Unit 2 - Types and Characteristics of Fixed-Income (Debt) Securities

What is the current yield of a 6% bond trading for 120 ($1,200)?

$60 / $1,200 = 5% This bond is trading at a premium

One year ago, ABC Widgets, Inc., funded an expansion to its manufacturing facilities by issuing a 20-year first mortgage bond. The bond is secured by the new building and land. The bond was issued with a 5.5% coupon and is currently rated Aa. The current market price of the bond is 105, resulting in a current yield of approximately A) 5.24%. B) 5.61%. C) 4.99%. D) 5.50%. Explanation Corporate bonds are quoted as a percentage of the $1,000 par value. A market price of 105 is equal to $1,050 (105% × $1,000). Each $1,000, 5.5% bond pays $55 of interest annually ($1,000 × 5.5% = $55). Current yield equals the annual interest divided by the current price of $1,050. The calculation is $55 ÷ $1,050, which is equal to approximately 5.24%. Because the bond is at a premium, the current yield must be below the nominal yield, which removes two of the choices from consideration. LO 2.e

A) 5.24%. Corporate bonds are quoted as a percentage of the $1,000 par value. A market price of 105 is equal to $1,050 (105% × $1,000). Each $1,000, 5.5% bond pays $55 of interest annually ($1,000 × 5.5% = $55). Current yield equals the annual interest divided by the current price of $1,050. The calculation is $55 ÷ $1,050, which is equal to approximately 5.24%. Because the bond is at a premium, the current yield must be below the nominal yield, which removes two of the choices from consideration. LO 2.e

Your client with $100,000 to invest is looking for maximum current income. Which of the following would offer the highest current return? A) $100,000 market value of corporate bonds selling at a premium and yielding 6% to maturity B) $100,000 AA rated corporate bonds trading at par with a 6% coupon rate C) $200,000 of utility common stock paying a current dividend of 3.5% D) $100,000 of zero-coupon bonds with a yield to maturity of 6%

A) $100,000 market value of corporate bonds selling at a premium and yielding 6% to maturity When you read the full question, including the answer choices, you can immediately disregard two of the four options. With $100,000 to invest, the answer cannot be to purchase $200,000 of anything. Maximizing current income excludes zero-coupon bonds because there is no current income. Now, to the correct choice. Why does a bond sell at a premium over par? Although there are exceptions, primarily it is because the coupon rate on that bond is higher than the current market interest rate. Therefore, with a higher coupon rate, the current income on the same amount of principal invested ($100,000 in our question) will always be higher for a bond selling at a premium. That is the KISS (Keep It Simple Student) answer. For those who want to delve further, here we go. For example, if current market interest rates are 6% (likely the case here because the AA rated bonds with a 6% coupon are trading at par), then a bond with a 7% coupon will be selling at a premium. The current yield on $100,000 of the 6% bonds would be $6,000 per year. If a bond's yield to maturity is 6% and it is selling at a premium, it must be that the coupon is higher than 6%. For example (and we're doing the math that you won't have to do), $93,000 par (93 times $1,000) value of bonds with a 7% coupon, selling at $100,000 (a premium over the $93,000), and maturing in 10 years has a YTM of 6%. Investing $100,000 into these bonds will result in current income of $6,510 per year ($93,000 par times the 7% coupon). LO 2.e

Which of the following is true of a zero-coupon bond? I. The rate of return is locked in. II. There is no reinvestment risk. III. The imputed interest is taxed as ordinary income on an annual basis. IV. A check for the interest is paid at maturity. A) I, II, and III B) I and IV C) I, III, and IV D) I only

A) I, II, and III Zero-coupon bonds pay no periodic interest and are always issued at a discount from par. The appreciation of the zero from its discounted purchase price to its face value is thought of as interest to the bondholder, but this annual "phantom income," so named because you don't receive it, is taxed as ordinary income on an annual basis. When the bond is purchased, the investor locks in that yield, and with nothing to reinvest, there is no reinvestment risk. At maturity, the investor receives the face value ($1,000) rather than a check for the interest. LO 2.j

A respected analyst reports that last week's T-bill rate at 6% is lower than the rate for the preceding week and lower than the average for the past month. Which of the following is true? A) Investors are paying more for T-bills. B) Stock prices are rising. C) The general level of interest rates is increasing. D) Investors are paying less for T-bills.

A) Investors are paying more for T-bills. When the rate is lower, the price has gone up; this means investors are paying more as interest rates are going down. There is nothing in this question that gives us enough information to evaluate the movement of stock prices. LO 2.f

Which of the following is unlikely to be issued at a discount? A) Jumbo CD B) Commercial paper C) Treasury bill D) Zero-coupon bond

A) Jumbo CD Jumbo (negotiable) CDs are one of the few money market instruments issued at face value. Unlike those issued at a discount, they are interest bearing. LO 2.k

An investor purchased a 6% corporate bond selling at par. Because the next interest payment date is not for another two months, the bond carries accrued interest of $20. Disregarding commissions, which of the following statements is correct? A) The buyer will pay $1,020, and the seller will receive $1,020. B) The buyer will pay $1,000, and the seller will receive $1,020. C) The buyer will pay $1,020, and the seller will receive $980. D) The buyer will pay $1,020, and the seller will receive $1,000.

