Unit 2 - Types & Characteristics of Fixed-Income (Debt) Securities (Testing) Flashcards
DERP Corporation has issued 5% convertible debentures maturing in 2040. The conversion price is $40 and the common is currently trading at $48 per share. One would expect the DERP debentures to be selling somewhat
A) below $1,000.
B) above $1,000.
C) below $1,200.
D) above $1,200.
“
D
Explanation: The first step here is to compute the parity price. A conversion price of $40 means the debenture is convertible into 25 shares of the common stock (par of $1,000 divided by $40 = 25 shares). With a current market price of $48 per share, the parity price of the convertible would be $1,200 (25 ? $48). Because convertible securities generally sell at a slight premium over their parity price, the debentures should have a current market value a bit higher than $1,200.
Which of the following is the most significant difference between corporate secured debt and unsecured debt?
A) Secured debt generally has longer maturities than unsecured debt.
B) Secured debt is rarely callable, while unsecured debt is generally callable.
C) Secured debt has specific collateral pledged to protect the lender’s interest.
D) Secured debt will carry a higher coupon than that issuer’s unsecured debt.”
C
Explanation: The key difference between secured debt and unsecured debt of a corporation is the concept of security. Secured debt gets its name from the fact that some assets of the issuer are pledged as collateral for the loan. Unsecured debt does not have that pledge the lender is relying on the general credit standing of the borrower. The length of maturities is not related to the debt being secured or unsecured, and the same is true about the call feature. The increased safety resulting from the pledge of the collateral results in the secured debt carrying a lower interest cost than the unsecured debt because of the additional safety.
Regardless of the nature of the issuer, one thing an investor in debt securities can expect is
A) an interest rate that varies with changes to market interest rates.
B) physical coupons that are clipped every six months for interest payments.
C) a stated maturity date.
D) priority in payout second only to stock with a prior lien.”
C
Explanation: It would be very rare to find a debt security without a stated date indicating when the debt will be paid off (the maturity date). In the majority of cases, debt securities have a fixed interest rate (which is why they are called fixed-income securities). There are some with variable rates, but the question would have to indicate that exception. No stock of any kind has priority over a debt security. Prior to 1986, you would have physical coupons on the bond, but none of them have been issued since then.
Your client in the 35% federal income tax bracket currently owns some corporate bonds with a coupon yield of 7%. In order to receive the same income after taxes, he would need to buy municipal bonds with a coupon of
A) 7.00%.
B) 9.45%.
C) 2.45%.
D) 4.55%.”
D
Explanation: Because the 7% on the corporate bond is fully taxable, the client receives a net of 4.55% ($70 per bond less 35% in taxes [$24.50], or $45.50 per year). Interest on municipal bonds is tax free, so a 4.55% coupon will result in the same amount of after-tax income.
High-yield bonds are frequently called junk bonds. Which of the following expresses the highest rating that would apply to a junk bond?
A) CCC
B) BBB
C) CC
D) BB”
D
Explanation: Investment-grade bonds run from a highest Standard and Poor’s rating of AAA (Aaa for Moody’s) down to BBB (Baa for Moody’s). When the rating gets to BB (or Ba), the bond is considered high yield, or a junk bond.
The DERP Corporation has an outstanding convertible bond issue that is convertible into eight shares of stock. If the current market price of the bond is 80, the parity price of the stock is
A) $100 per share.
B) $125 per share.
C) $64 per share.
D) $80 per share.”
A
Explanation: Parity means equal. With a conversion ratio of eight shares per bond, the investor can convert the bond into eight shares. If the bond is currently selling for $800, then, to be of equal value (parity), the eight shares must be selling at $100 each.
An investor buys 10M 6.6s of 10 at 67. The investor will receive annual interest of
A) $1,000.
B) $820.
C) $660.
D) $670.”
C
Explanation: Interpret “10M” as “$10,000 worth of.” The investor receives the nominal yield of the bonds, which is 6.6% of $10,000. The M is from the roman numeral for 1,000.
A client is trying to decide between a par value corporate bond carrying a coupon rate of 6.25% per year and a par value municipal bond that pays an annual coupon rate of 4.75%. Assuming all other factors are equal and your client is in a 28% marginal income tax bracket, which bond do you tell the client to purchase and why?
A) The municipal bond because its equivalent taxable yield is 6.60%
B) The corporate bond because the after-tax yield is 6.25%
C) The municipal bond because its equivalent taxable yield is 6.30%
D) The corporate bond because the after-tax yield is 4.50%”
A
Explanation: If we compute the tax-equivalent yield of the muni, we see that it is 6.60%, which is a higher return than the 6.25% on the corporate bond. The formula to get this starts by taking the investor’s tax bracket and subtracting it from 100%. 100% ? 28% = 72%. We then divide the muni coupon of 4.75% by the 72%, and the result rounds off to 6.6%.
A client plans to purchase a home within the next three months and will require $100,000 for the down payment. The client has the money in her DDA and asks you for your recommendation as to the best place to put the money. Your recommendation would probably be for the client to
A) purchase a GNMA for the monthly income.
B) move the money into a 1-year CD.
C) use the money to buy IPOs until the home is purchased.
D) keep the money where it is.”
D) Keep the money where it is
Explanation: DDA stands for demand deposit account, usually a checking account at a bank. Because this client cannot afford any risk to principal, and the bank account is covered by FDIC insurance, this is the most attractive option. The 1-year CD would offer more income, but there would likely be a penalty for early withdrawal. Even though the GNMA is directly backed by the U.S. government, it is subject to market fluctuation, a risk this client cannot take.
Investors interested in acquiring convertible debentures as part of their investment portfolio would
A) be interested in tax advantages available to convertible debt securities.
B) want the assurance of a guaranteed dividend on the underlying common stock.
C) seek to minimize changes in the bond price during periods of steady interest rates.
D) want the safety of a fixed-income investment along with potential capital appreciation.”
D
Explanation: Investors who want the safety of a fixed-income investment with the potential for capital gains would be most interested in purchasing a convertible debenture. However, because convertible debentures can be exchanged for common stock, their market price tends to be more volatile during times of steady interest rates than other fixed-income securities.
ABC’s stock has paid a regular dividend every quarter for the past several years. If the price of the stock has remained the same over the past year but the dividend amount per share has increased, it may be concluded that ABC’s
A) current yield per share has been unaffected.
B) current yield per share has increased.
C) yield to maturity has gone up.
D) current yield per share has decreased.”
B
Explanation: The current yield would have increased because current yield is the income (dividend) divided by price. A higher dividend divided by the same price results in a higher yield. Stocks do not have a yield to maturity.
Which of the following usually does not pay interest semiannually?
A) Treasury note
B) Public utility bond
C) GNMA
D) Treasury bond”
C
Explanation: GNMA pass-through certificates pay principal and the interest monthly. All other choices usually pay interest semiannually.
An investment in which of the following would expose the investor to the greatest capital risk?
