Ch. 2 Debt Securities Flashcards
An investor living on a fixed income has $10,000 to invest. His investment objectives are safety of principal and capital appreciation. Which of the following would be the most suitable investment?
[A] Common stock in a growth company
[B] A convertible corporate bond, rated grade A or better
[C] U.S. Savings bonds
[D] Money market fund
B.
A convertible corporate bond graded A or better would most likely achieve the results that the investor desires. The fact that the bond is rated A or better means that it is a high quality bond with little chance of defaulting on debt service payments. The convertible feature will offer the investor the appreciation potential that he is seeking because an increase in the underlying stock will cause the market value of the bond to also increase.
A large corporation has a substantial amount of convertible bonds outstanding. The bonds are callable at a slight premium over par ($102) and the conversion price of the bonds is $25. Common stock for the corporation is currently trading at $28 per share. The corporation wishes to reduce the amount of debt on its books and has decided to force a conversion of the bonds. How does the corporation go about doing so in this scenario?
[A] The corporation should go into default on interest payments for the bonds.
[B] The corporation should perform a primary offering of enough common stock to cover all conversions, which would force the conversion.
[C] The corporation should simply call in the outstanding bonds.
[D] The corporation should raise the conversion price from $25 to $50.
C.
If the corporation wants to force the conversion, they can simply call the bonds in at this point in time. The parity price of the bonds at this point in time in relation to the common stock is $1,120. The call price is $1,020. By issuing a call, all bondholders would be motivated to convert, because otherwise, they are walking away from $100 by awaiting the tender of the called bonds. Issuing additional common would dilute earnings and likely reduce the common share price, making conversion less appealing. Going into default would not be a means of forcing a conversion.
A corporate bond called at 108 1/8 would pay the bondholder:
[A] $1,084.50
[B] $1,081.25 plus accrued interest
[C] $1,081.25 minus accrued interest
[D] $1,000 plus accrued interest of $1.25
B.
The premium price of 108 1/8 would represent $1,081.25 (108 = $1080 1/8 x $10 = 1.25/$1081.25), and further the investor would be entitled to the accrued interest.
The nominal yield of a bond:
[A] is found by dividing the annual interest payout by the bond’s current market price.
[B] is found by factoring in the bond’s purchase price, coupon rate, time to maturity, and redemption value.
[C] is found by multiplying the bond’s current market value by the bond’s coupon rate.
[D] is found by multiplying the bond’s coupon rate by the bond’s par value and is the same as the coupon rate printed on the bond.
D.
The nominal yield of a bond is the same thing as the bond’s coupon rate. It is the fixed rate of interest paid on the bond on an annual basis, normally in two semi-annual payments. To find the actual dollar amount, the par value of the bond is multiplied by the coupon rate of the bond, giving the interest paid out in dollar form on an annual basis.
In a normal market, when there is a change in interest rates how do the yield to maturity and the current yield of a bond react?
[A] They move in the same direction.
[B] They move in opposite directions.
[C] They are unaffected by bond price movements.
[D] There is no relationship to each other.
A.
The current yield and the yield to maturity of a bond are always expected to move in the same direction and will both react when there is change in interest rates. The yield to maturity will always make the biggest move up or down because it considers the time to maturity whereas current yield does not consider time to maturity.
A corporate bond is purchased at a discount. Which of the following would best state its future rate of return?
[A] current yield
[B] coupon rate
[C] basis or yield to maturity
[D] stated discount
C.
When a bond is purchased at a discount, the yield to maturity will always be greater than the current yield or coupon rate because the calculation takes into consideration the difference between the price the investor paid and what the investor will receive at maturity which would increase the overall yield since the investor would have paid less than $1,000 (discount) but would receive $1,000 par value at maturity.
If a corporation is in liquidation, the holder of a subordinated debenture would be paid at what time?
[A] Before bank loans and before accounts payable.
[B] Before bank loans and after accounts payable.
[C] After bank loans and before accounts payable.
[D] After bank loans and after accounts payable.
D.
A subordinated debenture is one that is paid after any senior lien debt. If a corporation was in liquidation, bank loans and accounts payable would be paid before the holder of a subordinated debenture would receive any money.
Which best describes municipal bonds priced at par?
[A] All coupons yield the same return.
[B] Bonds will be issued with a face value of $100.
[C] Coupon rate for any given year equals the yield to maturity.
[D] Bonds are offered net of accrued interest.
C.
All yields (Nominal, Current, and Yield to Maturity) are equal when a bond is trading at par value.
The interest rate in a collateralized mortgage obligation:
[A] Is paid at the coupon rate over the life of a bond
[B] Varies depending on the federal funds rate
[C] Is based on variable coupon rates until stated maturity
[D] Varies depending on a differential from Treasury bond rates
A.
The interest rate on a CMO is a pre-determined fixed rate that is paid over the life of the bond.
If interest rates are declining, which of the following would be expected?
[A] Discount bonds will appreciate more than premium bonds.
[B] Premium bonds will appreciate more than discount bonds.
[C] All bonds will depreciate equally.
[D] All bonds will appreciate equally.
A.
When interest rates decline, all bond prices rise, but the discount bonds (lowest price) would appreciate more (and quicker) than the bonds trading at a premium.
Which of the following statements is true concerning yield spreads between Collateralized Mortgage Obligations (CMOs) and U.S. Treasuries of comparable maturities?
[A] U.S. Treasury Security yields are slightly higher than CMO yields.
[B] U.S. Treasury Security yields are substantially higher than CMO yields.
[C] CMO yields are higher than U.S. Treasury yields.
[D] U.S. Treasury and CMO yields are always equal.
C.
Since CMOs carry substantially more risk, their yield would be greater than the yield on U.S. government securities.
A decrease of 10 basis points for a $1,000 bond would represent which of the following decreases in the price of the bond?
[A] $100.00
[B] $10.00
[C] $1.00
[D] $.10
C.
Let’s first discuss the difference between a basis point and a bond point. A basis point is the measure of the change in yield. It is a small number, so a basis point measures that small change.
A basis point is equal to 1/100th of 1% of a bond or $.10. So on a $1,000 bond, one basis point is equal to $.10. So, ten basis points would be equal to $1.00. (10 X $.10 = $1.00)
A bond point deals with the price of a bond. A bond point is equal to 10 dollars.
ABC Corporation wants to issue $20,000,000 of debentures each of which would be convertible in 20 shares of common stock. How many common shares are issued if all the debentures are converted?
[A] 100,000
[B] 200,000
[C] 400,000
[D] 600,000
C.
$20,000,000 worth of bonds divided by par of $1,000 = 20,000 bonds
20,000 bonds X 20 shares per bond = 400,000 common shares issued
An investor who wishes to minimize market risk should buy
[A] short-term bonds.
[B] high-yield bonds.
[C] high-grade bonds.
[D] discount bonds.
A.
Market risk is the risk that the market price of the security will decline. Short term bonds are the most marketable of the bonds listed, and would be least susceptible to market risk.
When mortgages are pooled together to create a CMO product,
[A] an open-end investment company is created.
[B] a closed-end investment company is created.
[C] the mortgages are said to be securitized.
[D] the resulting equity securities are said to be amortized.
C.
In structuring a CMO, the issuer distributes the cash flow coming in from the mortgages to a series of different classes of short, medium, or long-term maturities of the CMO, which are called “tranches”. Because CMOs are backed by mortgages, which can be (and frequently are) prepaid prior to maturity, each CMO tranche will have an average life expectancy anywhere from 2 to 20 years. When the CMO is created it is called “securitization” of the mortgages or the mortgages are said to be “securitized”.
