Module 2 Debt Investments

Question 1

Which of these is a feature of zero-coupon bonds?

A)
Offer minimum price volatility
B)
Have a duration less than their term to maturity
C)
Eliminate reinvestment rate risk
D)
Have low interest rate risk

Answer 1

c Zero-coupon bonds are sold at a deep discount from par value and have no coupon payments. They are redeemed for their face value at maturity. These bonds have maximum price volatility and respond sharply to interest rate changes. Zero-coupon bonds have durations equal to their term to maturity.

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Question 2

Select the incorrect statement regarding foreign bonds.

A)
Yankee bonds are sold in the United States by companies outside of the United States and provide all interest payments in U.S. dollars.
B)
Foreign bonds may provide an investor with portfolio diversification benefits.
C)
Eurodollar bonds must be registered with the Securities and Exchange Commission (SEC).
D)
Yankee bonds are not subject to exchange rate risk, but they are subject to default risk.

Answer 2

c Eurodollar bonds do not have to be registered with the SEC.

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Question 3

Today, a U.S. Treasury STRIP (Separate Trading of Registered Interest and Principal of Securities) bond has been created with a $100,000 par value, seven-year, 3% Treasury note. Assuming prevailing seven-year market rates are 4%, calculate the market value of the principal unit (rounded to nearest dollar).

A)
$72,788
B)
$75,992
C)
$82,772
D)
$92,665

Answer 3

b The answer is $75,992. If prevailing market interest rates are 4%, the principal unit is priced as follows:

100,000 = FV

7 = N

4 = I/YR

0 = PMT

Solve for PV = 75,991.7813, or $75,992

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Question 4

A convertible bond has a 6.5% coupon rate, interest is paid semiannually, and the bond matures in five years. Comparable debt currently yields 7.5%. The bond is convertible into common stock at $25 per share. The current price of the stock is $28, and the current price of the convertible bond is $1,050. What is the investment value of the bond?

A)
$1,000.00
B)
$968.95
C)
$958.94
D)
$1,008.90

Answer 4

c A bond’s investment value is the same as its intrinsic value as a straight bond. Using a financial calculator, the bond price is determined using the following inputs:

N = 10 (5 x 2 periods per year)

I/YR = 7.5%

PMT = 1000 x 6.5% / 2 = $32.5

FV = $1,000

Solve for PV = –958.94, or $958.94.

NOTE: There are several examples on bond calculations in the blue boxes in the Module 2 text; however, it may be beneficial to skip ahead to Module 7 for some additional practice.

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Question 4

The intrinsic value of a preferred stock with an 8% dividend ($100 par stock) and a market interest rate of 7.5% is

A)
$107.50.
B)
$108.00.
C)
$106.67.
D)
$100.00.

Answer 4

c The answer is $106.67. The preferred stock is a perpetuity and priced by the equation:

P = D ÷ r = $8.00 ÷ 0.075 = $106.67.

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Question 5

Tom owns a taxable investment that earns 8% interest annually. Tom pays taxes at a marginal rate of 24%. Calculate the after-tax rate of return that Tom will receive on this investment.

A)
6.25%
B)
6.30%
C)
2.24%
D)
6.08%

Answer 5

The answer is 6.08%. The after-tax return is 8% × (1 − 0.24) = 6.08%.

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Question 6

To immunize a bond portfolio over a specific investment horizon, an investor would do which of the following?

A)
Match the maturity of each bond to the investment horizon.
B)
Match the average weighted maturity of the portfolio to the investment horizon.
C)
Match the duration of each bond to the investment horizon.
D)
Match the average weighted duration of the bond portfolio to the investment horizon.

Answer 6

d The answer is match the average weighted duration of the bond portfolio to the investment horizon. When a portfolio is immunized, its liabilities and expected future cash outflows are funded by making sure that the cash flow from investments (income and principal) will be there at the time that the cash outflow is needed. That is done by matching the duration, not the maturity, of the bond portfolio to the number of years until the cash outflow will occur. The duration of the portfolio as a whole should be matched, not the duration of each bond in the portfolio.

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Question 6

A convertible bond has a par value of 1,000, a current market value of $1,200, and an investment value of $1,050. The bond is convertible into 25 shares of common stock. What is the investment premium of this bond?

