Unit 4: Debt Securities
Which of the following are money market securities? Commercial paper Treasury bonds American depositary receipts Negotiable certificates of deposit A) I and III B) II and IV C) II and III D) I and IV
D) Explanation Commercial paper and negotiable certificates of deposit are short-term debt securities and are considered money market securities. LO 4.c
In a scenario of falling interest rates and a positive yield curve, assuming all to be of equal face value, which of the following bonds will appreciate the most? A) 1-year bond selling at a premium B) 20-year bond selling at a premium C) 1-year bond selling at a discount D) 20-year bond selling at a discount
D) Explanation In general, prices of long-term bonds are more volatile than prices of short-term bonds. Therefore, the 20-year bonds will appreciate more than the 1-year bonds when interest rates fall. Also, prices of bonds with low coupon rates tend to be more volatile than prices of bonds with high coupon rates. A bond sells at a discount when its coupon is lower than prevailing interest rates. Because of its lower coupon, the 20-year discount bond tends to appreciate more than the 20-year premium bond. LO 4.e
A bond investor who is looking for capital gains should invest in bonds when interest rates are A) high and expected to decline. B) high and expected to rise. C) low and expected to decline. D) low and expected to rise.
A) Explanation This is about the inverse relationship between interest rates and bond prices. As interest rates rise, bond prices fall. Conversely, when interest rates decline, bond prices increase. If an investor buys bonds when the current interest rates are high, a future decline in those interest rates will cause the price of the bonds to increase. LO 4.b
Your customer is interested in long-term corporate bonds. Which of the following interest rate environments makes a call protection feature most valuable to your customer? A) Volatile interest rates B) Declining interest rates C) Rising interest rates D) Stable interest rates
B) Explanation A call protection feature is an advantage to bondholders in periods of declining interest rates. When interest rates are falling, issuers are more likely to call in bonds previously issued at higher interest rates. For bondholders, calling bonds creates reinvestment risk, as they are unlikely to be able to reinvest at the rate they had been earning. Call protection gives the bond holder a specified length of time during which the bond cannot be called. LO 4.b
When a well-established corporation needs short-term borrowing for working capital needs, it will most likely issue A) a jumbo CD. B) commercial paper. C) a letter of credit. D) preemptive rights.
B) Explanation Commercial paper is the most common tool for corporations to raise short-term funds. A letter of credit is issued by a bank. On the exam, this would usually take the form of bankers' acceptances for those in the import/export business. Banks issue CDs, and preemptive rights are used for the sale of common stock. Stock is long-term capital. LO 4.c
Rank the following from safest to most risky. AAA-rated corporate bonds Blue-chip stocks U.S. government securities Tech stocks A) II, III, IV, I B) I, III, IV, II C) III, I, II, IV D) III, II, I, IV
C) Explanation It should be obvious that U.S. government securities would be first and tech stocks last. As for options II and III, stocks will fluctuate more in price than highly rated corporate bonds. LO 4.f
All of the following are characteristics associated with equity-linked notes (ELNs) except A) they can be exchange traded or traded over-the-counter (OTC). B) they are considered to be nonconventional structured investments. C) they have final payments at maturity linked to the return of an underlying stock or basket of stocks. D) they are equity securities.
D) Explanation Despite their name, ELNs are debt instruments, not equity instruments. They have a partial fixed return, as well as a final payment linked to the performance of a single stock or equity index. Some are exchange traded, while others trade OTC. FINRA, who considers ELNs to be nonconventional structured investments, has expressed concerns that investors might not fully understand ELNs or the risks associated with them. LO 4.g
Which of the following is a money market instrument? A) Short-term debt B) Preferred stock C) Common stock D) Long-term debt
A) Explanation A money market instrument is short-term debt with one year or less to maturity. LO 4.a
A convertible corporate bond with an 8% coupon yielding 7.1% is available but may be called sometime this year. Which feature of this bond would probably be least attractive to your client? A) Current yield B) Near-term call C) Coupon yield D) Convertibility
B) Explanation The near-term call would mean that no matter how attractive the bond's other features, the client may not have very long to enjoy them. LO 4.b
Your customer is interested in long-term corporate bonds. Which of the following interest rate environments makes a call protection feature most valuable to your customer? A) Volatile interest rates B) Stable interest rates C) Declining interest rates D) Rising interest rates
C) Explanation A call protection feature is an advantage to bondholders in periods of declining interest rates. When interest rates are falling, issuers are more likely to call in bonds previously issued at higher interest rates. For bondholders, calling bonds creates reinvestment risk, as they are unlikely to be able to reinvest at the rate they had been earning. Call protection gives the bond holder a specified length of time during which the bond cannot be called. LO 4.b
It would be most unusual to see which of the following issued at a discount? A) Banker's acceptance B) Commercial paper C) Jumbo CD D) Treasury bill
C) Explanation 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. LO 4.c
Which of the following choices is least similar to the others? A) Financial Guaranty Insurance Corp. B) Moody's. C) Fitch. D) Standard & Poor's.
A) Explanation Standard & Poor's, Fitch, and Moody's are all agencies that rate debt securities, including municipals and equity securities. The Financial Guaranty Insurance Corp. is one of several entities that insure municipal bonds. LO 4.f
Moody's Investment-Grade (MIG) rating would be applicable to A) a New York state revenue bond. B) a New York state university bond. C) a New York state revenue anticipation note. D) a New York state general obligation bond.
C) Explanation A MIG rating is provided for short-term municipal debt commonly referred to as notes (revenue anticipation notes). LO 4.f
An investor's portfolio contains the following four bonds: ABC 7% duein 2040 DEF 6% due in 2040 GHI 5% due in 2040 JKL 8% due in2040 Which of these bonds would show the greatest price change if interest rates jumped by one percentage point? A) JKL 8% due in 2040 B) DEF 6% due in 2040 C) GHI 5% due in 2040 D) ABC 7% due in 2040
C) Explanation The longer the duration, the greater the price volatility when there is a change to market interest rates. When all bonds have the same (or approximately the same) length of time to maturity, the bond with the lowest coupon rate will have the longest duration. Conversely, the one with the highest coupon rate will have the shortest duration and changes in interest rates will have the least impact on it. LO 4.e
When a bond is issued by a national government, it is called A) national debt. B) high-quality debt. C) sovereign debt. D) treasury debt.
