Chapter 3 - Types of Bonds

Question 1

An investor would receive an official statement when
A) making a capital contribution into a company as an equity investor.
B) investing in a private placement, or Regulation D offering.
C) purchasing a new offering of municipal bonds.
D) receiving an allocation of an initial public offering (IPO).

Answer 1

Answer Explanation:
An official statement is the primary disclosure document an investor would
receive when purchasing a new offering of municipal bonds. Among the
many disclosure items included are the risks associated with investing in
the bonds.

Textbook Reference: Please see textbook section 3.4.5.3

Question 2

Which one of the following is not a type of money market instrument?
A) Certificate of Deposit
B) Mortgage-backed security
C) Commercial paper
D) Banker’s Acceptance

Answer 2

Answer Explanation:
Money market instruments have maturities of less than one year. The most
important types of money market instruments are U.S. Treasury bills,
commercial paper, banker’s acceptances and certificates of deposit.

Textbook Reference: Please see textbook section 3.6

Question 3

In a corporate liquidation, which of the following securities have the
highest priority to receive any remaining assets?
A) Senior secured debt
B) Mezzanine debt
C) Preferred stock
D) Common stock

Answer 3

Answer Explanation:
Senior secured lenders are also called “hard asset lenders.” They place
first liens on specific corporate assets, such as equipment, vehicles or
buildings and these assets stand as collateral to make sure loans are
repaid.

Textbook Reference: Please see textbook section 3.1.2.3

Question 4

Marketable U.S. Treasury securities include which two of the
following?
I. SLGs
II. Treasury strips
III. Treasury Bills
IV. Series EE Bonds
A) III and IV
B) II and III
C) I and III
D) II and IV

Answer 4

Answer Explanation:
Both Treasury Bills and Treasury strips trade actively in the secondary
markets. SLGs and U.S. Savings bonds, (Series EE and Series HH
bonds) are non-negotiable.

Textbook Reference: Please see textbook section 3.2.1

Question 5

Which of the following requires a fiduciary to be appointed to act for
the benefit of bondholders?
A) The Glass-Steagall Act of 1933
B) The Trust Indenture Act of 1939
C) The SarbanesÂOxley Act of 2002
D) The Securities Exchange Act of 1934

Answer 5

Answer Explanation:
The Trust Indenture Act of 1939 requires that a trustee be appointed to act
for the benefit of bondholders. The Glass-Steagall Act of 1933 (officially the
Banking Act of 1933) was a law that established the Federal Deposit
Insurance Corporation (FDIC) in the United States and introduced banking
reforms. The Securities Exchange Act of 1934 governs the trading of U.S.
securities in the secondary market. The SarbanesOxley Act of 2002, also
known as the ‘Public Company Accounting Reform and Investor Protection
Act’ (in the Senate) and ‘Corporate and Auditing Accountability and
Responsibility Act’ (in the House) is commonly known as SarbanesOxley,
Sarbox or SOX.

Textbook Reference: Please see textbook section 3.1

Question 6

An investor that is interested in receiving as much tax exempt interest
income as possible, regardless of his residence location, should
consider which of the following securities?
A) A 10-year Treasury bond
B) A state of California GO bond
C) A Puerto Rico GO bond
D) An Industrial development Revenue bond issued in his state of
residence

Answer 6

Answer Explanation:
Municipal bonds issued by U.S. territories like Guam, Puerto Rico and U.S.
Virgin islands are tax exempt at the federal, state and local levels. Other
municipal bonds may be tax exempt at the state and local level as well, but
only if the bondholder resides in the state of issue. U.S. government
securities are taxable at the federal level, but tax exempt at the state level.

Textbook Reference: Please see textbook section 3.4.5.2

Question 7

All of the following are positive indicators for analysis of general
obligation bonds EXCEPT
A) An increase in fees from the use of the city’s convention center
B) The expansion of a local factory which is a large employer
C) A high rate of tax collections
D) An increase in the tax base

Answer 7

Answer Explanation:
An increase in fees from the use of the convention center is most likely
relevant to the analysis of revenue bonds, since the user fees pay debt
service expense. Increasing populations and an increasing tax base are
good indicators for GO analysis, as is a high rate of tax collection.

Textbook Reference: Please see textbook section 3.4.1

Question 8

An individual who purchases $100,000 Treasury Bond should be least concerned with
A) Gross Domestic Product
B) Economic conditions in the U.S.
C) Credit risk
D) Inflation risk

Answer 8

Answer Explanation
An owner of a Treasury bond should not be concerned with credit, or default, risk. The other items mentioned could certainly be factors in the determination of interest rates and Treasury bond prices.