A)
$100
B)
$200
C)
$75
D)
$150

Answer 6

D

Investment value = value if it were NOT convertible, so just a straight up bond. The premium factors in conversion price of the stock, so the fact that the premium is $200 and the investment value is $50 both over par, that means that the investment value was hit SOLELY by the interest rate decline, and the premium got a double whammy of both stock price appreciation AND interest rate declines.

The answer is $150. The investment premium is a measure of the downside risk of the bond and is the difference between the current market value and the investment value. $1,200 - $1,050 = $150 investment premium.

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Question 7

Which of the following statements correctly describe differences between corporate preferred stock and long-term bonds?

Bonds represent a creditor position; preferred stock represents an equity position.
Bonds pay a fixed amount of interest; preferred stock pays a fluctuating dividend based on earnings.
Interest paid by firms is a tax-deductible expense; dividends paid on preferred stock are not tax deductible.
Bonds usually are not rated; preferred stock usually is rated.
A)
I and III
B)
I and IV
C)
III and IV
D)
II and III

Answer 7

a Option II is not correct because preferred stock pays a fixed dividend. Option IV is not correct because almost all bonds, except some municipal and all U.S. government bonds, are rated.

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Question 7

Which of these statements regarding Treasury Inflation-Protected Securities (TIPS) is CORRECT?

A)
The principal value is adjusted for inflation every six months based on the Consumer Price Index (CPI), and one-half of the stated coupon rate is paid semiannually on the inflation-adjusted principal value.
B)
A semiannual inflation rate is combined with the stated coupon rate to determine the TIPS interest rate for the next six months.
C)
TIPS are issued at 50% of the par value with the par value being adjusted every six months for inflation.
D)
The TIPS coupon rate is adjusted every 12 months based on changes in the Consumer Price Index (CPI).

Answer 7

a

TIPS are every six months apparently

The answer is the principal value is adjusted for inflation every six months based on the CPI, and one-half of the stated coupon rate is paid semiannually on the inflation-adjusted principal value. TIPS coupon rate stays the same for the life of the security, but the interest payment changes based on the inflation-adjusted principal or par value.

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Question 8

The conversion value of a convertible bond with a conversion ratio of 25, a conversion price of $40, and a market price of the underlying stock of $32 is

A)
$900.
B)
$1,000.
C)
$200.
D)
$800.

Answer 8

d

So like, in this question you’ll essentially get 25 shares that are worth $32 each. This means the conversion value is $800 (way worse than par).

The conversion value is the value if converted and is determined by multiplying the market price of the underlying stock by the conversion ratio:

$32 × 25 = $800

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Question 8

Which one of these is CORRECT regarding preferred stock?

A)
Failure to pay preferred stock dividends results in bankruptcy.
B)
Preferred stock’s dividends are tax deductible for corporations.
C)
Preferred stock’s value is based on prevailing interest rates.
D)
Preferred stockholders have voting rights.

Answer 8

c Which one of these is CORRECT regarding preferred stock?

A)
Failure to pay preferred stock dividends results in bankruptcy.
B)
Preferred stock’s dividends are tax deductible for corporations.
C)
Preferred stock’s value is based on prevailing interest rates.
D)
Preferred stockholders have voting rights.

Question 9

The reason for using a ladder bond strategy is to

A)
lower interest rate risk.
B)
turn a paper loss into an actual loss.
C)
magnify gains.
D)
spread cash flows evenly over a given time horizon to eliminate default risk.

Answer 9

a For example, with a ladder bond strategy, instead of investing all money in a seven-year bond, an investor may divide the dollars among bonds with one, three, five, seven, and nine-year maturities. With this approach, instead of making a single bet on interest rates, the investor has both longer and shorter maturities, so that regardless of which way interest rates move the investor will not experience either great losses or great gains.

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Question 9

Yield curves are constructed from daily information published on U.S. Treasury bond

A)
yields-to-maturity.
B)
current yields.
C)
yields-to-call.
D)
coupon payments.

Answer 9

a The answer is yields-to-maturity. Yields-to-maturity represent a bond’s promised yield if held to maturity.

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Question 10

If an investor is looking to purchase bonds that are free from default risk, which of these should be purchased?

A)
Municipal bonds
B)
Revenue bonds
C)
Corporate bonds
D)
Government bonds

Answer 10

d The answer is government bonds. Unlike corporate, revenue, and municipal bonds, government bonds are free from default risk.