C) Explanation The term sovereign debt applies to securities issued by national governments. U.S. Treasuries are an example of sovereign debt issued here. Other countries have their versions. Not all are considered high quality, especially those issued by emerging economies. LO 4.d
Which of the following is a money market instrument? A) Common stock B) Preferred stock C) Long-term debt D) Short-term debt
D) Explanation A money market instrument is short-term debt with one year or less to maturity. LO 4.a
The SEC recognizes all of the following under the Credit Rating Agency Reform Act as being registered with the commission to rate debt instruments. Which of them historically has specialized in ratings for the insurance sector? A) Standard & Poor's B) Fitch Ratings C) Moody's D) A.M. Best
D) Explanation A.M. Best historically has specialized exclusively on the insurance marketplace. They issue financial strength ratings measuring insurance companies' ability to pay claims and rate financial instruments issued by insurance companies, such as bonds and notes. They can issue debt and financial strength ratings for other sectors as well under the Credit Rating Agency Reform Act. LO 4.f
If the dollar price of a municipal bond is 101 and, at that price, the basis is 6.10, the nominal yield is A) less than 6.10%. B) less than the coupon rate. C) exactly 6.10%. D) greater than 6.10%.
D) Explanation Basis is a common synonym for yield to maturity, especially for municipal bonds. For any bonds trading at a premium, the nominal yield (or coupon) is higher than the basis (YTM). For bonds at a premium, yields from lowest to highest are as follows: yield to call, yield to maturity, current yield, and nominal yield. LO 4.e
Many investors, especially institutions, diversify their fixed-income portfolios by purchasing bonds issued outside of the United States. When a French corporation issues a bond denominated in Swiss francs, it is known as A) a Eurofranc bond. B) sovereign debt. C) a eurobond. D) a Eurodollar bond.
D) Explanation Eurobond is the name given to a long-term debt instrument issued and sold outside the country of the currency in which it is denominated. In this case, the French company is borrowing in Swiss francs instead of the domestic currency (the euro). LO 4.d
The following is taken from the S&P Bond Guide: FLB Zr 37 87 87½. What is the coupon rate on this bond? A) 8.75% B) 0.37% C) 8.70% D) 0%
D) Explanation FLB is the issuer, Zr means zero coupon, 37 indicates the year of maturity (2037), 87 is the bid price ($870), and 87½ is the asked price ($875). LO 4.e
A customer buys a 5% bond at par. The bond is callable in five years at par and matures in 10 years. Which of the following statements is true? A) Nominal yield is higher than either YTM or YTC. B) YTC is higher than YTM. C) YTC is lower than YTM. D) YTC is the same as YTM.
D) Explanation If a bond is trading at par, the nominal yield (coupon rate) equals current yield equals yield to maturity (YTM) equals yield to call (YTC). YTC is higher than YTM if the bond is trading at a discount to par. YTC is lower than YTM if the bond is trading at a premium over par. Nominal yield is higher than either YTM or YTC if the bond is trading at a premium over par. LO 4.e
Interest and principal on a Eurodollar bond issued in Germany are paid A) in European Union euros. B) in German deutsche marks. C) in German euros. D) in U.S. dollars.
D) Explanation It is always the final part of the word that describes the currency of a eurobond. A Eurodollar bond pays in U.S. dollars, while a Euroyen bond would pay in Japanese yen. LO 4.d
The LLAW Manufacturing Company issued a 6.25% debenture 5 years ago. The bond is callable in seven years at 102 and matures in 15 years. The bond's current yield is 4.23%. If one of your customers decided to purchase this bond, they would have to understand they would be A) required to pay the call price. B) buying the bond at a price below par. C) receiving a yield to maturity in excess of 4.23%. D) paying a premium for the bond.
D) Explanation The first thing to notice is that the current yield is below the nominal (coupon) rate. That automatically tell us the bond is selling at a premium. Whenever a bond is selling at a premium, in increasing order, the order of the yields is yield to call, yield to maturity, current yield, and nominal yield. Therefore, if the current yield is 4.23%, the yield to mature cannot be higher than that; it must be less. As we say in the LEM, "if you pay more, you get less" and "if you pay less, you get more." The issuer pays the call price when, and if, the bond is called. LO 4.e
An investor's portfolio contains the following four bonds: ABC 7% duein 2040 DEF 6% due in 2040 GHI 5% due in 2040 JKL 8% due in2040 Which of these bonds would show the greatest price change if interest rates jumped by one percentage point? A) DEF 6% due in 2040 B) JKL 8% due in 2040 C) ABC 7% due in 2040 D) GHI 5% due in 2040
D) Explanation The longer the duration, the greater the price volatility when there is a change to market interest rates. When all bonds have the same (or approximately the same) length of time to maturity, the bond with the lowest coupon rate will have the longest duration. Conversely, the one with the highest coupon rate will have the shortest duration and changes in interest rates will have the least impact on it. LO 4.e
A 10-year bond, callable in five years at par, is sold at a discount. Rank the following yields from lowest to highest. Nominal yield Current yield Yield to call Yield to maturity A) II, I, IV, III B) I, II, III, IV C) IV, II, III, I D) I, II, IV, III
D) Explanation The lowest of all yields for a discount bond is the nominal yield (coupon rate), which is a fixed percentage of par. The highest possible return to the owner of a bond purchased at a discount would occur if the bond were called before maturity because less time must elapse for the investor to receive the discount. LO 4.e
Debt normally issued by big corporations with reliable credit ratings that seek to finance short-term needs best describes A) revenue anticipation notes. B) T-bills. C) certificates of deposit. D) commercial paper.
