Ch 8: US Treasury & Govt Agency Debt

What is the maturity range of a T-Note?

2 to 10 years

What is the dollar price of a T-bond with a bid of 98-24 and a par value of $100?

98 and 24/32. Convert fraction into a decimal 24 ÷ 32 = .75. Now multiply $100 by 98.75% = $98.75.

A competitive bid placed at a Treasury auction will indicate both ___________ and _________.

A competitive bid placed at a Treasury auction will indicate both quantity and price.

Describe an asset backed security.

A security whose value and income are collateralized by group of assets, usually bank receivables (e.g. mortgages).

The CMO tranche that provides the greatest safety of principal is the

A tranche (fast-pay tranche).

A Treasury bond with a par value of $1,000 has a quote of 95.15. The dollar value of this T-bond is: A) $955.00 B) $954.68 C) $956.50 D) $951.50

B) $954.68 U.S. government Treasury notes and Treasury bonds are quoted on a percentage of par plus a fraction basis. The fraction used to quote T-notes and T-bonds is 1/32 of a point. To determine the dollar value, first convert the fraction 15/32 to a decimal. If 15 is divided by 32, the result is .46875. Now the quote becomes 95.46875% of par. A T-bond with a quote of 95.46875% of $1,000 is equal to $954.68.

The current yield for a 9% Treasury bond trading at 101:14 is: A) 8.77% B) 8.87% C) 8.90% D) 8.93%

B) 8.87% Current yield is the interest rate divided by the asked price. It is 8.87% (9% interest rate divided by the asked price of 101 14/32 or 101.4375). Treasury bonds are quoted as a percentage of par in 32nds of a point.

A collateralized debt obligation (CDO) is BEST defined as a type of: A) REIT B) Asset-backed security C) Closed-end investment company D) Municipal revenue bond

B) Asset-backed security A collateralized debt obligation (CDO) is a type of asset-backed security. A CDO is issued as a bond, which is backed (collateralized) by a pool of bonds, loans, and various other assets. Ownership of this type of security is typically in the form of a tranche (slice), with any given tranche from the CDO carrying a different maturity and risk level. The return an investor can expect from this type of investment is based on the credit quality of the underlying assets contained in the pool. CDOs are similar in structure to collateralized mortgage obligations (CMOs). These investment vehicles are broadly categorized as asset-backed securities.

Which of the following statements is TRUE concerning a customer who purchases an original issue discount (OID) U.S. government security? A) Each year the customer will pay both federal and state income tax B) Each year the customer will pay only federal income tax C) Each year the customer will not pay any tax D) The customer will only pay tax at maturity

B) Each year the customer will pay only federal income tax The upward adjustment in the purchase price of an original issue discount bond is called accretion. The amounted accreted each year is considered interest income, which may or may not be taxable depending on the type of security. The interest on U.S. government securities is subject to federal income tax, but exempt from state and local income taxes.

Which of the following securities does NOT trade with accrued interest? A) Treasury bonds B) Treasury STRIPS C) Jumbo certificates of deposit D) Convertible bonds

B) Treasury STRIPS Securities that pay interest periodically or have a stated rate of interest (such as Treasury bonds, municipal bonds, corporate bonds, and certificates of deposit) trade with accrued interest. However, many money-market securities such as Treasury bills and bankers' acceptances trade at a discount and are, therefore, purchased without paying accrued interest. Zero-coupon bonds (e.g., Treasury STRIPS) do not pay periodic interest and are traded without accrued interest.

Which TWO of the following securities are typically sold at a discount? I. TIPS II. Treasury bills III. Bankers' acceptances IV. Collateralized mortgage obligations A) I and III B) I and IV C) II and III D) II and IV

C) II and III Treasury bills and bankers' acceptances are typically sold at a discount. The amount of interest is based on the difference between the purchase price and the face value.

Which TWO of the following statements are TRUE regarding Treasury bills? I. They're interest-bearing securities. II. They're discount securities. III. hey're issued in minimum denominations of $100. IV. They're issued in minimum denominations of $1,000. A) I and III B) I and IV C) II and III D) II and IV

C) II and III Treasury bills are issued at a discount and mature at face value. The T-bills discount represents interest. The minimum denomination for T-bills is $100.

