Series 7 STC Fundamentals of Debt (Ch. 5)

Question 1

A customer purchased a corporate bond at a 8.64 basis. If the basis has increased by 50 basis points, this means that:

The bond’s price has increased by 50%

The bond’s yield is now 9.14%

The bond’s yield is now 58.64%

Interest rates have decreased

Answer 1

The bond’s yield is now 9.14%

One basis point equals .01% or 1/100th of one percent. Another way to state the relationship is that in every 1% there are 100 basis points. Certain bonds are quoted and traded in terms of their yield. A bond with an 8.64 basis refers to one that’s trading at a price which provides the holder with a yield-to-maturity (YTM) of 8.64%. An increase of 50 basis points means that the bond is now trading at a 9.14 basis (8.64 + 0.50). This also indicates that interest rates have been increasing.

Question 2

When interest rates are fluctuating, which of the following statements is TRUE regarding the movement of short-term rates compared to long-term rates?

There’s no relationship between the fluctuations in long-term and short-term interest rates.

Long-term rates fluctuate more sharply than short-term interest rates.

Neither long nor short-term interest rates change.

Long-term rates change less sharply than short-term interest rates.

Answer 2

Long-term rates change less sharply than short-term interest rates.

When interest rates are fluctuating, short-term rates will fluctuate more sharply than long-term rates. However, in terms of prices, when interest rates are fluctuating, long-term bond prices are affected more than short-term bond prices.

Question 3

A corporate bond is trading at a price of 92. The bond’s coupon rate is 7% and it makes interest payments on January 1 and July 1. If the bond is purchased on Monday, September 19, for regular-way settlement, what’s the total purchase price of the bond?

$920

$15.36

$904.64

$935.36

Answer 3

$935.36

The total purchase price for the bond is the quoted price of 92, or 92% of par, plus the accrued interest. Since the bond was purchased on Monday, September 19, it will settle on Tuesday, September 20 (i.e., T + 1). Accrued interest is based on the number of days that have elapsed since the last interest payment, but doesn’t include the settlement date. Since the last interest payment was made on July 1, the investor will have 79 days of accrued interest (30 days in July + 30 days in August + 19 days in September). The total accrued interest is $15.36 ($70 interest payment x 79 days accrued interest ÷ 360 days in year). Therefore, the bond’s total purchase price is $935.36 ($920 bond price + $15.36 accrued interest).

Question 3

An investor is seeking to profit on falling interest rates and purchases a 30-year, 7% corporate bond at 130. Five years later, interest rates have risen and the investor decides to sell the bond for 108. What’s the investor’s taxable capital gain or loss on the trade?

$22 loss

$170 loss

$2,200 gain

$170 gain

Answer 3

$170 loss

Corporate bonds that are purchased at a premium (e.g., 130, or $1,300) must be amortized down to par value over the life of the bond. Since this bond has 30 years until maturity, the bond will be amortized by $10 each year ($1,300 purchase price - $1,000 par = $300 premium; $300 premium ÷ 30 years = $10 per year). The amortization will reduce the cost basis every year, thereby bringing the basis to par at maturity. After five years, the adjusted cost basis is $1,250 ($10 per year amortization x 5 years = $50 total amortization; $1,300 purchase price - $50 amortization = $1,250 adjusted basis). Since the bond was sold at 108, or $1,080, the investor will have a $170 loss ($1,080 sales proceeds - $1,250 cost basis = $170 loss).

Question 4

A bond is selling at a discount and yields have remained constant. As the bond gets closer to its maturity, what happens to its price?

It increases

It decreases

It remains the same

It will experience significant price changes

Answer 4

It increases

Although fixed income securities are subject to interest rate risk, that risk is of less concern if the security is being held to maturity and interest rates are not changing. If it’s assumed that there’s little risk of default by the issuer, the price of a bond that’s selling at a discount will increase and move toward par value as it gets closer to its maturity.

Question 4

Which of the following securities has the LEAST amount of capital risk?

Options

Bonds

Warrants

Stocks

Answer 4

Bonds

Capital risk is the risk of an investor losing her principal (i.e., the funds being invested in a security). When compared to the other securities, bonds have the least amount of capital risk. Bondholders receive the issuer’s promise that, at maturity, they will receive the principal amount of the bond, thereby minimizing the capital risk.