A) Mortgage bonds
B) Debentures
C) Preferred stock
D) Common stock”
D
Explanation: Capital risk is the risk of losing capital. Of the choices given, the greatest risk of losing capital is the common stock, as common shareholders come last in liquidation under bankruptcy proceedings.
If a company’s dividend increases by 5% but its market price remains the same, the current yield of the stock will
A) remain at 5%.
B) increase.
C) decrease.
D) remain at 7%.”
B
Explanation: The current yield of a stock is the annual dividend divided by the market price. If a company’s dividend increases and its market price remains the same, its current yield will increase.
Which of the following regarding corporate debentures are true?
I. They are certificates of indebtedness.
II. They give the bondholder ownership in the corporation.
III. They are unsecured bonds issued to finance capital expenditures or to raise working capital.
IV. They are the most senior security a corporation can issue.
A) I and III
B) I and II
C) II and IV
D) III and IV”
A
Explanation: Debentures are debt securities that represent unsecured loans of the issuer. They are senior to common and preferred stock in claims against an issuer. They are issued to finance capital expenditures or raise working capital.
A customer asks if there are any debt instruments providing income that might at least keep pace with inflation and offer some tax advantages. What suitable recommendation could be made that would meet the customer’s criteria?
A) ADRs
B) GNMAs
C) U.S. T-bills
D) TIPS”
D
Explanation: Treasury Inflation-Protected Securities (TIPS) are debt instruments specifically designed to provide income that keeps pace with inflation. Issued by the U.S. Treasury, the interest is tax exempt at the state and local levels. Neither GNMAs nor Treasury bills (T-bills) meet all of these criteria, and American depositary receipts (ADRs) are not debt instruments.
Richard purchased a 30-year bond for 103« with a stated coupon rate of 8.5%. What is the approximate yield to maturity for this investment if Richard receives semiannual coupon payments and expects to hold the bond to maturity?
A) 8.68%
B) 8.19%
C) 8.50%
D) 9.36%”
B
Explanation: No calculation is necessary here. Why not? Because anytime a bond is purchased at a premium over par (103«% is a premium), the YTM must be less than the nominal (coupon) rate. There is only one choice lower than 8.5%. It isn’t about your computational skills; it is about your understanding of the relationship between prices and yields.
One year ago, ABC Widgets, Inc., funded an expansion to its manufacturing facilities by issuing a 20-year first mortgage bond. The bond is secured by the new building and land and is callable at par 15 years after the issue date. The bond was issued with a 5.5% coupon and is currently rated Aa. If the current market price of the bond is 105,
A) the nominal yield is lower than the current yield.
B) the yield to call is lower than the yield to maturity.
C) the yield to maturity is higher than the current yield.
D) the yield to call is higher than the current yield.”
B
Explanation: When a bond is selling at a premium (105 means 105% of $1,000, or $1,050), the order from highest to lowest yield is nominal (coupon) yield, current yield, YTM, and YTC. If the bond is callable at a premium, the order could be changed, but it is highly unlikely that the exam will present that situation in a question.
A bond’s yield to maturity is
A) determined by dividing the coupon rate by the bond’s current market price.
B) the annualized return of a bond if it is held to call date.
C) set at issuance and printed on the face of the bond.
D) the annualized return of a bond if it is held to maturity.”
D
Explanation: The yield to maturity is the annualized return of a bond if it is held to maturity. The computation reflects the internal rate of return and is frequently referred to as the market required rate of return for a debt security. The rate set at issuance and printed on the face of the bond is the nominal or coupon rate. Dividing the coupon rate by the current market price of the bond provides the current yield. The return of a bond if it is held to the call date is the YTC.
An investor purchases a Treasury note and the confirmation shows a price of 102.21. Rounded to the nearest cent, the investor’s cost, excluding commissions, is
A) $102.21.
B) $1,022.10.
C) $1,022.21.
D) $1,026.56.”
D
Explanation: Treasury notes are quoted in 32nds, where each 32nd equals $0.3125. The 102 in the quote equals $1,020 and the 21/32 is an additional $6.56, bringing the total to $1,026.56.
A client is in the 28% marginal federal income tax bracket. Which of the following investments would produce the highest after-tax yield for the client?
A) A U.S. Treasury note yielding 7%
B) A public-purpose municipal bond yielding 6%
C) An A-rated corporate mortgage bond yielding 8%
D) A AAA-rated debenture yielding 7.75%”
“B
Explanation: This question is testing your knowledge and ability to compare the after-tax return on tax exempt municipal bonds (interest is not subject to federal income tax) with other securities whose interest is subject to federal income tax.
The first thing you need to recognize is that the interest on the public-purpose municipal bond is exempt from federal taxes. The interest on all of the other securities is subject to federal income tax. Therefore, to compare the municipal bond with the other answer choices to determine which security will have the highest after-tax yield, you will have to calculate the tax-equivalent yield on the 6% municipal bond. Here is how it looks for this question:
= municipal rate ö (100% ? tax bracket)
= 6% ö (100% ? 28%)
= 6% ö 0.72
= 8.33%
Now you can compare all four securities on a tax-equivalent yield basis. In this question, the municipal bond on a tax-equivalent yield basis will have a yield of 8.33%, and that is higher than any of the other choices.
Alternatively, we know that the investor keeps all of the 6% return on the municipal bond while on the others, federal income tax at the investor’s rate of 28% will be deducted from the actual interest received. Therefore, we can take each of the other choices, subtract 28%, and determine if any of them will have an after-tax return greater than 6%. The 7% Treasury note, after a 28% tax bite ($19.60), results in a net return to the investor of 5.04%. The 8% corporate bond nets 5.76% after subtracting the 2.24% in tax, and the 7.75% debenture’s after-tax yield is 5.58%. This is proof that the 6% municipal bond with no tax on the interest has the highest after-tax return of all of the choices shown.”
Assume that a corporation issued a 5% Aaa/AAA rated debenture at par. Two years later, similarly rated debt issues are being offered in the primary market at 5.5%. Which of the following statements regarding the outstanding 5% debenture are true?
I. The current yield on the debenture will be higher than 5%.
II. The current yield on the debenture will be lower than 5%.
III. The dollar price per bond will be higher than par.
IV. The dollar price per bond will be lower than par.
A) II and III
B) I and III
C) II and IV
D) I and IV”
D
Explanation: Because interest rates have risen after the issue of the 5% debenture, the bond’s price will be discounted to result in a higher current yield (computed as annual income divided by current market price). Accordingly, the discounting of the issue will make the 5% debenture competitive with new issues offered with a 5.5% coupon.
Which of the following is true of a zero-coupon bond?
I. The rate of return is locked in.
II> There is no reinvestment risk.
III> The imputed interest is taxed as ordinary income on an annual basis.