Collateralized mortgage obligations (CMOs) make interest payments to investors: A) Daily B) Weekly C) Monthly D) Quarterly

C) Monthly CMOs are issued in minimum denominations of $1,000, are backed by pass-through securities (FNMA, GNMA, and FHLMC), and pay interest and principal monthly.

All of the following government agencies are involved in the housing market, EXCEPT: A) FNMA B) FHLMC C) SBA D) GNMA

C) SBA The SBA is the Small Business Administration and is not involved in the housing market. The SBA is a federal agency involved in providing financial assistance to small businesses.

A Treasury bond is quoted 105.04 - 105.24. The purchase price that a customer would expect to pay would be: A) $1,051.25 B) $1,052.40 C) $1,054.00 D) $1,057.50

D) $1,057.50 U.S. Treasury notes and bonds are quoted in 32nds of a point. When purchasing the bond, the customer would pay the offering price of 105.24. To convert 105.24 into a dollar price: Step 1: 105.24 is equal to 105 24/32 Step 2: convert 24/32 into a decimal, which is .75 Step 3: convert 105.75% into a dollar price (105.75% x $1,000 = 1.0575 x $1,000 = $1,057.50) The customer would pay $1,057.50.

TIPS were created to address which type of risk? A) Liquidity risk B) Interest rate risk C) Credit risk D) Inflation risk

D) Inflation risk Treasury Inflation Protected Securities (TIPS) are a type of U.S. government bond that adjusts for inflation. The interest rate on a TIPS will not change, but when the Consumer Price Index (CPI) rises, the principal on a TIPS will increase and investors will receive more in interest. TIPS are created to keep up with, but not beat, inflation.

Which of the following securities are quoted and traded at a discount? A) Common stocks B) Corporate bonds C) U.S. Treasury notes D) U.S. Treasury bills

D) U.S. Treasury bills Of the choices given, the only securities that are quoted and traded at a discount are U.S. Treasury bills.

Each payment from GNMA will represent both ____________ and ____________.

Each payment from GNMA will represent both principal and interest.

How often do GNMA pass-throughs make payments?

GNMA pass-throughs make payments monthly.

What is the maturity range of a T-Bond?

More than 10 years

True or False: Agency-backed CMOs have high credit ratings.

True. They are usually highly rated because of the collateral backing them.

An article in The Wall Street Journal states that yields on Treasury bills have declined in the past month to 4.58% from 4.61%. This indicates that: A) Buyers of new bills paid more than buyers paid the previous month B) Buyers of new bills paid less than buyers paid the previous month C) Interest rates are increasing D) Buyers of new bills purchased the bills above par

A) Buyers of new bills paid more than buyers paid the previous month Treasury bills are purchased at a discount from the dollar amount on its face. The larger the discount, the higher the discounted yield to maturity. In this example, the discounted yield to maturity has gone down to 4.58% from 4.61% from the previous month. This indicates that buyers of new bills paid more for the Treasury bills (meaning the discount was less) than buyers paid the previous month.

Which of the following risks is considered unique to an investor holding a CMO? A) Prepayment risk B) Credit risk C) Interest-rate risk D) Reinvestment risk

A) Prepayment risk The risk that an investor will receive her principal earlier than projected (prepayment risk) instead of at one time is the most important risk concerning mortgage-backed securities such as CMOs. Although all fixed-income securities will have interest-rate risk, prepayment risk is unique to CMOs. Historically, CMOs have been highly rated, due to the underlying mortgages backing these securities. This risk did increase significantly in 2008.

Which CMO tranche provides the greatest safety of principal? A) The A tranche B) The Z tranche C) The companion tranche D) The floating rate tranche

A) The A tranche Tranche A (the fast-pay tranche) is the first to receive principal, while the Z tranche only receives payments after all of the other tranches are paid. The companion or support tranche is considered a very volatile tranche. A floating rate tranche simply adjusts its interest rate based on an index (e.g., LIBOR).

A 3-month Treasury bill is issued at a discount to yield 9.5%, and a corporate bond is issued to yield 9.5%. The bond is to mature in 10 years. If both are offered on the same day on a bond equivalent yield basis, which of the following statements is TRUE? A) The bill has a greater yield than the bond B) The bond has a greater yield than the bill C) The yield is the same for both D) The bond equivalent yield and tax equivalent yield are equal

A) The bill has a greater yield than the bond T-bills are issued and quoted on a discount yield basis, whereas corporate bonds are quoted on a yield-to-maturity basis. These yields are calculated in different manners. The bond equivalent yield of a T-bill is always higher than its discount yield.

