Fixed Income - Questions

Question 1

An investor buys a pure-discount bond, holds it to maturity, and receives its par value. For tax purposes, the increase in the bond’s value is most likely to be treated as:

A)
a capital gain.

B)
interest income.

C)
tax-exempt income.

Answer 1

B
Explanation
Tax authorities typically treat the increase in value of a pure-discount bond toward par as interest income to the bondholder. In many jurisdictions this interest income is taxed periodically during the life of the bond even though the bondholder does not receive any cash until maturity. (Module 42.1, LOS 42.d)

Question 2

Which of the following most accurately describes the maximum price for a currently callable bond?

A)
Its par value.

B)
The call price.

C)
The present value of its par value.

Answer 2

B
Explanation
Whenever the price of the bond increases above the strike price stipulated on the call option, it will be optimal for the issuer to call the bond. Theoretically, the price of a currently callable bond should never rise above its call price. (Module 42.2, LOS 42.f)

Question 3

Which of the following statements is most accurate with regard to floating-rate issues that have caps and floors?

A)
A cap is an advantage to the bondholder, while a floor is an advantage to the issuer.

B)
A floor is an advantage to the bondholder, while a cap is an advantage to the issuer.

C)
A floor is an advantage to both the issuer and the bondholder, while a cap is a disadvantage to both the issuer and the bondholder.

Answer 3

B
Explanation
A cap is a maximum on the coupon rate and is advantageous to the issuer. A floor is a minimum on the coupon rate and is, therefore, advantageous to the bondholder. (Module 42.2, LOS 42.e)

Question 4

What effects will an increase in yield volatility have on the values of a putable bond and a callable bond?

A)
One bond will increase in value and the other will decrease.

B)
Both bonds will decrease in value.

C)
Both bonds will increase in value.

Answer 4

A

Explanation
A callable bond is made up of a straight bond and a written call option. An increase in volatility increases the value of the call option and decreases the value of the callable bond. On the other hand, a putable bond is made up of an option-free (or straight) bond and a long put option. An increase in volatility increases the value of the put option and therefore increases the value of the putable bond.

(Module 42.2, LOS 42.f)

Question 5

A covenant that requires the issuer not to let the insurance coverage lapse on assets pledged as collateral is an example of a(n):

A)
affirmative covenant.

B)
inhibiting covenant.

C)
negative covenant.

Answer 5

A

Explanation
Covenants are classified as negative or affirmative. Affirmative covenants specify administrative actions a bond issuer is required to take, such as maintaining insurance coverage on assets pledged as collateral. Negative covenants are restrictions on a bond issuer’s actions, such as preventing an issuer from selling any assets that have been pledged as collateral or pledging them again as collateral for additional debt.

Question 6

Treasury Inflation Protected Securities, which provide investors with protection against inflation by adjusting the par value and keeping the coupon rate fixed, are best described as:

A)
capital-indexed bonds.

B)
indexed-annuity bonds.

C)
interest-indexed bonds.

Answer 6

A

Explanation
Indexed bonds that adjust the principal value while keeping the coupon rate fixed are best described as capital-indexed bonds. Interest-indexed bonds adjust the coupon rate. Indexed-annuity bonds are fully amortizing with the payments adjusted.

Question 7

A bond has a par value of $5,000 and a coupon rate of 8.5% payable semi-annually. The bond is currently trading at 112.16. What is the dollar amount of the semi-annual coupon payment?

A)
$425.00.

B)
$212.50.

C)
$238.33.

Answer 7

B

Explanation
The dollar amount of the coupon payment is computed as follows:

Coupon in $ = $5,000 × 0.085 / 2 = $212.50

(Module 42.2, LOS 42.e)

Question 8

A step-up coupon bond is structured such that its coupon rate increases:

A)
if a reference interest rate increases.

B)
on a predetermined schedule.

C)
if the issuer’s credit rating decreases.

Answer 8

B

Explanation
Step-up coupon bonds feature a coupon rate that increases on a predetermined schedule. Credit linked coupon bonds have a coupon rate that changes inversely with the issuer’s credit rating. Floating-rate notes have coupon rates that are based on a reference interest rate.