IV. A check for the interest is paid at maturity.
A) I only
B) I, III, and IV
C) I and IV
D) I, II, and III”
D
Explanation: Zero-coupon bonds pay no periodic interest and are always issued at a discount from par. The appreciation of the zero from its discounted purchase price to its face value is thought of as interest to the bondholder, but this annual “phantom income,” so named because you don’t receive it, is taxed as ordinary income on an annual basis. When the bond is purchased, the investor locks in that yield, and with nothing to reinvest, there is no reinvestment risk. At maturity, the investor receives the face value ($1,000) rather than a check for the interest.
The price of which of the following will fluctuate most with a change in interest rates?
A) Money market instruments
B) Short-term bonds
C) Long-term bonds
D) Common stock”
C
Explanation: Long-term debt prices fluctuate more than short-term debt prices as interest rates rise and fall.
An investor is analyzing various risks related to corporate and government bonds. She is interested in finding a risk that is more specific to corporate bonds than to government bonds. Which of the following options correctly defines that risk?
A) Default risk
B) Purchasing power risk
C) Liquidity risk
D) Interest rate risk”
A
Explanation: Default risk is avoided with U.S. government bonds. There is no chance (at least for test purposes) that timely payment of interest and principal will not be made on them. All bonds have interest rate and purchasing power risk. Although it is true that government bonds are generally more liquid than corporate bonds, many corporate bonds are exchange listed. That ensures good liquidity. More important is the test-taking skill. If you have to choose between lack of credit risk and lack of liquidity, it should be clear where the government bond comes out ahead.
An investor purchased a 6% corporate bond selling at par. Because the next interest payment date is not for another two months, the bond carries accrued interest of $20. Disregarding commissions, which of the following statements is correct?
A) The buyer will pay $1,020, and the seller will receive $980.
B) The buyer will pay $1,020, and the seller will receive $1,020.
C) The buyer will pay $1,000, and the seller will receive $1,020.
D) The buyer will pay $1,020, and the seller will receive $1,000.”
B
Explanation: When a bond is purchased or sold in between semiannual interest payment dates, the interest that has accrued since the previous payment is added to the purchaser’s price. In our question, $1,000 plus $20 equals $1,020. That interest belongs to the seller who has held that bond since the previous interest payment. Therefore, the seller receives the selling price ($1,000) plus the accrued interest of $20 for a total of $1,020. Remember, the buyer will be getting the full six months interest of $30 (6% of $1,000 is $30 semiannually) in two months. That represents $10 for the two months the bond was held plus reimbursement for the four months of interest paid to the seller. You will not need to know how to calculate the accrued interest; it will be given in the question as is the case here.
A new convertible debt security has a provision that it cannot be called for five years after the issue date. This call protection is most valuable to a recent purchaser of the security if
A) interest rates are falling.
B) interest rates are rising.
C) the market price of the underlying common stock is increasing.
D) interest rates are stable.”
C
Explanation: Convertible debt securities are more sensitive to the price of the underlying common stock than they are to interest rates. Call protection would enable this investor to hold on to the debt security while the stock rises in value rather than having it called away. Although it is true that call protection protects against a potential call when interest rates decline, the protection against a call when the underlying stock is rising is considered to be more valuable.
When referring to municipal bonds, the formula of (100 - tax bracket) is found in the computation of
A) current yield.
B) tax-equivalent yield.
C) return on investment.
D) yield to maturity.”
B
Explanation: The computation for the tax-equivalent yield of a municipal bond is performed by dividing the bond’s coupon rate by (1 ? the investor’s tax bracket). If the bond has a coupon of 4% and the investor is in the 20% bracket, the tax-equivalent yield is 4% divided by (1 ? 0.20), or 4% divided by 0.80 = 5%.
A European corporation seeking a short-term loan would probably be most concerned about an increase to
A) the SOFR.
B) the U.S. Treasury bill rate.
C) the Eurobond rate.
D) the Fed funds rate.”
“A
Explanation: For more than 40 years, the London Interbank Offered Rate, commonly known as LIBOR, was a key benchmark for setting the interest rates charged on adjustable-rate loans, mortgages, and corporate debt. Over the last decade, LIBOR has been burdened by scandals and crises. Effective January 2022, LIBOR is no longer being used to issue new short-term loans in the U.S. It was replaced by the Secured Overnight Financing Rate (SOFR) which many experts consider a more accurate and more secure pricing benchmark.
As is always the case with NASAA, we do not know when the exam questions will be updated. One thing we can promise you is that any question relating to this topic will not have both LIBOR and SOFR as choices, so you should choose whichever one appears.”
One of the likely consequences of a rating downgrade on a bond is
A) a reduction in the market price of the bond.
B) an increase to the coupon by the issuer.
C) the call feature will be employed.
D) the current yield will be reduced.”
A
Explanation: If the rating agencies downgrade the quality of a bond, potential investors will look to compensate for the increased risk by demanding a greater yield on the issuer’s bonds. This will inevitably result in a lower bond price. A change in rating is unlikely to lead to a call. In fact, with the reduction in the market price, the bond may be selling below par, giving the issuer the opportunity to retire the debt at a discount. Bonds are fixed-income securities because the coupon rate is fixed when the bond is issued and does not change.
As defined in the Securities Exchange Act of 1934, the term municipal security would include
A) a Province of Ontario library construction bond.
B) a U.S. Treasury bill.
C) a City of Chicago school district bond.
D) 50-year bonds issued by the Tennessee Valley Authority.”
C
Explanation: Under federal law, municipal bonds are those issued by any domestic political body or subdivision from the state level on down. Treasury bills and TVA issues are defined as government securities, not municipal securities. Under federal law, Canadian cities (or provinces) are not municipal securities.
Regarding convertible debentures, one characteristic of which your clients should be aware of is that
A) they generally pay a higher interest rate than nonconvertible debentures.
B) it is generally best to convert when the common stock is selling below its parity price.
C) the conversion feature protects against an early call.
D) they trade in line with the issuer’s common stock once the conversion price is reached.”
D
Explanation: The lower volatility of a convertible debenture stems from the fact that it has fixed interest payments and will be redeemed at maturity as any other bond or debenture would. No such guarantees apply to common stock.
Treasury bills are
A) callable.
B) issued at par.
C) issued in bearer form.
D) issued in book-entry form.”
D
Explanation: All Treasury securities are issued in book-entry form. Treasury bills are always issued at a discount and are never callable.
An 8% corporate bond is offered on an 8.25 basis. Which of the following statements are true?
I. Nominal yield is higher than YTM.
II. Current yield is higher than nominal yield.
III. Nominal yield is lower than YTM.
IV. Current yield is lower than nominal yield.
A)I and IV
B)II and IV
C)II and III
D)I and III”
C
Explanation: A bond offered on an 8.25 basis is the same as at a YTM of 8.25%. Because the yield quoted is higher than the 8% coupon, the bond is trading at a discount to par. For discount bonds, the nominal yield is lower than both the current yield and the yield to maturity.