Which of the following statements is TRUE concerning the tax treatment of CMOs? A) The interest is fully taxable B) The principal is fully taxable C) The interest is exempt from federal tax but subject to state and local taxes D) The interest and principal are exempt from state and local taxes

A) The interest is fully taxable The interest received from collateralized mortgage obligations (CMOs) is fully taxable (federal, state, and local taxes). The principal payments are considered a return of capital and are not taxable. Investors receive their principal payments each month instead of receiving the entire amount of principal at maturity.

Which of the following is NOT TRUE of private label CMOs? A) They are subject to less credit risk than agency CMOs B) They may be issued by investment banking firms C) They typically do not carry a AAA rating D) They are not considered obligations of the U.S. government

A) They are subject to less credit risk than agency CMOs Private label mortgage-backed securities are issued by financial institutions such as commercial banks, investment banks, and home builders and they contain some agency securities. However, a private label MBS typically contains other types of mortgage loans that are not agency securities. A private label MBS is not an obligation of the U.S. government or any GSE and its credit rating is assigned by an independent credit agency. A private label MBS has higher credit risk and is generally not given a AAA rating.

Which of the following statements is TRUE about agency CMOs? A) They're subject to less credit risk than private label CMOs. B) They offer a yield that's higher than private label CMOs. C) They're always backed by the full faith and credit of the U.S. government. D) They're used to finance municipal projects.

A) They're subject to less credit risk than private label CMOs. Agency collateralized mortgage obligations (CMOs) are created by GNMA, FNMA, and FHLMC and typically have less credit risk than CMOs that are created by financial institutions (i.e., private label CMOs). Although GNMA securities are backed by the U.S. government, FNMA and FHLMC don't receive government backing.

Which of the following bonds has the most interest-rate risk? A) A three-month Treasury bill B) A 30-year Treasury STRIP C) A 6%-coupon, 30-year Treasury bond D) A 3%-coupon, five-year Treasury note

B) A 30-year Treasury STRIP The bond with the most interest-rate risk or price volatility is the bond with the longest maturity and the lowest coupon. This price sensitivity is based on the concept of duration. The first step is to identify the bond or bonds that have the longest maturity. In this question, there are two bonds with 30-year maturities, which eliminates the possibility of the three-month and five-year bonds as the answer. The second step is to find the long-term bond that offers the lowest coupon rate. Since a T-STRIP is a form of zero-coupon bond, it clearly has more interest-rate risk than another long-term bond that offers a 6% coupon. Remember, the greatest price sensitivity based on interest rate fluctuation is a long-term bond with a low coupon.

Government-sponsored enterprise securities are comparable to direct government obligations with regard to all of the following statements, EXCEPT: A) They trade in the over-the-counter market B) All are government guaranteed C) Short-term securities are quoted on a discount yield D) Long-term securities are quoted as a percentage of par

B) All are government guaranteed Government-sponsored enterprise securities are not guaranteed by the government. The other statements are true.

A mortgage-backed security that is available in several "tranches," each with different cash flow characteristics, is a: A) Government National Mortgage Association pass-through certificate B) Collateralized Mortgage Obligation C) Public Housing Authority bond D) Real Estate Investment Trust

B) Collateralized Mortgage Obligation Collateralized mortgage obligations, or CMOs, are securities backed by pools of mortgages or pools of mortgage-backed securities, such as GNMA pass-throughs. However, unlike GNMA pass-throughs, a single issue of CMOs is divided into several classes, or tranches. When principal repayments are received by the CMO company or trust, the principal is paid to the various tranches according to a predetermined sequence of priority. Some tranches receive principal repayments immediately; others will not receive principal repayments for several years.

An investor buys $10,000 par value of 4% Treasury bonds due July 1, 2040. For tax purposes, the interest earned on these bonds is: I. Subject to federal income tax II. Exempt from federal income tax III. Subject to state income tax IV. Exempt from state income tax A) I and III B) I and IV C) II and III D) II and IV

B) I and IV Interest on U.S. government bonds is subject to federal income tax but exempt from state income tax. This is just the opposite of the tax treatment on municipal (state) bonds where the interest is exempt from federal tax, but may be subject to state tax.

