Unit 2 - Types & Characteristics of Fixed-Income (Debt) Securities (Study Guide)

Question 1

“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.
“

Answer 1

D

Choice A would be correct if the question referred to Moody’s.

Question 2

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.”

Answer 2

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.

Question 3

A bond would be considered speculative below which of the following Moody’s ratings?

A. A
B. Baa
C. BBB
D. Ba”

Answer 3

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.

Question 4

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 (%)?

Answer 4

• 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).”

Question 5

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?

Answer 5

• 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).”

Question 6

Solve for the conversion ratio as follows:

	 Par value: $1,000
	 Conversion price: $50
	 Conversion ratio: 20

Answer 6

$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.

Question 7

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?

Answer 7

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.

Question 8

What is nominal yield?

Answer 8

The interest stated on the face of the bond is called the nominal yield.

Question 9

What is the interest stated on the face of the bond called?

Answer 9

Nominal Yield

Question 10

What is Current Yield?

Answer 10

The current yield (%) is the return divided by the investment.

Question 11

Bond prices and yields have what type of relationship (Inverse or Direct)?

Answer 11

Inverse. When bonds trade at a discount, the yield increases, and vice versa.

Question 12

If a bond was bought at a discount, is the YTM higher or lower than the nominal yield (coupon rate) and the current yield?

Answer 12

The YTM of a bond bought at a discount is always higher than both the coupon rate (nominal yield) and the current yield.

Question 13

What is the current yield of a 6% bond trading for 80 ($800)?

Answer 13

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.

Question 14

If the bond has a YTC lower than its CY, it is trading at _______.

Answer 14

Premium

Question 15

If the bond has a YTM and CY that are equal, the bond is trading at _________.

Answer 15

Par

Question 16

If the bond has a YTM less than its YTC, the bond is trading at ________.

Answer 16

Discount

Question 17

If a bond has a YTM greater than its coupon, the bond is trading at ______________.

Answer 17

Discount

Question 18

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.”

Answer 18

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.”

Question 19

“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.”

Answer 19

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.”

Question 20

“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.”

Answer 20

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).”

Question 21

“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%”

Answer 21

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.

Question 22

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.”

Answer 22

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.

Question 23

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.”

Answer 23

A

**Explanation:* TIPS offer inflation protection and safety of principal because they are backed by the U.S. government.”

Question 24

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.”

Answer 24

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.

Question 25

A debenture is issued based on:

A. the general credit of the corporation.
B. a pledge of real estate.
C. a pledge of equipment.
D. the ability to levy taxes.”

Answer 25

A

Explanation: There are no pledged assets behind a debenture, merely the credit standing of the corporation. It is a corporate IOU.

Question 26

What is the liquidation priority of a corporation?

Common stockholders
Preferred stockholders
Secured creditors (e.g., mortgage bonds, equipment trust certificates, collateral trust bonds)
Subordinated debt holders
Unsecured creditors (e.g., general creditors including debenture holders)”

Answer 26

Liquidity occurs in the following order:

1. Secured creditors (e.g., mortgage bonds, equipment trust certificates, collateral trust bonds)
2. Unsecured creditors (e.g., general creditors including debenture holders)
3. Subordinated debt holders
4. Preferred stockholders
5. Common stockholders”

Question 27

If an investor watches the latest T-bill auction fall to 0.71% from 0.82%, the best interpretation is that:

A. investors who purchased bills at this auction paid more for them than purchasers at last week’s auction.
B. investors who purchased bills at this auction paid less for them than purchasers at last week’s auction.
C. investors who purchased T-bills 12 weeks ago paid less than subsequent purchasers.
D. these are 52-week T-bills.”

Answer 27

A

Explanation: The rates on the T-bills fell, so prices rose, and the investor paid more for the bills this week than last week. The decline in yields indicates there was good demand for the securities because the price rose, driving the yields down. The question does not indicate the price of T-bills 12 weeks ago; it is unclear if the investor paid less for the T-bills then. The 52-week (one-year) T-bills are the only ones auctioned monthly instead of weekly.

Question 28

Which of the following corporate securities has a specific corporate asset pledged as security for the debt?

A. A debenture
B. An equipment trust certificate
C. A guaranteed bond
D. A subordinated loan”

Answer 28

B

Explanation: There are three primary examples of secured corporate debt instruments on the exam. Those are: equipment trust certificates (secured by the pledged equipment); collateral trust bonds or certificates (secured by the securities pledged); and mortgages bonds (secured by real property pledged). A guaranteed bond is secured by a pledge made by a third party—no asset of the issuing corporation is pledged.”

Question 29

If an investor in the 27% federal income tax bracket invests in municipal general obligation bonds selling at par with a coupon of 4.5%, what is the tax equivalent yield?

A. 3.29%
B. 5.72%
C. 6.16%
D. 16.67%”

Answer 29

C

Explanation: The formula for computing tax equivalent yield is nominal (coupon) yield divided by (1 - federal income tax rate): .045 ÷ (1 - 0.27) = .045 ÷ 0.73 = 6.16%.

Question 30

A bond indenture states that payment of interest and principal will come from the collection of ad valorem taxes. This is most likely:

A. a municipal general obligation bond.
B. a municipal revenue bond.
C. a U.S. Treasury bond.
D. a corporate bond backed by property taxes.”

Answer 30

A

Explanation: Ad valorem taxes, most often taxes on real property, are the backing for municipal GO bonds. Corporations and the U.S. government do not collect property taxes.

Question 31

Janeece, who is in the 37% marginal income tax bracket, would like to purchase a bond for her investment portfolio. Assuming all the bonds are of similar investment quality, which would produce the highest after-tax yield?