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Question 11

Jennifer owns a state public purpose bond. She sells the bond and realizes a capital gain of $4,000. Prior to selling the bond, the total interest she had earned for the year was $99. Considering the sale and the interest amount, calculate the amount she must include in gross income.

A)
$3,901
B)
$4,000
C)
$4,099
D)
$99

Answer 11

b The interest on public purpose bonds is received tax-free by the holder. Only the capital gain realized on the sale is subject to income taxation.

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Question 11

Klaus Copenhagen’s objective is to receive income, and he is considering a preferred stock with a $1.50 dividend that is currently trading at $25. What would be the approximate price movement of this preferred stock if interest rates were to rise 1%?

A)
–14%
B)
–4%
C)
–7%
D)
–10%

Answer 11

a First, determine what the current interest rate is, $1.50 ÷ $25 = 0.06. Now, determine the percentage price movement if interest rates climb 1%—$1.50 ÷ 0.07 = $21.43. This is a decline of $3.57, or 14.28%.

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Question 12

The interest rate theory that states investors are compensated for the increased price risk of holding long-term maturities is known as

A)
preferred habitat theory.
B)
liquidity preference theory.
C)
market segmentation theory.
D)
unbiased expectations theory.

Answer 12

b The answer is liquidity preference theory. The liquidity preference theory holds that long-term bonds should provide higher returns than shorter-term obligations because investors are willing to sacrifice some yield to invest in short-term bonds in order to avoid the higher price volatility of longer-term issues.

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Question 13

Which of the following describes downside risk with respect to convertible bonds?

A)
The difference between the current market value of the bond and its conversion value.
B)
The difference between the conversion value of the bond and its investment value.
C)
The difference between the straight value of the bond and its conversion value.
D)
The difference between the current market value of the bond and its investment value.

Answer 13

d Downside risk with respect to convertible bonds is the difference between the current market value of the bond and its investment value.

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Question 13

Chris owns a bond that is convertible into common stock at $38 per share and has a coupon of 6.0%. Interest is paid semiannually. The current market price of the stock is $42 per share. The investment value of the bond is $1,050, and the bond currently sells for a market price of $1,225.

Which one of these percentages is closest to the downside risk of this bond?

A)
18.37%
B)
14.29%
C)
9.80%
D)
4.98%

Answer 13

b The answer is 14.29%. The downside risk of the bond is $175 ($1,225 current market price - $1,050 investment value). This translates into 14.29% ($175 downside risk ÷ $1,225 current market value).

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Question 13

Which of the following is CORRECT with respect to convertible bonds and convertible preferred stock if the value of the common stock rises?

A)
The value of convertible bonds and convertible preferred stock declines.
B)
The value of convertible bonds rises, but convertible preferred stock falls.
C)
The value of convertible bonds falls, but convertible preferred stock rises.
D)
The value of convertible bonds and convertible preferred stock rises.

Answer 13

d The value of any convertible will rise with a rise in the underlying common stock into which it can be converted. The convertibles will not necessarily have the same gain; it will depend on their premium and conversion terms.

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Question 14

Select which of these statements regarding Treasury notes and Treasury bonds is CORRECT.

Both Treasury notes’ and bonds’ interest payments are income tax free at the state and federal level.
Treasury notes and bonds are considered default risk free.
If held for more than one year, interest paid on Treasury bonds is eligible for long-term capital gain treatment.
Both Treasury notes and bonds are not traded in the secondary market.
A)
I and II
B)
III and IV
C)
II only
D)
I, III, and IV

Answer 14

c The answer is II only. Both Treasury notes and bonds are considered default risk free. Both obligations trade in the secondary market and pay interest, which is income tax free at both the state and local level, but taxed as ordinary income in the year earned at the federal level.

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Question 14

Martha owns a convertible bond that has a current market value of $1,200. The bond’s conversion ratio is 22 shares, and its conversion value is $1,100. The bond has a coupon of 8%, payable semiannually, and matures in 16 years. With market interest rates currently at 7.5%, the bond’s investment value is $1,050. Martha wants to sell the convertible bond if, assuming the stock falls in price, her risk of loss exceeds 10%.

Which one of these statements about this convertible bond is CORRECT?

A)
The downside risk is between 5% and 10%, and the bond should be retained.
B)
Downside risk cannot be calculated because the price of the stock is not given.
C)
Downside risk is not a factor when the conversion price exceeds the investment value of the bond.
D)
The downside risk exceeds 10%, and the bond should be sold.

