Bond Basics - quiz 1

When quoting bonds on a yield basis, the difference between a bond priced at a yield of 5.45 and a bond priced at a yield of 5.55 is:

10 Basis Points One basis point = .01%. The difference between 5.45 and 5.46 = .01%, or one basis point. In this case, the difference between 5.45 and 5.55 = .10%, or 10 basis points.

What is the benefit of a zero coupon bond?

D. Capital appreciation Zero coupon bonds do not make period payments. The bond is purchased at a deep discount price and builds internally until maturity, at which point the bond is redeemed at par. They are often called capital appreciation bonds because of this and they are used to accumulate capital that will be used at maturity. For example, parents of young children might buy zero coupon bonds at a deep discount and use them at maturity to pay for the kid's college expenses.

Which security is MOST subject to reinvestment risk?

High coupon bonds Reinvestment risk for bondholders is the risk that interest rates drop after issuance of the bonds; and that as interest payments are received over the life of the issue, they cannot be reinvested at the same rate. This risk is the greatest for high coupon bonds; and the lowest for low or zero coupon bonds.

Reinvestment risk is the risk that:

Interest rates will drop subsequent to bond issuance and interest payments will be reinvested at lower rates.

Which bond will exhibit the greatest price volatility?

A. 2% coupon bond with a 2 year maturity B. 0% coupon bond with a 1 year maturity C. 6% coupon bond with a 10 year maturity D. 0% coupon bond with a 9 year maturity D The longer the expiration, the more volatile a bond's price movements, which narrows the Choices to either C or D. The lower the coupon, the more volatile the bond's price movements, with the lowest coupon being "0." A 9-year zero coupon bond will actually be more volatile in price movements than a slightly longer maturity bond (10 years) with a fairly high coupon (6% in this case). The higher coupon means that more of the bond's value is represented by the interest stream than comes in early and this stabilizes the bond's price as market interest rates move.

Corporate bonds are quoted on what basis?

B. Dollar price Corporate bonds are usually term bonds - all bonds of an issue having the same interest rate and maturity. Term bonds are quoted on a percentage of par basis in 1/8ths, which is the same as a "dollar" quote.

Which would be a rating for short term municipal debt?

MIG (Moody's Investment Grade) ratings are used for short term municipal paper; P (Prime) ratings are used for short term corporate commercial paper. There is no such thing as MUN 1 rating

Which characteristics make a security least subject to liquidity risk?

Short term maturity and high credit rating Liquidity risk is the risk that a security can only be sold by incurring large transaction costs. The easiest securities to sell (meaning the most readily marketable) are those with high credit ratings and short term maturities.

A declining rate of inflation would lead to:

higher bond prices and lower bond yields

The current yield of a bond:

increases as bond market prices decline The current yield is the stated rate of interest as a percentage of market value. It will change as bond prices move - if bond prices rise, the current yield falls; if bond prices fall; the current yield rises.

The nominal yield of a bond will:

remain unchanged as bond prices fluctuate The nominal yield is the stated rate of interest as a percentage of par value. It does not change as bond prices move. However, the current yield and yield to maturity will be affected by changes in bond prices.

An investor is seeking a bond issue offering call protection. An issue having which features would NOT be an appropriate investment?

High stated interest rates and low stated call premiums An investor seeking call protection does not want the bonds to be called away. Most likely to be called are bonds with low call premiums and high interest rates. After calling the bonds, the issuer can refund the issue at lower rates, given that interest rates have fallen.

Reinvestment risk occurs in investment time horizons during which market interest rates are:

falling Reinvestment risk occurs when an investor is holding fixed income securities over a long time horizon during a time period when interest rates have been declining. As payments are received from these investments, they must be reinvested to maintain the overall rate of return on that portfolio - and if interest rates have been dropping, these payments are reinvested at lower and lower interest rates, lowering the overall rate of return on the portfolio.

A bond is rated BBB by Standard and Poor's. The bond is

Lowest Quality Investment Grade A BBB rating is the lowest investment grade rating for a bond. The investment grade ratings are AAA, AA, A, and BBB.

For bonds trading at a discount, rank the yield measures from lowest to highest?

Nominal, Current, Basis When bonds are trading at a discount, the stated (nominal) yield will be lowest. The current yield will be higher, since it is based on the discounted market price - not par value. The yield to maturity will be the next highest, since it includes the portion of the discount earned annually as part of the annual return in addition to the interest received.

