QBank 2
A transaction whereby an investor sells a bond for a loss, in order to reduce capital gains, while investing the proceeds of the sale in a bond of similar quality and maturity is considered A) an intermarket spread swap. B) a pure yield pickup swap. C) a substitution swap. D) a tax swap.
D) The answer is a tax swap. A tax swap results in a tax savings generated by the realized loss.
Identify the statement that best describes Treasury STRIPS (Separate Trading of Registered Interest and Principal of Securities). A) Zero-coupon bonds created by separating the semiannual coupon payments and the principal repayment portions of a U.S. Treasury note or bond B) A trust receipt issued by a U.S. government agency for shares of a domestic company purchased and held by a credit union C) A short-term draft drawn by a government agency on a major bank D) A negotiable, short-term, unsecured promissory note issued by a regional government agency
A) The answer is zero-coupon bonds created by separating the semiannual coupon payments and the principal repayment portions of a U.S. Treasury note and bond. Although the securities underlying Treasury STRIPS are the U.S. government's direct obligation, major banks and dealers perform the actual separation and trading.
Which one of these is CORRECT regarding preferred stock? A) Preferred stockholders have voting rights. B) Preferred stock's value is based on prevailing interest rates. C) Preferred stock's dividends are tax deductible for corporations. D) Failure to pay preferred stock dividends results in bankruptcy.
B) The answer is preferred stock's value is based on prevailing interest rates. The value for a preferred stock is its dividend divided by prevailing interest rates.
Revenue bonds are used to finance any municipal facility that generates sufficient income to satisfy the ongoing debt obligation. Which of these is NOT a type of revenue bond? A) Industrial development revenue bond B) Special tax bonds C) Housing debentures D) Special assessment bonds
C) The answer is housing debentures. New housing authority (or Section 8) bonds are an example of a revenue bond.
A convertible bond has a 6.5% coupon rate, interest is paid semiannually, and the bond matures in five years. Comparable debt currently yields 7.5%. The bond is convertible into common stock at $25 per share. The current price of the stock is $28, and the current price of the convertible bond is $1,050. What is the investment value of the bond? A) $958.94 B) $1,008.90 C) $1,000.00 D) $968.95
A) A bond's investment value is the same as its intrinsic value as a straight bond. Using a financial calculator, the bond price is determined using the following inputs: N = 10 (5 x 2 periods per year) I/YR = 7.5% PMT = 1000 x 6.5% / 2 = $32.5 FV = $1,000 Solve for PV = -958.94, or $958.94. NOTE: There are several examples on bond calculations in the blue boxes in the Module 2 text; however, it may be beneficial to skip ahead to Module 7 for some additional practice.
Martha owns a convertible bond that has a current market value of $1,200. The bond's conversion ratio is 22 shares, and its conversion value is $1,100. The bond has a coupon of 8%, payable semiannually, and matures in 16 years. With market interest rates currently at 7.5%, the bond's investment value is $1,050. Martha wants to sell the convertible bond if, assuming the stock falls in price, her risk of loss exceeds 10%. Which one of these statements about this convertible bond is CORRECT? A) The downside risk exceeds 10%, and the bond should be sold. B) The downside risk is between 5% and 10%, and the bond should be retained. C) Downside risk is not a factor when the conversion price exceeds the investment value of the bond. D) Downside risk cannot be calculated because the price of the stock is not given.
A) The answer is the downside risk exceeds 10%, and the bond should be sold. The downside risk of the bond is $170 ($1,200 current market value - $1,050 investment value). This translates into 14.17% ($170 downside risk ÷ $1,200 current market value). Therefore, the bond should be sold.
Which of these is a feature of zero-coupon bonds? A) Eliminate reinvestment rate risk B) Have a duration less than their term to maturity C) Offer minimum price volatility D) Have low interest rate risk
A) Zero-coupon bonds are sold at a deep discount from par value and have no coupon payments. They are redeemed for their face value at maturity. These bonds have maximum price volatility and respond sharply to interest rate changes. Zero-coupon bonds have durations equal to their term to maturity.
