know your bonds???

If a bond is purchased at a premium, which of the following statements are TRUE? I Yield to call is higher than the yield to maturity II Yield to call is lower than the yield to maturity III Yield to maturity is higher than the current yield IV Yield to maturity is lower than the current yield A. I and III B. I and IV C. II and III D. II and IV

The best answer is D. When a bond is purchased at a premium and called prior to its maturity date, the yield to call received will be lower than if the bond is held to maturity since the premium will be lost faster. Yield to maturity will always be lower than current yield for a premium bond because YTM includes the loss of the premium as a reduction of the overall return received from the bond; while current yield ignores this component (it is simply Annual Income / Current Market Price).

Which statement is FALSE when comparing Agency CMOs to Private Label CMOs? A. Agency CMOs carry the direct or implied guarantee of the U.S. Government while Private Label CMOs do not have such a guarantee B. Agency CMOs are backed by underlying mortgage backed pass-through certificates issued by that agency, while Private Label CMOs are backed by mortgage backed securities issued by private lenders and agencies C. Agency CMOs take on the credit rating of the underlying agency securities while Private Label CMOs are assigned credit ratings by independent credit ratings agencies D. Agency CMOs are traded in the public markets while Private Label CMOs can only be sold in private placements and cannot be traded

The best answer is D. Agency CMOs are created by Ginnie Mae, Fannie Mae, or Freddie Mac, using their own mortgage backed securities (MBSs) as the underlying collateral. Because the MBSs are AAA rated, the CMOs created from them are AAA rated as well. If it is an agency CMO created by Ginnie Mae, the securities have the direct backing of the U.S. Government; if the agency CMO is created by Fannie Mae or Freddie Mac, it has the implied backing of the U.S. Government. In contrast, "Private Label" CMOs are created by brokerage firms, who can use the MBSs of Ginnie, Fannie and Freddie as underlying collateral, but they also use MBSs created by the broker-dealer itself that have underlying collateral consisting of non-conforming jumbo mortgages that Ginnie, Fannie and Freddie won't buy because they are too large; and mortgage loans that the agencies won't buy because they do not meet the agency's underwriting standards (meaning they are risky). The credit rating of a "Private Label" CMO is established by a credit ratings agency such as Moody's based on the quality of the underlying collateral and is not automatically AAA.

When a bond increases in value due to market demand, this is termed: A. amortization B. accretion C. appreciation D. accumulation

The best answer is C. When an asset increases in value, this is termed appreciation.

Which statements are TRUE regarding the tax treatment of the annual adjustment to the principal amount of a Treasury Inflation Protection Security? I An annual upward adjustment due to inflation is taxable in that year. II An annual upward adjustment due to inflation is not taxable in that year. III An annual downward adjustment due to deflation is tax deductible in that year. IV An annual downward adjustment due to deflation is not tax deductible in that year. A. I and III B. I and IV C. II and III D. II and IV

The best answer is A. If the principal amount of a Treasury Inflation Protection Security is adjusted upwards due to inflation, the adjustment amount is taxable in that year as ordinary interest income. Conversely, if the principal amount of a Treasury Inflation Protection Security is adjusted downwards due to deflation, the adjustment is tax deductible in that year against ordinary interest income. (TIPS are usually purchased in tax qualified retirement plans that are tax-deferred. This avoids having to pay tax each year on the upwards principal adjustment.)

Which security has, as its return, the "pure" interest rate? A. Treasury Bill B. Treasury Note C. Treasury Bond D. Treasury STRIP

The best answer is A. Treasury securities are the safest investment - they have virtually no credit risk (default risk) and almost no marketability risk. They do have purchasing power risk (the risk of inflation eroding real returns), but this is only an issue for long-term maturities. Short-term Treasury Bills have almost no purchasing power risk as well, so they are considered to be a "risk-free" security. The "pure" interest rate is one that is free of any investment risks - it is the "pure" cost of borrowing without any "risk premium" added to the interest rate. Thus, the interest rate on a short-term T-Bill is the "pure" interest rate - the same thing as the risk-free rate of return.