GHI common stock has a $10 par value and is selling in the market for $60 per share. If the current quarterly dividend is $1, the current yield is
A)10%.
B)1.7%.
C)1%.
D)6.7%.”
D
Explanation: Current yield is determined by dividing the annual dividend of $4 ($1 per quarter ? 4 = $4) by the current stock price of $60 ($4 ö $60 = 6.7%). The par value of the common stock has no relevance to this question.
A client is in the 28% marginal federal income tax bracket. Which of the following investments would produce the highest after-tax yield for the client?
A)An A-rated corporate mortgage bond yielding 8%
B)A public-purpose municipal bond yielding 6%
C)A AAA-rated debenture yielding 7.75%
D)A U.S. Treasury note yielding 7%”
B
Explanation: This question is testing your knowledge and ability to compare the after-tax return on tax exempt municipal bonds (interest is not subject to federal income tax) with other securities whose interest is subject to federal income tax.
The first thing you need to recognize is that the interest on the public-purpose municipal bond is exempt from federal taxes. The interest on all of the other securities is subject to federal income tax. Therefore, to compare the municipal bond with the other answer choices to determine which security will have the highest after-tax yield, you will have to calculate the tax-equivalent yield on the 6% municipal bond. Here is how it looks for this question:
= municipal rate ÷ (100% - tax bracket)
= 6% ÷ (100% - 28%)
= 6% ÷ 0.72
= 8.33%
Now you can compare all four securities on a tax-equivalent yield basis. In this question, the municipal bond on a tax-equivalent yield basis will have a yield of 8.33%, and that is higher than any of the other choices.
Alternatively, we know that the investor keeps all of the 6% return on the municipal bond while on the others, federal income tax at the investor’s rate of 28% will be deducted from the actual interest received. Therefore, we can take each of the other choices, subtract 28%, and determine if any of them will have an after-tax return greater than 6%. The 7% Treasury note, after a 28% tax bite ($19.60), results in a net return to the investor of 5.04%. The 8% corporate bond nets 5.76% after subtracting the 2.24% in tax, and the 7.75% debenture’s after-tax yield is 5.58%. This is proof that the 6% municipal bond with no tax on the interest has the highest after-tax return of all of the choices shown.”
Which of the following would make a corporate bond more subject to liquidity risk?
I. Short-term maturity
II. Long-term maturity
III. High credit rating
IV. Low credit rating
A)II and III
B)II and IV
C)I and III
D)I and IV”
B
Explanation: Liquidity risk is the risk that when an investor wishes to dispose of an investment, no one will be willing to buy it, or that a very large purchase or sale will not be possible at the current price.
The available pool of purchasers for bonds with a low credit rating is much smaller than for those with investment-grade ratings (many institutions are only able to purchase bonds with higher credit ratings). As a result, the lower the credit rating, the greater chance of the bond having liquidity issues.
Similarly, bonds with short-term maturities attract many more investors than those with long-term maturities, causing the long-term bonds to be less liquid.”
Which of the following indicates a bond selling at a discount?
A) 10% coupon yielding 9%
B) 5% coupon yielding 5%
C) 7% coupon yielding 7.5%
D) 7% coupon yielding 6.5%”
C
Explanation: Whenever the yield is higher than the coupon, the bond is selling at a discount from the par value. When the question says “yielding,” it is generally referring to the yield to maturity. However, whether referring to the YTM or the current yield, the answer here is the same: the yield is higher than the coupon.
Which of the following is unlikely to be issued at a discount?
A) Zero-coupon bond
B) Jumbo CD
C) Treasury bill
D) Commercial paper”
B
Explanation: Jumbo (negotiable) CDs are one of the few money market instruments issued at face value. Unlike those issued at a discount, they are interest bearing.
A new client is looking for a recommendation. The client is 72 years old, has sufficient income from Social Security, and has a pension plan to cover all of her living expenses. She has just inherited $100,000. She wants to invest this money to have a bit more income so she can spoil her grandchildren. Which of the following would be antipodal to her wishes?
A) Treasury bonds
B) Jumbo CDs
C) Treasury STRIPS
D) Public utility stock”
C
Explanation: If she wants additional income, she cannot get that from Treasury STRIPS. They are zero-coupon bonds and pay nothing until maturity.
For a bond selling at a discount, the yield to maturity will be
A) higher than the nominal yield.
B) lower than the nominal yield.
C) higher than the yield to call.
D) equal to the nominal yield.”
A
Explanation: Yield to maturity is a measure of the total return on a long-term bond, including capital appreciation and interest, while nominal yield measures the interest rate stated on the face of the bond. An investor who buys a $1,000 bond at a discount (for less than $1,000) will receive the interest payments on the bond at the nominal rate and will still receive $1,000 for the bond when it matures. As a result, the total return will be higher than the nominal yield. When a bond is selling at a discount, the YTC will always be higher than the YTM.
A bond with a par value of $1,000 and a coupon rate of 8% paid semiannually is currently selling for $1,150. The bond is callable in 10 years at $1,100. In the computation of the bond’s yield to call, which of these would be a factor?
A) 60 payment periods
B) Present value of $1,100
C) Interest payments of $40
D) Future value of $1,150”
D
Explanation: The YTC computation involves knowing the amount of interest payments to be received, the length of time to the call, the current price, and the call price. A bond with an 8% coupon will make $40 semiannual interest payments. With a 10-year call, there are only 20 payment periods, not 60. The present value is $1,150 and the future value is $1,100, the reverse of the numbers indicated in the answer choices.
A client plans to purchase a home within the next three months and will require $100,000 for the down payment. The client has the money in her DDA and asks you for your recommendation as to the best place to put the money. Your recommendation would probably be for the client to
A) purchase a GNMA for the monthly income.
B) use the money to buy IPOs until the home is purchased.
C) keep the money where it is.
D) move the money into a 1-year CD.”
C
Explanation: DDA stands for demand deposit account, usually a checking account at a bank. Because this client cannot afford any risk to principal, and the bank account is covered by FDIC insurance, this is the most attractive option. The 1-year CD would offer more income, but there would likely be a penalty for early withdrawal. Even though the GNMA is directly backed by the U.S. government, it is subject to market fluctuation, a risk this client cannot take.
When an income-oriented investor wishes to compute the current yield of a specific investment, which one of these items would not be considered?
A) Net present value
B) Interest coupon
C) Dividends paid
D) Current market price”
A
Explanation: The current yield of any investment is the income return (dividends on equity; interest on debt) divided by the current market price. The NPV is a tool that evaluates the reasonableness of the price of an investment.
A customer bought a 10-year 6% AAA bond at par when it was issued. Two years later, if the CPI has increased from 2% to 4%, the price of the bond most likely
A) has stayed at par.
B) cannot be determined.
C) has increased.
D) has declined.”
D
Explanation: When inflation is on the rise, interest rates often rise. When interest rates increase, bond prices may be expected to decline.