Textbook Reference
Please see textbook section 3.2

Question 9

Which of the following receive the least amount of their revenue from property taxes?
A) County governments
B) City governments
C) School districts
D) State governments

Answer 9

Answer Explanation
State governments receive the bulk of their revenue from income and sales taxes. Property taxes are the main revenue source for local governments.

Textbook Reference
Please see textbook section 3.4.1

Question 10

The proceeds from a corporation’s sale of commercial paper must be used to finance
A) Long-term financial needs
B) Current transactions
C) Fixed assets
D) Capital projects

Answer 10

Answer Explanation
Proceeds from the sale of commercial paper must be used to finance current transactions, not permanent obligations, fixed assets or long-term financing needs. The maximum maturity allowed is just 270 days.

Textbook Reference
Please see textbook section 3.6.1

Question 11

The agreement between a municipal bondholder and the issuer is found in the
A) indenture
B) legal opinion
C) notice of sale
D) official statement

Answer 11

Answer Explanation
The agreement between the issuer of the municipal bond and the investor is contained in the bond indenture.

Textbook Reference
Please see textbook section 3.4.2.1

Question 12

When comparing liquidity differences between two corporate bonds, the most important factor to be considered is the
A) credit ratings of the two bonds
B) CUSIP number
C) maturity of the two bonds
D) coupons of the two bonds

Answer 12

Answer Explanation
The credit ratings of the bonds would be the most important factor to examine when comparing the liquidity differences of two corporate bonds.

Textbook Reference
Please see textbook section 3.1.5

Question 13

A municipal bond backed by the full faith and credit, as well as the taxing authority, of the issuer is called a
A) general obligation (GO) bond.
B) industrial development bond.
C) revenue bond.
D) Build America Bond.

Answer 13

Answer Explanation
GO bonds are backed by the full faith and credit, and also the taxing authority, of the issuer. This contrasts with revenue bonds, which are backed by specific revenues of the facility financed.

Textbook Reference
Please see textbook section 3.4.3

Question 14

Distributions from a CMO are made
A) Monthly and are taxed at all levels
B) Quarterly and are taxed at the federal level only
C) Monthly and are taxed at the federal level only
D) Quarterly and are taxed at all levels

Answer 14

Answer Explanation
Distributions from a CMO are made on monthly basis and are taxed at the federal, state, and local level. Their monthly distributions make them appropriate for investors who are seeking income on a monthly basis.

Textbook Reference
Please see textbook section 3.3.1

Question 15

Which of the following corporate securities has the highest priority in a bankruptcy proceeding?
A) Senior unsecured debt
B) Common stock
C) Mezzanine debt
D) Secured debt

Answer 15

Answer Explanation
Secured debt has the highest priority of corporate securities for repayment in a bankruptcy proceeding, followed by senior unsecured debt, mezzanine debt, and common stock.

Textbook Reference
Please see textbook section 3.1.2.3

Question 16

A $10,000 U.S. Treasury bond is quoted as Bid 102.8, Ask 16. How much would an investor pay to buy this bond?
A) $11,200
B) $10,216
C) $10,250
D) $10,225

Answer 16

Answer Explanation
Investors purchase at the ask price of 102.16. Treasuries are quoted in 32nds, so the asked price is actually 102 16/32nds (½) for each $100 of face value. 102.50 x 100 = $10,250.

Textbook Reference
Please see textbook section 3.2.2

Question 17

All of the following statements apply to Alternative Minimum Taxes (AMT) and municipal bonds EXCEPT
A) Bond confirmations will identify if AMT applies to the issue
B) The AMT must be calculated separately and compared to the normal tax calculation
C) The tax that must be paid is the lower of the AMT or normal income tax calculation
D) Interest from private activity bonds must be included in the calculation`

Answer 17

Answer Explanation
The alternative minimum tax (AMT) was designed to insure that persons with numerous tax deductions or credits pay a fair amount of income tax. A separate AMT calculation is made and the tax owed based on the greater of the two calculations must be paid. Private activity bonds are included in the AMT calculation. Confirmations include a notation to inform investors of bonds that may be subject to AMT.