Which of the following describes downside risk with respect to convertible bonds? A) The difference between the current market value of the bond and its conversion value. B) The difference between the current market value of the bond and its investment value. C) The difference between the straight value of the bond and its conversion value. D) The difference between the conversion value of the bond and its investment value.
B) Downside risk with respect to convertible bonds is the difference between the current market value of the bond and its investment value.
Which of the following risks relating to fixed-income investments have an offsetting effect on one another? A) Interest rate risk and default risk B) Interest rate risk and reinvestment rate risk C) Interest rate risk and call risk D) Interest rate risk and purchasing power risk
B) Interest rate risk and reinvestment rate risk have offsetting effects, and the offsetting of these two risks in a bond portfolio takes place through immunization (the matching of the durations of bonds to the durations of liabilities).
Jennifer owns a state public purpose bond. She sells the bond and realizes a capital gain of $4,000. Prior to selling the bond, the total interest she had earned for the year was $99. Considering the sale and the interest amount, calculate the amount she must include in gross income. A) $4,099 B) $4,000 C) $3,901 D) $99
B) The interest on public purpose bonds is received tax-free by the holder. Only the capital gain realized on the sale is subject to income taxation.
Cindy, 38, has been an active investor for many years. She currently has a money market mutual fund and has a number of equity mutual fund shares. She wants to maximize her return on an intermediate-term bond and plans to hold the bond to maturity. Which of these two bonds would be more appropriate for Cindy and why? Bond 1: callable at par value; BBB rated; coupon = 6%; matures in six years; selling for $863; duration = 5.16 Bond 2: callable at par value; A rated; coupon = 10%; matures in four years; selling for $1,103; duration = 3.5 Bond 1, because it is selling for a discount and is less likely to be called. Bond 1, because it has a higher yield to maturity than Bond 2. Bond 2, because its higher coupon gives it a better total return. Bond 2, because it has a higher yield to maturity than Bond 1. A) III and IV B) I and II C) I only D) II only
B) YTM for Bond 1 is calculated with the following inputs: - $863 = PV $1,000 = FV $1000 x 6% = $60/2 = $30 = PMT N = 12 (6 x 2 periods per year) Solve for I/YR = 9% YTM Bond 2 is calculated with the following inputs: -$1,103 = PV $1,000 = FV $1000 x 10% = $100/2 = $50 = PMT N = 8 (4 x 2 periods per year) Solve for I/YR = 7% In addition, Bond 1 is selling at a discount—unlike Bond 2 selling at a premium—so it is not likely to be called. NOTE: there are several examples on bond calculations in the blue boxes in Module 2; however, it may be necessary to skip ahead to Module 7 for some additional practice.
To immunize a bond portfolio over a specific investment horizon, an investor would do which of the following? A) Match the maturity of each bond to the investment horizon. B) Match the duration of each bond to the investment horizon. C) Match the average weighted duration of the bond portfolio to the investment horizon. D) Match the average weighted maturity of the portfolio to the investment horizon.
C) The answer is match the average weighted duration of the bond portfolio to the investment horizon. When a portfolio is immunized, its liabilities and expected future cash outflows are funded by making sure that the cash flow from investments (income and principal) will be there at the time that the cash outflow is needed. That is done by matching the duration, not the maturity, of the bond portfolio to the number of years until the cash outflow will occur. The duration of the portfolio as a whole should be matched, not the duration of each bond in the portfolio.
Which of these statements regarding the bond ladder strategy is CORRECT? A) A laddered portfolio will provide lower yields than a portfolio consisting entirely of short-term bonds. B) The bond ladder strategy is generally more aggressive than the barbell strategy. C) The bond ladder strategy is used to immunize a portfolio against interest rate risk. D) The bond ladder strategy involves the purchase of a mixture of very long-term and very short-term bonds.