D) Explanation This is the definition of commercial paper, as known as promissory notes. They are short-term corporate-issued instruments sold at a discount and maturing at par. LO 4.c
An issuer of a bond will apply to the rating services for a rating for the purpose of A) reducing interest rate risk. B) reducing the bond's duration. C) reducing liquidity risk. D) reducing credit risk.
D) Explanation What does the bond rating measure? It is a measurement of the credit risk. The higher the rating, the lower the credit risk and the reverse. With lower credit risk, the issuer will be able to borrow at a lower interest cost. Does the rating have an effect on the bond's liquidity? Possibly, but as is so often on the exam, you must select the answer that best fits the question. LO 4.f TERM English
A registered representative mentions a particular 6% municipal bond quoted on a 6.5% basis. Which of the following is correct? Six percent is the bond's coupon. Six percent is the bond's current yield. Six-and-a-half percent% is the bond's yield to maturity. Six-and-a-half percent% is the bond's current yield. A) I and IV B) II and IV C) II and III D) I and III
D) Explanation When a bond is referred to by a yield percentage, it is the coupon (nominal or stated) yield being referenced. Basis yield refers to yield to maturity (YTM). Hence, a 6% bond currently trading with a 6.5% YTM is correct. LO 4.e
In the United Kingdom, they are called gilts. In Germany, they are called Bunds. In France, they are called OATS. To investors, they are known as A) sovereign debt. B) eurobonds. C) commodities. D) stock exchanges.
A) Explanation Although it is highly unlikely that you would ever see any of these terms on the exam, you might need to know what sovereign debt is. For the United States, the sovereign debt (the debt issued by the sovereign nation) is Treasury securities. The safety of sovereign debt depends on the economy of the specific nation. You would probably not recommend the debt of a third-world country to a customer wishing to avoid risk. LO 4.d
In a discussion with one of your customers, the topic of alternative debt instruments is brought up. It seems that the customer was competing in a duplicate bridge tournament in town and one of the other competitors mentioned that they have been obtaining higher income returns from ELNs. When the customer asks you for the meaning of that abbreviation, you would reply A) equity-linked notes. B) equity-leveraged notes. C) exchange-leveraged notes. D) exchange-linked notes.
A) Explanation An ELN is an equity-linked note. That is a strange name for a debt product. The equity refers to the specific stock, a basket of stocks, or an equity index upon which the return is based. Therefore, the return is not fixed and can be higher or lower than anticipated depending on the selected equity's performance. There are foreign exchange-linked notes where the performance is based on currency rates, but that is unlikely to ever be a topic covered on the exam. There are no such products as exchange or equity-leveraged notes. LO 4.g
When a corporation issues a debt security, the terms of the loan are expressed in a document known as the bond's deed of trust. The deed of trust is sometimes referred to as A) the indenture. B) the bond resolution. C) the loan agreement. D) the debenture.
A) Explanation The indenture, sometimes also referred to as the deed of trust, states the issuer's obligation to pay back a specific amount of money on a specific date. A debenture is a debt security containing an indenture. Bond resolution is a term used for municipal bonds, not corporate debt. LO 4.a
An investor sells 10 5% bonds at a profit and buys another 10 bonds with a 5¼% coupon rate. The investor's yearly return will increase by A) $2.00 per bond. B) $2.50 per bond. C) $1.50 per bond. D) $1.00 per bond.
B) Explanation The first bonds are 5% and pay $50 per year per bond. The new bonds are 5¼% and pay $52.50 per year per bond, for a difference of $2.50 per bond. LO 4.e
Which of the following rate commercial paper issued by corporations? Moody's Standard & Poor's Municipal Securities Rulemaking Board Securities Exchange Commission (SEC) A) I and III B) II and IV C) II and III D) I and II
D) Explanation Moody's, Standard & Poor's, and Fitch's are all recognized as rating companies that would rate commercial paper issued by corporations. The SEC is a federal government regulatory body. LO 4.f
Which of the following does not issue commercial paper? A) Broker-dealers B) Corporations C) Finance companies D) U.S. Treasury
D) Explanation The U.S. Treasury does not issue commercial paper. Its short-term borrowing is done with Treasury bills. Commercial paper is unsecured, short-term corporate debt most commonly issued by finance companies but also by industrial corporations and broker-dealers. LO 4.c
If interest rates increase, the interest payable on outstanding corporate bonds will A) decrease. B) change according to the inverse payout theory. C) increase. D) remain unchanged.
D) Explanation The interest payable is the nominal yield, which is stated on the face of the bond. It is the percentage of face value the bond will pay each year, regardless of the prevailing interest rates in the market. It is the market price of bonds—not the interest payable—that responds inversely to changes in interest rates. LO 4.e
In general, commercial paper, a popular money market instrument, has a maturity not exceeding A) 270 days. B) 365 days. C) 90 days. D) 30 days.
A) Explanation Although there are rare cases where the maturity extends as long as 12 months (365 days), for exam purposes, think of CP with a maximum maturity of 270 days (9 months). LO 4.c
An investor is concerned about safety. When consulting the ratings, which of the following securities would appear to be least likely to default on its obligation to make timely payment of interest and principal? A) AAA rated common stock B) AA rated debenture C) BB rated sovereign debt D) A rated mortgage bond
A) Explanation When it comes to reducing default risk, "the As have it." That is, the more As in the rating, the lower the default risk. True, the common stock is rated triple A, but stock has no obligation to pay interest and repay principal. Why isn't the mortgage bond a safer bet than the debenture? Aren't secured bonds the safest? These are good questions, but the rating services take that into consideration when giving a rating. In their eyes, the debenture, an unsecured debt, merits a double A rating while the mortgage bond, even with the pledged collateral, can only be awarded a single A rating. Sovereign debt, the debt of a country's government, is usually quite safe, but history has shown us that governments can, and do, default. The BB rating here indicates a certain question as to the safety. LO 4.f
The term high-yield bond would apply to a bond with a Moody's rating of A) BB. B) BBB. C) Baa. D) Ba.