In 2019, a customer buys 5 GE 10% debentures, M '39 at 90. The interest payment dates are Feb 1st and Aug 1st. The bonds are callable as of 2024 at 107. The current yield on the bonds is:

11.11% $100/$900 = 11.11%

The yield to maturity of a bond:

increases as bond market prices decline Since both the Annual Interest and Annual Capital Gain are fixed, as the cost of the bond falls, the Yield to Maturity must rise. Since both the Annual Interest and Annual Capital Gain are fixed, as the cost of the bond rises, the Yield to Maturity must fall.

An investor believes that interest rates are peaking and wishes to buy long term fixed income securities that will assure the investor of receiving periodic payments at today's rates. The best recommendation is high grade:

non-callable bonds The investor wishes to receive periodic interest payments, so zero coupon obligations are not appropriate. Furthermore, if interest rates are currently high and the investor wants to "lock-in" these high rates, he or she will want a non-callable issue. If rates drop, the issuer cannot call these bonds. Puttable bonds are of no value unless interest rates rise, devaluing the bond. Then, the holder could exercise the put option and "put" the bond back to the issuer - usually at par.

Which of the following are considered to be creditors of a corporation?

A. Convertible Bondholders Bondholders are creditors of a company. Convertible bondholders are creditors of a company as long as they keep their bonds and do not convert to common shares. Common and preferred shareholders have an equity position. Warrant holders have a long term option to buy the stock. Warrants are considered equity-related securities, but they have neither an equity nor creditor stake in the corporation.

An outstanding bond issue which is currently trading at 103 1/4 is callable starting next year at 102 1/2. The call premium on the bond issue is:

2 1/2 points A bond "call premium" is simply the price above par at which the issuer has the right to call in the bonds from the bondholders. These bonds are callable at 102 1/2, hence the call premium is 2 1/2 points.

All of the following callable municipal bonds are trading at an 8% basis. Which is MOST likely to be called?

8 3/4% coupon rate callable at 100 in 2019 An issuer is most likely to call bonds which have high interest rates (high financing cost to the issuer) and low call premiums (the least expensive for the issuer to call in these bonds).

A bond with a "C" rating is considered to be:

A bond rated "C" is considered to be speculative and would have substantial credit risk. The ratings agencies cannot rate bonds for market risk - only for credit risk. The lowest investment grade rating is BBB. BB, and B ratings are considered to be medium grade. CCC, CC, and C are all speculative, with a C rating being the most speculative.

Which bond does NOT have interest rate risk?

A bond that is currently puttable If market interest rates rise, bond prices fall. If the bond has a put option, the holder can put the bond back to the issuer at par. Thus, it is protected against interest rate risk and its price will not fall below the put price.

If interest rates are rising, which statement about discount and premium bonds is TRUE?

Discount bonds will depreciate faster than premium bonds As a general rule, the longer the maturity on a debt issue, the greater the issue's price volatility in response to interest rate movements. Another general rule is that the lower the price of the issue (which would result from having a lower coupon), the greater the issue's price volatility in response to interest rate movements. As interest rates rise, bonds that are selling at a discount will fall proportionately more than bonds trading at an equivalent premium. This is true since the change in price as a percentage of the bond's cost is greater for a discount bond than for a premium bond.

All of the following will affect the marketability of corporate bonds EXCEPT:

For corporate bonds, the most marketable blocks are 5 bonds up to 100 bonds. Under 5 is an odd lot; over 100 is a large block which is more difficult to trade. The shorter the maturity, the more marketable the bond. The higher the rating, the more marketable the bond. The bond denominations have no effect on marketability.

If interest rates decline, which of the following is likely to happen?

Issuers will sell new issues with longer maturities and call outstanding bonds with high interest rates If interest rates decline, it is likely that issuers will call in outstanding bonds with high interest rates and refund (refinance) these issues at the lower current interest rates. When rates are low, issuers attempt to lock-in the low rate for the longest period of time by issuing long-term bonds. When rates are high, issuers sell shorter term debt, hoping that rates will drop so that they can refund the debt at maturity at lower rates.

28. Two 20-year corporate bonds are issued at par, with stated interest rates of 10%. One issue is puttable at par in 5 years, while the other is puttable at par in 10 years. If interest rates rise by 200 basis points shortly after issuance, which statement is TRUE?

