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93 Cards in this Set

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Concerning Moody's ratings, which is the most speculative in the investment grade category?
a. Aa
b. A
c. Baa
d. Ba
C
The top four ratings in both Moody's and S&P are referred to as "investment grade or bank quality". The top 4 ratings are:

Moody’s : Aaa, Aa, A, Baa
S&P : AAA, AA, A, BBB

If the question had simply asked for the most speculative, then Ba would have been the answer. (5-16)
Which of the following would probably be most leveraged?
a. A software company
b. A biotech company
c. A consumer electronics company
d. A utility company
D
A leveraged company is one with a large amount of outstanding debt(bonds). The utility company would be the most leveraged. Of the choices given, utilities are the heaviest users of debt and would have the greatest amount of interest charges (fixed charges). Therefore, utilities would be the most leveraged. The percentage of debt in a utility company's capitalization is usually greater than the other companies listed. (5-1)
FIXED CHARGES (S7) : A company's fixed expenses, such as bond interest, which it has agreed to pay, and that are deducted from income before earnings on equity are computed.
Which of the following Moody's rated bonds would be considered speculative?
a. Aaa
b. Aa
c. Baa
d. Ba
D
The top four Moody's ratings, Aaa, Aa, A, and Baa, are termed investment grade (basically nonspeculative). Ratings lower than Baa (such as Ba) would be considered speculative. The investment grade category in S&P ratings includes AAA, AA, A, and BBB. (5-16)
INVESTMENT GRADE (S7) : Refers to bonds rated in the top four rating categories by Moody's (Baa or higher) or Standard & Poor's (BBB or higher) that are eligible for investment by fiduciaries. See also: Legal List.
The City of Richmond, Virginia is issuing 8 1/4% general obligation bonds at 100% of their par value. The bonds will mature in 20 years. An investor purchasing a bond at its offering price and holding the bond for 20 years will receive a yield-to-maturity of:
a. 8.25%
b. Less than 8.25%
c. More than 8.25%
d. Cannot be determined
Explanation:
A
When a bond is purchased at its par value, the yield-to-maturity will be the same as the nominal yield or coupon rate. In this example, the coupon rate is 8 1/4%. Therefore, the yield-to-maturity would also be 8 1/4% (8.25%). When a bond is issued or purchased at a discount (below par value), the yield-to-maturity will be greater than the coupon rate. When a bond is issued or purchased at a premium (above par value), the yield-to-maturity will be lower than the coupon rate. (5-9)
NOMINAL YIELD (S7) : The stated rate of interest that a bond pays the holder, based on its par value. It is also known as the coupon, coupon rate, and fixed-interest rate.
COUPON RATE (S7) : The stated, fixed, or nominal interest rate for a bond.
All of the following are true about a bond issue having serial maturities EXCEPT:
a. All of the bonds mature on one date in the future
b. The bonds are priced on a yield-to-maturity basis
c. The issue has a decreasing outstanding principal
d. The issue has decreasing total interest payments
A
Serial bonds mature in successive years and are priced on a yield-to-maturity basis. As a serial issue nears its final maturity, the outstanding principal and total interest payments decrease. Term bonds all mature at one date in the future and are priced at a dollar price (percentage of par). (5-3)
A customer purchases ten 7% $1,000 par value bonds selling at a discount that have a yield-to-maturity of 9%. The customer will receive a semiannual interest payment of:
a. $350
b. $450
c. $700
d. $900
A
The customer will receive a semiannual interest payment of $350. The bond pays 7% interest based on the $1,000 par value. There are 10 bonds in this example which would have a par value of $10,000. Seven percent of $10,000 would be $700. Since interest is paid semiannually, the payment would equal $350. (5-3)
ABC Corporation has a capitalization that consists of a large amount of debt securities relative to a small amount of equity securities. ABC Corporation would be considered to have a capitalization that is:
a. Conservative
b. Ordinary
c. Under-leveraged
d. Leveraged
Explanation:
D
When a corporation has a capitalization that consists of a small amount of equity securities relative to a large amount of debt securities, that capitalization is said to be leveraged. (5-1)
When comparing long-term bonds to short-term bonds, all of the following are TRUE EXCEPT:
a. They usually have higher yields than short-term bonds
b. They usually provide greater liquidity than short-term bonds
c. They usually are more often callable than short-term bonds
d. Their market prices are more sensitive to interest rate changes than short-term bonds
B
All of the statements listed about long-term bonds as compared to short-term bonds are true except they usually provide greater liquidity than short-term bonds. (5-11)
The proceeds of the sale of a municipal bond issue are invested in U.S. government securities that are sufficient to cover interest, principal, and call premiums on an outstanding bond issue. The outstanding bonds are called:
a. Covered bonds
b. Safe bonds
c. Guaranteed bonds
d. Pre-refunded bonds
D
The outstanding bonds are called pre-refunded or advance-refunded bonds. The new issue is called a refunding issue. This is usually done when the issuer can borrow at lower rates and therefore save interest costs. (5-17)
If an investor is primarily seeking capital gains, when would be the best time to buy bonds?
a. When interest rates are high and are expected to drop
b. When interest rates are low and are expected to rise
c. When interest rates are stable and are expected to remain stable
d. When bond prices are low and interest rates are expected to rise
Explanation:
A
If an investor is primarily seeking capital gains, the best time to buy bonds would be when interest rates are high and expected to drop. Interest rates and bond prices have an inverse or opposite relationship. If interest rates decline, bond prices will go up to bring yields in line with the new lower coupon rates. (5-10)
If interest rates are expected to rise over a period of time, a municipality that must raise money would probably issue securities with:
a. Short-term maturities
b. Intermediate-term maturities
c. Long-term maturities
d. Call provisions
C
By issuing securities with long-term maturities, the municipality can lock in the rate of interest it has to pay on the bonds. Therefore, if interest rates are expected to rise over a period of time, the municipality would not be subject to these changes. This would provide the municipality with the capital it needed, without borrowing again at higher rates of interest, as it would have to do if it issued shorter or intermediate-term securities. (5-11)
A corporation is contemplating the refunding of its debt issues. The refunding could accomplish which of the following?