Question 5

If a municipal bond has a basis of 4.35 and a coupon rate of 4.95%, the bond is selling at:

A discount

Par value

A premium

A price that cannot be determined from the information given

Answer 5

A premium

Municipal bonds may be quoted on a yield-to-maturity basis, which is 4.35% in this example. Since the bond’s yield-to-maturity of 4.35% is lower than its nominal yield (coupon rate) of 4.95%, the bond is selling at a premium price above the par value of $1,000. On the other hand, if the yield-to-maturity was higher than the nominal yield, then the bond would be selling at a discount.

Question 6

Which of the following is NOT a type of call provision that’s established in a bond indenture?

Lottery call

In-whole call

Catastrophe call

Statutory call

Answer 6

Statutory Call

Callable bonds may be called in several different ways. In-whole calls occur when all of the bonds are called at the same time. If only a portion of the bonds are being called, it’s referred to as a partial or lottery call since a lottery is used to determine which bonds will be called. Catastrophe calls are used if the underlying collateral for a bond is destroyed. Statutory calls are not a type of call provision.

Question 7

Which of the following bonds will generally have the LOWEST interest rate?

A five-year bond with an AA- rating

A 20-year bond with an AA- rating

A five-year bond with an A+ rating

A 20-year bond with an A+ rating

Answer 7

A five-year bond with an AA- rating

Due to their lower credit risk, short-term bonds will generally have lower interest rates than long-term bonds. It’s much less likely that a company will default in a short time frame. Similarly, bonds with higher credit ratings are safer and have lower interest rates. The shortest term bonds with the highest credit ratings will pay the least amount of interest.

Question 8

If a bond has a basis of 6.26 and a coupon rate of 4.25%. In this case, the bond is selling at:

A price that cannot be determined from the information given

Par value

A discount

A premium

Answer 8

A discount

Since the bond has a yield-to-maturity (basis) of 6.26%, which is higher than the 4.25% nominal yield (coupon rate), the bond is selling at a price that is below the par value of $1,000 (i.e., at a discount). On the other hand, if the yield-to-maturity was lower than the nominal yield, then the bond would be selling at a premium.

Question 8

A Treasury note has a three-year maturity, a 3% coupon rate, $1,000 par value, and it pays semiannual interest on May 1 and November 1. If the bond was sold in the secondary market on Monday, February 7th, how many days of accrued interest does the buyer owe the seller?

97 days

98 days

99 days

100 days

Answer 8

99 days

Interest begins to accrue on the last interest payment date and is counted up to, but not including, the settlement date. The last interest payment was November 1 and Treasuries use actual days in each calendar month, rather than a 30-day month like corporate and municipal bonds. In addition, Treasuries settle in one business day (i.e., T+1); therefore, this bond trade settles on Tuesday, February 8. Ultimately, this means there are 99 days of accrued interest (30 days for November + 31 days for December + 31 days for January + 7 days for February).

Question 10

If a bond’s annual interest payment is divided by its current market price, the result is:

The bond’s current yield

The tax equivalent yield

The bond’s accretion

The bond’s yield-to-maturity

Answer 10

The bond’s current yield

Question 10

XYZ Corporation has recently issued $50 million of 20-year bonds. When the bonds were issued, the coupon rate was set at 5%. Each bond in the issue has a $1,000 par value and the bonds are callable in five years at 104. If an investor owns one bond and holds it to maturity, what will the investor receive at maturity?

$1,000

$1,025

$1,050

$1,040

Answer 10

$1,025

At maturity, the holder of the bonds will receive the par value of $1,000, plus the final interest payment. This bond will pay 5%, or $50, per year. However, since bonds pay interest semiannually, this 5% bond will pay two $25 payments each year. This means that the bond’s final payment will be $1,025 ($1,000 par + $25 interest payment). The call price is only paid if the bond is called prior to maturity.

Question 10

What’s the dollar value of a $10,000 par value bond that’s trading at 103 3/8?

$10,337.50

$1,033.75

$103,180

$1,031.80

Answer 10

$10,337.50

Corporate and municipal bonds are quoted as a percentage of par value and the minimum pricing increment is 1/8th of 1%. A bond trading at 103 3/8 is valued at 103.375% of par, which equals $1,033.75. Therefore, for a $10,000 par value bond, this equates to $10,337.50 (103.375% x 10,000).

Question 11

For tax purposes, what’s the annual amortization for a 10-year, 4.75% corporate bond that was purchased at 120?

