Types and Characteristics of Fixed Income (Debt) Securities and Methods Used to Determine Their Value

When a corporate bond has a convertible feature, it means A. the owner of the bond may exchange it for a pre-determined number of shares of the issuer's common stock B. the corporation may redeem the bond before its maturity date C. the owner of the bond may exchange it for a common stock of the issuer at a discount from the current market value D. the owner of the bond may exchange it for a bond paying a higher coupon rate

A. A convertible bond is usually a debenture that allows the owner to exchange it for a set number of shares of stock as stated in the bond indenture (or contract). This number will change only in response to the antidilutive provisions that go into effect in the case of a stock split or stock dividend and has nothing to do with the market price of the stock.

In the event of a company's insolvency, which of the following has first claim on assets? A. Bondholders. B. Preferred stockholders. C. Common stockholders. D. Members of the board of directors.

A. Bondholders have contractual rights to the assets of a business that must be honored on insolvency before claims of stockholders or directors.

All of the following debt instruments pay interest semiannually EXCEPT A. Ginnie Mae pass-through certificates B. U.S. Treasury notes C. U.S. Treasury bonds D. TIPS

A. Ginnie Maes pay interest on a monthly basis, not semiannually.

When a bond with a 6% coupon is selling for 90 I. the current yield is approximately 6.67% II. the bond is selling at a discount III. the bondholder will receive two semi-annual interest payments of $27 each IV. the yield to maturity is slightly less than the current yield A. I and II B. I, II and IV C. II and III D. III and IV

A. The current yield on a bond is the coupon divided by the current market price. In this example, 6 divided by 90. The price of 90 represents 90% of par, a discount of $100. Interest payments are based on the $1,000 face amount, so this investor would receive two semiannual payments of $30 each. On a discounted bond, the yield to maturity will always be higher than the current yield.

A bond offered at par has a coupon rate A. less than its yield to maturity B. less than its current yield C. equal to its current yield D. greater than its yield to maturity

C. When a bond is selling at par, its coupon or nominal rate, current yield, and yield to maturity are all the same.

Which of the following statements about zero-coupon bonds are TRUE? I. Zero-coupon bonds are sold at a deep discount from face value. II. Zero-coupon bonds pay periodic interest payments. III. The owner of a zero-coupon bond receives the face value only at maturity. A. I and II B. I and III C. II and III D. I, II, and III

B. A zero-coupon bond is a type of debt security that pays no periodic interest payments. Instead, they are sold at a deep discount from the maturity value and the investor receives return of that value only when the bonds mature.

A corporate bond is currently selling in the market at a price of 120. The bond is convertible at $25. The parity price is A. $25 per share B. $30 per share C. $40 per share D. $48 per share

B. The first step is determining the number of shares upon conversion. That would be found by dividing the $1,000 par value of the bond by the $25 conversion price. This tells us that the bond is convertible into 40 shares. Then, we divide the current market price of $1,200 by the 40 shares to arrive at the parity price (the price as which 40 shares is equal to $1,200).

A $1,000 bond with a nominal yield of 8% will pay how much interest each year? A. $40.00 B. $80.00 C. $160.00 D. There is no way to compute without knowing the current market price of the bond

B. The nominal yield (or coupon rate) is the interest rate stated on the bond and is the annual rate the issuer promises to pay on the bond until the bond matures. A $1,000 bond with an 8% nominal yield will pay $80 per year in interest. In all cases on the exam, the interest will be paid in two equal semi-annual installments, in this case, $40 each.

If your clients want to set aside $40,000 for when their child starts college, but do not want to endanger the principal, you should recommend A. corporate bonds with high rates of interest B. zero-coupon bonds backed by the U.S. Treasury C. general obligation municipal bonds for their tax benefits D. common stock

B. Treasury STRIPS are guaranteed by the U.S. government so there is no chance of default. They are zero-coupon bonds and offer no current income, which is appropriate for a client who wants 100% return paid at a future date for college expenses.

Corporate bonds are considered safer than common stock issued by the same company because A. the par value of bonds is generally higher than that of stock B. bonds and similar fixed-rate securities are guaranteed by SIPC C. bonds place the issuer under an obligation but stock does not D. if there is a shortage of cash, dividends are paid before interest

C. A bond represents a legal obligation to repay principal and interest by the company. Common stock carries no such obligation. SIPC insures broker-dealer client accounts, not bonds.