A) The buyer will pay $1,020, and the seller will receive $1,020. When a bond is purchased or sold in between semiannual interest payment dates, the interest that has accrued since the previous payment is added to the purchaser's price. In our question, $1,000 plus $20 equals $1,020. That interest belongs to the seller who has held that bond since the previous interest payment. Therefore, the seller receives the selling price ($1,000) plus the accrued interest of $20 for a total of $1,020. Remember, the buyer will be getting the full six months interest of $30 (6% of $1,000 is $30 semiannually) in two months. That represents $10 for the two months the bond was held plus reimbursement for the four months of interest paid to the seller. You will not need to know how to calculate the accrued interest; it will be given in the question as is the case here. LO 2.a

A new client is looking for a recommendation. The client is 72 years old, has sufficient income from Social Security, and has a pension plan to cover all of her living expenses. She has just inherited $100,000. She wants to invest this money to have a bit more income so she can spoil her grandchildren. Which of the following would be antipodal to her wishes? A) Treasury STRIPS B) Jumbo CDs C) Public utility stock D) Treasury bonds

A) Treasury STRIPS If she wants additional income, she cannot get that from Treasury STRIPS. They are zero-coupon bonds and pay nothing until maturity. LO 2.j

A European corporation seeking a short-term loan would probably be most concerned about an increase to A) the SOFR. B) the Fed funds rate. C) the U.S. Treasury bill rate. D) the eurobond rate.

A) the SOFR. For more than 40 years, the London Interbank Offered Rate—commonly known as LIBOR—was a key benchmark for setting the interest rates charged on adjustable-rate loans, mortgages, and corporate debt. Over the last decade, LIBOR has been burdened by scandals and crises. Effective January 2022, LIBOR is no longer being used to issue new short-term loans in the U.S. It was replaced by the Secured Overnight Financing Rate (SOFR) which many experts consider a more accurate and more secure pricing benchmark. As is always the case with NASAA, we do not know when the exam questions will be updated. One thing we can promise you is that any question relating to this topic will not have both LIBOR and SOFR as choices, so you should choose whichever one appears. LO 2.k

A $1,000 bond with a nominal yield of 8% will pay how much interest each year? A) $160 B) $80 C) $800 D) $40

B) $80 The nominal yield (or coupon rate) is the interest rate stated on the bond and is the rate the bondholder 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. LO 2.e

The longest initial maturity for U.S. T-bills is A) 39 weeks. B) 52 weeks. C) 2 years. D) 13 weeks.

B) 52 weeks. As money market instruments, the longest initial maturity of Treasury bills (T-bills) is 52 weeks. Those bills are auctioned every four weeks. T-bills of shorter maturities are auctioned weekly. The shortest initial maturity is four weeks. LO 2.f

Which of the following statements regarding credit risk is not true? A) Credit risk is the probability of the issuer defaulting on their payment obligations. B) An A-rated mortgage bond has less credit risk than a AA rated debenture. C) A rating downgrade may or may not result in a lower market price for a bond. D) Credit risk can be assessed by referring to the independent credit rating agencies.

B) An A-rated mortgage bond has less credit risk than a AA rated debenture. The rating agencies split bonds into two distinct classes: investment grade and noninvestment grade. The highest investment-grade rating is AAA (Aaa) and the lowest is BBB (Baa). The more As the bond has, the lower the credit risk. That is why the AA debenture has less credit risk than the A-rated mortgage bond. The rating agencies take into consideration any collateral, such as a mortgage, when giving the rating. LO 2.b

Which of the following expressions describes the current yield of a bond? A) Yield to maturity divided by par value B) Annual interest payment divided by current market price C) Annual interest payment divided by par value D) Yield to maturity divided by current market price

B) Annual interest payment divided by current market price The current yield on a bond is calculated by dividing the annual interest payment by the current market price of the bond. LO 2.e

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

B) Bondholders Bondholders have contractual rights to the assets of a business that must be honored on insolvency before claims of stockholders or directors. LO 2.g

A client of yours owns some convertible preferred stock. She notices an article in the business section of her local newspaper that reports the company is going to pay a 20% stock dividend on their common stock. How will this affect her? A) She will also receive 20% more shares because preferred stock has a priority claim ahead of common. B) If there is an antidilution clause, her conversion privilege will permit her to acquire 20% more shares than before the stock dividend. C) There will be no effect. D) More than likely, the price of the preferred stock will rise.

B) If there is an antidilution clause, her conversion privilege will permit her to acquire 20% more shares than before the stock dividend. Most convertible securities are sold with antidilutive clauses that provide for an adjustment in the number of shares based on stock splits or stock dividends. LO 2.d

A U.S. dollar-denominated bond that is sold outside the United States and the issuer's country but for which the principal and interest are stated and paid in U.S. dollars is best described as A) a Yankee bond. B) a Eurodollar bond. C) a eurobond. D) a Brady bond.

B) a Eurodollar bond. This is the definition of a Eurodollar bond. Yes, it is also a eurobond, but because the question specifies U.S. dollars, the more accurate choice is Eurodollar bond. A Yankee bond is U.S. dollar-denominated but is issued in the United States; Eurodollar bonds are not. Brady bonds are issued only by foreign governments, usually—but not always—are U.S. dollar-denominated, and are available for purchase in the United States. LO 2.i

When a U.S. resident investor purchases foreign bonds, A) depreciation of the bonds and appreciation of the foreign currency benefit the domestic investor. B) appreciation of both the bonds and the foreign currency benefits the domestic investor. C) depreciation of both the bonds and the foreign currency benefits the domestic investor. D) appreciation of the bonds and depreciation of the foreign currency benefit the domestic investor.

B) appreciation of both the bonds and the foreign currency benefits the domestic investor. In the same manner that purchasing foreign equities adds diversification to a portfolio, purchasing foreign bonds does as well. As with any security, if the value goes up (it appreciates), that is a benefit to the investor. When foreign securities are involved, there is another concern—currency risk. Because the foreign bond is denominated in the local currency, an increase in that currency's value versus the U.S. dollar means the semiannual interest payments will translate into more dollars. At maturity, the return of principal will be higher as well. Of course, it can go the other way if the market value or the foreign currency depreciates against the dollar. LO 2.i

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

B) equal to its current yield. When a bond is selling at par, its coupon or nominal rate, current yield, and yield to maturity are all the same. LO 2.e

A customer bought a 10-year 6% AAA bond at par when it was issued. Two years later, if the CPI has increased from 2% to 4%, the price of the bond most likely A) has increased. B) has declined. C) cannot be determined. D) has stayed at par.