D) Explanation High-yield bonds are those whose ratings fall below investment grade. Investment grade is the top four. Using Moody's descriptions, ratings run from Aaa to Aa to A to Baa to Ba to B and then below. The first rating below the top four is Ba. That is equivalent to a BB rating from Standard & Poor's (but the question asks specifically about Moody's). LO 4.f
A 5% bond is trading at a premium. Which of the following would be the bond's highest yield? A) Coupon yield B) Yield to maturity C) Dividend yield D) Current yield
A) Explanation If a bond is trading at a premium, its coupon rate will represent the highest of its yields. Bonds do not have a dividend yield. LO 4.e
Which of the following debt instruments trades with accrued interest? A) Negotiable CDs B) Treasury bills C) Zero-coupon issues D) Bankers acceptances
A) Explanation To trade with accrued interest, the security must pay interest. Of the choices, the only one that is interest bearing is the negotiable (jumbo) CD. All of the others are issued at a discount and return the face value at maturity. LO 4.c
The price of which of the following will fluctuate most with a change in interest rates? A) Short-term bonds B) Long-term bonds C) Common stock D) Money market instruments
B) Explanation Long-term debt prices fluctuate more than short-term debt prices as interest rates rise and fall. LO 4.e
Which of the following money market instruments is most often used by those in the import/export business? A) Commercial paper B) Variable rate demand notes C) Bankers' acceptances D) Negotiable CDs
C) Explanation Bankers' acceptances are loans guaranteed by a commercial bank that are typically used to finance international transactions. Although all of the choices are money market instruments, it is the BAs that are primarily used by those engaged in international business. LO 4.c
A 10-year bond, callable in five years at par, is sold at a discount. Rank the following yields from lowest to highest. Nominal yield Current yield Yield to call Yield to maturity A) I, II, III, IV B) II, I, IV, III C) I, II, IV, III D) IV, II, III, I
C) Explanation The lowest of all yields for a discount bond is the nominal yield (coupon rate), which is a fixed percentage of par. The highest possible return to the owner of a bond purchased at a discount would occur if the bond were called before maturity because less time must elapse for the investor to receive the discount. LO 4.e
If interest rates increase, the interest payable on outstanding corporate bonds will A) change according to the inverse payout theory. B) increase. C) decrease. D) remain unchanged.
D) Explanation The interest payable is the nominal yield, which is stated on the face of the bond. It is the percentage of face value the bond will pay each year, regardless of the prevailing interest rates in the market. It is the market price of bonds—not the interest payable—that responds inversely to changes in interest rates. LO 4.e
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 market price. B) To determine the bond's current yield, its stated rate must be compared against other fixed-rate investments in the client's portfolio. C) The bond is a discount bond. D) The bond's current yield is lower than its yield to maturity.
A) Explanation A bond's current yield is calculated by dividing its annual interest by its current (market) price. The current yield will be higher than its yield to maturity, which will include the premium return. The determination of a bond's yield is unrelated to other bonds. In addition, this is a premium bond, not a discount bond. LO 4.e
The legal contract stating the issuer's obligation to pay back a specific amount of money on a specific date to its bondholders is best described as A) the trust indenture. B) the prospectus. C) the official notice of sale. D) the official statement.
A) Explanation A trust indenture delineates the covenants or promises made by an issuer to its bondholders. Those would include the amount of the debt, the maturity date, and the rate of interest. A trustee would also be identified in the indenture who would act on behalf of the bondholders in the event of default on any of the indenture's provisions. LO 4.a
A term used to define certain alternative forms of debt financing, such as equity-linked notes (ELNs) and exchange-traded notes (ETNs), is A) structured products. B) principal protected products. C) high-risk investments. D) combination products.
A) Explanation In Notice to Members 05-59, FINRA defined a structured product as "securities derived from or based on a single security, a basket of securities, an index, a commodity, a debt issuance and/or a foreign currency." The most important thing for you to know for the exam is that these generally carry higher risk than other debt securities. These should be recommended only when the registered representative has a thorough understanding of the product and believes it is suitable for the specific investor. Yes, these are high-risk investments, but that is not the term used to describe them. LO 4.g
A corporation plans to make a public tender for 50% of its outstanding bonds. The price of the tender will be set by A) the issuer. B) the trustee. C) the paying agent. D) the transfer agent.
A) Explanation In a tender offer, the issuer is offering to buy back all or a portion of the issue at a stated price. The price of the tender is set by the issuer although the issuer may engage an underwriter to help it set the price. This could happen when interest rates have gone up, causing the price of the outstanding bonds to fall. From a practical standpoint, this would mean the corporation paying off debt at a price below face value. LO 4.b
Which of the following are characteristics of negotiable (sometimes referred to as jumbo) CDs? They are issued in amounts of $100,000 to $1,000,000. They are always FDIC insured to face value. They are always mature in one to two years. They trade in the secondary market. A) I and IV B) II and IV C) I and III D) II and III
A) Explanation Negotiable jumbo CDs are issued for $100,000 to $1,000,000 and trade in the secondary market. Most jumbo CDs are issued with maturities of less than a year. The FDIC insures up to $250,000 per account. LO 4.c
Which of the following statements regarding a bond quoted as QRS Zr 32 is true? A) The bond pays no interest until maturity. B) The interest payable is tax free. C) The bond pays $120 interest annually. D) The bond pays $12 interest annually.
A) Explanation QRS Zr 32 represents a zero coupon bond issued by the QRS Company maturing in 2032. Zero coupon bonds are bought at a discount and mature at face value. If a bond is held to maturity, the difference between the purchase price and the maturity price is considered interest, though it is taxed on a yearly basis. LO 4.e
A corporate bond is quoted in the Wall Street Journal as follows: Bid: 100½ Asked: 100¾ Bid Chg.: -⅛ YTM: 5.75% From this information, you know the nominal yield is A) greater than 5.75%. B) 5.625%. C) 5.75%. D) less than 5.75%.
