Kaplan series 65 Flashcards
One of the ways in which U.S. government agency issues differ from those offered directly by the U.S. Treasury is that agency issues
C)typically carry higher returns than Treasury issues because of the lack of direct government backing. —
Agencies, with very few exceptions (GNMA being one), do not carry the direct backing of the U.S. Treasury. While they are quite safe, that lack of direct backing causes their yields to be somewhat higher. Agencies are never traded on the stock exchanges, and their float is almost always smaller than Treasuries. Both are taxable on the federal level—
GNMA: Ginnie Mae is the only home-loan agency explicitly backed by the full faith and credit of the United States government.
All the following securities are issued at a discount except
CD’s ??
The call feature available on some bonds
allows the issuer the option to escape high interest rates if market rates decline.—
A callable bond is a debt security that can be redeemed early by the issuer before its maturity at the issuer’s discretion. A callable bond allows companies to pay off their debt early and benefit from favorable interest rate drops.
With respect to safety of principal, of the following investments, the least risky is:
A)exchange-listed warrants. –
B)equity options.
C)corporate AA debentures.
D)common stock.
Corporate AA debentures.
The least risky investment listed is the corporate debenture because, as a debt instrument, it has priority over the others.
Which of the following rates of return is used by investment professionals as the risk-free rate?
A)Federal funds rate
B)91-day Treasury bill rate
C)Discount rate
D)Prime rate
The interest rate used as the basis for a risk-free rate of return is the 91-day Treasury bill rate. T-bills are U.S.-government guaranteed, the rate is short-term, and the market risk is minimal.
A corporation issued a bond with a coupon of 6%, callable at 103. The bond matures in 2059. Current interest rates are 8%. It is most likely that
bond is selling at a discount —
only thing that matters here is the coupon rate of 6% and market rate of 8%, this tells us that the bond is selling at a discount because the coupon rate is lower than the market rate
Currently, a company issues 5% Aaa/AAA debentures at par. Two years ago, the corporation issued 4% AAA rated debentures at par. Which of the following statements regarding the outstanding 4% issue are true?
- The dollar price per bond will be higher than par.
- The dollar price per bond will be lower than par.
- The current yield on the issue will be higher than the coupon.
- The current yield on the issue will be lower than the coupon.
answer 2&3
Of the following securities, which is most commonly recommended to fund a child’s college education?
A)Treasury bills
B)Municipal bonds
C)Investment-grade corporate bonds
D)Zero-coupon Treasury bonds
Zero-coupon Treasury bonds
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.
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 corporate bond because the after-tax yield is 4.50%
B) The municipal bond because its equivalent taxable yield is 6.30%
C) The municipal bond because its equivalent taxable yield is 6.60%
D) The corporate bond because the after-tax yield is 6.25%
The municipal bond because its equivalent taxable yield is 6.6%.
If we compute the tax equivalent yield of the muni, we see that it is 6.6%, 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 that 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%.
Reference: 5.3.1.5 in the License Exam Manual
The longest initial maturity for U.S. T-bills is?
A) 52 weeks
As money market instruments, the longest initial maturity of Treasury bills (T-bills) is 52 weeks. Those bills are auctioned every four weeks. T-bills of shorter maturities are auctioned weekly. The shortest initial maturity is four weeks.
The longest initial maturity for U.S. T-bills is
A bond, preferred stock, or debenture exchangeable at the option of the holder (for common stock of the issuing corporation) is
A)a convertible security.
B)a synthetic security.
C)a collateral-backed equity security.
D)a nondilutive stock.
convertible security.
(A bond, preferred stock or debenture exchangeable at the option of the holder for common stock of the issuing corporation is convertible security.)
What happens to outstanding fixed-income securities when interest rates decline?
A)Prices increase
B)Yields increase
C)Coupon rates increase
D)No change
A)Prices increase
When the Fed increases the federal funds rate, the price of existing fixed-rate bonds decreases and the yields on new fixed-rate bonds increases. The opposite happens when interest rates go down: existing fixed-rate bond prices go up and new fixed-rate bond yields decline.
Which of the following best describes a Yankee bond?
D) A U.S. dollar–denominated bond issued by a non-U.S. entity inside the United States
(Yankee bonds are issued by non-U.S. entities in marketplaces inside the United States. The bonds are issued in U.S. dollars, meaning these foreign issuers will have currency risk if the dollar drops in value against their local currency.)
Which of the following is true of GNMA securities?
- Interest is subject to federal income tax.
- Interest is exempt from federal income tax.
- They are backed by farm mortgages.
- They are backed by residential mortgages.
1 & 4
Income received by investors in Government National Mortgage Association (GNMA) securities is subject to both state and federal income tax, and the asset backing them is residential mortgages. —–
Government National Mortgage Association (GNMA) approves private lending institutions to issue bonds that are backed by the full faith and credit of the U.S. government
Which of the following best describes the liquidation order when a company files for bankruptcy?
