Series 7 Qbank Quizzes

B)

They may be carried forward indefinitely until exhausted.

• Any taxpayer is permitted to reduce capital gains with realized capital losses. If the capital losses exceed the capital gains, up to $3,000 of the net capital loss may be deducted against taxable income. Anything in excess of that is carried forward and used against gains without limitation, or if there are no gains, taxable income, again with a $3,000 annual limit. Those losses can be carried forward with no time limit until they are all used against gains or income. Remember, the $3,000 limit applies only to the net losses that may be deducted against income; there is no limit to the amount of loss that can be netted against gains.

Which of the following is true with respect to excess capital losses realized by an individual taxpayer?

A)

They may be carried back up to three years and carried forward indefinitely until exhausted.

B)

They may be carried forward indefinitely until exhausted.

C)

They may be carried forward with a time limit of five years.

D)

No more than $3,000 per year may be used against

C)

I and III

• After a reverse split, there will be fewer shares outstanding. As a result, market price and earnings per share will increase. Overall, the market capitalization of the company will not change.

If a stock undergoes a 1-for-5 reverse split, which of the following increases?

1. Market price per share

2. Number of shares outstanding

3. Earnings per share

4. Market capitalization of the company

A)

III and IV

B)

II and III

C)

I and III

D)

I and II

A)

$0.45

• Because the stock is trading with rights (before the ex-rights date), the formula is (M ‒ S ) divided by (N + 1). Plugging the numbers in, we have ($40 ‒ $35) ÷ (10 + 1) = $5.00 ÷ 11 = $0.45.

  
  
  

XYZ Corporation, whose common stock is currently selling for $40 per share, is having a rights offering. The terms of the offering require 10 rights plus $35 to subscribe to one share of stock. Compute the theoretical value of a right before the ex-rights date.

A)

$0.45

B)

$3.50

C)

$0.55

D)

$0.50

A)

fewer shares that are each individually worth more than before the split.

An investor owns 100 shares of XYZ at $5 per share. After a 1:2 reverse split, the investor will own

A)

fewer shares that are each individually worth more than before the split.

B)

more shares that are each individually worth more than before the split.

C)

fewer shares that are each individually worth less than before the split.

D)

more shares that are each individually worth less than before the split.

A)

The investor can buy, sell, and receive dividends in U.S. dollars rather than a foreign currency.

• ADRs permit an American investor to purchase a certificate of deposit for stock (not stock itself) in a foreign company. The advantage is that the transactions are done in dollars, but the ADR itself does not carry a vote or stock rights and subjects the owner to currency risk.

  
  
  

Which of the following is an advantage of owning American depositary receipts (ADRs)?

A)

The investor can buy, sell, and receive dividends in U.S. dollars rather than a foreign currency.

B)

The investor receives preemptive rights should the issuer make an additional stock offering.

C)

The investor avoids the currency risk that characterizes many foreign investments.

D)

The investor has the right to vote at stockholders' meetings.

D)

After successful completion of the offering, the market price would rise slightly.

• Successful completion of a rights offering generally results in a slight decline in the market price of the stock. This is because the subscribers were able to purchase at a price below the current market. This would have a small dilutive effect, causing a slight reduction in the market price. The rights offering is of additional shares, so the number outstanding would increase. Most corporations use a standby underwriter who will buy any shares that were not exercised. Please note: From a test-taking skill point of view, when you have two answer choices that are the opposite of each other (the price would rise slightly or the price would decline slightly), in almost all cases, one of those two must be the correct answer.

Which of the following would least likely occur when a corporation engages in a rights offering?

A)

The number of outstanding shares would increase.

B)

After successful completion of the offering, the market price would decline slightly.

C)

The corporation would use a standby underwriter.

D)

After successful completion of the offering, the market price would rise slightly.

D)

Voting rights of preferred shareholders take precedence over those of common shareholders.

• Preferred shareholders do not generally have voting rights. Voting rights are characteristic of common stock, not preferred. Preferred stock is unlike debt securities in that it has no set maturity date. It is true that the dividend on a preferred stock is fixed, except in the case of an adjustable preferred where the dividend can be tied to a market interest rate and readjusted. The holder of a preferred stock has to sell the shares in the open market to close out her position.

Which of the following statements regarding preferred stock is not true?

A)

Because there is no set maturity value or redemption date, the holder of preferred stock has to sell her shares in the open market to close out her position.

B)

The dividend is fixed except in the case of adjustable preferred.

C)

Unlike debt, preferred stock has no set maturity date.

D)

Voting rights of preferred shareholders take precedence over those of common shareholders.

D)

whether the company should issue additional preferred stock.

• Common shareholders must vote to approve the issuance of additional preferred stock because additional preferred shares dilute the common shares' residual assets under a liquidation. Common shareholders do not vote to declare dividends. Board members select the chairman of the board. Shareholders do not get involved in the daily operational activity of the corporation.

Holders of common shares may generally vote on

A)

whether a cash dividend is to be declared.

B)

which member of the board of directors should be chairman.

C)

whether an administrative assistant should be promoted to management.

D)

whether the company should issue additional preferred stock.

C)

$3.00.

• Because the question is asking about the value on the ex-rights, it means we use the regular formula. That is, the (market price minus the subscription price) divided by the (number of rights it takes to buy one share). Plugging in the numbers gives us ($112 - $88) ÷ (8) = $24 ÷ 8 = $3.00

A corporation is having a rights offering. The terms of the offering require eight rights plus $88 to purchase one share. With the stock's current market price at $112 per share, the theoretical value of one right on the ex-rights date is

A)

$2.67.

B)

$0.30.

C)

$3.00.

D)

$0.27.

B)

They offer the holder an opportunity to purchase stock at a fixed price.

• Rights and warrants are equity securities granting the holders the ability to purchase shares of the issuer at a pre-determined price. In the case of a rights offering, the price is always below the current market price. In the case of warrants, the exercise price is always above the current market price. That means only the rights have intrinsic value when initially offered. It is the warrants that are frequently attached to a new issue to make the offering more attractive. It is only the rights where one must be a current stockholder to initially obtain them. After that, they trade in the secondary market.

Which of the following are characteristics of both stock rights and warrants?

A)

They are frequently used as a sweetener to attract purchasers to another security.

B)

They offer the holder an opportunity to purchase stock at a fixed price.

C)

When initially offered, neither one has intrinsic value.

D)

One must be a current stockholder to receive them.

A)

penny stock rules apply to both solicited and unsolicited transactions.

• The special penny stock rules only apply to solicited transactions. Because of the greater perceived risk of investing in penny stocks, it is required that the penny stock disclosure document fully describing the risks associated with penny stock investments be provided before any transactions in those securities may take place. However, a signed suitability statement (different than the risk disclosure) is not required for established customers. Statements of account activity must be provided monthly when an account holds penny stocks.

All of the following statements regarding penny stocks are true except

A)

penny stock rules apply to both solicited and unsolicited transactions.

B)

if an account holds penny stocks, broker-dealers must provide a monthly account statement to the customer.

C)

the SEC rules require that prospects, before their initial transaction in a penny stock, be given a copy of a risk disclosure document.

D)

established customers of the firm need not sign a suitability statement.

C)

100 votes for each of four individuals.

• With statutory voting, the shareholder has one vote for each share and can use those votes for each open seat on the board. Cumulative voting permits the shareholder to batch votes on a single seat. The cumulative voting method is advantageous to smaller shareholders.

MNO Corporation practices the statutory voting method. During the annual meeting, six people are running for the four available open seats on the board. An investor with 100 shares would be able to cast

A)

600 votes for one of the individuals.

