Bonds

Postive yield curve can signal?

A positive (or normal) yield curve occurs during periods of economic expansion and generally predicts that market interest rates will rise.

Downside risk of a convertible bond Market price $1080 Investment Value $890

Dollar or percentage decline from the current market price

A convertible bond's market value will NOT fall below its A) conversion value. B) downside value. C) call value. D) investment value.

Explanation A convertible bond's market value will not fall below its investment value. If the conversion premium is worthless, the bond still has value as a straight bond—its market value. LO 2.2.1

Question #29 of 30 Question ID: 1240041 Which of these statements correctly describes differences between preferred stock and long-term bonds? Interest paid by firms is a tax-deductible expense; dividends paid on preferred stock are not tax deductible. Bonds usually have a finite maturity; preferred stock is usually perpetual. Bonds pay a fixed amount of interest; preferred stock pays a fluctuating dividend based on earnings. Interest on bonds and preferred stock dividends are legal obligations of a firm that must be paid. A) I and II B) I and III C) II and III D) I, II and IV

Explanation The answer is I and II. Bonds pay a fixed periodic interest that is tax deductible by the firm; preferred stock dividends are fixed, but they are not tax deductible. Only the interest on bonds is a legal obligation that must be paid; dividends on preferred stock can be deferred (if there is a cumulative feature) or skipped. LO 2.5.1

Identify which of these statements regarding zero-coupon bonds is NOT correct. Zero-coupon bonds are purchased at par and defer interest payments until maturity. Because there are no coupon payments for zero-coupon bonds, no current income is recognized. A zero-coupon bond is issued at a discount and pays semiannual interest payments. Corporations may favor zero-coupon bonds because they have an extended period to use the money that has been raised by the offering. A) IV only B) I, II, and III C) I and IV D) II and III

Explanation The answer is I, II, and III. Zero-coupon bonds are issued at a discount and pay only the par value at maturity; 'interest' is not paid during the term of the bond but 'interest/growth' are paid at the end. Even though no periodic interest payments are made, the bondholder must recognize the accrued interest each year for income tax purposes. LO 2.1.1

Choose the CORRECT statement regarding yield curves. A) All of these statements are correct. B) A flat yield curve occurs when the economy is peaking and, therefore, no near-term change in future interest rates is expected. C) A normal yield curve occurs during periods of economic expansion and generally predicts that market interest rates will rise in the future. D) An inverted yield curve occurs when the Federal Reserve has tightened credit in an inflationary economy.

Explanation The answer is all of these statements are correct. The yield curve is a graph of interest rate yields for bonds of the same quality, ranging in maturity from 31 days to 30 years. An inverted yield curve predicts interest rates will fall and sometimes can signal an upcoming recession. LO 2.3.2

Identify which of these is NOT a characteristic of a normal yield curve. A) The curve has a tendency to slope upward and outward. B) A normal yield curve indicates that long-term market interest rates are higher than short-term rates. C) A normal yield curve occurs during periods of economic expansion. D) As the maturity date of bonds lengthens, the corresponding bond yield decreases.

Explanation The answer is as the maturity date of bonds lengthens, the corresponding bond yield decreases. When the maturity date of the bonds lengthen, the corresponding yields will increase. LO 2.4.1

Which of the following statements regarding duration is CORRECT? Risk-averse investors should consider bonds with low durations. Aggressive investors should consider bonds with low durations when they anticipate that interest rates will rise. A) Neither I nor II B) Both I and II C) II only D) I only

Explanation The answer is both I and II. Risk-averse investors should consider bonds with low durations. Aggressive investors should consider bonds with high durations when they anticipate that interest rates will decline, and they should consider bonds with low durations when they anticipate that interest rates will rise. LO 2.3.2

Identify the yield-curve theory that relies on the laws of supply and demand for various maturities of borrowing and lending. A) Unbiased expectations theory B) Brownian theory C) Liquidity premium theory D) Market segmentation theory

Explanation The answer is market segmentation theory. Market segmentation theory relies on the laws of supply and demand for various maturities of borrowing and lending. Unbiased expectations theory states that long-term rates consist of many short-term rates and that long-term rates will be the average of short-term rates. The liquidity premium theory is based on the unbiased expectations theory but incorporates a liquidity premium into the model.

Question #20 of 30 Question ID: 1415714 The interest rate theory that long-term rates consist of many short-term rates and that long-term rates will be the average of short-term rates is known as A) rate preference theory. B) market segmentation theory. C) preferred habitat theory. D) unbiased expectations theory.