Answer 14

The answer is the downside risk exceeds 10%, and the bond should be sold. The downside risk of the bond is $170 ($1,200 current market value - $1,050 investment value). This translates into 14.17% ($170 downside risk ÷ $1,200 current market value). Therefore, the bond should be sold.

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Question 15

The main purpose of a laddered bond portfolio is to

A)
have a higher yield to maturity.
B)
increase the duration of a bond portfolio.
C)
minimize the effect of changes in interest rates.
D)
achieve the highest possible capital gains when interest rates decline.

Answer 15

c The purpose of a laddered strategy is to minimize the effect of swings in interest rates. Rather than trying to forecast interest rates, an investor spreads out the bond investment over a period of time.

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Question 15

Revenue bonds are used to finance any municipal facility that generates sufficient income to satisfy the ongoing debt obligation. Which of these is NOT a type of revenue bond?

A)
Industrial development revenue bond
B)
Special tax bonds
C)
Special assessment bonds
D)
Housing debentures

Answer 15

d The answer is housing debentures. New housing authority (or Section 8) bonds are an example of a revenue bond.

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Question 15

Choose the agency issue which historically did NOT have an indirect backing and guarantee of the U.S. government.

A)
Student Loan Marketing Association
B)
Federal Home Loan Mortgage Corporation
C)
Federal National Mortgage Association
D)
Government National Mortgage Association

Answer 15

d The answer is Government National Mortgage Association. Historically, only GNMA had a direct backing and guarantee from the U.S. government.

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Question 15

If interest rates are expected to decrease in the near future, which of the following combinations of strategies is recommended?

A

Buy bonds with shorter maturities

Buy bonds with lower coupons

B

Buy bonds with higher coupons

Buy bonds with longer maturities

C

Buy zero-coupon bonds

Buy bonds with longer maturities

A)
Option A
B)
Option C
C)
None of these
D)
Option B

Answer 15

b, so option C in the question

When rates are expected to decline, low-coupon bonds with long maturities have the highest duration and can be expected to increase in price more than any other type of bond.

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Question 16

Consider the yield curves below. Assume yield curve 1 (YC1) changed to yield curve 2 (YC2) over a period of time.

Basically it’s a graph.
Y Axis % Yield
X Axis Years to Maturity
YC1 is above YC2, they kinda mimic each other.
YC1 looks like it peaks-ish about say 1 year in, vs YC2 looks like it peaks about 1.5-2 years in. They never cross or touch lines.

Which of the following can be interpreted from these yield curves?

The Fed has been decreasing the money supply.
Duration has decreased.
Interest rates for all time periods have decreased.
The yield curve was positive at the time of YC1.
A)
I and IV
B)
III and IV
C)
II and III
D)
I, III, and IV

Answer 16

b Option I is incorrect because the yield curve rises when the Fed tightens the money supply. Option II is incorrect because duration and interest rates are inversely related; when rates fall, duration rises.

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Question 16

Expecting rising interest rates, an investor sells his BB rated, 3.5% coupon bonds with 20-year maturities and purchases A rated, 6% coupon bonds with maturities of four years. The investor has executed

A)
a tax swap.
B)
an intermarket swap.
C)
a rate anticipation swap.
D)
a pure yield pickup swap.

Answer 16

c The answer is a rate anticipation swap. A rate anticipation swap seeks to take advantage or avoid the impact of expected changes in interest rates.

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Question 17

Select which of these statements regarding Series I savings bonds is CORRECT.

A)
A semiannual inflation rate is combined with the fixed rate of return to determine the Series I bond’s interest rate for the next six months.
B)
A fixed interest rate is paid on an inflation-adjusted principal amount every six months.
C)
Series I bonds pay semiannual interest in cash.
D)
Series I bonds are always subject to state and federal income taxation.

Answer 17

a The answer is a semiannual inflation rate is combined with the fixed rate of return to determine the Series I bond’s interest rate for the next six months. The interest rate is a combination of two separate rates: (1) a fixed rate of return that remains the same for the life of the bond and (2) a semiannual inflation rate based on changes in the Consumer Price Index (CPI) during the previous six-month period. The semiannual inflation rate is then combined with the fixed rate of return to determine the Series I bond’s interest rate for the next six months.