(Module 42.2, LOS 42.e)

Question 9

An investor holds $100,000 (par value) worth of TIPS currently trading at par. The coupon rate of 4% is paid semiannually, and the annual inflation rate is 2.5%. What coupon payment will the investor receive at the end of the first six months?

A)
$2,000.

B)
$2,025.

C)
$2,050.

Answer 9

This coupon payment is computed as follows:

coupon payment = ($100,000 × 1.0125 ) ( 0.04/2)= $2,025

Question 10

(!)Which of the following statements about U.S. Treasury Inflation Protection Securities (TIPS) is most accurate?

A)
The inflation-adjusted principal value cannot be less than par.

B)
The coupon rate is fixed for the life of the issue.

C)
Adjustments to principal values are made annually.

Answer 10

B
Explanation
For U.S. Treasury TIPS, the coupon rate is set at a fixed rate determined via auction. The principal that serves as the basis of the coupon payment and the maturity value is adjusted semiannually. Because of the possibility of deflation, the adjusted principal value may be less than par. (However, at maturity, the Treasury redeems the bonds at the greater of the inflation-adjusted principal or the initial par value).

(Module 42.2, LOS 42.e)

Question 11

PRC International just completed a $234 million floating rate convertible bond offering. As stated in the indenture, the interest rate on the bond is the lesser of 90-day LIBOR or 10%. The indenture also requires PRC to retire $5.6 million per year with the option to retire as much as $10 million. Which of the following embedded options is most likely to benefit the investor? The:

A)
10% cap on the floating interest rate.

B)
conversion option on the convertible bonds.

C)
sinking fund provision for principal repayment.

Answer 11

B

Explanation
The conversion privilege is an option granted to the bondholder. The cap benefits the issuer. A sinking fund is not an embedded option; it is an obligation of the issuer.

Question 12

(!!) Consider $1,000,000 par value, 10-year, 6.5% coupon bonds issued on January 1, 20X5. The market rate for similar bonds is currently 5.7%. A sinking fund provision requires the company to redeem $100,000 of the principal each year. Bonds called under the terms of the sinking fund provision will be redeemed at par. A bondholder would:

A)
be indifferent between having her bonds called under the sinking fund provision or not called.

B)
prefer not to have her bonds called under the sinking fund provision.

C)
prefer to have her bonds called under the sinking fund provision.

Answer 12

B

Explanation
With the market rate currently below the coupon rate, the bonds will be trading at a premium (!) to par value (дороже чем он будет стоить в конце, тк купон больше рынка). Thus, a bondholder would prefer not to have her bonds called under the sinking fund provision.

Question 13

To reduce the cost of long-term borrowing, a corporation with a below average credit rating could:

A)
decrease credit enhancement.

B)
issue commercial paper.

C)
issue securitized bonds.

Answer 13

C
Explanation
Commercial paper is only issued by corporations with top credit ratings. Decreasing credit enhancements increase the cost of borrowing.

Question 14

In the United States, debenture is defined as:

A)
a bond secured by specific assets.

B)
a short-term debt instrument.

C)
an unsecured bond.

Answer 14

C

Explanation
In the U.S. a debenture is defined as unsecured debt. Debenture refers to a bond backed by firm assets in the United Kingdom.

Question 15

Which of the following contains the overall rights of the bondholders?

A)
Covenant.

B)
Indenture.

C)
Rights offering.

Answer 15

B

Explanation
An indenture specifies the rights of bondholders and the obligations of the issuer. Covenants are specific provisions within the indenture. A rights offering is typically associated with an equity security. (Module 42.1, LOS 42.b)

Question 16

Assuming bond yields are greater than zero, which of the following statements about zero-coupon bonds is least accurate?

A)
A zero coupon bond may sell at a premium to par when interest rates decline.

B)
All interest is earned at maturity.

C)
The lower the price, the greater the return for a given maturity.

Answer 16

A

Explanation
Zero coupon bonds always sell below their par value, or at a discount prior to maturity. The amount of the discount may change as interest rates change, but a zero coupon bond will always be priced less than par if it has a positive yield.