A) Explanation The bid and asked prices show that the bond is being quoted at a premium (above par), with a yield to maturity of 5.75%. When bonds are trading at a premium, the nominal yield (coupon rate) is greater than the yield to maturity. LO 4.e
A bond you are recommending to a customer has call protection. What does that mean? A) It is the number of years into the issue before the issuer may exercise the call privilege. B) The issuer has set up a sinking fund to provide funds for the call. C) The issuer records the phone number of investors and puts it on the do-not-call list. D) It is the number of years into the issue before the investor may exercise the call privilege.
A) Explanation The definition of call protection is the length of time an investor is protected against the issuer exercising the right to call the bonds in. What is the maximum possible call protection? A noncallable bond. In many cases, the issuer sets up a sinking fund to use for the call, but that is not the definition of call protection. LO 4.b
When a corporation issues a debt security, the terms of the loan are expressed in a document known as the bond's indenture. The indenture is sometimes referred to as A) the deed of trust. B) the loan agreement. C) the debenture. D) the bond resolution.
A) Explanation The indenture, sometimes also referred to as the deed of trust, states the issuer's obligation to pay back a specific amount of money on a specific date. A debenture is a debt security containing an indenture. The bond resolution is a term used for municipal bonds not corporate debt. LO 4.a
What happens to outstanding fixed-income securities when market interest rates drop? A) The prices increase. B) The yields increase. C) Short-term fixed-income securities are affected most. D) The coupon rates increase.
A) Explanation When interest rates drop, the price of outstanding bonds rises to adjust to the lower yields on bonds of comparable quality. LO 4.b
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 lower than its yield to maturity. B) The bond's current yield is calculated by dividing its annual interest by its market price. 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.
B) Explanation A bond's current yield is calculated by dividing its annual interest by its current (market) price. The current yield will be higher than its yield to maturity, which will include the premium return. The determination of a bond's yield is unrelated to other bonds. In addition, this is a premium bond, not a discount bond. LO 4.e
DERF Corporation has a significant amount of cash on hand. The chief financial officer (CFO) has suggested to the chief executive officer (CEO) that it might be wise to pay off $10 million of the company's outstanding debt. There are four bond issues outstanding, and your broker-dealer is approached for advice on determining which issue to repay. Which of these four issues would the firm recommend? A) $10 million @6% due in 20 years, callable at par B) $15 million @8% due in 10 years, callable at 101 C) $30 million @12% due in 15 years, non-callable D) $25 million @5% due in 5 years, callable at 104
B) Explanation Anytime we have extra cash, it can make sense to pay off debt. Corporations feel the same way. When it comes to deciding which debt to repay, the wisest move is to pay down the debt with the highest interest cost. In this case, that would be the 12% bond. However, that bond is non-callable. Based on the inverse relationship between interest rates and bond prices, the 12% bond is going to be selling at a higher price than any of the others. Any savings in interest payments would be more than offset by the price the company would have to pay to buy the bond in the open market. The next highest interest rate is 8% and that bond will cost us a slight premium of $10 per bond to call. Although the 6% bond is callable at par, the company would be far better off removing an 8% debt than one at 6%. In fact, the 1 point call premium is saved after the first semiannual interest payment. A partial call, calling in $10 million of the 8% bond, should be the recommendation. LO 4.b
Two conservative customers in their 50s are interested in preserving principal and high-current income from their investments. From first to last, in which order are the following bonds ranked in meeting your customer's needs? Fort Worth Gas 5¼s of 35, rated A1 San Antonio Transit 5¼s of 35, rated AA+ Texas Telecom 5¼s of 35, rated AAA Dallas Electric 5¼s of 35, rated AA- A) IV, III, I, II B) III, II, IV, I C) III, IV, II, I D) I, II, III, IV
B) Explanation Because the maturity and coupon rates are all the same, we can rank the bonds by rating. Based on the ratings given, the highest-quality bond is the Texas Telecom, rated AAA, followed in order by the bonds rated AA+, AA-, and A1. LO 4.f
A bond with a 9% coupon, maturing in 18 years and 6 months, is selling at 120. The yield to maturity is closest to A) 11.66%. B) 7.05%. C) 9.00%. D) 7.50%.
B) Explanation Don't waste time trying to do the yield to maturity computation. This bond is selling at a premium (120% of par). Therefore, all of the computed returns must be lower than the 9% nominal (coupon) yield. Only two of them are. The 7.50% represents the current yield ($90 ÷ $1,200). We know from our charts that, just like a seesaw, the farther from the center you go, the bigger the move at the end. That means the nominal yield is the highest, followed by the current yield (CY), the yield to maturity (YTM), and finally the yield to call (YTC) as the lowest. Because only one choice is lower than the CY, you get the correct answer with minimal effort. LO 4.e
In recent years, much publicity has surrounded the rapid growth of start-up businesses. In most cases, the early financing was done privately. When private debt is used at the intermediate stage of a company's development, it is called A) intermediate debt. B) mezzanine debt. C) middle-risk debt. D) mid-term debt.
B) Explanation Just as the mezzanine in a theater is between the balcony and the orchestra levels, mezzanine debt represents financing supplied at the intermediate point in a new company's development. The funds are provided on a private basis and the investment carries a high degree of risk. As an alternative investment, it will be suitable for a very narrow range of customers. **This question deals with material not covered in your LEM, but it relates to recent rule changes and/or student feedback. LO 4.g
Which of the following is an example of sovereign debt? A) Sony Corporation debentures B) U.S. Treasury bonds C) Bank of England notes D) Royal Bank of Canada CDs
B) Explanation Sovereign debt represents loans to governments. On the exam, it is likely that the examples will be foreign governments, not U.S. Treasury securities. The Royal Bank of Canada is a privately owned corporation and its debts are not those of the Canadian government. Bank of England notes are the paper currency issued (e.g., the ₤10 and ₤20 notes). LO 4.d
When part of an issue of speculative bonds with a 25-year maturity are called, the effect on the remaining bonds will be to A) decrease their quality. B) improve their quality. C) increase their coupon rate. D) decrease their coupon rate.