B)

100 votes for each of six individuals.

C)

100 votes for each of four individuals.

D)

400 votes for one of the individuals.

D)

5 million

• This company has 10 million shares of common stock authorized. It has issued 5 million shares of which 1 million shares have been reacquired as treasury stock. That means there are 4 million shares still outstanding. The remaining 5 million are authorized but unissued. Remember that treasury stock is authorized and issued stock that is no longer outstanding.

DJX Corporation's charter has authorized 10 million shares of common stock. It has issued 5 million shares and has 1 million shares in its treasury. How many shares of DJX common stock are authorized but unissued?

A)

9 million

B)

4 million

C)

6 million

D)

5 million

C)

members must provide penny stock purchasers with quarterly statements showing the estimated market value of each penny stock purchased.

• Rule 15(g)6 requires members to provide penny stock purchasers with monthly statements showing the estimated market value of each penny stock purchased.

A penny stock is a non-Nasdaq, unlisted stock trading at less than $5 per share found on the OTC Pink Market. The SEC rules pertaining to these so designated securities are the 15(g) rules. All the following statements concerning the rules covering penny stocks are true except

A)

members must provide penny stock purchasers with a current bid and asked quote on the stock (to prevent the practice of quoting prices to customers that are away from the current market).

B)

members must provide penny stock buyers with information on the compensation to be earned by both the member and the registered representative as the result of the transaction.

C)

members must provide penny stock purchasers with quarterly statements showing the estimated market value of each penny stock purchased.

D)

customers, before their initial transaction in a penny stock, must be given a copy of the risk disclosure document. The member must receive written acknowledgment from the customer that the document has been received. Not surprisingly, the document describes penny stocks in less than flattering terms.

A)

The lower the coupon rate, the longer a bond’s duration; the higher the coupon rate, the shorter the duration.

• Generally, characteristics of duration dictate that the lower the coupon rate, the longer a bond's duration; the higher the coupon rate, the shorter the duration. The longer a bond's maturity, the longer the bond's duration. For coupon bonds, duration is always less than the bond's maturity. Duration for a zero coupon bond is always equal to its maturity.

The market price of fixed-income securities, especially bonds, is susceptible to changes in market interest rates. The term duration is used to measure the sensitivity of a debt security when interest rates change in the marketplace. Which of the following statements concerning duration is correct?

A)

The lower the coupon rate, the longer a bond’s duration; the higher the coupon rate, the shorter the duration.

B)

Duration for a zero coupon bond is rarely equal to its maturity.

C)

The higher the coupon rate, the longer a bond’s duration; the lower the coupon rate, the shorter the duration.

D)

For coupon bonds, duration is always more than the bond’s maturity.

B)

commercial paper.

• This is the definition of commercial paper, also known as promissory notes. They are short-term corporate-issued instruments sold at a discount and maturing at par.

Debt normally issued by big corporations with reliable credit ratings that seek to finance short-term needs best describes

A)

revenue anticipation notes.

B)

commercial paper.

C)

certificates of deposit.

D)

T-bills.

A)

invest in a mutual fund concentrating in foreign debt securities.

• For small investments, a mutual fund or exchange-traded fund (ETF) is usually going to be the most suitable choice. Most countries do not allow nonresident noncitizens to open local brokerage accounts, and that is a pretty impractical idea anyway. If your firm has an overseas office, it could be a source of information, but when only $2,500 is involved, purchasing individual bonds issued by a foreign nation is usually not reasonable.

  
  
  

One of your individual customers would like to add some foreign debt securities to their portfolio. When told that the investment would be $2,500, the best suggestion would be to

A)

invest in a mutual fund concentrating in foreign debt securities.

B)

use one of the overseas branches of your firm to suggest the appropriate issues.

C)

contact a broker-dealer in the foreign country of choice and open an account there.

D)

tell the customer that $2,500 is below the minimum purchase quantity of foreign bonds.

C)

Bankers’ acceptances

• Bankers' acceptances are loans guaranteed by a commercial bank that are typically used to finance international transactions. Although all of the choices are money market instruments, it is the BAs that are primarily used by those engaged in international business.

  
  
  

Which of the following money market instruments is most often used by those in the import/export business?

A)

Commercial paper

B)

Variable rate demand notes

C)

Bankers’ acceptances

D)

Negotiable CDs

C)

sovereign debt.

• The term sovereign debt applies to securities issued by national governments. U.S. Treasuries are an example of sovereign debt issued here. Other countries have their versions, such as the Gilts of the United Kingdom. These are not considered alternative investments. Alternative investments are structured products that are complex and not easy to understand. Two of the most popular structured products are the ELNs and the ETNs.

When a bond is issued by a national government, it is referred to as

A)

treasury debt.

B)

high-quality debt.

C)

sovereign debt.

D)

national debt.

D)

lower than the yield to maturity.

• When a bond is purchased at a premium ($1,020) and called for redemption, the investor's effective yield is the yield to that call date. That will be lower than the bond's yield to maturity because the premium is lost sooner.

A callable municipal bond maturing in 30 years is purchased at 102. The bond is callable at par in 15 years. If the bond is called at the first call date, the effective yield earned on the bond is

A)

not determinable.

B)

higher than the yield to maturity.

C)

the same as the yield to maturity.

D)

lower than the yield to maturity.

C)

declining.

• A corporation generally calls in its debt when interest rates are declining to replace old, higher interest rate debt with new, lower interest rate issues.

A corporation is likely to call eligible debt when interest rates are

A)

stable.

B)

rising.

C)

declining.

D)

volatile.

A)

YTC is the same as YTM.

• If a bond is trading at par, the nominal yield (coupon rate) equals current yield equals yield to maturity (YTM) equals yield to call (YTC). YTC is higher than YTM if the bond is trading at a discount to par. YTC is lower than YTM if the bond is trading at a premium over par. Nominal yield is higher than either YTM or YTC if the bond is trading at a premium over par.

A customer buys a 5% bond at par. The bond is callable in five years at par and matures in 10 years. Which of the following statements is true?

A)

YTC is the same as YTM.

B)

Nominal yield is higher than either YTM or YTC.

C)

YTC is higher than YTM.

D)

YTC is lower than YTM.

A)

7.6s of '45

• To begin with, let's be sure you understand the nomenclature used here. Each of the choices has two numbers. The first is the coupon rate of the bond and the second is the year the bond matures. For example, the 7.3s of '37 pay interest at a rate of 7.3% of the $1,000 par value per year and mature in 2037. The s is just to separate the two numbers. Interest rate risk is the loss in value due to a rise in interest rates. Because there is little difference in coupon rates, the bond with the longest maturity (highest duration) will experience the greatest fall in a rising interest rate market.

Which of the following bonds is most affected by interest rate risk?

A)

7.6s of '45

B)

7.8s of '42

C)

7.5s of '39

D)

7.3s of '37

C)

options.

• Money market instruments are short-term (one year or less to maturity) liquid debt instruments. Reverse repurchase agreements, repurchase agreements, commercial paper, CDs, and bankers' acceptances are examples. Options are not money market instruments.

All of the following are money market instruments except

A)

bankers' acceptances.

B)

reverse repurchase agreements.

C)

options.

D)

commercial paper.

A)

The bond's current yield is calculated by dividing its annual interest by its market price.

• A bond's current yield is calculated by dividing its annual interest by its current (market) price. For a premium bond the current yield will be higher than its yield to maturity, which will include the loss of the premium at maturity. The determination of a bond's yield is unrelated to other bonds. In addition, this is a premium bond, not a discount bond.

Which of the following statements regarding a $1,000 corporate 8.50% bond offered at 110 is true?