$0

$2

$20

$200

Answer 11

$20

Corporate bonds that are purchased at a premium (e.g., 120, or $1,200) must be amortized down to par value over the life of the bond. Since this bond has 10 years until maturity, the bond will be amortized by $20 each year ($1,200 purchase price - $1,000 par = $200 premium; $200 premium ÷ 10 years = $20 per year).

Question 12

What’s the current yield of a bond that pays $45 in semiannual interest and is trading at 101 1/2?

4.5%

9%

8.87%

4.43%

Answer 12

8.87%

The formula for calculating a bond’s current yield is the annual interest payment divided by the current market price of the bond. This question provides the semiannual interest; therefore, the annual interest payment is $90 ($45 semiannual x 2). Since the current price is $1,015 (i.e., 101 1/2), the current yield is 8.87% ($90 ÷ $1,015 = 0.0887 or 8.87%).

Question 12

A corporation’s stock listed on a national exchange and the corporation is in the process of issuing bonds. The bond offering will be structured as a term issue and all of the bonds will mature in three years. The dated date of the offering will be May 20th and the interest payment dates are October 1 and April 1. Based on the offering date and interest payment dates, the initial interest payment is:

A long coupon

An accrued interest payment

Based on actual days in each month and 365 days in the year

A short coupon

Answer 12

A short coupon

The dated date of a bond offering is the date from which interest begins to accrue. If the dated date doesn’t fall on one of the interest payment dates, the first coupon on a newly issued bond may be for more or less than the traditional six-month period. If the first coupon is for more than six months, it’s referred to as a long coupon. However, in this question, the first coupon is for less than six months (i.e., from May 20 to October 1) and is referred to as a short coupon.

Question 13

An investor recently purchased a 3%, five-year corporate bond at 110. If the investor sells the bond in two years for 109, what’s the investor’s capital gain or loss for tax purposes?

$10 gain

$100 loss

$10 loss

$30 gain

Answer 13

$30 gain

Corporate bonds that are purchased at a premium (e.g., 110, or $1,100) must be amortized down to par value over the life of the bond. Since this investor’s bond has five years until maturity, the bond will be amortized by $20 each year ($1,100 purchase price - $1,000 par = $100 premium; $100 premium ÷ 5 years = $20 per year). Each year, the investor can deduct the $20 amortization against the bond’s interest income. If the investor sold the bond after two years, the bond’s cost basis will be $1,060 ($1,100 purchase - year one amortization of $20 - year two amortization of $20). If the bond was sold at 109, or $1,090, the investor would have a $30 gain ($1,090 sales proceeds - $1,060 cost basis).

Question 13

On Tuesday, August 10, to supplement his other retirement income, a retired investor purchased an ABC Corporation 10-year non-callable bond that had a $1,000 par value and a 4% coupon. The bond pays interest every May 1 and November 1. At the time of the purchase, the investor paid $11.11 in accrued interest. How much taxable income will the investor report for the purchase year?

$20

$40

$31.11

$8.89

Answer 13

$8.89

Since the investor bought the bond after May 1, he would only receive the $20 interest payment in November. However, since he only owned the bond from August to November, he was not entitled to the full six months between interest payments. The seller (not the buyer) of the bond would pay taxes on the accrued interest that was earned from May through when the bond was sold. The buyer of the bond would only need to pay taxes on the semiannual payment minus what he paid in accrued interest. In this question, the buyer had to pay taxes on $8.89 of interest ($20 semiannual payment - $11.11 accrued interest).

Question 14

An investor purchased a seven-year ABC Corporation zero-coupon bond for $300. If the investor holds the bond to maturity and receives the $1,000 par value of the bond, what’s the capital gain or loss for tax purposes?

$300 gain

$10 gain

No gain or loss

$300 loss

Answer 14

No gain or loss

Corporate zero-coupon bonds must be accreted each year to bring the cost basis up to par by maturity. Since this bond was purchased at a discounted price of $300, the $700 difference ($1,000 par - $300 purchase price) must be accreted over the bond’s life. Because the bond has seven years to maturity, the annual accretion is $100 ($700 growth ÷ 7 years). If the bond is held to maturity, the accretion will bring the cost basis up to par and the investor will have no capital gain or losses for tax purposes. Each year that an investor owns a zero-coupon bond, the accretion is taxed as interest income.

Question 15

A bond issue that matures on the same date is referred to as a: Term bond Sinking fund bond Serial bond Zero-coupon bond

Answer 15

Term bond If all of the bonds of an offering are due to mature on the same date, it’s referred to as a term bond issue. Bonds with staggered maturity dates are referred to as serial bonds. Term bonds can be tougher to pay since the issuer needs to pay par value to all of the bondholders on the same date. Serial issues often have a level debt service since the par value is paid over several maturity dates.

