Unit 2

The best time for an investor seeking returns to purchase long-term, fixed-interest-rate bonds is when: A)short-term interest rates are high and beginning to decline. B)short-term interest rates are low and beginning to rise. C)long-term interest rates are low and beginning to rise. D)long-term interest rates are high and beginning to decline.

D)long-term interest rates are high and beginning to decline. Explanation The best time to buy long-term bonds is when interest rates have peaked. In addition to providing a high initial return, as interest rates fall, the bonds will rise in value. Reference: 2.2.7.6 in the License Exam Manual

All of the following bonds have 5 years to go to maturity. Which would have the greatest price change in response to a change in interest rates? A)7-½%, B rated, price 88. B)7-½%, A rated, price 102. C)7-½%, BBB rated, price 95. D)7-½%, AA rated, price 108.

A)7-½%, B rated, price 88. Explanation Factors increasing a bond's response to an interest rate change include: time to go to maturity, distance from par, and lower rating. The bond with a lowest ratings (B) and farthest from par (88) would have the greatest price change. Reference: 2.2.7.6 in the License Exam Manual

All of the following bonds have 5 years to go to maturity. Which would have the greatest price change in response to a change in interest rates? A)7-½%, B rated, price 88. B)7-½%, A rated, price 102. C)7-½%, AA rated, price 108. D)7-½%, BBB rated, price 95.

A)7-½%, B rated, price 88. Explanation Factors increasing a bond's response to an interest rate change include: time to go to maturity, distance from par, and lower rating. The bond with a lowest ratings (B) and farthest from par (88) would have the greatest price change. Reference: 2.2.7.6 in the License Exam Manual

During periods when the yield curve is normal, as market interest rates change, which is TRUE? A)Long-term bond prices move more sharply. B)Short-term bond prices move more sharply. C)There is no relationship between the relative price movements of short-term and long-term bonds. D)Both short-term and long-term bond prices move equally.

A)Long-term bond prices move more sharply. Explanation Long-term bond prices are more volatile than similar short-term prices, in large part due to the added risk of owning a longer-term debt security. Reference: 2.2.7.5 in the License Exam Manual

Question ID: 604898 Which of the following statements regarding a bond quoted as QRS Zr 12 is TRUE? A)The bond pays no interest until maturity. B)The interest payable is tax free. C)The bond pays $12 interest annually. D)The bond pays $120 interest annually.

A)The bond pays no interest until maturity. Explanation QRS Zr 12 represents a zero-coupon bond issued by the QRS Company maturing in 2012. Zero-coupon bonds are bought at a discount and mature at face value. If a bond is held to maturity, the difference between the purchase price and the maturity price is considered interest, though it is taxed on a yearly basis. Reference: 2.3.5 in the License Exam Manual

Question ID: 604909 If a customer sells a zero-coupon bond before maturity, gain or loss will be the difference between sales proceeds and: A)accreted value. B)discounted value. C)par value. D)original cost.

A)accreted value. Explanation Zero-coupon bonds must be accreted for tax purposes. Each year, the annual accretion is taxable to the holder. In addition, the customer may adjust the cost basis of the zero upward by the amount of the annual accretion. Reference: 2.3.5.2 in the License Exam Manual

In a period of loose money, corporate bond prices: A)increase. B)decrease. C)stay the same. D)fluctuate.

A)increase. Explanation In a period of loose money, interest rates fall. When interest rates fall, bond prices rise. Reference: 2.2.7.6 in the License Exam Manual

A callable municipal bond maturing in 30 years is purchased at 102. The bond is callable at par in 15 years. If the bond is called at the first call date, the effective yield earned on the bond is: A)lower than the yield to maturity. B)not determinable. C)higher than the yield to maturity. D)the same as the yield to maturity.

A)lower than the yield to maturity. Explanation If the bond is trading at a premium and it is called before maturity, the loss of the premium is compressed into a shorter period of time. This reduces the effective yield on the bond. If the bond is called, the effective yield is the yield to call. Reference: 2.2.7.4 in the License Exam Manual

PDQ Corporation has a 6-1/4% convertible preferred stock (conversion ratio of 4) outstanding. The stock has an antidilution covenant. If PDQ declares a 10% stock dividend, the antidilution covenant will adjust: A)the conversion price to $22.72. B)the par to $90. C)the conversion price to $27.50. D)the par to $110.