I. Reduce interest costs
II. Change the maturity schedule of the corporation's debt
III. Remove restrictive provisions from the indenture
a. I only
b. I and II only
c. II and III only
d. I, II, and III
D
Refunding means to replace a debt issue with another debt issue. A corporation can refund a debt issue to accomplish each of the choices. (5-17)
REFUNDING (S7) : The issuance of a new bond issue for the purpose of retiring an outstanding bond issue.
During periods of tight money, when the yield curve becomes inverted, the highest yield would probably be found in:
a. 3-month treasury bills
b. 3-month negotiable certificates of deposit
c. 5-year Treasury notes
d. 30-year municipal bonds
B
When interest rates have moved up due to a tight monetary policy, theyield curve may become inverted causing short-term rates to be higher than long-term rates. Moreover, negotiable certificates of deposit (CDs) , which are issued by banks, will generally have yields several basis points higher than T-bills which are of higher quality. (5-14)
A customer buys bonds with a $50,000 par value at 85 1/2. The bonds are callable at 110. If the customer holds the bonds to maturity he will receive:
a. $42,500
b. $50,000
c. $55,000
d. $85,000
B
At maturity, the holder of the bonds will receive the par value, which in this example is $50,000. (5-1)
A new convertible bond has a provision that it cannot be called for five years after the issue date. This call protection would be most valuable to a recent purchaser of the bond if:
a. Interest rates are falling
b. Interest rates are rising
c. Interest rates are stable
d. The yield curve slopes downward
A
The call protection would be most valuable to a recent purchaser of the bond if interest rates are falling. If interest rates fall, bond prices rise. Corporations will call back bonds when interest rates decline and issue new bonds with lower rates of interest. Bonds are usually callable at a small premium above par value. If the bonds are not callable, the investor can realize the full benefit of an increase in the market price of the bonds. (5-17)
The American Telephone Company announced in an ad in The Wall Street Journal that it intends to call for redemption all of its outstanding 10% callable bonds at 103 1/4 plus accrued interest. The market price of the bonds was 102 3/4 at the time of the announcement. Which alternative is most advantageous to the bondholder?
a. Redeem the bonds.
b. Sell the bonds at the current market price.
c. Do nothing and hope for a takeover bid from another company.
d. Hold the bonds to maturity and continue to earn interest.
A
When bonds are called for redemption, the bondholder can only redeem the bond at the callable price or sell them in the market. The bondholder cannot continue to hold the bonds in anticipation of a better offer or until maturity. (5-17)
Which of the following is NOT TRUE as it relates to a bond selling at a discount?
a. The yield-to-maturity is greater than the nominal yield.
b. The nominal yield is less than the current yield.
c. Interest rates most likely decreased after the bonds were issued.
d. The par value exceeds the market price.
C
If the par value of a bond is greater than the bond's market price, it is selling at a discount. A bond sells at a discount because of an increase in interest rates since the bond was issued. For a discount bond, the yield-to-maturity is highest, followed by the current yield, with the nominal yield being lowest. (5-9)
Pennsylvania Power Company has announced it will refund $100 million of its outstanding 12% bonds that were to mature in 2020. The bonds will be refunded at 106.75% of par value from the proceeds of a $100 million refunding issue. The refunding issue has a 6% coupon rate and matures in 2012.
The refunding will reduce all of the following EXCEPT the:
a. Interest cost to the issuer
b. Company's maturity schedule
c. Company's annual debt service obligation
d. Amount of outstanding debt
D
Pennsylvania Power has reduced the interest charges (from 12% to 6%) by advancing the repayment of its existing debt. The company is paying off the 12% bonds, due in 2020, with the issuance of another bond. It is also improving its debt service by reducing the interest rate from 12% to 6%, thereby reducing its fixed charges each year. However, the amount of debt outstanding will remain the same at $100 million. (5-17)
Pennsylvania Power Company has announced it will refund $100 million of its outstanding 12% bonds that were to mature in 2020. The bonds will be refunded at 106.75% of par value from the proceeds of a $100 million refunding issue. The refunding issue has a 6% coupon rate and matures in 2012.
Bondholders who owned 12% bonds maturing in 2020 will receive:
a. $1,067.50 plus accrued interest
b. The new 6% bonds being issued plus accrued interest
c. $1,000 plus accrued interest
d. The new 6% bonds being issued without accrued interest
Explanation:
A
The company is refunding the bonds at 106.75% of its par value. The bondholders who owned the 12% bonds will receive 106.75% of the $1,000 par value (106.75% x $1,000) for a total of $1,067.50 plus accrued interest. (5-17)
REFUNDING (S7) : The issuance of a new bond issue for the purpose of retiring an outstanding bond issue.
ACCRUED INTEREST (S7) : The interest due on a bond since the last interest payment was made. The buyer of the bond pays the market price plus accrued interest.
An outstanding municipal bond would most likely be called when interest rates:
a. Rise above the bond's nominal yield
b. Rise above the bond's yield to maturity
c. Fall below the bond's nominal yield
d. Fall below the bond's yield to maturity
C
Bonds may contain a provision that allows the issuer, at its option, to redeem the bonds before they mature. Call provisions usually benefit the issuer, which has the option of calling in the bonds when interest rates decline.
The issuer may then refinance the debt at a lower rate of interest. For instance, if an issuer's outstanding bond is paying a coupon rate (nominal yield) of 9% at a time when similar bonds are paying only 5%, it can reduce its interest costs by calling in the 9% bonds and issuing new ones at 5%.
As rates decline, the bond's yield to maturity or yield to call also would decline. (5-17)
The purpose of a sinking fund is for redeeming a corporation's:
a. Common stock
b. Warrants
c. Rights
d. Bonds
A
A sinking fund is setting aside monies to be used for the purpose of redeeming a corporation's bonds before or at maturity. (5-18)
SINKING FUND (S7) : Money regularly set aside by a company to redeem its bonds, debentures, or preferred stock from time to time as specified in the indenture or charter. Relative to a municipality, monies set aside to provide for retirement of a term issue at or before maturity.