A)

The bond's current yield is calculated by dividing its annual interest by its market price.

B)

The bond's current yield is lower than its yield to maturity.

C)

The bond is a discount bond.

D)

To determine the bond's current yield, its stated rate must be compared against other fixed-rate investments in the client's portfolio.

B)

currency risk.

• Because the ultimate value of the ADR is based on the underlying stock's value in its local currency, ADRs have currency risk. Both have market risk. You may not know business or financial risk, but you should know that currency risk is part of investing in ADRs.

  
  
  

Investing in ADRs presents certain risks that do not apply to investing in domestic stocks. One specific risk that applies only to ADRs is

A)

business risk.

B)

currency risk.

C)

financial risk.

D)

market risk.

D)

$24

• If the company is going to pay a common stock dividend, it must pay the preferred dividends first. A cumulative preferred stockholder must also receive all dividends in arrears. There is $16 due in back dividends, in addition to $8 this year, for a total of $24.

A customer owns cumulative preferred stock (par value of $100) that pays an 8% dividend. The dividend has not been paid this year or for the previous two years. How much must the company pay the customer per share before it may pay dividends to the common stockholders?

A)

$0

B)

$8

C)

$16

D)

$24

B)

$20.

• Par value divided by conversion price equals the number of shares into which the security is convertible. If this security is convertible into five shares, we need to know what number goes into $100 five times. That number is $20. The current market value of the preferred stock is unnecessary information.

A convertible preferred stock issue (par value $100) is selling at $125 and is convertible into five shares of common stock. The conversion price of the common stock is

A)

$1,200.

B)

$20.

C)

$25.

D)

$100.

D)

A prior lien preferred stock

• Stock means equity. Prior lien means that this preferred has priority over other preferred stock the company has issued. The other three are alternative forms of debt financing. Do not fall into the equity-linked note trap; it is a debt security.

Which of the following would be considered an equity security?

A)

A collateralized mortgage obligation

B)

An exchange-traded note

C)

An equity-linked note

D)

A prior lien preferred stock

C)

the market price of this stock will decline.

• Because preferred stock is a fixed-income investment, its market price moves inversely to changes in interest rates. As interest rates in the market go up, the price of preferred stock goes down. The dividend rate and par value of a preferred stock is fixed at issuance and do not change. It is rare to find a preferred stock with voting powers. Even then, they would never be voting on changing the dividend rate on a preferred stock. That is one of the benefits of adjustable-rate preferred stock. Because the dividend rate adjusts in response to changes in the market interest rate, the price generally remains relatively stable. How do we know this is not adjustable-rate preferred? Because the question would have to state that fact.

Sagacious Publishing Company (SPC) has issued a $25 par 4% preferred stock. If current market interest rates should rise, it is probable that

A)

SPC will increase the dividends to match market returns.

B)

SPC will lower the par value of the stock.

C)

the market price of this stock will decline.

D)

investors holding shares of this stock will vote to increase the dividends.

C)

Convertible preferred

• Convertible preferred stock is convertible into the issuer's common stock. This conversion feature has value if the market price of the underlying stock should increase. Because of that feature, issuers are able to attract investor interest with a lower dividend on this preferred stock compared with preferred stock that has no conversion feature. Therefore, it would be the least suitable investment for this client.

A registered representative has a customer looking to invest in stock for income. The customer is looking for the highest fixed rate of return available based on her risk profile. Which of the following would be least suitable?

A)

Callable preferred

B)

Cumulative preferred

C)

Convertible preferred

D)

Straight preferred

D)

I and IV

• Negotiable CDs are issued primarily by banks and backed by the issuing bank. They are issued at face value, and the minimum denomination is $100,000. These are sometimes referred to as jumbo CDs.

Which of the following statements regarding negotiable certificates of deposit (CDs) are true?

1. The issuing bank guarantees them.

2. They are issued at a discount.

3. Minimum denominations are $1,000.

4. They are traded in the secondary market.

A)

I and III

B)

II and III

C)

II and IV

D)

I and IV

C)

greater than 7.90%.

• The bid and asked prices show that the Treasury bond is being quoted at a premium (above par), with a yield to maturity of 7.9%. When bonds are trading at a premium, the nominal yield (coupon rate) is greater than the yield to maturity.

A Treasury bond is quoted in The Wall Street Journal as follows:

• Bid 100:15

• Asked 100:17

• Bid Chg. -1

• Yield 7.9

From this information, you know that the nominal yield is

A)

less than 7.90%.

B)

7.89%.

C)

greater than 7.90%.

D)

7.90%.

D)

the current yield will always be higher than the yield to maturity.

• When a bond is selling at a premium, all of the yields are lower than the nominal (coupon) yield. The sequence in descending order of yield is NY, CY, YTM, YTC.

When a bond is selling at a premium

A)

the nominal yield will always be lower than the yield to call.

B)

the yield maturity will always be higher than the nominal yield.

C)

the current yield will always be higher than the nominal yield.

D)

the current yield will always be higher than the yield to maturity.

B)

rights offering.

• When new shares are being offered to existing shareholders before the general public, it is done under the terms of a rights offering.

  
  
  

A corporate offering of 1 million additional shares to existing shareholders is a

A)

tender offer.

B)

rights offering.

C)

shelf offering.

D)

secondary offering.

C)

Income bond, convertible bond, nonconvertible bond

• The income (or adjustment) bond is the least suitable because it is issued by companies coming out of bankruptcy with interest payable only if the money is available. Therefore, it is not suitable given the objective. A convertible bond has a lower coupon than a nonconvertible bond because of the convertibility feature. Therefore, if seeking to maximize income, the corporate bond would be the most suitable of the three choices (from least to most: income bond, convertible bond, and nonconvertible bond).

An investor wants to maximize income using debt securities. Which of the following lists rank securities from the least suitable to the most suitable recommendation if income is the investment objective?

A)

Treasury bills, convertible bond, income bond

B)

Nonconvertible bond, convertible bond, income bond

C)

Income bond, convertible bond, nonconvertible bond

D)

Convertible bond, income bond, nonconvertible bond

D)

receive his loaned money before any of the equity investors in the company.

• It is not uncommon for founders of companies to lend money to the business to keep the company going. However, this is typically subordinated debt. Subordinated debt has priority over equity investors but goes behind all other creditors including unsecured debt such as debentures.

Joe Johnson is a founding partner of Ground Break Realty. The company was impacted negatively by rising interest rates and falling property values. There was concern that the firm needed an injection of liquidity to prevent failure, and Johnson lent the company funds to forestall bankruptcy. If the company goes bankrupt, Johnson will

A)

receive his loaned money first over any other investor because he is a founder of the company.

B)

not receive any money back because he is an owner of the company, and the loaned money is considered equity (the money represents an equity interest in the company).

C)

receive his money after the secured creditors but before the holders of standard debentures.

D)

receive his loaned money before any of the equity investors in the company.

C)

Exercise the call feature when the debt security’s conversion value exceeds the call price

• One of the investor benefits of a convertible security is that an increase in the market price of the underlying common stock will lead to a comparable increase in the price of the convertible. For example, when the market price of the common stock is $25 per share, a $1,000 convertible debenture with a conversion ratio of 50 shares per bond has a conversion value of $1,250 (50 shares times $25 per share). Because most convertibles are also callable, by calling the bonds at the stated call price (perhaps 102 or 103) the company can force the bond holders to convert the bonds. Using our example, why would investors hold onto the bonds knowing that, within about 30 days, they're going to get a check for $1,020 or so for each bond when they could convert and own shares worth $1,250 per bond. This is known as forced conversion. The coupon rate is fixed, and an investor would not want to convert to the stock just because the dividends on the stock are lower than the interest on the bond.

