Types of Characteristic of Fixed Income unit 13
All of the following are true of government agency bonds EXCEPT A) they are direct obligations of the U.S. government B) older ones have coupons attached, new ones are book entry C) they trade openly D) they are considered relatively safe investments
A) they are direct obligations of the U.S. government The only government agency that is a direct obligation of the U.S. government is the Ginnie Mae security. All of the others are moral obligations
The current yield on a bond with a coupon rate of 5.5% selling at 110 is A) 5% B) 5.5% C) 2% D) 6%
A) 5% The current yield of any security, equity, or debt is always the income return (dividend or interest) divided by the current market price. In this case, it is the annual interest of $55 ($1,000 x 5.5%) divided by $1,100 and that equals 5%.
One of your clients owns 2 different 6% corporate bonds maturing in 15 years. The first bond is callable in 5 years, while the second has 10 years of call protection. If interest rates begin to fall, which bond is likely to show a greater change in price? A) Bond with the 10-year call B) Both will increase by the same amount C) Both will decrease by the same amount D) Bond with the 5-year call
A) Bond with the 10-year call As interest rates fall, the investor benefits from having the highest interest rate for as long as possible. The price change will not be the same for both bonds. The greater the call protection, the more likely a bond will appreciate if rates fall. That additional call protection in essence lengthens the duration of the bond and, as we know, the longer the duration, the greater sensitivity to interest rate changes. In this case, with declining rates, bond prices will rise
Bright-Lite Incandescent Bulb, Inc., has recently suffered significant operating losses and is planning a bankruptcy filing. Which of the following debt issues have the most junior claim? A) Debentures B) Mortgage bonds C) Common stock D) Senior notes
A) 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
The price of which of the following will fluctuate most with fluctuating interest rates? A) Long-term bonds B) Money market instruments C) Common stock D) Short-term bonds
A) Long-term bonds Because of its longer duration, long-term debt prices will fluctuate more than short-term debt prices as interest rates rise and fall. When buying a debt instrument, one is really buying the interest payments and final principal payment. Money has a time value: the longer it takes to receive the money, the less it is worth today.
A money market mutual fund would be least likely to invest in which of the following assets? A) Newly issued U.S. Treasury notes B) Repurchase agreements C) Jumbo CDs D) Newly issued U.S. Treasury bills
A) Newly issued U.S. Treasury notes A money market mutual fund typically invests in money market instruments, those with a maturity date not exceeding 397 days. Treasury notes are issued with maturity dates of 2-10 years.
Which of the following should be considered a liquid asset for emergency fund purposes? A) Savings account B) Life insurance cash values C) A personal residence D) Stock mutual funds
A) 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. 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.
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 bond would be selling at par value. B) The bond would be selling at a premium. C) The yield to maturity of this bond is above 4%. D) The bond would be selling at a discount
A) Savings account 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.
Which of the following is CORRECT regarding zero-coupon bonds? A) They eliminate reinvestment rate risk. B) They have low interest rate risk. C) They sell at a premium. D) They offer minimum price volatility.
A) 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 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
One would look at the average maturities when doing a cash flow analysis for A) mortgage-backed pass-through securities B) Brady bonds C) subordinated debentures D) revenue bonds
A) mortgage-backed pass-through securities Mortgage-backed pass-through securities pass through interest and principal payments to their investors. The rate at which the cash flows are generated depends, among other things, on the rate at which the mortgages mature.
One of the reasons why the discounted cash flow method of valuation is useful in assessing the value of fixed income instruments is A) the predictability of income B) the availability of ratings C) the known maturity date D) the priority of claim on earnings
A) the predictability of income Discounted cash flow evaluates the expected cash flow from an investment and then factors in the time value of money. Obviously, if there is no predictable cash flow (as there is with the interest payments on a bond), there are no reliable numbers to plug into the formula.
Which of the following is unlikely to be issued at a discount? A) Zero-coupon B) bond Jumbo CD C) Commercial paper D) Treasury bill
B) bond 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.
A TIPS bond is issued in the principal amount of $1,000, paying 3.5%. Over the security's 5-year term, the inflation rate is 4%. What is the amount of the final semiannual interest check? A) $42.66 B) $21.33 C) $35.00 D) $17.50
B) $21.33 The semiannual interest of a TIPS bond is computed on the basis of the inflation-adjusted principal. Because the principal increases with the inflation rate, at the end of the 5-year term, it has grown to $1,219 ($1,000 × 102% ten times). Therefore, the final interest check is for $1,219 × 1.75% (remember that it is a semiannual check). The License Exam Manual (LEM) contains a step by step example of how this computation works.