B) Explanation Speculative bonds are those with lower ratings. They are considered to be of lower quality because the risk of timely payment and principal are higher than investment-grade bonds. When a company shows its determination to honor its debt by paying off some of it in advance, the rating associations take note of that and invariably increase the rating. Compare this to your personal credit score. Your score might be relatively low because you have a lot of outstanding debt. As you pay down that debt, your credit score is likely to increase. It is the same logic here. LO 4.f
Which of the following would be considered an equity security? A) An exchange-traded note B) A prior lien preferred stock C) A collateralized mortgage obligation D) An equity-linked note
B) Explanation Stock means equity. Prior lien means that this preferred has priority over other preferred stock the company has issued. The other three are alternative forms of debt financing. Do not fall into the equity-linked note trap; it is a debt security. LO 4.g
All of the following statements regarding negotiable jumbo certificates of deposit are true except A) they usually have maturities of less than one year. B) they are fully insured in any denomination by the FDIC. C) they are usually issued in denominations of $100,000 to $1,000,000. D) they are readily marketable.
B) Explanation The FDIC insures only up to $250,000. LO 4.c
Which of the following is not a characteristic of certificates of deposit (CDs)? A) A CD is often issued by a bank. B) The Federal Deposit Insurance Corporation (FDIC) provides insurance for CDs to $500,000. C) A CD can be negotiable or nonnegotiable. D) A CD may be payable to the bearer or registered in the name of the investor.
B) Explanation The FDIC provides insurance for CDs up to $250,000. All of the other characteristics are applicable to CDs. LO 4.c
It would be expected that your firm would employ heightened suitability standards when evaluating recommendations for A) sovereign debt. B) structured products. C) cumulative preferred stock. D) nonvoting common stock.
B) Explanation The higher the risk of the investment, the greater the need for checking suitability. Structured products, such as equity-linked notes and exchange-traded notes, are considered complex products. In many cases, FINRA has discovered that registered representatives had inadequate understanding of the investment, leading to their making unsuitable recommendations. LO 4.g
Two bonds currently quoted at a 5.50 basis mature in exactly 15 years. Their coupons are 6% and 7%, respectively. Which bond would experience the greatest appreciation in value if the yields dropped to a 5.20 basis? A) Both would appreciate the same amount B) The 7% bond C) The 6% bond D) Neither because both would decline in value
B) Explanation These bonds are selling at a premium (their coupons are above their yield to maturity, or basis). If the YTM declines to 5.20, it means that the prices of the bonds went up. Without getting too deep into the mathematics, in order for both bonds to have the same basis (5.20), the one with the 7% coupon must have a higher price because the $10 per year additional interest has to be offset by a larger annual "loss." Here is a general rule that will apply to your exam questions. When interest rates are falling, bonds with higher coupon rates are going to appreciate in price at a greater rate than bonds with lower coupon rates. Conversely, when interest rates are rising, those bonds with higher coupons will decrease in price at a slower rate than bonds with lower coupons. In our specific question, the 7% bond will have a greater price increase than the 6% bond. If, however, our question showed the bond selling at a discount, e.g., the basis (YTM) is 8%, the 7% bond would be selling closer to par value than the 6% bond. LO 4.e
A bond is currently priced at 96. Which of the following yields would be the highest? A) Nominal yield B) Yield to maturity C) Current yield D) Coupon yield
B) Explanation When a bond is selling at a discount (96 means 96% of par value, or $960), the investor's yield is greater than the stated coupon or nominal yield (those two terms are synonymous). Because the yield to maturity considers the $40 profit to be made when the bond matures, the YTM is higher than the current yield. LO 4.e
A corporation has $25 million of 5% bonds outstanding. The bonds are callable at 102. Current market interest rates are 6%. If the company would like to retire $10 million of the debt, it might be smart to A) exercise the call provision for $10 million face amount of the bonds. B) make a tender offer to purchase $10 million face amount of the bonds. C) issue $10 million of treasury stock and use the proceeds to retire the bonds. D) issue $10 million of new bonds at current rates and use the proceeds to call in outstanding ones.
B) Explanation When current market interest rates are 6%, bonds with a 5% coupon are selling at a discount. That means the company could make a public offer to buy the bonds back at a price somewhat below par value. In simple terms, they could retire $10 million of debt for less than $10 million. It would make no sense to call the bonds at 102 ($1,020) when they can be purchased for less than $1,000 each in the open market. Issuing new bonds to retire old ones, a practice known as refunding, is done when interest rates have fallen. In this question, interest rates have gone up making that plan incorrect. A company cannot issue treasury stock. Issued and outstanding stock becomes treasury stock when it is reacquired by the issuer. LO 4.b
Which of the following provisions of a new corporate debt issue would be least attractive to a potential investor? A) Significant collateral B) A high nominal yield C) A low call price D) A sinking fund
C) Explanation Investors can be wary when it comes to callable bonds. When interest rates decline and the investors are smiling over the higher than market rates they are earning, along comes the issuer and calls that bond in. The lower the call price, the more attractive it is for the issuer, not the investor. A sinking fund is like the escrow account on a home mortgage. Money is being put aside to make sure that when it is due, it is there. Obviously the investor would prefer a higher coupon (nominal) yield than a lower one and collateral always adds to the security of the debt. LO 4.b
Three 3% bonds are listed in the newspaper. One bond will mature in one year, another bond will mature in 10 years, and the third bond will mature in 20 years. If interest rates are going up, which bond will have the greatest decrease in value? A) None, as they will all have the same decrease in value B) The bond with the 10-year maturity C) The bond with the 20-year maturity D) The bond with the 1-year maturity
C) Explanation Long-term bonds have the greatest interest rate risk. A bond with only one year to maturity will trade very close to par. LO 4.e
The price of which of the following will fluctuate most with a change in interest rates? A) Short-term bonds B) Money market instruments C) Long-term bonds D) Common stock
C) Explanation Long-term debt prices fluctuate more than short-term debt prices as interest rates rise and fall. LO 4.e
All of the following are money market instruments except A) reverse repurchase agreements. B) commercial paper. C) options. D) bankers' acceptances.
