Debt Securities Flashcards
An investor has purchased a Bristol County Public Power System revenue bond. Which of the following statements is TRUE concerning this investment?
a. Earnings from the bond are exempt from federal, state, and local taxes.
b. Payment of principal and interest is ultimately the responsibility of Bristol County.
c. If the power system declares bankruptcy, the bonds will go into default.
d. The assets of the power system secure the bond
c. If the power system declares bankruptcy, the bonds will go into default
Interest from a revenue bond (a type of municipal bond) is exempt from federal income tax. However, it is generally exempt from state and local taxes only if purchased by a resident of the state of issuance. In addition, a revenue bond is backed by a stream of income from a specific project or facility. Unlike a general obligation bond, it is not backed by a general promise by the issuer to repay the debt.
In this example, only the revenue (not the assets) of the power system back the bonds. If the power system cannot produce enough revenue to pay the bond’s interest and/or principal, there will be a default. Bristol County is not obligated to use any other funds to make payments on the bonds. (2-39)
The last sale of a U.S. government bond was 98.4. The dollar value of the bond is:
a. $98.40 b. $981.00 c. $981.25 d. $984.00
c. $981. 25
U.S. government bonds are quoted in full points and 32nds of a point. A quote of 98.4 would be 98 and 4/32nds which, when converted into a decimal, would be 98.125. This would have a dollar value of $981.25. (2-27)
Two similar companies issue bonds at the same time. One company issues convertible bonds and the other issues nonconvertible bonds. Which two of the following statements are TRUE?
I. The convertible bonds will probably offer a higher coupon rate.
II. The convertible bonds will probably offer a lower coupon rate.
III. The convertible bonds will probably have a higher current yield.
IV. The nonconvertible bonds will probably have a higher yield to maturity.
a. I and III b. I and IV c. II and III d. II and IV
d. II and IV
Convertible bonds normally have a lower coupon rate than nonconvertible securities. The convertible bonds pay less interest and offer lower yields because the convertible feature gives individuals the ability to become stockholders at their discretion. Since the issuer is giving bondholders this advantage, it can offer a lower coupon rate. (2-20)
Which of the following legal documents clarifies the tax status of a municipal bond issue?
a. A prospectus
b. Form 1035
c. Form 1099
d. A legal opinion
d. A legal opinion
The legal opinion is the document that clarifies the tax status of a municipal bond’s interest. There is no prospectus issued for municipal bonds since they are exempt securities. (2-35)
Which of the following statements is CORRECT concerning an IDRB?
a. This is an International Depository Receipt that is issued to offshore investors.
b. This is a type of retirement plan for local government workers.
c. This is a type of municipal bond with a potential federal tax liability.
d. This is a type of Treasury zero-coupon, inflation indexed receipt
c. This is a type of municipal bond with a potential federal tax liability.
An Industrial Development Revenue Bond (IDRB) is a type of municipal issue used to finance the construction of a facility that will be used by a private corporation. Due to peculiarities of the U.S. tax code, interest on these bonds may increase certain clients’ federal tax liability. (2-39)
Interest on U.S. government bonds is:
a. Subject to federal and state income tax
b. Exempt from federal and state income tax
c. Subject to state income tax but exempt from federal income tax
d. Subject to federal income tax but exempt from state income tax
d. Subject to federal income tax but exempt from state income tax
Interest on U.S. government bonds is subject to federal income tax but exempt from state income tax. This is just the opposite of the tax treatment on municipal (state) bonds where the interest is exempt from federal but subject to state tax. This is based on the doctrine of powers between the federal government and state governments. Each government can tax the interest on its own obligations, but cannot tax the other’s. In addition, states usually do not tax the interest received from their obligations owned by residents of that particular state and, in effect, interest is completely tax-free. (2-31)
Which of the following statements are TRUE of a bond selling above par?
I. The current yield is lower than the nominal yield.
II. The nominal yield is less than the current yield.
III. The yield to maturity is lower than the nominal yield.
IV. The nominal yield always remains fixed.
a. I and III only b. I and IV only c. I, III, and IV only d. II, III, and IV only
c. I, III, and IV only
Bond prices and yields have an inverse (opposite) relationship; as a bond’s price increases, its yield decreases. Conversely, as prices decrease, yields increase. When a bond is selling above its par value, both the current yield and yield to maturity are below the nominal yield. The nominal yield is printed on the face of the bond and always remains fixed. (2-11, 2-12)
An investor has a need for high liquidity with low risk that the market price will substantially decline. Which of the following would you recommend as a suitable investment based on these criteria?
a. Treasury bonds
b. Municipal bonds
c. Treasury bills
d. Corporate bonds
c. Treasury bills
Based upon the investor’s investment criteria, Treasury bills would be most suitable, since a Treasury bill is a short-term instrument (maturing in one year or less) and has a low principal risk. There is also a considerable secondary market for Treasury bills making them highly liquid. (2-27)
An increase in which of the following would cause the price of a bond to drop?
a. The bond’s rating
b. The bond’s liquidity
c. The issuer’s financial strength
d. The general level of interest rates
d. The general level of interest rates
Interest rates and bond prices are inversely related. When interest rates increase, bond prices will fall. When interest rates decrease, bond prices will rise. An increase in choice (a), (b), or (c) would usually have a positive effect on a bond’s price. (2-11, 2-12)
When liquidating a corporation’s assets, in which order are claims satisfied?
a. Secured bondholders, preferred stockholders, common stockholders, general creditors
b. Secured bondholders, general creditors, preferred stockholders, common stockholders
c. General creditors, secured bondholders, common stockholders, preferred stockholders
d. Common stockholders, preferred stockholders, secured bondholders, general creditors
b. Secured bondholders, general creditors, preferred stockholders, common stockholders
The order in which claims are satisfied when liquidating a corporation's assets is: 1. Secured bondholders 2. General creditors 3. Preferred stockholders 4. Common stockholders (2-19)
Which of the following are traded and quoted at a discount?
a. Common stocks
b. Corporate bonds
c. U.S. Treasury notes
d. U.S. Treasury bills
d. U.S. Treasury bills
Of the choices given, the only securities traded and quoted at a discount are U.S. Treasury bills. (2-29)
Current Yield
calculation is….
Annual Interest / Current Market Price = Current Yield
Nominal Yield = 10%
Bond Price = $1,000
Current Yield - 100%
100/1000 = 100%
Taxable Equivalent Yield
calculation is….
Tax-Free Yield / (100% - Tax Bracket %) = Taxable Equivalent Yield
6% Tax-Free Municipal
25% Tax Bracket
6% / (100% - 25%) - 0.06 / 0.75 = 8% (0.08)
Net (After-Tax) Yield
calculation is….
Taxable Yield x (100% - Tax Bracket %) = Net (After-Tax) Yield
8% Corp Bond
25% Tax Bracket
8% x (100% - 25%) = 0.08 x 0.75 - 6% (0.06)