Textbook Reference
Please see textbook section 3.4.5.3

Question 18

The value of the conversion privilege of a convertible bond is based on the
A) par value of the bond
B) market value of the underlying stock
C) parity price of the underlying stock
D) conversion ratio of the bond

Answer 18

Answer Explanation
The value of the conversion privilege of a convertible bond is based on the value of the underlying common stock, as the investor can exchange the bond for the shares. The parity price is where investors are indifferent to owing the bond versus the common shares.

Textbook Reference
Please see textbook section 3.1.3

Question 19

An investor interested in a general obligation bond versus a revenue bond
A) Is greatly concerned about the credit risk of the issuer
B) Is willing to accept a lower yield in return for taking less risk
C) Has already determined that Treasury bonds are an inappropriate investment for them
D) Is demanding higher yield in return for greater risk

Answer 19

Answer Explanation
General Obligation bonds will offer a lower yield when compared to a revenue bond, in return for the lower amount of risk the investor is willing to take.

Textbook Reference
Please see textbook section 3.4.3

Question 20

A city passes a law that permits it to issue new municipal bonds to fund a new city government building. Which two of the following statements are TRUE?

I. This is a revenue bond issue
II. This is a general obligation bond issue
III. The issuer used statutory power to authorize this bond issue
IV. The issuer cannot proceed with this issue until it receives approval from the state legislature
A) I and IV
B) I and III
C) II and III
D) II and IV

Answer 20

Answer Explanation
GO bonds are used to build facilities for the public like government buildings. Statutory power refers to passing a law that will authorize a local municipality to proceed with issuance of a general obligation bond. This usually requires a voter referendum, but not approval from the state legislature.

Textbook Reference
Please see textbook section 3.4.1.1

Question 21

As compared to an issuer’s non-convertible debt, convertible bonds

I. Pay a higher coupon
II. Pay a lower coupon
III. Are typically classified as subordinated debt
IV. Are typically classified as non-subordinated debt
A) II and III
B) I and IV
C) I and III
D) II and IV

Answer 21

Answer Explanation
Convertible bonds provide the holder the choice of converting to shares of common stock. Because of this benefit to investors, convertible bonds pay less interest. When compared to non-convertible bonds, convertibles are classified as subordinated debt, which means they have a lower claim to the assets of the issuer in the event of liquidation.

Textbook Reference
Please see textbook section 3.1.3

Question 22

Which of the following securities carries no reinvestment rate risk?
A) Convertible debenture
B) 25-year debenture with a 5-year no call feature
C) STRIP
D) Treasury Note

Answer 22

Answer Explanation
As an asset category, zero-coupon bonds do not have reinvestment rate risk, as these types of bonds do not make any regular interest payments to investors.

Textbook Reference
Please see textbook section 3.2.1.5

Question 23

A government-sponsored enterprise that purchases and securitizes mortgages to ensure that funds are available for lending to home buyers is
A) Department of Housing and Urban Development (HUD)
B) Government National Mortgage Association (GNMA)
C) Federal National Mortgage Association (FNMA)
D) American Depository Receipts (ADRs)

Answer 23

Answer Explanation
Federal National Mortgage Association (FNMA) is a government-sponsored enterprise that purchases and securitizes mortgages to ensure that funds are available for lending to home buyers. Government National Mortgage Association (GNMA) is government-owned, as opposed to government-sponsored and guarantees investors timely payment of interest and repayment of principal on mortgage-backed securities backed by federally insured or guaranteed loans. The Department of Housing and Urban Development (HUD) is a department of the U.S. government that governs policy pertaining to homeownership, community development, and access to affordable housing. American Depository Receipts (ADRs) are used by non-U.S. companies to enable U.S. investors to purchase shares of the company’s stock and to enable that stock to trade on a U.S. stock exchange.

Textbook Reference
Please see textbook section 3.3.1

Question 24

Which of the following legislative acts exclusively regulates debt securities?
A) Securities Exchange Act of 1934
B) Securities Act of 1933
C) Investment Advisers Act of 1940
D) Trust Indenture Act of 1939

Answer 24

Answer Explanation
The Trust Indenture Act of 1939 exclusively regulates corporate debt securities and requires that a trust indenture be established between the issuer and the trustee on behalf of the bondholders to protect the bondholders’ rights.

Textbook Reference
Please see textbook section 3.1.1

Question 25

A security that typically has up to 270 days until its maturity date is a(n)
A) Treasury note
B) Open- end investment company
C) American Depository receipt
D) Commercial paper

Answer 25

Answer Explanation
Commercial paper is a short- term debt issuance of a corporation, proceeds normally used for the capital purposes of the business. CP usually has a maximum of 270 days until maturity.

