Unit 13
Knowing the average maturities would be most important when doing a cash flow analysis on
mortgage-backed 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.
A risk-averse investor, who had only invested funds in bank certificates of deposits, was informed by his investment adviser representative that higher returns with safety could be achieved by investing in U. S. Treasury notes with a 10-year maturity. The adviser representative assured his client that investment in federal government-backed securities is riskless. In this situation, the representative acted
unethically, because the agent failed to disclose that the customer retains interest rate risk Although Treasury securities do not carry default risk (principal and interest are guaranteed by the federal government), they are subject to interest rate risk. The prices of Treasury securities will decline if interest rates rise, subjecting the client to loss of principal should he sell them prior to maturity.
Which of the following are true of Ginnie Maes but NOT of other agency mortgage-backed securities?
Backed by the full faith and credit of the U.S. government Of the mortgage-backed government agency securities, only the Ginnie Maes are backed by the full faith and credit of the U.S. government. They are all collateralized by mortgages (the name, MBS gives that away) and, even the Ginnie Maes yield more than Treasury bonds. As an MBS, they all pass through the income and principal repayments to the investors.
Many fixed-income investors are looking to avoid loss of principal. Which of the following would likely have the lowest degree of exposure to credit risk?
Aa-rated corporate debenture A bond's rating takes into consideration all factors, including collateral and tax base. The higher the rating, the lower the credit risk.
A bank is advertising a no-cost DDA. Your client asks you to describe what that is. You would respond that DDA stands for
demand deposit account In the banking industry, the most common definition of DDA is demand deposit account, better known as a checking account.
Which of the following bonds is most likely to exhibit the greatest volatility due to interest rate changes? A bond with
low coupon and a long maturity. Other things equal, a bond with a low coupon and long maturity will have the longest duration and therefore greatest price volatility
The best time for an investor seeking returns to purchase long-term, fixed-interest-rate bonds is when
long-term interest rates are high and beginning to decline The best time to buy long-term bonds is when interest rates have peaked. In addition to providing a high initial return, as interest rates fall, the bonds will rise in value.
All of the following statements regarding bonds selling at a discount are correct EXCEPT
they are more likely to be called than comparable bonds selling at a premium Issuers tend to call bonds with higher coupons. Bonds trading at a premium have higher coupons than those trading at a discount (and are more likely to be called—wouldn't you pay off your high interest debt before the low interest debt?). The longer the duration, the more volatile the bond's price. Lower coupon rates mean a longer duration. If rates rise, prices fall. If a bond's rating falls, so does its price.
A U.S. dollar-denominated bond issued by a non-American company (or government), sold outside the United States and the issuer's country, but for which the principal and interest are stated and paid in U.S. dollars is best described as
a Eurodollar bond. This is the definition of a Eurodollar bond. Yes, it is also a Eurobond, but, because the question specifies U.S. dollars, the more accurate choice is Eurodollar bond. A Yankee bond is U.S. dollar-denominated, but is issued in the United States; Eurodollar bonds are not. Brady bonds are issued only by foreign governments, usually, but not always, U.S. dollar-denominated and are available for purchase in the U.S.
When comparing a time deposit account and a demand deposit account, you would expect
a higher rate of interest paid on the time deposit account The best example of a time deposit accounts is a CD. Money is deposited for a fixed length of time, generally at a fixed interest rate. Demand deposit accounts are checking accounts. Because the bank expects to have longer use of time deposit funds, interest rates are generally higher. DDAs offer the instant access of check-writing (or online payments). Typically CDs, have penalties for early withdrawal; there is no such charge on a checking account. Both are covered by FDIC up to the applicable limit.
The owner of a convertible debt issue
is a creditor of the issuer The owner of any bond is a creditor of the issuer. Dividends are only paid on stock and the investor will have to convert in order to be a stockholder. Because of the growth potential of the common stock, holders of convertible securities invariably accept a lower coupon rate. In almost all cases, convertible debt securities are debentures and, therefore, junior to secured bonds.
