Debt Securities

Question 1

The effect of steadily declining interest rates on the secondary bond market is:

I. Yields decrease
II. Prices decrease
III. Yields increase
IV. Prices increase

[A] I, II
[B] I, IV
[C] II, III
[D] III, IV

Answer 1

[B] I, IV

When interest rates decline, yields decline, and prices rise. Think about the see-saw.
Ch2 Sec2

Question 2

A customer holds a corporate bond with a coupon rate of 5.75%. This bond will pay how much interest on an annual basis?

[A] $5.75
[B] $57.50
[C] $575.00
[D] Annual coupon payments will depend on the market price at which the bond was purchased

Answer 2

[B] $57.50

A standard corporate bond will have a par value of $1,000. Coupon rates are based on par value (NOT market price), so a rate of 5.75% on a $1,000 would be $57.50 in annual interest related to the coupon rate ($1,000 par x 0.0575 (5.75%) = $57.50. This interest will be broken into two semi-annual interest payments, but the question asks for the annual payout.
Ch2 Sec1

Question 3

An Open-end Mortgage Bond issued by a corporation is one in which the property used to secure the bonds:

[A] Cannot be used to secure a later loan unless the later loan is lesser in claim.
[B] Can be used to secure additional debt as long as the additional bonds are subordinated.
[C] Can be used to secure additional bonds and all bonds rank equally.
[D] Can be used to secure additional debt and in the event of bankruptcy bonds would be repaid by earliest maturities first.

Answer 3

[C] Can be used to secure additional bonds and all bonds rank equally.

An Open-end Mortgage Bond issued by a corporation is one in which the property used to secure the bonds can be used to secure additional bonds and all bonds rank equally.
Ch2 Sec4

Question 4

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.

Answer 4

[C] the mortgages are said to be securitized.

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”.
Ch2 Sec6

Question 5

As interest rates change, existing bond prices will

[A] rise when interest rates decline and will decline when interest rates rise.
[B] rise regardless of whether interest rates are increasing or decreasing.
[C] decline when interest rates decline and will rise when interest rates rise.
[D] decline regardless of whether interest rates are increasing or decreasing.

Answer 5

[A] rise when interest rates decline and will decline when interest rates rise.

In a normal market, bond prices move in the opposite direction of interest rates.
When interest rates decline, existing bond prices typically increase or rise.
When interest rates rise, existing bond prices typically decline.
Ch2 Sec2

Question 6

Mr. C. Nate purchases a 15% corporate bond at par and, at that time, pays $60 in accrued interest. The bond pays interest annually. How much of the first annual interest payment will Mr. Nate report for tax purposes?

[A] $150
[B] $90
[C] $60
[D] $0

Answer 6

[B] $90

Mr. Nate paid $60 in accrued and received $150. The net amount Mr. Nate received is $90. This is the amount he will report for tax purposes.
Ch2 Sec2A

Question 7

Which of the following bond offerings would be required to have a trust indenture under the Trust Indenture Act of 1939?

[A] U.S. Treasury Bond
[B] airport authority revenue bond
[C] general obligation bond
[D] mortgage bond

Answer 7

[D] mortgage bond

Since the Trust Indenture Act of 1939 is applicable only to corporate bonds, the mortgage bonds would be the only bonds required to have a trust indenture.
Ch2 Sec3

Question 8

In a regular way delivery of municipal bonds, accrued interest is computed

[A] Up to and including the trade date.
[B] Up to and including the settlement date.
[C] Up to but not including the trade date.
[D] Up to but not including the settlement date.

Answer 8

[D] Up to but not including the settlement date.

Accrued interest is always computed up to but not including the settlement date of the transaction.
Ch2 Sec2A

Question 9

All of the following are true of a corporate bond with a call feature EXCEPT:

[A] Interest payments cease after the bond is called.
[B] It limits the upside potential on the bond.
[C] If the bond has a call premium, it normally declines in later years.
[D] The bond will be sold for a higher price because of the call feature.

Answer 9

[D] The bond will be sold for a higher price because of the call feature.