A. 2.25% U.S. Treasury note
B. 3.55% municipal bond
C. 3.75% U.S. Treasury bond
D. 5.25% corporate bond”

Answer 31

Janeece should purchase the municipal bond based on the following after-tax yield calculations:

U.S. Treasury bond [3.75% × (1 ? 0.37)]: 2.36%
Corporate bond [5.25% × (1 ? 0.37)]: 3.31%
Municipal bond (tax-free): 3.55%
U.S. Treasury note [2.25% × (1 – 0.37)]: 1.46%.”

Question 32

Which of the following statements is not true?

A. A country wishing to restructure its debt using Brady bonds would do so to save on debt servicing costs.
B. One of the benefits of holding convertible debentures is the option to convert
into the corporation’s common stock.
C. U.S. Treasury securities are backed by the full faith and credit of the United States of America.
D. A resident of France purchasing Eurodollar bonds does not incur currency risk.”

Answer 32

D

Explanation: As the name implies, Eurodollar bonds are denominated in U.S. dollars. That means that someone in France will have the risk that the euro, the home currency in France, will rise against the dollar and, as a result, interest payments will be worth less, as will the ultimate payback at maturity. Only U.S. residents have no currency risk with Eurodollar bonds. One of the benefits of Brady bonds is the ability of the sovereign government to borrow at a lower cost because of the collateral behind the bond. At least for exam purposes, there are no securities with a stronger guarantee of timely payment of interest and principal than those issued by the U.S. Treasury. Convertible debentures are convertible into the issuer’s common stock, which is a benefit if the stock rises in price.

Question 33

Advantages of Brady bonds to an American investor include all of the following except:

A. tax-free interest.
B. greater liquidity than found in most emerging market securities.
C. greater safety than most emerging market debt because of the collateral.
D. higher yields than on U.S. Treasury securities.”

Answer 33

A

The interest on Brady bonds is fully taxable to a U.S. investor. All of the other statements are true.

Question 34

All of the following are advantages of Eurodollar bonds except

A. because they are U.S. dollar denominated, they bear no currency risk to U.S. investors.
B. greater transparency.
C. they are rated by U.S. rating agencies, so the risk is clear.
D. they may offer higher yields than domestic bonds from the same issuer.”

Answer 34

B

Eurodollar bonds are not registered with any regulatory agency. As a result, there is a certain lack of transparency.

Question 35

What is Call Protection?

Answer 35

Call protection is the number of years into the issue before the issuer may exercise the call provision.

Question 36

A bond issue that may be retired in advance of maturity at the option of the issuer is said to have

A. a callable feature.
B. an optional reserve.
C. a conversion feature.
D. a cumulative feature.”

Answer 36

A

Explanation: A callable bond has a provision that the issuer, at its option, may redeem that bond at a specified price known as the call or redemption price. As we will see below, the conversion feature may be exercised by the investor, not the issuer.”

Question 37

If each of the following bonds matures in 10 years and has the same rating, which is the most volatile?

A. Zero coupon bond with 6% yield
B. Zero coupon bond with 8% yield
C. Corporate bond priced at par with 6% yield
D. Corporate bond priced at par with 8% yield”

Answer 37

A

Explanation: Zero coupon bonds are more volatile than bonds with coupon payments. The most volatile bonds are the bonds with the lowest yield or coupon rate and the longest time to maturity. Because the bonds have the same maturity, the zero coupon bond with 6% yield will be the most volatile.

Question 38

One of your customers is a new parent. The customer wishes to deposit a lump sum into an investment offering a guaranteed return in 18 years, just in time for college. Which of the following bonds maturing in 18 years would offer the greatest safety?

A. A corporate zero-coupon bond with a AAA rating
A municipal zero-coupon bond with a AAA rating
C. An unrated Treasury STRIP
D. A high-yield corporate bond “

Answer 38

C

Explanation: Treasury securities are not rated because the backing of the U.S. Treasury implies no default risk. Even with AAA ratings, a lot can happen to a corporation or a municipality in 18 years, making the STRIP the best choice for safety.

Question 39

The LIBOR rate is established on a daily basis in

A. Liberia.
B. Libya.
C. London.
D. New York.”

Answer 39

C

The LIBOR is the London Interbank Offered Rate (technically the ICE-LIBOR now) and, as shown, the L stands for London, UK.

Question 40

A company realizes money from the sale of surplus equipment. It would like to invest this money but will need it in 4–6 months and must take that into consideration when selecting an investment. You would recommend

A. preferred stock.
B. Treasury bills.
C. AAA rated bonds with long-term maturities.
D. common stock.”

Answer 40

B

For this client, the appropriate investment is a money market instrument, and nothing is safer than a T-bill.

Question 41

One would expect to have checkbook access to a:

A. CMO.
B. DDA.
C. GNMA.
D. LIBOR.”

Answer 41

B

DDA stands for demand deposit account, most often a checking account at a bank.

Question 42

Which of the following statements about jumbo CDs is not correct?

A. Negotiable CDs do not have a prepayment penalty.
B. FDIC insurance applies up to $250,000.
C. They are secured by pledged assets of the issuing bank.
D. Jumbo CDs pay interest semiannually.”

Answer 42

C

The jumbo (negotiable) CDs traded in the money market are unsecured debt of the issuer.

Question 43

Which of the following have no interest rate risk?

A. Negotiable CDs
B. Commercial paper
C. U.S. Treasury bonds
D. Time deposits at your local bank”

Answer 43

D

Explanation: Time deposits, either in the form of a savings account or a certificate of deposit, have no interest rate risk. Because these do not trade in “the market,” the value is not subject to changes in market interest rates.