If a bond is purchased at a discount, which of the following statements are TRUE? A. I and III B. I and IV C. II and III D. II and IV

The best answer is A. When a bond is purchased at a discount and called prior to its redemption date, the yield to call received will be higher than if the bond is held to maturity since the discount will be earned faster. Yield to maturity will always be higher than current yield for a discount bond because YTM includes the earning of the discount as part of the overall return received from the bond; while current yield ignores this component (it is simply Annual Income / Current Market Price).

Homeowners will prepay mortgages: I when interest rates fall II when interest rates rise III so they can refinance at lower rates IV so they can refinance at higher rates A. I and III B. I and IV C. II and III D. II and IV

The best answer is A. Homeowners will prepay mortgages when interest rates fall, so they can refinance at more attractive lower current rates. They tend not to prepay mortgages when interest rates rise, since there is no benefit to a refinancing.

The nominal yield on a bond is: A. stated interest rate / bond par value B. stated interest rate / bond market value C. market interest rate / bond par value D. market interest rate / bond market value

The best answer is A. The nominal yield is the stated rate of interest on the bond, based on par value.

Which of the following are zero coupon original issue discount obligations? A. I and IV only B. II and III only C. II, III, IV D. I, II, III, IV

The best answer is A. Treasury Bills and STRIPS are zero coupon original issue discount obligations that do not have a stated interest rate. Treasury Notes and Bonds are issued at par with a stated interest rate.

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

The best answer is C. The bond was issued with a coupon of 8%. Currently, yield for a similar issue is 7%. Therefore, interest rates have fallen subsequent to the issuance of the bond; or the credit quality of the bond has improved. When interest rates fall, yields on bonds already trading must also fall. What causes this is a rise in the dollar price of the issue - the bond now trades at a premium.

Which of the following statements are TRUE about Treasury Receipts? I An investment in Treasury Receipts has no reinvestment risk II An investment in Treasury Receipts is subject to reinvestment risk III The interest income on Treasury Receipts is subject to Federal income tax annually IV The interest income on Treasury Receipts is subject to Federal income tax at maturity A. I and III B. I and IV C. II and III D. II and IV

The best answer is A. Treasury Receipts are, essentially, zero-coupon obligations, that are purchased at a discount, and which are redeemable at par at a pre-set date. Thus, there is no reinvestment risk, since semi-annual interest payments are not received. The implicit rate of return is locked-in when the security is purchased, and the customer will earn that rate of return if the security is held to maturity. The annual accretion amount is taxable, since the underlying securities are U.S. Governments. At maturity, the receipt will have an adjusted cost basis of par, and will be redeemed at par, for no capital gain or loss.

When comparing the effect of changing interest rates on prices of a CMO issues versus the prices of regular bond issues, which of the following statements are TRUE? I When interest rates rise, mortgage backed pass through certificates fall in price faster than regular bonds of the same maturity II When interest rates rise, mortgage backed pass through certificates fall in price slower than regular bonds of the same maturity III When interest rates fall, mortgage backed pass through certificates rise in price faster than regular bonds of the same maturity IV When interest rates fall, mortgage backed pass through certificates rise in price slower than regular bonds of the same maturity A. I and III B. I and IV C. II and III D. II and IV

The best answer is B. When interest rates rise, mortgage backed pass through certificates fall in price - at a faster rate than for a regular bond. This is true because when the certificate was purchased, assume that the expected life of the underlying 15 year pool (for example) was 12 years. Thus, the certificate was priced as a 12 year maturity. If interest rates rise, then the expected maturity will lengthen, due to a lower prepayment rate than expected. If the maturity lengthens, then for a given rise in interest rates, the price will fall faster.