Question 16

Sinking funds are used for ______ bonds

Answer 16

Term

Question 16

What's the dated date of a bond? The date from which interest begins to accrue for a new bond The date on which a bond trade settles The date on which a bond matures and the bondholder receives par value The date on which an issuer defaults

Answer 16

The date from which interest begins to accrue for a new bond The dated date is the date from which interest begins to accrue on a new bond. In other words, it's like the date of birth for a bond. The settlement date is the date on which a bond trade settles, while the maturity date is the date on which a bond matures.

Question 17

For the issuer, all of the following are benefits of prerefunding a bond issue, EXCEPT: The elimination of restrictions (defeasance) Paying less in debt service The ability to call the bonds immediately An increase in the bond's rating

Answer 17

The ability to call the bonds immediately Prerefunding a bond allows an issuer to lock in a lower interest rate before a bond's call protection has expired. Although the issuer cannot call the bonds immediately, it does give the issuer a lower debt service (i.e., interest and principal). For a prerefunded bond, since the money is put in escrow and invested in Treasuries, the bonds typically receive the highest credit rating (i.e., AAA or Aaa).

Question 17

T/F. Prerefunding a bond allows an issuer to lock in a lower interest rate before a bond's call protection has expired. Although the issuer cannot call the bonds immediately, it does give the issuer a lower debt service (i.e., interest and principal). For a prerefunded bond, since the money is put in escrow and invested in Treasuries, the bonds typically receive the highest credit rating (i.e., AAA or Aaa).

Answer 17

True

Question 18

Four municipal bonds are maturing in 2050 and are all selling at a 7.00 basis. Which of the following bonds is MOST likely to be refunded? 5 1/2% callable in 2040 at 103 6 1/2% callable in 2041 at 100 7% callable in 2040 at 103 7 1/2% callable in 2041 at 100

Answer 18

7 1/2% callable in 2041 at 100 The most common reason for a municipality to refund an outstanding issue is to save interest costs. If a municipality can borrow money at a lower rate than the outstanding issue, it can use this money to refund the outstanding issue and thereby save on interest cost. The bonds are selling at a 7.00% yield, which means that the municipality can expect to issue new bonds with a 7.00% interest rate. Since the municipality can only save money by refunding an issue with a higher interest rate, it will refund the 7 1/2% bonds.

Question 18

A retired investor has a portfolio of fixed-income securities and is using the interest from it to supplement income he receives from Social Security. One of the investor's corporate bonds was purchased for 104 and had a two-year maturity. What's the investor's taxable capital gain or loss if the bond is held until maturity? No gain or loss $40 gain $40 loss $20 loss

Answer 18

No gain or loss Corporate bonds that are purchased at a premium (e.g., 104, or $1,040) must be amortized down to par value over the life of the bond. Since this bond has two years until maturity, the bond will be amortized by $20 each year ($1,040 purchase price - $1,000 par = $40 premium; $40 premium ÷ 2 years = $20 per year). The amortization will reduce the cost basis every year, thereby bringing the basis to par at maturity. This means there will be no gain or loss if the bond is held to maturity ($1,000 par - $1,000 adjusted cost basis = $0 gain/loss).

Question 18

MLM Corporation has issued $20 million of bonds that mature in five years. The bonds have a 5% interest rate, are priced at 98 1/4, and are offered at a basis of 5.40. If an investor buys $5,000 of MLM's bonds, what's his return if the bonds are held to maturity? 5% 5.09% 5.4% 1.75%

Answer 18

5.4% The basis of a bond is synonymous with its yield-to-maturity. If a bond's basis is 5.40, the yield that will be earned if an investor holds the bonds to maturity is 5.40%. The yield that falls between the 5% nominal yield and the 5.40% yield-to-maturity is the current yield. The formula for calculating a bond's current yield is annual interest divided by the current market price. This bond's current yield is 5.09% ($50 interest ÷ $980.25 price). Notice that, since the bond is trading at a discount, the current yield of 5.09% falls between the nominal yield of 5% and the yield-to-maturity of 5.40%.

