverse relationship to a bond's duration except A) current yield. B) yield to maturity. C) time to maturity. D) coupon rate.

C) Time to maturity *The relationship between the time to maturity (length) and duration is a linear one. That is, the longer the time until the bond matures, the higher (longer) the duration - it is a direct relationship. Yields, on the other hand, have an inverse relationship with duration. That is, the higher the yield, the lower (shorter) the duration.

Which of the following bonds would appreciate the most if interest rates fell? A) 30-year maturity, selling at a discount B) 15-year maturity, selling at a premium C) 15-year maturity, selling at a discount D) 30-year maturity, selling at a premium

A) 30-year maturity selling @ a discount *The general rule of thumb is that bonds with long-term maturities will have greater fluctuations in price than will short-term maturities, given the same move in interest rates. Furthermore, discounted bonds, with their lower coupon rates, have a longer duration than a bond selling at a premium and will respond more favorably to falling rates than will those premium bonds. Thus, the 30-year discounted bond will move faster than the others.

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

D) $10,225 *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.

Rank the following bonds in order of shortest to longest duration. 1. ABC 8s of 2040 2. DEF 9s of 2041 3. GHI 5s of 2039 4. JKL zeros of 2035 A) I, II, IV, III B) IV, II, I, III C) III, I, II, IV D) II, I, III, IV

D) 2, 1, 3 & 4 *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.

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) Treasury STRIPS, maturing in 2036 B) 5% Treasury bond, maturing in 2037 C) 6% Treasury bond maturing in 2035 D) 8% Treasury bond maturing in 2036

D) 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.

Managers of bond portfolios who anticipate an increase in interest rates should A) decrease the portfolio duration B) increase the portfolio duration C) assume higher risk in the secondary market D) invest in high-yield or junk bonds

A) Decrease the portfolio duration *A bond portfolio manager who anticipates periods of rising interest rates should decrease the duration of a bond portfolio to minimize the price decline. Duration is inversely related to changes in market and coupon interest rates.

Your client owns a 91-day T-bill, a 2-year T-note, a 20-year T-bond, and a 20-year STRIP. The market price of which of these is likely to have the smallest movement when there are changes to the discount rate? A) T-bill B) STRIP C) T-note D) T-bond

A) T-Bill *As a short-term instrument (short duration), the price fluctuations of a T-bill are very small when there is a change to interest rates. Longer term instruments have much larger price movements.

The discounted cash flow method is frequently used to assess the value of a bond. When making the DCF computation, it would NOT be necessary to know the bond's A) nominal yield B) rating C) number of remaining interest payments D) principal amount

B) Rating *As it is strictly a mathematical computation, a subjective item, such as the bond's rating, has no place in the computation.