A)the conversion price to $22.72. Explanation The stock is convertible at $25 ($100 par / 4 shares). To determine the new conversion price, $100 / 4.4 shares = $22.72, or divide $25 by 110%. Reference: 2.5.2.6 in the License Exam Manual

A Notice of Defeasance informs bondholders that: A)the funds for the principal and the interest are in escrow. B)the purpose of the issue has been defeated and the bonds are called. C)the interest and the principal will not be paid. D)the facility has been condemned and the bonds have been called

A)the funds for the principal and the interest are in escrow. Explanation A defeased issue is one in which the issuer placed U.S. government securities in the bank as collateral for the old issue. Reference: 2.1.7.3 in the License Exam Manual

Expressed as a percentage of par, one basis point equals: A)1/1000 of 1% B)1/100 of 1% C)1/10 of 1% D)10%

B)1/100 of 1% Explanation One basis point equals 1/100 of 1% of par. 1% of par ($1,000) equals $10, therefore one basis point equals 1/100 of $10 or $.10 (ten cents). Reference: 2.1.5.1 in the License Exam Manual

Consider a municipal bond issue that has been defeased. Which of the following statements is NOT true? A)The marketability of the issue increases. B)The rating on the issue decreases. C)The issue is no longer considered part of the issuer's outstanding debt. D)The issue is now backed by U.S. government securities.

B)The rating on the issue decreases. Explanation Once a municipal issue has been defeased (pre-refunded), its rating increases as it is now backed by U.S. government securities held in escrow. As the rating of a bond increases, so does its marketability. Once defeased, the issue is no longer considered part of the issuer's outstanding debt (although it will remain outstanding with interest paid until called). Reference: 2.1.7.3 in the License Exam Manual

A condition in which long-term debt instruments have higher yields than short-term debt instruments is also called a: A)flat yield curve. B)positive yield curve. C)inverted curve. D)negative yield curve.

B)po Explanation A chart showing a curve with long-term debt instruments having higher yields than short-term debt instruments is often referred to as a positive yield curve. Reference: 2.2.7.5 in the License Exam Manual sitive yield curve.

All of the following statements are true regarding eurodollar bonds EXCEPT: A)they are issued in bearer form. B)they are registered with the SEC. C)interest is paid once a year. D)they are not subject to withholding taxes.

B)they are registered with the SEC. Explanation Eurodollar bonds are issued in bearer form, pay interest once a year, and are not subject to withholding taxes. They are issued outside the United States and are therefore not subject to SEC registration. Reference: 2.10.4.2 in the License Exam Manual

A customer bought a bond that yields 6-½% with a 5% coupon. If the bond matures at this point, the customer will receive: A)$1,000 plus a call premium. B)$1,050. C)$1,025. D)$1,065.

C)$1,025. Explanation Upon redemption of a bond, whatever current interest rates may be, the investor receives par ($1,000) plus the final semiannual interest payment ($25 in this case), for a total of $1,025. Reference: 2.1.2 in the License Exam Manual

A 7% bond is selling to yield 4-½%. The next time interest is paid, an investor who owns $10,000 face amount of the bonds will receive: A)$700. B)$225. C)$350. D)$450.

C)$350. Explanation The bond is a 7% bond. The total amount paid each year on 10 bonds is $700. The amount paid for a 6 month's interest is $350. Reference: 2.1.2 in the License Exam Manual

Question ID: 604884 An investor purchases a corporate bond at par to yield 5.5% to maturity. If he sells the bond at a price equivalent to a 5% yield to maturity two years later, the investor incurs: A)no taxable result at this time. B)tax-free income. C)a capital gain. D)a capital loss.

C)a capital gain. Explanation Yields fall as bond prices rise. Because the bond is trading at a higher price than when it was purchased, its yield to maturity has dropped from 5.5% to 5%. The consequence of the sale is a capital gain, because the investor sold the bond that was purchased for par at a premium. Reference: 2.2.7.6 in the License Exam Manual

An inverted yield curve is the result of: A)investors buying short-term bonds and selling long-term bonds. B)investors moving from equities to debt instruments. C)investors buying long-term bonds and selling short-term bonds. D)investors moving from debt instruments to equity instruments.

