Chapter 4

Question 1

The price of which of the following will fluctuate most with a change in interest rates?

Answer 1

• Long-term bonds

- Long-term debt prices fluctuate more than short-term debt prices as interest rates rise and fall.

Question 2

If the dollar price of a municipal bond is 101 and, at that price, the basis is 6.10, the nominal yield is

Answer 2

• greater than 6.10%.
• 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.

Question 3

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?

Answer 3

• 20-year bond selling at a discount
• This is all about duration. The longer the duration, the greater the price volatility of the bond. That is why prices of long-term bonds are more volatile than prices of short-term bonds. We know from the inverse relationship between bond prices and interest rates that falling interest rates lead to higher bond prices. 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 because they have a longer duration. 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.

Question 4

The industry term “junk bond” applies to a bond with a Standard and Poor’s rating no higher than

Answer 4

• BB
• 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.

Question 5

A bond investor who is looking for capital gains should invest in bonds when interest rates are

Answer 5

• high and expected to decline.
• 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.

Question 6

Which of the following expressions describes the current yield of a bond?

Answer 6

• Annual interest payment divided by current market price
• The current yield on a bond is calculated by dividing the annual interest payment by the current market price of the bond.

Question 7

A 5% bond is trading at a premium. Which of the following would be the bond’s highest yield?

Answer 7

• Coupon yield
• 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.

Question 8

The Union Fidelity Bank of Highville has issued jumbo CDs with a term of three years and a fixed interest rate of 3.5%. The minimum denomination of the CDs is $100,000, and the CDs are callable at 101% of face value beginning on the first anniversary of the issue date. Under which of the following circumstances is it most likely that the bank would exercise the call feature on that anniversary date?

Answer 8

• Five-year jumbo CDs are currently being issued with a fixed interest rate of 2.7%.
• As is the case with other fixed payment callable issues, whenever interest rates decline, it is generally beneficial to call in the older issue. In this case, the bank would pay an extra 1% to redeem but could refinance at a rate that is at least .8% lower and extend the maturity. We say at least .8% lower because with the new five-year CDs paying 2.7%, if the bank wanted to keep to the same final maturity date (two more years), it is expected that the rate on two-year CDs would be lower than that of CDs with a five-year maturity.

Question 9

What happens to outstanding fixed-income securities when market interest rates drop?

Answer 9

• The prices increase.
• When interest rates drop, the price of outstanding bonds rises to adjust to the lower yields on bonds of comparable quality.

Question 10

A bond analyst plots the yields of AAA corporate bonds and compares them to the yields of U.S. Treasury bonds with similar maturities. This is known as

Answer 10

• yield curve analysis.
• The plotting of bond yields results in a curve, usually one where the longer the time to maturity, the higher the yield. The term yield curve analysis is the proper way to describe comparing the yields of highly-rated corporate bonds to those of Treasury bonds. When the spread between the yields is narrow, economic conditions in the United States are generally favorable. If the spread (sometimes called the credit spread) widens, it is generally a sign of a worsening economy. ** This question deals with material not covered in your LEM, but it relates to recent rule changes and/or student feedback.

Question 11

Nickelplate Manufacturing Corporation (NMC) is capitalized with 1 million shares of a 6% $50 par callable preferred stock and 10 million shares of $1 par common stock. With the preferred stock currently selling at $75 per share and the common stock at $60 per share, the current yield of the preferred stock is closest to

Answer 11

• 4%
• Current yield on any security, stock or bond, is the annual income (dividend on stock, interest on bond) divided by the current market price per share (or per bond). The math in this question is the dividend of $3 (a 6% $50 par preferred stock is paying an annual dividend of 6% of $50, or $3 per share) divided by the current market price of the preferred stock ($75). The quotient is .04 or 4%. What about the common stock? All of that information is just to distract you. We cannot compute the current yield of the common stock because we do not have any information about its dividend.

Question 12

A bond would be considered speculative below which of the following Standard & Poor’s (S&P) ratings?

Answer 12

• BBB
• A rating of BBB is the lowest investment-grade rating assigned by S&P. Any rating beneath this is considered speculative.

Question 13

Which of the following is not a characteristic of certificates of deposit (CDs)?

Answer 13

• The Federal Deposit Insurance Corporation (FDIC) provides insurance for CDs to $500,000.
• The FDIC provides insurance for CDs up to $250,000. All of the other characteristics are applicable to CDs.

Question 14

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

Answer 14

• sovereign debt
• 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.

Question 15

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.

Answer 15

• I and III
• 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.

Question 16

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?

Answer 16

• YTC is the same as YTM.
• 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.

Question 17

bond indenture

Answer 17

• terms of bond loan
• also referred to as the deed of trust
• states issuers obligation to pay back a specific amount of money on a specific date

Question 18

coupon rate = nominal yield

Answer 18

• money lent to a issuer for a set period at a fixed annual interest rate
• once set it never changes during the life of a bond

Question 19

If a bond with a 5% coupon is currently yielding 6%, is it selling at a discount, a premium, or par?

