Series 7 STC U.S. Treasury and Gov. Agency (Ch. 8)

Question 1

A U.S. Treasury bond is selling in the market at 95.18. The dollar value of this bond is:

$951.80

$955.62

$958.75

$952.18

Answer 1

$955.62

U.S. Treasury bonds are quoted in full points and 32nds of a point. A T-bond quote of 95.18 represents 95 18/32. By converting the fraction to a decimal, the quote becomes 95.5625 percent of the par value of $1,000. Therefore, $1,000 x 95.5625% = $955.62.

Question 2

A TIPS is issued at par and has a coupon of 4.0%. What’s its principal value if the CPI increases 3%?

$1,040

$40

$1,030

$1,070

Answer 2

$1,030

TIPS are bonds that are issued by the U.S. Treasury and are designed to protect investors from inflation. When inflation rises, as measured by the Consumer Price Index (CPI), the principal on a TIPS bond will increase by the same amount that the CPI rises. In this question, the bond started with a par (principal) amount of $1,000. If the CPI increases by 3%, the new principal amount is $1,030 ($1,000 x 3% = $30, and $1,000 + $30 = $1,030).

Question 3

Treasury STRIPS:

Have a fixed interest rate and principal that’s adjusted for inflation

Are zero-coupon bonds with a variety of maturities

Provide tax-free income to investors

Have prepayment risk

Answer 3

Are zero-coupon bonds with a variety of maturities

Treasury STRIPS are zero-coupon securities that are purchased at a discount and will mature at par value. STRIPs provide growth, rather than income, and have a wide range of maturities. As with other securities that are issued by the U.S. Treasury, they’re exempt from state (not federal) income tax. Collateralized mortgage obligations (CMOs) and mortgage-backed agency securities are subject to prepayment risk. Treasury Inflation Protected Securities (TIPS) are a type of Treasury security and they offer a fixed interest rate and a principal amount that’s adjusted for inflation.

Question 4

Interest on which of the following securities is NOT subject to state taxes?

A collateralized mortgage obligation (CMO)

A convertible bond

A Eurodollar bond

A Treasury note

Answer 4

A Treasury note

Interest that’s paid on corporate debt (i.e., a convertible bond or Eurodollar bond) is subject to both federal and state taxes. Interest received from a mortgage-backed security (e.g., a CMO) is also subject to both federal and state income tax. Interest on Treasury notes, as well as on all direct U.S. government debt obligations, is subject to federal taxes, but exempt from state taxes.

Question 5

An investor is about to retire and is concerned about having enough income to supplement his Social Security retirement savings. He wants to buy a conservative investment that can help offset inflation. The investor purchases Treasury Inflation-Protected Securities (TIPS) with a face value of $100,000 and a coupon rate of 2 3/4%. Six months later, he reads that the CPI is up 3 1/2%. What’s the approximate amount of the next interest payment?

$1,375

$1,423

$2,750

$3,500

Answer 5

$1,423

Since the CPI rose 3 1/2%, the principal of the TIPS will increase by 3 1/2% ($100,000 + [$100,000 x 3.5%]) = $103,500. The interest will be calculated by multiplying the adjusted face amount by the coupon rate of 2 3/4%, then that amount is divided by two since interest is paid semiannually. In this case, ($103,500 x 2.75%) / 2 = $1,423.13. Remember, the stated rate is an annual rate and will not change.

Question 5

A U.S. government bond is selling in the market at 95.28. The dollar value of this bond is:
QID: 5050792Mark For Review

$950.87

$952.80

$9,587.50

$958.75

Answer 5

$958.75

U.S. government bonds are quoted as a percentage of par with a fraction in 32nds of a point. Therefore, a T-bond quoted at 95.28 is equal to 95 28/32. By converting the fraction to a decimal, the quote becomes 95.875% of the par value of $1,000. Ultimately, $1,000 x 95.875% = $958.75.

Question 6

What type of bond is subject to both state and federal income tax?

T-notes

TANs

CDOs

STRIPS

Answer 6

CDOs

Collateralized debt obligations (CDOs) are subject to both state and federal income tax. Municipal bonds and notes (e.g., Tax Anticipation Notes, or TANs) are exempt from federal taxes. Treasury securities, including T-notes and STRIPs, are exempt from state income taxes.