What action could a corporation take that would result in the forced conversion of an outstanding convertible debt security?

A)

Reduce the dividends on the common stock to a rate lower than the interest on the debt security

B)

Reduce the coupon rate below the dividend rate on the common stock

C)

Exercise the call feature when the debt security’s conversion value exceeds the call price

D)

Exercise the conversion feature when the debt security’s conversion value exceeds the call price

B)

$23.

• A conversion price of $20 means the conversion ratio is 50 (i.e., each bond can be converted into 50 shares of common stock). $1,150 ÷ 50 = $23 parity price.

A convertible corporate bond with a conversion price of $20 is trading at 115. The parity price of the common stock is

A)

$17.

B)

$23.

C)

$20.

D)

$26.

B)

In a bearish equity market, convertible bonds would at least provide income and allow you to benefit from upside market movement if the equity market turns bullish later.

• The chief benefit of convertible bonds is that they pay interest even when the underlying stock is down. But you can benefit from growth if the stock turns bullish later. Having bonds called in early is not a benefit because you will have reinvestment risk and have to reinvest the principal in a lower-interest-rate environment. Even though you would not pay commissions on the conversion of the bond into stock, the conversion price is usually set higher than the market value of the stock and that worsens in a bearish market. Convertible bonds are more marketable, but if you are looking for income rather than trading the bonds, the yields are lower than the nonconvertible bonds, making them less attractive from an income viewpoint.

There are many reasons to invest in a convertible bond. Which of the following is a reason to invest in a convertible bond?

A)

Convertible bonds can be called in early if interest rates fall, allowing you to receive your principal back faster than waiting for the bond to mature.

B)

In a bearish equity market, convertible bonds would at least provide income and allow you to benefit from upside market movement if the equity market turns bullish later.

C)

In a bearish equity market, convertible bonds provide growth potential in the underlying stock, and it might actually be cheaper to obtain the stock by converting the bond into stock rather than paying commissions when buying the common stock in the market.

D)

Convertible bonds provide interest income that is stable, and the bonds are more marketable than nonconvertible bonds of the company that pay higher stated yields if you are seeking income.

C)

guaranteed as to payment of principal and interest by another corporation.

• A guaranteed corporate bond is one guaranteed by another corporation that typically has a higher credit rating than the issuing corporation and is in a control relationship with it.

Corporate bonds that are guaranteed are

A)

required to maintain a self-liquidating sinking or surplus fund.

B)

guaranteed as to payment of principal and interest by the U.S. government.

C)

guaranteed as to payment of principal and interest by another corporation.

D)

insured by Assured Guaranty Corporation.

B)

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.

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)

Senior notes

B)

Debentures

C)

Common stock

D)

Mortgage bonds

C)

zero-coupon bond prices are more stable than other types of bonds.

• Zero-coupon bonds pay no interest during the life of the bond. Rather, investors purchase zeros at a deep discount from par. The difference between the discounted price and the maturity value is the interest the investor receives from the bond. In other words, zeros pay no interest until maturity. The effect of this is that their prices fluctuate more than other types of bonds when traded on the secondary market. Investors typically pay income tax on the phantom interest as it accrues each year.

All the following statements concerning zero-coupon bonds are true except

A)

zero-coupon bonds may be issued by the U.S. Treasury, corporations, and state and local governments.

B)

zero coupon bonds are most often issued with long-term maturities.

C)

zero-coupon bond prices are more stable than other types of bonds.

D)

zero-coupon bonds pay no interest during the life of the bond.

C)

equity-linked notes.

• An ELN is an equity-linked note. That is a strange name for a debt product. The equity refers to the specific stock, a basket of stocks, or an equity index upon which the return is based. Therefore, the return is not fixed and can be higher or lower than anticipated depending on the selected equity's performance. There are foreign exchange-linked notes where the performance is based on currency rates, but that is unlikely to ever be a topic covered on the exam. There are no such products as exchange or equity-leveraged notes.

In a discussion with one of your customers, the topic of alternative debt instruments is brought up. It seems that the customer was competing in a duplicate bridge tournament in town and one of the other competitors mentioned that they have been obtaining higher income returns from ELNs. When the customer asks you for the meaning of that abbreviation, you would reply

A)

exchange-linked notes.

B)

exchange-leveraged notes.

C)

equity-linked notes.

D)

equity-leveraged notes.

A)

subordinated debentures.

• The lowest claim level of creditor of a corporation would be the holder of a subordinated debenture. The other debt instruments are secured.

  
  
  

The creditor with the lowest priority claim to the assets of a corporation during a liquidation would be the holder of its

A)

subordinated debentures.

B)

equipment trust certificate.

C)

C-rated mortgage bonds.

D)

collateral trust certificates.

B)

I and II

• Moody's, Standard & Poor's, and Fitch's are all recognized as rating companies that would rate commercial paper issued by corporations. The SEC is a federal government regulatory body.

Which of the following rate commercial paper issued by corporations?

1. Moody's

2. Standard & Poor's

3. Municipal Securities Rulemaking Board

4. Securities Exchange Commission (SEC)

A)

II and IV

B)

I and II

C)

II and III

D)

I and III

A)

A convertible debenture

• Because convertible securities (debentures or preferred stock) are convertible into common stock, it is typical for their price fluctuations to be similar to those of the underlying stock. In fact, some portfolio managers consider convertible debentures to be part of their allocation to equity rather than fixed income.

Which of the following investments would be most likely to react to market events in a manner similar to common stock?

A)

A convertible debenture

B)

A preferred stock

C)

An income bond

D)

Commercial paper

C)

20-year maturity, 4% coupon

• Bonds with longer maturities tend to be more sensitive to interest rate changes. Bonds offering lower coupons are generally more sensitive to interest rates than higher-yielding counterparts.

  
  
  

The market price of fixed-income securities, especially bonds, is highly sensitive to changes in market interest rates. Based on that knowledge and assuming that all of these bonds were purchased at par value, which of the following will have the greatest price change when market interest rates decrease?

A)

20-year maturity, 6% coupon

B)

10-year maturity, 4% coupon

C)

20-year maturity, 4% coupon

D)

10-year maturity, 6% coupon

C)

The current value will fluctuate significantly, but the investment income will remain relatively unchanged.

• For a fund with a fixed portfolio of long-term municipal bonds, the market value of the portfolio will fluctuate with changing interest rates, but the income will remain unchanged.

If a fund has a fixed portfolio of municipal bonds with long maturities, how will substantial changes in general interest rates affect the fund's portfolio?

A)

The current value will not change, but the investment income will fluctuate significantly.

B)

Both the income and the current value will fluctuate significantly.

C)

The current value will fluctuate significantly, but the investment income will remain relatively unchanged.

D)

Both the income and the current value will remain unchanged.

A)

The regional chain should seek to get their parent company to support them through the issuance of guaranteed bonds which although unsecured would be safer than direct debenture of the struggling chain.

• Although it is true that high yield (junk) bonds have a higher priority than stockholders in a default, it is not the best answer. Due to the fact the regional chain has a larger parent company, it would be more likely to raise capital through the parent company by the issuance of guaranteed debt which is actually unsecured but would normally have a higher credit rating than the distressed smaller company. Mortgage bonds, although secured, do not guarantee that investors would get back all their money as the underlying property might be distressed and be of lower value when liquidated.

A large national grocery chain owns several smaller regional supermarkets. The regional chain that operates in Chicago is experiencing some economic hardship, and the chain gets its debt downgraded by Standard & Poor's. The chain is desperate to raise capital to deal with a lack of cash flow. What method would be the best for raising capital?

