Series 7 STC Fundamentals of Debt (Ch. 5) Flashcards
A customer purchased a corporate bond at a 8.64 basis. If the basis has increased by 50 basis points, this means that:
The bond’s price has increased by 50%
The bond’s yield is now 9.14%
The bond’s yield is now 58.64%
Interest rates have decreased
The bond’s yield is now 9.14%
One basis point equals .01% or 1/100th of one percent. Another way to state the relationship is that in every 1% there are 100 basis points. Certain bonds are quoted and traded in terms of their yield. A bond with an 8.64 basis refers to one that’s trading at a price which provides the holder with a yield-to-maturity (YTM) of 8.64%. An increase of 50 basis points means that the bond is now trading at a 9.14 basis (8.64 + 0.50). This also indicates that interest rates have been increasing.
When interest rates are fluctuating, which of the following statements is TRUE regarding the movement of short-term rates compared to long-term rates?
There’s no relationship between the fluctuations in long-term and short-term interest rates.
Long-term rates fluctuate more sharply than short-term interest rates.
Neither long nor short-term interest rates change.
Long-term rates change less sharply than short-term interest rates.
Long-term rates change less sharply than short-term interest rates.
When interest rates are fluctuating, short-term rates will fluctuate more sharply than long-term rates. However, in terms of prices, when interest rates are fluctuating, long-term bond prices are affected more than short-term bond prices.
A corporate bond is trading at a price of 92. The bond’s coupon rate is 7% and it makes interest payments on January 1 and July 1. If the bond is purchased on Monday, September 19, for regular-way settlement, what’s the total purchase price of the bond?
$920
$15.36
$904.64
$935.36
$935.36
The total purchase price for the bond is the quoted price of 92, or 92% of par, plus the accrued interest. Since the bond was purchased on Monday, September 19, it will settle on Tuesday, September 20 (i.e., T + 1). Accrued interest is based on the number of days that have elapsed since the last interest payment, but doesn’t include the settlement date. Since the last interest payment was made on July 1, the investor will have 79 days of accrued interest (30 days in July + 30 days in August + 19 days in September). The total accrued interest is $15.36 ($70 interest payment x 79 days accrued interest ÷ 360 days in year). Therefore, the bond’s total purchase price is $935.36 ($920 bond price + $15.36 accrued interest).
An investor is seeking to profit on falling interest rates and purchases a 30-year, 7% corporate bond at 130. Five years later, interest rates have risen and the investor decides to sell the bond for 108. What’s the investor’s taxable capital gain or loss on the trade?
$22 loss
$170 loss
$2,200 gain
$170 gain
$170 loss
Corporate bonds that are purchased at a premium (e.g., 130, or $1,300) must be amortized down to par value over the life of the bond. Since this bond has 30 years until maturity, the bond will be amortized by $10 each year ($1,300 purchase price - $1,000 par = $300 premium; $300 premium ÷ 30 years = $10 per year). The amortization will reduce the cost basis every year, thereby bringing the basis to par at maturity. After five years, the adjusted cost basis is $1,250 ($10 per year amortization x 5 years = $50 total amortization; $1,300 purchase price - $50 amortization = $1,250 adjusted basis). Since the bond was sold at 108, or $1,080, the investor will have a $170 loss ($1,080 sales proceeds - $1,250 cost basis = $170 loss).
A bond is selling at a discount and yields have remained constant. As the bond gets closer to its maturity, what happens to its price?
It increases
It decreases
It remains the same
It will experience significant price changes
It increases
Although fixed income securities are subject to interest rate risk, that risk is of less concern if the security is being held to maturity and interest rates are not changing. If it’s assumed that there’s little risk of default by the issuer, the price of a bond that’s selling at a discount will increase and move toward par value as it gets closer to its maturity.
Which of the following securities has the LEAST amount of capital risk?