Question 7

For trades involving T-bonds, regular-way settlement is on:

One business day after the trade date

The same day as the trade date

The second business day after the trade date (skip a day)

The fourth business day after the trade date

Answer 7

One business day after the trade date (T+1)

Transactions involving Treasuries, including T-bonds, settle one business day after the trade date (i.e., T + 1). Corporate and municipal securities also settle one business day after the trade date (i.e., T + 1). As a separate issue, Regulation T requires investors to pay for their portion of a trade by no later than the second business day after regular way settlement (i.e., S + 2, which is also considered T + 3). Treasuries are not subject to Regulation T, which means that customers must pay for their Treasury trades on the settlement date (i.e., T + 1).

Question 8

An investor purchased a 4.0% TIPS with an original principal amount of $1,000. If the adjusted principal amount is $1,020, how much interest will the investor receive on her next payment?

$20.00

$20.40

$40.00

$40.80

Answer 8

$20.40

Treasury Inflation-Protected Securities (TIPS) pay a fixed rate of interest semiannually; however, that fixed rate is based on a principal amount that’s adjusted for inflation. The adjustment to principal is based on the Consumer Price Index (CPI). Interest payments are calculated by multiplying the adjusted principal by the annual interest rate. In this question, the 4.0% rate of interest is multiplied against the principal of $1,020 for an annual interest amount of $40.80. As a result, the next semiannual payment will equal $20.40.

Question 9

What U.S. government agency provides liquidity to the student loan makers as well as financing for state student loan agencies?

SLMA

FHLMC

FNMA

FFCB

Answer 9

SLMA

The Student Loan Marketing Association, also referred to as SLMA or Sallie Mae, provides liquidity to student loan makers by buying student loans or lending funds directly to student loan makers. This is similar to how GNMA, FNMA, and FHLMC operate in U.S. mortgage markets.

Question 9

What bond has a fixed rate of interest, but a principal value that’s adjusted for inflation?

T-bills

Treasury Receipts

TIPS

STRIPS

Answer 9

TIPS

Treasury Inflation-Protected Securities (TIPS) are securities that are issued by the U.S. Treasury and protect investors from inflation. TIPS have a fixed interest rate, but their principal will be adjusted upwards during inflationary periods.

Question 9

For a Treasury note, interest accrues based on:

30 days per month, 360 days per year, plus settlement of T+1

Actual number of days per month, 365 days per year, plus settlement of T+2

Actual number of days per month, 365 days per year, plus settlement of T+1

30 days per month, 360 days per year, plus settlement of T+2

Answer 9

Actual number of days per month, 365 days per year, plus settlement of T+1

For Treasury notes and Treasury bonds, interest accrues based on actual number of days per month and a year consisting of 365 days. The settlement date for these Treasury securities is T+1 (i.e., the next business day following the trade date).

Question 10

An investor’s goal is to buy a security that establishes a fixed return for a long period, but has no reinvestment risk. Which of the following BEST suits the investor’s needs?

Treasury bills

Common stock

AAA corporate bonds

Treasury STRIPS

Answer 10

Treasury STRIPS

The typical yield-to-maturity calculation assumes that each interest payment is reinvested at the same yield. For most debt securities, there would be no guarantee that the investor could reinvest at the same yield (reinvestment risk). Treasury STRIPS are a form of zero-coupon bond (long-term) that pays no interest and therefore has no reinvestment risk.

Question 10

At a Treasury auction, the non-competitive tenders agree to pay:

The lowest of the accepted competitive tenders

The highest of the accepted competitive tenders

The average price of the security in the secondary market

Par value

Answer 10

The lowest of the accepted competitive tenders

The U.S. Treasury uses a single price (Dutch) auction to sell its bonds. Non-competitive bids (tenders) are filled first, followed by the execution of competitive bids. Every order that’s accepted will pay the lowest of the accepted competitive bids. For example, the three competitive bids that are entered for a T-bond auction are at 90, 95, and 99. The Treasury will first accept the highest tender of 99, and will then move to the next highest tender of 95. If all of the bonds are allocated (i.e., sold) after the 95 bids are filled, then the non-competitive bidders will pay 95 for their bonds because it is the lowest of the accepted competitive tenders. Although the price of 90 is a lower price, it was not a price that was accepted (i.e., that order was not filled).

Question 11

Compared to Treasury securities, agency securities are:

More liquid and lower yielding

More liquid and higher yielding

Less liquid and lower yielding

Less liquid and higher yielding

Answer 11

Less liquid and higher yielding

In general, agency issues are not as liquid as Treasury securities since the issues are typically smaller in size and are not traded as frequently. Lower liquidity and a slightly higher credit risk for the agencies that are not directly backed by the U.S. government means that agencies have slightly higher yields than Treasuries.