Question 18

A 20-year bond has a coupon rate of 4.3% and has eight years of call protection from the issuance. If the bond's yield-to maturity is 5.23%, the bond is trading at: Par value 5.23% more than par value A premium to par A discount to par

Answer 18

A discount to par A bond's yield is inversely related to its price. Since this bond's yield-to-maturity (5.23%) has increased above its interest rate (4.3%), the bond's price must have fallen (i.e., it's trading at a discount).

Question 18

When comparing bonds that are rated Aaa to bonds that are rated Baa each of which have similar maturities and coupon rates, the higher rated bonds will normally have which of the following? Lower coupon payments Higher yields Higher default risk Lower market prices

Answer 18

Lower coupon payments Higher rated bonds have less default risk, higher market prices, and lower coupon payments. On the other hand, low rated bonds tend to have higher yields because investors demand a higher return for the increased credit risk. Ultimately, investors will pay more for bonds that have lower risk (i.e., higher ratings).

Question 19

Higher rated bonds have _____ (higher/lower) coupon rates

Answer 19

Lower

Question 20

A customer buys bonds with a $50,000 par value at 85 1/2 per bond. The bonds are callable at 110. If the customer holds the bonds to maturity, he will receive: $42750 $50,000 $55,000 $85,500

Answer 20

$50,000 At maturity, the holder of the bonds will receive the par value, which is $50,000 in this example. The call price and market value are both irrelevant.

Question 21

A customer of a broker-dealer bought $50,000 worth of LMN Corporation bonds with a 7.25% interest rate at paid 98 1/4 per bond. The bonds will mature in 15 years and are callable in four years at par. What yield will be included on the customer's trade confirmation? Nominal yield Yield-to-call Current yield Yield-to-maturity

Answer 21

Yield-to-maturity Bond trade confirmations must disclose the lower of the yield-to-maturity or yield-to-call. For bonds trading at a discount (e.g., 98 1/4), the yield-to-maturity will be lower. Generally, the yield-to-call will be lower for a bond that's trading at a premium.

Question 22

Bond trade confirmations must disclose the _______ (higher/lower) of the yield-to-maturity or yield-to-call.

Answer 22

Lower

Question 23

If a municipal bond has a basis of 6.35 and a coupon rate of 6.15%, the bond is selling at: A discount Par value A premium A price that cannot be determined from the information given

Answer 23

A discount Municipal bonds may be quoted on a yield-to-maturity basis, which is 6.35% in this example. Since the bond's yield-to-maturity of 6.35% is higher than its nominal yield (coupon rate) of 6.15%, the bond is selling at a discounted price below the par value of $1,000. On the other hand, if the yield-to-maturity was lower than the nominal yield, then the bond would be selling at a premium.

Question 24

An investor recently purchased a 3%, five-year corporate bond at 110. What's the bond's cost basis for tax purposes on its maturity date? $1,100 $20 $1,000 $0

Answer 24

$1,000 Corporate bonds that are purchased at a premium (e.g., 110, or $1,100) must be amortized down to par value over the life of the bond. Since this investor's bond has five years until maturity, the bond's basis will be amortized by $20 per year ($1,100 purchase price - $1,000 par = $100 premium; $100 premium ÷ 5 years = $20 per year). Each year, the investor can deduct the $20 amortization against the bond's $30 of interest income, thereby reducing the taxes on the bond's interest payments. However, the annual amortization reduces the bond's cost basis. At maturity, the cost basis will be reduced to the par value and the investor will have no gain or loss.

Question 24

A customer buys a 6 3/4% municipal bond at 101 3/4. The bond's yield-to-maturity is: 6 3/4% Less than 6 3/4% More than 6 3/4% Par plus 1 3/4%

Answer 24

Less than 6 3/4% The customer bought the bond at 101 3/4, which is at a premium over the $1,000 par value of the bond. If she holds the bond to maturity, her yield will be less than 6 3/4% because a bond that's purchased at a premium will have a yield-to-maturity that's less than the coupon rate of 6 3/4%.

Question 25

A corporation has issued a 4% bond, but its yield is currently 3.82%. The bond is trading at: A discount A premium At par At parity

Answer 25

A premium Bond prices and yields are inversely related. Since the yield (yield-to-maturity) has fallen below the bond's interest rate, the bond is trading above par value (i.e., at a premium). If the bond's price had fallen below par, the yield (yield-to-maturity) would be higher than the bond's interest rate.