A)

The regional chain should seek to get their parent company to support them through the issuance of guaranteed bonds which although unsecured would be safer than direct debenture of the struggling chain.

B)

The regional chain should issue preferred stock to the investors letting them know that preferred shareholders have a preference in liquidation above general creditors.

C)

The regional chain should issue high-yield corporate bonds to attract investors because they are safer than issuing stock to the investors if the company defaults.

D)

The regional chain should issue secured mortgage bonds to investors because the investors would be guaranteed to get their money back even if the regional chain defaults.

C)

I and III

• The basis quote is the bond's yield to maturity. The difference between a basis of 3.35% and a basis of 3.21% is 14 basis points. What is it that causes a bond's yield to fall? It is the inverse relationship between interest rates and bond prices. The price has gone up because interest rates have fallen.

  
  
  

One of your customers purchased a municipal bond at a basis of 3.35%. Several weeks later, the bond's basis is now 3.21%. Which of the following statements is true?

1. The bond's yield to maturity has fallen by 14 basis points.

2. The bond's price has fallen by 14 basis points.

3. Market interest rates have likely decreased.

4. The bond's rating has likely fallen.

A)

II and III

B)

I and IV

C)

I and III

D)

II and IV

A)

state and local government securities (SLGS).

• SLGS are issued not by a municipality, but by the U.S. Treasury Department to assist local governments in complying with arbitrage restrictions imposed by the IRS. The other choices are examples of short-term funding used by municipalities.

All of the following are examples of short-term municipal obligations except

A)

state and local government securities (SLGS).

B)

tax anticipation note (TAN).

C)

tax and revenue anticipation note (TRAN).

D)

bond anticipation notes (BAN).

B)

more than 3½% but less than 3¾%.

• With a coupon of 3½% and a basis (yield to maturity) of 3¾%, we know the bond was purchased at a discount. GO bonds are municipal bonds, and when a municipal bond is purchased in the secondary market at a discount, the accretion of the discount is taxed as ordinary income. Therefore, a portion of the investor's return will be taxable, making the actual return slightly less than the yield to maturity.

An investor buys a GO bond in the secondary market with a coupon of 3½% that has a basis of 3¾%. If the bond is held until maturity, the investor's actual yield will be

A)

3½%.

B)

more than 3½% but less than 3¾%.

C)

more than 3¾% .

D)

3¾%.

C)

No capital gain

• Original issue discount profit at maturity is treated as part of the tax-free interest on a municipal bond. However, for a municipal bond bought at a discount in the secondary market, the discount is considered ordinary income subject to tax.

A customer purchases $100,000 of original issue discount municipal bonds. How will this trade be considered for tax purposes when the bonds mature?

A)

Taxable as short-term gain

B)

Fully taxable on capital gain

C)

No capital gain

D)

Taxable as long-term gain

C)

6% municipal, basis 5.5%, due 2028

• The only bond priced at a premium is 6% municipal, basis 5.5%, due 2028. On a premium bond, the yield to call will be lower than the yield to maturity.

Of the following callable bonds, which confirmation must show yield to call?

A)

6% municipal, par, due 2038

B)

6% municipal, basis 6.5%, due 2028

C)

6% municipal, basis 5.5%, due 2028

D)

6% municipal, basis 7%, due 2038

C)

$10 loss

• If a municipal bond is purchased at a premium, the premium must be amortized over the time until maturity. An $80 premium on a 16-year municipal bond indicates that $5 will be amortized each year ($80 ÷ 16 = $5). Ten years at $5 per year is $50 of amortization. Therefore, after 10 years the tax basis would be $1,080 minus $50 or $1,030 (103). Because the sale was for 102 ($1,020), the customer has a $10 loss on one bond.

A customer purchases an XYZ municipal bond at 108. It is scheduled to mature in 16 years. After owning the bond for 10 years, she sells the bond at 102. What capital gain or loss must she report for tax purposes at the time of the sale?

A)

$60 loss

B)

$20 gain

C)

$10 loss

D)

$10 gain

C)

the legal opinion is qualified with restrictions and conditions.

• The word qualified describes the legal opinion, not the attorney (or bond counsel) who issued it. A qualified legal opinion is one in which the bond counsel expresses reservations about conditions that may affect the bond's status. An unqualified legal opinion is rendered without restriction or condition.

A qualified legal opinion issued for a municipal bond underwriting means that

A)

the revenue bond issue has certain debt limitations.

B)

the bond counsel is considered competent.

C)

the legal opinion is qualified with restrictions and conditions.

D)

the bond attorney is qualified to express her opinion on the bond

A)

auction rate securities (ARS).

• ARS are long-term securities issued by municipalities that use a Dutch auction to reset interest rates at short-term intervals. The reset rate is known as the clearing rate and establishes the rate paid during the period following the auction.

Long-term securities issued by municipalities that use a Dutch auction method to reset short-term interest rates known as clearing rates are

A)

auction rate securities (ARS).

B)

real estate investment trusts (REITs).

C)

American depositary receipts (ADRs).

D)

collateralized mortgage obligations (CMOs).

A)

donor income limits apply.

• Unlike the Coverdell ESA, there are no donor income limits with a 529 plan. All of the other statements are true as to 529 plans.

All of the following are characteristics of 529 plans except

A)

donor income limits apply.

B)

an official statement (OS) must be provided to any prospective purchaser.

C)

there is no age limit on the beneficiary.

D)

the assets can be transferred to a family member if not used by the original beneficiary.

A)

evidence of insurance.

• Delivery of certificates for securities traded as insured securities must be accompanied by evidence of insurance. Although noted on the confirmation, the evidence itself need not accompany or appear on the confirmation.

The State of Maine is issuing $20 million of AAA callable general obligation bonds underwritten by Threadneedle Investment Bankers. The bonds have a par value of $5,000, are insured, and have an unqualified legal opinion. A non-institutional customer purchased 10 of the bonds at par ($50,000). All of the following must be disclosed to the customer on his confirmation except

A)

evidence of insurance.

B)

trade date and time of execution.

C)

information on call features.

D)

number of bonds purchased.

A)

I and IV

• The term flow of funds relates to revenue bond offerings only and describes the priority of disbursing revenues from the project. Generally, the revenues are deposited into a general collection account for disbursement into other accounts, as specified in the trust indenture found in the bond contract.

  
  
  

Which of the following statements regarding the flow of funds found within a municipal trust indenture are true?

1. It describes the disbursement of funds for revenue bond issues.

2. It describes the disbursement of funds for general obligation issues.

3. It is found within the official statement.

4. It is found within the bond contract.

A)

I and IV

B)

I and III

C)

II and IV

D)

II and III

D)

I and III

• Municipal bond analysts examine an issuer's net total debt to determine an issue's safety. Debt that is not a burden on the municipality is not included in total debt. Defeased debt and paid-up debt can be removed from the municipality's debt accounts. Direct debt is debt issued by the municipality, and overlapping debt is the municipality's share of debt issued by authorities that draw revenues from the same sources as the municipality. Together, direct debt and overlapping debt constitute the municipality's net total debt.

  
  
  

A municipal issuer's net total debt is made up of which of the following?

1. Direct debt

2. Defeased debt

3. Overlapping debt

4. Paid-up debt

A)

II and III

B)

I and II

C)

III and IV

D)

I and III

B)

Trust Indenture Act of 1939

• The Trust Indenture Act of 1939 protects investors in corporate bonds should the issuing company default. While the Securities Act of 1933 and the Securities Exchange Act of 1934 both have provisions dealing with corporate debt securities, the Trust Indenture Act of 1939 is the only act that affects them exclusively.