When comparing a time deposit account and a demand deposit account, you would expect
A) lower penalties for withdrawing funds from a time deposit account.
B) FDIC insurance on the time deposit account but not on the demand deposit account.
C) a higher rate of interest paid on the time deposit account.
D) easier access to the funds in a time deposit account.”
C
Explanation: The best example of a time deposit account is a CD. Money is deposited for a fixed length of time, generally at a fixed interest rate. Demand deposit accounts are checking accounts. Because the bank expects to have longer use of time deposit funds, interest rates are generally higher. DDAs offer the instant access of check-writing (or online payments). Typically CDs, have penalties for early withdrawal; there is no such charge on a checking account. Both are covered by FDIC up to the applicable limit.
Which of the following statements is true if a corporate bond is callable?
A) The issuing corporation may change the coupon rate at any time by giving the owner of the bond written notice.
B) The issuing corporation has the option to redeem the bond before it matures.
C) The owner of the bond may exchange it for shares of stock.
D) The owner of the bond may demand that the issuing corporation redeem the bond before it matures.”
B
Explanation: A callable bond is one that may be redeemed by the issuing corporation before it matures. One reason a corporation might call a bond is to sell new bonds with a lower interest rate.
Of the following securities, which is most commonly recommended to fund a child’s college education?
A) Treasury bills
B) Zero-coupon Treasury bonds
C) Investment-grade corporate bonds
D) Municipal bonds”
B
Explanation: Zero-coupon bonds, particularly those carrying the guarantee of the U.S. Treasury, are a favored investment vehicle for saving for a child’s higher education. They have the advantage of providing a certain, quantifiable sum at a certain date in the future.
XYZ Corporation’s A-rated convertible debenture is currently selling for 90. If the bond’s conversion price is $40, what is the parity price of the stock?
A) $36.00 per share
B) $40.00 per share
C) $22.50 per share
D) $44.00 per share”
A
Explanation: If the bond’s conversion price is $40, it means the bond is convertible into 25 shares ($1,000 par value divided by the $40 conversion price). Parity means equal, so what does each share have to be worth so that 25 of them are equal to $900? Remember, bonds are quoted as a percentage of the $1,000 par value, so a price of 90 means $900. Dividing $900 by 25 shares results in a parity price of $36. That does not mean the stock is selling for $36 per share (probably a bit less), but at $36, holding the bond, or converting into the stock, gives the investor equal value. Some students quickly see that the bond is 10% below its par value, so the stock?to be equal?must be 10% below the conversion price. Take 10% off $40 and the result is $36. Either way works.
The most common collateral securing a Brady bond is
A) U.S. Treasury zero-coupon bonds with a maturity corresponding to the maturity of the individual Brady bond.
B) an asset, or group of assets, pledged by the borrowing entity.
C) the credit standing of the sovereign nation issuing the Brady bond.
D) the credit standing of the banking institution acquiring the Brady bond.”
A
Explanation: Although other securities may be pledged, the most common is zero-coupon U.S. Treasuries, selected to mature at roughly the same time as the specific Brady bond. An investor purchasing a Brady with collateralized principal knows that, at maturity, a third-party paying agent will receive a payment from the U.S. Treasury that will be used to repay the principal on the Brady issue. In the event of default, the bondholder will receive the principal collateral on the maturity date.
An investor interested in investing in sovereign debt would most likely purchase
A) Sweden 2.5s of 2032.
B) bonds issued by the Bank of the United States.
C) bonds backed by gold sovereigns.
D) European Central Bank debt issues.”
A
Explanation: Sovereign debt refers to bonds and other debt instruments issued by a specific country. The European Central Bank manages the currency of the many countries that have adopted the euro. There is no such thing as the Bank of the United States, and gold sovereigns are coins?they are not used to back debt.
A customer buys a 5% bond at par. The bond is callable in 5 years at par and matures in 10 years. Which of the following statements is true?
A) YTC is the same as YTM.
B) YTC is higher than YTM.
C) YTC is lower than YTM.
D) Nominal yield is higher than either YTM or YTC.”
A
Explanation: If a bond is trading at par, the nominal yield (coupon rate) = current yield = yield to maturity = yield to call (unless the call price is at a premium, in which case the YTC would be higher). YTC is higher than YTM if the bond is trading at a discount to par. YTC is lower than YTM if the bond is trading at a premium over par. Nominal yield is higher than either YTM or YTC if the bond is trading at a premium over par.
Issuing callable bonds is advantageous to the issuer because it allows the company to
A) issue fixed-income securities at a yield lower than usual.
B) replace a high, fixed-rate issue with a lower issue after the call date.
C) call in the bonds at less than par value and capture the difference as income.
D) take advantage of high interest rates.”
B
Explanation: Callable bonds allow the company to take advantage of reduced interest rates by calling in high bonds with high interest rates and replacing them with lower ones. The marketplace requires that the company pay a higher coupon rate on callable bonds compared to ones that are not callable. This compensates the investor for taking the risk of a future call. The call price would never be less than the par value.
All of the following statements regarding Government National Mortgage Association (GNMA) pass-through securities are true except
A) the minimum initial investment is $1,000.
B) GNMAs are considered to be the riskiest of the agency issues.
C) investors own an undivided interest in a pool of mortgages.
D) investors receive a monthly check representing both interest and a return of principal.”
B
*Explanation:** GNMA securities, which are backed by the full faith and credit of the U.S. government, are considered to be the safest, not riskiest, of the agency issues. The minimum denomination is $1,000 and payments to investors are made monthly. Because the asset is a pool of mortgages, just like a personal home mortgage, each payment consists of interest and principal.
The yield to maturity is
A) the annualized return of a bond if it is held to maturity.
B) set at issuance and printed on the face of the bond.
C) the annualized return of a bond if it is held to call date.
D) determined by dividing the coupon rate by the current market price of the bond.”
A
Explanation: The yield to maturity reflects the annualized return of a bond if it is held to its maturity. The computation reflects the internal rate of return and is frequently referred to as the market required rate of return for a debt security. The rate set at issuance and printed on the face of the bond is the nominal or coupon rate. Dividing the coupon rate by the current market price of the bond provides the current yield. The return of a bond if it is held to the call date is the yield to call.
Which of the following investments would provide the highest after-tax income to your client in the 35% federal income tax bracket?
A) 7% bond issued by Canadian Province M
B) 5% general obligation municipal bond issued by State H
C) 6% U.S. Treasury bond
D) 8% debenture issued by the LMN Corporation”
D
Explanation: Only the State H bond is exempt from federal income tax. Using the tax-equivalent yield formula of the muni coupon divided by (100% minus the investor’s tax bracket %), we get 5% divided by 65%, or 7.7%. That’s a better deal than receiving 6% on the Treasury and paying taxes as well as 7% on the Canadian bond (although you learned that securities issued by Canadian provinces were exempt from registration under the Uniform Securities Act, that has nothing to do with U.S. income taxes). However, with a TEY of 7.7%, your client would take home more with the 8% taxable corporate security. You can also work backward to get the correct answer. Simply subtract 35% tax from each of the choices (other than the muni) and see which is the highest. In this case, 8% minus a 35% tax equals 5.2%?just a bit higher than the 5% coupon on the municipal bond.