B) has declined. When inflation is on the rise, interest rates often rise. When interest rates increase, bond prices may be expected to decline. LO 2.e

One would expect to have checkbook access to a A. CMO B. DDA C. GNMA D. LIBOR

B. DDA

An investor purchases a Treasury note and the confirmation shows a price of $102.25. Rounded to the nearest cent, the investor's cost, excluding commissions, is A) $102.25. B) $1,020.25. C) $1,027.81. D) $1,022.50.

C) $1,027.81. Treasury notes are quoted in 32nds, where each 32nd equals $0.3125. The 102 in the quote equals $1,020 and the 25/32 is an additional $7.81, bringing the total to $1,027.81. LO 2.c

GHI currently has earnings of $4.00 and pays a $0.50 quarterly dividend. If GHI's market price is $40.00, the current yield is A) 1.25%. B) 10.00%. C) 5.00%. D) 15.00%.

C) 5.00%. The quarterly dividend is $0.50, so the annual dividend is $2.00; $2 ÷ $40 market price = 5% current yield. LO 2.e

The value of which of the following would be least likely to be impacted by changes in interest rates? A) A convertible preferred stock B) A laddered bond portfolio C) A bank CD maturing in 5 years D) A U.S. Treasury bond issued 25 years ago with a 30-year maturity

C) A bank CD maturing in 5 years This question is dealing with interest rate (or money-rate) risk. That risk refers to the inverse relationship between the price of fixed-income investments and interest rates. That is, when interest rates go up, the price of fixed-income securities falls (and vice versa). However, this risk only affects investments that are marketable (those with a fluctuating market price). Bank CDs are nonnegotiable (we're not referring to the negotiable jumbo CDs with a maturity of one year or less) and, as a result, will not fluctuate in price, regardless of changes to interest rates. In this case, interest rate risk is eliminated. That is one of the reasons why the exam's first choice for capital preservation is insured bank CDs. Will a laddered bond portfolio reduce interest rate risk? Yes, but it will not eliminate it. Is a convertible preferred (or bond) less subject to changes in interest rates than one without the conversion feature? Yes, but the risk is still there. Does a 30-year T-bond with 5 years remaining to maturity have a short duration and, therefore, a reduced interest rate risk? Yes, but the price of the bond will still be affected by changes in the market interest rates. LO 2.k

Which of the following is true of Ginnie Maes but not of other agency mortgage-backed securities? A) Are pass-through securities B) Yield more than T-bonds C) Backed by the full faith and credit of the U.S. government D) Collateralized by mortgages

C) Backed by the full faith and credit of the U.S. government Of the mortgage-backed government agency securities, only the Ginnie Maes are backed by the full faith and credit of the U.S. government. They are all collateralized by mortgages (the name MBS gives that away), and even the Ginnie Maes yield more than Treasury bonds. As an MBS, they all pass through the income and principal repayments to the investors. LO 2.f

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

C) Bondholders Bondholders have contractual rights to the assets of a business that must be honored on insolvency before claims of stockholders or directors. LO 2.g

An investor interested in monthly interest income should invest in A) utility company stock. B) corporate bonds. C) GNMAs. D) Treasury bonds.

C) GNMAs. GNMAs pay monthly interest and principal, treasury bonds pay semiannual interest, utility stocks pay quarterly dividends, and corporate bonds pay semiannual interest. LO 2.f

Assume that a corporation issued a 5% Aaa/AAA rated debenture at par. Two years later, similarly rated debt issues are being offered in the primary market at 5.5%. Which of the following statements regarding the outstanding 5% debenture are true? I The current yield on the debenture will be higher than 5%. IIThe current yield on the debenture will be lower than 5%. III The dollar price per bond will be higher than par. IV The dollar price per bond will be lower than par. A) I and III B) II and IV C) I and IV D) II and III

C) I and IV Because interest rates have risen after the issue of the 5% debenture, the bond's price will be discounted to result in a higher current yield (computed as annual income divided by current market price). Accordingly, the discounting of the issue will make the 5% debenture competitive with new issues offered with a 5.5% coupon. LO 2.e

An 8% corporate bond is offered on an 8.25 basis. Which of the following statements are true? I Nominal yield is higher than YTM. II Current yield is higher than nominal yield. III Nominal yield is lower than YTM. IV Current yield is lower than nominal yield. A) II and IV B) I and IV C) II and III D) I and III

C) II and III A bond offered on an 8.25 basis is the same as at a YTM of 8.25%. Because the yield quoted is higher than the 8% coupon, the bond is trading at a discount to par. For discount bonds, the nominal yield is lower than both the current yield and the yield to maturity. LO 2.e

Which of the following should be considered a liquid asset for emergency fund purposes? A) Stock mutual funds B) Life insurance cash values C) Savings account D) A personal residence

C) Savings account A savings account can be accessed immediately if funds are needed right now. The redemption period for mutual funds is seven days. That is quick but not same day as the savings account is. Another factor is that there could be a redemption or back-end load to cash in the fund shares, while there is no fee to draw on a savings account. Life insurance cash values can take 30 days or longer, and selling a house is not the way to meet an emergency. LO 2.k

A customer asks if there are any debt instruments providing income that might at least keep pace with inflation and offer some tax advantages. What suitable recommendation could be made that would meet the customer's criteria? A) ADRs B) GNMAs C) TIPS D) U.S. T-bills

C) TIPS Treasury Inflation-Protected Securities (TIPS) are debt instruments specifically designed to provide income that keeps pace with inflation. Issued by the U.S. Treasury, the interest is tax exempt at the state and local levels. Neither GNMAs nor Treasury bills (T-bills) meet all of these criteria, and American depositary receipts (ADRs) are not debt instruments. LO 2.f

On the initial public offering, an investor buys a $10,000 Aa-rated, 20-year corporate bond with a 4% coupon rate. One year later, the prevailing market rate is 5% and the bond has had its rating increased to Aa1. Which of the following statements is most likely true with reference to the current market price of this bond? A) The yield to maturity of this bond is above 4%. B) The bond would be selling at a premium. C) The bond would be selling at a discount. D) The bond would be selling at par value.

