Unit 13 Bonds
The longest initial maturity for U.S. T-bills is:
Answer: 52 weeks. As money market instruments, the longest initial maturity of Treasury Bills is 52 weeks. Those bills are auctioned once per month. T-bills of shorter maturities are auctioned weekly. The shortest initial maturity is 4 weeks.
A mortgage-backed security (MBS), such as a Ginnie Mae, makes a combination principal and interest payment to an investor. This payment will be: A. partly taxed as ordinary income and partly a tax-free return of principal B. taxed as a capital gain if underlying mortgage is prepaid C. taxed as ordinary income D. tax free
Answer: A. All interest payments made a MBS are taxed as ordinary income. Mortgage-backed securities may make principal and interest payments to investors, which would be partly taxed as ordinary income and partly a tax-free return of principal.
Assume that a corporation issues a 5% Aaa/AAA-rated debenture at par. Two years later, similarly rated debt issues are being offered in the primary market at 5.5%. Which of the following statements regarding the outstanding 5% debenture are TRUE? I. The current yield on the debenture will be higher than 5%. II. The current yield on the debenture will be lower than 5%. III. The dollar price per bond will be higher than par. IV. The dollar price per bond will be lower than par. A. I and IV B. II and III C. II and IV D. I and III
Answer: A. Because interest rates have risen after the issue of the 5% debenture, the bond's price will be discounted to result in a higher current yield (computed as annual income divided by current market price). Accordingly, the discounting of the issue will make the 5% debenture competitive with new issues offered with a 5.5% coupon.
The current yield of a callable bond selling at a premium is calculated: A. as a percentage of its market value B. as a percentage of its call price C. as a percentage of its par value D. to its maturity date
Answer: A. Current yield for any security is always computed on the basis of the current market value.
A bond purchased at $900 with a 5% coupon and a 5-year maturity has a current yield of: A. 5.56% B. 5.00% C. 7.80% D. 7.40%
Answer: A. 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.
Which of the following expressions describes the current yield of a bond? A. Yield to maturity divided by par value B. Annual interest payment divided by current market price C. Annual interest payment divided by par value D. Yield to maturity divided by current market price
Answer: B. The current yield on a bond is calculated by dividing the annual interest payment by the current market price of the bond.
What is the principal value of a TIPS bond after 2 years if the coupon is 5% and the inflation rate is 8%? A. $1,100 B. $1,103.81 C. $1,160 D. $1,169.86
Answer: D. 8%/2 since it's semi annually and you do it 4 times for the 2 year period so: 1000 x 1.04 (104%) = 1040 1040 x 1.04 = 1081.6 1081 x 1.04 = 1124.864 1124.864 x 1.04 = $1169.86
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? A. Baa-rated municipal revenue bond B. Ba-rated corporate mortgage bond C. A-rated general obligation municipal bond D. Aa-rated corporate debenture
Answer: D. A bond's rating takes into consideration all factors, including collateral and tax base. The higher the rating, the lower the credit risk.
Which of the following statements regarding callable bonds is correct? A. They are unaffected by changes in market yields. B. They offer lower yields than comparable noncallable bonds. C. They are only issued by government entities. D. They usually provide a call risk premium.
Answer: D. 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 is a discounted cash flow computation? A. Holding Period Return B. Standard Deviation C. Current Yield D. Net Present Value
Answer: Net Present Value. A key component of a DCF computation is using the time value of money. None of these, other than NPV, consider the time value of money.
Annual interest payment divided by the current dollar (market) price is:
Answer: current yield
Which of the following bonds would most likely be exposed to the greatest amount of interest rate risk? A. GHI 7s of 2042 B. JKL 4s of 2020 C. ABC 5s of 2040 D. DEF 6s of 2041
Answer C. 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.
If a customer buys a 6% bond maturing in 8 years on a 7.33 basis, the price of the bond is: A. Below par B. Above par C. Inverted D. At par
Answer: A. A bond with a basis, or yield to maturity, greater than its coupon is trading at a discount, or below par.
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 million D. they are secured obligations of the issuing bank
Answer: D. 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.
Your client with $100,000 to invest is looking for maximum current income. Which of the following would offer the highest current return? A. $200,000 of utility common stock paying a current dividend of 3.5% B. $100,000 of zero-coupon bonds with a yield to maturity of 6% C. $100,000 AA-rated corporate bonds trading at par with a 6% coupon rate D. $100,000 market value of corporate bonds selling at a premium and yielding 6% to maturity
Answer: D. Bonds selling at a premium have higher coupons than those selling at par. Therefore, the current yield on those bonds is higher than the ones at par, even though they would have the same yield to maturity. The zero-coupon bonds offer no current income and the investor only has $100,000 to invest, so the utility stock is not a viable option.