Textbook Reference
Please see textbook section 3.6.1

Question 26

Commercial paper is exempt from securities registration requirements as long as maturities do not exceed
A) 180 days
B) 270 days
C) One year
D) 90 days

Answer 26

Answer Explanation
Commercial paper is generally exempt from securities registration requirements under the 33 Act, as long as maturities do not exceed 270 days. However, transactions in commercial paper are not exempt from anti-fraud provisions of U.S. securities law

Textbook Reference
Please see textbook section 3.6.1

Question 27

Another name for a repo is
A) Sale/leaseback agreement
B) Counterparty swap
C) Collateralized loan facility
D) Sale-and-repurchase agreement

Answer 27

Answer Explanation
Repos are also called sale-and-repurchase agreements. Technically, they are not instruments or securities but rather transactions in which one party sells a high-quality instrument for cash and agrees to buy it back at a different price.

Textbook Reference
Please see textbook section 3.6.4

Question 28

The standard denomination in which banker’s acceptances are sold is
A) $10,000
B) $1 million
C) $100,000
D) $5,000

Answer 28

Answer Explanation
The standard BA denomination is $100,000. Smaller amounts are called odd-lots

Textbook Reference
Please see textbook section 3.6.3

Question 29

A convertible bond’s conversion price is
A) the number of shares of stock that can be exchanged for each bond.
B) the spread between the market price of the convertible bond and the price at which it can be converted.
C) the price at which a convertible bond can be converted into shares of the company’s stock.
D) the current value of the bond if it were converted today.

Answer 29

Answer Explanation
The conversion price is the price at which a convertible bond can be converted into shares of the company’s stock. This is calculated as par value of the bond divided by the conversion ratio. A convertible bond’s conversion price will be defined in the offering memorandum and the indenture. The conversion premium is the spread between the market price of the convertible bond and the price at which it can be converted, expressed as a percentage. The conversion ratio is the number of shares of stock that can be exchanged for each bond. This is calculated as the par value of the bond divided by the conversion price. The conversion value is the current value of the bond if it is was converted today.

Textbook Reference
Please see textbook section 3.1.3.1

Question 30

A discount bond issued by a broker-dealer, secured by interest and principal payments from Treasury securities, is known as a(n)
A) Income bond
B) Treasury Strip
C) Treasury bond
D) Treasury Receipt

Answer 30

Answer Explanation
A Treasury Receipt is essentially a zero-coupon bond structured by a broker-dealer and backed by the cash flows from Treasury securities.

Textbook Reference
Please see textbook section 3.2.1.6

Question 31

Which of the following projects is most likely funded by a revenue bond issue?
A) A municipal government building
B) A new bus depot
C) A city recreation complex
D) A new public golf course

Answer 31

Answer Explanation
Transit authorities that generate revenue from the sale of tickets or fares are funded by revenue bond issues. Projects that are free to the public, or for the good of the public, are backed by GO bonds, and include public golf courses, other sports and recreation complexes, public schools and municipal government buildings.

Textbook Reference
Please see textbook section 3.4.2

Question 32

When a municipal bond trades in the secondary market, any transactions take place

I. On an exchange
II. Over the counter
III. Through an auction
IV. Dealer to Dealer
A) II and IV
B) II and III
C) I and IV
D) I and III

Answer 32

Answer Explanation
Secondary trading of municipal securities takes place in the over the counter market. This market is a decentralized dealer to dealer marketplace and includes only firms that are registered with the MSRB.

Textbook Reference
Please see textbook section 3.4

Question 33

What is a major difference between a retail bank certificate of deposit (CD) and a banker’s acceptance (BA)?
A) BAs are not money market instruments
B) BAs are not backed by banks
C) BAs are not FDIC-insured
D) BAs have longer maturities

Answer 33

Answer Explanation
Although the bank deposits on which BAs are drawn generally are FDIC-insured, BAs themselves are not FDIC-insured. If both the issuer and bank file bankruptcy, the BA could default.

Textbook Reference
Please see textbook section 3.6.3

Question 34

U.S. Treasury auctions are dominated by a group of financial institutions authorized to serve as commercial trading counterparties of the New York Federal Reserve. They are called
A) Treasury Direct dealers
B) Government Syndicate Members
C) Primary dealers
D) Auction licensees

Answer 34

Answer Explanation
Although Treasury auctions are open to the public, they are dominated by large institutions called primary dealers. These institutions are authorized to serve as commercial trading counterparties of the New York Federal Reserve.

