Chapter 2 - Debt Securities Flashcards
A bond that was yielding 3.65% yesterday is currently yielding 3.75%. Which two of the following statements are true?
I. The bond’s price went down since yesterday
II. The bond’s price went up since yesterday
III. The bond’s yield is 10 basis points more today.
IV. The bonds yield is 1/10th basis point more today.
A) I and IV
B) I and III
C) II and IV
D) II and III
Correct Answer:
B) I and III
Answer Explanation
There is an inverse relationship between bond prices and bond yields. Because the bond’s yield is more today, its price fell. Basis points measure the change in interest rate. Each basis point equals 1/100 of a percent. (A change of 1 percent = 100 basis points). A change from 3.65% to 3.75% is a change of 10 basis points.
Textbook Reference
Please see textbook section 2.1.7
When a bond’s market price increases, what is the impact on its nominal yield?
A) Nominal yield will increase.
B) Nominal yield will decline.
C) There will be no change in nominal yield.
D) There will be increased volatility in the nominal yield.
Correct Answer:
C) There will be no change in nominal yield
Answer Explanation
Nominal yield is the bonds annual interest or coupon rate. It is a percentage of par value and fixed over the life of the bond.
Textbook Reference
Please see textbook section 2.2.1
A corporate bond that is currently trading at 95 pays a semi-annual coupon of $25. What is the current yield?
A) 0.05
B) 0.0526
C) 0.025
D) 0.0263
Correct Answer:
0.0526
Answer Explanation
A bond’s current yield is calculated by dividing the annual interest income by the current market price. $50/$950 = 5.26%.
Textbook Reference
Please see textbook section 2.2.2
Which of the following statements regarding debt securities are true?
I. A purchaser of a bond is a creditor of the corporation
II. The corporation is a creditor of a bondholder
III. Bonds are generally issued with a par value of $100
IV. Bonds are generally issued with a par value of $1,000
A) I and IV
B) II and IV
C) II and III
D) I and III
Correct Answer:
A) I and IV
Answer Explanation
Investors that purchase bonds are creditors of the corporation, because the corporation owes them principal and periodic interest for the use of their money. Bonds are usually issued with a par value of $1,000. The stated rate of interest is a percentage of the bond’s par value.
Textbook Reference
Please see textbook section 2.1
An issuer is most likely to call a bond which has
A) a low coupon and a call premium when interest rates are rising
B) a high coupon and no call premium when interest rates are falling
C) a high coupon and a call premium when interest rates are falling
D) a low coupon and no call premium when interest rates are rising
Correct Answer:
B) a high coupon and no call premium when interest rates are falling
Answer Explanation
Issuers strive to keep their cost of borrowing as low as possible. To do this, they call bonds with high coupons when rates are have fallen. They can then issue new bonds at a lower rate and reduce borrowing costs. A call premium is an additional amount that must be paid to call the bonds. To keep costs as low as possible, the issuer would prefer to call a bond with no call premium.
Textbook Reference
Please see textbook section 2.1.9
Which of the following is TRUE of the yield of a bond that is trading at a price that is $80 more than its face value?
A) Its current yield will be the same as its coupon yield
B) Its current yield will be higher than its coupon yield
C) Its coupon yield will be higher than its current yield
D) Its current yield will be $80 less than its coupon yield
Correct Answer:
C) Its coupon yield will be higher than its current yield
Answer Explanation
Coupon yield stays constant over the life of a bond while current yield changes with bond’s market price. If a bond is trading above face value, its current yield will be lower than its coupon yield. If a bond is trading below face value, current yield will be the greater of the two. Current yield goes up as bond prices decrease, and vice versa.
Textbook Reference
Please see textbook section 2.2.5
Which of these bond features is the most attractive to a corporate issuer?
A) High sinking fund requirement
B) Nonrefundable
C) High interest rate
D) Low call premium
Correct Answer:
D) Low call premium
Answer Explanation
Low call premiums are attractive to issuers because it allows the issuer to call the bond away from investors for a lower price. High interest rates require a larger interest expense for issuers, nonrefundable bonds do not allow an issuer to reissue bonds if interest rates decrease, and a high sinking fund require an issuer to maintain a large reserve of cash to maintain the bond. Only the low call premium is beneficial to issuers.
