Lesson 2.3: Corporate and Treasury Debt Securities

Question 1

What two investments would offer your clients the best chance of minimizing inflation risk?

Answer 1

**Common stock & TIPS (Treasury Inflation-Protected Securities) **

Historically, common stock has been the best hedge against inflation. TIPS (Treasury Inflation-Protected Securities) are government-guaranteed debt issues that automatically adjust the principal based upon the inflation rate.

Question 2

The longest initial maturity for U.S. T-bills is:

(might be called the 13-week or 3-month bill on the exam)

Answer 2

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.

All Treasury securities are issued in book-entry form. Treasury bills are always issued at a discount and are never callable.

Question 3

Regarding corporate debentures:

Answer 3

They are certificates of indebtedness. & They are unsecured bonds issued to finance capital expenditures or to raise working capital.

Question 4

Government National Mortgage Association (GNMA) securities (AKA: Ginnie Mae):

Answer 4

Interest is subject to federal income tax. & They are backed by residential mortgages.

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.

Only Ginnie Mae securities are backed by the full faith and credit of the U.S. government. Other agency securities have lines of credit at the Treasury, but this credit does not constitute a full guarantee.

Question 5

The following debt instruments pay interest semiannually:

Answer 5

I. municipal revenue bonds.
II. industrial development bonds.
III. municipal general obligation bonds.

Question 6

Ginnie Mae (GNMA) pass-through certificates.

Answer 6

Ginnie Maes pay interest monthly, not semiannually. (key point)

I. they are backed by the U.S. government.
II. interest on GNMAs is not exempt from state and local taxes.
III. they provide funds for residential mortgages.

GNMA securities, which are backed by the full faith and credit of the U.S. government, are considered to be the safest, not riskiest, of the agency issues. The minimum denomination is $1,000 and payments to investors are made monthly. Because the asset is a pool of mortgages, just like a personal home mortgage, each payment consists of interest and principal.

Question 7

A mortgage-backed security (MBS), such as a Ginnie Mae, makes a combination principal and interest payment to an investor. This payment will be:

Answer 7

partly taxed as ordinary income and partly a tax-free return of principal.

All interest payments made on a mortgage-backed security (MBS) are taxed as ordinary income. MBSs may make principal and interest payments to investors, which are partly taxed as ordinary income and partly tax-free returns of principal.

Question 8

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?

Answer 8

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.

Question 9

Debentures

Answer 9

Debentures are unsecured corporate debt obligations.

Is an unsecured long-term debt security issued by a corporation.

A debenture is a long-term debt security issued by a corporation with no specific asset pledged as security for the loan.

Debentures are corporate long-term debt securities issued on the general credit of the corporation and are not backed by any specific assets. The term prior lien means there is a secured claim against a specific asset. Preferred stock is not a debt security, and general obligation bonds are municipal, not corporate, securities.

Question 10

One of the types of security offering the greatest degree of safety to an investor is:

Answer 10

Mortage Bond

Secured debt is safer than unsecured debt. The debt obligations with pledged assets as security for the loan is a mortgage bond.

Question 11

What rate of return is used by investment professionals as the risk-free rate?

Answer 11

91-day Treasury bill 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

Question 12

A risk-averse investor, who had only invested funds in bank certificates of deposits, was informed by his investment adviser representative that higher returns with safety could be achieved by investing in U.S. Treasury notes with a 10-year maturity. The adviser representative assured the client that investment in federal government-backed securities is riskless. In this situation, the representative acted:

Answer 12

unethically because the agent failed to disclose that the customer retains interest rate risk.

Although Treasury securities do not carry default risk (principal and interest are guaranteed by the federal government), they are subject to interest rate risk. The prices of Treasury securities will decline if interest rates rise, subjecting the client to loss of principal if he sells them prior to maturity.

Question 13

All of the following are true of government agency bonds except:

A) they are direct obligations of the U.S. government.
B) older ones have coupons attached, while new ones are book-entry.
C) they are considered relatively safe investments.
D) they trade openly.

Answer 13

A) they are direct obligations of the U.S. government.

The only government agency that is a direct obligation of the U.S. government is the Ginnie Mae security. All of the others are moral obligations.

Question 14

A client has TIPS with a coupon rate of 3.5%. The inflation rate has been 4% for the last year. What is the inflation-adjusted return?

Answer 14

3.5%

Treasury Inflation-Protected Securities (TIPS) adjust the principal value each six months to account for the inflation rate. Therefore, the real rate of return will always be the coupon.

Question 15

The Straitened Corporation filed for bankruptcy. One of your clients held a mortgage secured by the corporation’s building. When the building was sold, the proceeds were less than the mortgage balance, creating a deficiency balance. Where does this investor’s claim stand?

Answer 15

As a general creditor on a pro rata basis

Secured creditors, such as those holding mortgage bonds, always have priority in a liquidation. If it happens, as in this question, that the assets securing the debt are insufficient to satisfy the claim, the balance is considered to be an unsecured debt. In that case, those bondholders are considered general creditors and share in any remaining assets proportionate to the amount of the deficiency. The Latin legal term for this is pari passu, but we don’t expect you’d see that on the exam.

Question 16

What type of risk is a mortgage-backed security most likely to experience?

Answer 16

Reinvestment risk

A mortgage-backed security, such as a Ginnie Mae, is most likely to experience reinvestment-rate risk. As mortgages are paid off early and refinanced in the event of declining interest rates, the interim cash flows received from the obligation must be reinvested in lower-yielding securities. This is the practical effect of prepayment risk.

Question 17

Securities issued by which of the following agencies offer direct government backing?

A) Federal Home Loan Mortgage Corporation (Freddie Mac)
B) Federal National Mortgage Association
C) Government National Mortgage Association
D) Federal Intermediate Credit Bank

Answer 17

C) 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.

Question 18

A respected analyst reports that last week’s T-bill rate at 6% is lower than the rate for the preceding week and lower than the average for the past month. Which means?

Answer 18

Investors are paying more for T-bills.

When the rate is lower, the price has gone up; this means investors are paying more as interest rates are going down. There is nothing in this question that gives us enough information to evaluate the movement of stock prices.

Question 19

Which U.S. government securities do not bear a stated interest rate but are sold at a discount through weekly auctions?

Answer 19

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.

Question 20

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:

Answer 20

typically carry higher returns than Treasury issues because of the lack of direct government backing.

Agencies, with only a 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.

Question 21

Bright-Lite Incandescent Bulb, Inc., recently suffered significant operating losses and is planning a bankruptcy filing. Which of the following debt issues have the most junior claim?

A) Common stock
B) Mortgage bonds
C) Debentures
D) Senior notes

Answer 21

C) Debentures

Although the most junior claim of all is that of the common stockholder (equity), this question is about the priority of debt issues. In that case, the most junior (last in line) of the creditors are the holders of the company’s debentures.