Call features are less desirable to the investor so the bonds usually sell for a lower price.
Ch2 Sec5

Question 10

Which of the following is NOT permitted in a CMO advertisement?

[A] A comparison of the risks of investing in CDs vs. CMOs.
[B] A description of the initial issue tranche.
[C] The maturity date must be prominently displayed.
[D] The risks of investing in CMOs.

Answer 10

[A] A comparison of the risks of investing in CDs vs. CMOs.

CMO advertisements must NOT contain comparisons between CMOs and any other investments, including CDs (CMOs are not as safe as CDs.).
Ch2 Sec6

Question 11

Which security could be issued with conversion privileges?

[A] Preferred stock
[B] Common stock
[C] Negotiable CDs
[D] Bankers’ Acceptances

Answer 11

[A] Preferred stock

Preferred stock (and corporate bonds) could be issued with conversion privileges, which is the right of the owner of these securities to convert them into another security, usually common stock.
Ch2 Sec5

Question 12

The Trust Indenture Act of 1939 regulates corporate debt issues and requires the designation of a trustee. What duty does this trustee have?

[A] The trustee is charged with ensuring that the proper filing procedures take place with relation to the issue and SEC registration.
[B] The trustee is charged with allocating any remaining bonds that may not have been sold in the initial issuance.
[C] The trustee is charged with acting on behalf of bondholders and ensuring that the rights of these bondholders are not infringed upon.
[D] The trustee is charged with being the liaison to the SEC in relation to all matters associated with the bond issue.

Answer 12

[C] The trustee is charged with acting on behalf of bondholders and ensuring that the rights of these bondholders are not infringed upon.

The Trust Indenture Act of 1939 pertains to corporate debt issues and requires that each corporate debt issue has an indenture and a trustee. The trustee’s main function is the representation of bondholders and ensuring the safeguarding of bondholder rights.
Ch2 Sec3

Question 13

Which of the following is TRUE of collateralized debt obligations (CDOs)?

[A] They are a pool of mortgages that is packaged and sold to investors.
[B] They are backed by the U.S. government.
[C] They are considered equity securities.
[D] They are considered asset backed securities.

Answer 13

[D] They are considered asset backed securities.

CDOs are considered asset backed securities because they are backed by a pool of assets including mortgages, auto loans, corporate debt, and credit card debt. These asset-backed debts (loans) are packaged and sold to investors.
Ch2 Sec7

Question 14

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.

Answer 14

[C] CMO yields are higher than U.S. Treasury yields.

Since CMOs carry substantially more risk, their yield would be greater than the yield on U.S. government securities.
Ch2 Sec6

Question 15

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

Answer 15

[C] basis or yield to maturity

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.
Ch2 Sec2

Question 16

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

Answer 16

[B] $1,081.25 plus accrued interest

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.
Ch2 Sec3

Question 17

Mr. Jones purchased $10,000 par value of 8% bonds to yield 5%. On the normal interest payment date, he will receive:

[A] $250
[B] $400
[C] $500
[D] $800

Answer 17

[B] $400

“Normal” interest payment date is semi-annual and based on the coupon rate not yield. Mr. Jones has purchased $10,000 worth of bonds, or ten (10) $1,000 bonds. So we can multiply the overall par value of the bonds by the coupon rate to find the annual interest, then divide by 2 to find the semi-annual payment.

$10,000 x .08 = $800 (annual interest)

$800 / 2 = $400 (semi annual payment)
Ch2 Sec1

Question 18

Which of the following statements is TRUE about agency CMOs v. private CMOs?

[A] Private CMOs can contain agency CMOs in their portfolios.
[B] Private CMOs are not covered by rating agencies.
[C] Agency CMOs can be issued by corporations such as banking companies.
[D] Principal payments only in agency CMOs are guaranteed by the U.S. government.

Answer 18

[A] Private CMOs can contain agency CMOs in their portfolios.

