Chapter 05: Fundamentals of Debt

Question 1

Interest is paid every ____ months on dates that are based on _______.

Answer 1

Interest is paid every 6 months on dates that are based on the maturity date.

Question 2

Represents the total of all the interest payments over the bonds life and the bonds par values at maturity

Answer 2

Debt service

Question 3

If any payments by an issuer are missed, it’s considered to be in ____.

Answer 3

If any payments by an issuer are missed, it’s considered to be in default.

Question 4

For an issuer, raising capital through ___ is considered to be _______ since the issuer is borrowing against its net worth

Answer 4

For an issuer, raising capital through debt is referred to as leverage financing since the issuer is borrowing against its net worth

Question 5

When a corporation has more _____ than _____ outstanding, it’s considered a leveraged issuer.

Answer 5

When a corporation has more debt than equity outstanding, it’s considered a leveraged issu

Question 6

True or false. Regardless of the amount and investor pays for a bond, if it’s held to maturity, the issuer is obligated to pay the par value

Answer 6

True

Question 7

The _____________ is generally fixed at the time the bond is issued

Answer 7

The rate of interest is generally fixed at the time the bond is issued

Question 8

Is defined as the fixed rate of interest earned on a bond. This rate is set at the time the bond is issued

Answer 8

Coupon rate

Question 9

A Bond’s interest rate is set at the time of issuance and generally remains fixed for the life of the bond. However, in some cases, as interest rates move up or down, the coupon rate will be adjusted to reflect market conditions.

These are known as ___________ or _________.

Answer 9

These are known as variable or floating rate securities

Also, adjustable rate bonds

Question 10

True or false. Bonds pay interest on the 1st or 15th of the month to ease paperwork issues

Answer 10

True

Question 11

True or false. Newly issued bonds pay interest from the dated date otherwise known as the date from which interest begins to accrue, which may not fall on the 1st or the 15th.

Answer 11

True

Question 12

If the first coupon is for more than 6 months, it’s referred to as a _________.

Answer 12

If the first coupon is for more than 6 months, it’s referred to as a long coupon

Question 13

If the first coupon is for less than 6 months, it’s referred to as a __________

Answer 13

If the first coupon is for less than 6 months, it’s referred to as a short coupon

Question 14

True or false. Since bond interest is paid semiannually, a bond holder who sells a bond between interest payments is usually entitled to the interest earned during the period when he still owned the bond. This accrued interest is the amount of interest the seller is entitled to receive and the amount the buyer is required to pay

Answer 14

True

Question 15

How often does interest accrue on corporate and municipal bonds?

Answer 15

On the basis of a 360 day year with each month having 30 days

Question 16

Note

If a coupon date is on the 15th of the month for a corporate or Municipal Bond, there will be 16 days remaining in that month. This is because the calculation begins at the date of the last coupon payment and goes up to, but doesn’t include, the settlement date.

Question 17

How is accrued interest calculated on Treasury bonds and treasury notes

Answer 17

On the basis of a 365-day year with actual days in each month

Question 18

What does it mean for a bond to trade flat?

Answer 18

A bond is said to trade “flat” when it is traded without any accrued interest. In other words, the buyer of the bond does not pay the seller for the interest that has accumulated since the last interest payment (also known as the coupon payment) up to the trade date. This contrasts with a bond trading “with accrued interest,” where the buyer compensates the seller for that portion of the interest

For example:

Zero-coupon bonds: These bonds do not make periodic interest payments. (T-bills)
Instead, they are issued at a discount to their face value and redeemed at their face value upon maturity. Since there are no interest payments to accrue, zero-coupon bonds always trade flat.

Question 19

If the bonds of an offering will mature sequentially over several years, it’s referred to as a _________.

Answer 19

Serial bond issue

• with cereal issues, an investor could purchase a quantity of bonds that mature at the same time or, if she wishes, she could purchase the bonds with different maturities

Question 20

Define credit risk

Answer 20

Credit risk is a recognition that an issuer may default and may not be able to meet its obligations to pay interest and principal to the bond holders

Question 21

What are a bond investors two choices when dealing with the realities of reinvestment risk

Answer 21

(1.) Accept a lower rate of return, or (2.) Assume a higher degree of risk to keep her returns stable

Question 22

What are the three different measures for determining a bond yield

Answer 22

Nominal yield, current yield, and yield to maturity

Question 23

A bonds ______ is the same as its coupon rate

Answer 23

Nominal yield or stated yield.

Ex: if a bond holder purchases a 6% Bond, then her nominal yield is 6%.

Question 24

While the __________ is based on a Bond’s par value, __________ is based on the bonds current market price

Answer 24

While the nominal yield is based on a Bond’s par value, current yield is based on the bonds current market price

Question 25

Define current yield

Answer 25

Current yield essentially measures what a bond investor receives for what she pays

Question 26

A Bond’s Annual interest / Current Market Price = ____________

Answer 26

Current yield

Question 27

If an investor purchases a 6% bond that has a par value of $1,000 for $800, what’s her current yield?

Answer 27

Current Yield = $60/$800 = .075 or 7.5%

Question 28

When a Bond’s yield _______ is being described, it may also be referred to as the yield or basis.