Five years ago, an investor purchased an ABC Corporation BBB-rated debenture with a coupon of 6% maturing in 2037. Currently, new BBB-rated debentures maturing in 2037 are being issued with coupons of 5%. Based on the discounted cash flow method, one could say that the present value of the investor's security is
more than the par value The discounted cash flow method is just a technical way of computing the value of a security that demonstrates the inverse relationship between interest rates and bond prices. The discount rate here is the current market rate of 5%. Because this investor's debenture is paying at a rate of 6%, its cash flow is more valuable than a 5% bond; therefore, it will sell at a premium (above par).
A TIPS bond is issued in the principal amount of $1,000, paying 3.5%. Over the security's 5-year term, the annual inflation rate is 6%. What is the principal value of the bond at the end of 4 years?
$1,267 The unique feature of a TIPS bonds is its semi-annual adjustment to principal based on the inflation rate. With an annual inflation rate of 6%, there is a 3% increase to the principal value every 6 months. The arithmetic is $1,000 multiplied by 103% consecutively 8 times (there are 8 semi-annual periods in 4 years). Be sure to stop at 4 years—the question doesn't ask for the ending value for the 5th year.
One popular method of determining the value of certain securities is discounted cash flow. Using the DCF with the current discount rate at 3%, which of the following would be expected to have the highest market value?
ABC Corporation debenture maturing in 25 years with a 5% coupon The current discount rate represents market interest rates. At 3%, each of these bonds should sell at a premium (their coupon rates are higher than 3%). When a bond is paying interest at a rate higher than the current market rate, the longer the investor will be receiving that higher rate, the higher the premium. Therefore, the 5% bond with 25 years to maturity will have the highest present value using the DCF.
A bond purchased at $900 with a 5% coupon and a 5-year maturity has a current yield of
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.
Several years ago, an investor purchased an investment-grade bond with a 6% coupon. Today that bond is priced to yield 4.6% to maturity in 5 years. If the bond is called at par in one year, the bond's yield would be
less than 4.6%. Let's take things in order. A bond with a 6% coupon is showing a YTM below 6%, the bond must be selling at a premium. When bonds selling at a premium are called in advance of the maturity date, the "loss" (the difference between the premium and the par value") is recognized sooner than expected. This results in a yield to call (YTC) that is less than the YTM.
Which of the following statements regarding convertible bonds is NOT true?
Coupon rates are usually higher than nonconvertible bond rates of the same issuer. Because convertible debentures offer investors the opportunity to gain from increases in the issuer's common stock, those investors are willing to accept a lower coupon (interest) rate than debt securities without the convertible feature. Debentures are debt securities making their holders creditors of the issuer. At the time the debenture is issued, the bond indenture indicates the conversion rate. That rate is fixed and does not change over the life of the security. In general, the conversion feature will be exercised only if the market price of the underlying stock has risen to the point where the investor is better off owning the stock than the debenture. One of the benefits of owning this security is that, as a debt instrument, if the stock price falls below the conversion price, the debenture will trade in the market like a comparable non-convertible issue. That is, it will trade at a market price offering a yield similar to non-convertible debt securities of the same quality and maturity.
Your client with $100,000 to invest is looking for maximum current income. Which of the following would offer the highest current return?
$100,000 market value of corporate bonds selling at a premium and yielding 6% to maturity When you read the full question, including the answer choices, you can immediately disregard two of the four options. With $100,000 to invest, the answer cannot be to purchase $200,000 of anything. Maximizing current income excludes zero-coupon bonds because there is no current income. Now, to the correct choice. Why does a bond sell at a premium over par? Although there are exceptions, primarily it is because the coupon rate on that bond is higher than the current market interest rate. Therefore, with a higher coupon rate, the current income on the same amount of principal invested ($100,000 in our question) will always be higher for a bond selling at a premium. That is the K.I.S.S (Keep It Simple Student) answer. For those who want to delve further, here we go. For example, if current market interest rates are 6% (likely the case here because the AA-rated bonds with a 6% coupon are trading at par), then a bond with a 7% coupon will be selling at a premium. The current yield on $100,000 of the 6% bonds would be $6,000 per year. If a bond's yield to maturity is 6% and it is selling at a premium, it must be that the coupon is higher than 6%. For example (and we're doing the math that you won't have to do), $93,000 par (93 times $1,000) value of bonds with a 7% coupon, selling at $100,000 (a premium over the $93,000), maturing in 10 years has a YTM of 6.0%. Investing $100,000 into these bonds will result in current income of $6,510 per year ($93,000 par times the 7% coupon).