A bond purchased at $900 with a 5% coupon and a 5-year maturity has a current yield of A) 7.40% B) 5.56% C) 7.80% D) 5.00%
B) 5.56% Current yield is determined by dividing the annual interest payment by the current market price of the bond ($50 / $900 = 5.56%). Years to maturity is not a factor in calculating current yield.
When investing in a foreign bond fund, a customer will profit if I. the U.S. dollar strengthens II. the U.S. dollar weakens III. foreign currencies strengthen IV. foreign currencies weaken A) I and IV B) II and III C) II and IV D) I and III
B) II and III Because the fund is purchasing bonds denominated in foreign currencies, a weakening of the U.S. dollar or strengthening of foreign currencies will be beneficial.
When an investor notices that a bond's coupon yield is lower than its current yield, that is an indication that the bond A) is probably rated investment grade B) is selling at a discount C) is in danger of going into default D) is selling at a premium
B) is selling at a discount The coupon yield, or nominal yield, is the rate stated on the face of the bond. It never changes. However, because the current yield is computed by dividing the coupon rate by the current market price, this return will constantly be in flux. Anytime the price of the bond is below par (selling at a discount), its current yield will be higher than the coupon
Ginnie Mae pass-throughs will pay back both principal and interest A) semiannually B) monthly C) annually D) quarterly
B) monthly Ginnie Mae (GNMA) securities are called pass-through certificates because the monthly home mortgage payments, which consist of both principal and interest, pass through to the GNMA investor monthly.
When doing cash flow analysis on a mortgage-backed pass-through security, you would want to know A) whether there is a real estate "bubble" B) the average maturities C) size of the tranche being analyzed D) the quality of the mortgages
B) the average maturities Mortgage-backed pass-through securities pass through interest and principal payments to their investors. The rate at which the cash flows are generated depends, among other things, on the rate at which the mortgages mature.
In order to perform a discounted cash flow estimation of the value of a bond, it would be necessary to know all of the following EXCEPT A) the future cash flow B) the parity price of the bond C) the number of interest payments D) the discount rate
B) the parity price of the bond In its simplest iteration, discounted cash flow is nothing more than taking all the money you are scheduled to receive over a given future period and adjusting that for the time value of money (the discount rate). Parity price is only relevant to convertible bonds.
Which of the following municipal bonds would be most subject to interest rate risk? A) 7.8s '35 on a 7.4% basis B) 7.5s '29 on a 7.2% basis C) 8s '40 on a 7.8% basis D) 7s '28 on a 7½% basis
C) 8s '40 on a 7.8% basis The longer the duration of a bond, the greater the interest rate risk. The 8s '40 on a 7.8% basis, (YTM), is a bond with a 2040 maturity, which is the longest maturity (without a substantially higher coupon) of the choices available. Remember, duration is a function of coupon and length to maturity. If the coupons are relatively close, the longest maturity is the one with the longest duration (and greatest sensitivity to changes in interest rates). There is a giveaway to this answer if you look carefully. The greater the risk, the greater the reward and the 8s '40 have the highest yield, indicating that investors are demanding a higher return for the greater risk.
An investor has created a laddered bond portfolio by placing $100,000 into zero-coupon bonds with maturities of 1, 5, 10, and 20 years. The average duration of this portfolio is approximately A) 7.5 years. B) 22.9 years. C) 9 years. D) 11.39 years.
C) 9 years. Because there is an equal face amount of each maturity, the average duration of the portfolio is the average of the duration of the 4 bonds. Because these are zero-coupon bonds, their duration is their maturity. The math is 1 + 5 + 10 + 20 = 36 divided by 4 or 9 years.
An investor is considering the purchase of $100,000 maturity value of zero-coupon AAA-rated corporate bonds scheduled to mature in 20 years. Among the risks that this investor will be assuming are I. default risk II. interest rate risk III. prepayment risk IV. reinvestment risk A) III and IV B) I and IV C) I and II D) II and III
C) I and II Even though these bonds are rated AAA, 20 years is a long time and it is possible that this corporation may not even exist when the maturity date arrives. Adding to the risk is the fact that there are no interest payments in the interim. That is why the most commonly recommended zero-coupon bonds are those issued or guaranteed by the U.S. Treasury. Because zero-coupon bonds have the longest duration for their maturity of any bonds, they have the greatest exposure to interest rate changes. Prepayment risk is only found with mortgage-backed securities, and one of the benefits of zeroes is that there is no reinvestment risk.