  
  
  

Which of the following legislative acts exclusively regulates debt securities?

A)

Securities Exchange Act of 1934

B)

Trust Indenture Act of 1939

C)

Securities Act of 1933

D)

Investment Advisers Act of 1940

A)

extraordinary call.

• An extraordinary call can occur at an unknown point in time prior to maturity. The issuer has the right to call the bonds, generally at par, when a certain event occurs, typically a catastrophe. Although catastrophe calls are unplanned or unexpected, the term that will be used for this type of call is extraordinary.

It is not uncommon for municipal revenue bonds to have a catastrophe call provision. Another term that might be used for this provision is

A)

extraordinary call.

B)

unplanned call.

C)

premium call.

D)

unexpected call.

A)

a failed auction.

• An inherent risk associated with ARS is the potential for a failed auction. These can occur due to a lack of demand, resulting in no bids being submitted when it is time to reset the rate. ARS use a Dutch auction method to reset the clearing rate paid in the upcoming period.

An inherent risk associated with auction rate securities (ARS) is the potential to have

A)

a failed auction.

B)

a reset rate.

C)

a clearing rate.

D)

a Dutch auction.

D)

the credit rating of the bonds is dependent on the credit rating of the municipality.

• The debt service for IRBs is derived from the lease payments made by the leasing corporation to the issuing municipality. Therefore, the credit rating of the bonds is dependent on the credit worthiness of the leasing corporation, not the issuing municipality.

  
  
  

All of the following statements regarding industrial revenue bonds (IRBs) are true except

A)

interest is paid from rental payments received from corporations that have leased the property or equipment from the municipality.

B)

they can be issued by municipalities to build facilities that will be owned by the municipality but leased to a local corporation.

C)

they can be issued by municipalities to provide local industries with funds for expansion.

D)

the credit rating of the bonds is dependent on the credit rating of the municipality.

C)

the total of interest and principal payable by the issuer plus any amount required to be deposited into a sinking fund.

Debt service is best described as

A)

net interest on a new issue of a municipal bond.

B)

total of the direct debt of a municipality and the debt of its political subdivisions.

C)

the total of interest and principal payable by the issuer plus any amount required to be deposited into a sinking fund.

D)

services provided by the paying agent for a bond issue.

D)

reflects the time value of money.

• The TIC method uses present value calculations that consider the time value of money (as opposed to NIC, which does not consider the timing of interest payments). It is a more complicated calculation than NIC. The IRS is not concerned with this issue.

  
  
  

In the context of municipal bond underwritings, the true interest cost (TIC) is different from the net interest cost (NIC) because it

A)

reflects the credit risk.

B)

produces a lower cost of borrowing for the issuer.

C)

is the method required by the IRS.

D)

reflects the time value of money.

B)

Corporate net lease payments

• Corporate net leases back up IDRs, which means the credit of the bond is as good as the credit of the corporation that signs the net lease.

Which of the following secures an industrial revenue bond (IDR)?

A)

Municipal taxes

B)

Corporate net lease payments

C)

Trustee guarantees

D)

State taxes

A)

Tax anticipation notes (TANs)

• Municipalities issue TANs to raise funds immediately. The community expects general tax revenues to generate the necessary funds to pay off the notes. RANs are eventually funded by revenues other than tax receipts, and BANs are eventually funded through the sale of bonds.

Which of the following are funded by general tax receipts?

A)

Tax anticipation notes (TANs)

B)

Hospital revenue bonds

C)

Revenue anticipation notes (RANs)

D)

Bond anticipation notes (BANs)

B)

General obligation (GO) bond

• Municipal bonds are suitable for the portfolio of an investor who is in a high tax bracket because the interest is exempt from federal income tax. A GO bond is a better recommendation than an industrial revenue bond because the interest on industrial revenue bonds is likely subject to the AMT.

If an investor is in the highest federal income tax bracket and is subject to the alternative minimum tax (AMT), which of the following securities should an agent recommend?

A)

Corporate bond

B)

General obligation (GO) bond

C)

Treasury bond

D)

Industrial revenue bond

C)

In a bearish equity market, convertible bonds would at least provide income and allow you to benefit from upside market movement if the equity market turns bullish later.

• The chief benefit of convertible bonds is that they pay interest even when the underlying stock is down. But you can benefit from growth if the stock turns bullish later. Having bonds called in early is not a benefit because you will have reinvestment risk and have to reinvest the principal in a lower-interest-rate environment. Even though you would not pay commissions on the conversion of the bond into stock, the conversion price is usually set higher than the market value of the stock and that worsens in a bearish market. Convertible bonds are more marketable, but if you are looking for income rather than trading the bonds, the yields are lower than the nonconvertible bonds, making them less attractive from an income viewpoint.

  
  
  

There are many reasons to invest in a convertible bond. Which of the following is a reason to invest in a convertible bond?

A)

In a bearish equity market, convertible bonds provide growth potential in the underlying stock, and it might actually be cheaper to obtain the stock by converting the bond into stock rather than paying commissions when buying the common stock in the market.

B)

Convertible bonds provide interest income that is stable, and the bonds are more marketable than nonconvertible bonds of the company that pay higher stated yields if you are seeking income.

C)

In a bearish equity market, convertible bonds would at least provide income and allow you to benefit from upside market movement if the equity market turns bullish later.

D)

Convertible bonds can be called in early if interest rates fall, allowing you to receive your principal back faster than waiting for the bond to mature.

B)

the bonds are trading flat.

• Bonds trading without accrued interest are trading flat. Every bond trades flat twice a year: when the bond settles on an interest payment date. However, that is not the case here because this trade would settle on April 23 and interest payment dates are January and July 1. The price is a hint. A 4% bond selling at 22% of par indicates that this bond is likely in default of interest and that is why it is trading flat.

On Wednesday, April 22, 2020, your customer purchased a block of City Y 4% Recreation Authority term revenue bonds quoted at 22. The bond's stated interest payment dates are J/J 1. After receiving the confirmation, the customer called you and asked why there was no additional cost for accrued interest. The most likely reason for that is

A)

the accrued interest is paid by the seller.

B)

the bonds are trading flat.

C)

there was a mistake on the confirmation and it will be rectified shortly.

D)

the trade settled on an interest payment date.

D)

I and III

• The coupon interest the issuer will pay and the amount of proceeds the issuer receives are important to the issuer because they determine the actual cost of borrowing. The spread and basis at which the bonds will be resold are important to the underwriters but not to the issuer.

In a competitive bid, which of the following would the issuer need to determine net interest cost?

1. Total coupon interest the issuer will pay

2. Basis

3. The amount of proceeds the issuer receives

4. Spread

A)

III and IV

B)

I and II

C)

II and IV

D)

I and III

D)

zero-coupon bond prices are more stable than other types of bonds.

• Zero-coupon bonds pay no interest during the life of the bond. Rather, investors purchase zeros at a deep discount from par. The difference between the discounted price and the maturity value is the interest the investor receives from the bond. In other words, zeros pay no interest until maturity. The effect of this is that their prices fluctuate more than other types of bonds when traded on the secondary market. Investors typically pay income tax on the phantom interest as it accrues each year.

All the following statements concerning zero-coupon bonds are true except

A)

zero-coupon bonds may be issued by the U.S. Treasury, corporations, and state and local governments.

B)

zero-coupon bonds pay no interest during the life of the bond.

C)

zero coupon bonds are most often issued with long-term maturities.

D)

zero-coupon bond prices are more stable than other types of bonds.

B)

state and local governments.