C) Explanation Money market instruments are short-term (one year or less to maturity) liquid debt instruments. Reverse repurchase agreements, repurchase agreements, commercial paper, CDs, and bankers' acceptances are examples. Options are not money market instruments. LO 4.c
Which of the following statements regarding negotiable certificates of deposit (CDs) are true? The issuing bank guarantees them. They are callable. Minimum denominations are $1,000. They can be traded in the secondary market. A) II and IV B) I and III C) I and IV D) II and III
C) Explanation Negotiable CDs are issued primarily by banks and backed by the issuing bank. The minimum denomination is $100,000. These are sometimes referred to as jumbo CDs. LO 4.c
The industry term "junk bond" applies to a bond with a Standard and Poor's rating no higher than A) C. B) BBB. C) BB. D) B.
C) Explanation Once a bond's rating has fallen below the top four grades (AAA, AA, A, and BBB), it is no longer considered investment grade. At that point, BB (or Moody's Ba) or lower, it is considered a high-yield or junk bond. LO 4.f
Which of the following would be considered an equity security? A) Negotiable CDs B) Equity-linked notes C) Preemptive rights D) Exchange-traded notes
C) Explanation Rights (and warrants) are included in the term equity security. Confusingly, equity-linked notes are debt securities, even though the term equity is in the name. On this exam, notes always represent a form of debt security. LO 4.g
Which of the following is not considered a debt security? A) Debenture B) Promissory note C) Prior lien preferred stock D) Equipment trust certificate
C) Explanation Stock, whether preferred or common, represents equity (ownership) and is never considered a debt security. The most common example of a promissory note on the exam is commercial paper, a money market instrument. Debentures represent an unsecured debt of the issuer. Equipment trust certificates represent debt secured by specific equipment, typically rolling stock. LO 4.a
All of the following statements regarding negotiable jumbo certificates of deposit are true except A) they usually have maturities of less than one year. B) they are readily marketable. C) they are fully insured in any denomination by the FDIC. D) they are usually issued in denominations of $100,000 to $1,000,000.
C) Explanation The FDIC insures only up to $250,000. LO 4.c
The coupon on a bond can be described as its A) current yield. B) basis. C) nominal yield. D) yield to call.
C) Explanation The coupon on a bond is also known as the nominal yield, and it indicates the annual interest paid. For example, a 4% bond pays $40 of interest per year. LO 4.e
The coupon on a bond can be described as its A) current yield. B) yield to call. C) nominal yield. D) basis.
C) Explanation The coupon on a bond is also known as the nominal yield, and it indicates the annual interest paid. For example, a 4% bond pays $40 of interest per year. LO 4.e
A customer purchased a 5% bond yielding 6%. A year before the bond matures, new bonds of the same quality are being issued at 4%, and the customer sells the 5% bond. The customer probably did which of the following? Bought it at a discount Bought it at a premium Sold it at a discount Sold it at a premium A) II and IV B) I and III C) I and IV D) II and III
C) Explanation The customer purchased the 5% bond when it was yielding 6% (at a discount). The customer sold the bond when other bonds of like kind, quality, and maturity were yielding 4%. The bond is now at a premium. Therefore, the customer realized a capital gain. LO 4.e
A callable municipal bond maturing in 30 years is purchased at 102. The bond is callable at par in 15 years. If the bond is called at the first call date, the effective yield earned on the bond is A) not determinable. B) higher than the yield to maturity. C) lower than the yield to maturity. D) the same as the yield to maturity.
C) Explanation When a bond is purchased at a premium ($1,020) and called for redemption, the investor's effective yield is the yield to that call date. That will be lower than the bond's yield to maturity because the premium is lost sooner. LO 4.e
A corporation has $25 million of 5% bonds outstanding. The bonds are callable at 102. Current market interest rates are 6%. If the company would like to retire $10 million of the debt, it might be smart to A) issue $10 million of new bonds at current rates and use the proceeds to call in outstanding ones. B) issue $10 million of treasury stock and use the proceeds to retire the bonds. C) make a tender offer to purchase $10 million face amount of the bonds. D) exercise the call provision for $10 million face amount of the bonds.
C) Explanation When current market interest rates are 6%, bonds with a 5% coupon are selling at a discount. That means the company could make a public offer to buy the bonds back at a price somewhat below par value. In simple terms, they could retire $10 million of debt for less than $10 million. It would make no sense to call the bonds at 102 ($1,020) when they can be purchased for less than $1,000 each in the open market. Issuing new bonds to retire old ones, a practice known as refunding, is done when interest rates have fallen. In this question, interest rates have gone up making that plan incorrect. A company cannot issue treasury stock. Issued and outstanding stock becomes treasury stock when it is reacquired by the issuer. LO 4.b
A bond has a 7% coupon and an offering price of 108. The bond matures in ten years. An investor purchasing this bond at the offering price would have a yield to maturity closest to A) 7.80%. B) 7.50%. C) 7.22%. D) 5.96%
D) Explanation "When you pay more, you get less," Anytime a bond is purchased at a premium (a price above par), the yield to maturity (as well as the current yield and yield to call) must be lower than the nominal yield (the coupon rate). If you stop and think for a moment, there can be only one possibly correct answer. With a coupon rate of 7%, the answer must be something less than that. As will likely be the case on the exam, there is only one choice that is less than 7%. If you want to do the computation using our formula, it is: Annual interest - (premium ÷ years to maturity) ÷ average price of the bond. Plugging in the numbers we have: $70 - ($80 ÷ 10) ÷ [($1,080 + $1,000) ÷ 2]. This works out to: $62 ÷ $1,040 = 5.96%. However, as stated above, with only one number below the coupon rate, that has to be it. A variation of this question has two choices below the coupon. If that were the case here, the other choice would be 6.48%. That is the current yield ($70 ÷ $1,080). You need to remember that with a bond selling at a premium, the YTM will always be lower than the CY.