Although these are private CMOs which can be issued by corporations such as banks they can contain agency CMOs in their portfolios. Although they may contain agency CMOs in their portfolio, private-label CMOs are not guaranteed by the U.S. government.
Ch2 Sec6

Question 19

A bond selling at a premium to its par value means

[A] the current yield will be lower than the nominal yield.
[B] the current yield will be equal to the nominal yield.
[C] the current yield will be higher than the nominal yield.
[D] general level of interest rates are higher than when the bond was first issued.

Answer 19

[A] the current yield will be lower than the nominal yield.

Bond yields and prices have an inverse relationship meaning that as one increases the other would decrease. Therefore, if a bond is selling at a premium (above par), its current yield would have to be lower than its nominal (or par) yield.
Ch2 Sec2

Question 20

Which of the following factors is the LEAST important in analyzing the investment quality of a mortgage bond?

[A] The collateral held by the trustee bank
[B] The current phase of the economic cycle
[C] The trustee bank holding the title to the collateral
[D] The credit rating issued by a nationally recognized rating agency

Answer 20

[C] The trustee bank holding the title to the collateral

The trustee bank is merely the legal owner of the real estate being pledged as collateral for the loan. In the event of default by the issuer, the trustee would initiate foreclosure proceedings against the property.
Ch2 Sec4

Question 21

A long-term Corporate Bond trading in the secondary market has a Nominal Yield of 10% and a Basis of 7%. The Current Yield is 9% and the Par Value is $1,000. The bond is trading at a

[A] premium.
[B] discount.
[C] par.
[D] premium above parity.

Answer 21

[A] premium.

Bonds are trading at a premium when the Yield To Maturity or Basis is less than the Coupon Rate/Nominal Yield. Parity is a consideration when discussing convertible securities and comparing market value to the market value of the common stock to which the securities convert.
Ch2 Sec2

Question 22

All of the following are correct regarding corporate convertible bonds EXCEPT:

[A] Nominal yields on convertible bonds are normally lower than non-convertibles of the same quality.
[B] Market prices of convertible bonds fluctuate more than non-convertibles of the same quality.
[C] Lowering the conversion price of a convertible bond would cause the number of shares the bond converts into to be lower.
[D] Convertible bonds generally trade at a premium to common stock.

Answer 22

[C] Lowering the conversion price of a convertible bond would cause the number of shares the bond converts into to be lower.

Lowering the conversion price of a convertible bond would cause the number of shares the bond converts into to be higher. For example, if a convertible bond had a conversion price of 50, it could only convert into 20 shares of the stock. If the conversion price were lowered to 40, the bond could convert to 25 shares. (1,000/50 vs. 1,000/40)
Ch2 Sec5

Question 23

Which of the following would NOT be related to equity securities that a corporation would distribute?

[A] Preferred stock
[B] Subordinated debentures
[C] Pre-emptive rights
[D] Subscription warrants

Answer 23

[B] Subordinated debentures

Preferred stock is an equity security. Pre-emptive rights and subscription warrants are both derivatives of equities which would allow a holder to purchase equity securities. Debentures are debt instruments and would NOT be related to equity securities.
Ch2 Sec4

Question 24

An RR makes the following statements about private CMOs to his customer. Which statement is FALSE?

[A] A private CMO is backed jointly by the issuer and the federal government.
[B] Private CMOs can include letters of credit.
[C] Home builders can issue CMOs.
[D] Credit agencies rate private CMOs.

Answer 24

[A] A private CMO is backed jointly by the issuer and the federal government.

The false statement is: A private CMO is backed jointly by the issuer and the federal government. Private CMOs are backed by the issuer only.
Ch2 Sec6

Question 25

A corporation has outstanding $5,000,000 of 9 1/2% 20-year debentures, with a conversion price of $40. Assuming the common stock is selling at $35 per share and the convertible bonds are selling at a 5% premium over parity, the market price of the bonds would be:

[A] 87.5
[B] 91.875
[C] 100
[D] 105

Answer 25

[B] 91.875

The formula for determining the parity price for bonds is:

Par / Conversion Price = Number of common shares produced at conversion

Shares x Market Price of common = Parity Price of Bond (PPoB)

(PPoB x Premium) + PPoB = Market Price of Bond

1000 / 40 = 25 shares
25 * 35 = 875
875 * .05 = 43.75 + 875 = $918.75
or 91.875 points

Ch2 Sec5A

Question 26

Which of the following best describes the “Call Premium” of a bond?