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Question 17

The yield curve theory that states current long-term interest rates contain an implicit prediction of future short-term interest rates is known as

A)
liquidity preference theory.
B)
preferred habitat theory.
C)
unbiased expectations theory.
D)
market segmentation theory.

Answer 17

c The answer is unbiased expectations theory. The unbiased expectations theory states that long-term rates consist of many short-term rates and that long-term rates will be the average (or geometric mean) of short-term rates.

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Question 17

Chuck owns a convertible bond that has a conversion price of $40 per share and a coupon of 5.5%. Interest is paid semiannually. The current market price of the stock is $41 per share. The investment value of the bond is $940, and the bond currently sells for a market price of $1,120. What is the downside risk of this bond?

A)
$85
B)
$120
C)
$180
D)
$95

Answer 17

c The answer is $180. The downside risk of a convertible bond is the dollar or percentage decline from the current market price of the convertible bond to the investment value of the bond: $1,120 - $940 = $180.

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Question 17

One advantage of convertible bonds is that they

A)
offer the ability to buy the underlying stock at a discount.
B)
have a higher coupon rate than the underlying stock’s dividend.
C)
have higher coupon rates than straight coupon bonds.
D)
are usually offered only by firms with high bond credit ratings.

Answer 17

b The coupon rate on the convertible bond is usually greater than the stock’s dividend yield because the stock usually pays little, if any dividends. This enables the investor to get a higher periodic cash flow while waiting for the stock to appreciate.

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Question 18

A $1,000 bond may be converted into common stock at $40 per share. The current market price of the stock is $35 per share. The bond matures in 15 years, has a 7% coupon, and a current market price of $914. The current interest rate paid on comparable debt is 8%. Calculate the conversion value of the bond and determine which of these statements are CORRECT.

The bond is selling at a premium over its conversion value.
The bond should be converted because its conversion value is less than its value as a bond.
The bond should not be converted because its conversion value is less than its value as a bond.
The market price of the stock will increase as the market price of the bond increases.
A)
I only
B)
I and III
C)
I, III, and IV
D)
I and II

Answer 18

b The answer is I and III. The bond is currently selling for a premium ($914) over its conversion value [($1,000 ÷ 40) × $35 = $875]. Therefore, the bond should not be converted.

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Question 18

Which of the following risks relating to fixed-income investments have an offsetting effect on one another?

A)
Interest rate risk and reinvestment rate risk
B)
Interest rate risk and default risk
C)
Interest rate risk and call risk
D)
Interest rate risk and purchasing power risk

Answer 18

a Interest rate risk and reinvestment rate risk have offsetting effects, and the offsetting of these two risks in a bond portfolio takes place through immunization (the matching of the durations of bonds to the durations of liabilities).

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Question 18

Identify the statement that best describes Treasury STRIPS (Separate Trading of Registered Interest and Principal of Securities).

A)
A negotiable, short-term, unsecured promissory note issued by a regional government agency
B)
A trust receipt issued by a U.S. government agency for shares of a domestic company purchased and held by a credit union
C)
A short-term draft drawn by a government agency on a major bank
D)
Zero-coupon bonds created by separating the semiannual coupon payments and the principal repayment portions of a U.S. Treasury note or bond

Answer 18

d The answer is zero-coupon bonds created by separating the semiannual coupon payments and the principal repayment portions of a U.S. Treasury note and bond. Although the securities underlying Treasury STRIPS are the U.S. government’s direct obligation, major banks and dealers perform the actual separation and trading.

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Question 18

A convertible bond’s market value will NOT fall below

A)
a floor guaranteed by the issuer.
B)
none of the these.
C)
its investment value.
D)
its conversion value.

Answer 18

c The answer is its investment value. A convertible bond’s market value will not fall below its investment value.

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Question 18

What is the downside risk of a 6% coupon convertible bond currently trading at $1,040 with a maturity of 12 years and a conversion value of $950? The current interest rate on comparable debt is 7.5%.

A)
$50
B)
$90
C)
$40
D)
$157

Answer 18

d The downside risk of a convertible bond is the difference between the market price and its investment value. To determine the investment value, calculate what the bond would be worth based just on interest rates. Use a financial calculator with the following inputs:

$1,000 = FV

$1000 x 6% = $60/2 = $30 = PMT

N = 24 (12 x 2 periods per year)

7.5% = I/YR

Solve for PV = $882.66. The current market price of the bond is $1,040, so $1,040 – $882.66 = $157.33. The conversion value, which is higher ($950), is not relevant in determining downside risk.