Question 11

Treasury bills are quoted:

On a percentage of par basis using 1/8 of 1% as the minimum price increment

On a discount yield basis

On a percentage of par basis using 1/32 of 1% as the minimum price increment

Using the PSA model

Answer 11

On a discount yield basis

T-bills are quoted on a discounted yield basis, not as a percentage of their par value. The yield represents the percentage discount from the face value of the security. T-notes and T-bonds are quoted using a percentage of par and 1/32nd of 1% as the minimum price change. Corporate and municipal bonds use a percentage of par, but use 1/8th of 1% as the minimum price increment. The PSA model is used to estimate prepayment rates for mortgage-backed securities (MBS), such as CMOs and agency securities. The PSA model doesn’t provide a price or value directly.

Question 12

Corporate Bonds are quoted on what basis?

Answer 12

1/8th (eighths)

Question 12

A client purchases a TIPS with a 2% coupon and, over the course of the year, the CPI increases by 1%. Which of the following statements is TRUE?

The client will earn 2% on an adjusted principal amount.

The client will earn 2% on a fixed principal amount.

The client will earn 3% on an adjusted principal amount.

The client will earn 3% on a fixed principal amount.

Answer 12

The client will earn 2% on an adjusted principal amount.

Treasury Inflation-Protected Securities (TIPS) are U.S. government securities whose principal is inflation-adjusted based on the Consumer Price Index (CPI). With TIPS, the rate of interest is fixed, but the principal amount on which the interest is paid will be inflation adjusted. Since it’s the principal being adjusted for inflation, the return (in this example) is consistently 2% of the principal amount; however, the principal may be higher or lower than par due to the adjustments for inflation. At maturity, investors receive either the par value or the adjusted principal value, whichever is greater. TIPS are typically purchased as protection against inflation or purchasing-power risk.

Question 13

When the U.S. Treasury auctions its securities, what type of order is a retail investor MOST LIKELY to enter?

Stop

Hold at rate

Competitive

Non-competitive

Answer 13

Non-competitive

At the auction for Treasuries, investor can either submit a competitive or non-competitive bid (tender). Competitive bids specify a price, while non-competitive bids don’t specify a price. Smaller investors typically enter non-competitive bids since they’re filled first. However, the price and yield for bonds that are sold at a Treasury auction are determined by the competitive bids.

Question 14

Which of the following securities always trade at a discount?

Treasury bonds

Treasury notes

TIPS

Treasury bills

Answer 14

Treasury bills

Question 15

Which CMO tranche has the longest average life?

The A tranche

The Z tranche

The planned amortization tranche

The floating rate tranche

Answer 15

The Z tranche

The A Tranche (the fast-pay tranche) is the first to receive principal, while the Z tranche only receives payments after all of the other tranches are paid. Therefore, the Z tranche has the longest average life. Floating rate tranches have interest rates that fluctuate based on an interest-rate index (e.g., SOFR). Planned amortization tranches provide a predetermined schedule of principal repayments and a more predictable maturity.

Question 16

A Treasury bond with a principal value of $1,000 is priced at 94-18. What’s the dollar price of this bond?

$945.63

$945.50

$1,000

$941.80

Answer 16

$945.63

Question 16

What’s the current yield of a T-bond that pays $25 in semiannual interest and is trading at 101.20?

5%

2.5%

2.46%

4.92%

Answer 16

4.92%

The current yield of a bond is found by dividing the yearly interest payment by the current market price of the bond. This question provides the semiannual interest; therefore, the annual interest payment is $50 ($25 semiannual x 2). With a price of $1,016.25 (101.20 or 101 20/32nds, which is 101.625%), the bond’s current yield is 8.87% ($50 ÷ $1,016.25 = 0.0492 or 4.92%).

Question 17

For investors who own agency backed CMOs, which of the following risks are the GREATEST concern in a rising interest-rate environment?

Prepayment risk and credit risk

Extension risk and credit risk

Prepayment risk and interest-rate risk

Extension risk and interest-rate risk

Answer 17

Extension risk and interest-rate risk

Extension risk is associated with a rising interest-rate environment in which mortgage holders refinance or repay their mortgages at a slower rate. Therefore, the holder of a CMO will receive less principal than anticipated and may be forced to own the security for longer than anticipated. Many CMOs are created from government agency mortgage-backed securities (MBS), which have a minimal amount of credit risk. As is true for most fixed-income securities, CMOs carry interest-rate risk and this is a significant concern when interest rates are rising.