When evaluating two CMOs backed by GNMAs, one having a 6% yield and the other having a 10% yield, which TWO of the following statements are TRUE? I. Prepayment risk is greater for the CMO with the 10% yield II. Prepayment risk is greater for the CMO with the 6% yield III. Credit risk is greater for the 10% CMO IV. Credit risk is the same for both securities A) I and III B) I and IV C) II and III D) II and IV

B) I and IV Prepayment risk measures the possibility that homeowners will refinance (prepay) their mortgages. Historically, the speed of prepayment increases when interest rates fall. If this happens, payments will flow into the CMOs at an accelerated rate, forcing investors to reinvest these monies at lower-than-anticipated rates. Therefore, the CMO with the higher interest rate will have higher prepayment risk. GNMA-backed CMOs are highly rated and, therefore, have little credit risk. Since both CMOs are backed by GNMAs, credit risk is minimal for both pools.

Which TWO of the following statements are TRUE of U.S. Treasury bills? I. They do not have a stated rate of interest II. They mature in more than one year III. The interest received is taxed in the year they are sold IV. They are issued at a discount A) I and III B) I and IV C) II and III D) II and IV

B) I and IV Treasury bills do not have a stated rate of interest (a coupon rate). They are issued at a discount below their face value, and the difference received is considered interest, which is taxable in the year the securities mature (not in the year they are sold). They are sold in minimum amounts of $100 and currently are issued with maturities of 4, 13, 26, and 52 weeks.

An investor has a $5 million position in long-term Treasury bonds. Which of the following types of risk is the investor's greatest concern? A) Liquidity risk B) Inflationary risk C) Credit risk D) Prepayment risk

B) Inflationary risk Of the choices listed, the greatest concern would be inflationary risk, which is the risk that inflation would erode the investor's purchasing power. When invested in a fixed-income security, an increase in inflation may be detrimental. Note: If it was Treasury Inflation-Protected Securities (TIPS), they would be adjusted for the inflation rate. The Treasury market is generally a liquid market (being able to sell quickly). Treasury bonds are backed by the U.S. government (they have no credit risk) and may not be prepaid prior to maturity (they have no prepayment risk). Another risk the investor would have is interest-rate risk, the risk that an increase in interest rates could cause the bond price to fall, which is not one of the choices.

Which of the following statements is NOT a feature of GNMA pass-through certificates? A) They are backed by the U.S. government B) Interest is subject to federal tax but is exempt from state tax C) Interest and principal payments are made on a monthly basis D) Pools consist of fixed-rate residential mortgages

B) Interest is subject to federal tax but is exempt from state tax The Government National Mortgage Association (Ginnie Mae) is an agency of the United States government. It guarantees a pool of mortgages purchased by investors through Ginnie Mae pass-through certificates. These instruments pay interest and principal monthly at a stated rate on the remaining principal. The repayment of principal and interest is guaranteed by the United States government. Ginnie Mae pass-through certificates are purchased in $25,000 minimums. Interest received from Ginnie Mae pass-through certificates is subject to federal, state, and local taxes.

Regarding the FHLMC, which of the following statements TRUE? A) It's referred to as Fannie Mae. B) Its securities are issued only in book entry form. C) The interest paid on its securities is exempt from federal taxes. D) Its securities are backed by the full faith and credit of the U.S. government.

B) Its securities are issued only in book entry form. The Federal Home Loan Mortgage Corporation (FHLMC) is typically referred to as Freddie Mac. Its securities are only issued in book entry form, but interest that's paid to investors is taxable. FHLMC is only government-sponsored and is not backed by the full faith and credit of the U.S. government.

All of the following are advantages of CMOs, EXCEPT: A) There are a variety of bond classes available B) They produce tax-free interest C) They generally have AAA ratings D) They are available in denominations as low as $1,000

B) They produce tax-free interest The interest payments from a CMO are fully taxable. CMOs offer various bond classes (called tranches) carrying different rates and different levels of risk. The securities in the underlying portfolio are government agencies giving CMOs the AAA rating.

A corporation has raised money that it needs to use within the next six months. In which of the following should the corporation invest the funds until they are needed? A) AAA-rated corporate bonds B) U.S. Treasury bills C) Index funds D) High-quality preferred stocks

B) U.S. Treasury bills The corporation will need the money in six months and will want to minimize capital risk. Therefore, it should invest in the security with the least capital risk. Money-market instruments, such as T-bills, are an appropriate choice for investors with the objective of preservation of capital.

