Debt/Corp Bonds
Nickelplate Manufacturing Corporation (NMC) is capitalized with 1 million shares of a 6% $50 par callable preferred stock and 10 million shares of $1 par common stock. With the preferred stock currently selling at $75 per share and the common stock at $60 per share, the current yield of the preferred stock is closest to
Current yield on any security, stock or bond, is the annual income (dividend on stock, interest on bond) divided by the current market price per share (or per bond). The math in this question is the dividend of $3 (a 6% $50 par preferred stock is paying an annual dividend of 6% of $50, or $3 per share) divided by the current market price of the preferred stock ($75). The quotient is .04 or 4%. What about the common stock? All of that information is just to distract you. We cannot compute the current yield of the common stock because we do not have any information about its dividend.
Nickelplate Manufacturing Corporation (NMC) is capitalized with 1 million shares of a 6% $50 par callable preferred stock and 10 million shares of $1 par common stock. Your customer's required rate of return on fixed income investments is 8%. The NMC preferred stock would be an appropriate addition to this customer's portfolio only if the stock was not priced in excess of
How does a 6% preferred stock return 8%? Remember the inverse relationship between interest rates and fixed income security prices. As one goes up, the other goes down. An increased return results from a decreased price. The math is basic algebra. We know the annual dividend is $3 per share (6% of $50 = $3); that is fixed. What number results in a payment of $3 providing an 8% return? Divide 3.00 by $8 and the answer is $37.50. You could also do this question by working backwards. Multiply each of the choices by 8% and the one where the product is $3 is correct.
When part of an issue of speculative bonds with a 25-year maturity are called, the effect on the remaining bonds will be to
Speculative bonds are those with lower ratings. They are considered to be of lower quality because the risk of timely payment and principal are higher than investment-grade bonds. When a company shows its determination to honor its debt by paying off some of it in advance, the rating associations take note of that and invariably increase the rating. Compare this to your personal credit score. Your score might be relatively low because you have a lot of outstanding debt. As you pay down that debt, your credit score is likely to increase. It is the same logic here.
A 7% convertible debenture is selling at 101, and it is convertible into the common stock of the same corporation at $25. The common stock is currently trading at $23. What is the parity price of the debenture?
To determine the parity price of the bond, first find the number of shares the debenture is convertible into (conversion ratio) by dividing par value by the conversion price ($1,000 / $25 = 40 shares). Next, multiply the current price of the common by the conversion ratio. The result is the parity price of the bond (40 shares × $23 = $920).
ranking yield for discounts (high to low)
YTC, YTM, CY, Nominal (coupon) premium is opposite
LT Debt
more than 5 years, usually 20-30 years
Debenture
not backed by anything other than credit
If a bond has a YTC less than CY
premium
duration
sensitivity of a debt security
brokered CDs
sold by BDs longer holding period than jumbo fees are higher than jumbo may or may not be covered by fdic not redeemable before maturity
When a bond is issued by a national government, it is referred to as
sovereign debt
when ir increase
the longer the duration, the more the price decline, and the longest term to maturity with the lowest coupon rate will have the longest duration.
negotiable CD
unsecured time deposits (no collateral) readily transferrable only mm that redeems at face value plus interest covered by fdic minimum denomination is $100,000
YTM<YTC
discount
YTM> coupon
discount
The current yield on a bond with a coupon rate of 7.5% currently selling at 105½ is approximately
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 7.1%.
ELNs
return at maturity based on return of single stock, basket of stocks, or equity index credit, market, liquidity, call, risks
Corporate bonds that are guaranteed are
A guaranteed corporate bond is one guaranteed by another corporation that typically has a higher credit rating than the issuing corporation and is in a control relationship with it.
current yield
return/ investment
ir decrease
As interest rates decrease, the value of older bonds (with their higher coupons) increases. The higher the coupon, the greater the increase. When their coupons are the same, the longer the time to maturity, the more valuable that higher coupon rate.
liquidation priority
secured creditors, unsecured creditors, sub debt holders, pref, common
when bonds are at a discount
CY > Coupon
when bonds are at a premium
Coupon> Current yield
If a fund has a fixed portfolio of municipal bonds with long maturities, how will substantial changes in general interest rates affect the fund's portfolio?
For a fund with a fixed portfolio of long-term municipal bonds, the market value of the portfolio will fluctuate with changing interest rates, but the income will remain unchanged.
You have a client who is about to retire and wants to rearrange his portfolio to have predictable income. Which of the following would not be a good investment vehicle?
Income bonds, also known as adjustment bonds, are issued when a company is reorganizing and coming out of bankruptcy. Income bonds pay interest only if the company has enough income to meet the interest payment. As a result, these bonds normally trade flat without accrued interest. Therefore, they are not suitable for customers seeking income.
Money Market Ratings
MIG, F, SP (lower numbers are better)
MM issued
at a discount
YTM and CY are equal
par
near-term call
The near-term call would mean that no matter how attractive the bond's other features, the client may not have very long to enjoy them.
An investor purchases a PQR convertible bond at 98 on June 18, 1994. The bond is convertible at $25, and on June 19, 1995, when the common stock is trading at $26 per share, the investor converts his bond into the stock. For tax purposes, these transactions will result in
The process of converting a convertible bond into common stock is not a taxable event. When the stock is sold, the taxable event occurs.