C) The bond would be selling at a discount. When interest rates go up, bond prices go down. Had interest rates remained the same, the slight improvement in rating would have probably caused the bond to sell at a very slight premium, but that rating increase is not nearly strong enough to offset a 25% increase in market interest rates. Because this bond would be selling at a discount, its YTM would be above 4%, but the question is asking about the current market price, not the yield. LO 2.e

An investor owns a debenture convertible into 20 shares of the issuer's common stock. After a 2-for-1 stock split, the terms of the debenture provide for conversion into 40 shares. This is because the debenture has A) increased its par value to $2,000 to account for the split. B) warrants attached. C) an antidilution clause. D) preemptive rights.

C) an antidilution clause. Most convertible securities are sold with antidilutive clauses that provide for an adjustment in the number of shares based on stock splits or stock dividends. LO 2.d

Treasury bills are A) callable. B) issued in bearer form. C) issued in book-entry form. D) issued at par.

C) issued in book-entry form. All Treasury securities are issued in book-entry form. Treasury bills are always issued at a discount and are never callable. LO 2.f

When an investor owns a convertible security where, upon conversion, the account value would remain the same, it is considered that the convertible and the common are selling at A) equivalent value. B) the nominal yield. C) parity. D) the arbitrage level.

C) parity. Parity means equal. When one can convert the security and realize the same value, it is said that both are at parity. LO 2.d

If investors hold bonds until maturity, their realized rate of return, assuming all interim cash flows are reinvested at that same rate, would be equal to A) the income return. B) the price return. C) the yield to maturity. D) the coupon return.

C) the yield to maturity. The yield to maturity is an investor's total return if they purchase the bond at any point and then hold it until maturity, assuming all interim cash flows are reinvested at that same YTM. This takes into consideration any capital gain or loss; therefore, the yield to maturity will fluctuate with the bond's price. LO 2.e

All of the following statements regarding bonds selling at a discount are correct except A) they can indicate that interest rates have risen. B) they can indicate that the issuer's credit rating has fallen. C) they are more likely to be called than comparable bonds selling at a premium. D) they will appreciate more than comparable bonds selling at a premium if interest rates fall.

C) they are more likely to be called than comparable bonds selling at a premium. Issuers tend to call bonds with higher coupons. Bonds trading at a premium have higher coupons than those trading at a discount (and are more likely to be called—wouldn't you pay off your high-interest debt before the low-interest debt?). The longer the duration, the more volatile the bond's price. Lower coupon rates mean a longer duration. If rates rise, prices fall. If a bond's rating falls, so does its price. LO 2.j

A bond selling for $20 above par would be quoted A) 1,020. B) 1,200. C) 120. D) 102.

D) 102. Bonds are quoted in percentages of $1,000 (par) (1% of $1,000 = $10). The proper quote would be 102; 102 is 102% of $1,000. LO 2.c

During the past year, the market price of Kapco common stock has increased from $47 to $50 per share. Over that period, Kapco's earnings per share (EPS) have increased from $2.00 to $2.50 per share, and their dividend payout ratio has decreased from 50% to 40%. Based on this information, the current yield on Kapco common stock is A) 4.26%. B) 2.13%. C) 6.34%. D) 2.00%.

D) 2.00%. The current yield on a stock is computed by dividing the annual dividend rate by the current market price. With EPS of $2.50 and a 40% payout ratio, the annual dividend is $1.00. This dollar divided by the current market price of $50.00 results in a current return of 2%. LO 2.e

A company with 20 million shares outstanding paid $36 million in dividends. If the current market value of the company's shares is $36, the current yield is A) 2%. B) not determinable from the information given. C) 10%. D) 5%.

D) 5%. The current yield formula is annual dividends per share divided by current market price. The dividends per share are $36 million ÷ 20 million shares = $1.80 per share. Current yield is $1.80 ÷ $36.00 = 5%. LO 2.e

Which of the following rates of return is used by investment professionals as the risk-free rate? A) Discount rate B) Federal funds rate C) Prime rate D) 91-day Treasury bill rate

D) 91-day Treasury bill rate The interest rate used as the basis for a risk-free rate of return is the 91-day Treasury bill rate. T-bills are U.S.-government guaranteed, the rate is short term, and the market risk is minimal. LO 2.f

The Straitened Corporation filed for bankruptcy. One of your clients held a mortgage secured by the corporation's building. When the building was sold, the proceeds were less than the mortgage balance, creating a deficiency balance. Where does this investor's claim stand? A) After the unsecured creditors B) After the secured creditors C) There is no further claim once the building has been sold D) As a general creditor on a pro rata basis

D) As a general creditor on a pro rata basis Secured creditors, such as those holding mortgage bonds, always have priority in a liquidation. If it happens, as in this question, that the assets securing the debt are insufficient to satisfy the claim, the balance is considered to be an unsecured debt. In that case, those bondholders are considered general creditors and share in any remaining assets proportionate to the amount of the deficiency. The Latin legal term for this is pari passu, but we don't expect you'd see that on the exam. LO 2.g

