Unit 6&7 Review (Part 2)
Which of the following would have the least impact in marketing a municipal bond issue? A) The dated date of the issue B) The size of the block offered C) The rating of the issue D) The maturity of the issue
A) The dated date of the issue The dated date of a bond issue is merely the date on which the issue begins to accrue interest. As such, it would have less to do with the marketing efforts related to a new issue than would items such as the size of the block offered, the rating of the issue (how financially strong it is), and the maturity. LO 6.e
With regard to municipal bonds, an extraordinary call is most commonly invoked when A) a catastrophe destroys the facility backing a revenue bond. B) the economic cycle indicates that interest rates will be sharply increasing. C) property tax proceeds exceed expectations enabling the municipality to retire its GO bonds ahead of schedule. D) it appears that the issuer's credit rating will be downgraded.
A) a catastrophe destroys the facility backing a revenue bond. An extraordinary call is frequently referred to as a catastrophe call. Because the payments on a revenue bond are generally supported by a revenue-producing facility, destruction or damage to that facility is considered a catastrophe. In most cases, the proceeds from the insurance policy protecting that facility are used to call in the bonds. LO 6.b
An investor purchases $10,000 worth of Treasury bills on November 27 and holds them until they mature on March 30 of the following year. For purposes of taxation, the interest from those Treasury bills is treated as A) ordinary income subject to federal income tax. B) a short-term gain. C) tax-free income. D) partially ordinary income and partially capital gain.
A) ordinary income subject to federal income tax. Interest on Treasury bills, notes, and bonds is taxable as ordinary income at the federal level. It is exempt from state and local taxation. LO 7.e
One of the benefits of adding a sinking fund provision to a municipal bond issue is that the bond will generally A) receive a higher rating. B) have a longer maturity. C) carry a higher coupon. D) receive more favorable tax treatment.
A) receive a higher rating. Adding a sinking fund provision to a bond issue invariably results in a higher rating for the security. The fact that money is put aside to repay the principal on a regular basis offers greater safety. A higher rating results in a lower coupon, not a higher one. After all, the higher the rating, the lower the risk, and that means the issuer is able to borrow at a lower cost. Although the sinking fund itself does not change the maturity date, having a sinking fund enables the issuer to use partial calls to redeem the bond ahead of the final maturity date. A sinking fund has nothing to do with tax treatment. LO 6.a
All of the following would be found in a bond resolution for a new municipal issue except A) the costs to be incurred by the issuer in connection with the offering. B) the issuer's obligations to bondholders. C) covenants to which the issuer must adhere. D) a description of the issue.
A) the costs to be incurred by the issuer in connection with the offering. The bond resolution (or the bond contract) spells out the characteristics of the issue (maturities, call features, etc.), the issuer's responsibilities to bondholders, and any restrictive covenants to which the issuer must adhere. Costs to be incurred by the issuer have no impact on bondholders. LO 6.a
When recommending industrial development revenue bonds, registered representatives would be remiss if they did not discuss A) the tax bracket of the individual and the alternative minimum tax. B) the potential for taxable capital gains. C) the speculative nature of the bonds. D) the guarantees offered by the issuing municipality.
A) the tax bracket of the individual and the alternative minimum tax. Industrial development revenue bonds (IDRs) are municipal bonds generally backed by a lease or similar obligation entered into by a corporation. That is the backing and defines the risk level. The IRS defines interest received from industrial development revenue bonds (IDRs) as a tax preference item. As such, the income received might be subject to taxation under the alternative minimum tax. This tax usually applies to individuals who are in the higher tax brackets and would be an important determinant when evaluating the suitability of the investment. LO 6.f
A municipality has an ad valorem tax rate of 10 mills. A piece of real property is assessed at $100,000 and has a market value of $125,000. The annual taxes paid on the property are A) $125. B) $1,000. C) $1,250. D) $100.
B) $1,000. Ad valorem tax rates are based on mills with one mill being equal to $0.001 (1/10th of a cent). The amount of taxes to be paid on the property is determined by multiplying the millage rate—in this case, one cent (10 mils at $0.001 = $0.01)—times the assessed property value ($100,000). The market value is irrelevant. For those who have difficulty determining where the decimal point goes, on any question like this, drop the last three 000s from the assessed value and multiply by the millage rate. In this question, that would be $100 times 10 and that equals the correct answer of $1,000. LO 6.c
A county taxes real property at a millage rate of 15. If your customer owns real property in the county and the assessed value is 80% of the current market value of $150,000, the annual tax is A) $1,200. B) $1,800. C) $2,250. D) $180.