You are meeting with a relatively unsophisticated investor who doesn't understand very much about stocks and bonds. When asked, "can you list the advantages of owning common stock as compared to bonds?" among other reasons, you could reply
bonds must be surrendered at maturity or at a call while the owner of common stock can hold the investment as long as desired One negative of owning bonds is that the bond will ultimately mature or be called and the bondholder has no choice but to surrender the security. With common stock, the investor has total control over the length of the holding period. Although there are many positive benefits to owning bonds compared to common stock, among them is priority in the event of liquidation and regular payment of interest. Yes, common stock has limited liability, but the same is true of the bondholder—if the company goes under, the bondholder's maximum loss is the investment. Even then, because of its seniority, it is less likely that the entire investment will be lost.
Mr. Beale buys 10M 6.6s of 10 at 67. What will his annual interest be?
$660.00 Interpret "10M" as "$10,000 worth of." Beale receives the nominal yield of the bonds, which is 6.6% of $10,000. The M is from the roman numeral for 1,000.
Which of the following would be most likely to increase a bond's liquidity?
A higher rating 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. The absence of call protection is negative to many investors thus limiting the number of potential investors.
Which of the following bonds would most likely be exposed to the greatest amount of interest rate risk?
ABC 5s of 2040 The bond with the longest duration is generally going to have the greatest exposure to interest rate risk. Because there is very little difference between maturity dates of 2040 through 2042, the bond with the lowest coupon will have the longest duration. The 4s of 2020 have a relatively short duration, even though their coupon is low.
Which of the following projects is most likely to be financed by a general obligation rather than a revenue bond?
Public library Hospitals, airports, and golf courses all generate revenue and can be financed with revenue bond issues. Public libraries are financed through GO bond sales with the backing of taxes.
Although there are a number of risks to owning a debt security that are common to all investors, which specific risk is avoided when a U.S. resident purchases a Eurodollar bond?
Currency risk Eurodollar bonds are denominated in dollars; therefore, no currency risk exists for a U.S. resident.
Which of the following usually does NOT pay interest semiannually?
GNMA GNMA pass-through certificates pay principal and the interest monthly. All other choices usually pay interest semiannually.
Which of the following agency securities is guaranteed by the U.S. government?
Ginnie Mae Only Ginnie Mae securities are backed by the full faith and credit of the U.S. government. Other agency securities have lines of credit at the Treasury, but this credit does not constitute a full guarantee.
Which of the following bonds would be the least price sensitive to changes in market interest rates?
Zero due in one year with a YTM of 6% In almost every question like this, the zero will have the longest duration and the greatest price sensitivity to interest rate changes. This is the odd case where the zero is due so soon that its duration is by far the shortest of any of the choices. Shorter duration means less price sensitivity.
To secure the debt that a subsidiary is offering, a railroad holding company transfers to a trustee the common stock of another subsidiary. The offering is one of
collateral trust certificates When a company uses the securities of one subsidiary to collateralize a bond issue of another subsidiary, the bonds are known as collateral trust certificates.
If the coupon rate on a bond increases, the duration of the bond will
decrease The higher the coupon, the shorter the duration.
An investor purchasing 10 corporate bonds at a price of 102¼ each will pay
$10,225.00 At 102¼, each bond cost $1,022.50 (102 = 1,020 and ¼ of $10 = $2.50). There are 10 bonds so the total is $1,022.50 × 10 = $10,225. U13LO2
Your client is interested in investing in preferred stocks in an effort to receive dividend income. The client's target goal is a 6% current return on investment (ROI). If the RIF Series B preferred stock is paying a quarterly dividend of $.53, your client's goal will be achieved if the RIF can be purchased at
$35.33 First, take the quarterly dividend and annualize it (4 × $.53 = $2.12). Then, divide that number by 6% and you get $35.3333, which rounds down to $35.33. Or, if you wish, but it takes more time, multiply each of the choices by 6% to see which of them equals $2.12.
An investor in the 25% federal income tax bracket is considering the purchase of some fixed-income instruments. Which of the following would provide the investor with the greatest after-tax return?