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? A. Bond C, CCC-rated corporate debenture with an 8% coupon rate B. Bond D, AAA-rated Treasury note with a 2.55% coupon rate C. Bond B, BBB-rated municipal bond with a 3.75% coupon rate D. Bond A, A-rated corporate debenture with a 6.5% coupon rate
Answer: D. 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%
One of the likely consequences of a rating downgrade on a bond is: A. an increase to the coupon by the issuer. B. the current yield will be reduced. C. the call feature will be employed. D. a reduction in the market price of the bond.
Answer: D. If the rating agencies downgrade the quality of a bond, potential investors will look to compensate for the increased risk by demanding a greater yield on the issuer's bonds. This will inevitably result in a lower bond price. A change in ratings is unlikely to lead to a call. In fact, with the reduction in the market price, the bond may be selling below par giving the issuer the opportunity to retire the debt at a discount. Bonds are fixed-income securities because the coupon rate is fixed when the bond is issued and does not change.
Knowing the average maturities would be most important when doing a cash flow analysis on: A. Common Stock B. REITs C. Preferred Stock D. Mortgage-backed securities
Answer: D. 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 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?
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.
An investor owns a TIPS bond with an initial par value of $1000. Coupon rate is 6%, and during the first year, the inflation rate is 9%. How much interest would be paid for the year?
TIPS bonds have a fixed coupon rate with a principal that varies each 6 months based on the inflation rate. With an annual inflation rate of 9%, each 6 months, the principal increases by 4.5% (half of the annual rate). Each semiannual coupon is half of the 6% rate times the new principal. The arithmetic is: $1,000 × 104.5% = $1,045 × 3% = $31.35 plus, $1,045 × 104.5% = $1,092 × 3% = $32.76. Adding the 2 interest payments together results in a total of $64.11 for the year.
Which of the following statements regarding a $1,000 corporate 8.50% bond offered at 110 is true? A. The bond's current yield is calculated by dividing its annual interest by its current market price. B. The bond's current yield is lower than its yield to maturity. C. The bond is a discount bond. D. To determine the bond's current yield, its stated rate must be compared against other fixed-rate investments in the client's portfolio.
Answer: A. A bond's current yield is calculated by dividing its annual interest by its current (market) price. In this case, it would be $85 ÷ $1,100. The current yield will be higher than its yield to maturity, which takes into consideration the $100 difference between the purchase price and the par value (a loss of $100). The determination of a bond's yield is unrelated to other bonds. In addition, this bond is selling at a premium (more than $1,000), not at a discount (less than $1,000).
A sudden decrease in market interest rates will have the effect of increasing the trading price of an existing bond because: A. the present value of the bond's future cash flows increases B. a reduction in market interest rates generally signifies a stronger economy C. lower interest rates will result in a higher rating for the bond D. the future value of the bond's present cash flows increases
Answer: A. Bond valuations using discounted cash flow take into consideration the present value of the bond's future cash flows. That is, the greater the value of the interest payments to be received in the future, the higher the price of the bond. When market interest rates decline, because the coupon rate of the existing bond is fixed, the present value of those interest payments increases, creating a higher value for the bond.
Which of the following are characteristics of commercial paper? I. Backed by money market deposits II. Negotiated maturities and yields III. Issued by insurance companies IV. Not registered with the SEC A. II and IV B. III and IV C. I and II D. I and III
Answer: A. Commercial paper represents the unsecured debt obligations of corporations needing short-term financing. Both yield and maturity are open to negotiation. Because commercial paper is issued with maturities of no more than 270 days, it is exempt from registration under the Securities Act of 1933.
GNMA mortgage-backed securities are: A. a direct obligation of the U.S. government B. backed exclusively by a pool of mortgages C. exempt from federal income tax for the interest payments received by the bondholders D. available to investors through a minimum purchase of $5,000
Answer: A. GNMA securities are a direct obligation of the U.S. government and are backed by a pool of mortgages. The monthly payments are partially a return of principal and partially taxable interest, which is subject to state and federal income tax. GNMA pass-through securities are available to investors with a minimum issue price of $25,000.
The minimum face amount of a negotiable CD is: A. $100,000 B. $25,000 C. $10,000 D. $50,000
Answer: A. 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.
