Unit 2 - Types & Characteristics of Fixed-Income (Debt) Securities (Study Guide) Flashcards
“According to Standard & Poor’s rating system, the 4 highest grades of bonds (from best to lowest grade) are
A. Aaa; Aa; A; Baa.
B. A; Aa; Aaa; B.
C. B; A; AA; AAA.
D. AAA; AA; A; BBB.
“
D
Choice A would be correct if the question referred to Moody’s.
Which of the following statements regarding bond interest is true?
A. Bond prices have an inverse relationship to interest rates.
B. Bond prices have a direct relationship to interest rates.
C. The par value of a bond will increase as market interest rates fall.
D. The par value of a bond will decrease as market interest rates fall.”
A.
Explanation: Bond prices have an inverse relationship to interest rates. If interest rates go up, prices for those bonds trading in the secondary markets will go down. Conversely, if interest rates decline, bond prices rise. Par value is a fixed number for the life of the bond.
A bond would be considered speculative below which of the following Moody’s ratings?
A. A
B. Baa
C. BBB
D. Ba”
B
Explanation: A rating of Baa is the lowest investment-grade rating assigned by Moody’s. Any rating beneath this is considered speculative. If the question asked about Standard & Poor’s, then the correct choice would be BBB.
Corporate and municipal bonds are quoted as a percentage of par. What is: the Par Value? What is each bond point (%)? What are the fractions of Par (%)?
- Par Value is $1000
- Each Bond point is 1%
- Fractions are in 1/8
Example: A bond quoted at 90 1/4= $902.50 (90% * $1,000 = $900 + 1/4 * $10 [$2.50] = $902.50).”
Government bonds are quoted as a percentage of par. What is: the Par Value? What is each bond point ($)? What are the decimals of Par valued at?
- Par Value is $1000;
- Each Bond point is $10;
- Fractions are in 0.1 represents 1/32 of a point
Example: A government bond quoted at 101.24 = $1,017.50 (101% * $1,000 = $1,010 + 24/32 [which is 3/4] * $10 [$7.50] = $1,017.50).”
Solve for the conversion ratio as follows:
Par value: $1,000 Conversion price: $50 Conversion ratio: 20
$60
Explanation: The parity stock price is found by dividing $1,200 by 20. The parity price of the common is $60. That is, if one were to convert the bond when the 20 shares received have a market value of $60 each, the investor would have the same $1,200 as the market value of the bond.
RST debenture is convertible to common at $50 with a Conversion Ratio of 20. If the common is trading for $45, what is the parity price of the debenture?
Start by solving for the conversion ratio:
Par Value: $1000
Conversion Price: $50
Conversion Ration: 20
The debenture’s parity price is found by multiplying 20 × $45, which is $900. Using the percentage method, you can determine that the market price of the common stock is 10% below that of the conversion price (5 ÷ 50 = 10%). Reducing the debenture price of $1,000 by 10% results in a parity price of the debenture of $900.
What is nominal yield?
The interest stated on the face of the bond is called the nominal yield.
What is the interest stated on the face of the bond called?
Nominal Yield
What is Current Yield?
The current yield (%) is the return divided by the investment.
Bond prices and yields have what type of relationship (Inverse or Direct)?
Inverse. When bonds trade at a discount, the yield increases, and vice versa.
If a bond was bought at a discount, is the YTM higher or lower than the nominal yield (coupon rate) and the current yield?
The YTM of a bond bought at a discount is always higher than both the coupon rate (nominal yield) and the current yield.
What is the current yield of a 6% bond trading for 80 ($800)?
7.5%
Explanation: Find the solution as follows: $60 ÷ $800 = 7.5%. This bond is trading at a discount. When prices fall, yields rise. The current yield is greater than the nominal yield when bonds are trading at a discount.
If the bond has a YTC lower than its CY, it is trading at _______.
Premium
If the bond has a YTM and CY that are equal, the bond is trading at _________.
Par
If the bond has a YTM less than its YTC, the bond is trading at ________.
Discount
If a bond has a YTM greater than its coupon, the bond is trading at ______________.
Discount
When a bond with a 6% coupon is selling for 90, each of the following statements is correct except:
A. The current yield is approximately 6.67%.
B. The bond is selling at a discount.
C. The bondholder will receive two semiannual interest payments of $27 each.
D. The yield to maturity is slightly higher than the current yield.”
C
Explanation: A bond with a 6% coupon is going to make two semiannual interest payments of $30 each, regardless of the bond’s market price. After all, the loan was $1,000 at 6% interest, and that won’t change. A price of 90 is 90% of the $1,000 par— clearly a discount. The current yield is the $60 annual interest divided by the $900 price or 6.67%, and that is a bit lower than the yield to maturity because, if we hold the bond to maturity, we’re going to get back the full $1,000, which will represent a $100 profit. Please see the chart at the Test Topic Alert above.”
“Disregarding commissions, an investor selling a U.S. Treasury bond for a price of 104:16 will receive:
A. $104.16.
B. $104.50.
C. $1,041.60.
D. $1,045.00.”
D
Explanation: Treasury bonds are quoted in 32nds and as a percentage of par. A quote of 104.16 is 104 16/32 or 104 1/2% of par. With par always being $1,000, the proceeds of the sale are
$1,045.”
“A 4.67% convertible debenture is selling at 102. It is convertible into the common stock of the same corporation at $25. The common stock is currently trading at $23. If the stock were trading at parity with the debenture, the price of the stock would be:
A. $25.00.
B. $25.25.
C. $25.50.
D. $44.35.”
C
Explanation: To determine the parity price of the common, first find the number of shares the debenture is convertible into (conversion ratio) by dividing par value by the conversion price ($1,000 / $25 = 40 shares). Next, divide the current price of the bond by the conversion ratio. The result is the parity price of the common stock (1,020 / 40 = $25.50).”
“Five percent XYZ debentures are trading for $1,250. Other similarly rated bonds are being offered at 4.25%. What is the current yield on the 5% XYZ debentures?
A. 1.5%
B. 4.0%
C. 5.0%
D. 6.25%”
B
Explanation: Current yield is defined as the annual income (or coupon rate) from a bond divided by the bond’s current market price. Accordingly, $50 / $1,250 = .04 × 100 = 4%. The current yield will be lower than the coupon rate when the bond is trading at a premium. Please note that there is unnecessary information given in this question. You do not need to know anything about other bonds.
When Treasury bills are issued, they are quoted at:
A. a premium over par.
B. 100% of the par value.
C. Par value with interest coupons attached.
D. z discount from principal with no coupons attached.”
D
Explanation: Treasury bills are always issued at a discount; they pay no interest. The investor profits by receiving back par value and makes the difference between the discounted purchase price and the par received at maturity. All government bonds are now book entry (electronic record); there has not been a Treasury note or bond issued since July 1986 with interest coupons attached.
A customer wishes to buy a security providing periodic interest payments, safety of principal, and protection from purchasing power risk. The customer should purchase
A. TIPS.
B. TIGRS.
C. CMOs.
D. STRIPS.”
A
**Explanation:* TIPS offer inflation protection and safety of principal because they are backed by the U.S. government.”
All of the following debt instruments pay interest semiannually except:
A. Ginnie Mae pass-through certificates.
B. U.S. Treasury notes.
C. U.S. Treasury bonds.
D. TIPS.”
A
Explanation: A unique feature of Ginnie Maes is that they pay interest on a monthly basis, not semiannually. In addition to the interest, investors receive their share of that portion of the mortgage payments that represented principal repayment.