Bond Basics
Overview of Nominal Yield The current yield of a bond: A increases as bond market prices decline B increases as bond market prices increase C is unaffected by changes in market interest rates D will vary with the earnings of the issuer
A
Summary of Risks A customer who has taken his portfolio and invested it only in money market instruments is most likely concerned with: A purchasing power risk B credit risk C political risk D business risk
A
Interest Rate Movements Effect on Bond Prices If market rates of interest increase, bonds issued at par would trade at (a): A discount B premium C par D parity
A As interest rates rise in the market, bond prices will fall As interest rates fall in the market, bond prices will rise
Bond Quotes Bonds quoted on a percentage of par basis are generally: A term bonds B series bonds C serial bonds D short term maturities
A Bonds quoted on a percentage of par basis are term bonds. Municipal bonds quoted in basis points (yield quotes) are serial bonds.
Maturity Which statement is TRUE about bond price changes that result from interest rate movements? A Short term bond prices move slower than long term bond prices B Long term bond prices move slower than short term bond prices C Both short term and long term prices move at equivalent rates D No relationship exists between short term and long term bond price movements
A Long term bond prices are more volatile than short term bond prices as interest rates move. Thus, short term bond prices are more stable (move more slowly) as interest rates change compared to long maturities.
Interest Rate Risk (Market Risk) A customer wishes to invest in corporate bonds that offer minimum market risk. Which recommendation is appropriate? A Bonds with short term maturities B High yield bonds C Guaranteed bonds with medium term maturities D Bonds with long term maturities and high call premiums
A Market risk for a bondholder is the risk of rising interest rates forcing the price of a bond to drop. As interest rates rise, the price of a long term bond falls faster than that of a short term bond. To avoid market risk, a bondholder would want to invest in the shortest maturity possible.
Ratings Overview Which of the ratings agencies listed below would most likely rate a municipal revenue anticipation note for credit risk? A Moody's B Morningstar C Fitch's D Best's
A Moody's and Standard and Poor's are, by far, the largest of the ratings firms. Fitch's is a much smaller ratings agency and concerns itself mainly with rating corporate issues. Morningstar rates mutual funds, not municipal bonds.
Political Risk Which risk is unique to investing internationally in less-developed countries? A Political risk B Market risk C Marketability risk D Default risk
A Political risk is the risk of investing internationally in countries that have weak political systems.
Long Term Ratings A bond is rated Aaa by Moody's. The bond is: A Highest Quality Investment Grade B High Quality Investment Grade C Low Quality Investment Grade D Highest Level Speculative Grade
A The ratings for all long term debt are: Moody's: Aaa Aa A Baa Ba B Caa Ca C Standard and Poor's: AAA AA A BBB BB B CCC CC C The top 4 ratings for each are "investment grade."
Yield Comparisons When a bond trades at a premium, which bond yield will be the highest? A Nominal B Yield to maturity C Current D Basis
A When a bond trades at a premium, the 4 yields, from lowest to highest are: Yield To Call Yield To Maturity Current Nominal When a bond trades at a discount, the 4 yields, from lowest to highest are: Nominal Current Yield To Maturity Yield To Call
Bond Price Movements An investor buys a bond at a discount. Later in the year, the bond is trading at a premium. This is termed: A Amortization B Appreciation C Accretion D Accumulation
B
Call / Put Effect on Bond Prices as Interest Rates Move Two 20-year corporate bonds are issued at par, with stated interest rates of 10%. One issue is callable at par in 5 years, while the other is callable at par in 10 years. If interest rates drop by 200 basis points shortly after issuance, which statement is TRUE? A The bond callable in 5 years will appreciate more than the bond callable in 10 years B The bond callable in 10 years will appreciate more than the bond callable in 5 years C Both bonds will appreciate by equal amounts D The rate of appreciation depends on the credit rating of the bonds
B
Definition of Call Premium A bond call premium is the amount: A below par at which the issuer has the right to call bonds B above par at which the issuer has the right to call bonds C above par at which a bond is currently trading D at which the issuer would make money by calling in outstanding bonds
B
Flat Yield Curve During a period when the yield curve is flat: A short term bond prices are more volatile than long term bond prices B long term bond prices are more volatile than short term bond prices C short term and long term bond prices are equally volatile D no relationship exists between short term and long term bond price changes
B
Price of a Bond When bonds are trading at a large discount, which of the following statements are TRUE? I The deeper the discount, the more volatile the bond's price movement in response to interest rate changes II The deeper the discount, the less volatile the bond's price movement in response to interest rate changes III Discount bonds with long maturities are more volatile than ones with short maturities IV Discount bonds with short maturities are more volatile than ones with long maturities A I and III B I and IV C II and III D II and IV
B
Normal Yield Curve When short term interest rates are lower than long term interest rates, the yield curve is said to be: A flat B normal C inverted D bell shaped
B A normal yield curve is an ascending curve - with short term rates lower than long term rates.