An investor owns a TIPS bond with an initial par value of $1,000. The coupon rate is 6%, and during the first year, the inflation rate is 9%. How much interest would be paid for the year? A. $64.11 B. $65.40 C. $90.00 D. $60.00
Answer: A. TIPS bonds have a fixed coupon rate with a principal that varies each 6 months based on the inflation rate. With an annual inflation rate of 9%, each 6 months, the principal increases by 4.5% (half of the annual rate). Each semiannual coupon is half of the 6% rate times the new principal. The arithmetic is: $1,000 × 104.5% = $1,045 × 3% = $31.35 plus, $1,045 × 104.5% = $1,092 × 3% = $32.76. Adding the 2 interest payments together results in a total of $64.11 for the year.
As defined in the Securities Exchange Act of 1934, the term municipal security would include all of the following EXCEPT: A. an Illinois Tool Company debt issue backed by its full faith and credit B. a New Jersey Turnpike revenue bond C. a city of Atlanta, GA public library bond D. a State of Texas general obligation bond
Answer: A. The Illinois Tool Company is a corporation, even though it has a state in its name. Under federal law, municipal bonds are those issued by any domestic political body or subdivision from the state level on down.
Which of the following would best describes a Yankee bond? A. U.S. dollar-denominated bond issued by a non-U.S. entity inside the United States B. U.S. dollar-denominated bond issued by a U.S. entity inside the United States C. U.S. dollar-denominated bond issued by a non-U.S. entity outside the United States D. U.S. dollar-denominated bond issued by a U.S. entity outside the United States
Answer: A. Yankee bonds are issued by non U.S. entities in market places within the United States. The bonds are issued in US dollars meaning these foreign issuers will have currency risk if the dollar drops in value against their local currency.
Market interest rates rise by 50 basis points. If each of these bonds has about the same maturity date, which of the following would decline the least? A. Treasury bond issued at par carrying a 6% coupon B. Treasury bond issued at par carrying a 7% coupon C. AA corporate bond carrying a 7% coupon D. AAA corporate bond carrying a 6% coupon
Answer: B. All other factors being equal, bonds of higher quality experience less price volatility than do bonds of lower quality. Treasury securities have higher quality than other debt securities due to the elimination of default risk. When market interest rates rise, bonds having higher coupons will decline less than bonds having lower coupons.
A corporation is capitalized with common stock, senior preferred stock, mortgage bonds, and subordinated debentures. Your client, who holds $10,000 of the debentures, is concerned about the future viability of the enterprise. You can inform the client that the debentures have a claim: A. ahead of the common stock, the preferred stock, and the bonds B. ahead of the common stock and the preferred stock, but after the bonds C. ahead of the common stock, but after the preferred stock and the bonds D. behind the bonds, the preferred stock, and the common stock
Answer: B. Any debt security, even a subordinated debenture, has a claim ahead of all equity. However, it is subordinated to all other debt.
The discounted cash flow method is frequently used to assess the value of a bond. When making the DCF computation, it would NOT be necessary to know the bond's: A. nominal yield B. rating C. principal amount D. number of remaining interest payments
Answer: B. As it is strictly a mathematical computation, a subjective item, such as the bond's rating, has no place in the computation.
Which of the following is a characteristic of an investment-grade general obligation municipal bond? A. The bond retains a direct claim on specific property. B. The taxing authority of the issuing government or municipality backs the issue's repayment. C. The bond's main source of investment risk is financial risk. D. The bond's periodic interest is paid to investors only when sufficient revenue is collected by the municipality.
Answer: B. 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.
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 number of interest payments B. the parity price of the bond C. the future cash flow D. the discount rate
Answer: B. 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.
All of the following statements regarding bonds selling at a discount are correct EXCEPT: A. they can indicate that interest rates have risen B. they are more likely to be called than comparable bonds selling at a premium C. they can indicate that the issuer's credit rating has fallen D. they will appreciate more than comparable bonds selling at a premium if interest rates fall
Answer: B. 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.
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 7%. Based on the discounted cash flow method, one could say that the present value of the investor's security is: A. equal to the par value B. less than par value C. more than par value D. negative
Answer: B. 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 7%. Because this investor's debenture is paying at a rate of 6%, its cash flow is less valuable than a 7% bond; therefore, it will sell at a discount (below par).
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. Eurobond B. Eurodollar bond C. Brady bond D. Yankee bond
Answer: B. 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.