C)investors buying long-term bonds and selling short-term bonds. Explanation When investors believe that interest rates may decline soon, they seek to lock in the current rate of return by buying long-term bonds. Increased demand increases the price and causes the yields on long-term debt instruments to fall. In addition, selling short-term bonds depresses prices, causing yields to rise. As a result, the yield curve takes on a negative slope. Short-term yields are then higher than long-term yields, which is the definition of an inverted curve. Reference: 2.2.7.5 in the License Exam Manual

An investor seeking a high level of income combined with a moderate level of risk would purchase: A)convertible bonds. B)income bonds. C)mortgage bonds. D)junk bonds.

C)mortgage bonds. Explanation Bonds provide a semiannual stream of fixed income. Because convertible bonds normally have a lower coupon rate than nonconvertible bonds-and income bonds only pay interest if the company declares a payment-the best choice is the mortgage bond, which is secured by real estate. Reference: 2.3.1.1 in the License Exam Manual

Question ID: 604920 A convertible bond callable at 101 is trading at 105. The bond is a 4% bond convertible at $25. The common stock is trading at $27. If an investor bought the bond and converted, his profit would be: A)$20. B)$40. C)$75. D)$30.

D)$30. Explanation First, calculate the number of shares each bond will convert to: $1,000 (par) / $25 per share = 40 shares per bond. With market value at 105, each bond costs $1,050. What is the stock parity price? $1,050 / 40 shares = $26.25 per share stock parity price. CMV of the stock minus stock parity price equals profit (or loss). $27.00 − $26.25 = $.75 per share × 40 shares = $30. Reference: 2.5.2.5 in the License Exam Manual

Current yield on an 8-1/4% Treasury bond at 104.24 is: A)7.75%. B)7.91%. C)8.08%. D) 7.88%.

D)7.88%. Explanation Current yield on a bond is computed by dividing the annual interest by the market price. Here, the annual interest is $82.50 and the market price of the bond is $1,047.50. Therefore, $82.50 / $1,047.50 = 7.88%. A quote of 104.24 for a T-bond represents a price of $1,047.50 computed as a percentage of par in 32nds of one bond point as follows; 104.24 is 104% of par = $1,040 and 24/32nds of one bond point ($10) = $7.50. $1040 + $7.50 = $1047.50. Reference: 2.2.7.2 in the License Exam Manual

If a bond has a basis price of 7%, which of the following would most likely be refunded? A)Coupon 6-½%, maturing in 2033, callable in 2013 at 103. B)Coupon 7-½%, maturing in 2033, callable in 2013 at 103. C)Coupon 6-½%, maturing in 2033, callable in 2013 at 100. D)Coupon 7-½%, maturing in 2033, callable in 2013 at 100.

D)Coupon 7-½%, maturing in 2033, callable in 2013 at 100. Explanation An issuer is most likely to refund the issue that will cost it the most money over the life of the issue. Always use the following order in making this choice: (1) highest coupon, (2) lowest call premium, (3) earliest call date, and (4) longest maturity. Reference: 2.1.7.2 in the License Exam Manual

Libby sees a tombstone advertisement for a new issue of Southwest Barge subordinated convertible debentures. The bonds will carry an 11-1/4% coupon, are convertible into common stock at $10.50, and are being issued to the public at 100. The proceeds of the issue will be used specifically for purchasing new Southwest barges. Libby's concerns about the issue could include: A)she should not be concerned as the bonds will be first in liquidation. B)the company might demand that she accept common stock for her bond. C)the new barges might sink, and the collateral would be gone. D)the issue may be junior-in-lien to another security issue.

D)the issue may be junior-in-lien to another security issue. Explanation The word "subordinated" is the key to the question. A subordinated bond has other debt holders ahead of it in the event of liquidation. The barges do not serve as collateral as the bonds are identified as debentures, and having to convert to common stock is not a threat since she is the one that will, if she desires, exercise the conversion privilege. Reference: 2.3.2.2 in the License Exam Manual