The tranche with the longest maturity and, therefore, the last to receive interest and principal payments within a CMO, is known as the: A) PAC tranche B) Z-tranche C) Supersinker D) Companion tranche

B) Z-tranche The separate classes of a CMO are known as tranches. The longest maturity is frequently called the Z-tranche or the accrual bond, and does not receive interest or principal payments until the shorter maturing tranches have been retired.

A GNMA pass-through is quoted 98.10 to 98.18. This quote represents a spread per $1,000 face value of: A) $0.08 B) $0.80 C) $2.50 D) $8.00

C) $2.50 GNMA pass-through certificates (as well as T-notes and T-bonds) are quoted in 32nds of a point. The spread of .08 represents 8/32 or 1/4 (.25) of a point. One point (1%) for a bond is equal to $10 ($1,000 x 1%); therefore, 1/4 of a point is equal to $2.50 per $1,000.

If interest rates increase, which of the following securities has the LARGEST price change? A) A Treasury note trading at a discount B) A Treasury note trading at a premium C) A Treasury bond trading at a discount D) A Treasury bond trading at a premium

C) A Treasury bond trading at a discount When interest rates increase, outstanding bond prices will decline in value. The prices of bonds with longer-term maturities will fall more than those with shorter-term maturities. Treasury bonds have maturities of up to 30 years, whereas Treasury notes have maturities of up to 10 years. The prices of bonds that are selling at a discount will fall more sharply than those selling at a premium. A bond with a high coupon will tend to trade at a premium, while a bond with a low coupon will tend to trade at a discount. The bond with the high coupon will repay an investor sooner than a bond with a low coupon since the investor will be earning more money from the higher coupon. Therefore, bonds that have longer maturities and/or lower coupon rates will have a higher degree of interest rate risk. Ultimately, if interest rates increase, a long-term bond that's selling at a discount will decrease (in percentage terms) more than a long-term bond that's selling at a premium.

Which of the following securities has prepayment risk? A) Mortgage bonds issued by a utility company B) Bonds issued by Freddie Mac C) Collateralized mortgage obligations D) Commercial paper

C) Collateralized mortgage obligations Many homeowners pay off their mortgages early. When interest rates fall, homeowners have an incentive to refinance and pay off their existing mortgages. These prepayments are passed through to the pools holding the old mortgages. The investors then need to reinvest this large amount of principal at a time when interest rates have declined. This is referred to as prepayment risk and it is associated with mortgage-backed securities such as CMOs. Although both Fannie Mae (FNMA) and Freddie Mac (FHLMC) issue mortgage-backed securities, the choice in this question "Bonds issued by Freddie Mac" covers the bonds of these issuers, which do not have prepayment risk.

The PSA Model is used when pricing: A) Put options B) Preferred stock C) Collateralized mortgage obligations D) Treasury notes

C) Collateralized mortgage obligations The cash flows, future payments that a bondholder will receive, determine the market price of the bond. Collateralized mortgage obligations (CMOs) have uncertain cash flows due to the prepayments (early retirement) of mortgages. Prepayment risk is the risk that homeowners will pay off their mortgages early and the clients who invested in the securities backed by the mortgage will receive their principal prior to maturity. The Public Securities Association (now SIFMA), an association of financial services firms, created a standard model for estimating the prepayment rate for mortgage-backed securities including CMOs. This is called the PSA Model.

Which TWO of the following statements are TRUE of Treasury bills? I. The interest received is taxed in the year the securities are purchased II. The interest received is exempt from state and local taxes III. The interest received is based on the difference between the purchase price and face value IV. The difference between the purchase price and face value is considered a capital gain A) I and III B) I and IV C) II and IIl D) II and IV

C) II and IIl The interest received on a Treasury bill is based on the difference between the discounted purchase price and the face value received when the bill is redeemed at maturity, and is taxable as interest, not a capital gain. This amount is taxable in the year the bill matures (not when it is purchased), and the interest is subject to federal income tax, but exempt from state and local income taxes.

Which of the following is a risk for an owner of a TIPS? A) Liquidity risk B) Inflation risk C) Interest rate risk D) Credit risk

C) Interest rate risk Treasury Inflation Protected Securities (TIPS) are a type of U.S. government bond that adjusts for inflation. The adjustment is designed to offset inflation risk for investors. Since TIPS are issued by the U.S. Treasury, they have very little liquidity risk and no default (i.e., credit) risk. However, if interest rates rise, TIPS prices will fall and investors could experience a loss. In other words, TIPS are subject to interest rate risk.