Question 25

A bond trader purchased five bonds for 105 and they mature in 20 years. If the bonds are sold after 10 years for 103, the trader has: A $20 capital loss A $100 capital loss A $25 capital gain A $5 capital gain Bonds that are purchased at a premium must be amortized each year to reduce the cost basis to par value at maturity. A bond that's purchased at $1,050 (105) has a $50 premium and, over 20 years, it must be amortized by $2.50 per year ($50 premium ÷ 20 years = $2.50). After 10 years, the bond's cost basis will be $1,025. When the bond is sold at $1,030 (103), the trader will have a $5 gain per bond ($1,030 sales proceeds - $1,025 cost basis). it's important to note that the investor purchased five bonds; therefore, the total gain is actually $25 ($5 gain x 5 bonds).

Answer 25

A $25 capital gain Bonds that are purchased at a premium must be amortized each year to reduce the cost basis to par value at maturity. A bond that's purchased at $1,050 (105) has a $50 premium and, over 20 years, it must be amortized by $2.50 per year ($50 premium ÷ 20 years = $2.50). After 10 years, the bond's cost basis will be $1,025. When the bond is sold at $1,030 (103), the trader will have a $5 gain per bond ($1,030 sales proceeds - $1,025 cost basis). it's important to note that the investor purchased five bonds; therefore, the total gain is actually $25 ($5 gain x 5 bonds).

Question 26

A corporate bond has been purchased at a premium and is callable at par. Place the bond's yields in order from lowest to highest. Yield-to-call, yield-to-maturity, current yield, nominal yield Nominal yield, current yield, yield-to-maturity, yield-to-call Yield-to-maturity, current yield, yield-to-call, nominal yield Nominal yield, yield-to-maturity, current yield, yield-to-call

Answer 26

Yield-to-call, yield-to-maturity, current yield, nominal yield If a bond is trading above at a premium (above par), the yield-to-call will be the lowest yield, followed by the yield-to-maturity, and then the current yield. For premium bonds, the nominal yield will be the highest yield since market interest rates have fallen below the bond's nominal yield.

Question 26

If a bond is currently selling at a discount, then: The current yield is equal to the nominal yield The current yield is lower than the nominal yield Interest rates are currently lower than when the bond was originally issued The current yield is higher than the nominal yield

Answer 26

The current yield is higher than the nominal yield Bond yields and prices have an inverse (opposite) relationship, which means that as one increases, the other decreases. If a bond is selling at a discount (below par), its current yield is higher than its nominal yield. For example, an investor owns an 8% bond that's trading at $900. The bond's nominal yield is 8% and its current yield is found by dividing the annual interest by the current market price. This bond's current yield is 8.89% ($80 ÷ $900), which is higher than its 8% nominal yield.

Question 27

Who derives the MOST benefit from a call provision being attached to a bond offering? Underwriters Common stockholders Bondholders Issuers

Answer 27

Issuers A call provision allows the issuer to buy back its bonds on a specified date (or dates) and at a preset price prior to maturity. Bonds will generally be called when interest rates fall, thereby allowing an issuer to refinance its bonds at a lower rate.

Question 28

A bond has an eight-year maturity and is currently trading for 92. If the bond's yield-to-maturity is 8.92%, what's the bond's interest rate? 8.92% 9.7% 7.9% 10%

Answer 28

7.9% Since the bond is trading at a discount (92, or $920), the yield-to-maturity has risen above the bond's interest rate. Because the discount bond's yield-to-maturity is 8.92%, the interest rate must be lower than 8.92%. As a result, the only possible answer is 7.90%.

Question 29

The annual accretion on a corporate zero-coupon bond: Increases the bond's cost basis and is taxable at the investor's ordinary income rate Increases the bond's costs basis, but is considered tax-free interest income Doesn't change the bond's cost basis, but is taxable at the long-term capital gains rate Decreases the bond's cost basis and is taxable at the investor's ordinary income rate

Answer 29

Increases the bond's cost basis and is taxable at the investor's ordinary income rate Corporate zero-coupon bonds don't pay regular interest; instead, the bonds are sold at a large discount and pay par value at maturity. For tax purposes, the bond's value will be accreted (increased) every year and the accreted amount is considered interest income. Investors must pay taxes on the accreted value as if they had received it in cash. Since investors pay taxes each year, the bond's cost basis will increase each year by the accreted amount.

Question 29

What's the annual taxable accretion for a five-year corporate zero-coupon bond that was purchased for $600? $120 $80 $0 $200

Answer 29

$80 Corporate zero-coupon bonds must be accreted each year to bring the cost basis up to par by maturity. Since this bond was purchased at a discounted price of $600, the $400 difference ($1,000 par - $600 purchase price) must be accreted over the bond's life. Because the bond has five years to maturity, the annual accretion is $80 ($400 growth ÷ 5 years).