A tombstone ad states that the McGee Oil Company is offering $200,000,000 of 8 1/2% bonds due July 1, 2026 at 99 1/2% of their par value. The yield-to-maturity on the bond is:
a. 8%
b. Less than 8 1/2%
c. 8 1/2%
d. Greater than 8 1/2%
D
The 8 1/2% bonds are being offered at a discount at 99 1/2% of their $1,000 par value. An investor who purchased the bonds at the offering and held the bonds to maturity would receive the par value of $1,000. The investor would therefore have a yield-to-maturity that is greater than 8 1/2%. (5-9)
An investor owns $10,000 worth of XYZ Corporation convertible bonds callable at 102. Prior to the call the bonds are selling in the market at 103. If the corporation calls the bonds at the call price, the investor will receive:
a. $10,000
b. $10,200
c. $10,300
d. $10,500
B
When bonds are called for redemption, the owner receives the call price. The call price is 102 for a total of $10,200 ($1,020 per bond times 10 bonds). Before the call the bonds are selling in the market for $10,300; however, when the call is announced the market price of the bond will gravitate to $10,200. (5-17)
Dow Chemical bonds are listed in the NYSE bond table as having a nominal yield of 6.6% and having closed the previous day at 91 7/8. An owner of 10 bonds would receive a yearly interest payment of:
a. $600
b. $660
c. More than $660
d. Less than $660
B
A nominal yield of 6.6% for a corporate bond with a $1,000 par value would equal $66 in interest payments. If an investor owned 10 bonds, he would receive an annual interest payment of $660. (5-3)
NOMINAL YIELD (S7) : The stated rate of interest that a bond pays the holder, based on its par value. It is also known as the coupon, coupon rate, and fixed-interest rate.
Dow Chemical bonds are listed in the NYSE bond table as having closed the previous day at 91 7/8. The closing price of Dow Chemical bonds is:
a. $910.88
b. $917.80
c. $918.75
d. $1,000.00
C
The closing price of 91 7/8 is equal to 91 7/8% of the $1,000 par value. When converted to a decimal, it equals .91875 of $1,000. Therefore, the correct answer is $918.75. (5-2)
Alabama Power 5 1/4s of '08 are listed in the bond table as having closed the previous day at 88 3/4. A buyer of 10 bonds at the close would have to pay:
a. $880.75
b. $8,850.00
c. $8,875.00
d. $8,900.00
C
The market price of 88 3/4 is 88 3/4% of $1,000. When converted to a decimal it is .8875 of $1,000, which equals a dollar value of $887.50. A purchaser of 10 bonds would have to pay $887.50 x 10 = $8,875. (5-2)
ABC Corporation has issued two $1,000 par value bonds with the same coupon rate, one paying interest annually and the other paying interest semiannually. If both bonds are held to maturity in 10 years, the bond paying interest annually will have a total return that is:
a. Less than the bond paying interest semiannually
b. More than the bond paying interest semiannually
c. The same as the bond paying interest semiannually
d. Two times greater than the bond paying interest semiannually
C
The bond paying interest annually will have a yield-to-maturity which is less than the bond paying interest semiannually. Yields-to-maturity assume a reinvestment and compounding of interest. The compounding of interest will be greater for the bond paying semiannual interest. (5-7)
Which of the following would have the least capital risk for a client?
a. Options
b. Bonds
c. Warrants
d. Stocks
C
When compared to the other securities, bonds have the least capital risk. At maturity, the investor would receive the principal amount of the bond thus minimizing the capital risk. (5-1, 4-2, 4-11, 14-19)
When a bond is selling at a premium:
a. The market price is greater than the par value
b. The current yield is higher than the nominal yield
c. It is a better quality bond than one selling at a discount
d. The yield-to-maturity is greater than the current yield
A
The only true statement given is the market price is greater than the par value. The other choices are incorrect. When a bond is selling at a premium, the current yield is lower than the coupon rate. Bonds that are selling at a premium are not necessarily of better quality than bonds selling at a discount. (5-10)
When a bond is registered as to principal only, this means that the bond has been issued:
a. With no coupons attached and the bond is registered in the name of the owner
b. In the name of the owner without coupons attached
c. With coupons attached only
d. In the name of the owner but with bearer coupons attached
A
When a bond is registered as to principal only, the bond has been issued in the name of the owner with bearer coupons attached. (5-1)
A customer wants safety and preservation of capital. He should purchase:
a. Income bonds
b. Options
c. Securities in a margin account
d. AAA bonds
D
AAA bonds would offer an investor safety and preservation of capital. The risk of default for a AAA bond is minimal. The investor realizes income as well as safety and preservation of capital. (5-15)
The current yield on a $1,000 par value 5% bond selling at $800 maturing in 10 years is:
a. 5.00%
b. 5.60%
c. 6.25%
d. 8.50%
D
The current yield is found by dividing the yearly interest payment of $50 by the market price of $800. This equals 6.25%. The fact that the bond will mature in 10 years is not necessary to find the current yield (it is needed to find the yield-to-maturity). (5-7)
Relative to a municipal bond purchased at a discount, place the following in the proper sequence from lowest to highest.