Question 18

Which of the following securities is subject to prepayment risk?

Collateralized mortgage obligations (CMOs)

U.S. Treasury bills

Commercial paper with one-year maturity

Open-end investment company shares

Answer 18

Collateralized mortgage obligations (CMOs)

Mortgage-backed securities, such as CMOs, are subject to prepayment risk. Prepayment risk is tied to the possibility of homeowners paying off their mortgages early. When interest rates fall, homeowners have an incentive to refinance and pay off their existing mortgages. These prepayments are then passed through to the pools that hold the old mortgages. At this point, the pass-through investors will need to reinvest this large amount of principal at a time when interest rates have declined. None of the other answer choices are mortgage-backed securities

Question 19

What securities are most likely used to create asset-backed securities?

Jumbo mortgages

Qualified mortgages

Stocks

Home equity loans

Answer 19

Home equity loans

Similar to a collateralized mortgage obligation (CMO), asset-backed securities (ABS) are bonds which are backed by a pool of assets. However, unlike CMOs, ABS are secured by a pool of loans that don’t include mortgages. Instead, they typically consist of home equity loans, credit card receivables, auto loans, or student loans.

Question 20

Do Asset-Backed Securities (ABS) consist of pools of mortgages?

Answer 20

No

Question 21

All of the following details are TRUE of U.S. government agency bonds, EXCEPT that they:

Are taxable at the federal level

May be issued in book-entry form

Are a direct obligation of the U.S. government

Are generally a low-risk investment

Answer 21

Are a direct obligation of the U.S. government

While Treasury bonds, bills, and notes are direct obligations of the U.S. government, only certain agency securities (e.g., GNMA pass-throughs) have direct government backing.

Question 22

A GNMA pass-through is quoted 98.10 to 98.18. This quote represents a spread per $1,000 face value of:

$0.08

$0.80

$2.50

$8.00

Answer 22

$2.50

GNMA pass-through certificates (as well as T-notes and T-bonds) are quoted in 32nds. The spread of .08 represents 8/32 or 1/4 (.25) and has a value of $2.50 per $1,000.

Question 23

An investor is very concerned about the future of the economy. He’s also worried that there may be a rise in corporate bankruptcies and believes that there will be a dramatic increase in both inflation and interest rates over the next several years. What should his registered representative recommend:

T-bonds

STRIPS

TIPS

Blue-chip common stock

Answer 23

TIPS

Treasury Inflation-Protected Securities (TIPS) are direct obligations of the U.S. government and are considered free from credit risk. They will provide the client with safety of principal and protection from inflation and rising interest rates. The principal of the bond is adjusted semiannually based on the CPI. This will protect the principal from inflation, but also, since the coupon is paid on a greater face amount, cash flow will increase. T-bonds and STRIPS are not subject to credit risk, but they don’t provide a hedge against rising interest rates and a loss of purchasing power due to inflation. Historically, during periods of high inflation, common stock prices have not fared well.

Question 24

GNMA securities are quoted on what basis?

Answer 24

1/32

Question 25

An investor purchased a $10,000 Treasury bond that has an 8% coupon and matures 11-1-36. He purchased the bond on Monday, October 7 for regular-way settlement. He sold the bond on March 9 of the next year for a cash settlement. What amount of interest income was taxable for the year?

$49.32

$55.89

$117.26

$200.00

Answer 25

$49.32

When the investor purchased the bond on October 7, he paid the seller accrued interest from the last interest payment date, up to but not including the settlement date of October 8. The last interest payment date was May 1. The buyer, therefore, owed the seller a total of 160 days of accrued interest (May = 31 days, June = 30 days, July = 31 days, August = 31 days, September = 30 days, October = 7 days). To determine the dollar amount paid, multiply the annual interest payment of $800 by the portion of the year in question:
$800 x 160/365 = $350.68

This means that when the buyer received his $400 semiannual interest payment on November 1, $350.68 represented the amount he paid to the seller and $49.32 represented interest income. Only the interest income of $49.32 received that year is taxable to the investor.

Question 25

Three-month and six-month Treasury bills are auctioned by the Federal Reserve Board:

Daily

Weekly

Monthly

Annually

Answer 25

Weekly

Question 26

Which of the following risks is considered unique to an investor who owns a CMO?