NOTE: there are several examples on bond calculations in the blue boxes in Module 2; however, it may be beneficial to skip ahead to Module 7 for some additional practice.

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Question 18

Bonds issued by state and local governments that are backed by the full faith and credit of the issuing government and repaid by the issuing municipality’s taxing power are categorized as

A)
general obligation bonds.
B)
revenue anticipation bonds.
C)
revenue bonds.
D)
tax anticipation notes.

Answer 18

a General obligation bonds (GOs) are the most secure of all municipal debt because they are backed by the full faith and credit of the issuer. Municipalities may increase taxes to make principal and interest payments on any debt issue; therefore, a voter referendum is usually required to approve their issuance.

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Question 18

Carol sells her AA rated 5% YTM bond for $940 and buys a BB-rated 6% bond for $900. Both bonds mature in four years. This transaction illustrates which of these swaps?

A)
A substitution swap
B)
An intermarket swap
C)
A pure yield pickup swap
D)
A rate anticipation swap

Answer 18

c The answer is a pure yield pickup swap. In a pure yield pickup swap, a lower YTM bond is substituted for a higher YTM bond.

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Question 18

Which one of these risks is specifically related to mortgage pass-through securities?

A)
Liquidity risk
B)
Prepayment risk
C)
Default risk
D)
Credit risk

Answer 18

b The answer is prepayment risk. The payments received from mortgage-backed securities consist of both interest and principal payments. When interest rates fall, homeowners refinance their homes, thereby paying off the principal on the original mortgages. This prepayment of principal is called prepayment risk.

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Question 18

Ellen purchased a BB rated convertible bond of TCD Corporation that has a 10% coupon and matures in nine years. Comparable debt (BB rated, nine years to maturity) yields 12%. The bonds are convertible at $32 per share of common stock, and the current market price of TCD common stock is $25.

What is the conversion value of this bond?

A)
$800.00
B)
$781.25
C)
$916.25
D)
$893.50

Answer 18

b The answer is $781.25. The conversion value = conversion ratio × market price of common stock. Therefore, the conversion value equals ($1,000 ÷ $32) × $25 = $781.25.

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Question 18

Which of the following correctly illustrates a characteristic of an investment-grade general obligation municipal bond?

A)
The bond’s periodic interest is paid to investors only when sufficient revenue is collected by the municipality.
B)
The taxing authority of the issuing government or municipality backs the issue’s repayment.
C)
The bond retains a direct claim on specific property.
D)
The bond’s main source of investment risk is financial risk.

Answer 18

b General obligation bonds are backed by the full faith and credit of the government issuing the debt and are repaid through taxes collected by the government body. The main source of investment risk for a municipal security is interest rate risk. General obligation bonds do not retain a claim on specific property. The government issuing the bonds uses its taxing authority to pay the interest and repay the principal. Revenue bonds, not general obligation bonds, pay interest when sufficient revenue is collected from the financed project.

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Question 18

Cindy, 38, has been an active investor for many years. She currently has a money market mutual fund and has a number of equity mutual fund shares. She wants to maximize her return on an intermediate-term bond and plans to hold the bond to maturity.

Which of these two bonds would be more appropriate for Cindy and why?

Bond 1: callable at par value; BBB rated; coupon = 6%; matures in six years; selling for $863; duration = 5.16
Bond 2: callable at par value; A rated; coupon = 10%; matures in four years; selling for $1,103; duration = 3.5
Bond 1, because it is selling for a discount and is less likely to be called.
Bond 1, because it has a higher yield to maturity than Bond 2.
Bond 2, because its higher coupon gives it a better total return.
Bond 2, because it has a higher yield to maturity than Bond 1.
A)
II only
B)
I and II
C)
I only
D)
III and IV

Answer 18

b Explanation
YTM for Bond 1 is calculated with the following inputs:

• $863 = PV

$1,000 = FV

$1000 x 6% = $60/2 = $30 = PMT

N = 12 (6 x 2 periods per year)

Solve for I/YR = 9%

YTM Bond 2 is calculated with the following inputs:

-$1,103 = PV

$1,000 = FV

$1000 x 10% = $100/2 = $50 = PMT

N = 8 (4 x 2 periods per year)

Solve for I/YR = 7%

In addition, Bond 1 is selling at a discount—unlike Bond 2 selling at a premium—so it is not likely to be called.