[A] The amount by which the bond trades above par value
[B] The amount above par value which the issuer must pay to call the bond in for redemption
[C] The amount above par which the investor must pay to purchase the bond
[D] The amount the investor would receive upon sale of the bond in the secondary market

Answer 26

[B] The amount above par value which the issuer must pay to call the bond in for redemption

A call premium is the amount over par that an issuer has to pay to an investor for redeeming the security early.
Ch2 Sec5

Question 27

Which of the following would be the effect on a collateralized mortgage obligation (CMO) if interest rates declined?

[A] Lengthen the average life of the CMO by 10 years or more.
[B] Decrease the market price of the CMO.
[C] Lengthen the average life of the CMO by 5 or more years.
[D] Shorten the average life of the CMO.

Answer 27

[D] Shorten the average life of the CMO.

A collateralized mortgage obligation (CMO) is subject to interest rate risk and implied call risk. CMOs are fixed income securities, so they are subject to inverse reaction like other fixed income securities: their current market prices will rise when interest rates fall.
Also, when interest rates go down (including home mortgage rates) homeowners will refinance their mortgages to take advantage of the lower mortgage rates. Consequently, they will pre-pay their existing mortgage prior to maturity and thus shorten (not lengthen) the average life of the CMO that is comprised of these mortgages.
Ch2 Sec6

Question 28

If an investor is primarily seeking capital gains, when would be the best time to buy bonds?

[A] When the interest rates are stable and are expected to remain stable.
[B] When interest rates are low and are expected to rise.
[C] When bond prices are low and interest rates are expected to rise.
[D] When interest rates are high and are expected to drop.

Answer 28

[D] When interest rates are high and are expected to drop.

A decline in interest rates causes prices to rise. An investor seeking capital gains would want to buy when interest rates are high and sell when they are low and prices have been driven up.
Ch2 Sec2

Question 29

An investor is buying a bond in the secondary market. Accrued interest on this bond

[A] is owed to the buyer of the bond since the last interest payment date.
[B] is owed to the seller of the bond since the last interest payment date.
[C] is neither received by the buyer or seller.
[D] is paid to both the buyer and the seller by the issuing entity.

Answer 29

[B] is owed to the seller of the bond since the last interest payment date.

Accrued interest is interest that has accumulated on a bond since the last interest payment date, but has not yet been paid. If an investor buys a bond, the investor will have to pay accrued interest to the seller, who is owed the accrued interest since the last interest payment date.
Ch2 Sec2A

Question 30

Which of the following parties pays accrued interest when it comes to secondary market transactions in bonds?

[A] The issuer of the bond
[B] The seller of the bond
[C] The buyer of the bond
[D] The broker-dealer of the seller of the bond

Answer 30

[C] The buyer of the bond

Accrued interest is paid by the buyer of a bond and is received by the seller of the bond. Accrued interest is interest that accumulates from the last interest payment date on a bond. If a bond is sold between interest payment dates, then the person who owned the bond (the seller) is owed the accrued interest through the sale of the bond. The buyer of the bond pays for accrued interest and receives the next full interest payment from the issuer.
Ch2 Sec2A

Question 31

Negotiable CDs are

[A] guaranteed by the U.S. Government.
[B] guaranteed by the banks that offer them.
[C] guaranteed by private insurance companies.
[D] not guaranteed.

Answer 31

[B] guaranteed by the banks that offer them.

Ch2 Sec7

Question 32

A customer has a portfolio of various corporate and Treasury bonds. She tells her registered representative that she believes interest rates are going lower and she wants to maintain a portfolio of bonds. Given the customer’s concern, the RR should recommend that the client

[A] begin swapping her existing bonds for bonds selling at a premium.
[B] extend the overall maturity and increase the call protection on her bond portfolio.
[C] attempt to shorten the overall maturity on her bond portfolio.
[D] sell corporate bonds and buy Treasury bonds.