A bond issue where the bonds have the same maturity but different dates of issuance is a: A. term bond offering B. series bond offering C. serial bond offering D. combined serial and term bond offering

The best answer is B. A bond issue where the bonds have the same maturity but different dates of issuance is a series bond issue. These are rarely issued and are used to finance long-term construction projects where all of the money is not needed at once.

CMOs are: I available in $1,000 denominations II available in $25,000 denominations III quoted in 1/8ths IV quoted in 1/32nds A. I and III B. I and IV C. II and III D. II and IV

The best answer is B. CMOs are available in $1,000 denominations unlike the underlying pass-through certificates which are available only in $25,000 denominations. CMOs are quoted in 32nds, similar to the underlying pass-through certificates. Often CMO tranches are quoted on a "yield spread" basis to equivalent maturing Treasury issues.

Which of the following statements are TRUE about the Federal National Mortgage Association (FNMA)? I FNMA is a publicly traded corporation II FNMA is owned by the U.S. Government III FNMA pass through certificates are guaranteed by the U.S. Government IV FNMA pass through certificates are not guaranteed by the U.S. Government A. I and III B. I and IV C. II and III D. II and IV

The best answer is B. Fannie Mae performs the same functions as Ginnie Mae except that its pass through certificates are not guaranteed by the U.S. Government; and it has been "sold off" as a public company. Its stock was listed for trading on the NYSE, but Fannie went "bust" in 2008 after purchasing too many "sub prime" mortgages and was placed into government conservatorship. Its shares were delisted from the NYSE and now trade OTC in the Pink OTC Markets.

Which of the following statements are TRUE regarding Government National Mortgage Association pass-through certificates? I GNMA securities are guaranteed by the U.S. Government II GNMA securities are not guaranteed by the U.S. Government III Reinvestment risk for GNMAs is the same as for equivalent maturity U.S. Government bonds IV Reinvestment risk for GNMAs is greater than that for equivalent maturity U.S. Government bonds A. I and III B. I and IV C. II and III D. II and IV

The best answer is B. GNMA securities are guaranteed by the U.S. Government. Reinvestment risk is greater for Ginnie Maes than for U.S. Governments. If the mortgages backing a Ginnie Mae Pass Through Certificate are prepaid (if interest rates have dropped), the certificate holders receive payments that are a return of principal, and that, when reinvested at lower current rates, produce a lower return (this is reinvestment risk). In contrast, payments received from other Treasury securities consist of interest only, so if interest rates drop over the time period these securities are held, only the interest must be reinvested at lower rates; there is no principal return that must be reinvested until maturity.

Which bond does NOT have interest rate risk? A. A bond that is currently callable B. A bond that is currently puttable C. A bond with a high current coupon D. A bond with a low current coupon

The best answer is B. 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.

During a period when the yield curve has a normal ascending shape, which statement is TRUE? 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. Both short term and long term prices are equally volatile D. No relationship exists between long term and short term bond price movements

The best answer is B. 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.

When comparing Fannie Mae certificates to Ginnie Mae certificates, which of the following statements are TRUE? I Ginnie Mae certificates are rated slightly higher than Fannie Mae certificates II Fannie Mae certificates are rated slightly higher than Ginnie Mae certificates III Ginnie Mae certificates will have a slightly higher yield than Fannie Mae certificates IV Fannie Mae certificates will have a slightly higher yield than Ginnie Mae certificates A. I and III B. I and IV C. II and III D. II and IV

The best answer is B. Since Ginnie Mae certificates are guaranteed by the U.S. Government, they are rated slightly higher than Fannie Mae certificates. In the same sense, though, since Fannie Mae certificates have a bit more risk (they are NOT guaranteed directly by the U.S. Government), they will have a slightly higher yield than Ginnie Mae certificates.