Therefore, a 7.44% ________, a 7.44% yield and a 7.44% basis are synonymous

Answer 28

Yield to maturity

Question 29

What does it mean when a call feature is labeled “ in whole “

Answer 29

This means that the entire issue is being called at one time

Question 30

What does it mean for a call to be partial

Answer 30

A partial call means that some of the bonds will be retired early, While others still remain outstanding (lottery calls)

Question 31

Both _____ and ______ calls must be disclosed to a client prior to a bonds purchase and noted on the confirmation. However, due to the unlikelhood of occurrence, _______ are exempt from the disclosure requirement.

Answer 31

Both partial and in-whole calls must be disclosed to a client prior to a bonds purchase and noted on the confirmation. However, due to the unlikelhood of occurrence, catastrophic calls are exempt from the disclosure requirement.

Question 32

The income generated by issuing new bonds (at a lower rate) that is growing in an escrow account is used in a process called _______ in order pay off outstanding bonds (higher rates) in time for their scheduled call dates.

Answer 32

Prerefunding

Question 33

When money is deposited into an escrow account and used to pay off a bond at its maturity date, it’s referred to as being _________

Answer 33

When money is deposited into an escrow account and used to pay off a bond at its maturity date, it’s referred to as being escrowed-to-maturity

Question 34

When money is deposited into an escrow account and used to pay off a bond at its call date, it’s referred to as being _________.

Answer 34

When money is deposited into an escrow account and used to pay off a bond at its call date, it’s referred to as being escrowed-to-call

Question 35

The interest received from investment in a corporate bond is taxed at ____________.

Answer 35

The same rate as the investors ordinary income

Question 36

Interest received from an investment in a corporate bond is subject to ____, _____, and _________ and taxed in the year in which is received.

Answer 36

Interest received from an investment in a corporate bond is subject to federal, state, and local taxation and is taxable in the year in which it is received

Question 37

True or false. If a corporate bond is sold in the secondary market, the seller must include the amount of accrued interest received and treat it as ordinary income

Answer 37

True

Question 38

True or false. When reporting income, the buyer of a bond in the secondary Market, must include the amount of the interest payment minus any accrued interest paid at the time of purchase

Answer 38

True

Question 39

Since zero - coupon bonds do not pay periodic interest, the bonds value gradually increases over its term, and the difference between the purchase price and the face value at maturity represents the interest income for the bondholder. This increase in value over time is referred to as _______.

Answer 39

Since zero - coupon bonds do not pay periodic interest, the bonds value gradually increases over its term, and the difference between the purchase price and the face value at maturity represents the interest income for the bondholder. This increase in value over time is referred to as accretion

Question 40

If a zero - coupon Bond is purchased at 60 with 20 years to maturity, the bonds cost basis is adjusted upward each year by two points ( the 40- point discount from par is divided by the 20 years to maturity).

Since this accreted amount is treated as ordinary income, taxes must be paid accordingly despite the fact that no physical funds were received ( also known as Phantom income)

Answer 40

Note

For this reason, many investors purchase zero - coupon issues within tax - deferred accounts to avoid this Phantom income taxation. If the bond is sold prior to maturity, any capital gain or loss is calculated by using the bonds accreted cost basis

Question 41

A change in basis (yield) has the greatest effect on the price of ______ maturity bonds.

Answer 41

A change in basis (yield) has the greatest effect on the price of longer maturity bonds.

Logic: this is due to the fact that the cash flows from a long-term Bond are spread out over a longer period of time, making the bonds price more sensitive to changes in interest rates than short-term bonds.

For example: a 1% increase in interest rates may cause the price of a 10-year bond to fall by 8-10%, while the price of a 2-year bond may only fall by 2-3%.

Question 42

refers to a bond’s yield after its been adjusted for inflation (yield minus inflation rate)

Answer 42

The real interest rate, also referred to as the real rate of return

Question 43

___________ are typically the only acceptable securities for use as collateral in the escrow account for advance refunding of municipal bonds.

Answer 43

Treasury obligations

This is because Treasury obligations are considered to be the highest quality and lowest risk securities available in the market, and they are backed by the full faith and credit of the U.S. government. This provides investors with a high level of assurance that the securities held in the escrow account will generate the cash flows necessary to repay the outstanding debt on the original bonds. Additionally, Treasury obligations are highly liquid, meaning they can be easily bought and sold in the market, which is important in case the escrow account needs to be liquidated before the original bonds become callable.

Question 44

is the rate of interest that the Federal Reserve charges member banks for loans

Answer 44

the discount rate

Question 45

is the method used to call term bonds.

Answer 45

Random Selection or a “lottery”

Logic: The random selection method, or lottery, is used to ensure fairness and equal treatment of bondholders. This approach also helps maintain investor confidence in the bond market, as it avoids potential biases or manipulations. If the issuer were to selectively redeem bonds with the highest coupon rates, they could be seen as favoring certain investors over others, leading to discontent among bondholders and potentially affecting future bond sales.

Question 46

Is the amount of Interest owed to the seller of a bond in between interest payments

Answer 46

Accrued interest

Remember most bonds pay interest on the first or 15th of the month to ease paperwork issues

Question 47

In general, when interest rates change, the prices of ______ bonds will fluctuate more than the prices of ___ bonds

Answer 47

In general, when interest rates change, the prices of long-term bonds will fluctuate more than the prices of short-term bonds

Question 48

_____ interest rates change more often and more sharply (they’re more volatile) than _____ rates

Answer 48

Short-term interest rates change more often and more sharply than long-term rates