B) $1,800. Ad valorem tax rates are based on mills with one mill being equal to $0.001 (1/10th of a cent).The amount of taxes to be paid on the property is determined by multiplying the millage rate—in this case, one and one half cents (15 mils at $0.001 = $0.015)—times the assessed property value ($120,000). Remember, this county is only taxing the assessed value which is 80% of the market value. As you can see, there is an answer choice that corresponds to the millage rate on the market value, so if you use the wrong number, they'll help you get the question wrong. For those who have difficulty determining where the decimal point goes, on any question like this, drop the last three zeros from the assessed value and multiply by the millage rate. In this question, that would be $120 times 15 and that equals the correct answer of $1,800. LO 6.c
A customer purchases five 6.25% U.S. Treasury notes at 98.24. How much will the customer receive on each interest payment date? A) $312.50 B) $156.25 C) $153.50 D) $154.30
B) $156.25 Although minimum purchase denominations can be less, always use par value ($1,000) for these calculations. A 6.25% bond pays $62.50 annually (6.25% × $1,000 = $62.50). Therefore, a customer purchasing five bonds receives $312.50 each year. Because Treasury notes pay semiannually, each interest payment equals $156.25. LO 7.b
A municipal bond is purchased at a discount in the secondary market at 90. The face amount is $10,000, and the bond has 10 years to maturity. If the bond is sold for 97 after five years, what is the taxable gain? A) $700 B) $200 C) $300 D) Capital gains not taxable
B) $200 When a municipal bond is bought at a discount in the secondary market, the discount is accreted and taxable as ordinary income. Accretion increases cost basis. Therefore, five years later, the bond's cost basis is 95. At that point, the customer has a two-point capital gain. Had the bond been bought as an original issue discount, the annual accretion is considered interest income and is not taxable. LO 6.e
On February 13, your customer buys an 8% Treasury bond maturing in 2019 for settlement on February 14. If the bonds pay interest on January 1 and July 1, how many days of accrued interest are added to the buyer's price? A) 14 B) 44 C) 45 D) 43
B) 44 Accrued interest for government bonds is figured on an actual-days-elapsed basis. The number of days begins with the previous coupon date and continues up to, but not including, the settlement date. The bonds pay interest on January 1. There are 31 days of accrued interest for January. The bonds settle February 14. There are 13 days of accrued interest for February. Do not count the settlement date (31 + 13 = 44 days). LO 6.e
Which of the following statements regarding distributions from a Section 529 education savings plan is true? A) Distributions can be used for college education expenses only. B) Distributions can be used for K-12 and college education expenses. C) Distributions can be used for preschool education expenses only. D) Distributions can be used for K-12 education expenses only.
B) Distributions can be used for K-12 and college education expenses. Distributions from Section 529 plans can be used for grades K-12, as well as college education expenses. LO 6.g
An investor purchases a municipal bond at par to yield 5.5% to maturity. Two years later, if he sells the bonds at a price equivalent to a 5% yield to maturity, the investor incurs A) a capital loss. B) a capital gain. C) tax-free income. D) no taxable result at this time.
B) a capital gain. Yields fall as bond prices rise. Because the yield to maturity has dropped, the bond is trading at a higher price than when it was purchased. The consequence of the sale is a capital gain because the investor sold the bond that was purchased for par at a premium. LO 6.e
Municipal bonds—known as dollar bonds—are generally quoted A) net yield. B) as a percentage of par. C) yield to maturity. D) yield to call.
B) as a percentage of par. Although municipal bonds are usually quoted on a yield basis, actively traded bonds known as dollar bonds are often quoted as a percentage of par (price). The term dollar bond comes from the quote being made in dollars. Remember that a percentage of par value ($1,000) equals a dollar price. LO 6.a
All of the following are characteristics of 529 plans except A) the assets can be transferred to a family member if not used by the original beneficiary. B) donor income limits apply. C) there is no age limit on the beneficiary. D) an official statement (OS) must be provided to any prospective purchaser.
B) donor income limits apply. Unlike the Coverdell ESA, there are no donor income limits with a 529 plan. All of the other statements are true as to 529 plans. LO 6.g
A registered representative with discretionary authority requires customer authorization before purchasing A) noncallable zero-coupon bonds. B) municipal bonds where a control relationship exists. C) noninvestment-grade bonds. D) junk bond funds.
B) municipal bonds where a control relationship exists. Even though the representative has discretionary authority to trade the account, the Municipal Securities Rulemaking Board requires that the representative receive customer permission before purchasing bonds where the firm has a control relationship with the issuer. LO 6.h
An investor in a high-income tax bracket owns a number of municipal bonds and wants to add some to a 401(k) plan he participates in and perhaps his IRA. As a registered representative, you would advise that this is A) suitable due to his high-income tax bracket. B) not suitable because the interest payments from municipal bonds are tax free already and have no place in a tax-advantaged (tax-deferred) account such as a 401(k) plan or IRA. C) not suitable because the investor already owns municipal bonds, and this would be a duplication of the same asset class in his tax-advantaged accounts. D) suitable because the investor already understands the advantages of owning tax-free interest paying instruments without any further suitability qualifications needed.