During periods of deflation, which of the following investments tends to perform the best? A) Common stock B) Treasury inflation-protected securities C) Long-term debt D) Short-term debt

C) Long-term debt During deflationary periods, interest rates and the price of goods will be declining, which generally has a negative impact on the stock market. The consumer price index (CPI), to which the principal on TIPS is linked, declines in value during periods of deflation resulting in decreasing principal on TIPS. The fixed interest on TIPS would also decline. Bonds perform better when interest rates decrease, with long-term debt appreciating more than short-term debt. Long-term zeros would tend to perform best during deflationary periods.

Which of the following agencies would NOT be used to back a CMO? A) FNMA B) GNMA C) SLMA D) FHLMC

C) SLMA The Student Loan Marketing Association (SLMA), also known as Sallie Mae, provides liquidity to student loan makers and financing for state student loan agencies. Securities issued by SLMA are not backed by the U.S. government. Interest earned on Sallie Mae securities is subject to federal tax, but state and local taxes vary by state. Since SLMA does not deal in mortgages, it would not be used to fund a collateralized mortgage obligation (CMO). CMOs contain mortgage-backed securities issued by GNMA, FNMA, and FHLMC.

If interest rates decline, the risk for an investor in a mortgage-backed security is: A) That payment of principal will decrease and reinvested funds will earn more B) That payment of principal will decrease and reinvested funds will earn less C) That payment of principal will increase and reinvested funds will earn less D) That payment of principal will increase and reinvested funds will earn more

C) That payment of principal will increase and reinvested funds will earn less When interest rates decline, a mortgage-backed security (MBS) will return principal to investors at an accelerated pace as the owners of the mortgages seek to refinance or accelerate the payment of their mortgages (prepayment risk). Investors who own MBS securities will receive additional principal, and if these funds are reinvested, will receive a lower market rate of interest.

All of the following choices are part of the Federal Farm Credit System, EXCEPT: A) Banks for Cooperatives B) Federal Intermediate Credit Banks C) Federal Land Banks D) Federal National Mortgage Association

D) Federal National Mortgage Association The Federal Farm Credit System is composed of the Banks for Cooperatives, Federal Intermediate Credit Banks, and Federal Land Banks.

Which of the following securities is NOT backed by the credit of the U.S. government? A) Treasury bills B) Treasury STRIPS C) Government National Mortgage Association (GNMA) bonds D) Federal National Mortgage Association (FNMA) bonds

D) Federal National Mortgage Association (FNMA) bonds Federal National Mortgage Association (FNMA) bonds are issued by a privately owned organization and are not backed by the U.S. government. All of the other choices are directly backed by the U.S. government.

Which of the following securities is NOT guaranteed by the U.S. government? A) Treasury notes B) Treasury bills C) Government National Mortgage Association (Ginnie Mae) certificates D) Federal National Mortgage Association (Fannie Mae) bonds

D) Federal National Mortgage Association (Fannie Mae) bonds Of the choices given, the only obligations that are not guaranteed by the U.S. government are FNMA (Fannie Mae) bonds. FNMA was created as a government-chartered private corporation. It borrows funds and uses the proceeds to purchase conventional residential mortgages. Although FNMA can borrow funds from the U.S. government, the securities it issues are not directly backed by the U.S. government.

Private label mortgage-backed securities are issued by which of the following entities? A) The Federal National Mortgage Association B) Real estate investment trusts C) The Government National Mortgage Association D) Financial institutions

D) Financial institutions Mortgage-backed securities (MBS) may be issued by a U.S. government agency, such as the Government National Mortgage Association (GNMA or Ginne Mae), or a government-sponsored enterprise (GSE), such as the Federal National Mortgage Association (FNMA or Fannie Mae) or the Federal Home Loan Mortgage Association (FHLMC or Freddie Mac). The securities issued by these three entities are commonly referred to as agency securities and receive high ratings (e.g., AAA). A collateralized mortgage obligation (CMO) is an example of this form of MBS. Mortgage-backed securities are also issued by financial institutions such as commercial banks, investment banks, and home builders. These securities are referred to as private label MBS and may contain some agency securities, however, they typically contain other types of mortgage loans that are not agency securities. A private label MBS is not an obligation of the U.S. government or any GSE and its credit rating is assigned by an independent credit agency. A private label MBS has a higher degree of credit risk and is generally not given a AAA rating.