Textbook Reference
Please see textbook section 2.1.9
An assessment by an independent agency of an issuers ability and willingness to make full and timely payments of amounts due on its debt obligations is known as a
A) growth profile
B) stock rating
C) credit rating
D) assessment rating
Correct Answer:
C) credit rating
Answer Explanation
A credit rating is an assessment by an independent rating agency of a company’s ability and willingness to make full and timely payments of amounts due on its debt obligations. Credit ratings are typically required for companies seeking to raise debt financing in the capital markets as only a limited class of investors will participate in a corporate debt offering without an assigned credit rating on the new issue. The three primary credit rating agencies are Moody’s, S&P, and Fitch. Nearly every public debt issuer receives a rating from Moody’s, S&P, and/or Fitch. Moody’s uses an alphanumeric scale, while S&P and Fitch both use an alphabetic system combined with pluses (+) and minuses (-) to rate the creditworthiness of an issuer.
Textbook Reference
Please see textbook section 2.3.5.1
A buyer is not responsible for paying a seller any accrued interest since the last coupon payment in a bond that trades
A) flat.
B) thin.
C) ex-coupon.
D) round lot.
Correct Answer:
A) flat
Answer Explanation
If a bond trades “flat,” the buyer is not responsible for paying interest that has accrued since the last interest payment.
Textbook Reference
Please see textbook section 2.4
A municipal bond’s coupon rate is 3%. The same issuer is now issuing bonds of similar quality and maturity with a coupon rate of 3.5%. The 3% bond will
A) Trade at its par value because the issuer will increase the coupon on the 3% bond to ensure parity with newly issued bonds
B) Trade at a premium in the secondary market
C) Trade at a discount in the secondary market
D) Continue to trade in the secondary market at its par value with no adjustment to the coupon rate
Correct Answer:
C) Trade at a discount in the secondary market
Answer Explanation
A bond trades at a discount in the secondary market when its coupon rate is lower than prevailing interest rates.
Textbook Reference
Please see textbook section 2.1.6
An investor should expect the greatest price increase in which of the following if interest rates decline?
A) Short-term bonds selling at a premium
B) Short-term bonds selling at a discount
C) Long-term bonds selling at a discount
D) Long-term bonds selling at a premium
Correct Answer:
C) Long-term bonds selling at a discount
Answer Explanation
Because of the inverse relationship between price and yield, when interest rates fall, bond prices rise. Longer maturities have more market risk, so their prices rise more than shorter maturities. Bonds selling at a discount also rise more sharply than those selling at a premium.
Textbook Reference
Please see textbook section 2.3.1
Which of the following factors affect a debt obligation’s coupon?
I. Ratings
II. Maturity
III. Covenants
IV. Security
A) I, II, and III only
B) I only
C) I and II only
D) I, II, III, and IV
Correct Answer:
D) I, II, III and IV
Answer Explanation
Coupon refers to the annual interest rate (“pricing”) paid on a debt obligation’s principal amount outstanding. It can be based on either a floating rate (typical for bank debt) or a fixed rate (typical for bonds). Bank debt generally pays interest on a quarterly basis, while bonds generally pay interest on a semiannual basis. There are a number of factors that affect a debt obligation’s coupon, including the type of debt (and its investor class), ratings, security, seniority, maturity, covenants, and prevailing market conditions.
Textbook Reference
Please see textbook section 2.1.6
A 4% municipal bond is trading in the secondary market for 96. Which two of the following statements about the bond’s current yield are true?
I. The bond’s current yield is 4%
II. The bond’s current yield is 4.17%
III. The bond’s CY is less than its YTM
IV. The bond’s CY is greater than its YTM
A) I and IV
B) II and III
C) II and IV
D) I and III
Correct Answer:
B) II and III
Answer Explanation
Current yield is calculated by dividing the annual interest rate of the bond (4%) by the current price (96). Because the bond is trading at a discount its current yield is greater than the coupon rate, and its YTM is greater than its current yield.
Textbook Reference
Please see textbook section 2.2.5
Retiring an outstanding bond issue at maturity by using money from the sale of a new offering is known as
A) Refunding
B) Serial Retirement
C) Restructuring
D) Redeeming
Correct Answer:
A) Refunding
Answer Explanation
When issuers sell new bonds to retire an outstanding bond issue they are engaged in refunding. Pre-refunding or advance refunding occur if the issuers sells the new bonds in advance of the first available call date, typically to lock in a lower interest rate.
Textbook Reference
Please see textbook section 2.1.9
Who is the owner of a bearer bond?