An investor is analyzing various risks related to corporate and government bonds. She is interested in finding a risk that is more specific to corporate bonds than to government bonds. Which of the following options correctly defines that risk? A) Interest rate risk B) Purchasing power risk C) Liquidity risk D) Default risk

D) Default risk Default risk is avoided with U.S. government bonds. There is no chance (at least for test purposes) that timely payment of interest and principal will not be made on them. All bonds have interest rate and purchasing power risk. Although it is true that government bonds are generally more liquid than corporate bonds, many corporate bonds are exchange listed. That ensures good liquidity. More important is the test-taking skill. If you have to choose between lack of credit risk and lack of liquidity, it should be clear where the government bond comes out ahead. LO 2.g

Which of the following is a direct obligation of the U.S. government? A) Bank for cooperatives bonds B) Government bond mutual funds C) Fannie Maes D) Ginnie Maes

D) Ginnie Maes Ginnie Maes are backed by the full faith and credit of the United States. Other agencies have a moral, but not direct, government backing. Government bond mutual funds are not backed by the U.S. government. LO 2.f

A customer purchased a 5% U.S. government bond yielding 6%. A year before the bond matures, new U.S. government bonds are being issued at 4%, and the customer sells the 5% bond. The customer probably did which of the following? I. Bought it at a discount II. Bought it at a premium III. Sold it at a discount IV. Sold it at a premium A) II and IV B) II and III C) I and III D) I and IV

D) I and IV The customer purchased the 5% bond when it was yielding 6% (at a discount). The customer sold the bond when other bonds of like kind, quality, and maturity were yielding 4%. The bond is now at a premium. Therefore, the customer realized a capital gain. LO 2.e

A customer asks if there are any debt instruments providing income that might at least keep pace with inflation and offer some tax advantages. What suitable recommendation could be made that would meet the customer's criteria? A) ADRs B) U.S. T-bills C) GNMAs D) TIPS

D) TIPS Treasury Inflation-Protected Securities (TIPS) are debt instruments specifically designed to provide income that keeps pace with inflation. Issued by the U.S. Treasury, the interest is tax exempt at the state and local levels. Neither GNMAs nor Treasury bills (T-bills) meet all of these criteria, and American depositary receipts (ADRs) are not debt instruments. LO 2.f

A customer purchased new issue bonds at par two years ago. Since then, the cost of living as measured by the consumer price index (CPI) has declined by almost half and the current yield on the bonds has also declined. Which of the following best describes the value of the bonds purchased? A) Their market price has declined. B) Their market price has remained unchanged. C) It cannot be determined from the information presented. D) Their market price has increased.

D) Their market price has increased. The annual coupon interest payment on the bonds has not changed, but the current yield has. If the yield has decreased, it means the market price of the bonds must have increased. For example, if the bond has a 5% coupon but the current yield is now 4%, the bond's price must be 125 ($1,250) because $50 annual interest on $1,250 is a current return of 4%. Remember the inverse relationship: if interest rates decline, bond price rise (and vice versa). LO 2.e

When a corporation domiciled in the United Kingdom issues U.S. dollar-denominated bonds in the United States, it is issuing A) Ameribonds. B) eurobonds. C) ADRs. D) Yankee bonds.

D) Yankee bonds. Yankee bonds are foreign bonds, denominated in U.S. dollars and issued in the United States by foreign banks and corporations. ADRs are issued in the United States by domestic banks and represent receipts for securities traded on foreign exchanges. Eurobonds are issued by a borrower in a foreign country, denominated in a currency other than one native to the issuer's country. Yankee bonds are a form of eurobond, but that is not the best answer to this specific question. LO 2.i

Of the following securities, which is most commonly recommended to fund a child's college education? A) Municipal bonds B) Investment-grade corporate bonds C) Treasury bills D) Zero-coupon Treasury bonds

D) Zero-coupon Treasury bonds Zero-coupon bonds, particularly those carrying the guarantee of the U.S. Treasury, are a favored investment vehicle for saving for a child's higher education. They have the advantage of providing a certain, quantifiable sum at a certain date in the future. LO 2.j

Corporate long-term debt securities that are issued on the general credit of the issuer and are not otherwise secured are called A) preferred stock. B) prior lien bonds. C) general obligation bonds. D) debentures.

D) debentures. Debentures are corporate long-term debt securities issued on the general credit of the corporation and are not backed by any specific assets. The term prior lien means there is a secured claim against a specific asset. Preferred stock is not a debt security, and general obligation bonds are municipal, not corporate, securities. LO 2.g

When an investor notices that a bond's coupon yield is lower than its current yield, this is an indication that the bond A) is in danger of going into default. B) is selling at a premium. C) is nearing its maturity date. D) is selling at a discount.

D) is selling at a discount. A bond's current yield is the coupon (nominal) yield divided by the current market price. When those two are the same, the bond is selling at its par (face) value. When selling below par (at a discount), the coupon yield will be lower than the current yield (if you pay less, you get more). Although a bond's market price will generally get closer to par as the maturity date approaches, anytime the price of the bond is below par (selling at a discount), its current yield will be higher than the coupon. LO 2.e

The yield to maturity is A) set at issuance and printed on the face of the bond. B) determined by dividing the coupon rate by the current market price of the bond. C) the annualized return of a bond if it is held to call date. D) the annualized return of a bond if it is held to maturity.