7% Ba rated corporate bond The greatest after-tax return is provided by the instrument listed that, after subtracting 25% for income tax, leaves the investor with the greatest amount. Because the Treasury bond, the CD, and the corporate bond are all taxable at the same rate, the 7% bond must be the best deal. Even though the municipal bond is not taxed, its 4.8% net yield is far lower than the 5.25% ($70 − 25% tax) return on the corporate bond.
A bond with a par value of $1,000 and a coupon rate of 6% paid semi-annually, is currently selling for $1,200. The bond is callable in 15 years at 105. In the computation of the bond's yield to call, which of these would be a factor?
Interest payments of $30 The YTC computation involves knowing the amount of interest payments to be received, the length of time to the call, the current price and the call price. A bond with a 6% coupon will make $30 semi-annual interest payments. With a 15-year call, there are 30 semi-annual payment periods, not 15. The present value is $1,200 and the future value is $1,050, the reverse of the numbers indicated in the answer choices.
Which of the following is NOT a money market instrument?
Newly issued Treasury notes Commercial paper, Treasury bills, and banker's acceptances are debt instruments with maturities of 1 year or less and are therefore money market instruments. A newly issued Treasury note would have a maturity of 2 to 10 years and therefore would not be a money market instrument.
A TIPS bond pays interest at the rate of 4%. If the annual inflation rate is 5%, what is the principal value after the 4th year?
$1,218.40 A TIPS bond's principal increases every 6 months based on the inflation (not the coupon) rate. An annual inflation rate of 5% means the adjustment every 6 months is 2.5% of the principal. At the test center, enter $1,000 and then multiply times 102.5%. Take that result and continue to multiply times 102.5% a total of 8 times (there are 8 six-month periods in 4 years). If you remember our shortcut, you simply take the annual inflation rate, multiply that by the number of years, and then take that percentage of the $1,000 par value. That would be 5% x 4 years or 20% of $1,000 = $200 principal adjustment. That would make the principal $1,200, and we said "take the next highest answer" and that will be correct.
The DERP Corporation has an outstanding convertible bond issue with a conversion price of $125 per share. If the current market price of the bond is 80, the parity price of the stock is
$100.00 per share What does parity mean? It means that 2 things have equal value. What 2 things do we have here? We have the convertible bond and, because it is convertible, it can be "converted" into common stock. There is a number where the value of the bond and the value of the stock are the same—this price is the parity price. The bond is currently valued at $800 (80% of par). Anytime the investor wishes, he can exchange (convert) that bond into DERP's stock at $125 per share. But, that conversion is based not on a market price, which can fluctuate every day—it is based on the amount of the money initially borrowed—the $1,000 par value of the bond. DERP is saying that it will allow you to exchange the $1,000 they owe you for stock at $125 per share. Simple division results in the ability to convert into 8 shares. Now we have everything we need to compute the parity (equal) price. If the bond is currently valued at $800 and we can convert it into 8 shares, what does each of those shares have to be worth so that the stock is also valued at $800? Dividing 800 / 8 = $100 per share. That means that if the stock is selling for $100 per share, and we decide to convert the bond, we'll have the same $800 in value. Some students find the answer a quicker way. If the bond is selling at 80% of its par value, then, to be equal, the stock must be selling at 80% of the conversion value (80% × $125 = $100).
Which of the following would you NOT expect to see issued at a discount?
Bank jumbo CD Of these securities, only the bank jumbo (negotiable) CDs are always interest bearing and issued at par or face value.
A bond investor's portfolio consists of the following 3 bonds: ABC First Mortgage bond, current market value of $4 million with a duration of 5 years. DEF Debenture, current market value of $5 million with a duration of 8 years. U.S. Treasury bond, current market value of $1 million with a duration of 10 years. What is the average duration of the portfolio?
7 years It is unlikely that you will have a question this complicated on the exam, but, just in case, we wanted to show you the way to do it. Computing average duration of a bond portfolio involves taking each bond and figuring the proportion of the portfolio its duration represents. In this question, ABC is 40% of the portfolio so we take 40% of its 5-year duration (2). Then, we do the same with the other two bonds. DEF is 50% of 8 (4) and the Treasury bond is 10% of 10 (1). When we add the 3 numbers together, it results in an average duration of 7 years.