I. Current yield
II. Nominal yield
III. Yield-to-maturity
a. I, II, and III
b. II, I, and III
c. III, I, and II
d. III, II, and I
B
A bond trading at a discount has a nominal yield that is less than its yield-to-maturity. Current yield falls between the nominal yield and yield-to-maturity. A bond trading at a premium has a nominal yield which is higher than the yield-to-maturity, with the current yield in between the other two yields. (5-9)
A 5% $1,000 par value bond sells at $900 and is redeemed in 10 years. What is the amount of interest per year?
a. $10
b. $40
c. $45
d. $50
D
The dollar amount of interest a bond pays is computed as a percentage of the par value. In this example, the coupon rate is 5%. The interest income per year is $50 (5% of $1,000 par value equals $50). (5-3)
The securities that are deposited in an escrow account for an advanced refunding are:
a. Revenue bonds
b. General obligation bonds
c. Federal agency bonds
d. Treasury bonds
D
Only Treasury obligations are acceptable securities as escrow when abond is being advanced refunded. (5-17)
New Issue
$50,000,000
City of Denver, Colorado
Pollution Control Bonds
Par Value $1,000
Amount : $50,000
Rate : 5 1/2%
Maturity : July 1, 2017
Date Price : 100

Amount : $60,000
Rate : 6 1/2%
Maturity : July 1, 2018
Date Price : 100

Based on the above information, which of the following statements can be made about the bonds maturing in 2017?
I. The yield to maturity will be the same as the nominal rate.
II. The yearly interest payment is $55 per bond.
III. The bond will yield 5 1/2%.
IV. The bonds will all be issued at the same dollar price.
a. I only
b. I and II only
c. I, II, and III only
d. I, II, III, and IV
D
The bonds maturing on July 1, 2017 have a nominal yield of 5 1/2% and have been issued at 100 which means 100% of their par value of $1,000. Given this information, it can be determined that they will have the same yield to maturity as the nominal rate. The yearly interest payment will be $55 per bond. The bond will yield 5 1/2%. Both bonds will be issued at the same dollar price. (5-2, 5-9)
A company has $50,000,000 par value convertible bonds outstanding. The coupon rate is 8%. The bonds are currently selling at 96. What is the current yield?
a. 7.0%
b. 7.5%
c. 8.0%
d. 8.3%
D
To find the current yield of the bonds, divide the yearly interest paid on the bonds by the current market value of the bonds. The yearly interest is $80. The market value of a bond is $960. Therefore, the current yield equals 8.3% ($80 divided by $960 equals 8.3%). (5-7)
CURRENT YIELD (S7) : A security's annual income divided by its current market price.
Mrs. Smith buys a 6 3/4% municipal bond at 101 3/4. The yield-to-maturity on the bond is:
a. 6 3/4%
b. Less than 6 3/4%
c. More than 6 3/4%
d. Par plus 1 3/4%
B
Mrs. Smith bought the bond at 101 3/4 which is at a premium over the $1,000 par value of the bond. If she holds the bond to maturity, her yield will be less than 6 3/4%, since a bond bought at a premium will have a yield-to-maturity that is less than the coupon. (5-10)
An investor sells ten 5% bonds and buys another 10 bonds with a
5 1/4% coupon rate. The investor's yearly cash flow from the bonds will have increased by:
a. $1.00 per bond
b. $1.50 per bond
c. $2.00 per bond
d. $2.50 per bond
Explanation:
D
The investor's yearly return will have increased by $2.50 per bond. The increase is 1/4% (5% to 5 1/4%) which is 1/4 of 1% of the par value of $1,000, which equals $2.50. (5-3)
Three bonds all have the same coupon rate of 6%. Bond A has a five-year maturity. Bond B has a one-year maturity. Bond C has a six-month maturity. If interest rates change, which bond would have the greatest dollar change in price?
a. Bond A
b. Bond B
c. Bond C
d. All of the bonds would change equally in price
A
The greatest change in dollar price would be for Bond A, with the five-year maturity. When interest rates change, the bonds with the longest maturities would show the greatest change in price because these bonds are subject to greater market risk. When the general level of interest rates change, long-term bonds fluctuate more widely in price than short-term bonds. (5-11)
A municipal bond issue with an inverted yield scale would have:
a. Lower yields on the shorter maturities than on the longer maturities
b. Higher yields on the shorter maturities than on the longer maturities
c. Yields the same on all maturities
d. Prices higher on the shorter maturities than on the longer maturities
B
A municipal bond issue with an inverted yield scale would have higher yields on the shorter maturities and lower yields on the longer maturities. (5-14)
Which of the following would increase most in price if interest rates decline?
a. Short-term bonds selling at a discount
b. Long-term bonds selling at a discount
c. Short-term bonds selling at a premium
d. Long-term bonds selling at a premium
B
When interest rates decline, bond prices will rise. The longer maturities will rise more than the shorter maturities due to market risk. Bonds selling at a discount will rise more sharply than those selling at a premium. (5-11)
Which of the following would most likely have a mandatory sinking fund?
a. Serial issue
b. Balloon issue
c. Term issue
d. Convertible issue
C
A term issue is one in which all the bonds mature in one specific year. To accumulate monies to help retire the bonds, the issuer will deposit monies (above the amount to pay interest) into a sinking fund. These monies will generally be used to retire some of the bonds prior to maturity. (5-18)
Which of the following would be characteristic of a call protection provision?
a. Money is required to be deposited in a sinking fund to call the bond.
b. It is a provision prohibiting the calling of the bond during its early years.
c. It is a provision requiring the issuer to call the bond at a specific premium.
d. It is a provision requiring the issuer to call the bond.
B
A provision prohibiting the calling of the bond during the early years would be characteristic of a call protection provision. (5-17)
An investor purchases a 20-year 5% bond at par value which will yield 5 3/4% if called at the first call date in five years. The yield-to-maturity on bond is:
a. 5%
b. More than 5%
c. Between 5% and 5 3/4%
d. 5 3/4%
A
The bond has a coupon rate of 5%. If the bond is purchased at its par value and is not called but held to maturity, the bond yield will be the same as the coupon rate, which is 5%. (5-9)
A municipality would refund a revenue bond issue for all of the following reasons EXCEPT to:
a. Reduce interest charges
b. Issue new bonds at lower interest rates
c. Reduce the market value of outstanding bonds that are not refunded
d. Eliminate restrictions in the bond resolution
C
A municipality would refund a revenue bond issue if interest rates declined to reduce interest charges, to issue new bonds at lower interest rates, and to eliminate restrictions in the bond resolution. The municipality would not refund an issue to reduce the market value of the outstanding bonds. The market value of the outstanding bonds will be determined by supply and demand and by the general level of interest rates. (5-17)
REVENUE BOND (S7) : A bond issue that is secured by a pledge of the revenues of a specific project.