D) the annualized return of a bond if it is held to maturity. The yield to maturity reflects the annualized return of a bond if it is held to its maturity. The computation reflects the internal rate of return and is frequently referred to as the market required rate of return for a debt security. The rate set at issuance and printed on the face of the bond is the nominal or coupon rate. Dividing the coupon rate by the current market price of the bond provides the current yield. The return of a bond if it is held to the call date is the yield to call. LO 2.e

A bond indenture states that payment of interest and principal will come from the collection of ad valorem taxes. That is most likely A. a municipal general obligation bond B. a municipal revenue bond C. a US Treasury bond D. a corporate bond backed by property taxes

A. a municipal general obligation bond

If each of the following bonds matures in 10 years and has the same rating, which is the most volatile? A. Zero coupon bond with 6% yield B. Zero coupon bon with 8% yield C. Corporate bond priced at par with 6% yield D. Corporate bond priced at par with 8% yield

A. Zero coupon bond with 6% yield

A bond issue that may have retired in advance of maturity at the option of the issuer is said to have A. a callable feature B. an optional reserve C. a conversion feature D. a cumulative feature

A. a callable feature

Which of the following statements regarding bond interest is TRUE? A. Bond prices have an inverse relationship to interest rates B. Bond prices have a direct relationship to interest rates C. The par value of a bond will increase as market interest rates fall D. The par value of a bond will decrease as market interest rates fall

A. Bond prices have an inverse relationship to interest rates

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

A. Ginnie Mae pass-through certificates

A customer wishes to buy a security providing periodic interest payments, safety of principal, and protection from purchasing power risk. The customer should purchase A. TIPS B. TIGRS C. CMOs D. STRIPS

A. TIPS

If an investor watches the latest T-bill auction fall to 0.71% from 0.82%, the BEST interpretation is that A. investors who purchased bills at this auction paid more for them than purchasers at last week's auction B. investors who purchased bills at this auction paid less for them than purchasers at last week's auction C. investors who purchased T-bills 12 weeks ago paid less than subsequent purchasers D. these are 52-week T-bills

A. investors who purchased bills at this auction paid more for them than purchasers at last week's auction

Advantages of Brady bonds to an American investor include all of the following EXCEPT A. tax-free interest B. greater liquidity than found in most emerging market securities C. greater safety than most emerging market debt because of the collateral D. higher yields than on US Treasury securities

A. tax-free interest

A debenture is issued based on A. the general credit of the corporation B. a pledge of real estate C. a pledge of equipment D. the ability to levy taxes

A. the general credit of the corporation

Bright-Lite Incandescent Bulb, Inc., recently suffered significant operating losses and is planning a bankruptcy filing. Which of the following debt issues have the most junior claim? A) Senior notes B) Debentures C) Common stock D) Mortgage bonds

B) Debentures Although the most junior claim of all is that of the common stockholder (equity), this question is about the priority of debt issues. In that case, the most junior (last in line) of the creditors are the holders of the company's debentures. LO 2.g

If a company's dividend increases by 5% but its market price remains the same, the current yield of the stock will A) remain at 5%. B) increase. C) remain at 7%. D) decrease.

B) increase. The current yield of a stock is the annual dividend divided by the market price. If a company's dividend increases and its market price remains the same, its current yield will increase. LO 2.e

Treasury bills are A) issued in bearer form. B) issued in book-entry form. C) callable. D) issued at par.

B) issued in book-entry form. All Treasury securities are issued in book-entry form. Treasury bills are always issued at a discount and are never callable. LO 2.f

A mortgage-backed security (MBS), such as a Ginnie Mae, makes a combination principal and interest payment to an investor. This payment will be A) tax free. B) partly taxed as ordinary income and partly a tax-free return of principal. C) taxed as a capital gain if underlying mortgage is prepaid. D) taxed as ordinary income.

B) partly taxed as ordinary income and partly a tax-free return of principal. All interest payments made on a mortgage-backed security (MBS) are taxed as ordinary income. MBSs may make principal and interest payments to investors, which are partly taxed as ordinary income and partly tax-free returns of principal. LO 2.f

Although bonds are issued by many different entities, most of their features are the same. With few exceptions, included in that list of similarities would be all of these except A) a stated maturity date. B) safety of principal. C) price movement that is inverse to interest rates. D) a stated interest date.

B) safety of principal. The safety of principal largely depends on the issuer. For example, there are no bonds as safe as U.S. Treasury bonds. On the other hand, there are some corporate bonds that are quite speculative. In general, all bonds have a stated maturity date and interest rate, and they are exposed to interest rate risk. That is the risk that as interest rate rise, the price of the bonds will decline. LO 2.a

Money market instruments are A) long-term debt. B) short-term debt. C) intermediate debt. D) long-term equity.

B) short-term debt. Money market instruments are high-quality debt securities with maturities that do not exceed one year. LO 2.k

One of the ways in which U.S. government agency issues differ from those offered directly by the U.S. Treasury is that agency issues A) are more likely to be issued in larger amounts. B) typically carry higher returns than Treasury issues because of the lack of direct government backing. C) are taxable on the federal level while Treasury issues are not. D) frequently trade on the NYSE while Treasuries never do.