Each of the following debt securities would be considered investment grade EXCEPT A. corporate subordinated junior unsecured debentures with an A rating B. municipal water authority revenue bonds with a Baa rating C. corporate first lien mortgage bonds with a BB rating D. U.S. Treasury bills

C. Investment grade is defined as BBB (S&P) or Baa (Moody's) and higher. When giving the rating, collateral, or lack of same, is already taken into consideration. All you do is look at the letters.

Which of the following statements about municipal bonds is NOT true? A. The interest on municipal bonds is usually not subject to federal income tax. B. Municipal bonds are bonds issued by governmental units at levels other than the federal. C. Municipal bonds are generally considered riskier than corporate bonds. D. Municipal bonds generally carry lower coupon rates than corporate bonds of the same quality

C. Municipal bonds are generally considered second only to U.S. Treasury instruments in relative safety. Because of their tax-free yield, their coupon rates are lower than corporate bonds of the same quality.

An investor in the 25% federal income tax bracket purchasing an unrated public works revenue bond issued by State A that carries a 3% coupon would have a tax equivalent yield of A. 2.25% B. 3.00% C. 4.00% D. None of these because it is unlikely that an unrated bond will be able to make timely interest payments

C. Tax equivalent yield is computed by dividing the coupon rate of the municipal bond by (100% minus tax bracket). In this case, the calculation is 3% divided by 75% (or 0.75) and results in a TEY of 4%. You can always work backward to check by deducting the 25% tax from each answer to see which one results in the 3% coupon. The fact that the bond is unrated has little or nothing to do with the ability of the issuer to pay the interest.

What would likely happen to the market value of existing bonds during an inflationary period coupled with rising interest rates? A. The nominal yield of the bonds would decrease. B. The price of the bonds would increase. C. The price of the bonds would decrease. D. The price of the bonds would stay the same

C. The market price of outstanding bonds falls when interest rates rise because bond prices have an inverse relationship with interest rates. That is, when an investor can get a higher nominal (coupon) yield on a new bond, the old one paying a lower rate of interest just isn't worth as much so the price goes down. Remember, the nominal yield is the coupon rate stated on the face of the bond and that never changes.

An investor purchasing 5 bonds priced at 102 each would expect to pay a total of (disregard commissions) A. $102 B. $510 C. $1,020 D. $5,100

D. A bond price of 102 represents 102% of the $1,000 par value or $1,020. With 5 bonds, the investor would pay a total of 5 × $1,020 or $5,100.

Which of the following statements is TRUE of a corporate bond with a call feature? A. The owner of the bond may demand that the issuing corporation redeem the bond before it matures. B. The issuing corporation may change the coupon rate at any time by giving the owner of the bond written notice. C. The owner of the bond may exchange it for shares of stock. D. The issuing corporation has the option to redeem the bond before it matures.

D. A callable bond is one that may be redeemed by the issuing corporation before it matures. One reason a corporation might call a bond is because it can now borrow at a lower interest rate.

True or False? A resident of France purchasing Eurodollar bonds does not incur currency risk.

F. As the name implies, Eurodollar bonds are denominated in U.S. dollars. That means that someone in France will have the risk that the Euro, the home currency in France, will rise against the dollar and, as a result, interest payments will be worth less as will the ultimate payback at maturity. Only U.S. residents have no currency risk with Eurodollar bonds

True or False? In most cases, convertible securities sell right at their parity price.

F. Because of the perceived extra safety of the convertible security (either a preferred stock or debenture, both having senior claim over the common), the general case is that convertible securities sell at somewhat of a premium over their parity price.

True or False? One of the benefits of holding convertible debentures is the option to convert into the corporation's common or preferred stock.

F. Convertible debentures are convertible into the issuer's common, not preferred stock.

True or False? A country wishing to restructure its debt using Brady bonds would do so to save on debt servicing costs.

T. One of the benefits of Brady bonds is the ability of the sovereign government to borrow at a lower cost because of the collateral behind the bond.

True or False? Call protection is of greatest benefit when interest rates are falling.

T. When interest rates fall, issuers can borrow at a lower rate so they will be highly motivated to call in the old debt and replace it with debt at a lower interest rate.