The bond puttable in 10 years will depreciate more than the bond puttable in 5 years If a bond is puttable at par in the near future, any price decline due to rising interest rates will be suppressed since the holder is able to put the bond back to the issuer sooner. Thus, the bond puttable in 10 years will depreciate more than the bond that is puttable in 5 years if interest rates rise.

Issuers will call their bonds when interest rates:

have declined The best answer is B. Issuers call in bonds when interest rates have declined. The issuer can retire the "old" high interest rate debt; and issue new bonds at lower current market rates; reducing its interest cost.

An investor expects that interest rates will decline over the next 5 years. Which of the following is an appropriate investment?

10 year bonds puttable at par in 5 years If interest rates decline, it is likely that issuers will call in outstanding bonds and refund the issues at the lower current interest rates. An investor who expects interest rates to drop should avoid callable issues or issues with adjustable interest rates (since each year as interest rates drop, the rate on the bond is dropped). Short term bonds are also not a good choice because at maturity the proceeds will be rolled into a new lower coupon issue as rates fall. Non callable bonds are fine, as are bonds with put options. The put option will only be used if interest rates rise, decreasing the value of the bond. Then, the bondholder would exercise the option and "put" the bonds to the issuer at par.

Which of the following would be a quote for an airline bond?

105 5/8 An airline bond is a corporate bond. Corporate bonds are quoted on a percentage of par basis in 1/8ths. 105 5/8 = 105.625% of $1,000 par = $1,056.25 per bond. **Corporate bonds are quoted on a percentage of par basis in 1/8ths. 99 **1/2 = 99.50% of $1,000 par = $995.00 per bond. Note that corporate, municipal and government bonds are not quoted in penny movements, as is the case with equities.

Which of the following would be a quote for a U.S. Government bond?

99-16 99-16 = 99 16/32nds = 99.50% of $1,000 par = $995.00 per bond. U.S. Government bonds are quoted on a percentage of par basis in 32nds. 105-20 = 105 20/32nds = 105.625% of $1,000 par = $1,056.25 per bond.

A customer has a discretionary account at a brokerage firm. The customer calls the registered representative handling the account and states "Buy $50,000 of investment grade corporate bonds" with at least 5 years to maturity and a minimum 8% yield. To comply with the customer's instructions, the registered representative must choose bonds that are rated, at a minimum:

Baa The investment grades published by Moody's are: Aaa Highest Investment Grade Aa Upper Medium Investment Grade A Lower Medium Investment Grade Baa Lowest Investment Grade Any bond with a rating below Baa is considered to be speculative. To comply with the customer's requirement that the bonds be investment grade, a Baa rated bond is the lowest that could be purchased.

As interest rates rise, which following statement is TRUE?

Bonds trading at large discounts fall faster in price than bonds trading at small discounts. The general rule is the lower the price of the bond, the faster that bond's price will move as market interest rates change. Premium bonds will fall more slowly than discount bonds in a rising rate environment. Large premium bonds have a higher price than small premium bonds, so their change in price as a percentage of current market value is smaller. Deep (large) discount bonds have a lower price than small discount bonds, hence their prices move faster. Deep discount bonds have a lower price than small discount bonds, so their change in price as a percentage of current market value is higher.

A customer has heard about the explosive growth in China and wants to make investments in Chinese companies. Which risk is NOT associated with this potential investment?

Mortality risk Mortality risk is associated with insurance products, not bonds. Investing in overseas debt entails numerous risks! Political risk is the risk of investing internationally in countries that have weak political systems. Thus, the bondholder has very little in the way of legal protection. Another consideration is exchange rate risk. This is the risk that the foreign currency weakens against the U.S. dollar (which is the same as the U.S. dollar strengthening). When the "weakened" foreign currency is converted back into its value in U.S. dollars, it buys "fewer" U.S. dollars, so the value of the investment in terms of U.S. dollars, declines. In addition, any bond purchaser incurs some level of marketability risk and some level of default risk.

Regarding bonds with put options, which statement is TRUE?

Once the option is exercisable, the bond's price will not fall below the option price if interest rates rise Put options are exercisable at the option of the bondholder; once the option is exercisable, the bond price cannot fall below the option price, since the bondholder can always "put" the bond to the issuer for this amount. This benefits the bond investor if interest rates rise. The put price represents a floor on the market price of the bond. Because the put option removes some of the market risk from the bond, this feature is valued by bondholders, who will accept lower yields on bonds having this option.