Which of the following would make a corporate bond more subject to liquidity risk? I. Short-term maturity II. Long-term maturity III. High credit rating IV. Low credit rating A) I and III B) II and III C) II and IV D) I and IV
C) II and IV Liquidity risk is the risk that when an investor wishes to dispose of an investment, no one will be willing to buy it, or that a very large purchase or sale would not be possible at the current price. The available pool of purchasers for bonds with a low credit rating is much smaller than for those with investment-grade ratings (many institutions are only able to purchase bonds with higher credit ratings). As a result, the lower the credit rating, the greater chance of the bond having liquidity issues. Similarly, bonds with short-term maturities attract many more investors than those with long-term maturities, causing the long-term bonds to be less liquid.
Which of the following is a characteristic of an investment-grade general obligation municipal bond? A) The bond's periodic interest is paid to investors only when sufficient revenue is collected by the municipality. B) The bond's main source of investment risk is financial risk. C) The taxing authority of the issuing government or municipality backs the issue's repayment. D) The bond retains a direct claim on specific property
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.
Which of the following investments gives the investor the least exposure to reinvestment risk? A) Treasury notes B) Preferred stock in a growth company C) Treasury STRIPS/zero-coupon bonds D) Common stock in an electric utility
C) Treasury STRIPS/zero-coupon bonds Treasury STRIPS (Separate Trading of Registered Interest and Principal of Securities) are zero-coupon bonds paying no interest. Thus, there is no income to reinvest during the holding period and therefore no reinvestment risk.
An investor purchases a 30-year zero-coupon corporate bond. The bond was issued by a Fortune 500 company. Her investment is subject to all of the following risks except A) default risk. B) purchasing power risk. C) reinvestment risk. D) interest rate risk.
C) reinvestment risk Zero-coupon bonds are not subject to reinvestment risk because there is nothing to reinvest. However, they are subject to purchasing power, interest rate, and default risk.
A corporation issued a bond with a coupon of 6%, callable at 103. The bond matures in 2059. Current interest rates are 8%. It is most likely that A) the bond will go into default. B) the bond will be called. C) the bond is selling at a discount. D) the coupon will be increased
C) the bond is selling at a discount. There is excess information in this question (a favorite trick of the test authors). We don't need to know the call price or the maturity date. Simple, we have a 6% bond when current market interest rates are 8%. The inverse relationship between interest rates and bond prices teaches us that this bond is going to be selling at a discount. Bonds are called when interest rates go down, not rise. The coupon on a bond is fixed.
Annual interest payment divided by current dollar price of a bond is A) the tax-equivalent yield B) the yield to maturity C) the current yield D) the nominal yield
C) the current yield The current yield is the annual interest (in dollars) divided by the bond's market price (in dollars). A bond's nominal yield is the coupon yield, or stated interest rate. Yield to maturity takes into account the bond's price, as well as its interest rate.
Which of the following indicates a bond selling at a discount? A) 5% coupon yielding 5% B) 10% coupon yielding 9% C) 7% coupon yielding 6.5% D) 7% coupon yielding 7.5%
D) 7% coupon yielding 7.5% Whenever the yield is higher than the coupon, the bond is selling at a discount from the par value.
The minimum face amount of a negotiable CD is: A) $50,000.00 B) $10,000.00 C) $25,000.00 D) $100,000.00
D) $100,000.00 Negotiable CDs are issued in the minimum face amount of $100,000. These are called jumbo CDs and are traded in blocks of $1 million.
A corporate bond that pays interest semiannually has a par value of $1,000, matures in 5 years, and has a yield to maturity of 10%. What is the value of the bond today if the coupon rate is 8%? A) $1,144.31 B) $1,221.17 C) $1,051.23 D) $922.78
D) $922.78 How did we calculate that? We used tool that you won't have available at the test center (a financial calculator), but there is a great tool you will have - common sense. When a bond has a yield to maturity that is greater than its coupon rate, the bond must be selling at a discount and that only leaves one possible answer. The only way to get a 10% return on an 8% bond is to buy it at a price below par.
BFJ Corp's 5% convertible bond is trading at 120. The bond is convertible at $50. An investor buying the bond now and immediately converting into common stock, would receive A) 24 shares B) 2.4 shares C) 20 shares plus cash for fractional shares D) 20 shares
D) 20 shares The conversion ratio always uses the par value ($1,000), never the current market price. With a par value of $1,000 and a conversion price of $50 per share, this bond is convertible into 20 shares ($1,000 / $50). Remember, the number of shares in a conversion never changes. When the market price changes, the parity price changes, but that isn't relevant to this question.