You are the portfolio manager for Home Fund, Inc., a mortgage-backed securities mutual fund. Which type of risk concerns you in a falling interest rate environment? A) Credit risk B) Political risk C) Homeowner risk D) Prepayment risk

D) Prepayment risk Like most debt instruments, mortgage-backed securities (MBSs) are subject to interest-rate risk, the risk that the security's value will fall as interest rates rise. However, MBSs are also subject to risk when interest rates fall. Falling rates cause an increase in prepayments on the underlying mortgages, and this money must be reinvested in new, lower-coupon securities. This is known as prepayment risk. Mortgage-backed securities, and the funds that invest in them, tend to perform best when interest rates are stable.

Which of the following securities have the highest degree of credit risk? A) Ginnie Mae MBS B) Freddie Mac MBS C) Treasury Inflation-Protected Securities D) Private Label MBS

D) Private Label MBS Mortgage-backed securities (MBS) may be issued by a U.S. government agency, such as the Government National Mortgage Association (GNMA or Ginne Mae), or a government-sponsored enterprise (GSE), such as the Federal National Mortgage Association (FNMA or Fannie Mae) or the Federal Home Loan Mortgage Association (FHLMC or Freddie Mac). The securities issued by these three entities are commonly referred to as agency securities and receive high ratings (e.g., AAA). A collateralized mortgage obligation (CMO) is an example of this form of MBS. Mortgage-backed securities are also issued by financial institutions such as commercial banks, investment banks, and home builders. These securities are referred to as private label MBS and may contain some agency securities, however, they typically contain other types of mortgage loans that are not agency securities. A private label MBS is not an obligation of the U.S. government or any GSE and its credit rating is assigned by an independent credit agency. A private label MBS has a higher degree of credit risk and is generally not given a AAA rating.

Interest on U.S. government bonds is: A) Subject to federal and state income tax B) Exempt from federal and state income tax C) Subject to state income tax but exempt from federal income tax D) Subject to federal income tax but exempt from state income tax

D) Subject to federal income tax but exempt from state income tax Interest on U.S. government bonds is subject to federal income tax but exempt from state income tax. This is just the opposite of the tax treatment on municipal (state) bonds where the interest is exempt from federal but subject to state tax. This is based on the doctrine of powers between the federal government and state governments. Each government can tax the interest on its own obligations, but cannot tax the other's. In addition, states usually do not tax the interest received from their obligations owned by residents of that particular state and, in effect, interest is completely tax-free.

Interest on U.S. Treasury securities is: A) Subject to federal and state income tax B) Exempt from federal and state income tax C) Subject to state income tax, but exempt from federal income tax D) Subject to federal income tax, but exempt from state income tax

D) Subject to federal income tax, but exempt from state income tax Interest on U.S. Treasury securities is subject to federal income tax, but exempt from state income tax. This is the opposite of the tax treatment on municipal (state) bond interest, which may be subject to state tax, but is exempt from federal tax.

Interest on Federal Farm Credit system and FHLB securities is subject to which taxes?

Federal only, and exempt from state and local

If interest rates increase, CMOs are subject to.....

extension risk.

Which of the following statements is NOT TRUE concerning the Student Loan Marketing Association (Sallie Mae)? A) It issues securities that can be redeemed to pay for college education B) It issues securities that are not backed by the U.S. government C) It purchases federally sponsored student loans D) It provides loans to educational institutions

A) It issues securities that can be redeemed to pay for college education The Student Loan Marketing Association (known as SLMA or Sallie Mae) provides liquidity to student loan makers by purchasing federally sponsored student loans. It also lends funds directly to educational institutions. Sallie Mae securities are not backed by the full faith and credit of the U.S. government, but the SLMA maintains a direct line of credit with the U.S. government. It does not issue securities that can be redeemed to pay for college education.

What system is used for the issuance of Treasury securities?

An auction

What does ownership of a GNMA pass-through certificate represent?

An undivided interest in a pool of residential mortgages

What are T-STRIPS?

Any T-Note/T-Bond where a BD has stripped the interest and principal payments to sell separately as zero-coupons

Can compare CMOs to any other security?

Any type of retail communication or correspondence may not compare CMOs to any other security, especially bank CDs.