1.Common stockholders
2.Debenture holders
3.Preferred stockholders
4.Secured creditors
4,2,3,1
Secured creditors, including secured bondholders, have the first claim on assets. They are followed by general creditors, including debenture holders. The final claim is that of stockholders (equity) with preferred coming ahead of common.
It is not uncommon to find a fixed-income security issued with a call feature. The feature is usually of most benefit to
A) The issuer.
The call feature enables the issuer to redeem (call in or buy back) the security at a specified price, usually beginning with a specified number of years after the security is issued. How does this benefit the issuer? If the cost of money (interest rates) has declined since the fixed-income security was issued, the issuer can float a new issue with interest (or dividends in the case of preferred stock) based on that lower cost of funds and use the money raised to call in the existing securities currently paying a higher return. It is the same concept as refinancing a mortgage when interest rates go down.
A U.S. dollar–denominated bond that is sold outside the United States and the issuer’s country but for which the principal and interest are stated and paid in U.S. dollars is best described as
Eurodollar bond.
This is the definition of a Eurodollar bond. Yes, it is also a eurobond, but because the question specifies U.S. dollars, the more accurate choice is Eurodollar bond. A Yankee bond is U.S. dollar–denominated but is issued in the United States; Eurodollar bonds are not. Brady bonds are issued only by foreign governments, usually—but not always—are U.S. dollar–denominated, and are available for purchase in the United States.
When referring to municipal bonds, the formula of (1 − tax bracket) is found in the computation of
tax-equivalent yield
(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%)
When a U.S. resident investor purchases foreign bonds,
appreciation of both the bonds and the foreign currency benefits the domestic investor.
In the same manner that purchasing foreign equities adds diversification to a portfolio, purchasing foreign bonds does as well. As with any security, if the value goes up (it appreciates), that is a benefit to the investor. When foreign securities are involved, there is another concern—currency risk. Because the foreign bond is denominated in the local currency, an increase in that currency’s value versus the U.S. dollar means the semiannual interest payments will translate into more dollars. At maturity, the return of principal will be higher as well. Of course, it can go the other way if the market value or the foreign currency depreciates against the dollar.
An investor is trying to decide whether to purchase $10,000 face amount of a U.S. Treasury bond or a highly rated corporate bond. The price of the Treasury bond is 102.20 while the price of the corporate bond is 99 3/8. If the investor decides to purchase the Treasuries, disregarding commissions, the price difference is
325
The first step is remembering that Treasuries are quoted in 32nds. That means that 102.20 is 102 and 20/32 which is 102 5/8. Subtract 99 3/8 from 102 5/8 to get 3 2/8 or 3 1/4. On a $1,000 bond, that is $32.50. Then, note that this investor is purchasing 10 bonds, so the difference in price is $32.50 times 10 or $325.
Your client in the 28% federal income tax bracket currently owns some U.S. government bonds with a coupon yield of 6%. In order to receive the same income after taxes, she would need to buy municipal bonds with a coupon of
4.32%.
Because the 6% on the government bond is fully taxable on a federal basis, the client receives a net of 4.32% ($60 per bond less 28% in taxes [$16.80], or $43.20 per year). Interest on municipal bonds is tax free, so a 4.32% coupon will result in the same amount of after-tax income.
In general, from the choices given, the type of security offering the greatest degree of safety to an investor is
C) a mortgage bond
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.
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
current yield per share has increased
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 U.S. government securities do not bear a stated interest rate but are sold at a discount through weekly auctions?
Treasury bills
Treasury bills bear no stated interest rate. They are sold at a discount through weekly auctions and are actively traded in the money market. Treasury notes and Treasury bonds both carry stated interest rates.
Bond prices are quoted as a percentage of
face Value / Par Value
Bond prices are quoted as a percentage of par value. On the exam, the par value of bonds is always $1,000.
Which two of the following investments would offer your clients the best chance of minimizing inflation risk?
- Common stock
- Callable preferred stock
- Money market mutual funds
- TIPS
1&4
Historically, common stock has been the best hedge against inflation. TIPS (Treasury Inflation Protection Securities) are Government guaranteed debt issues that automatically adjust the principal based upon the inflation rate.
Which of the following statements regarding a zero-coupon corporate bond is true?
A)The investor reports the difference between the purchase price and maturity value as ordinary income at maturity.
B)These bonds have higher reinvestment risk as to interest than bonds paying semiannual interest.
C)Bonds selling at a premium have a yield lower than the coupon rate.
D)The investor has phantom income, which must be reported on an annual basis.
The investor has phantom income, which must be reported on an annual basis.
Explanation:
On a taxable zero-coupon bond, the annual imputed interest is reported for tax purposes. Because this income is not actually received annually, it is referred to as phantom income. Zero-coupon bonds always sell at a discount from their maturity value—never at a premium—and one risk that zero-coupon bonds avoid is reinvestment risk because there are no interest payments to reinvest
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?