A) The bearer of the bond certificate
B) The underwriter
C) The registered principal
D) The purchaser
Correct Answer:
A) The bearer of the bond certificate
Answer Explanation
Bearer bonds, which were issued in the U.S. for many decades, functioned much like cash in that the bearer of the bond certificate was considered the rightful owner. Unlike other investment securities, the ownership and transactions involving ownership of bearer bonds are not formally recorded. In 1982, Congress passed legislation that eliminated new bearer bonds. Now, there is only one form of note issued in the U.S. in bearer form – a Federal Reserve Note – i.e., the cash or currency in your wallet.
Textbook Reference
Please see textbook section 2.1.1
If a bond declines in price, which of the following results in yield will occur?
A) Coupon yield will rise
B) Current yield will fall
C) Coupon yield will fall
D) Current yield will rise
Correct Answer:
D) Current yield will rise
Answer Explanation
Coupon yield, or nominal yield, doesn’t change over the life of the bond, so it isn’t sensitive to price changes. Current yield is the sum of annual coupon (interest) payments divided by the bond’s current price. It moves inversely with prices. As bond prices decline, the current yield rises; as bond prices increase, the current yield falls.
Textbook Reference
Please see textbook section 2.2.2
A bond is selling at a price of 81 with all coupons since July of 2011 attached. This bond is said to be
A) Trading and interest
B) Trading with recall
C) trading flat with unpaid coupons attached
D) Trading short
Correct Answer:
C) trading flat with unpaid coupons attached
Answer Explanation
When coupons from previous interest payments are attached, the interest has not been paid. Such bonds are termed “trading flat”.
Textbook Reference
Please see textbook section 2.4
When a municipal bond is sold, the amount of accrued interest:
A) Includes the settlement date when calculated
B) Is calculated based on actual day months
C) Is added to the price paid to the seller
D) Is only included in the price if the bond is trading flat
Correct Answer:
C) Is added to the price paid to the seller
Answer Explanation:
The accrued interest calculation for municipal bonds is:
- Based on 360 day years and 30 day months.
- Is added to the price paid to the seller.
- Includes interest payable up to the settlement date only.
Additional: Bonds that trade flat do not include accrued interest
Textbook Reference
Please see textbook section 2.4
The calculation of accrued interest for government bonds:
A) Is subtracted from the price owed to the seller
B) Is based on 360 day years
C) Is not included on the confirmation
D) Includes the last interest payment date
Correct Answer:
D) Includes the last interest payment date
Answer Explanation:
The accrued interest calculation for a government bond is:
- Based on actual day years and months.
- Is added to the price the seller receives at settlement and included in the total price.
- Includes interest on the prior coupon date up to, but not including, the settlement date.
Textbook Reference
Please see textbook section 2.4
An investor buys a 6.0% coupon bond to yield 6.1%. What will most likely happen to the price of the bond as maturity approaches?
A) The price will increase towards par.
B) The price will fall to zero.
C) The price will remain constant.
D) The price will decrease towards par.
Correct Answer:
A) The price will increase towards par
Answer Explanation
This bond has a coupon of 6.0% and a yield-to-maturity of 6.1%, indicating that the bond is trading at a discount. The price of a bond will always trend towards par as maturity approaches. Given that this bond is trading at a discount (e.g. 90% of par), the price would need to increase to arrive at par value.
Textbook Reference
Please see textbook section 2.1.8
All of the following statements regarding variable rate bonds are true EXCEPT
A) the lender assumes interest rate risk
B) they typically have greater price volatility than fixed rate bonds
C) an index or other common base rate such as LIBOR is usually used to determine the rate payable for each period
D) the amount of interest paid varies over the life of the loan
Correct Answer:
B) they typically have greater price volatility than fixed rate bonds
Answer Explanation
The price of a variable rate bond remains relatively stable because the interest rate adjusts to prevailing conditions. As the name implies, the rate of interest paid will vary over the life of the bond. The amount of interest is tied to an underlying index; LIBOR + a spread is frequently used as the base rate. Lenders take on the interest rate risk because the interest payments they receive are subject to fluctuation.
Textbook Reference
Please see textbook section 2.1.4.1
What is the nominal yield of a bond with par value of $1,000, market value of $800, and interest payments of $40 per year?
A) 4%
B) It depends on prevailing interest rates.
C) 2%
D) 5%
Correct Answer:
A) 4%
Answer Explanation
Nominal yield is the coupon rate, which is the annual interest paid divided by par value. It does not change over the life of a bond.
Textbook Reference
Please see textbook section 2.2.1
Two bonds have relatively equal credit quality and terms to maturity. Which of the following statements is true?
A) The bonds will have equal coupon rates.
B) The bond with the higher coupon is more marketable.
C) The bond with the higher coupon will trade at a lower price.
D) The bond with the lower coupon is more liquid.