Which of the following characteristics is NOT an advantage of CMOs? A) Various bond classes B) Tax-free interest C) Highly rated D) $1,000 denominations

B) Tax-free interest The interest payments from a CMO are fully taxable. All of the other items are considered advantages of CMOs.

Corporate and municipal bonds are quoted in 8ths, while T-Notes and T-Bonds are quoted in ______.

Corporate and municipal bonds are quoted in 8ths, while T-Notes and T-Bonds are quoted in 32nds.

A customer purchased a government security, and later discovered that it was nonnegotiable. This security could have been: A) A Treasury bill B) Commercial paper C) A GNMA pass-through D) An EE savings bond

D) An EE savings bond U.S. savings bonds, which include EE, HH, and I bonds, are nonnegotiable. This means purchasers may not resell them to other investors in the secondary market. They can only be redeemed.

Which of the following securities is exempt from state taxes? A) Corporate stock B) Convertible bonds C) Federal National Mortgage Association (FNMA) bonds D) Treasury notes

D) Treasury notes All of the choices listed are subject to state taxes except Treasury notes, which are U.S. government obligations and are subject to federal taxes, but exempt from state taxes.

How is interest on Treasuries treated for tax purposes?

Exempt at the state and local level, but subject to federal tax

True or False: The settlement date for T-Bills purchased at the auction is the next business day.

False. Settlement at auction is the Thursday following the auction. Next business day is for secondary market trading.

True or False: T-Bills are quoted on a dollar basis.

False. T-Bills are quoted on a discount yield basis.

______ is the mortgage-backed agency that is fully backed by the U.S. Government.

GNMA is the mortgage-backed agency that is fully backed by the U.S. Government.

The CMO tranche with the lowest amount of prepayment risk is the

Planned Amortization Class (PAC).

What risk is primarily associated with mortgage-backed securities?

Prepayment risk

Which security has no connection to CMOs - GNMA, FNMA, FHLMC or SLMA?

Student Loan Marketing Association (SLMA) - GNMA, FNMA, and FHLMC are associated.

The following would be a quote for what security? Bid 4.26 Asked 4.22

T-Bill

T-Bills are issued in maturities of: ____ week, ____ week, ____ week, and ____ week

T-Bills are issued in maturities of: 4 week, 13 week, 26 week, and 52 week

Which tranche has the most predictable cash flow and maturity?

The PAC (Planned Amortization Class) tranche

Since T-STRIPS are sold at a discount and mature at par, what must be done to their basis each year?

The discount must be accreted each year

What price do non-competitive bidders agree to pay at a Treasury auction?

The lowest price (highest yield) of the accepted competitive bids

The minimum face value of a T-Bill, T-Note or T-Bond is $______.

The minimum face value of a T-Bill, T-Note or T-Bond is $100.

The principal value of TIPS may be adjusted based on changes to the __________________________.

The principal value of TIPS may be adjusted based on changes to the Consumer Price Index (CPI).

Which tranche has the most unpredictable cash flow and maturity?

The support or companion tranche

The tranche that is the last to receive cash flow is the ____________.

The tranche that is the last to receive cash flow is the Z tranche.

Though subject to federal tax, interest on Treasuries is exempt from ________ and ________ tax.

Though subject to federal tax, interest on Treasuries is exempt from state and local tax.

What are TIPS?

Treasury Inflation-Protected Securities

True or False: The interest rate on TIPS is fixed, but the principal may be adjusted.

True

True or False: Interest paid on GNMA, FNMA, FHLMC, and SLMA agency bonds is fully taxable to investors.

True. The interest is taxed at the federal, state, and local level.

With CMOs, the term ____________ represents separate bond classes.

With CMOs, the term tranche represents separate bond classes.

Is a CMO considered a derivative?

Yes

Treasury Inflation Protected Securities (TIPS) were designed to keep pace with inflation, but are subject to what kind of risk?

interest rate risk.

If interest rates decline, CMOs are subject to...

prepayment risk.

Interest received on mortgage-backed securities (GNMA, FNMA, and FHLMC) is subject to what taxes?

subject to federal, state, and local taxes; however, a portion of their monthly income is a return of capital and not subject to tax.

government sponsored CMOs are guaranteed by _____________ and have less credit risk

the GSE or U.S. government

Private label CMOs are subject to the credit risk of ___________

their issuers