Prepayment risk

Credit risk

Interest-rate risk

Reinvestment risk

Answer 26

Prepayment risk

Question 27

A security that’s backed by a pool of loans and various other assets with varying amounts of credit risk is a:

Collateralized mortgage obligation (CMO)

Ginnie Mae (GNMA) pass-through certificate

Collateralized debt obligation (CDO)

Real estate investment trust (REIT

Answer 27

Collateralized debt obligation (CDO)

CMOs are made up of mortgages, while CDOs include a wider range of debt

Question 27

When the U.S. Treasury auctions its securities, what type of order is an institutional investor MOST LIKELY to enter?

Market

Limit

Competitive

Non-competitive

Answer 27

Competitive

At the auction for Treasuries, investor can either submit a competitive or non-competitive bid (tender). Competitive bids specify a price, while non-competitive bids don’t specify a price. In addition, competitive bids must be entered for orders that exceed a certain size, typically $5 million. As a result, many institutions are required to enter competitive bids.

Question 28

A quote of 2.01 - 1.75 is a quote for which of the following securities?

Treasury bills

Treasury notes

Treasury bonds

A mortgage-backed security

Answer 28

Treasury bills

Question 29

An investor purchases a Treasury Inflation Protected Security (TIPS) that has a coupon rate of 3%. In the first year, if the inflation rate increased by 4%, which of the following statements is TRUE?

The new annual interest payment is $30.

The new principal value is $1,040.

The new principal value is $1,010.

The new annual interest payment is $40.

Answer 29

The new principal value is $1,040.

The principal on a TIPS will be adjusted for inflation. If the rate of inflation increases by 4%, the principal will increase by 4% to $1,040 ($1,000 par x 4%). The new interest payment is based on the original coupon rate of 3% multiplied by the new principal of $1,040, which equals $31.20 ($1,040 x 3%).

Question 29

What’s used to measure the prepayment rate for mortgage-backed securities?

Consumer Price Index

Gross Domestic Product

Sequential pay CMO

PSA Model

Answer 29

PSA Model

The PSA Model estimates the prepayment rate for mortgage-backed securities as measured against a benchmark. If a CMO is assigned a PSA number that’s equal to 100, the assumption is that the prepayment speed will remain stable. If the PSA number is greater than 100, the prepayment speed is expected to be faster than normal, while if it’s less than 100, the prepayment speed is expected to be slower than normal. If interest rates decline, homeowners will refinance, thereby increasing prepayments (i.e., rising PSA). If interest rates increase, there will be a decline in the prepayment of mortgages and the PSA number will fall.

Question 29

Mortgage-backed securities (MBS) may be issued by all of the following, EXECPT:

A U.S. government agency

A municipality

An investment bank

A commercial bank

Answer 29

A municipality

Mortgage-backed securities (MBS) may be issued by a U.S. government agency, such as the Government National Mortgage Association (GNMA or Ginnie Mae), or a government-sponsored enterprise (GSE), such as the Federal National Mortgage Association (FNMA or Fannie Mae) or the Federal Home Loan Mortgage Association (FHLMC or Freddie Mac). The securities issued by these three entities are commonly referred to as agency securities and receive high ratings (e.g., AAA). Mortgage-backed securities are also issued by financial institutions such as commercial banks, investment banks, and home builders. These securities are referred to as private label MBS and may contain some agency securities; however, they typically contain other types of mortgage loans that are not agency securities. Municipalities don’t issue mortgage-backed securities (MBS).

Question 30

A Treasury bond has a 15-year maturity, a 5% coupon rate, $1,000 par value, and pays semiannual interest on January 1 and July 1. If the bond was sold in the secondary market on Tuesday, November 7, how many days of accrued interest does the buyer owe the seller?

131 days

129 days

128 days

130 days

Answer 30

130 days

Accrued interest begins on the last interest payment and is counted up to, but not including the settlement date. The last interest payment was July 1 and Treasury bonds use the actual days in a month and a 365-day year. Since Treasury bonds settle on the next business day (i.e., T+1), this trade settles on Wednesday, November 8. This means that there are 130 days of accrued interest (31 days for July + 31 days for August + 30 days for September + 31 days for October + 7 days for November = 130 days).

Question 31

All of the following are characteristics of mortgage-backed securities, EXCEPT:

They’re created by the pooling of mortgages.

They’re traded in the over-the-counter market.

They’re collateralized by mortgage loans on real properties.

They provide tax-free income at the state level.

Answer 31

They provide tax-free income at the state level.

Mortgage-backed securities represent ownership in a pool of mortgages on real properties and they trade in the over-the-counter market. However, the interest from a mortgage-backed security is taxable at both the state and federal level.