B) not suitable because the interest payments from municipal bonds are tax free already and have no place in a tax-advantaged (tax-deferred) account such as a 401(k) plan or IRA. While municipal bonds can be suitable for those in higher income tax brackets, they have no place in tax-advantaged (tax-deferred) accounts such as 401(k) plans or IRAs because the interest paid is already tax free. LO 6.f
The bond resolution includes all covenants between A) the issuer and the Municipal Securities Rulemaking Board. B) the issuer and the trustee acting for the bondholders. C) the bond counsel and the bondholders. D) the issuer and the bond counsel.
B) the issuer and the trustee acting for the bondholders. The bond resolution describes not only the characteristics of the proposed offering, but also the obligations the issuer has to its bondholders. LO 6.b
If a municipal bond rated BBB is prerefunded, all of the following statements are true except A) the rating of the issue will increase. B) the marketability of the issue will decrease. C) the issue is now backed by U.S. government securities. D) funds required to meet debt servicing have been set aside in escrow.
B) the marketability of the issue will decrease. When funds are escrowed to call in a bond at a predetermined call date, the bond is said to be prerefunded. The money set aside is invested in government securities, which makes the issue very safe and highly marketable. The rating of prerefunded bonds is AAA, as they are now backed by U.S. government securities. LO 6.d
The trust indenture of a revenue bond will show all of the following except A) the rate covenant. B) the reoffering yields. C) the revenue pledge. D) the application of flow of funds.
B) the reoffering yields. Reoffering yields are unrelated to trust indentures. However, the trust indenture for a revenue bond issue does include covenants (or promises) between the issuer and the trustee for the bondholders' benefit. Among these covenants are the flow of funds and the rate covenant. LO 6.b
All of the following might affect the credit rating of a municipal revenue issue except A) the debt service coverage ratio. B) the tax rates of nearby municipalities. C) the rate covenants set forth in the indenture. D) the quality of the facilities management.
B) the tax rates of nearby municipalities. The credit rating of a revenue issue would not be affected by tax rates in surrounding municipalities. LO 6.b
All of the following trade with accrued interest except A) jumbo certificates of deposit. B) zero coupon bonds. C) Treasury bonds. D) convertible bonds.
B) zero coupon bonds. Zero coupon bonds are issued at a deep discount from face value instead of providing semiannual interest payments. T-bonds, convertible bonds, and CDs all make periodic interest payments; thus, the seller receives any accrued interest from the buyer. LO 6.e
If a municipal bond is issued at par and later purchased for 97 plus accrued interest of $32, what is the purchaser's cost basis? A) $938 B) $1,000 C) $970 D) $1,002
C) $970 The purchase price of 97 ($970) represents the cost basis of the bond. The accrued interest paid by the buyer has no impact on the cost basis and represents the amount of interest that the seller is due, based on the holding period of the bond from its last interest payment date. The buyer will receive the full six-month interest payment the next time the coupon is paid. LO 6.f
Achieving a Better Life Experience (ABLE) accounts are tax-advantaged savings accounts for individuals with disabilities and their families. The ABLE Act limits eligibility to individuals with significant disabilities where the age of onset of the disability occurred before turning age A) 30. B) 21. C) 26. D) 18.
C) 26. One need not be under the age of 26 to be eligible to establish an ABLE account. One could be over the age of 26, but as long as the onset of the disability occurred before age 26, the person is eligible to establish an ABLE account. LO 6.g
Under Municipal Securities Rulemaking Board rules, which of the following would indicate a control relationship between a municipal dealer and an issuer? A) The principal of the dealer lives within the municipality B) The dealer is engaged as an underwriter for the issuer C) A dealer's officer sits on the issuer's board of trustees D) The dealer was an underwriter of the municipality's last issue
C) A dealer's officer sits on the issuer's board of trustees A control relationship exists if someone represents both an issuer and municipal securities dealer. LO 6.h
Who attests to the legality of a bond issue and issues a legal opinion on a proposed new municipal bond issue? A) State administrator B) Case attorney C) Bond counsel D) Syndicate manager
C) Bond counsel The issuer hires a firm or an individual to act on its behalf as bond counsel. LO 6.a
Which of the following may only be accomplished after applying the additional bonds test for a revenue bond? A) Prerefunding an outstanding bond issue B) Increasing the project's user charges C) Issuing new bonds with an equal lien on the project's revenues D) Spending revenues already allocated for project expansion
C) Issuing new bonds with an equal lien on the project's revenues The additional bonds test must be met under the provisions of a revenue bond indenture before additional bonds with an equal lien on project revenues can be issued. The conditions under which additional bonds may be issued are specified in the bond indenture. This is an open-end covenant. LO 6.b
Which of the following statements about municipal brokers' brokers is not true? A) They perform specialized trades for institutions. B) They do not perform retail trades with individual investors. C) They perform trades on a principal basis only. D) They do not maintain inventories.