Textbook Reference
Please see textbook section 3.2.1.1

Question 35

A school district has overspent its budget and is in need of funds to meet current expenses for the next 90 days. It will most likely issue
A) RANs.
B) TANS.
C) GOs.
D) PHAs.

Answer 35

Answer Explanation
Tax anticipation notes (TANs) are short term municipal instruments that are issued in anticipation of an upcoming tax collection. Schools are supported by property taxes, so TANs can be used to provide interim financing until the tax revenue is available.

Textbook Reference
Please see textbook section 3.4.4.1

Question 36

Which of the following debt instruments is always issued at a discount?
A) Subordinated Debentures
B) Convertible Bonds
C) Treasury Bills
D) Treasury Bonds

Answer 36

Answer Explanation
Treasury Bills are always issued at a discount and mature to their face value, as they are zero coupon securities. All zeroes are issued at a discount.

Textbook Reference
Please see textbook section 3.2.1.1

Question 37

An investment which is a multi –class debt instrument backed by a pool of mortgage pass-through securities is a(n)
A) REIT.
B) ELN.
C) ETF.
D) CMO.

Answer 37

Answer Explanation
These types of structures are commonly known as collateralized mortgage obligations (CMOs). The structure is sold to investors in the form of “tranches”, each having their own individual characteristics and risks.

Textbook Reference
Please see textbook section 3.3.2

Question 38

With regard to municipal taxing authority, which of the following statements is TRUE?
A) States usually rely on property taxes to back GO bond issues.
B) A high debt limit is viewed as a greater sign of safety than a low debt limit.
C) Most cities and counties may issue GO bonds without voter referendums.
D) The taxing authority of municipalities varies widely depending on applicable state or local laws.

Answer 38

Answer Explanation
Municipal taxing authority and statutes that address types and amounts of taxes vary considerably. Most local government bond issues require voter approval or referendums before they can be issued. States typically rely on sales or income taxes for backing of bond issues. A low debt limit is typically viewed more favorably because the municipality potentially has less outstanding debt to service.

Textbook Reference
Please see textbook section 3.4.1

Question 39

Which of the following statements is true of Treasury Notes?
A) They are issued at a discount and mature to face value
B) They cannot be traded in the secondary market
C) They are the shortest maturity of U.S. government securities
D) They have a minimum purchase amount of $100

Answer 39

Answer Explanation
$100 is the minimum purchase amount for U.S. Treasury Notes, which are medium term Treasury securities. They mature in the range of two to ten years, and yield a steady stream of interest payments, payable every 6 months. They are generally issued at par and trade actively in the over-the-counter market.

Textbook Reference
Please see textbook section 3.2.1.2

Question 40

Which two of the following statements correctly state the tax treatment that applies to municipal securities?

I. Capital gains are fully taxable
II. Capital gains are tax deductible
III. Interest payments are generally tax free at the federal level
IV. Interest payments are taxable at the federal level but exempt at the state level.
A) II and IV
B) I and III
C) II and III
D) I and IV

Answer 40

Answer Explanation
Municipal securities pay interest that is generally tax exempt at the federal level, and may also be exempt at the state tax level. Capital gains are fully taxable.

Textbook Reference
Please see textbook section 3.4.5.2

Question 41

Alice buys Treasury Inflation-Protected Securities (TIPS) with an original principal value of $10,000. She wants to know what the principal will be if she holds to maturity. The answer is

A) $10,000
B) It can be higher than $10,000 but not lower
C) It can be lower than $10,000 but not higher
D) It can be either lower or higher than $10,000

Answer 41

B) It can be higher than $10,000 but not lower

Answer Explanation
In TIPS, the interest payments and principal value at maturity are indexed to the Consumer Price Index for All Urban Consumers (CPI-U). At maturity, the TIPS holder can receive more than the original principal if inflation is positive. But he/she can’t receive less than original principal if inflation is negative (deflation).

Textbook Reference
Please see textbook section 3.2.1.4

Question 42

When an investor purchases a ‘tranche’, he is purchasing a unit of a(n)
A) STRIP
B) pool of heavily traded equity securities
C) open-end investment company
D) CMO

Answer 42

Answer Explanation
The term ‘tranche’ is associated with CMOs. Many CMOs are comprised of several different components, or tranches, each with unique investment characteristics and objectives.

Textbook Reference
Please see textbook section 3.3.2