All of the following are characteristics associated with equity-linked notes (ELNs) except A) they have final payments at maturity linked to the return of an underlying stock or basket of stocks. B) they are considered to be nonconventional structured investments. C) they can be exchange traded or traded over-the-counter (OTC). D) they are equity securities.
D) Explanation Despite their name, ELNs are debt instruments, not equity instruments. They have a partial fixed return, as well as a final payment linked to the performance of a single stock or equity index. Some are exchange traded, while others trade OTC. FINRA, who considers ELNs to be nonconventional structured investments, has expressed concerns that investors might not fully understand ELNs or the risks associated with them. LO 4.g
One of your individual customers would like to add some foreign debt securities to their portfolio. When told that the investment would be $2,500, the best suggestion would be to A) tell the customer that $2,500 is below the minimum purchase quantity of foreign bonds. B) contact a broker-dealer in the foreign country of choice and open an account there. C) use one of the overseas branches of your firm to suggest the appropriate issues. D) invest in a mutual fund concentrating in foreign debt securities.
D) Explanation For small investments, a mutual fund or exchange-traded fund (ETF) is usually going to be the most suitable choice. Most countries do not allow nonresident noncitizens to open local brokerage accounts, and that is a pretty impractical idea anyway. If your firm has an overseas office, it could be a source of information, but when only $2,500 is involved, purchasing individual bonds issued by a foreign nation is usually not reasonable. LO 4.d
A customer buys a 5% bond at par. The bond is callable in five years at par and matures in 10 years. Which of the following statements is true? A) YTC is higher than YTM. B) YTC is lower than YTM. C) Nominal yield is higher than either YTM or YTC. D) YTC is the same as YTM.
D) Explanation If a bond is trading at par, the nominal yield (coupon rate) equals current yield equals yield to maturity (YTM) equals yield to call (YTC). YTC is higher than YTM if the bond is trading at a discount to par. YTC is lower than YTM if the bond is trading at a premium over par. Nominal yield is higher than either YTM or YTC if the bond is trading at a premium over par. LO 4.e
When part of an issue of speculative bonds with a 25-year maturity are called, the effect on the remaining bonds will be to A) decrease their coupon rate. B) decrease their quality. C) increase their coupon rate. D) improve their quality.
D) Explanation Speculative bonds are those with lower ratings. They are considered to be of lower quality because the risk of timely payment and principal are higher than investment-grade bonds. When a company shows its determination to honor its debt by paying off some of it in advance, the rating associations take note of that and invariably increase the rating. Compare this to your personal credit score. Your score might be relatively low because you have a lot of outstanding debt. As you pay down that debt, your credit score is likely to increase. It is the same logic here. LO 4.f
The ELLA Distributing Company issued a bond with a nominal yield of 5%. The bond matures in 12 years and is currently trading at 94. The bond's yield to maturity is closest to A) 5.00%. B) 5.32%. C) 4.64%. D) 5.67%.
D) Explanation The first point to notice is that the bond is trading at a discount. When bonds trade at a discount, our yield chart and example tells us that the yields, in ascending order, are nominal yield, current yield, yield to maturity, and yield to call. That last one is of no relevance to this question because a call feature is not mentioned anywhere. Therefore, we know that the yield to maturity must be greater than the nominal (coupon) yield of 5%. There are only two choices that are, so if you are running out of time or do not remember how to do this, at least you have a 50% chance. However, 50% doesn't pass the exam, so let's make that 100%. The yield to maturity computation is tricky, but current yield is not. It is simply the coupon divided by the current market price. In our question, that is 5% divided by 94 equals 5.32% (or $50 divided by $940). We know the yield to maturity for a bond selling at a discount is higher than its current yield. That means the correct answer must be greater than 5.32%. If you have a question like this on the actual exam, there will be only one choice higher than the current yield. As shown in the LEM, the YTM calculation goes like this: [annual interest + (discount divided by the number of years to maturity)] divided by the average price of the bond Plugging in the numbers, we get a numerator of $50 + ($60 divided by 12 years) = $50 + $5 = $55. The denominator is ($940 + $1,000) divided by 2 = $1,940 divided by 2 = $970. Solve by dividing $55 by $970 and the answer is 5.67%. LO 4.e
One of your customers calls and asks you about a security with an S&P rating of SP-2. The customer is most likely asking about which of the following? A) Commercial paper B) A municipal bond C) Your firm's privacy notice D) A municipal noteYour customer is interested in long-term corporate bonds. Which of the following interest rate environments makes a call protection feature most valuable to your customer? A) Volatile interest rates B) Stable interest rates C) Declining interest rates D) Rising interest rates Explanation A call protection feature is an advantage to bondholders in periods of declining interest rates. When interest rates are falling, issuers are more likely to call in bonds previously issued at higher interest rates. For bondholders, calling bonds creates reinvestment risk, as they are unlikely to be able to reinvest at the rate they had been earning. Call protection gives the bond holder a specified length of time during which the bond cannot be called. LO 4.b
D) Explanation The three major rating services each have their own rating system for short-term municipal debt (notes). In the case of Standard and Poor's, the ratings are SP-1, SP-2, and SP-3 in declining order of quality. Regulation S-P (with the hyphen between the S and P) deals with privacy notices. Although it is unlikely to be tested, commercial paper is rated A-1, A-2, A-3, and then into the "Bs." LO 4.f