Treasury bills are
-issued in book entry form All Treasury securities are issued in book entry form. Treasury bills are always issued at a discount and are never callable.
MNO is planning to raise capital through an offering of 30-year bonds. Which call price would be most beneficial to MNO?
102 MNO would benefit most from the ability to call bonds at the lowest possible price. The call feature enables MNO to buy the bonds before maturity to reduce their fixed interest costs. A call price of 102 requires the lowest call premium of the options shown.
A client has indicated that his primary objective is maximizing current income regardless of the risk. Which of the following mutual funds would probably be most suitable for achieving that goal?
DEF High-Yield Bond Fund High-yield (junk) bonds, although carrying more risk, produce higher current income than other funds.
Securities issued by which of the following issuers have the direct backing of the U.S Treasury?
Government National Mortgage Association (Ginnie Mae) Bonds issued or guaranteed by the Government National Mortgage Association (Ginnie Mae) are backed by the "full faith and credit of the U.S. government," just like Treasuries. Bonds issued by government-sponsored enterprises (GSE) such as the Federal National Mortgage Association (Fannie Mae), the Federal Home Loan Mortgage (Freddie Mac), and The Federal Agricultural Mortgage Corporation (Farmer Mac) are not backed by the same guarantee as federal government agencies. Bonds issued by GSEs carry credit risk. The GSEs are publicly traded companies whose shares are registered with the SEC.
Rank the following bonds in order of shortest to longest duration. ABC 8s of 2040 DEF 9s of 2041 GHI 5s of 2039 JKL zeros of 2035
II, I, III, IV A bond's duration consists of two interrelated components; the coupon and the length to maturity. When the coupon rates are approximately the same, the bond with the nearest maturity will have the shortest duration and that with the latest maturity, the longest duration. When the maturities are approximately the same, the bond with the highest coupon will have the shortest duration and the one with the lowest coupon (and you can't get lower than zero) will have the longest duration. Unless maturing very soon, zero coupon bonds (certainly on the exam) will always have the longest duration because they receive no interest payments over the life of the bond. In this example, the maturity dates for the interest bearing bonds are very close (a 2 year spread on bonds maturing in about 25 years) and the zero's maturity is not nearly soon enough to be a factor. Therefore, the bond with the 9% coupon will have the shortest duration, followed closely by the 8% and a good bit behind, the 5%, with the zero bringing up the rear.
A respected analyst reports that last week's T-bill rate at 6% is lower than the rate for the preceding week and lower than the average for the past month. Which of the following is TRUE?
Investors are paying more for T-bills. When the rate is lower, the price has gone up; this means investors are paying more as interest rates are going down.
Which of the following statements about municipal bonds is NOT true?
Municipal bonds are generally considered riskier than corporate bonds. Municipal bonds are generally considered second only to treasury instruments in relative safety.
Which of the following debt instruments generally present the least amount of default risk?
Municipal general obligation bonds Because the full taxing power of the municipality backs a general obligation municipal bond, it will exhibit the least amount of default risk. A corporate debenture is an unsecured bond with a greater degree of risk, as is a junk or high-yield corporate bond.
Being concerned about price volatility, a bond investor wishes to compute the duration of a bond being considered for her portfolio. Which of the following is NOT a necessary component of that calculation?
Rating of the bond Although it is true that lower-rated bonds tend to have greater price volatility than high-rated ones, the rating has nothing to do with the calculation of the bond's duration. Duration is simply the weighted average of the cash flows an investor will receive over time, discounted to the bond's present value. Those cash flows come from the coupon and the return of the par value at maturity. The market price represents the present value of those future cash flows.
Which of the following should be considered a liquid asset for emergency fund purposes?
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.
Which of the following statements regarding U.S. government agency securities is TRUE?
They generally offer higher yields than direct U.S. obligations. In most cases, securities issued by U.S. government agencies are obligations of that agency rather than the U.S. government. As such, they carry slightly higher risk and that means investors demand a higher return. The do not trade on any exchange and their interest, like that of all U.S. government securities, is taxable on the federal level.
Which of the following statements regarding callable bonds is correct?
They usually provide a call risk premium. Callable bonds are normally called only when interest rates fall. The call premium (a percent above par value that the issuer will pay when called) helps to compensate bondholders for the lower interest rate at which they will be able to reinvest the proceeds. Callable bonds have greater risk for investors (call risk) and therefore offer higher yields than noncallable bonds.