Which of the following statements about municipal bonds is not true?
A) The interest on municipal bonds is usually not subject to federal income tax.
B) Municipal bonds are bonds issued by governmental units at levels other than the federal.
C) Municipal bonds are generally considered riskier than corporate bonds.
D) Municipal bonds generally carry lower coupon rates than corporate bonds of the same quality.”
C
Explanation: Municipal bonds are generally considered second only to Treasury instruments in relative safety.”
If investors hold bonds until maturity, their realized rate of return, assuming all interim cash flows are reinvested at that same rate, would be equal to
A) the yield to maturity.
B) the coupon return.
C) the price return.
D) the income return.”
A
Explanation: The yield to maturity is an investor’s total return if they purchase the bond at any point and then hold it until maturity, assuming all interim cash flows are reinvested at that same YTM. This takes into consideration any capital gain or loss; therefore, the yield to maturity will fluctuate with the bond’s price.
A bond purchased at $900 with a 5% coupon and a five-year maturity has a current yield of
A) 7.40%.
B) 7.80%.
C) 5.56%.
D) 5.00%.”
C
Explanation: Current yield is determined by dividing the annual interest payment by the current market price of the bond ($50 ÷ $900 = 5.56%). Years to maturity is not a factor in calculating current yield.
Money market instruments are
A) long-term equity.
B) intermediate debt.
C) short-term debt.
D) long-term debt.”
C
Explanation: Money market instruments are high-quality debt securities with maturities that do not exceed one year.
A corporation has issued a 4% $60 par convertible stock with a conversion price of $20. With the preferred stock selling at $66 per share, an investor holding 100 shares of this stock will benefit by converting if the price of the common stock is
A) below $22.00 per share.
B) above $22.00 per share.
C) above $18.20 per share.
D) above $20.00 per share.”
B
Explanation: With a conversion price of $20 and a par value of $60, this preferred stock is convertible into three shares of the company’s common stock. We divide the current price of the preferred ($66) by the three shares to arrive at the parity price of $22. If the common stock is selling for more than the parity price, the investor can benefit by converting and selling the stock in the marketplace.
An unsecured long-term debt security issued by a corporation is known as
A) a collateral trust bond.
B) a mortgage bond.
C) a debenture.
D) an equipment trust certificate.”
C
Explanation: A debenture is a long-term debt security issued by a corporation with no specific asset pledged as security for the loan.
When discussing convertible debt securities, it would be incorrect to state that
A) holders have a fixed interest rate.
B) the issuer pays a lower interest rate.
C) holders receive a higher interest rate.
D) holders may share in the growth of the common stock.”
C
Explanation: Because of the possibility of participating in the growth of the common stock through an increase in the market price of the common, the convertible can be issued with a lower interest rate.
A client approaches the investment adviser representative handling the advisory account with a request to find a preferred stock that will offer a 6% income return. The investment adviser representative suggests a stock paying a $0.28 quarterly dividend. That stock will exactly meet the income objective if it has a current market price of
A) $4.67.
B) $11.91.
C) $6.72.
D) $18.67.”
D
Explanation: The first thing to do is annualize the dividend by multiplying the $0.28 by 4. Once we have the annual dividend of $1.12, divide by 6% and the result is $18.6666, or $18.67 properly rounded. If you left your math skills at home, all you have to do is multiply each of the choices by 6% to see which one is closest to $1.12.
In general, from the choices given, the type of security offering the greatest degree of safety to an investor is
A) a debenture.
B) preferred stock.
C) a mortgage bond.
D) common stock.”
C
Explanation: Debt securities, because they are an obligation of the issuer, are generally considered safer than equity securities. Secured debt is safer than unsecured debt. The only one of these debt obligations with pledged assets as security for the loan is the mortgage bond. Debentures are unsecured corporate debt obligations.
Although bonds are issued by many different entities, most of their features are the same. With few exceptions, included in that list of similarities would be all of these except
A) a stated interest date.
B) a stated maturity date.
C) price movement that is inverse to interest rates.
D) safety of principal.”
D
Explanation: The safety of principal largely depends on the issuer. For example, there are no bonds as safe as U.S. Treasury bonds. On the other hand, there are some corporate bonds that are quite speculative. In general, all bonds have a stated maturity date , interest rate, and interest payment date, and they are exposed to interest rate risk. That is the risk that as interest rates rise, the price of the bonds will decline.
One of the benefits of adding foreign debt securities to an investor’s portfolio is
A) receiving income in foreign currency.
B) potentially higher yields.
C) potentially higher risk.
D) reduced taxation.”
B
Explanation: The interest rates paid on debt in many foreign countries, especially those in emerging economies, is higher than that available domestically. The tradeoff is higher risk. Receiving interest payments in foreign currency involves not only currency risk but the added expense of conversion into U.S. dollars. (ADRs are for equity, not debt securities.) In many cases, investors pay both foreign and U.S. tax on the interest.
Which of the following statements regarding convertible bonds is not true?
A) Coupon rates are usually higher than nonconvertible bond rates of the same issuer.
B) If there is no advantage to converting the bonds into common stock, they would sell at a price based on their market value without the convertible feature.
C) Convertible bondholders are creditors of the corporation.
D) The conversion rate is set at issuance and does not change.”
A
Explanation: Because convertible debentures offer investors the opportunity to gain from increases in the issuer’s common stock, those investors are willing to accept a lower coupon (interest rate) than debt securities without the convertible feature. Debentures are debt securities, making their holders creditors of the issuer. At the time the debenture is issued, the bond indenture indicates the conversion rate. That rate is fixed and does not change over the life of the security. In general, the conversion feature will be exercised only if the market price of the underlying stock has risen to the point where the investor is better off owning the stock than the debenture. One of the benefits of owning this security is that, as a debt instrument, if the stock price falls below the conversion price, the debenture will trade in the market like a comparable nonconvertible issue. That is, it will trade at a market price offering a yield similar to nonconvertible debt securities of the same quality and maturity.
Although there are a number of risks to owning a debt security that are common to all investors, which specific risk is avoided when a U.S. resident purchases a Eurodollar bond?
A) Currency risk
B) Interest rate risk
C) Inflation risk
D) Default risk”
A
Explanation: Eurodollar bonds are denominated in dollars; therefore, no currency risk exists for a U.S. resident.
A TIPS bond is issued in the principal amount of $1,000, paying 3.5%. Over the security’s 5-year term, the annual inflation rate is 6%. What is the principal value of the bond at the end of 4 years?