Purchasing Power Risk A rising rate of inflation would lead to: I lower bond prices II higher bond prices III lower bond yields IV higher bond yields A I and III B I and IV C II and III D II and IV
B A rising rate of inflation will lead to higher interest rates. If interest rates rise, then bond prices will drop.
Liquidity Risk Which characteristics make a security least subject to liquidity risk? I Short term maturity II Long term maturity III Low credit rating IV High credit rating A I and III B I and IV C II and III D II and IV
B 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.
Duration Which bond will exhibit the greatest price volatility? A 10-year bond; 7% coupon; 8% yield; duration of 7.25 B 8-year bond; 0% coupon; 7% yield; duration of 8.00 C 4-year bond; 4% coupon; 3% yield; duration of 3.74 D 2-year bond; 2% coupon; 1% yield; duration of 1.97
B The longer the expiration, the more volatile a bond's price movements, which narrows the Choices to either A or B. The lower the coupon, the more volatile the bond's price movements, with the lowest coupon being "0." An 8-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 (7% in this case).
Short Term Ratings Moody's Investment Grade (MIG) rating is used for: A Municipal long term bonds B Municipal short term notes C Corporate long term bonds D Corporate short term notes
B The ratings for short term corporate debt are: Moody's: P1 (Prime 1) P2 (Prime 2) P3 (Prime 3) NP (Not Prime) Standard and Poor's: A1 A2 A3 The top 2 ratings for each are "investment grade" The ratings for short term municipal debt are: Moody's: MIG1 (Moody's Investment Grade 1) MIG2 MIG3 SG (Speculative Grade) The top 2 ratings are "investment grade"
U.S. Government Bond Quote Example Which of the following would be a quote for a U.S. Government bond with a dollar price of $1,012.50? A 101.25 B 101-8 C 101 1/4 D 101 4/16
B U.S. Government bonds are quoted as a percentage of $1,000 par in fractions of 1/32nds.
Yield to Call - Calculation An 8% corporate bond with 20 years left to maturity is currently trading at 120. The bond is callable in 4 years at 104. If a client buys the bond and then the issuer calls it in 4 years, the yield to call will be: A 2.98% B 3.57% C 3.63% D 6.66%
B YTC = Net Annual Return / Average Value YTC is Net Annual Return / Average Value. The annual income is 8% of $1,000 par = $80 per year. The bond can be purchased at 120, but it will be called in 4 years at 104, so there will be a 16 point ($160) loss over 4 years = 4 point loss ($40) per year. The Net Annual Return is: Annual Income ($80) - Annual Loss ($40) = $40 The Average Value is: $1,200 Purchase Price + $1,040 Redemption Price / 2 = $2,240 / 2 = $1,120 YTC is: $40 / $1,120 = 3.57%
Overview of Nominal Yield The nominal yield of a bond will: A increase as bond prices fall B remain unchanged as bond prices fluctuate C increase as bond prices rise D decrease as bond prices rise
B 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.
Call Occurrence When interest rates have fallen, an issuer will: I call the outstanding low interest rate bonds II call the outstanding high interest rate bonds III issue new bonds with lower interest rates IV issue new bonds with higher interest rates A I and III B I and IV C II and III D II and IV
C
Corporate Bond Quotes Example Which of the following would be a quote for an airline bond? A 105.625 B 105-20 C 105 5/8 D 105 10/16
C
Coupon As interest rates move, which statements are TRUE regarding bond price volatility? I The shorter the maturity, the greater the bond's price volatility II The longer the maturity, the greater the bond's price volatility III The lower the coupon rate, the greater the bond's price volatility IV The higher the coupon rate, the greater the bond's price volatility A I and III B I and IV C II and III D II and IV
C
Inverted Yield Curve During periods when the yield curve is inverted, which statements are TRUE? I Debt defaults are probably at historically high levels II Issuers are likely to sell non-callable bonds III Debt investors expect that interest rates will fall in the future IV Debt investors expect that economic activity will decline A II, III, IV B I, II, III C I, III, IV D I, II, III, IV
C
Junk (Speculative Grade) The rating level at which a bond is first considered to be speculative is: A A B Aa C Ba D Baa
C
Overview of Nominal Yields A corporation has issued 8% AA rated sinking fund debentures at par. Three years later, similar issues are being offered in the primary market at 7%. Which are TRUE statements about the outstanding 8% issue? I The current yield will be higher than the nominal yield II The current yield will be lower than the nominal yield III The dollar price of the bond will be at a premium to par IV The dollar price of the bond will be at a discount to par A I and III B I and IV C II and III D II and IV
C
Put Features An investor is most likely to put a bond with a tender option at par when: A interest rates are stable B interest rates are falling C interest rates are rising D interest rates are volatile
C
Summary of Bonds Which statements are TRUE? I Most of the value of a bond is established by the present value of the first payment II Most of the value of a bond is established by the present value of the last payment III The longer the maturity of a bond, the greater the bond's price volatility IV The shorter the maturity of a bond, the greater the bond's price volatility A I and III B I and IV C II and III D II and IV
C
Yield Curve Summary During periods when a normal yield curve exists, which of the following statements are TRUE? I Long term bond prices are less volatile than short term bond prices II Long term bond prices are more volatile than short term bond prices III Yields on long term maturities are greater than yields on short term maturities IV Yields on short term maturities are greater than yields on long term maturities A I and III B I and IV C II and III D II and IV
C
Default Risk Assessment A 65-year old customer wishes to invest part of his retirement funds with the dual objectives of enhanced income and safety of principal. The customer notices that "C" rated corporate bonds yield significantly more than equivalent maturity Treasury issues and asks you, the registered representative, whether these would be an appropriate investment. The best response is to tell the customer that this is a: A good idea since corporate bonds are extremely safe investments since they are guaranteed by the issuing corporation B good idea because the yield spread between corporates and Treasuries guarantees a superior return C bad idea because "C" rated corporate bonds have a much higher risk of default than Treasury issues D bad idea because "C" rated corporate bonds are not permitted investment vehicles for retirement fund proceeds
C "C" rated bonds are true "junk" with a high risk of default. This is a totally inappropriate investment for a retiree who needs income.