Options
Bonds
Warrants
Stocks
Bonds
Capital risk is the risk of an investor losing her principal (i.e., the funds being invested in a security). When compared to the other securities, bonds have the least amount of capital risk. Bondholders receive the issuer’s promise that, at maturity, they will receive the principal amount of the bond, thereby minimizing the capital risk.
If a municipal bond has a basis of 4.35 and a coupon rate of 4.95%, the bond is selling at:
A discount
Par value
A premium
A price that cannot be determined from the information given
A premium
Municipal bonds may be quoted on a yield-to-maturity basis, which is 4.35% in this example. Since the bond’s yield-to-maturity of 4.35% is lower than its nominal yield (coupon rate) of 4.95%, the bond is selling at a premium price above the par value of $1,000. On the other hand, if the yield-to-maturity was higher than the nominal yield, then the bond would be selling at a discount.
Which of the following is NOT a type of call provision that’s established in a bond indenture?
Lottery call
In-whole call
Catastrophe call
Statutory call
Statutory Call
Callable bonds may be called in several different ways. In-whole calls occur when all of the bonds are called at the same time. If only a portion of the bonds are being called, it’s referred to as a partial or lottery call since a lottery is used to determine which bonds will be called. Catastrophe calls are used if the underlying collateral for a bond is destroyed. Statutory calls are not a type of call provision.
Which of the following bonds will generally have the LOWEST interest rate?
A five-year bond with an AA- rating
A 20-year bond with an AA- rating
A five-year bond with an A+ rating
A 20-year bond with an A+ rating
A five-year bond with an AA- rating
Due to their lower credit risk, short-term bonds will generally have lower interest rates than long-term bonds. It’s much less likely that a company will default in a short time frame. Similarly, bonds with higher credit ratings are safer and have lower interest rates. The shortest term bonds with the highest credit ratings will pay the least amount of interest.
If a bond has a basis of 6.26 and a coupon rate of 4.25%. In this case, the bond is selling at:
A price that cannot be determined from the information given
Par value
A discount
A premium
A discount
Since the bond has a yield-to-maturity (basis) of 6.26%, which is higher than the 4.25% nominal yield (coupon rate), the bond is selling at a price that is below the par value of $1,000 (i.e., at a discount). On the other hand, if the yield-to-maturity was lower than the nominal yield, then the bond would be selling at a premium.
A Treasury note has a three-year maturity, a 3% coupon rate, $1,000 par value, and it pays semiannual interest on May 1 and November 1. If the bond was sold in the secondary market on Monday, February 7th, how many days of accrued interest does the buyer owe the seller?
97 days
98 days
99 days
100 days
99 days
Interest begins to accrue on the last interest payment date and is counted up to, but not including, the settlement date. The last interest payment was November 1 and Treasuries use actual days in each calendar month, rather than a 30-day month like corporate and municipal bonds. In addition, Treasuries settle in one business day (i.e., T+1); therefore, this bond trade settles on Tuesday, February 8. Ultimately, this means there are 99 days of accrued interest (30 days for November + 31 days for December + 31 days for January + 7 days for February).
If a bond’s annual interest payment is divided by its current market price, the result is:
The bond’s current yield
The tax equivalent yield
The bond’s accretion
The bond’s yield-to-maturity
The bond’s current yield
XYZ Corporation has recently issued $50 million of 20-year bonds. When the bonds were issued, the coupon rate was set at 5%. Each bond in the issue has a $1,000 par value and the bonds are callable in five years at 104. If an investor owns one bond and holds it to maturity, what will the investor receive at maturity?
$1,000
$1,025
$1,050
$1,040
$1,025
At maturity, the holder of the bonds will receive the par value of $1,000, plus the final interest payment. This bond will pay 5%, or $50, per year. However, since bonds pay interest semiannually, this 5% bond will pay two $25 payments each year. This means that the bond’s final payment will be $1,025 ($1,000 par + $25 interest payment). The call price is only paid if the bond is called prior to maturity.