A) $1,267
B) $1,300
C) $1,344
D) $1,240”
A
Explanation: The unique feature of a TIPS bonds is its semiannual adjustment to principal based on the inflation rate. With an annual inflation rate of 6%, there is a 3% increase to the principal value every 6 months. The arithmetic is $1,000 multiplied by 103% consecutively 8 times (there are 8 semiannual periods in 4 years). Be sure to stop at 4 years - the question doesn’t ask for the ending value for the 5th year. If this math is too challenging, there is a simple method that always works. That simple method has you take the annual inflation rate (6% = $60) for 4 years ($240) and add that to the original $1,000 face value. That is $1,240, and the correct answer on the exam will always be the next higher number ($1,267 in this case). This simple step means you are calculating the simple interest while the bond’s principal growth is actually compounding.
To secure the debt that a subsidiary is offering, a railroad holding company transfers to a trustee the common stock of another subsidiary. The offering is one of
A) secured income notes.
B) equipment trust certificates.
C) collateral trust certificates.
D) guarantee trust bonds.”
C
Explanation: When a company uses the securities of one subsidiary to collateralize a bond issue of another subsidiary, the bonds are known as collateral trust certificates.
Probably the most significant characteristic of municipal bonds for investors is
A)that their coupon yields are higher than comparably rated corporate issues.
B) their exemption from federal income tax.
C)their exemption from registration on the state and federal level.
D) their safety.”
B
Explanation: Municipal bonds are unique in that their interest is not subject to federal income tax. As a result, their coupon yields are generally lower than corporate bonds with a similar rating; you get to keep all of the interest instead of paying taxes on it. The fact that they are exempt from registration with state and federal agencies is of little, if any, consequence to the typical investor. Although they tend to be quite safe, if safety is the primary concern, the investor would turn to U.S. Treasuries or government agency securities.
Securities issued by which of the following issuers have the direct backing of the U.S Treasury?
A) Federal National Mortgage Association (Fannie Mae)
B) Government National Mortgage Association (Ginnie Mae)
C)Federal Agricultural Mortgage Corporation (Farmer Mac)
D) Federal Home Loan Mortgage Corporation (Freddie Mac)”
B
Explanation: Bonds issued or guaranteed by the Government National Mortgage Association (Ginnie Mae) are backed by the “full faith and credit of the U.S. government,” just like U.S. Treasuries. Bonds issued by government-sponsored enterprises (GSE), such as the Federal National Mortgage Association (Fannie Mae), the Federal Home Loan Mortgage Corporation (Freddie Mac), and the Federal Agricultural Mortgage Corporation (Farmer Mac), are not backed by the same guarantee those issued by federal government agencies. Bonds issued by GSEs carry credit risk. The GSEs are publicly traded companies whose shares are registered with the SEC.
The DERP Corporation has an outstanding convertible bond issue with a conversion price of $125 per share. If the current market price of the bond is 80, the parity price of the stock is
A) $100.00 per share.
B) $156.25 per share.
C) $125.00 per share.
D) $64.00 per share.”
B
Explanation: What does parity mean? It means that two things have equal value. What two things do we have here? We have the convertible bond, and because it is convertible, it can be converted into common stock. There is a number where the value of the bond and the value of the stock are the same; this price is the parity price.
The bond is currently valued at $800 (80% of par). Anytime the investor wishes, he can exchange (convert) that bond into DERP’s stock at $125 per share. However, that conversion is not based on a market price, which can fluctuate every day; it is based on the amount of money initially borrowed - the $1,000 par value of the bond.
DERP is saying that it will allow you to exchange the $1,000 they owe you for stock at $125 per share. Simple division results in the ability to convert into 8 shares.
Now we have everything we need to compute the parity (equal) price. If the bond is currently valued at $800 and we can convert it into 8 shares, what does each of those shares have to be worth so that the stock is also valued at $800? Dividing 800 ÷ 8 = $100 per share. That means that if the stock is selling for $100 per share and we decide to convert the bond, we’ll have the same $800 in value.
Some students find the answer a quicker way. If the bond is selling at 80% of its par value, then to be equal, the stock must be selling at 80% of the conversion value (80% ? $125 = $100).”
The owner of a convertible debt issue
A) is a creditor of the issuer.
B) has the choice of receiving the bond’s interest or dividends on the underlying stock, whichever is higher.
C) generally expects a higher current return than with a nonconvertible bond of the same quality and maturity.
D) is generally in a senior position to other bondholders.”
A
Explanation: The owner of any bond is a creditor of the issuer. Dividends are paid only on stock, and the investor will have to convert in order to be a stockholder. Because of the growth potential of the common stock, holders of convertible securities invariably accept a lower coupon rate resulting in a lower current yield (return). In almost all cases, convertible debt securities are debentures and, therefore, junior to secured bonds.
If an investor pays 95.28 for a Treasury bond, how much did the bond cost?
A) $95.28
B) $9,528.00
C) $950.28
D) $958.75”
D
Explanation: Treasury bonds are quoted as a percentage of par ($1,000) plus 32nds. In this case, the price is $950 plus 28/32 (i.e., 7/8) of $10, for a total of $958.75.
In general, among the advantages to investing in Brady bonds over those issued by countries classified as emerging economies is
A) higher yields.
B) greater risk.
C) increased liquidity.
D) shorter maturities.”
C
Explanation: Brady bonds are issued to take over the debt of failing commercial loans in emerging economies. They are secured by collateral - often U.S. Treasury zero-coupon bonds - thereby making them more secure than direct issues of that country. This backing also increases the liquidity as there is a larger pool of potential investors. These benefits cause the yields to be lower - less risk, less reward. There is nothing unique about the maturities of Brady bonds.
Which of the following projects is most likely to be financed by a general obligation rather than a revenue bond?
A)Public library
B) Municipal hospital
C) Public golf course
D) Expansion of an airport”
A
Explanation: Hospitals, airports, and golf courses all generate revenue and can be financed with revenue bond issues. Public libraries are financed through general obligation (GO) bond sales with the backing of taxes.
An investor purchasing 10 corporate bonds at a price of 102 1/4 each will pay
A) $1,020.25.
B) $10,202.50.
C) $1,022.50.
D) $10,225.00.”
D
Explanation: At 102 1/4, each bond costs $1,022.50 (102 = 1,020 and 1/4 of $10 = $2.50). There are 10 bonds, so the total is $1,022.50 x 10 = $10,225.
A bond with a par value of $1,000 and a coupon rate of 6% paid semiannually is currently selling for $1,200. The bond is callable in 15 years at 105. In the computation of the bond’s yield to call, which of these would be a factor?
A) Interest payments of $30
B) Present value of $1,050
C) 15 payment periods
D) Future value of $1,200”
A
Explanation: The yield to call (YTC) computation involves knowing the amount of interest payments to be received, the length of time to the call, the current price, and the call price. A bond with a 6% coupon will make $30 semiannual interest payments. With a 15-year call, there are 30 semiannual payment periods, not 15. The present value is $1,200 and the future value is $1,050, which is the reverse of the numbers indicated in the answer choices.