A client is trying to decide between a par value corporate bond carrying a coupon rate of 6.25% per year and a par value municipal bond that pays an annual coupon rate of 4.75%. Assuming all other factors are equal and your client is in a 28% marginal income tax bracket, which bond do you tell the client to purchase and why? A) The corporate bond because the after-tax yield is 6.25% B) The municipal bond because its equivalent taxable yield is 6.3% C) The corporate bond because the after-tax yield is 4.5% D) The municipal bond because its equivalent taxable yield is 6.6%
D) The municipal bond because its equivalent taxable yield is 6.6% If we compute the tax-equivalent yield of the muni, we see that it is 6.6%, which is a higher return than the 6.25% on the corporate bond. The formula to get this starts by taking the investor's tax bracket and subtracting that from 100%. 100% − 28% = 72%. We then divide the muni coupon of 4.75% by the 72% and the result rounds off to 6.6%.
An investor in the 28% income tax bracket is considering purchasing either an 8% municipal bond or a 10% corporate bond. Which of the following regarding the bonds is TRUE? A) The yields of the bonds are equivalent on an after-tax basis. B) The yield difference cannot be determined. C) The corporate bond yield is higher than the municipal yield after taxes. D) The municipal yield is higher than the corporate yield on an after-tax basis.
D) The municipal yield is higher than the corporate yield on an after-tax basis. Investors are interested in their return after taxes (what they get to keep). The 2 bonds must be compared on a tax- equivalent basis. For example, the tax-equivalent yield of a municipal bond equals tax-free yield divided by 100% minus tax rate. The tax-equivalent rate in this case is 0.08 ÷ 0.72 (100% − 28%) = 11.11%. In other words, a client in the 28% tax bracket would have to invest in a taxable bond that yields 11.11% to get the same after-tax return that the 8% tax- free bond offers.
A bond offered at par has a coupon rate A) greater than its yield to maturity B) less than its yield to maturity C) less than its current yield D) equal to its current yield
D) 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.
All of the following are true of negotiable, jumbo certificates of deposit EXCEPT A) they are readily marketable B) they usually have maturities of 1 year or less C) they are usually issued in denominations of $100,000 to $1 D) million they are secured obligations of the issuing bank
D) million they are secured obligations of the issuing bank Negotiable CDs are general obligations of the issuing bank; they are not secured by any specific asset. They do qualify for FDIC insurance (up to $250,000), but that is not the same as stating that the bank has pledged specific assets as collateral for the loan.
If a group of money managers were having a discussion and the term LIBOR was mentioned, the topic would most likely be: A) current economic conditions in Liberia B) contract negotiations with the employee's union C) long-term borrowing rates D) short-term borrowing rates
D) short-term borrowing rates The British Banker's Association LIBOR is the most widely used benchmark or reference rate for short-term interest rates worldwide. The acronym stands for London Interbank Offered Rate.
The portfolio manager of the Insatiate Bond Fund, an open-end investment company, believes that interest rates are going to increase in the near future. As such, it would be wise for that manager to A) increase the equity portion of the portfolio. B) shift into higher-rated bonds. C) lengthen the average duration of the portfolio. D) shorten the average duration of the portfolio
D) shorten the average duration of the portfolio Increasing interest rates lead to declining bond prices, regardless of the ratings. This is interest-rate risk. Those bonds with the longest duration have the most sensitivity to that risk while short-term maturities are only slightly affected. Reducing the average duration of the portfolio means that the average maturities will be shortened, thus reducing the effects of an increase to interest rates.
A popular tool used by analysts is discounted cash flow (DCF). Most use this tool to evaluate A) the future value of future cash flows to determine the value at a specified date in the future. B) the future value of present cash flows to determine an appropriate current value. C) the present value of future cash flows to determine the value at a specified date in the future. D) the present value of future cash flows to determine an appropriate current value.
D) the present value of future cash flows to determine an appropriate current value. The principle behind a DCF computation is that an investment made currently is worth an amount equal to the sum of all the future cash flows expected to be received. These future cash flows are discounted to arrive at a fair value.
An investor interested in acquiring a convertible bond as part of his investment portfolio would A) want the assurance of a guaranteed dividend on the underlying common stock B) be interested in tax advantages available to convertible debt securities C) seek to minimize changes in the bond price during periods of steady interest rates 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 An investor who wants the safety of a fixed-income investment with the potential for capital gains would be most interested in purchasing a convertible bond. However, because convertible bonds 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.