One of your customers calls and asks you about a security with an S&P rating of SP-2. The customer is most likely asking about which of the following?
The three major rating services each have their own rating system for short-term municipal debt (notes). In the case of Standard and Poor's, the ratings are SP-1, SP-2, and SP-3 in declining order of quality. Regulation S-P (with the hyphen between the S and P) deals with privacy notices. Although it is unlikely to be tested, commercial paper is rated A-1, A-2, A-3, and then into the "Bs."
paying agent
trust dept of a bank transmit payments of interest and principal to investors
A bond has a 7% coupon and an offering price of 108. The bond matures in ten years. An investor purchasing this bond at the offering price would have a yield to maturity closest to
"When you pay more, you get less," Anytime a bond is purchased at a premium (a price above par), the yield to maturity (as well as the current yield and yield to call) must be lower than the nominal yield (the coupon rate). If you stop and think for a moment, there can be only one possibly correct answer. With a coupon rate of 7%, the answer must be something less than that. As will likely be the case on the exam, there is only one choice that is less than 7%. If you want to do the computation using our formula, it is: Annual interest - (premium ÷ years to maturity) ÷ average price of the bond. Plugging in the numbers we have: $70 - ($80 ÷ 10) ÷ [($1,080 + $1,000) ÷ 2]. This works out to: $62 ÷ $1,040 = 5.96%. However, as stated above, with only one number below the coupon rate, that has to be it. A variation of this question has two choices below the coupon. If that were the case here, the other choice would be 6.48%. That is the current yield ($70 ÷ $1,080). You need to remember that with a bond selling at a premium, the YTM will always be lower than the CY.
The basis of a bond with a 5% nominal yield maturing in twenty years and selling at 85 is approximately
A bond's basis is its yield to maturity (YTM). It is not necessary to do the YTM calculation because it could only be one choice. We can easily compute the current yield by dividing the $50 annual interest by the $850 current market price. That is about 5.88%. The YTM must be higher than that because it includes the eventual profit realized when the bond matures at par. There is only one selection that is higher than 5.88%. The calculation would follow our formula of: Annual interest + (discount ÷ number of years to maturity) ÷ (Current market price + par) ÷ 2) Plugging in the numbers, we have: ($50 + [$150 ÷ 20 years]) = ($50 + $7.50) divided by ([$850 + $1,000] ÷ 2]) = $57.50 ÷ ($1,850 ÷ 2) = $57.50 ÷ $925= 6.22%
In the United Kingdom, they are called gilts. In Germany, they are called Bunds. In France, they are called OATS. To investors, they are known as
Although it is highly unlikely that you would ever see any of these terms on the exam, you might need to know what sovereign debt is. For the United States, the sovereign debt (the debt issued by the sovereign nation) is Treasury securities. The safety of sovereign debt depends on the economy of the specific nation. You would probably not recommend the debt of a third-world country to a customer wishing to avoid risk.
an investor purchases a corporate zero coupon bond at $510. The bond matures in seven years. Four years later, the bond is sold at a price of $690. What are the tax consequences of the sale?`
The amount of the discount is $490. This must be accreted over the seven years until maturity. the annual accretion is $70. After four years, there is $280 of accretion. Because the annual accretion is added to t he investor's cost basis, the basis is now $790. The bond's sale price if $690 is now $100 below the accreted basis- Loss of $100
An investor's portfolio contains the following four bonds: ABC 7% due in 2040 DEF 6% due in 2040 GHI 5% due in 2040 JKL 8% due in2040 Which of these bonds would show the greatest price change as a percentage of its current market price if interest rates jumped by one percentage point?
The longer the duration, the greater the price volatility (price change as a percentage of current value) when there is a change to market interest rates. When all bonds have the same (or approximately the same) length of time to maturity, the bond with the lowest coupon rate will have the longest duration. Conversely, the one with the highest coupon rate will have the shortest duration and changes in interest rates will have the least impact on it.
Two bonds currently quoted at a 5.50 basis mature in exactly 15 years. Their coupons are 6% and 7%, respectively. Which bond would experience the greatest appreciation in value if the yields dropped to a 5.20 basis?
These bonds are selling at a premium (their coupons are above their yield to maturity, or basis). If the YTM declines to 5.20, it means that the prices of the bonds went up. Without getting too deep into the mathematics, in order for both bonds to have the same basis (5.20), the one with the 7% coupon must have a higher price because the $10 per year additional interest has to be offset by a larger annual "loss." Here is a general rule that will apply to your exam questions. When interest rates are falling, bonds with higher coupon rates are going to appreciate in price at a greater rate than bonds with lower coupon rates. Conversely, when interest rates are rising, those bonds with higher coupons will decrease in price at a slower rate than bonds with lower coupons. In our specific question, the 7% bond will have a greater price increase than the 6% bond. If, however, our question showed the bond selling at a discount, e.g., the basis (YTM) is 8%, the 7% bond would be selling closer to par value than the 6% bond
A bond investor who is looking for capital gains should invest in bonds when interest rates are
This is about the inverse relationship between interest rates and bond prices. As interest rates rise, bond prices fall. Conversely, when interest rates decline, bond prices increase. If an investor buys bonds when the current interest rates are high, a future decline in those interest rates will cause the price of the bonds to increase.