Which of the following investments gives the investor the least exposure to reinvestment risk?
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.
Which of the following U.S. government securities do NOT bear a stated interest rate but are sold at a discount through weekly auctions?
Treasury bills Treasury bills bear no stated interest rate. They are sold at a discount through weekly auctions and are actively traded in the money market. Treasury notes and Treasury bonds both carry stated interest rates.
The most common collateral securing a Brady bond is
U.S. Treasury zero-coupon bonds with a maturity corresponding to the maturity of the individual Brady bond Although other securities may be pledged, the most common is zero-coupon U.S. Treasuries, selected to mature at roughly the same time as the specific Brady bond. An investor purchasing a Brady with collateralized principal knows that, at maturity, a third-party paying agent will receive a payment from the U.S. Treasury that will be used to repay the principal on the Brady issue. In the event of default, the bondholder will receive the principal collateral on the maturity date.
A bond issued by the GEMCO Corporation has been rated BBB by a major bond rating organization. This bond would be considered
an investment-grade corporate bond An investment-grade bond has a bond rating between AAA and BBB. Lower-rated bonds are considered high-yield bonds and are often referred to as junk bonds. The bond may or may not be secured—the rating does not indicate that fact.
An analyst wishes to assess the value of a fixed income security by taking the income payments scheduled to be received over a given future period and adjusting that for the time value of money. This analytical tool is known as
discounted cash flow The discounted cash flow (DCF) for a fixed income security (bond) is a summary of the expected interest payments that has been adjusted to reflect the time value of money. With all other things being equal, the bond with the higher DCF is the better investment.
Municipal bonds are often called tax-exempts. This refers to the exemption of their income from
federal income taxes Although municipal bonds are sometimes exempt from state income tax (if issued in the state of residence of the taxpayer), all references to tax exemption refer to their exemption from federal income taxes.
In general, among the advantages to investing in Brady bonds over those issued by countries classified as emerging economies is
increased liquidity Brady bonds are issued to take over the debt of failing commercial loans in emerging economies. They are secured by collateral, often U.S. Treasury zero-coupon bonds thereby making them more secure than direct issues of that country. This backing also increases the liquidity as there is a larger pool of potential investors. These benefits cause the yields to be lower—less risk, less reward. There is nothing unique about the maturities of Brady bonds.
Which of the following are general characteristics of negotiable jumbo CDs?
issued in amounts of $100,000 to $1 million Negotiable jumbo CDs are issued for $100,000 to $1 million and trade in the secondary market. Most jumbo CDs are issued with maturities of 1 year or less. Being negotiable in the secondary market, there is no prepayment penalty. These CDs generally pay interest on a semi-annual basis, not monthly.
One of the benefits of adding foreign debt securities to an investor's portfolio is
potentially higher yields The interest rates paid on debt in many foreign countries, especially those in emerging economies, is higher than that available domestically. The trade-off is higher risk. Receiving interest payments in foreign currency involves not only currency risk, but the added expense of conversion into U.S. dollars (ADRs are for equity, not debt securities). In many cases, investors pay foreign and U.S. tax on the interest.
One of the advantages of owning a corporation's debentures is that you have prior claim over
preferred stockholders Holders of a company's debentures are general creditors and, as such, only have prior claim over equity holders.
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
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.
When an investor divides the coupon rate of a municipal bond by the complement of her tax rate, she is computing the bond's
tax-equivalent yield. The computation for the tax-equivalent yield of a municipal bond is performed by dividing the bond's coupon rate by the complement of the investor's tax rate (1 - the investor's tax bracket). If the bond has a coupon of 4% and the investor is in the 20% bracket, the tax-equivalent yield is 4% divided by (1 - .20) or 4% divided by .80 = 5%.
The yield to maturity is
the annualized return of a bond if it is held to maturity The yield to maturity reflects the annualized return of a bond if it is held to its maturity. The computation reflects internal rate of return and is frequently referred to as the market required rate of return for a debt security. The rate set at issuance and printed on the face of the bond is the nominal or coupon rate. Dividing the coupon rate by the current market price of the bond provides the current yield. The return of a bond if it is held to the call date is the yield to call.