Answer 32

[B] extend the overall maturity and increase the call protection on her bond portfolio.

The customer feels that interest rates are going to go down so she should attempt to lock in the longest maturities possible in her portfolio. This calls for extending the overall maturity of the bond portfolio. The customer should also attempt to eliminate the possibility of early calls of her bonds, so she should increase the call protection for her portfolio.
In order to achieve this, the customer should make changes to her portfolio by selling bonds with the shortest maturities and buying bonds with longer maturities. Also, she should sell bonds that are callable now or soon to be callable and buy new ones with callable dates that are much further out.

Ch2 Sec5

Question 33

ABC Corporation has little or no track record of sales and earnings and wants to raise capital by issuing debt securities. The corporation would most likely issue securities that would be called:

[A] Debentures
[B] Preferred Stock
[C] Junk Bonds
[D] Subordinated Bonds

Answer 33

[C] Junk Bonds

Ch2 Sec4

Question 34

Interest payments to investors on CMOs are subject to which of the following?

[A] State income tax only
[B] Federal income tax only
[C] Both federal and state income tax
[D] Neither federal nor state income tax

Answer 34

[C] Both federal and state income tax

Ch2 Sec6

Question 35

Which of the following BEST describes a call feature?

[A] This is a feature of a bond that allows the bond to be converted to common stock at the option of the issuer.
[B] A feature that allows the issuer of a bond to redeem the bond ahead of the final maturity date, typically including a premium above face value of the bond and most commonly used when interest rates have decreased.
[C] This is a feature of a bond that allows the bond’s coupon rate to be adjusted upward or downward in relation to interest rates in the current market.
[D] A feature that forces the issuer to redeem a bond ahead of schedule at the option of the bondholder.

Answer 35

[B] A feature that allows the issuer of a bond to redeem the bond ahead of the final maturity date, typically including a premium above face value of the bond and most commonly used when interest rates have decreased.

Ch2 Sec5

Question 36

Which of the following callable bonds currently trading at an 8% basis would most likely be refunded?

[A] 5 1/2% of 2025, callable at 100
[B] 8 1/2% of 2035, callable at 100
[C] 8% of 2035, callable at 103
[D] 6 1/2% of 2025, callable at 103

Answer 36

[B] 8 1/2% of 2035, callable at 100

The highest coupon is 8.5%, so that is the correct answer. When a company is refunding, it wants to get rid of paying a high coupon. With a 8.5% bond it is paying $85 per year per bond. If interest rates are dropping, let’s say to 2%, it could replace paying $85 per bond with $20 per bond annually. The bonds callable at par with the highest coupon would most likely be called by the issuer. The highest coupon callable at par would be the best situation for the issuer since it would eliminate the high coupon payment and are callable at par rather than at a premium.
Ch2 Sec5

Question 37

An investor purchases the following bonds, all at a premium above par value:

XYZ 5% non-callable bonds maturing in 15 years
XYZ 5.10% non-callable bonds maturing in 20 years
XYZ 5.25% non-callable bonds maturing in 25 years

Several months after these bonds are purchased, the going rates on bonds have moved an average of 20 basis points. Of this investor’s purchases, which will show the largest adjustment in terms of price because of the change in the going rate?

[A] The bonds are all trading in the secondary bond market and will all be affected equally.
[B] The 25-year bonds will be affected the most.
[C] The 15-year bonds will be affected the most.
[D] The bonds are all trading in the secondary bond market and have fixed coupons, so their prices will not be affected by fluctuations in new bond rates.

Answer 37

[B] The 25-year bonds will be affected the most.