The value of which of the following would be least likely to be impacted by changes in interest rates? A. A U.S. Treasury bond issued 25 years ago with a 30-year maturity B. A bank CD maturing in 5 years C. A convertible preferred stock D. A laddered bond portfolio
Answer: B. This question is dealing with interest rate (or money-rate) risk. That risk refers to the inverse relationship between the price of fixed-income investments and interest rates. That is, when interest rates go up, the price of fixed-income securities falls (and vice versa). However, this risk only affects investments that are marketable (those with a fluctuating market price). Bank CDs are nonnegotiable (we're not referring to the negotiable jumbo CDs with a maturity of 1 year or less) and, as a result, will not fluctuate in price, regardless of changes to interest rates. In this case, interest rate risk is eliminated. That is one of the reasons why the exam's first choice for capital preservation is insured bank CDs. Will a laddered bond portfolio reduce interest rate risk? Yes, but it will not eliminate it. Is a convertible preferred (or bond) less subject to changes in interest rates than one without the conversion feature? Yes, but the risk is still there. Does a 30-year T-bond with 5 years remaining to maturity have a short duration and, therefore, a reduced interest rate risk? Yes, but the price of the bond will still be affected by changes in the market interest rates.
One of the ways in which U.S. government agency issues differ from those offered directly by the U.S. Treasury is that: A. agency issues frequently trade on the NYSE while Treasuries never do B. agency issues are more likely to be issued in larger amounts C. agency issues typically carry higher returns than Treasury issues because of the lack of direct government backing D. agency issues are taxable on the federal level while Treasury issues are not
Answer: C. Agencies, with only a very few exceptions, GNMA being one, do not carry the direct backing of the U.S. Treasury. While they are quite safe, that lack of direct backing causes their yields to be somewhat higher. Agencies are never traded on the stock exchanges and their float is almost always smaller than Treasuries. Both are taxable on the federal level.
Treasury bills are: A. issued at par B. callable C. issued in book entry form D. issued in bearer form
Answer: C. All Treasury securities are issued in book entry form. Treasury bills are always issued at a discount and are never callable.
A company has two outstanding bond issues, both with a coupon rate of 8%. Bond A will mature in 2 years, while Bond B will mature in 15 years. If market interest rates were to increase to 10%, which of the following statements is CORRECT? A. The company will attempt to postpone the maturity of Bond A. B. Both bonds will be selling at a premium. C. Bond B will be selling at a greater discount than Bond A. D. Bond B will be selling at a greater premium than Bond A.
Answer: C. An increase in interest rates in the marketplace will cause the price of a debt security to fall. The nearer the maturity, the shorter the duration, hence the less impact. Therefore, Bond B with a much longer maturity (and longer duration) will see its market price fall far more than Bond A.
A bond is selling at a premium over par value. Therefore, its: A. yield to maturity is greater than its current yield B. nominal yield is less than its current yield C. current yield is less than its nominal yield D. none of the above
Answer: C. Any bond selling at a premium will yield less than the coupon rate (nominal yield). Conversely, of course, a bond trading at a discount will certainly yield more. Remember, there is an inverse relationship between bond prices and bond yields.
A sudden decrease in market interest rates will have the effect of increasing the trading price of an existing bond because: A. a reduction in market interest rates generally signifies a stronger economy B. the future value of the bond's present cash flows increases C. the present value of the bond's future cash flows increases D. lower interest rates will result in a higher rating for the bond
Answer: C. Bond valuations using discounted cash flow take into consideration the present value of the bond's future cash flows. That is, the greater the value of the interest payments to be received in the future, the higher the price of the bond. When market interest rates decline, because the coupon rate of the existing bond is fixed, the present value of those interest payments increases, creating a higher value for the bond.
Which of the following statements represents an advantage of a municipal general obligation bond over a revenue bond? A. A GO bond is not charged against the municipality's borrowing limits. B. Only a facility's users pay for a GO bond. C. A GO bond generally involves less risk to the investor. D. A GO bond issuer is required to conduct a feasibility study.
Answer: C. GO bonds are generally less risky than revenue bonds because they are backed by taxes rather than revenues.
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 number of interest payments B. the discount rate C. the parity price of the bond D. the future cash flow
Answer: C. 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.
The DERP Corporation has an outstanding convertible bond issue that is convertible into 8 shares of stock. If the current market price of the bond is 80, the parity price of the stock is: A. $80 per share B. $125 per share C. $100 per share D. $64 per share
Answer: C. Parity means equal. With a conversion ratio of 8 shares per bond, the investor can convert the bond into 8 shares. If the bond is currently selling for $800, then, to be of equal value (parity), the 8 shares must be selling at $100 each.