Which statements are TRUE regarding Treasury Inflation Protection securities? I In periods of deflation, the amount of each interest payment will decline II In periods of deflation, the amount of each interest payment is unchanged III In periods of deflation, the principal amount received at maturity will decline below par IV In periods of deflation, the principal amount received at maturity is unchanged at par A. I and III B. I and IV C. II and III D. II and IV

The best answer is B. Treasury "TIPS" are Treasury Inflation Protection Securities - the principal amount of these securities is adjusted upwards with the rate of inflation. Even though the interest rate is fixed, the holder receives a higher interest payment, due to the increased principal amount. When the bond matures, the holder receives the higher principal amount. In periods of deflation, the principal amount is adjusted downwards. Even though the interest rate is fixed, the holder receives a lower interest payment, due to the decreased principal amount. In this case, when the bond matures, the holder receives par - not the decreased principal amount.

For bonds trading at a premium, rank the yield measures from lowest to highest? I Nominal II Current III Basis IV Yield to Call Basis A. I, II, III, IV B. IV, III, II, I C. II, I, III, IV D. I, III, II, IV

The best answer is B. 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.

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

The best answer is C. A put option at par allows the bondholder to "put" the bond back to the issuer at par value. Usually, such an option can only be exercised after the issue has been outstanding in the market for 5 to 10 years, depending on the specifics of the trust indenture. A bondholder purchases a bond with such an option because it protects him from market risk. If interest rates rise, the value of a typical bond without this option would drop. The option allows the bondholder to "put" the bond back to the issuer, receiving par for each bond. Thus, in a period of rising interest rates, the holder of a "puttable" bond is protected from market risk once the option is exercisable.

A bond issue with a single issue date and differing maturities is a: A. term bond offering B. series bond offering C. serial bond offering D. combined serial and term bond offering

The best answer is C. A serial bond offering is one with all bonds issued on the same date, but with differing maturities. This compares to a term bond issue, where all the bonds are issued on the same date; and all the bonds mature on the same date. Most municipal bond issues and corporate equipment trust certificates are serial bonds. It allows issuers to schedule principal repayment as an annual budget item.

Which of the following statements regarding collateralized mortgage obligations are TRUE? I Each tranche has a different level of market risk II Each tranche has a different level of credit risk III Each tranche has a different yield IV Each tranche has a different expected maturity A. I and II only B. III and IV only C. I, III, IV D. I, II, III, IV

The best answer is C. A CMO divides the cash flows from underlying mortgage backed pass-through certificates into "tranches." Each tranche, in effect, represents a differing expected maturity, hence each tranche has a different level of market risk. Since each tranche represents a differing maturity, the yield on each will differ. New CMOs have special classes of tranches called PAC (Planned Amortization Class) and TAC (Targeted Amortization Class) tranches. These tranches are given a greater certainty of repayment at the projected date, by allocating earlier than expected repayments to so-called "companion" tranches, before prepayments are applied to these tranches. Credit risk for CMO tranches is the same for all tranches, since it is based on the quality of the underlying mortgage backed securities held in trust.

Arrange the following CMO tranches from highest to lowest yield: I Plain vanilla II Targeted amortization class III Planned amortization class IV Companion A. I, II, III, IV B. IV, III, II, I C. IV, I, II, III D. II, III, IV, I

The best answer is C. Companion tranches are the "shock absorber" tranches, that absorb prepayment risk out of a TAC (Targeted Amortization Class) tranche; or both prepayment risk and extension risk out of a PAC (Planned Amortization Class) tranche. Because the companion absorbs both of these risks, it has the greatest risk and trades at the highest yield. A Plain Vanilla tranche is not relieved of either extension risk or prepayment risk, so it will offer a yield that is higher than a PAC or a TAC, but lower than the yield on a companion. A TAC is only relieved of prepayment risk, so its yield will be lower than a Plain Vanilla tranche. However, the TAC yield will be higher than the yield on a PAC, which is relieved of both extension and prepayment risk, while the TAC is only relieved of prepayment risk.