One of the reasons why the discounted cash flow method of valuation is useful in assessing the value of fixed income instruments is
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.
If your customer wants to set aside $40,000 for when his child starts college, but does not want to endanger the principal, you should recommend
zero-coupon bonds backed by the U.S. Treasury Treasury STRIPS are guaranteed by the U.S. government, so there is no chance of default. They are zero-coupon bonds and offer no current income, which is appropriate for a client who wants 100% return paid at a future date for college expenses.
An investor purchases a TIPS bond with a 4% coupon. If during the first year the inflation rate is 9%, the approximate principal value of the security at the end of that year will be
$1,092. The principal value of a TIPS bond is adjusted semiannually by the inflation rate. The exact calculation would be $1,000 x 104.5% x 104.5% which equals $1,092.025. Each six months, the interest is paid on that adjusted principal and that is why the security keeps pace with inflation. Obviously, the answer must be something a bit higher than $1,090 because of the semiannual compounding.
If an investor pays 95.28 for a Treasury bond, how much did the bond cost?
$958.75 Treasury bonds are quoted as a percentage of par, ($1,000), plus 32nds. In this case, the price is $950 plus 28/32 (i.e., 7/8) of $10, for a total of $958.75.
The current yield on a bond with a coupon rate of 7.5% currently selling at 105½ is approximately
7.11% A bond with a coupon rate of 7.5% pays $75 of interest annually. Current yield equals annual interest amount divided by bond market price, or $75 ÷ $1,055 = 7.109%, or approximately 7.11%.
Kate, age 59, has an investment portfolio exceeding $250,000. She considers herself a moderate to conservative investor. To generate additional income, she is anticipating adding bonds to her portfolio. She lives in a state that does not have an income tax and she is in the 28% federal income tax bracket. Which of the following bonds would be the best recommendation for her portfolio?
Bond A, A-rated corporate debenture with a 6.5% coupon rate Even though Bond C has the highest after-tax rate of return, this bond would not be appropriate for Kate based on her risk tolerance. Therefore, Bond A would be the best choice. Calculations: Bond A: 6.5 × (1 - 0.28) = 4.68% Bond B: 3.75% Bond C: 8% × (1 - 0.28) = 5.76% Bond D: 2.55% × (1 - 0.28) = 1.84%
Which of the following are characteristics of commercial paper? It represents a loan by the holder to the issuer. It is a certificate of ownership in the corporation. It is commonly issued to raise working capital for a corporation. It is junior in preference to convertible preferred stock.
I and III Commercial paper instruments are debt securities; they represent loans to the issuing corporation by the holder. They are commonly issued to raise working capital and, as debt obligation, are senior in preference to preferred stock in claims against an issuer.
Which of the following would make a corporate bond more subject to liquidity risk? Short-term maturity Long-term maturity High credit rating Low credit rating
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.
Assuming all of the following mature at about the same time, which of the following bonds should experience the greatest price decline if interest rates rise by 1%?
Treasury bond issued at par and carrying a 4% coupon This is an example of duration. With approximately equal maturity dates, the bond with the lowest coupon will always have the longest duration. The longer the duration, the greater the susceptibility to price changes due to fluctuations in interest rates.
Some analysts use the discounted cash flow to determine the theoretical value of a debt security. Under DCF, the bond price can be summarized as the sum of the
present value of the par value repaid at maturity plus the present value of the coupon payments A bond's price can be calculated using the present value approach. As with any security or capital investment, the theoretical fair value of a bond is the present value of the stream of cash flows it is expected to generate. Therefore, the value of a bond is obtained by discounting the bond's expected cash flows to the present using an appropriate discount rate. The two choices using future value of the par value at maturity make no sense because we already know that is $1,000 (or whatever the par value might happen to be).
Probably the most significant characteristic of municipal bonds for investors is
their exemption from federal income tax Municipal bonds are unique in that their interest is not subject to federal income tax. As a result, their coupon yields are generally lower than corporate bonds with a similar rating—you get to keep all of the interest instead of paying taxes on it. The fact that they are exempt from registration with state and federal agencies is of little, if any, consequence to the typical investor. Although they tend to be quite safe, if safety is the primary concern, the investor would turn to Treasuries or government agency securities.