Question 29

All of the following terms are used to find the amount of interest a bond pays, EXCEPT: Nominal yield Current yield Interest rate Coupon rate

Answer 29

Current Yield The amount of interest that a bond pays is based on the interest rate multiplied by the bond's par value, which is often $1,000. The interest rate is also referred to as the coupon rate or nominal yield. However, the current yield of a bond represents what an investor's return is based on the current price of a bond. The formula for calculating the current yield is the bond's annual interest divided by the bond's current market price.

Question 30

If interest rates are low and expected to rise, which of the following bonds will decrease the most in price? A bond maturing in 15 years which is non-callable A bond maturing in five years which is non-callable A bond maturing in 30 years which is non-callable A bond maturing in 25 years which is callable in 10 years

Answer 30

A bond maturing in 30 years which is non-callable. If interest rates are low and expected to rise, the prices of outstanding bonds will decrease. Most importantly, the longer a bond's maturity, the greater the price decrease. The non-callable bond with a 30-year maturity will typically experience the greatest price decrease due to rising interest rates.

Question 30

What's the lowest investment-grade rating given by S&P? Aaa BBB Baa BB

Answer 30

BBB S&P's investment-grade ratings are AAA, AA, A, and BBB. AAA is the highest rating, while BBB is the lowest rating of the investment-grade category. For Moody's, Aaa is the highest investment-grade rating, while Baa is Moody's lowest investment-grade rating.

Question 31

Two years ago, GHI Corporation issued a 6.25% 10-year bond. At the time of issuance, the bond's yield-to-maturity was 5.36%. In the years after the bond was issued, market rates have fallen and the yield on the GHI bond is now 4.35%. Which of the following statements is TRUE regarding GHI's bond price? The bond was originally issued at a premium, but is now trading at a discount. The bond was originally issued at a discount, but is now trading at a premium. The bond's price is unrelated to the bond's yield-to-maturity. The bond was issued at a premium and is now trading for an even larger premium.

Answer 31

The bond was issued at a premium and is now trading for an even larger premium. Bond prices and yields are inversely related. Since the bond's original yield was 5.36%, which is less than the coupon rate of 6.25%, it was originally sold at a premium. Since the yield is now 4.35% and even less than the bond's 6.25% coupon rate, the bond's price must have risen even further above par value. In other words, since the yield fell the price must have risen.

Question 32

If a bond is currently selling at par value, then: The current yield is lower than the nominal yield The current yield is equal to the nominal yield The current yield is higher than the nominal yield Interest rates are currently lower than when the bond was originally issued

Answer 32

The current yield is equal to the nominal yield

Question 33

An investor purchased a AA-rated bond at 106. The bond's interest rate is 3.5% and there are 17 years remaining until maturity. What's the bond's yield-to-maturity? 3.045% 6% 3.5% 3.3%

Answer 33

3.045% Bond yields are inversely related to bond prices. For a bond trading at a premium, the yield-to-maturity will be below the bond's coupon rate (3.5%). In this question, there are two answers that are lower than the bond's interest rate of 3.5%. To find the correct answer, the bond's current yield needs to be calculated. The formula for calculating the current yield is the bond's annual interest divided by the current market price. For this question, the current yield is 3.3% ($35 annual interest ÷ $1,060 current market price); therefore, the yield-to-maturity must be lower than that. As a result, the only answer that works is 3.045%.

Question 33

How is accrued interest calculated for municipal bonds? As determined by FINRA's rules that are outlined in the Uniform Practice Code (UPC) By using actual days per month and a 365-day year In the same way that accrued interest is calculated for U.S. Treasury bonds By using a 30-day month and a 360-day year

Answer 33

By using a 30-day month and a 360-day year For corporate and municipal bonds, accrued interest is calculated using 30 days per month and a 360-day year. On the other hand, U.S. Treasury bonds use the actual days in a month and a 365-day year.

Question 33

How can a client maximize profits from decreasing interest rates? By purchasing a laddered portfolio of bonds with different maturities By purchasing premium bonds By purchasing bonds with short-term maturities By executing periodic trades to lock in maturities

Answer 33

By purchasing bonds with short-term maturities If an investor buys bonds that have short-term maturities, this will minimize loss in principal due to fluctuating interest rates. The prices of short-term bonds will have less fluctuation in response to interest rate swings than the prices of long-term bonds. In addition, premium bonds (those priced above par) are less volatile than discount bonds (those priced below par).