What’s the dollar value of a $10,000 par value bond that’s trading at 103 3/8?
$10,337.50
$1,033.75
$103,180
$1,031.80
$10,337.50
Corporate and municipal bonds are quoted as a percentage of par value and the minimum pricing increment is 1/8th of 1%. A bond trading at 103 3/8 is valued at 103.375% of par, which equals $1,033.75. Therefore, for a $10,000 par value bond, this equates to $10,337.50 (103.375% x 10,000).
For tax purposes, what’s the annual amortization for a 10-year, 4.75% corporate bond that was purchased at 120?
$0
$2
$20
$200
$20
Corporate bonds that are purchased at a premium (e.g., 120, or $1,200) must be amortized down to par value over the life of the bond. Since this bond has 10 years until maturity, the bond will be amortized by $20 each year ($1,200 purchase price - $1,000 par = $200 premium; $200 premium ÷ 10 years = $20 per year).
What’s the current yield of a bond that pays $45 in semiannual interest and is trading at 101 1/2?
4.5%
9%
8.87%
4.43%
8.87%
The formula for calculating a bond’s current yield is the annual interest payment divided by the current market price of the bond. This question provides the semiannual interest; therefore, the annual interest payment is $90 ($45 semiannual x 2). Since the current price is $1,015 (i.e., 101 1/2), the current yield is 8.87% ($90 ÷ $1,015 = 0.0887 or 8.87%).
A corporation’s stock listed on a national exchange and the corporation is in the process of issuing bonds. The bond offering will be structured as a term issue and all of the bonds will mature in three years. The dated date of the offering will be May 20th and the interest payment dates are October 1 and April 1. Based on the offering date and interest payment dates, the initial interest payment is:
A long coupon
An accrued interest payment
Based on actual days in each month and 365 days in the year
A short coupon
A short coupon
The dated date of a bond offering is the date from which interest begins to accrue. If the dated date doesn’t fall on one of the interest payment dates, the first coupon on a newly issued bond may be for more or less than the traditional six-month period. If the first coupon is for more than six months, it’s referred to as a long coupon. However, in this question, the first coupon is for less than six months (i.e., from May 20 to October 1) and is referred to as a short coupon.
An investor recently purchased a 3%, five-year corporate bond at 110. If the investor sells the bond in two years for 109, what’s the investor’s capital gain or loss for tax purposes?
$10 gain
$100 loss
$10 loss
$30 gain
$30 gain
Corporate bonds that are purchased at a premium (e.g., 110, or $1,100) must be amortized down to par value over the life of the bond. Since this investor’s bond has five years until maturity, the bond will be amortized by $20 each year ($1,100 purchase price - $1,000 par = $100 premium; $100 premium ÷ 5 years = $20 per year). Each year, the investor can deduct the $20 amortization against the bond’s interest income. If the investor sold the bond after two years, the bond’s cost basis will be $1,060 ($1,100 purchase - year one amortization of $20 - year two amortization of $20). If the bond was sold at 109, or $1,090, the investor would have a $30 gain ($1,090 sales proceeds - $1,060 cost basis).
On Tuesday, August 10, to supplement his other retirement income, a retired investor purchased an ABC Corporation 10-year non-callable bond that had a $1,000 par value and a 4% coupon. The bond pays interest every May 1 and November 1. At the time of the purchase, the investor paid $11.11 in accrued interest. How much taxable income will the investor report for the purchase year?
$20
$40
$31.11
$8.89
$8.89
Since the investor bought the bond after May 1, he would only receive the $20 interest payment in November. However, since he only owned the bond from August to November, he was not entitled to the full six months between interest payments. The seller (not the buyer) of the bond would pay taxes on the accrued interest that was earned from May through when the bond was sold. The buyer of the bond would only need to pay taxes on the semiannual payment minus what he paid in accrued interest. In this question, the buyer had to pay taxes on $8.89 of interest ($20 semiannual payment - $11.11 accrued interest).