Call Risk All of the following callable municipal bonds are trading at an 8% basis. Which is MOST likely to be called? A 6 3/4% coupon rate callable at 103 in 2021 B 7 1/2% coupon rate callable at 103 in 2021 C 8 3/4% coupon rate callable at 100 in 2021 D 8 3/4% coupon rate callable at 105 in 2021
C 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).
Nominal Yield Example In 2021, a customer buys 1 PDQ 10%, $1,000 par debenture, M '36, at 115. The interest payment dates are Jan 1st and Jul 1st. The nominal yield on the bond is: A 8.37% B 8.69% C 10.00% D 10.23%
C Annual Interest/Par = 10/1,000 = 10
Creditors of a Corporation Which of the following are considered to be creditors of a corporation? A Common Shareholders B Preferred Shareholders C Convertible Bondholders D Right holders
C 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. Rights, warrants and options are all equity derivatives.
Corporate Bond Quotes How are corporate bonds quoted? A Coupon B Yield to Maturity C Whole and Fractional D Decimal
C Corporate bonds are quoted as a percentage of par value, with each "whole" point movement representing 1% of $1,000 par or $10. The minimum price increment is 1/8th of 1%, so it is a fraction of par. Thus, corporate bonds are quoted in whole and fractional points. For example, a corporate bond quoted at 100 1/8 is priced at 100.125% of $1,000 par = $1,001.25.
Computation of Call Premium A corporate bond was issued on Jan 1, 2013, that matures on Jan 1, 2033. The trust indenture allows the corporation to call the bond starting in 2018 at a price equaling 100 1/2 plus an additional 1/8 point premium for every 6 month period remaining until maturity. If the bond is called on Jan 1, 2029, the redemption price will be: A 102 1/2 B 102 C 101 1/2 D 100 1/2
C If the bond is called on Jan 1, 2029, it has 4 years left to maturity. This is the same as 8 - six month periods. For each six month period prior to maturity that the bond is called, 1/8 point is added to the call premium (total equals 1 point). Since the call price is 100 1/2 plus the additional premium of 1 point, the total call price is 101 1/2.
Marketability Risk Which of the following affect the marketability of corporate bonds? I Bond rating II Maturity III Block size IV Bond denominations A I only B II only C I, II, III D II, III, IV
C The higher rated a bond, the more marketable it is. The shorter the maturity, the more marketable it is. 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 bond denominations have no effect on marketability.
Exchange Rate Risk Exchange rate risk is a factor to consider when investing in foreign debt issues and the: I U.S. dollar depreciates in value II U.S. dollar appreciates in value III foreign currency depreciates in value IV foreign currency appreciates in value A I and III B I and IV C II and III D II and IV
C This is the risk that the foreign currency weakens against the U.S. dollar (which is the same as the U.S. dollar strengthening).
Call Protection An issuer has issued a 20 year bond at par that is not callable for 10 years. In the 11th year, the bond is callable at 103; in the 12th year it is callable at 102; in the 13th year, it is callable at 101; in the 14th year and after, it is callable at 100 (Par).
Call protection is the period of time after issuance of a bond, during which the issuer cannot call the debt. 10 years of call protection
Yield Curve Analysis Yield curve analysis is useful for an investor in debt securities because: I the curve shows market expectations for interest rates II investors can compare rates of return relative to changing maturities III the yield of a specific security can be compared to the market expectation for similar securities IV the curve can show relative demand for differing maturities by comparing the change in yield to the change in maturity A I, II only B II, III only C I, III, IV D I, II, III, IV
D
Reinvestment Risk Which security is MOST subject to reinvestment risk? A Zero coupon bonds B Low coupon bonds C Medium coupon bonds D High coupon bonds
D 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.
Municipal Basis Quotes 10 basis points equals: A .01% B .1% C 1% D 10%
One basis point equals .01% movement in interest rates, so 10 basis points equals a .1% movement in interest rates.