Indexed bonds, such as Treasury Inflation-Protected Securities (TIPS)
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.
The interest from which of the following bonds is exempt from federal income tax?
1.State of California bonds
2.City of Anchorage bonds
3.Treasury bonds
4.GNMA bonds
1&2
Municipal bonds are exempt from federal income tax. Treasury bonds are exempt from state tax but not federal tax. GNMAs are subject to federal, state, and local income tax.
The yield to maturity is
A)the annualized return of a bond if it is held to maturity.
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.
GNMA mortgage-backed securities are
A)a direct obligation of the U.S. government.
B)exempt from federal income tax for the interest payments received by the bondholders.
C)available to investors through a minimum purchase of $5,000.
D)backed exclusively by a pool of mortgages.
A direct obligation of the U.S. government
GNMA securities are a direct obligation of the U.S. government and are backed by a pool of mortgages (which is why the choice “backed exclusively by a pool of mortgages” is not the best choice). The monthly payments are partially a return of principal and partially taxable interest, which is subject to state and federal income tax. GNMA pass-through securities are available to investors with a minimum issue price of $1,000.
Richard purchased a 30-year bond for 103½ 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?
8.50%
No calculation is necessary here. Why not? Because anytime a bond is purchased at a premium over par (103½ % 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 the relationship between prices and yields.
Kate, age 59, has an investment portfolio exceeding $250,000. She considers herself a moderate to conservative investor. To generate additional income, she is anticipating adding bonds to her portfolio. She lives in a state that does not have an income tax and she is in the 28% federal income tax bracket. Which of the following bonds would be the best recommendation for her portfolio?
C) Bond A, A-rated corporate debenture with a 6.50% coupon rate
Even though Bond C has the highest after-tax rate of return, this bond would not be appropriate for Kate based on her risk tolerance. Therefore, Bond A would be the best choice.
Calculations:
Bond A: 6.5 × (1 - 0.28) = 4.68%
Bond B: 3.75%
Bond C: 8% × (1 - 0.28) = 5.76%
Bond D: 2.55% × (1 - 0.28) = 1.84%
A bond offered at par has a coupon rate
B)equal to its current yield.
When a bond is selling at par, its coupon or nominal rate, current yield, and yield to maturity are all the same.
If a customer buys a 6% bond maturing in eight years on a 7.33 basis, the price of the bond is
below par
(A bond with a basis, or yield to maturity, greater than its coupon is trading at a discount, or below par)
An investor interested in monthly interest income should invest in
GNMAs
pay monthly interest and principal, treasury bonds pay semiannual interest, utility stocks pay quarterly dividends, and corporate bonds pay semiannual interest.
Securities issued by which of the following agencies offer direct government backing?
A)Federal Intermediate Credit Bank
B)Federal National Mortgage Association
C)Government National Mortgage Association
D)Federal Home Loan Mortgage Corporation (Freddie Mac)
Government National Mortgage Association
FNMA, FHLMC, and FICB are considered GSEs (government-sponsored enterprises), and although their securities are quite safe, they do not have the direct backing of the Treasury. It is important to remember for the exam that the only security without the word Treasury in its name that is backed by the U.S. government is a GNMA.
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
above $22 per share
(With a conversion price of $20 and a par value of $60, this preferred stock is convertible into 3 shares of the company’s common stock. We divide the current price of the preferred ($66) by the 3 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.)
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
above $1,200
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.
The annual interest payment divided by the current dollar price of a bond is
Current yield
Coupon yield, also known as the coupon rate, is the annual interest rate established when the bond is issued that does not change during the lifespan of the bond. Current yield is the bond’s coupon yield divided by its current market price.
What rate of interest would a bank in England charge another British bank for a short-term loan?
D) SOFR
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.
A bond with a par value of $1,000 and a nominal yield of 6% paid semiannually is currently selling for $1,300. The bond matures in 25 years and is callable in 15 years at $1,080. In the computation of the bond’s yield to call, which of these would be a factor?
Interest payments of $30
*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. With a 15-year call, there are only 30 semiannual interest payment periods, not 50. The present value is $1,300 and the future value is $1,080; the reverse of the numbers indicated in the answer choices.
An investor buys 10M RAN 6.6s of 32 at 67. What is the total purchase price?
C)$6,700.
For those of you not familiar with bond listings, this means that the investor bought $10,000 (10M) of the RAN Corporation bonds with a 6.6% coupon (interest rate stated on the face of the bond) that mature in 2032 (32). The price is 67, which represents 67% of $10,000, or $6,700.
The net asset value of an international bond fund can be expected to increase if which of these occur?
1.Interest rates rise abroad.
2.Interest rates fall abroad.
3.The U.S. dollar strengthens.
4.The U.S. dollar weakens.
2 & 4