An investor purchased a seven-year ABC Corporation zero-coupon bond for $300. If the investor holds the bond to maturity and receives the $1,000 par value of the bond, what’s the capital gain or loss for tax purposes?
$300 gain
$10 gain
No gain or loss
$300 loss
No gain or loss
Corporate zero-coupon bonds must be accreted each year to bring the cost basis up to par by maturity. Since this bond was purchased at a discounted price of $300, the $700 difference ($1,000 par - $300 purchase price) must be accreted over the bond’s life. Because the bond has seven years to maturity, the annual accretion is $100 ($700 growth ÷ 7 years). If the bond is held to maturity, the accretion will bring the cost basis up to par and the investor will have no capital gain or losses for tax purposes. Each year that an investor owns a zero-coupon bond, the accretion is taxed as interest income.
A bond issue that matures on the same date is referred to as a:
Term bond
Sinking fund bond
Serial bond
Zero-coupon bond
Term bond
If all of the bonds of an offering are due to mature on the same date, it’s referred to as a term bond issue. Bonds with staggered maturity dates are referred to as serial bonds. Term bonds can be tougher to pay since the issuer needs to pay par value to all of the bondholders on the same date. Serial issues often have a level debt service since the par value is paid over several maturity dates.
Sinking funds are used for ______ bonds
Term
What’s the dated date of a bond?
The date from which interest begins to accrue for a new bond
The date on which a bond trade settles
The date on which a bond matures and the bondholder receives par value
The date on which an issuer defaults
The date from which interest begins to accrue for a new bond
The dated date is the date from which interest begins to accrue on a new bond. In other words, it’s like the date of birth for a bond. The settlement date is the date on which a bond trade settles, while the maturity date is the date on which a bond matures.
For the issuer, all of the following are benefits of prerefunding a bond issue, EXCEPT:
The elimination of restrictions (defeasance)
Paying less in debt service
The ability to call the bonds immediately
An increase in the bond’s rating
The ability to call the bonds immediately
Prerefunding a bond allows an issuer to lock in a lower interest rate before a bond’s call protection has expired. Although the issuer cannot call the bonds immediately, it does give the issuer a lower debt service (i.e., interest and principal). For a prerefunded bond, since the money is put in escrow and invested in Treasuries, the bonds typically receive the highest credit rating (i.e., AAA or Aaa).
T/F. Prerefunding a bond allows an issuer to lock in a lower interest rate before a bond’s call protection has expired. Although the issuer cannot call the bonds immediately, it does give the issuer a lower debt service (i.e., interest and principal). For a prerefunded bond, since the money is put in escrow and invested in Treasuries, the bonds typically receive the highest credit rating (i.e., AAA or Aaa).
True
Four municipal bonds are maturing in 2050 and are all selling at a 7.00 basis. Which of the following bonds is MOST likely to be refunded?
5 1/2% callable in 2040 at 103
6 1/2% callable in 2041 at 100
7% callable in 2040 at 103
7 1/2% callable in 2041 at 100
7 1/2% callable in 2041 at 100
The most common reason for a municipality to refund an outstanding issue is to save interest costs. If a municipality can borrow money at a lower rate than the outstanding issue, it can use this money to refund the outstanding issue and thereby save on interest cost. The bonds are selling at a 7.00% yield, which means that the municipality can expect to issue new bonds with a 7.00% interest rate. Since the municipality can only save money by refunding an issue with a higher interest rate, it will refund the 7 1/2% bonds.
A retired investor has a portfolio of fixed-income securities and is using the interest from it to supplement income he receives from Social Security. One of the investor’s corporate bonds was purchased for 104 and had a two-year maturity. What’s the investor’s taxable capital gain or loss if the bond is held until maturity?