C) They perform trades on a principal basis only. A broker's broker does not maintain an inventory of bonds. Therefore, they do not act as principals; they act as agents only in trades between dealers or institutions. They do not do retail business. LO 6.d
If a municipal bond has a call provision, this will tend to A) make the bond more attractive to investors because most bonds are called at a premium. B) place a floor on how low the price will decline. C) make the bond less attractive to investors because a call would terminate the interest payments. D) have no effect on the price.
C) make the bond less attractive to investors because a call would terminate the interest payments. The possibility of a call is unattractive to the investor. In most cases, bonds are called when their interest rate is above the current market rate. This means the investor must give up that higher yielding security. It is attractive to the issuer because with a call, the bonds are bought back at par or a small premium, and interest payments end. LO 6.d
The function of a broker's broker in the municipal bond business is to do which of the following? I. Help sell municipal bonds that a syndicate has been unable to sell II. Protect the identity of the firm on whose behalf the broker's broker is acting III. Help prepare bids for an underwriting syndicate IV. Serve as a wholesaler, offering bonds at a discount from the current bid and offer
D) I and II A broker's broker helps sell the bonds a syndicate has left and does not disclose the identity of the firm on whose behalf it is acting. Brokers' brokers do not charge fees for quoting a security, do not maintain inventory, and act solely as agents earning a commission for their services. LO 6.d
In addition to their tax advantages, municipal bonds are often purchased for their safety. Your client wishing to purchase municipal bonds with the utmost in safety should buy A) general obligation bonds. B) double-barreled bonds. C) moral obligation bonds. D) New Housing Authority bonds.
D) New Housing Authority bonds. NHAs, sometimes called Public Housing Authority or PHA bonds, have the backing of the federal government. As such, they are the safest of all municipal securities. LO 6.b
A quotation on a municipal security between dealers is assumed to be A) an indication of interest. B) a nominal quote. C) a workable quote. D) a bona fide quote.
D) a bona fide quote. Municipal bond quotations between dealers are required to be bona fide, or firm, quotes. They are required to be fair and reasonably related to the current market. LO 6.a
The Municipal Securities Rulemaking Board (MSRB) writes the rules in the municipal bond market. The MSRB A) must comply with IRS regulations. B) is not regulated as an SRO by the SEC. C) is the enforcement body in the municipal bond market. D) does not enforce its own rules.
D) does not enforce its own rules. The MSRB writes the rules for the municipal bond market, but is not an enforcement authority. The rules are enforced by other regulatory bodies depending on who the bond dealer making the trade is. If it was completed by a community bank, the FDIC is the enforcement body. If it is done by a member bank of the Federal Reserve, the regulator is the Federal Reserve Board (FRB). If the trade is made through a FINRA member firm, then FINRA is the enforcer. The SEC has regulatory authority over the MSRB and all other self-regulatory organizations (SROs) not the IRS. LO 6.h
An institutional investor is seeking a quote on $2 million of term bonds issued by the City Water Authority. These are the 3s of 2050 and would be quoted A) by current yield. B) by yield to maturity. C) using the dealer's bid price. D) in dollars as a percentage of par.
D) in dollars as a percentage of par. Term bonds are often called dollar bonds because they are quoted in a dollar price. That price is a percentage of par. Serial bonds are quoted on their basis (yield to maturity). A purchaser is going to be quoted based on the dealer's ask price (the bid price is when the customer is selling). The 3s of 2050 means that the coupon is 3% and the maturity date is 2050. LO 6.a
Municipal bonds that are backed by the income from specific projects are known as A) income bonds. B) general obligation bonds. C) debenture bonds. D) revenue bonds.
D) revenue bonds. Principal and interest on municipal revenue bonds are paid from revenues of a particular project, whereas general obligation bonds are backed by the full taxing authority of the municipality. LO 6.b
The dated date on a municipal bond issue is A) the settlement date. B) the trade date. C) the date on which the bonds are delivered to the buyer. D) the date on which the bonds begin accruing interest.
D) the date on which the bonds begin accruing interest. The dated date is the date on which newly issued bonds begin to accrue interest. LO 6.e
All of the following are characteristics of Section 8 bonds except A) they are backed by the U.S. government. B) they are also known as Public Housing Authority (PHA) and New Housing Authority (NHA) bonds. C) they are used to finance subsidized housing. D) they are a type of general obligation bond.
D) they are a type of general obligation bond. Section 8 bonds are municipal revenue bonds backed by the U.S. government to help finance low- and moderate-income public housing. They are also known as PHA or NHA bonds. LO 6.b