Question 17

An investor most concerned with reinvestment risk would be least likely to:

A)
eliminate reinvestment risk by holding a coupon bond until maturity.

B)
prefer a lower coupon bond to a higher coupon bond.

C)
prefer a noncallable bond to a callable bond.

Answer 17

A

Explanation
The key term here is coupon bond. While an investor in a fixed-coupon bond can usually eliminate interest rate risk by holding a bond until maturity, the same is not true for reinvestment risk. The receipt of periodic coupon payments exposes the investor to reinvestment risk. A noncallable bond reduces reinvestment risk by reducing the risk of repayment. Thus, an investor most concerned with reinvestment risk would prefer a noncallable bond to a callable bond. Since lower coupon bonds have lower reinvestment risk, this same investor would prefer a lower coupon bond to a higher coupon bond.

(Module 42.2, LOS 42.f)

Question 18

Allcans, an aluminum producer, needs to issue some debt to finance expansion plans, but wants to hedge its bond interest payments against fluctuations in aluminum prices. Jerrod Price, the company’s investment banker, suggests a commodity index floater. This type of bond is least likely to provide which of the following advantages?

A)
Payment structure helps protect Allcan’s credit rating.

B)
The bond’s coupon rate is linked to the price of aluminum.

C)
Allows Allcans to set coupon payments based on business results.

Answer 18

C

Explanation
The coupon rate is set in the bond agreement (indenture) and cannot be changed unilaterally. Non-interest rate indexed floaters are indexed to a commodity price such as oil or aluminum. Business results could be impacted by numerous factors other than aluminum prices.

Both of the other choices are true. By linking the coupon payments directly to the price of aluminum (meaning that when aluminum prices increase, the coupon rate increases and vice versa), the non-interest index floater allows Allcans to protect its credit rating during adverse circumstances.

(Module 42.2, LOS 42.e)

Question 19

A bond whose periodic payments are all equal is said to have a(n):

A)
bullet structure.

B)
amortizing structure.

C)
balloon structure.

Answer 19

B

Explanation
Only a fully amortizing structure features payments that are all equal. A bullet structure pays a series of equal coupons but the final coupon is paid at the same time as the bond’s principal. A final payment that includes a lump sum in addition to the last interest payment is referred to as a balloon payment.

(Module 42.2, LOS 42.e)

Question 20

As compared to an equivalent noncallable bond, a callable bond’s yield should be:

A)
higher.

B)
lower.

C)
the same.

Answer 20

A

Explanation
A callable bond favors the issuer. Hence, the value of the bond is discounted by the value of the option, which means the yield will be higher.

Question 21

A purchase of a new bond issue by a single investor is most accurately described as a(n):

A)
underwritten offering.

B)
grey market transaction.

C)
private placement.

Answer 21

С

Explanation
In a private placement, an entire bond issue is sold to a single investor or a small group of investors, rather than being offered to the public.

(Module 43.1, LOS 43.c)

Question 22

!!!
Which of the following coupon payment structures represents a leveraged inverse floater?

A)
10% – 0.75 times 180-day Libor.

B)
6% – 30-day Libor.

C)
8% – 1.5 times 90-day Libor.

Answer 22

С

Explanation
A leveraged inverse floater has a coupon that increases or decreases by more than the change in its reference rate. A deleveraged inverse floater has a coupon that increases or decreases by less than the change in its reference rate.
а) – deleveraged
b) - not leveraged –> a simple inverse floater

Question 23

The bid-ask spread for a bond most likely conveys information about:

A)
both its liquidity and its credit quality.

B)
its credit quality, but not its liquidity.

C)
its liquidity, but not its credit quality.

Answer 23

C

Explanation
Bond dealers’ bid-ask spreads depend primarily on the liquidity of an issue. Spreads are narrower for highly liquid issues and wider for less liquid issues. Credit quality and liquidity are both reflected in yield spreads.

(Module 43.1, LOS 43.d)

Question 24

TBTF Bank issues credit-linked notes (CLNs) that have 5-year debentures of Ossien Company as their reference asset. If Ossien defaults on its debentures, the CLNs will be redeemed:

A)
for less than their par value.