• SLGS securities are purchased by municipal issuers that are subject to IRS yield restrictions when they invest the proceeds of a prerefunding. The monies placed in escrow are invested in SLGS, which are government securities whose interest rates are arranged to comply with IRS restrictions.

State and local government securities (SLGS) are purchased by

A)

commercial banks.

B)

state and local governments.

C)

accredited investors.

D)

institutions.

D)

zero-coupon bonds are not a good choice because they are taxed on a large capital gain at maturity.

• Zero-coupon bonds accrete in value every year. The accretion does not get paid out as actual income. However, this phantom income is actually taxed every year as ordinary income. Zero coupons held to maturity have no capital gains because the bond was not traded.

An investor calls an agent at New England Investment Brokers and Advisors and asks about the tax implications of various bond choices. The investor has a long-term objective and wants steady income but does not want to pay taxes on the income. The investor heard that zero-coupon bonds have no taxable income. The agent may tell the investor all the following except

A)

zero-coupon bonds have no income payment but are actually taxable every year.

B)

zero-coupon bonds are not a good choice because they have phantom income which accretes the value of the bond but does not actually get distributed to the investor as income every year.

C)

the client should consider municipal bonds if they are in a high tax bracket.

D)

zero-coupon bonds are not a good choice because they are taxed on a large capital gain at maturity.

B)

Yield to call

• When a bond issue is prerefunded, the issuer is going to redeem the bond on the first call date. The yield must be quoted to call.

The City of Podunk has an outstanding 25-year maturity issue that is callable in seven years. It has prerefunded the issue and established an escrow account containing the proper government securities with face amounts and maturities approximating the call provisions of the original issue. In quoting the original issue, which of the following must be used?

A)

Current yield

B)

Yield to call

C)

Yield to maturity

D)

The lower of the yield to call or the yield to maturity

B)

Zero-coupon bonds

• Zero-coupon bonds make no payments until maturity, and therefore, would not be suitable investments for those with an income objective. Typically, preferred shares (because of the fixed dividend they pay) and corporate or government securities, which make interest payments, would be suitable investments to meet an income objective.

Your new client lists income as the primary investment objective for an account with your broker-dealer. Which of the following investments would not be suitable?

A)

Corporate preferred shares

B)

Zero-coupon bonds

C)

Corporate debt securities

D)

Ginnie Mae government securities

B)

municipal notes.

• Short-term notes are not part of the visible supply, which measures the dollar amount of new issues scheduled over the coming month.

The visible supply includes all of the following except

A)

general obligation bonds.

B)

municipal notes.

C)

industrial development bonds.

D)

revenue bonds.

B)

Federal Home Loan Bank

• The Federal Land Bank, Bank for Cooperatives, and Federal Intermediate Credit Bank are all parts of the FFCS. The Federal Home Loan Bank is not.

  
  
  

Which of the following is not part of the Federal Farm Credit System (FFCS)?

A)

Federal Intermediate Credit Bank

B)

Federal Home Loan Bank

C)

Bank for Cooperatives

D)

Federal Land Bank

B)

Credit risk

• Among mortgage-back securities, securities offered by GNMA are directly backed by the United States government. Extension risk is the uncertainly that mortgages will not be paid off as quickly as estimated. Prepayment risk is the opposite. Interest-rate risk is understood best as the risk of interest rates going up, causing the price of the security to go down.

Pass-through securities offered by the Government National Mortgage Association (GNMA) are least likely to have which of the following risks?

A)

Interest-rate risk

B)

Credit risk

C)

Prepayment risk

D)

Extension risk

A)

Treasury bonds.

• The interest on U.S. government securities (such as Treasury bonds) is exempt from state and local income taxes but not federal income taxes. Dividends (whether reinvested or not), Ginnie Maes, and corporate bonds of all types and/or ratings are taxable on all levels.

The income from all of the following securities is taxable on the federal, state, and local income tax levels except

A)

Treasury bonds.

B)

GNMA certificates.

C)

corporate BBB bonds.

D)

reinvested mutual fund dividends.

D)

A treasury STRIP scheduled to mature in 16 years

• Treasury STRIPs are zero-coupon bonds, backed in full by the U.S. government. Purchased at a discount and maturing at face value in the future, they are suitable investments for those wishing to save for anticipated future expenses, such as college tuition. A CMO maturing in five years doesn't align with the time horizon for this child's college education and carries other unsuitable risks. A money market fund would hardly meet the growth requirement needed to meet college tuition needs. For exam purposes, municipal bonds are a suitable choice only when something in the question indicates that the investor is in a high income tax bracket.

A married couple with a two-year-old child have $25,000 to deposit towards an investment to help meet the financial obligations for the child's college education. Given the following choices, which of the following is likely the most suitable investment?

A)

A money market mutual fund

B)

A diversified portfolio of insured municipal bonds with an average duration of 18 years

C)

A collateralized mortgage obligation (CMO) tranche rated AAA and scheduled to mature in five years

D)

A treasury STRIP scheduled to mature in 16 years

D)

$196

• The 10M means $10,000. Remember your Roman numerals? M equals 1,000. His tax liability is as follows: $1,000 times 7% equals $70 annual interest per bond; $70 times 10 equals $700 annual interest, which is taxable only by the federal government; and $700 times 28% equals a $196 tax liability.

A customer owns 10M of 7% U.S. Treasury bonds. He is in the 28% federal tax bracket and the 10% state tax bracket. What is his annual tax liability on these bonds?

A)

$266

B)

$98

C)

$70

D)

$196

A)

Bills, notes, bonds.

• Treasury bills have a maturity of less than one year, Treasury notes mature in 2 to 10 years, and Treasury bonds mature in 10 years or more.

  Therefore, the ascending order of maturity is bills → notes → bonds.

An investor wants to build a Treasury securities ladder that begins with the shortest-term security and ends with the longest-term security.

Which of the following correctly lists the securities in the order the investor would purchase them?

A)

Bills, notes, bonds.

B)

Notes, bills, bonds.

C)

Bonds, notes, bills.

D)

Bills, bonds, notes.

D)

9s of 35 with a basis quote of 7.0%

• MSRB Rule G-15 deals with customer confirmations. Under that rule, callable bonds sold on a yield basis must reflect the lower of the yield to maturity (YTM) or the yield to call. When a bond is selling at a premium, the YTC is always going to be the lower yield. No calculations are necessary for this question because there is only one bond selling at a premium—the bonds with a 9% coupon maturing in 2035. We know this because whenever the basis (the YTM) is lower than the coupon, the bond must be selling at a premium. The 8% bonds yielding 8% are at par, and the other two choices are selling at a discount because their yields are higher than their coupons.

The Municipal Securities Rulemaking Board (MSRB) has rules regarding quotations on callable municipal bonds. For which of the following would the customer confirmation be required to show the yield to call?

A)

8s of 38 with a basis quote of 8.0%

B)

6s of 37 with a basis quote of 7.5%

C)

7s of 35 with a basis quote of 9.5%

D)

9s of 35 with a basis quote of 7.0%

D)

the dated date on a municipal bond that has been outstanding for two years.

• On the dated date, new issue interest starts to accrue. Once the issue makes its first interest payment to bond holders, the dated date is no longer used to compute accrued interest because there is a prior interest payment date.

All of the following information must be disclosed on a municipal bond confirmation of sale except

A)

the source of revenue backing a municipal revenue bond.

B)

the name of the guaranteeing corporation in an industrial development revenue bond issue.

C)

in-whole call dates.

D)

the dated date on a municipal bond that has been outstanding for two years.

C)

an official statement.