C) The answer is the bond ladder strategy is used to immunize a portfolio against interest rate risk. It is an investment strategy in which equal amounts of money are invested in a series of bonds with staggered maturities. The barbell strategy involves the purchase of a mixture of very long-term and very short-term bonds. The laddered portfolio will provide higher yields than a portfolio consisting entirely of short-term bonds. The barbell strategy is generally more aggressive than the ladder strategy because the barbell strategy only utilizes short-term and long-term bonds.
Bonds issued by state and local governments that are backed by the full faith and credit of the issuing government and repaid by the issuing municipality's taxing power are categorized as A) tax anticipation notes. B) revenue bonds. C) revenue anticipation bonds. D) general obligation bonds.
D) General obligation bonds (GOs) are the most secure of all municipal debt because they are backed by the full faith and credit of the issuer. Municipalities may increase taxes to make principal and interest payments on any debt issue; therefore, a voter referendum is usually required to approve their issuance.
Darla, a U.S. citizen and resident of Georgia, owns a 5% coupon corporate bond, a 4% coupon State of Georgia municipal bond, and a 3% coupon U.S. Treasury note. Darla's marginal state income tax rate is 6% and federal tax rate is 24%. If Darla invested equal amounts in each of the three bonds, what is her after-tax rate of return on the portfolio? A) 2.86% B) 4.91% C) 4.00% D) 3.26%
D) The answer is 3.26%. Because the corporate bond is taxable by the state and the federal government, its after-tax return is 3.5% [5% × (1 - 0.30)]. The State of Georgia municipal is not taxable by either government entity. The Treasury note is taxable by the federal government; therefore, its after-tax return is 2.28% [3% × (1 - 0.24)]. Averaging the three rates equals 3.26% [(3.5% + 4% + 2.28%) ÷ 3].
An investor wants all of her bonds to mature in 10 years. She buys two bonds immediately, two bonds two years from now, and two more bonds four years from now. As a result, the bonds purchased immediately have a maturity of 10 years, the bonds purchased two years later have a maturity of eight years, and the bonds purchased four years later have a maturity of six years. Select the type of bond strategy she is using for her portfolio. A) Bond ladder B) Bond swap C) Bond barbell D) Bond bullet
D) The answer is bond bullet. When using the bond bullet strategy, an investor purchases a series of bonds with similar maturities focused on one point in time. This strategy may be an effective method in matching duration to the cash needs of an investor.
The risk associated with volatility in the price of securities due to shifts in the yield curve is A) unsystematic risk B) financial risk C) liquidity risk D) interest rate risk
D) The answer is interest rate risk. When a yield curve shifts, that means that interest rates have changed. When interest rates change, bond prices change. If rates rise, bond prices fall; if rates fall, bond prices rise.
The yield curve theory that states current long-term interest rates contain an implicit prediction of future short-term interest rates is known as A) liquidity preference theory. B) market segmentation theory. C) preferred habitat theory. D) unbiased expectations theory.
D) The answer is unbiased expectations theory. The unbiased expectations theory states that long-term rates consist of many short-term rates and that long-term rates will be the average (or geometric mean) of short-term rates.
The conversion value of a convertible bond with a conversion ratio of 25, a conversion price of $40, and a market price of the underlying stock of $32 is A) $900. B) $1,000. C) $200. D) $800.
D) The conversion value is the value if converted and is determined by multiplying the market price of the underlying stock by the conversion ratio: $32 × 25 = $800
One advantage of convertible bonds is that they A) offer the ability to buy the underlying stock at a discount. B) are usually offered only by firms with high bond credit ratings. C) have higher coupon rates than straight coupon bonds. D) have a higher coupon rate than the underlying stock's dividend.
D) The coupon rate on the convertible bond is usually greater than the stock's dividend yield because the stock usually pays little, if any dividends. This enables the investor to get a higher periodic cash flow while waiting for the stock to appreciate.