Correct Answer:
B) The bond with the higher coupon is more marketable
Answer Explanation
All other factors being equal, bonds with higher coupons are more marketable, and more attractive to investors than bonds with lower coupons. Investors will pay more for the bond with the higher coupon unless it is more risky. Bonds of equal credit quality and terms to maturity will likely have similar yields, but their coupon rates of interest may be very different.
Textbook Reference
Please see textbook section 2.1.4
A bond with ten years to maturity is bought at a price of $860. The annual adjustment to its cost basis will be
A) amortization of $70.
B) amortization of $14.
C) accretion of $70.
D) accretion of $14.
Correct Answer:
D) accretion of $14
Answer Explanation
Bonds purchased at a discount are accreted, meaning adjusted upwards towards par value each year. The accretion is calculated on a straight-line basis, by dividing the discount off par ($140) by the number of years to maturity (10). Assume a bond’s par value is $1,000.
Textbook Reference
Please see textbook section 2.5
Saving for the future is a primary investment goal for many people. Which of the following products may help an investor achieve this goal?
A) Money-market mutual funds
B) Defensive stocks
C) High-yield bonds
D) Zero-coupon bonds
Correct Answer:
D) Zero-coupon bonds
Answer Explanation
Zero-coupon bonds may be beneficial to help people save for future events, such as a child’s college education, or retirement.
Textbook Reference
Please see textbook section 2.1.5
An investor holds a callable bond that has been called by the issuer. This investor now faces
A) credit risk
B) interest rate risk
C) call risk
D) reinvestment risk
Correct Answer:
D) reinvestment risk
Answer Explanation
Issuers call bonds when interest rates decline, so they can refinance their debt at a lower rate. An investor who has a bond called away is subject to reinvestment risk, because the investor may have difficulty finding as good a deal for the money.
Textbook Reference
Please see textbook section 2.3.3
A bond has a call provision, effective three years following the original issuance date. This call feature is likely to be utilized if
A) Interest rates have gradually risen over the ensuing three- year period
B) The issuer is not considering a refunding of its debt for the next few years
C) The issuer’s sinking fund commitment has not been fulfilled
D) interest rates have declined since the original issuance date
Correct Answer:
D) interest rates have declined since the original issuance date
Answer Explanation
An issuer would be inclined to exercise a call feature on a bond when interest rates have declined from what they were when the bond was originally issued. When the bond is called, the issuer can either retire that particular issue, thereby eliminating any further obligation to make interest payments, or may elect to do a refunding, which would effectively replace a higher coupon bond with a lower coupon bond, based on whatever level interest rates have declined to.
Textbook Reference
Please see textbook section 2.1.9
A corporation will call in some of its outstanding bonds. When the bonds are called, the issuer
A) will offer the investor another bond with a lower interest rate.
B) must make one final interest payment to the bondholder.
C) will pay the investor par value plus accrued interest to that date.
D) will pay the investor the current market value of the bond plus accrued interest to that date.
Correct Answer:
C) will pay the investor par value plus accrued interest to that date.
Answer Explanation
When an issuer calls in a bond, it will pay the bondholder the par value of the bond, plus any accrued interest to that date. Once the bond is called, there will be no further interest payments made on the bond.
Textbook Reference
Please see textbook section 2.4
Which two of the statements below define settlement terms of U.S. government and municipal securities?
I. Regular way settlement for U.S. Treasury securities is T + 3.
II. Regular way settlement for municipal securities is T + 1.
III. Cash settlement for municipal securities is the same day as the trade.
IV. The terms of cash settlement for municipal securities and U.S. Treasury securities are the same
A) III and IV
B) II and IV
C) I and III
D) I and II
Correct Answer:
A) III and IV
Answer Explanation
Regular way settlement for U.S. Treasury securities is trade date + 1 business day; for municipal securities regular way settlement is T + 2. Cash settlement for both U.S. Treasury and municipal securities is the same day as the trade date.
Textbook Reference
Please see textbook section 2.4
On Monday, March 1st a customer purchases a Treasury bond for regular way settlement. The bond pays semi-annual interest on January 1 and July 1. How many days of accrued interest are added to the buyer’s price?
A) 61 days
B) 63 days
C) 60 days
D) 59 days
Correct Answer:
C) 60 days
Answer Explanation
Regular way settlement for government bonds is T+1, and the accrued interest calculation is based on actual day months. There are 31 days in January, 28 in February, and 1 day in March (the buyer’s price includes interest that goes up to, but does not include the settlement date).