During periods when interest rates are rising, which of the following fixed income securities offers the greatest protection from "interest rate risk"?

The basic truths regarding bond price volatility and interest rate movements are: The longer the maturity, the greater the bond's price volatility in response to interest rate movements; and The lower the coupon rate, the greater the bond's price volatility in response to interest rate movements. Based on these truths, the most volatile bonds will be those with long maturities and low coupon rates. (By the way, these will be the bonds trading at the largest discounts.) This question only examines the second factor, since the maturities are equivalent for all choices. The bond with the lowest price volatility will be the one with the highest coupon rate. Bonds with low coupon rates exhibit greater price volatility. Thus, to minimize price volatility due to interest rate movements ("interest rate risk"), high coupon bonds are appropriate.

If a callable bond is purchased at a premium, and is then called at par which of the following is TRUE?

The yield to call is lower than the nominal yield The yield to call will be lower than the yield to maturity if the bond was purchased at a premium (which will be lost faster if the bond is called early). Since the bond is purchased at a premium, both yield to call and yield to maturity must be lower than the nominal yield. Debt: Bond Basics: Yield to Call If a bond is called prior to its maturity date, then the yield to call will differ from the yield to maturity. If a discount bond is called prior to its maturity date (an unlikely event), then the annual capital gain component of the yield to maturity formula is earned "faster," increasing the yield to call above the yield to maturity. If a premium bond is called prior to its maturity date (a likely event), then the annual capital loss component of the yield to maturity formula occurs "faster," decreasing the yield to call below the yield to maturity. When a bond trades at a discount, the 4 yields, from lowest to highest are: Nominal Current Yield To Maturity Yield To Call When a bond trades at a premium, the 4 yields, from lowest to highest are: Yield To Call Yield To Maturity Current Nominal

A 30-year bond is issued in 2019 with the following call schedule: Redemption Date Redemption Price 2039 104 2040 103 2041 102 2042 101 2043 100 and after This issue has how many years of "call protection"?

To make callable issues marketable to the public, investors are protected from calls for a stated period after the bonds' issuance. In this example, the bonds issued in 2019 are first callable in 2039 so the investor has 20 years of "call protection" with this issue.

Which investment has the lowest level of reinvestment risk?

Treasury Bill Reinvestment risk is an issue for investments that make periodic payments held over long time horizons. If interest rates drop during the investment time horizon, the periodic payments received from these long-term securities must be reinvested at lower and lower current market rates, reducing the overall rate of return on the portfolio. Short-term investments have minimal reinvestment risk; and zero-coupon obligations have no reinvestment risk.

For bonds trading at a premium, rank the yield measures from highest to lowest:

When bonds are trading at a premium, the yield to call will be the lowest measure since the annual return is reduced by the annual amortized portion of the premium that will be "lost" over the life of the bond to the call date. The next highest yield will be the yield to maturity, since the premium will be lost over a longer "life" than if the bond is called early. Current yield will be higher than yield to maturity, since it does not include the annual premium loss. Stated yield will be the highest since it is the return based on par value.

Which statement is TRUE regarding the effect of market interest rate movements on callable and puttable bond prices?

When interest rates fall, the call price tends to set a ceiling on the market price of the bond and when interest rates rise, the put price tends to set a floor on the market price of the bond. If interest rates drop, it is more likely that an issuer will call its bonds. As interest rates drop, bond prices in the market will rise. The price will not rise by as much for a callable issue as that for a non-callable issue. The reason: Why would someone pay a premium for an issue that is likely to be called off the market? The put price for a "puttable bond" sets a floor under the market price of the bond during periods of rising interest rates. The price will never drop much below par (assuming that the put price is at par) once the option is exercisable, because if it did, customers would buy as many of the bonds as possible and "put" them to the issuer at par for a capital gain.