Answer 19

• Anytime you are getting a yield higher than the coupon rate, the bond has to be selling at a discount from par. Conversely, if the bond had a 5% coupon, but the current return was 4%, the bond must be selling at a premium to par.
• If you pay more you get less (discount)
• if you pay less you get more (premium)

Question 20

zero coupon bond (Zr)

Answer 20

• always sold at a discount
• BCD Zr 36 @ 6.45%
• BCD = issuer, Zr = zero coupon bond, 2036 = maturity date, YTM = 6.45%

Question 21

current yield

Answer 21

• CY = current yield

- annual income / current market price

Question 22

yields from lowest to highest

Answer 22

nominal, CY, YTM, YTC

Question 23

YTM (yield to maturity) = bond basis

Answer 23

• annual interest - (premium / years to maturity) /

average price of the bond

Question 24

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 use some of that cash to reduce the company’s outstanding debt by $10 million. 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 most likely recommend?

Answer 24

• $15 million @8% due in 10 years, callable at 101
• 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.

Question 25

A corporate bond is quoted at 102⅝. A customer buying 10 bonds would pay

Answer 25

• $10,262.50.
• Par ($1,000) × 102% = $1,020. Five-eighths of one bond point ($10) equals 0.625 times $10 equals $6.25. Therefore, the quote reading 102⅝ equals $1,026.25 per bond ($1,020 + $6.25). Because we are told the customer is buying 10 bonds, we multiply $1,026.25 by 10 bonds, which equals the amount the customer will need to pay to make the entire purchase: $10,262.50.

Question 26

The current yield on a bond with a coupon rate of 7.5% currently selling at 105½ is approximately

Answer 26

• 7.1%
• A bond with a coupon rate of 7.5% pays $75 of interest annually. Current yield equals annual interest amount divided by bond market price, or $75 / $1,055 = 7.109% or approximately 7.1%.

Question 27

Which of the following is not a characteristic of certificates of deposit (CDs)?

Answer 27

• The Federal Deposit Insurance Corporation (FDIC) provides insurance for CDs to $500,000.
• The FDIC provides insurance for CDs up to $250,000. All of the other characteristics are applicable to CDs.

Question 28

The following is taken from the S&P Bond Guide: FLB Zr 37 87 87½. What is the coupon rate on this bond?

Answer 28

• 0%
• 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).

Question 29

Moody’s Investment-Grade (MIG) rating would be applicable to

Answer 29

• a New York state revenue anticipation note.

- A MIG rating is provided for short-term municipal debt commonly referred to as notes (revenue anticipation notes).

Question 30

All of the following are money market instruments except

Answer 30

• options
• 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.

Question 31

Nickelplate Manufacturing Corporation (NMC) is capitalized with 1 million shares of a 6% $50 par callable preferred stock and 10 million shares of $1 par common stock. Your customer’s required rate of return on fixed income investments is 8%. The NMC preferred stock would be an appropriate addition to this customer’s portfolio only if the stock was not priced in excess of

Answer 31

• $37.50
• How does a 6% preferred stock return 8%? Remember the inverse relationship between interest rates and fixed income security prices. As one goes up, the other goes down. An increased return results from a decreased price. The math is basic algebra. We know the annual dividend is $3 per share (6% of $50 = $3); that is fixed. What number results in a payment of $3 providing an 8% return? Divide 3.00 by $8 and the answer is $37.50. You could also do this question by working backwards. Multiply each of the choices by 8% and the one where the product is $3 is correct.

Question 32

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?

Answer 32

• Declining interest rates
• 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.

Question 33

The XYZ Corporation has issued some 4% callable bonds maturing in 20 years. The bonds are callable at 102 commencing in 10 years. Regarding these bonds, which of the following statements is not correct?

Answer 33

• These bonds will appreciate faster in declining interest rate markets than comparable bonds without a call feature.
• All things being equal, callable bonds will not show as much appreciation in a declining interest rate market as bonds without a call feature. Logically, as interest rates fall, those bonds will be called making them less attractive than bonds where the higher interest rate payments will continue until maturity. It is correct that the premium ($20 in this question) is generally not going to equal the amount of interest that the investor would have been able to earn on the bond. It is some compensation, but not full. The bonds will be called when interest rates have declined, and the investor will now have the cash but faces the reinvestment risk of having to put the money to work at those lower interest rates.

Question 34

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?

Answer 34

• The 7% bond
• 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.

Question 35

An analyst is comparing the yields of U.S. Treasury bonds and AAA-rated corporate bonds with similar maturities. This measurement would indicate an improving economy when

Answer 35

• the yield spread is narrowing.
• You should understand that the greater the risk, the higher the yield on the bond. Many analysts compare the difference between yields on bonds with the same maturity but different quality (rating) to get a sense of the market sentiment. One common measurement is the difference in yields between Treasuries and corporate bonds. This difference is called the yield or credit spread and tends to widen when economic conditions sour and narrow when they get better. You will never see (at least on the exam and probably in the real world as well) the yield on a corporate bond lower than a Treasury bond when the maturities are similar. It is the spread, the difference in yields, that is important. ** This question deals with material not covered in your LEM, but it relates to recent rule changes and/or student feedback.

Question 36

The term high-yield bond would apply to a bond with a Moody’s rating of

Answer 36

• Ba.
• 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)