Remember that short-term bonds react the quickest while long-term bonds react the most or greatest. So in this case, the 25-year bonds will see the largest adjustment over time.
Ch2 Sec2

Question 38

The final tranche of a CMO is generally known as

[A] A companion bond
[B] PAC (Planned Amortization Class)
[C] TAC (Targeted Amortization Class)
[D] A Z-bond

Answer 38

[D] A Z-bond

Ch2 Sec6

Question 39

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

Answer 39

[B] A convertible corporate bond, rated grade A or better

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.
Ch2 Sec5

Question 40

The primary difference between yield to maturity (YTM) and the current yield (CY) on corporate bonds is:

[A] YTM uses coupon rate and CY does not.
[B] YTM uses time remaining until maturity. CY does not.
[C] CY uses time remaining until maturity. YTM does not.
[D] CY uses coupon rate in its calculation. YTM does not.

Answer 40

[B] YTM uses time remaining until maturity. CY does not.

Current yield only considers coupon rate and market value, whereas YTM considers coupon rate, market rate and time until maturity.
Ch2 Sec2A

Question 41

A customer holds a corporate bond with a coupon rate of 5.75%. This bond will pay how much interest on an annual basis?

[A] $5.75
[B] $57.50
[C] $575.00
[D] Annual coupon payments will depend on the market price at which the bond was purchased

Answer 41

[B] $57.50

A standard corporate bond will have a par value of $1,000. Coupon rates are based on par value (NOT market price), so a rate of 5.75% on a $1,000 would be $57.50 in annual interest related to the coupon rate ($1,000 par x 0.0575 (5.75%) = $57.50. This interest will be broken into two semi-annual interest payments, but the question asks for the annual payout.
Ch2 Sec1

Question 42

When a conversion takes place, what occurs?

[A] Existing bonds are traded into the issuer for new bonds.
[B] The issuer performs a second issue of bonds to retire an existing issue with the proceeds.
[C] The issuer uses excess cash on hand to retire bonds prior to their original maturity date.
[D] Existing bonds are tendered to the issuer for equity securities, most frequently common stock.

Answer 42

[D] Existing bonds are tendered to the issuer for equity securities, most frequently common stock.

The most accurate description listed when it comes to conversion is the tender of bonds for equity securities. A conversion feature on a bond or preferred stock allows the holder to “tender” or turn in the bond or preferred stock in exchange for shares of common stock. Each of the other items listed applies to early retirement of existing bonds or refunding of existing bond issues.
Ch2 Sec5

Question 43

Mr. C. Nate purchases a 15% corporate bond at par and, at that time, pays $60 in accrued interest. The bond pays interest annually. How much of the first annual interest payment will Mr. Nate report for tax purposes?

[A] $150
[B] $90
[C] $60
[D] $0

Answer 43

[B] $90

Mr. Nate paid $60 in accrued and received $150. The net amount Mr. Nate received is $90. This is the amount he will report for tax purposes.
Ch2 Sec2A

Question 44

An investor is buying a bond in the secondary market. Accrued interest on this bond

[A] is owed to the buyer of the bond since the last interest payment date.
[B] is owed to the seller of the bond since the last interest payment date.
[C] is neither received by the buyer or seller.
[D] is paid to both the buyer and the seller by the issuing entity.

Answer 44

[B] is owed to the seller of the bond since the last interest payment date.

Accrued interest is interest that has accumulated on a bond since the last interest payment date, but has not yet been paid. If an investor buys a bond, the investor will have to pay accrued interest to the seller, who is owed the accrued interest since the last interest payment date.
Ch2 Sec2A

Question 45

If a customer believes that interest rates will decline substantially, she should invest in

[A] a 1 yr Certificate of Deposit @ 10%.
[B] a long term variable rate Corporate Bond yielding 12 1/2%.
[C] a long term Corporate Bond with a coupon rate of 10%, callable in 3 years @ par, at a 9% basis.
[D] a long term Corporate Bond with a coupon rate of 10% at a 12% basis, non callable.

Answer 45

[D] a long term Corporate Bond with a coupon rate of 10% at a 12% basis, non callable.