B) typically carry higher returns than Treasury issues because of the lack of direct government backing. Agencies, with only a few exceptions (GNMA being one), do not carry the direct backing of the U.S. Treasury. While they are quite safe, that lack of direct backing causes their yields to be somewhat higher. Agencies are never traded on the stock exchanges and their float is almost always smaller than Treasuries. Both are taxable on the federal level. LO 2.f

Janeece, who is in the 37% marginal income tax bracket, would like to purchase a bond for her investment portfolio. Assuming all the bonds are of similar investment quality, which would produce the highest after-tax yield? A. 2.25% US Treasury note B. 3.55% municipal bond C. 3.75% US Treasury bond D. 5.25% corporate bond

B. 3.55% municipal bond

Five percent XYZ debentures are trading for $1,250. Other similarly rated bonds are being offered at 4.25%. What is the current yield on the 5% XYZ debentures? A. 1.5% B. 4.0% C. 5.0% D. 6.25%

B. 4.0%

Which of the following corporate securities has a specific corporate asset pledged as security for the debt? A. A debenture B. An equipment trust certificate C. A guaranteed bond D. A subordinated loan

B. An equipment trust certificate

A bond would be considered speculative below which of the following Moody's ratings? A. A B. Baa C. BBB D. Ba

B. Baa

A company realizes money from the sale of surplus equipment. It would like to invest this money but will need it in 4-6 months and must take that into consideration when selecting an investment. You would recommend A. preferred stock B. Treasury bills C. AAA rated bonds with long-term maturities D. common stock

B. Treasury bills

All of the following are advantages of Eurodollar bonds EXCEPT A. because they are US dollar denominated, they bear no currency risk to US investors B. greater transparency C. they are rated by US rating agencies, so the risk is clear D. they may offer higher yields than domestic bonds from the same issuer

B. greater transparency

If an investor in the 27% federal income tax bracket invests in municipal general obligation bonds selling at par with a coupon of 4.5%, what is the tax equivalent yield? A. 3.29% B. 5.72% C. 6.16% D. 16.67%

C. 6.16%

One of your customers is a new parent. The customer wishes to deposit a lump sum into an investment offering a guaranteed return is 18 years, just in time for college. Which of the following bonds maturing in 18 years would offer the greatest safety? A. A corporate zero coupon bond with a AAA rating B. A municipal zero coupon bond with a AAA rating C. An unrated Treasury STRIP D. A high-yield corporate bond

C. An unrated Treasury STRIP

The LIBOR rate is established on a daily basis in A. Liberia B. Libya C. London D. New York

C. London

Which of the following statements regarding a zero-coupon corporate bond is true? A) Bonds selling at a premium have a yield lower than the coupon rate. B) These bonds have higher reinvestment risk as to interest than bonds paying semiannual interest. C) The investor has phantom income, which must be reported on an annual basis. D) The investor reports the difference between the purchase price and maturity value as ordinary income at maturity.

C) The investor has phantom income, which must be reported on an annual basis. On a taxable zero-coupon bond, the annual imputed interest is reported for tax purposes. Because this income is not actually received annually, it is referred to as phantom income. Zero-coupon bonds always sell at a discount from their maturity value—never at a premium—and one risk that zero-coupon bonds avoid is reinvestment risk because there are no interest payments to reinvest. LO 2.j

Which of the following is a characteristic of an investment-grade general obligation municipal bond? A) The bond's main source of investment risk is financial risk. B) The bond retains a direct claim on specific property. C) The taxing authority of the issuing government or municipality backs the issue's repayment. D) The bond's periodic interest is paid to investors only when sufficient revenue is collected by the municipality.

C) The taxing authority of the issuing government or municipality backs the issue's repayment. General obligation bonds are backed by the full faith and credit of the government issuing the debt and are repaid through taxes collected by the government body. The main source of investment risk for a municipal security is interest rate risk. General obligation bonds do not retain a claim on specific property. The government issuing the bonds uses its taxing authority to pay the interest and repay the principal. Revenue bonds, not general obligation bonds, are dependent on revenue collected from the financed project. LO 2.h

Which of the following is correct regarding zero-coupon bonds? A) They have low interest rate risk. B) They sell at a premium. C) They eliminate reinvestment rate risk. D) They offer minimum price volatility.

C) They eliminate reinvestment rate risk. Zero-coupon bonds are sold at a deep discount from par value and have no coupon payments. Because there is nothing to reinvest, there is no reinvestment risk. That is why many investors prefer zero-coupon bonds for specific goals, such as college education for children. The tradeoff is that no coupon also means higher interest rate risk. These bonds have maximum price volatility and respond sharply to interest rate changes. LO 2.j

The call feature available on some bonds A) allows bond issuers to extend the life of the bond. B) allows the issuer to refinance the debt if interest rates rise above the call rate. C) allows the issuer the option to escape high interest rates if market rates decline. D) may be used to convert the bond into preferred shares.

C) allows the issuer the option to escape high interest rates if market rates decline. Many bonds have a call feature that allows the issuer to call in the bonds, assuming the issuer has the cash available to pay them off, and escape high interest rates if market interest rates decline. If the company does not have the cash, it may issue a new bond at the lower prevailing interest rate and use that money to pay off the old bonds. This is known as refunding and, in essence, is no different from refinancing the mortgage on a home. LO 2.j

A 4.67% convertible debenture is selling at 102. It is convertible into the common stock of the same corporation at $25. The common stock is currently trading at $23. If the stock were trading at parity with the debenture, the price of the stock would be A. $25.00 B. $25.25 C. $25.50 D. $44.35

C. $25.50

Which of the following statements about jumbo CDs is not correct? A. Negotiable CDs do not have a prepayment penalty B. FDIC insurance applies up to $250,000 C. They are secured by pledged assets of the issuing bank D. Jumbo CDs pay interest semiannually

C. They are secured by pledged assets of the issuing bank

When a bond with a 6% coupon is selling at 90, each of the following statements is correct EXCEPT A. the current yield is approximately 6.67% B. the bond is selling at a discount C. the bondholder will receive two semiannual interest payments of $27 each D. the yield to maturity is slightly higher than the current yield

C. the bondholder will receive two semiannual interest payments of $27 each

What is current yield of a 6% bond trading for 80 ($800)?

Current yield = annual income / current market price $60 / $800 = 7.5% This bond is trading at a discount

Which of the following statements regarding convertible debentures is true? A) The issuer has the right to convert the debentures during the time period specified in the indenture. B) The issuer pays a higher rate of interest compared with a comparable nonconvertible debenture. C) The debenture holders receive a variable rate of interest. D) When compared with similar nonconvertible debentures, convertible debentures are issued with a lower coupon rate.