No gain or loss
$40 gain
$40 loss
$20 loss
No gain or loss
Corporate bonds that are purchased at a premium (e.g., 104, or $1,040) must be amortized down to par value over the life of the bond. Since this bond has two years until maturity, the bond will be amortized by $20 each year ($1,040 purchase price - $1,000 par = $40 premium; $40 premium ÷ 2 years = $20 per year). The amortization will reduce the cost basis every year, thereby bringing the basis to par at maturity. This means there will be no gain or loss if the bond is held to maturity ($1,000 par - $1,000 adjusted cost basis = $0 gain/loss).
MLM Corporation has issued $20 million of bonds that mature in five years. The bonds have a 5% interest rate, are priced at 98 1/4, and are offered at a basis of 5.40. If an investor buys $5,000 of MLM’s bonds, what’s his return if the bonds are held to maturity?
5%
5.09%
5.4%
1.75%
5.4%
The basis of a bond is synonymous with its yield-to-maturity. If a bond’s basis is 5.40, the yield that will be earned if an investor holds the bonds to maturity is 5.40%. The yield that falls between the 5% nominal yield and the 5.40% yield-to-maturity is the current yield. The formula for calculating a bond’s current yield is annual interest divided by the current market price. This bond’s current yield is 5.09% ($50 interest ÷ $980.25 price). Notice that, since the bond is trading at a discount, the current yield of 5.09% falls between the nominal yield of 5% and the yield-to-maturity of 5.40%.
A 20-year bond has a coupon rate of 4.3% and has eight years of call protection from the issuance. If the bond’s yield-to maturity is 5.23%, the bond is trading at:
Par value
5.23% more than par value
A premium to par
A discount to par
A discount to par
A bond’s yield is inversely related to its price. Since this bond’s yield-to-maturity (5.23%) has increased above its interest rate (4.3%), the bond’s price must have fallen (i.e., it’s trading at a discount).
When comparing bonds that are rated Aaa to bonds that are rated Baa each of which have similar maturities and coupon rates, the higher rated bonds will normally have which of the following?
Lower coupon payments
Higher yields
Higher default risk
Lower market prices
Lower coupon payments
Higher rated bonds have less default risk, higher market prices, and lower coupon payments. On the other hand, low rated bonds tend to have higher yields because investors demand a higher return for the increased credit risk. Ultimately, investors will pay more for bonds that have lower risk (i.e., higher ratings).
Higher rated bonds have _____ (higher/lower) coupon rates
Lower
A customer buys bonds with a $50,000 par value at 85 1/2 per bond. The bonds are callable at 110. If the customer holds the bonds to maturity, he will receive:
$42750
$50,000
$55,000
$85,500
$50,000
At maturity, the holder of the bonds will receive the par value, which is $50,000 in this example. The call price and market value are both irrelevant.
A customer of a broker-dealer bought $50,000 worth of LMN Corporation bonds with a 7.25% interest rate at paid 98 1/4 per bond. The bonds will mature in 15 years and are callable in four years at par. What yield will be included on the customer’s trade confirmation?
Nominal yield
Yield-to-call
Current yield
Yield-to-maturity
Yield-to-maturity
Bond trade confirmations must disclose the lower of the yield-to-maturity or yield-to-call. For bonds trading at a discount (e.g., 98 1/4), the yield-to-maturity will be lower. Generally, the yield-to-call will be lower for a bond that’s trading at a premium.
Bond trade confirmations must disclose the _______ (higher/lower) of the yield-to-maturity or yield-to-call.
Lower
If a municipal bond has a basis of 6.35 and a coupon rate of 6.15%, the bond is selling at:
A discount
Par value
A premium
A price that cannot be determined from the information given
A discount
Municipal bonds may be quoted on a yield-to-maturity basis, which is 6.35% in this example. Since the bond’s yield-to-maturity of 6.35% is higher than its nominal yield (coupon rate) of 6.15%, the bond is selling at a discounted price below the par value of $1,000. On the other hand, if the yield-to-maturity was lower than the nominal yield, then the bond would be selling at a premium.