Exchange rate risk is most likely to be caused by investing in debt issues that are:

denominated in a foreign currency When an investment is made that is denominated in a foreign currency, , the investor assumes exchange rate risk. This is the risk that the foreign currency weakens against the U.S. dollar (which is the same as the U.S. dollar strengthening). There are dollar denominated investments available both in and outside of the U.S. so the location of the investment is not the determining factor--the denominating currency of the instrument is the determinant. For example, assume that an investment is made in $100,000 of bonds denominated in Japanese Yen when the Yen is trading at 100 to the U.S. dollar. Thus, $100,000 x 100 Yen per U.S. dollar = 1,000,000 Yen being spent. Also assume that each bond costs 10,000 Yen, so 100 bonds are purchased at $100 each. Now assume that the bonds do not move in price, but the Yen weakens to 200 Yen to the U.S. dollar (each U.S. dollar now "buys" 200 Yen instead of 100 Yen). This means that 100 bonds are still priced at 10,000 Yen each in Japan. However, because each U.S. dollar is worth 200 Yen, the bonds are now worth 10,000 Yen / 200 Yen per U.S. dollar = $50 each. Thus, the bonds are now worth 1/2 of what was paid for them, solely due to the movement in currency exchange rates.

Issuers are MOST likely to call their outstanding fixed income securities:

during periods of high levels of inflation when stock prices have reached a trough Issuers are most likely to call in their securities when interest rates have bottomed. The issuer can issue new securities at lower current interest rates, and can use the proceeds to call the outstanding securities that are paying a higher rate of interest. When stock prices have peaked, this usually indicates that interest rates have fallen, making stocks a relatively more attractive investment than fixed income securities that are paying lower rates of interest. During such periods, issuers will sell common stock at high market prices, and use the proceeds to retire outstanding debt with high interest rates. Regarding periods of inflation and deflation, as the inflation rate increases, interest rates tend to rise, since an "inflation premium" is added to the real interest rate that is paid on fixed income securities. Conversely, as deflation occurs, interest rates tend to fall as that "inflation premium" is eliminated from interest rate levels.

Securities subject to reinvestment risk are those that are:

long term and make periodic payments to investors Reinvestment risk occurs when an investor is holding fixed income securities over a long time horizon during a time period when interest rates have been declining. As payments are received from these investments, they must be reinvested to maintain the overall rate of return on that portfolio - and if interest rates have been dropping, these payments are reinvested at lower and lower interest rates, lowering the overall rate of return on the portfolio.

Reinvestment risk is a concern for an investor who invests in securities that make periodic payments over:

long-term time horizons during which interest rates are falling Reinvestment risk occurs when an investor is holding fixed income securities over a long time horizon during a time period when interest rates have been declining. As payments are received from these investments, they must be reinvested to maintain the overall rate of return on that portfolio - and if interest rates have been dropping, these payments are reinvested at lower and lower interest rates, lowering the overall rate of return on the portfolio.

A customer who has taken his portfolio and invested it only in money market instruments is most likely concerned with:

purchasing power risk If there a high level of inflation (purchasing power risk), then interest rates start to rise. This causes bond prices to fall. It also causes stock prices to fall, because companies have to pay higher interest rates on bonds that they issue, depressing profits, and companies have a hard time raising prices as fast as their input costs rise, also depressing profits. Because interest rates rise when there is substantial inflation, money market rates go up as well. However, these securities do not lose value because their maturity is short, and when they mature, the proceeds are reinvested in other money market instruments offering high yields. These are one of the best investments during inflationary times.

An investor who expects interest rates to drop would invest in:

puttable debt issues If interest rates decline, it is likely that issuers will call in outstanding bonds and refund the issues at the lower current interest rates. An investor who expects interest rates to drop should avoid callable issues or issues with adjustable interest rates (since each year as interest rates drop, the rate on the bond is dropped). If they expect rates to fall, investors would also likely prefer to lock in the current higher rate by purchasing long term bonds - but that is not offered as a choice! Non-callable bonds are fine, as are bonds with put options. The put option will only be used if interest rates rise, decreasing the value of the bond. Then, the bondholder would exercise the option and "put" the bonds to the issuer at par.

A customer is 100% invested in an S&P 500 Index Fund. This portfolio has:

systematic risk The basic idea of diversification of a portfolio is that it reduces risk. If a portfolio consists of only a few positions, an adverse event affecting one of the positions can result in a big loss. If the portfolio consists of a broad range of positions, an adverse event affecting only a single position will not have as big a negative impact. A portfolio that is fully diversified still has risk. It is said to only have "systematic" risk, which is the same as market risk. If the overall market drops, the portfolio will likely drop by a similar percentage. A portfolio that is not fully diversified is said to have both "systematic" and "nonsystematic" risk. As more and more positions are added to the portfolio, the "nonsystematic risk" is diversified away, leaving the portfolio only with "systematic" risk.