D) When compared with similar nonconvertible debentures, convertible debentures are issued with a lower coupon rate. A conversion feature is a benefit to the debtholder. It allows the debtholder a choice to either continue holding the debt represented by the debenture or to convert it into shares of common stock of the underlying issuer. Everything that is done in the securities industry has to be a win-win situation. The win for the debtholder in this instance is the ability to take advantage of the capital appreciation potential the common stock may offer, and the win for the issuer is that by offering something extra to the debenture purchaser, that purchaser is willing to accept a lower interest rate on the debt (as compared to a nonconvertible debenture), therefore giving the issuer a lower cost of capital. It is the debtholder, not the issuer, who determines when and if to convert. LO 2.j

A bond of standard size has a nominal yield of 6%, paid in the customary fashion. The bond matures in 10 years, is callable at $105 in 5 years, and is currently priced at $110. An investor calculating the bond's yield to call would include A) 20 payment periods. B) the loss of $100 at maturity. C) the gain of $50 when called. D) the semiannual interest payments of $30.

D) the semiannual interest payments of $30. The yield to call computation involves knowing the amount of interest payments to be received, the length of time to the call, the current price, and the call price. A bond with a 6% coupon (nominal yield) will make $30 interest payments twice each year. Remember, unless otherwise stated, bonds have a par value of $1,000 and customarily pay interest semiannually. With a 5-year call, there are only 10 payment periods, not 20. The loss at call is $50 ($1,100 - $1,050); there is no gain, and the loss at maturity of $100 is only relevant for YTM, not YTC. LO 2.e

A bond of standard size has a nominal yield of 6%, paid in the customary fashion. The bond matures in 10 years, is callable at $105 in 5 years, and is currently priced at $110. An investor calculating the bond's yield to call would include A) the loss of $100 at maturity. B) the gain of $50 when called. C) 20 payment periods. D) the semiannual interest payments of $30.

D) the semiannual interest payments of $30. The yield to call computation involves knowing the amount of interest payments to be received, the length of time to the call, the current price, and the call price. A bond with a 6% coupon (nominal yield) will make $30 interest payments twice each year. Remember, unless otherwise stated, bonds have a par value of $1,000 and customarily pay interest semiannually. With a 5-year call, there are only 10 payment periods, not 20. The loss at call is $50 ($1,100 - $1,050); there is no gain, and the loss at maturity of $100 is only relevant for YTM, not YTC. LO 2.e

A risk-averse investor, who had only invested funds in bank certificates of deposits, was informed by his investment adviser representative that higher returns with safety could be achieved by investing in U.S. Treasury notes with a 10-year maturity. The adviser representative assured the client that investment in federal government-backed securities is riskless. In this situation, the representative acted A) properly because Treasury notes are suitable for a risk-averse customer. B) properly because Treasury notes carry no risk of principal default. C) unethically because Treasury notes are unsuitable for a risk-averse customer. D) unethically because the agent failed to disclose that the customer retains interest rate risk.

D) unethically because the agent failed to disclose that the customer retains interest rate risk. Although Treasury securities do not carry default risk (principal and interest are guaranteed by the federal government), they are subject to interest rate risk. The prices of Treasury securities will decline if interest rates rise, subjecting the client to loss of principal if he sells them prior to maturity. LO 2.f

Investors interested in acquiring convertible debentures as part of their investment portfolio would A) seek to minimize changes in the bond price during periods of steady interest rates. B) be interested in tax advantages available to convertible debt securities. C) want the assurance of a guaranteed dividend on the underlying common stock. D) want the safety of a fixed-income investment along with potential capital appreciation.

D) want the safety of a fixed-income investment along with potential capital appreciation. Investors who want the safety of a fixed-income investment with the potential for capital gains would be most interested in purchasing a convertible debenture. However, because convertible debentures can be exchanged for common stock, their market price tends to be more volatile during times of steady interest rates than other fixed-income securities. LO 2.j

Disregarding commissions, an investor selling a US Treasury bond for a price of 104:16 will receive A. $104.16 B. $104.50 C. $1,041.60 D. $1,045.00

D. $1,045.00

Which of the following statements is NOT true? A. A country wishing to restructure its debt using Brady bonds would do so to save on debt servicing costs B. One of the benefits of holding convertible debentures is the option to convert into the corporation's common stock C. US Treasury securities are backed by the full faith and credit of the USA D. A resident of France purchasing Eurodollar bonds does not incur currency risk

D. A resident of France purchasing Eurodollar bonds does not incur currency risk

According to Standard & Poor's rating system, the 4 highest grades of bonds (from best to lowest grade) are A. Aaa; Aa; A; Baa B. A; Aa; Aaa; B C. B; A; AA; AAA D. AAA; AA; A; BBB

D. AAA; AA; A; BBB A = Moody's

Which of the following have no interest rate risk? A. Negotiable CDs B. Commercial paper C. US Treasury bonds D. Time deposits at your local bank

D. Time deposits at your local bank

When Treasury bills are issued, they are quoted at A. a premium over par B. 100% of the par value C. par value with interest coupons attached D. a discount from principal with no coupons attached

D. a discount from principal with no coupons attached

Lowest to highest bond price, discount

Nominal CY YTM YTC

Lowest to highest bond price, premium

YTC YTM CY Nominal

If a bond has a YTM greater than its coupon, the bond is trading at

discount

If the bond has a YTM less than its YTC, the bond is trading at

discount

If the bond has a YTM and CY that are equal, the bond is trading at

par

If the bond has a YTC lower than its CY, it is trading at

premium