A percentage of par quote is also known as a: A. firm quote B. yield quote C. dollar quote D. basis quote

The best answer is C. Dollar Bonds - most corporate, government, and any municipal issues which are term bonds - are quoted on a percentage of par basis. Anytime a bond is quoted as a percentage of par, it is quoted on a dollar basis. In contrast, municipal serial issues are quoted on a yield basis.

Which of the following would NOT purchase STRIPS? I Pension fund II Money market fund III Individual seeking current income IV Individual wishing to avoid reinvestment risk A. I and III B. I and IV C. II and III D.II and IV

The best answer is C. Pension funds and retirement accounts are the large purchasers of STRIPS. These zero-coupon bonds are purchased at a deep discount and are held to maturity to fund future retirement liabilities. There is little credit risk, because the U.S. Treasury is a top credit. There is no current income because they don't pay until maturity. They have a huge amount of purchasing power risk as a long-term zero coupon obligation, but this is not an issue if they are held to maturity. Retirement plan managers like STRIPS because they don't have to worry about reinvestment risk - there are no semi-annual interest payments to reinvest! It is an investment that can be "tucked away" for 20 or 30 years, with no further work or worry on the part of the retirement fund manager.

In 2022, a customer buys 1 PDQ 10%, $1,000 par debenture, M '37, 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%

The best answer is C. The nominal yield is the stated rate of interest on the bond, based on par value. $100 $1,000 = 10%

Which of the following statements are TRUE about CMOs? I CMO issues have a serial structure II CMO issues are rated AAA III CMO issues are more accessible to individual investors than regular pass-through certificates IV CMO issues have a lower level of market risk than regular pass-through certificates A. I and II only B. III and IV only C. I, II, III D. I, II, III, IV

The best answer is D. All of the statements are true about CMOs. CMOs have a lower level of market risk (risk of price volatility due to movements in market interest rates) than do mortgage backed pass-through certificates. Because CMO issues are divided into tranches, each specific tranche has a more certain repayment date, as compared to owning a mortgage backed pass-through certificate. Thus, the price movement of that specific tranche, in response to interest rate changes, more closely parallels that of a regular bond with a fixed repayment date. As interest rates rise, CMO values fall; as interest rates fall, CMO values rise. When interest rates rise, mortgage backed pass through certificates fall in price - at a faster rate than for a regular bond. This is true because when the certificate was purchased, assume that the average life of the underlying 15 year pool (for example) was 12 years. Thus, the certificate was priced as a 12 year maturity. If interest rates rise, then the average maturity will lengthen, due to a lower prepayment rate than expected. If the maturity lengthens, then for a given rise in interest rates, the price will fall faster.

Which of the following statements are TRUE regarding CMOs? I CMOs make payments to holders monthly II CMOs receive the same credit rating as the underlying pass-through securities held in trust III CMOs are subject to a lower level of prepayment risk than the underlying pass-through certificates IV CMOs are available in $1,000 denominations A. II, III, IV B. I, II, IV C. I, III, IV D. I, II, III, IV

The best answer is D. Most CMOs make payments to holders monthly; though there are some issues that pay quarterly or semi-annually. CMOs are subject to a lower degree of prepayment risk than the underlying pass-through certificates. During periods of falling interest rates, prepayments of mortgages in a pool are applied pro-rata to all holders of pass-through certificates.

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

The best answer is 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.

Which statements are TRUE when comparing Treasury Notes to Treasury Bills? I Treasury Bills have a longer initial maturity II Treasury Notes have a longer initial maturity III Treasury Bills pay interest semi-annually IV Treasury Notes pay interest semi-annually A. I and III B. I and IV C. II and III D. II and IV

The best answer is D. Treasury Notes have a maximum maturity of 10 years and pay interest semi-annually. T-Bills have a maximum maturity of 12 months; and are original issue discount obligations that mature at par. When the bills mature, the difference between the purchase price and the redemption value at par is the interest income that is earned.