NOTE: there are several examples on bond calculations in the blue boxes in Module 2; however, it may be necessary to skip ahead to Module 7 for some additional practice.

LO 2.3.2

Question 19

Darla, a U.S. citizen and resident of Georgia, owns a 5% coupon corporate bond, a 4% coupon State of Georgia municipal bond, and a 3% coupon U.S. Treasury note. Darla’s marginal state income tax rate is 6% and federal tax rate is 24%. If Darla invested equal amounts in each of the three bonds, what is her after-tax rate of return on the portfolio?

A)
4.00%
B)
4.91%
C)
2.86%
D)
3.26%

Answer 19

d The answer is 3.26%. Because the corporate bond is taxable by the state and the federal government, its after-tax return is 3.5% [5% × (1 – 0.30)]. The State of Georgia municipal is not taxable by either government entity. The Treasury note is taxable by the federal government; therefore, its after-tax return is 2.28% [3% × (1 – 0.24)]. Averaging the three rates equals 3.26% [(3.5% + 4% + 2.28%) ÷ 3].

LO 2.1.1

Question 19

You want to generate additional income from your portfolio, and are considering purchasing either bonds or preferred stocks. Which of the following statements is NOT correct concerning the characteristics of bonds and preferred stocks?

A)
In the event of a company’s bankruptcy, bondholders would be paid first ahead of preferred stock shareholders.
B)
Bonds pay interest while preferred stocks pay dividends.
C)
Corporations pay taxes on preferred stock dividends prior to distribution to preferred shareholders, whereas interest on bonds is a deductible expense.
D)
Bonds are subject to more interest rate risk than preferred stocks.

Answer 19

d Because preferred stock does not have a maturity date, it is subject to more interest rate risk than bonds.

LO 2.5.1

Question 19

An investor pays a premium for a convertible bond because

A)
the investor is buying a straight bond and selling a call option.
B)
the investor is buying a straight bond and selling a put option.
C)
the investor is buying a straight bond and buying a put option.
D)
the investor is buying a straight bond and buying a call option.

Answer 19

d

you’re buying the bond AND you’re buying the ability to buy stock at a given price (call).

The investor is long the straight bond (bought) and long the call option (bought).

LO 2.2.1

Question 19

An investor wants all of her bonds to mature in 10 years. She buys two bonds immediately, two bonds two years from now, and two more bonds four years from now. As a result, the bonds purchased immediately have a maturity of 10 years, the bonds purchased two years later have a maturity of eight years, and the bonds purchased four years later have a maturity of six years. Select the type of bond strategy she is using for her portfolio.

A)
Bond barbell
B)
Bond bullet
C)
Bond ladder
D)
Bond swap

Answer 19

b The answer is bond bullet. When using the bond bullet strategy, an investor purchases a series of bonds with similar maturities focused on one point in time. This strategy may be an effective method in matching duration to the cash needs of an investor.

LO 2.3.1

Question 19

Which of these statements correctly explain zero-coupon bonds?

A)
They have low interest rate risk.
B)
They sell at a premium.
C)
They eliminate reinvestment rate risk.
D)
They offer minimum price volatility.

Answer 19

c The answer is they eliminate reinvestment rate risk. Zero-coupon bonds are sold at a deep discount from par value and have no coupon payments. They are redeemed for their face value at maturity. These bonds have maximum price volatility and respond sharply to interest rate changes.

LO 2.1.1

Question 19

The coupon rate or nominal yield of a bond is the stated annual interest rate that will be paid each period for the term of the bond. Select the statement that best describes how the coupon rate is stated.

A)
As a percentage of the annuitized value of the bond
B)
As a percentage of the par value of the bond
C)
As a percentage of the discount rate of the bond
D)
As a percentage of the intrinsic value of the bond

Answer 19

b

Question 20

Which of these statements regarding the bond ladder strategy is CORRECT?

A)
The bond ladder strategy involves the purchase of a mixture of very long-term and very short-term bonds.
B)
A laddered portfolio will provide lower yields than a portfolio consisting entirely of short-term bonds.
C)
The bond ladder strategy is used to immunize a portfolio against interest rate risk.
D)
The bond ladder strategy is generally more aggressive than the barbell strategy.