Term bond quotes are based on:
a. Yield-to-maturity
b. Current yield
c. Nominal yield
d. Dollar price
D
Term bonds (bond issues which have one maturity date) are quoted based on a dollar price. Term bonds are also known as dollar bonds. Municipal serial bonds (which have several maturity dates) are quoted on a yield-to-maturity basis. (5-3)
A municipal bond with a 6% coupon is priced to a 7% basis. If this bond's yield-to-maturity increased by 40 basis points:
a. The yield-to-maturity would be 5.60%
b. The yield-to-maturity would be 6.40%
c. The yield-to-maturity would be 6.60%
d. The yield-to-maturity would be 7.40%
D
The 6% bond is priced to a 7% yield-to-maturity (basis). If the bond's basis increased by 40 points, the new yield-to-maturity would be 7.40%. (5-8)
BASIS (S7) : (1) Bonds: An investor's yield to maturity.
(2) Taxation: Cost used to determine capital gain or loss on an investment.
(3) Used in DPPs to calculate maximum losses allowed for tax purposes. In general, basis consists of the investor's original contribution plus recourse loans.
From the issuer's perspective, when comparing term bonds and serial bonds, serial bonds have:
a. Declining interest payments and declining principal amounts
b. Increasing interest payments and increasing principal amounts
c. Stable interest payments and stable principal amounts
d. None of the above
A
Serial bonds have different maturity dates with lesser amounts of debt outstanding as time goes by. The bonds will have declining interest payments and principal amounts. Term bonds, by comparison, mature at the same time and would have stable interest payments with the principal paid on one maturity date. (5-3)
SERIAL BONDS (S7) : Bonds of the same issue that have different maturity dates. They mature each year for a set number of years.
When comparing long-term bonds and short-term bonds, all of the following are true EXCEPT:
a. Long-term bonds generally have higher yields
b. Fluctuations in the dollar price of long-term bonds are usually greater than short-term bonds when the general level of interest rates change
c. Long-term bonds generally provide greater liquidity than short-term bonds
d. There is more purchasing power risk with long-term bonds when compared to short-term bonds
C
When comparing long-term bonds and short-term bonds, all of the choices listed are true except long-term bonds generally provide greater liquidity than short-term bonds. Short-term bonds do not suffer from as large a price movement as long-term bonds when interest rates are changing. Long-term bonds are open to greater market risk, interest rate risk, and purchasing power risk. Both individual and institutional investors alike are more willing to accept a lower return (yield) in favor of more stable principal (less severe price swings). (5-11)
A 10% New York City GO bond matures in 20 years. The bond is callable in 8 years at 103. All of the following are true regarding this bond EXCEPT:
a. The investor has 8 years of call protection
b. The issuer must pay investors a 3-point call premium to exercise the call privilege on the bonds
c. The investor will receive more for the bond if it is called versus holding the bond to maturity
d. The investor may exercise the call provision any time after the 8th year
D
The call premium of a bond refers to the amount above par value which the issuer must pay the owner of the bond when the bond is called. Issuers usually call outstanding bonds when interest rates have dropped and they are able to issue new bonds at lower rates of interest. The issuer would have to make an outlay of cash to call back the bonds, but would save money because of the lower rate of interest the issuer would have to pay on the new bonds. A call provision is exercised by an issuer and not the bondholder. (5-17).
Which of the following risk factors are the most important for purchasers of long-term high-grade bonds?
a. The ability to pay interest when due
b. The ability to pay principal upon maturity
c. Limited marketability
d. Purchasing power risk
D
Long-term high-grade bonds are relatively safe investments, but do have purchasing power risk. Because the amount of interest income is fixed, the purchasing power of the interest income may decline over the long term because of inflation. The rise in inflation would reduce the amount of goods and services that could be purchased with the fixed amount of dollars. (5-15)
A customer owns 500 shares of XYZ stock selling at $15 per share and $20,000 par value of State of Alabama GO bonds selling at 101. If both securities increased by 2 1/2 points, the dollar value of the increase would be:
a. $1,200
b. $1,300
c. $1,750
d. $2,500
C
The increase would be $1,750. Each point for stock is equal to $1. Each point for bonds is worth $10. A 2 1/2 point increase in the stock position is equal to $1,250 ($2.50 x 500 shares). A 2 1/2 point increase in the bond position is equal to $500 (20 bonds x $25). A $1,250 increase for the stock + a $500 increase for the bonds = a $1,750 total increase. (5-2)
American Telephone Company of Ohio is offering $50,000,000 worth of 9% bonds at a price of 99.25% of par value. An investor buying the bonds would receive yearly interest of:
a. $ 90.00 per $1,000 face amount
b. $ 99.25 per $1,000 face amount
c. $ 100.00 per $1,000 face amount
d. $1,000.00 per $1,000 face amount
A
The bonds have a coupon rate of 9%. The bonds pay 9% of their par value of $1,000 each year or $90 (9% of $1,000 = $90) in interest payments. (5-3)
If interest rates decline, which of the following securities would probably have the greatest increase in market value?
a. Short-term bonds
b. Intermediate-term bonds
c. Long-term bonds
d. Treasury bills
C
When interest rates decline, the securities with the longest maturities will have the greatest price increase. (5-11)
An investor purchases a 4% bond at a premium and holds the bond to maturity. Which of the following could represent the yield to maturity on the bond?
a. 3.5%
b. 4.0%
c. 4.5%
d. 5.0%
A
Since the investor purchased the bond at a premium, the yield-to-maturity would have to be less than the nominal yield of 4%. The only choice given in which the yield-to-maturity is less than the nominal yield of 4% is 3.5%. (5-10)
NOMINAL YIELD (S7) : The stated rate of interest that a bond pays the holder, based on its par value. It is also known as the coupon, coupon rate, and fixed-interest rate.