Explanation The answer is unbiased expectations theory. The unbiased expectations theory states that long-term rates consist of many short-term rates and that long-term rates will be the average of short-term rates.

The yield curve graphically plots A) yield on the y-axis and price on the x-axis. B) price on the y-axis and time on the x-axis. C) price on the y-axis and yield on the x-axis. D) yield on the y-axis and time on the x-axis.

Explanation The answer is yield on the y-axis and time on the x-axis. Yield on the y-axis, plotted against time, on the x-axis, is the yield curve.

An investor would consider converting a convertible bond into common stock if the bonds

Market price is less than Conversion price Bonds conversion value exceeds its market price

Series HH bonds

Not sold since September 2004. Pay a fixed rate of interest every six months until maturity redemption whichever comes first. Interest is reportable for tax purposes in the year it is earned.

Coupon Paying bond primary risks

Purchasing power risk Interest Rate risk Default risk Reinvestment risk

A client is considering the purchase of a $25 par preferred stock to add income to his portfolio. The stock has an 8% stated annual dividend rate and will never change. The investor's discount rate is 12%. What is the most the investor should pay for this stock? A) $3.20 B) The value cannot be determined without an appropriate growth rate. C) $16.67 D) If the required return exceeds the coupon rate, another valuation method must be used.

The answer is $16.67. The zero growth or dividend in perpetuity formula would apply: 8% of $25 par is $2.00, so $2.00 ÷ 0.12 = $16.67 LO 2.5.1

Norma owns ABC Corporation bonds of AA rated quality that mature in seven years, pay semiannual interest, and have a coupon of 8%. Similar bonds (AA rated, seven years to maturity) yield 9%. The ABC Corporation bonds are convertible into common stock at $26 per share, and the current market price of ABC common stock is $23. What is the conversion value of an ABC Corporation bond? A) $884.61 B) $766.47 C) $851.85 D) $923.08

The answer is $884.61. The conversion value = conversion ratio × market price of common stock. Therefore, the conversion value equals ($1,000 ÷ $26) × $23 = $884.61.

Terri has been an active investor for many years, and her present portfolio consists of listed stocks, penny stocks, and options. She earns approximately $175,000 annually, has $35,000 in cash to invest, and is in the 32% marginal income tax bracket. Terri is interested in accumulating wealth for the future and does NOT need current income. Which one of these fixed-income securities best suits Terri's needs at this time? A) AAA rated, par value, short-term, U.S. Treasury bond B) A rated, par value, short-term, corporate debenture bond C) AAA rated, premium, intermediate-term, tax-free, municipal general obligation bond D) A rated, discount, long-term, tax-free, municipal revenue bond

The answer is A rated, discount, long-term, tax-free, municipal revenue bond. Because Terri is in a high income tax bracket, an investment-grade municipal bond would be the best choice. The long-term nature of this bond may afford Terri a higher net interest payment than the other bonds.

Portfolio immunization is designed to protect bondholders from which of the following risks? Interest rate risk Reinvestment rate risk Default risk A) I and III B) I and II C) II and III D) I, II, and III

The answer is I and II. Portfolio immunization protects bondholders from fluctuations in interest rates and from reinvestment rate risk but does not protect against default risk.

Identify which of these statements regarding bonds is CORRECT. 1.If a bond is issued in registered form, payments will be made to the owner of record. 2.If a bond is issued in bearer form, payments will be made to whoever holds or possesses the bond. 3.A bond acquired in the secondary market at a discount is called a market discount bond. 4.The amount attributable to a market discount is always includable in income in the year of acquisition.

The answer is I, II and III. Only statement IV is incorrect. A bond is a debt security obligating the issuer to make periodic interest payments and to repay the principal at the time of maturity. The amount attributable to a market discount is generally not includable in income until sale or disposition of the bond, and then it is treated as interest income. LO 2.1.1

Which of these describe similarities between preferred stock and long-term bonds? 1.Both dividends and interest are tax-deductible expenses for the issuing corporations. 11.Both generally pay a fixed periodic payment. 111.Both preferred dividends and interest must be paid before common stock cash dividends are paid.

The answer is II and III. Both preferred stock and long-term bonds generally pay a fixed periodic payment, and both preferred dividends and interest must be paid before common stock cash dividends are paid.