An investor interested in investing in sovereign debt would most likely purchase: A. bonds issued by the Bank of the United States. B. European Central Bank debt issues. C. Sweden 2.5s of 2032. D. bonds backed by gold sovereigns.
Answer: C. Sovereign debt refers to bonds and other debt instruments issued by a specific country. The European Central Bank manages the currency of the 19 countries who have adopted the Euro. There is no such thing as the Bank of the United States and gold sovereigns are coins - they are not used to back debt.
A municipal bond has a coupon of 6.25%, and at the present time, its yield to maturity is 6.75%. From this information, it can be determined that the municipal bond is trading: A. at a premium B. at par C. at a discount D. flat
Answer: C. The YTM is greater than the nominal yield, or coupon yield. Therefore, the bond is trading at a discount.
Which of the following statements regarding corporate zero-coupon bonds is TRUE? A. They have lower price volatility than other bonds B. They are beneficial for investors in higher tax brackets C. The discount is in lieu of periodic interest payments. D. Interest is paid semiannually.
Answer: C. The investor in a corporate zero-coupon bond receives the return in the form of growth of the principal amount over the bond's life. The bond is purchased at a deep discount and redeemed at par at maturity. That discount from par represents the interest that will be earned at maturity date. However, the discount is accreted annually and the investor pays taxes yearly on the imputed interest creating "phantom income." Zero-coupon bonds have greater, not lower price, volatility.
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: A. $1,090. B. $1,045. C. $1,092. D. $1,040.
Answer: C. 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.
Which of the following bonds has the shortest duration? A bond with: A. a 20-year maturity, 6% coupon rate. B. a 10-year maturity, 6% coupon rate. C. a 10-year maturity, 10% coupon rate. D. a 20-year maturity, 10% coupon rate.
Answer: C. Two factors go into the computation of a bond's duration - the length to maturity and the coupon rate. When the maturities are the same, the bond with the highest coupon has the shortest duration. When the coupons are the same, the bond with the nearest maturity has the shortest duration. The 10% bond maturing in 10 years "wins" on both counts. It has the nearest maturity with the highest coupon. All else being equal, a bond with a longer duration will be more sensitive to changes in interest rates.
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 is most likely TRUE with reference to the current market price of this bond? A. Not enough info B. Premium C. Discount D. Par Value
Answer: C. 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.
A customer purchased new issue bonds at par 2 years ago. Since then, the CPI has declined by almost half and the current yield on his bonds has also declined. Which of the following best describes the value of the bonds he purchased? A. This cannot be determined from the information presented. B. Their market price has declined. C. Their market price has remained unchanged. D. Their market price has increased.
Answer: D. Because inflation is down and bond yields have declined, the bonds are selling for a premium due to an increase in value.
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 corporate bond yield is higher than the municipal yield after taxes. C. The yield difference cannot be determined. D. The municipal yield is higher than the corporate yield on an after-tax basis.
Answer: D. 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 = tax-free yield/(100% - 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.
Which of the following bonds is most likely to exhibit the greatest volatility due to interest rate changes? A bond with: A. a high coupon and a short maturity. B. a high coupon and a long maturity. C. a low coupon and a short maturity. D. a low coupon and a long maturity.
Answer: D. Other things equal, a bond with a low coupon and long maturity will have the longest duration and therefore greatest price volatility.
Which of the following is NOT a valuation method for a fixed-income security? A. Conversion parity B. Discounted cash flow C. Dividend discount model D. Price-to-earnings ratio
Answer: D. The P/E ratio is only used with common stock. The parity price is a way to value a convertible bond or convertible preferred stock. DCF is one of the most popular ways to value bonds. The DDM can be used with preferred stock, which, because of its fixed dividend, is considered in the general category of fixed-income security.
For a bond selling at a discount, the yield to maturity will be: A. equal to the nominal yield B. higher than the yield to call C. lower than the nominal yield D. higher than the nominal yield
Answer: D. Yield to maturity is a measure of the total return on a long-term bond, including capital appreciation and interest, while nominal yield measures the interest rate stated on the face of the bond. An investor who buys a $1,000 bond at a discount (for less than $1,000) will receive the interest payments on the bond at the nominal rate and will still receive $1,000 for the bond when it matures. As a result, the total return will be higher than the nominal yield. When a bond is selling at a discount the YTC will always be higher than the YTM.