An announcement in The Wall Street Journal states that New York State plans an advanced refunding of its 7 1/2% Dormitory Bonds through the issuance of a special $50,000,000 bond issue. This means that:
a. Existing bondholders will receive a new bond with a lower rate of interest
b. Existing bondholders will receive a new bond with a higher rate of interest
c. Proceeds from the sale of a new bond issue will be put in an escrow account to retire the existing bond issue
d. The Dormitory bonds will be convertible into Treasury bonds
C
Advance refunding means that proceeds from the sale of the new bond issue will be put in an escrow account to retire the existing bond issue. If a municipality wants to engage in advance refunding (or prerefunding), as is the case in this example, the municipality will sell the new issue with the proceeds of the sale going into an escrow account containing U.S. government securities. The U.S. government securities would be purchased with a maturity date which coincides with the issue's call date. This allows the refunded issue to be retired using the proceeds from the matured government securities. (5-17)
ADVANCE REFUNDING (S7) A method of eliminating a bond issue as an obligation of the issuer. This is accomplished by issuing a new bond issue and using the proceeds to purchase government obligations which will be escrowed and used to provide debt service on the original issue. The escrowed funds may provide debt service until maturity of the original issue (escrowed to maturity) or until the first call date (prerefunded to the call). See also: Defeased Bonds.
A .05 change in basis would have the greatest effect on which of the following 6.00% coupon bonds?
a. 2 year maturity at a 7.00 yield
b. 2 1/4 year maturity at a 7.05 yield
c. 2 1/2 year maturity at a 7.10 yield
d. 2 3/4 year maturity at a 7.15 yield
D
A change in basis (yield) has the greatest effect on the price of longer maturity bonds. Therefore, the longest maturity bond would be affected the most. (5-11)
When comparing high-grade bonds to low-grade bonds, lower grade bonds will have:
I. Higher yields
II. Lower yields
III. Higher market prices
IV. Lower market prices
a. I and IV
b. I and III
c. II and III
d. II and IV
A
One of the basic principles of investing is the greater the risk, the greater the return; the lower the risk, the lower the return. Since lower grade bonds are riskier than higher grade bonds they will have higher yields and lower market prices. (5-15)
Four municipal bonds have the same maturity date. Which of the following would cost an investor the greatest dollar amount when purchased?
a. A 4 3/4% coupon bond offered on a 5.10 basis
b. A 5 1/4% coupon bond offered on a 5.00 basis
c. A 5 3/4% coupon bond offered on a 6.00 basis
d. A 6 1/4% coupon bond offered on a 6.50 basis
B
When bonds are purchased at a discount (below the $1,000 par value) the yield-to-maturity (basis) will be greater than the coupon rate(nominal yield). This is the case in all of the choices listed except where the coupon rate of 5 1/4% is greater than the yield-to-maturity of 5%. This would mean that an investor purchased the bond at a premium (above the $1,000 par value) and paid the greatest dollar amount. (5-10)
Which of the following would probably have the greatest fluctuation in price when interest rates move up or down?
a. Commercial paper
b. Treasury bills
c. Treasury notes
d. Treasury bonds
D
Treasury bonds would have the greatest fluctuation in price. They have the longest maturity and would be exposed to the risks of the marketplace for the longest period of time. (5-11, 7-1)
Municipal bond rating organizations are primarily concerned with the risk of:
a. Declining purchasing power
b. Market price fluctuations
c. Default
d. Illiquidity
C
Municipal bond rating organizations are primarily concerned with the risk of default. (5-15)
A bond is selling at a premium. This is indicative of all of the following EXCEPT:
a. The yield-to-maturity is less than the nominal yield
b. The market price exceeds the par value
c. Interest rates have increased since the bond was issued
d. The nominal yield is greater than the current yield
C
The amount that the market price exceeds the par value is known as a premium. One reason for selling at a premium would be a decrease in interest rates after the bonds were issued. When looking at the yields for premium bonds, the nominal yield would be the highest, followed by the current yield with the yield-to-maturity being the lowest yield of the three. (5-10)
All of the following statements are TRUE regarding yield curves EXCEPT:
a. In an ascending curve, short-term rates are lower than long-term rates
b. They are fixed and may only be changed by commercial banks
c. In a descending curve, short-term rates are greater than long-term rates
d. In a flat yield curve, both short-term and long-term rates are equal
B
Yield curves are ascending (upward sloping from the shorter to longer maturities) when money is "easy." When this occurs, short-term rates are lower than long-term rates. A descending yield curve, which is indicative of a tight money situation, will show short-term rates higher than long-term rates. A flat yield curve will indicate that short-term and long-term rates are approximately the same. (5-14)
When comparing bonds rated Aaa to bonds rated Baa, with similar maturities and coupon rates, the lower rated bonds will normally have:
I. Lower market prices
II. Higher market prices
III. Lower yields
IV. Higher yields
a. I and III
b. I and IV
c. II and III
d. II and IV
B
As a bond's quality (rating) increases, its risk decreases meaning a lower rate of return (yield) for the bond. Also, highly rated bonds tend to have a greater market price than lower rated securities. Low rated bonds tend to have lower market prices with higher yields to compensate investors for the risk involved in the investment. (5-16)
Which of the following results in the highest real interest rate?
a. A bond yields 8% when inflation is at 3%.
b. A bond yields 12% when inflation is at 8%.
c. A bond yields 10% when inflation is at 7%.
d. A bond yields 6% when inflation is at 4%.
A
The real interest rate, also called the real rate of return, refers to yields adjusted for inflation (yield minus inflation rate). Choice "a" provides the highest real interest rate (8% bond yield minus 3% inflation rate = 5% real interest rate). (5-15)
Rank the following ratings from highest to lowest.