Bonds have an inverse reaction to interest rate movements, when interest rates go down the prices of outstanding bonds will rise. In addition, long term bonds react the greatest to interest rate changes compared with bonds with shorter maturities. The non callable feature stated in the correct answer is also appealing because it gives the investor some protection against her bonds being called by the issuer when interest rates fall.
Ch2 Sec2

Question 46

The public offering price of a bond is $1,000 and the bond has a coupon of 5%. If interest rates remain unchanged, what could you expect regarding the price of the bond?

[A] The bond would remain at par value.
[B] The bond would trade at a premium.
[C] The bond would trade at a discount.
[D] The bond price would be depreciated.

Answer 46

[A] The bond would remain at par value.

Bonds that trade for $1,000 are said to trade at “par.” Bonds that trade for a price above $1,000 are said to trade at a premium. Bonds that trade below $1,000 are said to trade at a discount. Depreciation refers to an accounting practice for physical assets, such as equipment.
Ch2 Sec2

Question 47

General Motors Corporation 6 1/2’s of ‘31 describe a bond with

[A] $65 annual interest with a quote of 310
[B] $65 annual interest maturing in 2031
[C] $650 annual interest maturing in 2031
[D] $6.50 annual interest with a quote of 310

Answer 47

[B] $65 annual interest maturing in 2031

$65 annual interest maturing in 2031. If instead of using the word “of” they would have used “at,” then the answer would have been A.
Ch2 Sec1

Question 48

In a regular way delivery of municipal bonds, accrued interest is computed

[A] Up to and including the trade date.
[B] Up to and including the settlement date.
[C] Up to but not including the trade date.
[D] Up to but not including the settlement date.

Answer 48

[D] Up to but not including the settlement date.

Accrued interest is always computed up to but not including the settlement date of the transaction.
Ch2 Sec2A

Question 49

Which of the following factors is the LEAST important in analyzing the investment quality of a mortgage bond?

[A] The collateral held by the trustee bank
[B] The current phase of the economic cycle
[C] The trustee bank holding the title to the collateral
[D] The credit rating issued by a nationally recognized rating agency

Answer 49

[C] The trustee bank holding the title to the collateral

The trustee bank is merely the legal owner of the real estate being pledged as collateral for the loan. In the event of default by the issuer, the trustee would initiate foreclosure proceedings against the property.
Ch2 Sec4

Question 50

The yield on a convertible bond will decrease when the price of the underlying stock

[A] increases.
[B] decreases.
[C] is at parity with the bond
[D] remains unchanged.

Answer 50

[A] increases.

If a bond is convertible into common stock, the price of the bond will tend to move with the price of the stock. When the price of the underlying stock increases, the yield on the bond will decrease (remember, as bond yields decrease, bond prices increase).
Ch2 Sec2

Question 51

Which of the following bond offerings would be required to have a trust indenture under the Trust Indenture Act of 1939?

[A] U.S. Treasury Bond
[B] airport authority revenue bond
[C] general obligation bond
[D] mortgage bond

Answer 51

[D] mortgage bond

Since the Trust Indenture Act of 1939 is applicable only to corporate bonds, the mortgage bonds would be the only bonds required to have a trust indenture.
Ch2 Sec3

Question 52

All of the following are TRUE of commercial paper EXCEPT:

[A] Commercial paper is considered a short-term instrument.
[B] Commercial paper is generally issued by corporations.
[C] Commercial paper is used by corporations in the financing of international trade.
[D] Commercial paper is issued with maturities of up to 270 days.

Answer 52

[C] Commercial paper is used by corporations in the financing of international trade.

Commercial paper is issued at a discount, is an unsecured promissory note with a maximum maturity of 270 days - but is not used to finance foreign trade (that would be a Banker’s Acceptance). Commercial Paper is generally used to finance accounts receivable of the corporation.
Ch2 Sec7

Question 53

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

Answer 53

[B] $1,081.25 plus accrued interest

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.
Ch2 Sec3

Question 54

The effect of steadily declining interest rates on the secondary bond market is:

I. Yields decrease
II. Prices decrease
III. Yields increase
IV. Prices increase

[A] I, II
[B] I, IV
[C] II, III
[D] III, IV

Answer 54

[B] I, IV

When interest rates decline, yields decline, and prices rise. Think about the see-saw.
Ch2 Sec2

Question 55

Higher quality debt issues of the same face value, maturity, and coupon, when compared to low quality debt issues, exhibit which two of the following?