Which of these describe differences between preferred stock and long-term bonds? Preferred stock usually has a shorter maturity than long-term bonds. Corporations receive more favorable tax treatment when investing in preferred stock than when investing in long-term bonds. Preferred stock dividends are a stronger legal obligation to the firm than interest payments on long-term bonds. The market price of preferred stock tends to fluctuate more than the market price of long-term bonds. A) II and III B) I and IV C) II and IV D) I and III

The answer is II and IV. Corporations receive preferential tax treatment when investing in preferred stock. The market price of preferred stocks is more volatile than long-term bonds when interest rates fluctuate. LO 2.5.1

Which of these statements regarding bond portfolio immunization is CORRECT? Immunization allows an investor to ensure that the value of his or her bond portfolio remains the same, regardless of whether interest rates increase or decrease. Immunization is accomplished by creating a portfolio whose duration is equal to the investor's investment time horizon. Immunization allows investors to earn a current yield that is equal to the yield to maturity. Immunization allows an investor to earn a specific rate of return, regardless of whether interest rates increase or decrease. A) III only B) I and II C) I, III, and IV D) II and IV

The answer is II and IV. Immunization attempts to protect the yield of a bond portfolio from changes in interest rates. An immunized portfolio is expected to provide a specific return over the investment time horizon. If interest rates change during the investment period, the capital losses are expected to be offset by the gains on reinvestment income. Immunization is accomplished by creating a portfolio whose duration is equal to the investor's investment time horizon. LO 2.3.1

Barbara, a Louisiana resident, is in the 35% marginal federal income tax bracket and the 6% marginal state income tax bracket. Select the bond that would provide Barbara with the highest after-tax rate of return. A) Corporate bond with a coupon rate of 8% B) Texas municipal bond with a coupon rate of 5.8% C) Louisiana municipal bond with a coupon rate of 5.5% D) U.S. Treasury bond with a coupon rate of 6% Explanation

The answer is Louisiana municipal bond with a coupon rate of 5.5%. U.S. Treasury bond (exempt from state income tax): 6% × (1 - 0.35) = 3.90% Corporate bond: 8% × [1 - (0.35 + 0.06)] = 4.72% Texas municipal bond (exempt from federal income tax): 5.8% × (1 - 0.06) = 5.45% Louisiana municipal bond (exempt from both federal and state income tax): 5.5% LO 2.1.1

Which of the following statements is CORRECT? If an investor expects a decline in market interest rates, she should attempt to construct a portfolio of long maturity bonds with low coupon rates. If the investor expects an increase in market interest rates, he should attempt to construct a portfolio of short maturity bonds with high coupon rates.

The answer is both I and II. The portfolio in Statement I will provide the investor with a portfolio that has the maximum interest rate sensitivity to take advantage of the capital gains experienced by bonds from the decrease in market interest rates. The portfolio in Statement II will provide the investor with a portfolio that has the minimum interest rate sensitivity to minimize the capital losses experienced by bonds from the increase in market interest rates.

Immunization offsets which two risks in a bond portfolio? A) Interest rate risk and reinvestment rate risk B) Liquidity risk and market risk C) Reinvestment rate risk and call risk D) Interest rate risk and default risk

The answer is interest rate risk and reinvestment rate risk. Immunization offsets interest rate risk and reinvestment rate risk.

What is one disadvantage of investing in convertible bonds?What is one disadvantage of investing in convertible bonds? A) The yield to maturity tends to be lower than that of similar nonconvertible bonds. B) The likelihood of a call increases as the price of the underlying stock decreases. C) There is substantial business and market risk. D) The dividend yield on the underlying stock is usually greater than the interest income on the bonds.

The answer is the yield to maturity tends to be lower than that of similar nonconvertible bonds. A disadvantage of investing in a convertible bond is that its yield to maturity tends to be lower than a similar nonconvertible bond due to the conversion feature. LO 2.2.1

Normal yield curve

during periods of economic expansion and generally predicts that market interest rates will rise in the future.

flat yield curve

economy is peaking and, therefore, no change in future interest rates is expected.

Revenue Bonds

investments secured by the revenue generated by a state or municipal project Secured by a specific Pledge or property They are a type of full faith and credit bond

Series EE savings bond

is bought at half its face value

Inverted yield Curve

occurs when the Federal Reserve has tightened credit in an overheating economy.

Unbiased Expectations Theory

the current long-term rate is the average of today's short-term rate and expected future short-term rates.