I. Baa3
II. Ba1
III. A1
IV. A2
a. IV, III, II, I
b. IV, III, I, II
c. III, IV, II, I
d. III, IV, I, II
D
For Moody's ratings, each category below Aaa is divided into three subheadings: 1 (high), 2 (medium), and 3 (low). The proper sequence for the choices given is A1, A2, Baa3, Ba1. (5-16)
The State of North Carolina is offering $100,000,000 of general obligation bonds with serial maturities. The bonds maturing in 2017 have an interest rate of 5 1/2% and a yield to maturity of 5.60%. This means the bonds are being offered:
a. At par
b. At a premium
c. At a discount
d. To yield 5 1/2%
C
Since the bonds have a yield-to-maturity of 5.60% (which is greater than the 5 1/2% coupon rate), the bonds are being offered at less than their face or par value. These bonds were therefore issued at a discount. (5-9)
Refunding will most likely occur when interest rates are:
a. Higher than when the issue was originally sold
b. Lower than when the issue was originally sold
c. Approximately the same as when the issue was originally sold
d. Following an inverted yield curve
B
Refunding would probably occur when interest rates are lower than when the issue was originally sold. The net result would be a reduction in the amount of interest being paid by the issuer. (5-17)
Bonds selling at a premium have a higher:
a. Market price than par value
b. Yield than nominal yield
c. Credit rating than bonds selling at a discount
d. Current yield than nominal yield
A
Bonds selling at a premium have a higher market price than par value. They have a lower yield than nominal yield and they do not necessarily have a higher credit rating than bonds selling at a discount. The credit rating is determined by many factors that are unrelated to the current market price of the bond. (5-10)
A customer purchases a municipal bond with 25 years remaining to maturity. The bond has been pre-refunded to its first call date. The issue is callable in 7 years at 108, declining to par in 14 years. It also has a sinking fund call provision which begins in 17 years at par. For confirmation purposes, the bond should be priced to the:
a. First call date
b. First par call
c. Sinking fund date
d. Final maturity date
A
When a bond is pre-refunded, the only applicable date is the first call feature. Therefore, the bond must be priced to the first call date. (5-18)
In a discussion with a client, a registered representative refers to a bond yield that has been reduced by the inflation rate. This yield is known as the:
a. After-tax yield
b. Discount rate
c. Real interest rate
d. LIBOR
C
The real interest rate is the yield of a security reduced by the inflation rate. While it represents earnings remaining once inflation is taken into account, the real interest rate does not factor in the tax consequences. The discount rate is the rate of interest that the Federal Reserve charges member banks for loans. LIBOR (the London Interbank Offered Rate) is the rate of interest banks in London charge each other for short-term loans. (5-15)
Which two of the following conditions are generally TRUE when the yield curve inverts?
I. Interest rates are relatively low.
II. Interest rates are relatively high.
III. Interest rates are expected to fall.
IV. Interest rates are expected to rise.
a. I and III only
b. I and IV only
c. II and III only
d. II and IV only
C
The yield curve often inverts when interest rates are relatively high but are expected to fall in the near future. In such an environment, investors prefer to lock in relatively high long-term rates. The increased demand for long-term debt drives these prices up (and their yields down), as compared to short-term debt, causing the yield curve to invert. (5-14)
How would preferred stock most likely be affected by an increase in interest rates?
a. Its market value would increase
b. Its market value would decrease
c. Its conversion ratio would increase
d. There would be no effect
B
Since preferred stock is a fixed-income security, it is affected by interest rates in the same way as bonds. If interest rates rise, the value of existing bonds and preferred stock will fall. If interest rates fall, the value of existing bonds and preferred stock will rise. (5-8, 4-14)
Which of the following are normally TRUE regarding the pricing of municipal bonds?
I. Serial bonds are priced on a yield-to-maturity basis.
II. Serial bonds are priced on a dollar basis.
III. Term bonds are priced on a yield-to-maturity basis.
IV. Term bonds are priced on a dollar basis.
a. I and III only
b. I and IV only
c. II and III only
d. II and IV only
B
Normally, traders quote bonds issued in a serial maturity on a yield basis, where the yield quoted is the lower of yield-to-call or yield-to-maturity. Term bonds are normally quoted using the dollar pricing (percentage of par) method and are sometimes referred to as dollar bonds. For example, a trader may quote a term bond at a price of 98. This means that the bond is quoted at 98% of par value, or $980 ($1,000 par x 98%). (5-3)
A new issue of municipal, government, or corporate securities with maturities greater than one year, must be issued in:
a. Bearer or registered form
b. Bearer form only
c. Registered as to principal form only
d. Fully registered form only
A
All new issues of municipal, government, or corporate bonds with maturities greater than one year must be issued in fully registered form. Depending on the specific security, there may or may not be certificates issued. Book entry is a type of registered form in which case, no certificate is issued. (5-1)
Four municipal bonds maturing in 2019 are all selling at a 7.00 basis. Which is most likely to be refunded?
a. 5 1/2% callable in 2014 @ 103
b. 6 1/2% callable in 2013 @ 100
c. 7% callable in 2014 @ 103
d. 7 1/2% callable in 2013 @ 100
D
The most common reason for a municipality to refund an outstanding issue is to save interest costs. If a municipality can borrow money at a lower rate than the outstanding issue, it could use this money to refund the outstanding issue and thus save interest cost. The bonds are selling at a 7.00% yield. The municipality could then expect to borrow new monies at a 7.00% interest rate. The municipality could only save money by refunding an issue with a higher interest rate, 7 1/2%. (5-17)
For an investor, which of the following call features would be LEAST desirable on a 20-year municipal bond selling at a premium?
a. 5-year premium call
b. 5-year par call
c. 15-year premium call
d. 15-year par call
Explanation:
B
A premium bond will have the lowest yield (be affected most) if it is callable in the shortest time, 5 years, and at the lowest price, par. (5-17)
A 6% bond is selling at a 6.25% basis. The bond will mature in 25 years and has 3 call dates. Which of the following would give the investor the best return?