Which of the following is not a money market instrument?
A) Commercial paper
B) Banker’s acceptances
C) Newly issued Treasury notes
D) Treasury bills”
C
Explanation: Commercial paper, Treasury bills, and banker’s acceptances are debt instruments with maturities of one year or less and are therefore money market instruments. A newly issued Treasury note would have a maturity of two to 10 years and therefore would not be a money market instrument.
Which of the following are general characteristics of negotiable jumbo CDs?
A) Always mature in one to two years with a prepayment penalty for early withdrawal
B) Trade only in the primary market
C) Typically pay interest on a monthly basis
D) Issued in amounts of $100,000 to $1 million”
D
Explanation: Negotiable jumbo CDs are issued for $100,000 to $1 million and trade in the secondary market. Most jumbo CDs are issued with maturities of one year or less. Being negotiable in the secondary market, there is no prepayment penalty. These CDs generally pay interest on a semiannual basis, not monthly.
Which of the following would you not expect to see issued at a discount?
A) Commercial paper
B) Bank jumbo CD
C) Treasury bill
D) Zero-coupon bond”
C
Explanation: Of these securities, only the bank jumbo (negotiable) CDs are always interest bearing and issued at par or face value.
Your client is interested in investing in preferred stocks in an effort to receive dividend income. The client’s target goal is a 6% current return on investment (ROI). If the RIF Series B preferred stock is paying a quarterly dividend of $0.53, your client’s goal will be achieved if the RIF can be purchased at
A) $22.55.
B) $35.33.
C) $8.83.
D) $50.00.”
B
Explanation: First, take the quarterly dividend and annualize it (4 x $0.53 = $2.12). Dividing that number by 6% gets you $35.3333, which rounds down to $35.33. Alternatively if you wish (but which takes more time), multiply each of the choices by 6% to see which of them equals $2.12.
One of the advantages of owning a corporation’s debentures is that you have prior claim over
A) general creditors.
B) secured creditors.
C) employees.
D) preferred stockholders.”
D
Explanation: Holders of a company’s debentures are general creditors and, as such, have prior claim only over equity holders.
You are meeting with a relatively unsophisticated investor who doesn’t understand very much about stocks and bonds. The investor asks, “Can you list the advantages of owning common stock as compared to bonds?” Among other reasons, you could reply that
A) income payments are more reliable.
B) bonds have priority over any equity security in the event of liquidation.
C) there is limited liability.
D) bonds must be surrendered at maturity or at a call while the owner of common stock can hold the investment as long as desired.”
D
Explanation: One negative of owning bonds is that the bond will ultimately mature or be called and the bondholder has no choice but to surrender the security. With common stock, the investor has total control over the length of the holding period. Although there are many benefits to owning bonds compared to common stock, among them is priority in the event of liquidation and regular payment of interest. Yes, common stock has limited liability, but the same is true of bonds; if the company goes under, the bondholder’s maximum loss is the investment. Even then, because of the seniority of bonds, it is less likely that the entire investment will be lost.
A bond issued by the GEMCO Corporation has been rated BBB by a major bond-rating organization. This bond would be considered
A) secured.
B) callable.
C) an investment-grade corporate bond.
D) a high-yield corporate bond.”
D
Explanation: An investment-grade bond has a bond rating between AAA and BBB. Lower-rated bonds are considered high-yield bonds and are often referred to as junk bonds. The bond may or may not be secured; the rating does not indicate that fact.
The current yield on a bond with a coupon rate of 7.5% currently selling at 105 1/2 is approximately
A) 6.50%.
B) 8.00%.
C) 7.50%.
D) 7.11%.”
D
Explanation: A bond with a coupon rate of 7.5% pays $75 of interest annually. Current yield equals annual interest amount divided by bond market price, or $75 ÷ $1,055 = 7.109%, or approximately 7.11%.
Which of the following would be most likely to increase a bond’s liquidity?
A) No call protection
B) A longer maturity
C) A higher rating
D) A lower rating
C
Explanation: Liquidity risk is the risk that when an investor wishes to dispose of an investment, no one will be willing to buy it or that a very large purchase or sale would not be possible at the current price. The available pool of purchasers for bonds with a low credit rating is much smaller than for those with investment-grade ratings. (Many institutions are only able to purchase bonds with higher credit ratings.) As a result, the lower the credit rating is, the greater the chance is of the bond having liquidity issues. Similarly, bonds with short-term maturities attract many more investors than those with long-term maturities, causing the long-term bonds to be less liquid. The absence of call protection is negative to many investors, thus limiting the number of potential investors.
MNO is planning to raise capital through an offering of 30-year bonds. Which call price would be most beneficial to MNO?
A) 106
B) 110
C) 104
D) 102”
D
Explanation: MNO would benefit most from the ability to call bonds at the lowest possible price. The call feature enables MNO to buy the bonds before maturity to reduce their fixed interest costs. A call price of 102 requires the lowest call premium of the options shown.
Which of the following statements regarding U.S. government agency securities is true?
A) Interest received on agency securities is exempt from federal income tax.
B) They are direct obligations of the U.S. government.
C) They generally trade on the major stock exchanges.
D) They generally offer higher yields than direct U.S. obligations.”
D
Explanation: In most cases, securities issued by U.S. government agencies are obligations of that agency rather than the U.S. government. As such, they carry slightly higher risk, and that means investors demand a higher return. They do not trade on any exchange. Their interest, like that of all U.S. government securities, is taxable on the federal level while being tax exempt on the state level.
The GHIJ Corporation has a 3% convertible debenture outstanding with a conversion price of $40. The bond’s current market price is 126. The most probable reason for this is
A) the current market price of the GHIJ common stock is approximately $50 per share.
B) interest rates have risen since the debenture was issued.
C) the current market price of the GHIJ common stock is approximately $35 per share.
D) GHIJ?s earnings have risen since the debenture was issued.”
A
Explanation: With a conversion price of $40, the bond is convertible into 25 shares. Convertible securities generally sell at a slight premium to their parity price, which - at $1,260 - would be $50.40 per share.
Which of the following debt instruments generally presents the least amount of default risk?
A) High-yield corporate bonds
B) Municipal general obligation bonds
C) Municipal revenue bonds
D) Convertible senior debentures”
B
Explanation: Because the full taxing power of the municipality backs a general obligation municipal bond, it will exhibit the least amount of default risk. A corporate debenture is an unsecured bond with a potentially greater degree of risk, as is a junk or high-yield corporate bond.
A client has indicated that his primary objective is maximizing current income regardless of the risk. Which of the following mutual funds would probably be most suitable for achieving that goal?
A) ABC Growth and Income Fund
B) JKL Municipal Bond Fund
C) DEF High-Yield Bond Fund
D) GHI Index Fund”
C
Explanation: High-yield (junk) bonds, although carrying more risk, produce higher current income than other funds.