• The document prepared by or on behalf of the issuer of municipal securities in connection with a primary offering that discloses material information on the offering of such securities is the official statement. It serves the same basic purpose as the prospectus for SEC-registered offerings, just with a different name. The new issue worksheet and official notice of sale are for municipal securities broker-dealers, not for investors.

Investors in new municipal bond issues receive a disclosure document known as

A)

the official notice of sale.

B)

the new issue worksheet.

C)

an official statement.

D)

a prospectus.

D)

Original issue discount

• Because the bond is being issued by a syndicate, it is a new issue (i.e., an original issue). Because the yield (4%) is higher than the coupon (3%), it is an original issue discount.

  
  
  

A 3% bond with 20 years to maturity is being issued by a syndicate with a reoffering yield of 4%. What is the term used to describe this bond?

A)

High-yield bond

B)

Secondary market discount

C)

Original issue premium

D)

Original issue discount

C)

6 to 7%.

• Because the interest on a municipal bond is tax-free on the federal level, the effective after-tax yield is generally the same as the coupon. That is, a bond paying 6% interest, with none of it taxable, will have an after-tax yield of 6%. This question deals with an exception. This bond is purchased in the secondary market on a 7% basis or yield to maturity (YTM). Whenever the YTM is higher than the coupon, the bond is priced at a discount from par. That means the investor is going to receive the difference between the discounted purchase price and the par value when the bond matures. When the bond is purchased in the secondary markets, that difference is accreted over the remaining life of the bond and is taxed each year as ordinary (taxable) income. Therefore with the annual accretion of the discount (that annual profit per se) being taxable, the effective after-tax return will be higher than the 6% coupon, but not equal to the 7% yield to maturity.

A customer purchases a 6% municipal bond in the secondary market on a 7% basis. The effective after-tax yield is

A)

7%.

B)

6%.

C)

6 to 7%.

D)

greater than 7%.

D)

6.12%

• When the yield on the corporate taxable bond is given and the question asks for the equivalent after-tax yield of a tax-free municipal bond, we calculate that as follows: corporate rate × (1 − investor's tax bracket). In this case, 0.09 × (1 − 0.32) = 0.09 × 0.68 = 0.0612, or 6.12%. Without all of those zeros, it is 9% × 68% = 6.12%. Alternatively, just subtract the 32% tax from 9%. That would be 9% − (9% × 32%) = 9% − 2.88% tax = 6.12%. Remember, because the investor is paying taxes at a rate of 32%, she is keeping only 68% of the income received on a taxable security compared to 100% on a tax-free municipal bond.

  When the coupon rate of the tax-free security is given and the question is asking about the tax-equivalent yield of that security (it will always be higher than the coupon), we need to divide. Divide the municipal coupon rate by (100% minus the tax bracket). For example, if this question has said that the coupon on the municipal bond was 6.12% and asked for the TEY, you would divide 6.12% by 68%. Do that on your calculator and the result is 9%. The key to remembering which formula works is that when the coupon on the taxable security is given, the answer will always be lower than that coupon. That means subtracting. When the coupon on the tax-free security is given, the answer will always be higher than that coupon and that means dividing.

Your client is considering two bonds: an ABC Corporation mortgage bond with a coupon yield of 9% and a municipal bond issued by the state that she resides in. If your client is in the 32% tax bracket, what is the tax-free equivalent yield for the corporate mortgage bond so that she will be able to compare it to the tax-free municipal bond she is considering?

A)

4.10%

B)

13.24%

C)

2.88%

D)

6.12%

C)

The tax covenant

• Unless something in the question refers to special taxes, revenue bonds do not have tax backing. The other items are included in the bond resolution (or trust indenture). The rate covenant is a promise to maintain rates sufficient to pay expenses and debt service. The maintenance covenant is a promise to maintain the equipment and facility/facilities. The insurance covenant is a promise to insure any facility.

Which of the following details would not be found on the bond resolution for a revenue bond?

A)

The insurance covenant

B)

The maintenance covenant

C)

The tax covenant

D)

The rate covenant

A)

Revdex.

• Revdex is an index of yields on 25 revenue bonds with 30-year maturities that are traded in the secondary market.

All of the following might be used to measure the marketability of a new municipal general obligation issue except

A)

Revdex.

B)

visible supply.

C)

placement ratio.

D)

S&P's ratings.

C)

an increase in municipal assessed valuations

• An increase in assessed property values would theoretically mean an increase in taxes collected, thus increasing a municipality's credit standing.

All of the following would be indications of a deteriorating credit situation except

A)

an increase in tax delinquencies.

B)

an increase in personal bankruptcies.

C)

an increase in municipal assessed valuations.

D)

an increase in the per capita debt.

A)

your firm controls the bonds for one hour.

• A municipal securities dealer may quote a bond price that is firm for a certain time. This is called an out-firm with recall quote. Generally, these quotes are firm for an hour (or half hour) with a five-minute recall period. During this time, the municipal dealer cannot offer those bonds to anyone else—they are under the control of your firm.

Your FINRA member firm takes 100 GO bonds from a municipal bond dealer out-firm for one hour. This means that

A)

your firm controls the bonds for one hour.

B)

the municipal bond dealer has one hour to sell these bonds to another member at a greater price.

C)

after one hour, your firm owns the bonds.

D)

the municipal bond dealer has one hour to change the quoted price.

D)

The position has a limited gain and loss potential.

• This is a spread position. All spreads (debit or credit), whether put or call spreads, have a limited gain and loss potential.

customer of a broker-dealer is long 1 MMS July 60 call and short 1 MMS July 70 call. Which of the following is true?

A)

The position has an unlimited loss potential.

B)

The position has an unlimited gain potential.

C)

The position has an unlimited loss potential and a limited gain potential.

D)

The position has a limited gain and loss potential.

B)

a corporation against its own stock.

• Corporations are not permitted to write calls against their own stock. If exercised, they would have to issue shares at the strike price, and this would have a dilutive effect on shareholders.

  
  
  

All of the following accounts are permitted to write calls except

A)

an individual in a margin account.

B)

a corporation against its own stock.

C)

a custodian in an UTMA account against a long stock position.

D)

a mutual fund against a long stock position.

D)

deliver cash equal to the intrinsic value of the contract.

• The IRX is the 13-week Treasury bill. It is generally accepted that this security, more than any other, directly reflects changes in interest rates. Investors in yield-based options are making a bet on the future trend of interest rates. Just as with equity options, we use the phrase "call up and put down." That is, if the investor believes interest rates will rise, the strategy is to buy a call option. If a decline in rates is expected, the investor will buy a put option. Like some other of the non-equity based options, upon exercise, yield-based options settle in cash. That is because there is no delivery of the underlying security. If you buy an IRX call and exercise it, you're not going to be buying Treasury bills. The writer must deliver the in-the-money amount in cash.

  For example, a yield-based option with a strike price of 15 reflects a yield of 1.5%. Assume an investor believes that rates on T-bills—currently at 1.5%—will rise in the near term. The investor could purchase a call option with a 15 strike price (at the money). If rates rise to 2.0%, the investor could exercise and receive cash equal to the intrinsic value of the option.

  Rates have gone up by 5 points—15 to 20—so the investor would receive $500 because each point is worth $100. Profit would be the $500 received on exercise less the premium paid. On the other hand, the investor could have closed her position, profiting from the difference between the premium paid and the premium received on closing.

The writer of an IRX U.S. Treasury bill yield-based option, if exercised, must

A)

deliver T-bills.equal to the dollar amount of T-bills in the contract 

B)

receive cash.equal to amount the contract is in-the-money

C)

receive Treasury bills

D)

deliver cash equal to the intrinsic value of the contract.