Answer 20

c The answer is the bond ladder strategy is used to immunize a portfolio against interest rate risk. It is an investment strategy in which equal amounts of money are invested in a series of bonds with staggered maturities. The barbell strategy involves the purchase of a mixture of very long-term and very short-term bonds. The laddered portfolio will provide higher yields than a portfolio consisting entirely of short-term bonds. The barbell strategy is generally more aggressive than the ladder strategy because the barbell strategy only utilizes short-term and long-term bonds.

LO 2.3.1

Question 21

An individual with a short-term investment time horizon would choose what type of bonds when interest rates are expected to rise?

A)
Short-term bonds
B)
Low-coupon, long-term bonds
C)
Long-term bonds
D)
High-yield bonds

Answer 21

a

basically you’re waiting for the rates to rise, you dont wanna invest in a long term bond, because when rates rise you’ll have a discounted undervalued bond.
This I didn’t know - the reason you don’t want to invest in high yield bonds in this scenario is that risk of their default rises alongside interest rates.

The answer is short-term bonds. Long-term bonds are affected by interest rate changes more than short-term bonds. If interest rates are expected to rise, an investor should invest in short-term bonds until rates peak. Risk of default of high-yield bonds increases when rates rise.

LO 2.3.2

Question 22

The risk associated with volatility in the price of securities due to shifts in the yield curve is

A)
financial risk
B)
unsystematic risk
C)
interest rate risk
D)
liquidity risk

Answer 22

c The answer is interest rate risk. When a yield curve shifts, that means that interest rates have changed. When interest rates change, bond prices change. If rates rise, bond prices fall; if rates fall, bond prices rise.

LO 2.4.1

Question 22

An investor who carefully chooses a bond that has a duration that matches the investor’s required holding period is practicing

A)
a passive holding strategy.
B)
an active management strategy.
C)
an immunization strategy.
D)
an indexing strategy.

Answer 22

c The answer is an immunization strategy. An investor who chooses a bond that has a duration equal to the investor’s desired holding period is practicing immunization. Because a bond’s reinvestment rate risk and price risk tend to ‘offset’ each other, immunization can be used to cancel out interest rate risk.

LO 2.3.1

Question 23

Which of these investments should be recommended during periods of falling interest rates?

A)
Short-term bonds
B)
Long-term bonds
C)
Money market mutual funds
D)
U.S. Treasury bills

Answer 23

b The answer is long-term bonds. If an investor anticipates a drop in interest rates, he or she should take a more bullish attitude toward interest-sensitive investments like long-term bonds.

LO 2.3.2

Question 24

The reason for using a barbell bond strategy is to

A)
maximize the potential capital gain in a bond portfolio.
B)
offset price and reinvestment rate risk.
C)
increase interest rate risk.
D)
decrease default risk.

Answer 24

b The purpose for using a barbell strategy in a bond portfolio is to offset the opposite effects of interest rates on bond prices. If rates rise, short-term bonds can be reinvested at higher rates. If rates drop, long-term bonds are used to lock in rates.

LO 2.3.1

Question 25

A transaction whereby an investor sells a bond for a loss, in order to reduce capital gains, while investing the proceeds of the sale in a bond of similar quality and maturity is considered

A)
a substitution swap.
B)
a tax swap.
C)
a pure yield pickup swap.
D)
an intermarket spread swap.

Answer 25

b The answer is a tax swap. A tax swap results in a tax savings generated by the realized loss.

LO 2.3.1

Question 26

An active bond management strategy, where one bond is swapped for another bond with similar characteristics but a higher yield to maturity, is considered

A)
an intermarket spread swap.
B)
a pure yield pickup swap.
C)
a substitution swap.
D)
a rate anticipation swap.

Answer 26

c The answer is a substitution swap. A substitution swap is an active investment strategy whereby one bond is swapped for another bond with almost identical characteristics other than yield to maturity. The substitution swap capitalizes on bond market inefficiency. An intermarket spread swap involves the exchange of one type of bond (e.g., government bond) with another type of bond (e.g., corporate bond). This occurs when investors believe one type of bond is currently mispriced in relation to the other. The goal of this type of swap is to capitalize on a yield to maturity (YTM) disparity across bond markets. A pure yield pickup swap involves selling short-term bonds and purchasing long-term bonds. A rate anticipation swap is one in which bonds are swapped as a result of expected changes in interest rates.

LO 2.3.1