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.”