I. Lower Yields
II. Lower Market Prices
III. Higher yields
IV. Higher Market Prices

[A] I and II
[B] I and III
[C] I and IV
[D] III and IV

Answer 55

[C] I and IV

High quality debt generally has lower yields, because the investor forfeits yield in lieu of quality. With lower yields you also have higher prices.

When investors buy bonds of higher quality they “give-up” yield in order to get the safety they are looking for – remember the old adage “The greater the risk, the greater the return” also goes the other way, “The lower the risk, the lower the return” which is the case here. A bond that is offering a lower yield will have a higher price, which is what causes the “yield” to be lower since the customer pays more to buy the bond.
Ch2 Sec4

Question 56

A 5% debenture is convertible into common stock at $30 per share. The common stock is trading at 37 1/2 and the bonds are trading at 126 1/2. The corporation calls the bonds at 106 as permitted by the indenture. The bondholder, in this case, should be advised to either:

I. Convert the bonds into common stock.
II. Sell the bonds at the current market price.
III. Hold the bonds and await the call.
IV. Refuse to tender the bonds.

[A] I or II
[B] III
[C] IV
[D] III or IV

Answer 56

[A] I or II

The investor’s choices are:

Sell = $1,265
Call = $1,060
Convert = $1,248.75

1,000/30 = 33.3 x $37.50 = $1,248.75

Therefore the best choices would be to sell or convert.
Ch2 Sec5A

Question 57

Which of the following would represent a quote for a railroad bond?

[A] 106 1/2
[B] 106 16/32
[C] 106.50
[D] 106.16

Answer 57

[A] 106 1/2

A railroad bond quote would be a corporate bond. Corporate bonds are quoted in eighths only (1/8). (They will use the lowest denominator in the quote, for example: 2/8 = 1/4, 4/8 = 1/2) Government securities are the only securities quoted using decimals and 32nds. Last, 16ths are not normally used in quoting corporate or government securities.
Ch2 Sec1

Question 58

Which of the following statements about call features found on securities such as preferred stock or bonds is CORRECT?

[A] Call features should not be a consideration as they do not impact the security’s return.
[B] Call features are required on all long-term bonds.
[C] Call features are beneficial to the issuer of the securities.
[D] Call features are beneficial to the investor purchasing the securities.

Answer 58

[C] Call features are beneficial to the issuer of the securities.

Call features allow the issuing company to “call in” their securities prior to their specified maturity date. These features are beneficial to issuers because they allow the issuer to call securities if lower costs of borrowing (lower rates of interest on bonds/dividends on preferred stocks) can be acquired. These features significantly affect securities, they are not required, and they are not beneficial to investors because the investor may end up with a lower return because of the call feature.
Ch2 Sec5

Question 59

A debt security that can be backed by various assets such as auto loans, mortgages, or credit card debt is called a(n)

[A] REIT
[B] ETN
[C] CDO
[D] ETF

Answer 59

[C] CDO

A CDO (Collateralized Debt Obligation) is a debt security that can be backed by several types of debt such as corporate debt, auto loans, and mortgages.  ETNs are a form of unsecured debt instrument.  ETFs are generally comprised of a basket of securities.  REITs issue shares of common stock and are an equity security.
Ch2 Sec6

Question 60

If a corporation is in liquidation, the holder of a subordinated debenture would be paid at what time?

[A] Before bank loans and before general creditors.
[B] Before bank loans and after general creditors.
[C] After bank loans and before general creditors.
[D] After bank loans and after general creditors.

Answer 60

[D] After bank loans and after general creditors.

A subordinated debenture is one that is paid after any senior lien debt. If a corporation was in liquidation, bank loans and general creditors including accounts payable would be paid before the holder of a subordinated debenture would receive any money.
Ch2 Sec4