Textbook Reference
Please see textbook section 2.4
Which of the following call dates would be LEAST beneficial for an investor?
A) 10 years
B) 15 years
C) 5 years
D) 20 years
Correct Answer:
C) 5 years
Answer Explanation
Investors prefer a longer call date in order to better protect themselves from call and reinvestment rate risk.
Textbook Reference
Please see textbook section 2.1.9
A corporate bond valued at “300 over” comparable treasury securities is
A) less risky than treasury securities
B) yielding 300 basis points more than treasury securities
C) selling at $300 over the price of treasury securities
D) trading at a premium
Correct Answer:
B) yielding 300 basis points more than treasury securities
Answer Explanation
The expression “300 over” refers to the yield of a bond being 300 basis points greater than that of a comparable security.
Textbook Reference
Please see textbook section 2.1.7
The accrued interest that is added to the price the seller receives at settlement of a municipal bond that was purchased in a secondary market transaction:
A) Starts on the dated date.
B) Is calculated based on actual day months.
C) Starts on the day following the prior interest payment date.
D) Does not include interest paid on the settlement date.
Correct Answer:
D) Does not include interest paid on the settlement date.
Answer Explanation
Accrued interest for municipal bonds is:
1. Calculated based on 30-day months
2. Starts on the date of the prior interest payment
Additional 2 points:
1. It does not include interest payable on the settlement date
2. The dated date is only relevant for the calculation of accrued interest on newly issued municipal bonds.
Textbook Reference
Please see textbook section 2.4
An investor purchases a 6% bond for 115. Rank the yield computations for this bond from highest to lowest.
I. Current yield
II. Nominal yield
III.Yield to call
IV. Yield to maturity
A) II, I, IV, III
B) II, IV, I, III
C) II, IV, III, I
D) II, I, III, IV
Correct Answer:
A) II, I, IV, III
Answer Explanation
When a bond is trading at a premium, the nominal yield (i.e. coupon) is the highest rate, followed by the current yield, yield to maturity, and yield to call.
Textbook Reference
Please see textbook section 2.2.5
The market perceives which two of the following to have the greatest risk?
I. bonds with high credit ratings
II. bonds with low credit ratings
III. bonds with short terms to maturity
IV. bonds with long terms to maturity
A) II and IV
B) I and IV
C) II and III
D) I and III
Correct Answer:
A) II and IV
Answer Explanation
Bonds with low credit ratings have a higher degree of default risk. Bonds with long term maturities have a higher degree of interest rate risk.
Textbook Reference
Please see textbook section 2.3.5
What does yield to maturity (YTM) measure in a bond, assuming the bond is held to its scheduled maturity?
A) Yield discounted by time value
B) Total return
C) The value of interest payments
D) Yield
Correct Answer:
B) Total return
Answer Explanation
YTM measures the total return of a bond, held from the current date through scheduled maturity. It includes both scheduled interest payments and any capital gain or loss – i.e., the difference, if any, between the current price and maturity value. The denominator in YTM is the current bond price. So, YTM changes as current bond prices change.
Textbook Reference
Please see textbook section 2.2.3
When does settlement normally occur for government securities?
A) T
B) T+2
C) T+3
D) T+1
Correct Answer:
D) T+1
Answer Explanation
Settlement for government securities usually occurs on the day after trade date (T+1).
Textbook Reference
Please see textbook section 2.4
A 20-year U.S. Treasury bond was bought at a price of $945 in July. By the end of the year, its price had increased to $1,075. What most likely caused the price to rise?
A) The U.S. Treasury called in older bonds
B) The U.S. Treasury issued new bonds
C) Interest rates rose
D) Interest rates fell
Correct Answer:
D) Interest rates fell
Answer Explanation
The most likely factor that caused a change in the trading value of a bond is a change in prevailing market interest rates. The inverse relationship between bond price and interest rates instructs that when interest rates go down, bond prices go up. Likewise, if rates go up, bond prices go down.
Textbook Reference
Please see textbook section 2.1.6
A municipal bond that is offered at a yield to maturity higher than its coupon rate is recognized as trading
A) At a premium
B) flat
C) At par
D) At a discount
Correct Answer:
D) At a discount
Answer Explanation
If a bond’s yield to maturity is more than its coupon rate, the bond is trading at a discount. The YTM calculation reflects the impact on the investor’s return of the amount of premium or discount paid when the bond is purchased. If the bond is purchased at a discount, the investor’s rate of return on the bond at maturity is more than the stated rate, or coupon, of the bond when it was issued.
Textbook Reference
Please see textbook section 2.2.5