B)
for their par value plus a premium.

C)
immediately for their par value.

Answer 24

a

Explanation
A credit-linked note (CLN) returns less than the full principal amount at redemption if a credit event on a reference asset has occurred. A CLN returns its full principal at redemption if a credit event on a reference asset has not occurred. In effect the CLN buyer takes on the credit risk of the reference asset.

= TBTF Bank выпускает кредит и одновременно продает a credit default swap (CDS) – 5-year debentures of Ossien Company.
суть CLN: CDS добавляет премиум к купонам. но если происходит дефолт – CLN не может выплатить полную сумму

Question 25

Which of the following statements about debt securities is least accurate?

A)
A medium-term note (MTN) is a corporate bond with an original maturity of 2 to 10 years.

B)
A securitized bond is a security whose cash flows are linked to a pool of underlying loans or financial instruments.

C)
Commercial paper is a short-term vehicle for corporate borrowing.

Answer 25

А

Explanation
The name “medium-term note” does not imply anything about the original maturity of the security.

(Module 43.2, LOS 43.g)

Question 26

The interest rate on excess reserves borrowed by one bank from another bank is most accurately described as a(n):

A)
central bank funds rate.

B)
interbank lending rate.
C)
reserve swap rate.

Answer 26

а

Explanation
Required reserves are deposits with a country’s central bank. Banks that deposit more than the required amount with the central bank are said to have excess reserves and may lend these to other banks. This lending is said to take place in the central bank funds market and the interest rates on such loans are known as central bank funds rates.

Question 27

!!A bond is quoted at 96.25 bid and 96.75 ask. Based only on this information, this bond is most likely:

A)
a corporate bond.

B)
non-investment grade.

C)
relatively illiquid.

Answer 27

с

Explanation
The spread between the bid and ask prices is one-half percent of par, which most likely reflects an illiquid market for this bond. Bonds with liquid secondary markets typically have bid-ask spreads of approximately 10 to 12 basis point

Question 28

Compared to a term repurchase agreement, an overnight repurchase agreement is most likely to have a:

A)
higher repo rate and repo margin.

B)
lower repo rate and higher repo margin.

C)
lower repo rate and repo margin.

Answer 28

С

Explanation
Both the repo rate and the repo margin tend to be higher for longer repo terms. Therefore an overnight repo should have a lower repo rate and a lower repo margin than a term (i.e., longer than overnight) rep

Question 29

Which type of issuer is most likely to issue bonds by auction?

A)
Corporate.

B)
Municipal.

C)
Sovereign.

Answer 29

С

Explanation
Many national governments use auctions to issue sovereign bonds. Corporate bonds are typically issued in an underwriting or private placement process while municipal bonds are typically issued in a negotiated or underwritten process.

Question 30

Medium-term notes (MTNs) most likely:

A)
have maturities between 2 and 10 years.

B)
are sold through an underwritten offering.

C)
have less liquidity than long-term bonds of the same issuer.

Question 31

Settlement for corporate bond trades is most likely to happen on what basis?

A)
Cash settlement.

B)
Trade date + 1 day.

C)
Trade date + 3 days.

Answer 31

c

Trade date + 1 day. – government bonds

Question 32

The interbank funds market is most accurately described as:

A)
banks’ borrowing of reserves from the central bank.

B)
trading of negotiable certificates of deposit.

C)
unsecured short-term loans from one bank to another.

Answer 32

c

Explanation
The interbank funds market refers to short-term unsecured loans between banks. It does not refer to trading of negotiable certificates of deposit. Borrowing from the central bank is said to occur in the central bank funds market.

Question 33

A repurchase agreement is described as a “reverse repo” if:

A)
a bond dealer is the lender.

B)
collateral is delivered to the lender and returned to the borrower.

C)
the repurchase price is lower than the sale price.

Answer 33

a

Explanation
Bond dealers frequently use repurchase agreements as sources of funding. When a bond dealer enters a repo as the lender instead of the borrower, the agreement is referred to as a reverse repo.