a. If the bond is called after 10 years at 103
b. If the bond is called after 15 years at 102
c. If the bond is called after 20 years at 101
d. If the bond is held to maturity
A
The bond is selling at a discount. The first call in 10 years at 103 would give the investor the best return. The investor receives the highest call price in the shortest number of years. (5-17, 5-9, 5-10)
Interest rates had been very high. During the past three years rates have decreased dramatically, reaching historically normal level. The present yield curve would most likely be:
I. Ascending
II. Positive
III. Inverted
IV. Negative
a. I and II
b. I and III
c. II and III
d. III and IV
A
If rates have declined for the past three years and reached a normal level, the present yield curve would most likely be ascending which is also referred to as positive or upward sloping. (5-14)
What type of risk do zero-coupon bonds eliminate?
a. Credit risk
b. Purchasing power risk
c. Reinvestment risk
d. Market risk
C
Zero-coupon bonds are issued at a discount and do not pay semiannual interest. Therefore, there are no interest payments to reinvest, eliminating reinvestment risk. When investing in fixed-income investments, one of the uncertainties is whether interest rates will allow an investor to realize the total return that was calculated at the time of the investment (yield to maturity). Zero-coupon bonds do not have reinvestment risk, but they do have extreme interest-rate risk because the bonds' duration will equal the years to maturity. (5-4, 5-15)
Which bond has the most interest-rate risk?
a. A 3-month Treasury bill
b. A zero-coupon 30-year Treasury STRIPS
c. A 6%-coupon 30-year Treasury bond
d. A 3%-coupon 5-year Treasury note
B
The bond with the most interest-rate risk or price volatility is the one with the longest maturity and lowest coupon. (5-11)
Mr. Jones bought an 8% debenture at a 7.20 basis. If the bonds are currently trading 15 basis points higher:
a. Mr. Jones' yield-to-maturity has increased to 7.35%
b. The bond's coupon has increased to 8.15%
c. The bond's market price has decreased
d. Mr. Jones' investment has not been affected
C
When the investor bought the bond, he established a yield-to-maturity of 7.20%. This will remain the same over the life of his investment. The coupon rate was established when the bonds were issued and will never change. However, when yields in the market increase, the market price of outstanding bonds will decrease. (5-7)
Yields increase = Bonds prices decrease
Place the following ratings in the proper order from highest to the lowest.
I. A
II. Aa
III. Aaa
IV. Baa
a. II, I, III, and IV
b. III, I, IV, and II
c. III, II, I, and IV
d. IV, I, II, and III
C
The highest Moody's rating is Aaa followed by Aa, A, and Baa. (5-16)
When a bond is called, the bondholder receives the:
a. Call price
b. Call price plus accrued interest
c. Market price
d. Market price plus accrued interest
B
The bondholder receives the call price (either par or premium) plus any accrued interest earned up to the call date. (5-17)
An RR sees that a CMO is yielding 5.95% while the comparable Treasury is yielding 5.10%. This means that:
a. The CMO is rated below investment grade
b. The yield pick-up on the CMO is 85 basis points
c. The annual cash flow from the CMO is $85 greater than the Treasury
d. The yield curve is inverted
B
If the yield on a CMO is 85 basis points higher (5.95 - 5.10) than a comparably maturing Treasury security, the CMO provides a yield pick-up of 85 basis points. (5-8)
A call premium is best described as the amount the:
a. Investor pays above the par value
b. Common stock is above the conversion price
c. Issuer pays above 100 to retire bonds prior to maturity
d. Bondholder receives at maturity
C
A bond issue's indenture will usually require that if an issuer calls bonds (redeems prior to maturity) it must pay the bondholder a premium (above face value). (5-17)
Relative to bearer bonds, all of the following are reasons for rejection EXCEPT:
a. Mutilated coupon
b. Lack of legal opinion
c. No endorsement by owner
d. Lack of seal on certificate
C
A bearer bond does not require endorsement (signature) by the owner. (5-1)
When examining a bond chart in the newspaper to decide on a purchase, which of the following would be used to calculate the current yield?
a. annual dividend
investor's cost
b. annual dividend
current market value
c. semi-annual interest
investor's cost
d. annual interest
current market value
D
When deciding on a bond purchase, the current yield is determined by dividing the annual interest by the current market value. If an investor owns a bond, his current yield is the annual interest divided by the investor's cost. (5-7)
The real interest rate is best defined as the:
a. Interest earned by an investor after taxes
b. Interest rate charged to investors in a margin account
c. Interest earned that exceeds the inflation rate
d. Amount that the prime rate exceeds the discount rate
C
The real interest rate received by an investor is the amount of interest received minus the inflation rate. If an investor is receiving a 10% interest rate when inflation is at 6%, the real interest rate received is 4% (10% - 6%). (5-15)
An investor is expecting a sharp decline in interest rates in the near future. To capitalize on this situation the investor should buy:
a. Premium bonds with short maturities
b. Premium bonds with long maturities
c. Discount bonds with short maturities
d. Discount bonds with long maturities
D
Long-term bond prices are more volatile than short-term bond prices. Discount bond prices are more volatile than premium bond prices. If the investor expects interest rates (yields) to decline, he is anticipating rising bond prices. The bonds which will rise (fluctuate) the most are long-term, discount bonds. (5-11)
Which of the following interest rate environments makes call protection MOST valuable?
a. Increasing
b. Stable
c. Volatile
d. Decreasing
D
Call protection would be most valuable to a purchaser of bonds when interest rates decline. If interest rates fall, existing bond prices rise. A municipality would likely call bonds when interest rates decline so it may issue new bonds with lower rates of interest. Although bonds may be callable at a small premium above par value, if the bonds are not callable, the investor may realize the full benefit of an increase in the market price of the bonds. (5-17)
If interest rates increase, which of the following securities would have the most price change?
a. A Treasury note trading at a discount
b. A Treasury note trading at a premium
c. A Treasury bond trading at a discount
d. A Treasury bond trading at a premium
Explanation:
C
When interest rates increase, outstanding bond prices will decline in value. The prices of longer-term maturities will fall more than the shorter-term maturities. Treasury bonds have maturities of up to 30 years, whereas Treasury notes have maturities of up to 10 years. Bonds selling at a discount will fall more sharply than those selling at a premium. (5-11)