Question 33

From the issuer's perspective, when comparing term bonds and serial bonds, serial bonds have: Declining interest payments and declining principal amounts Increasing interest payments and increasing principal amounts Stable interest payments and stable principal amounts Stable interest payments and declining principal payments

Answer 33

Declining interest payments and declining principal amounts Serial bonds have different maturity dates with lesser amounts of debt outstanding as time goes by. As a result, the bonds have declining interest payments and principal amounts. In comparison, term bonds mature at the same time and have stable interest payments with all of the principal paid on one maturity date.

Question 34

A corporate bond has a par value of $1,000, a market price of 93, and a coupon of 4%. What's the bond's current yield? 4.3% 4.0% 9.3% The same as the bond's basis

Answer 34

4.3% The formula for calculating a bond's current yield is Annual Interest ÷ Current Market Price. In this case, the current yield is 4.30% ($40 ÷ $930).

Question 34

If a 10-year, 6% corporate bond is trading at 108 in the secondary market, what's its yield-to-maturity? 6% 5.56% 4.97% 8%

Answer 34

4.97% Bond yield is a measure of an investor's rate of return on a bond. As bond prices rise, yields will fall below the bond's coupon rate. For that reason, a bond trading at 108 will have a current yield and yield-to-maturity that are below its interest rate of 6%. For a bond at a premium, the yield-to-maturity will fall even more than the current yield. In order to find the correct answer, calculate the current yield by dividing the annual interest by the bond's price, which is 5.56% ($60 interest ÷ $1,080 current price). Since 4.97% is the only answer that's lower than the current yield of 5.56%, it must be the correct answer. The yield-to-maturity doesn't need to be calculated for the exam.

Question 35

A corporate bond is trading at a discount and has a 10-year maturity. The bond is callable in three years at 102, and also in eight years at par value. Under FINRA regulations, which of the bond's yields will be quoted? Yield-to-maturity Yield-to-call in three years at 102 Yield-to-call in eight years at par Current yield

Answer 35

Yield-to-maturity Broker-dealers must quote the lower of the yield-to-maturity or the yield-to-call, which is referred to as quoting the "yield-to-worst.". For bonds that are priced at a discount, the yield-to-maturity will be lower than the yield-to-call and is the yield that's quoted to customers and on trade confirmations.

Question 36

A registered representative has recently advised an 80-year-old investor to buy a zero-coupon bond that matures in 25 years. The investor has an income objective and generally only invests in conservative investments. Which of the following statements is TRUE regarding the representative's recommendation? Zero-coupon bonds are generally suitable for conservative investors who are seeking income. Zero-coupon bonds are used for capital appreciation and the representative's recommendation is unsuitable. Zero-coupon bonds are only suitable when interest rates are falling and should therefore be sold when interest are rising. The recommendation is only suitable if the zero-coupon bond is AAA rated.

Answer 36

Zero-coupon bonds are used for capital appreciation and the representative's recommendation is unsuitable. Since zero-coupon bonds don't pay semi-annual interest, they're generally unsuitable for income investors. In addition, bonds with long-term maturities are unsuitable for older investors, even if the bond has a high credit rating.

Question 36

When comparing long-term bonds and short-term bonds, which of the following statements is TRUE? Long-term bonds generally have higher yields. When the general level of interest rates change, fluctuations in the dollar prices of long-term bonds are usually less than for short-term bonds. Long-term bonds generally provide greater liquidity than short-term bonds. There's more purchasing power risk with short-term bonds when compared to long-term bonds.

Answer 36

Long-term bonds generally have higher yields. Long-term bonds generally have more interest rate and purchasing power risk than short-term bonds. Investors who buying long-term bonds require higher yields to compensate for the added risks. When interest rates fluctuate, short-term bonds are generally more liquid and have less price volatility.

Question 37

What's the current yield of a bond that pays $20 in semiannual interest and is trading at 93? 2% 4% 2.15% 4.3%

Answer 37

4.3% The formula for calculating a bond's current yield is the annual interest payment divided by the current market price of the bond. This question provides the semiannual interest; therefore, the annual interest payment is $40 ($20 semiannual x 2). Since the current price is $930 (i.e., 93), the current yield is 4.30% ($40 ÷ $930 = 0.04301 or 4.30%).