Chapter 2

What are basis points (bps)?

a unit of measurement where 1 basis point equals 0.01%, so 100 bps equal 1%.

What is a serial bond?

A type of bond issue where bonds mature at different intervals, with a portion maturing each year.

What do credit ratings indicate?

Credit ratings assess a bond's credit quality and can affect its liquidity.

What does amortization of premium bonds involve?

it adjusts the cost basis of bonds purchased at a premium downwards to par by maturity.

What is the Dated Date?

The date when interest begins to accrue on fixed income securities.

What is the refunding process?

Calling a bond to issue a new bond with a lower coupon rate when interest rates have fallen.

What information does the EMMA website provide?

The Electronic Municipal Market Access website offers updates on issuers, municipal bonds, and their credit ratings.

How are bond quotations typically expressed?

Bonds are quoted as a percentage of par, often including fractions like 1/8ths or 1/32nds.

What happens when a bond's credit rating is upgraded?

Its price will increase and its yield will decrease.

What occurs if a bond is called prior to maturity?

The investor may receive a call premium and final interest upon redemption.

How many days of accrued interest are added if a bond pays interest on June 1 and December 1 and is purchased on September 1?

93 days.

What happens if an investor sells 10 XYZ April 20 Puts when XYZ is trading at $25?

The options expire worthless, and the investor retains the premium.

If a Town of X bond has a YTM of 2.50% and a yield to call of 2.75%, how is it priced?

Below par value.

Which statement about bond maturity is NOT true?

Long-term bonds generally provide greater liquidity than short-term bonds.

Which maturity bond usually pays the highest yield?

30-year maturity bonds.

What determines the interest paid by a floating-rate bond?

The value of a widely accepted bond benchmark.

What is the current yield of an 8% XYZ bond purchased for $900 now worth $980?

8.2%.

What type of bond allows early redemption by the issuer with a premium?

Callable bond.

When is an issuer likely to call a bond?

When interest rates are falling.

Who has the right to demand early redemption in a puttable bond?

Only the investor.

What does a sinking fund do for bondholders?

It ensures funding to retire bonds at maturity.

Which yield remains constant throughout the bond's life?

Nominal yield.

What happens to a bond's current yield if the market price drops?

It will increase.

What type of bond is indicated if a bond has a current yield of 4.5% and a nominal yield of 4.7%?

Premium bond.

Which call date is used in yield-to-call calculations?

The first call date.

For a bond trading at a discount, which yield is the lowest?

Nominal yield.

For zero-coupon bonds, which yield is most meaningful?

Yield to maturity.

Which bond appreciates the most as interest rates fall?

30-year, zero-coupon bond.

Which bond type is free from reinvestment risk?

Zero-coupon bond.

What is the lowest S&P rating considered investment-grade?

BBB.

Which yield type does not change over the full life of the bond?

Nominal yield.

A callable municipal bond is being issued with "call protection". According to the indenture of this bond, the bond may be called

A. after the expiration of the call protection period.

B. prior to the end of the call protection period.

C. at any time while the call protection is in effect.

D. only during the month when the bond is scheduled to mature.

Correct Answer

A. A bond (municipal or corporate) that has call protection may not be called while the call protection is in effect. The issuer must wait until the call protection period expires in order to be able to call the bond. Bonds that have call protection are generally safer for investors.

Regarding Treasury securities, they

A. carry no credit risk but are subject to purchasing power and interest rate risk

B. are subject to credit risk and purchasing power risk, but not interest rate risk.

C. are subject to all of the same risks as any other fixed-income security.

D. are exempt from purchasing power risk, but are subject to credit risk and interest rate risk.

A. carry no credit risk but are subject to purchasing power and interest rate risk.

Treasury bonds do not carry credit risk (as the US Government can print money), but they do carry purchasing power (inflation) and interest rate risk.

How often is the interest income on zero-coupon bonds taxed?

At maturity

The interest income is not taxable

Annually

every six months

annually,

Although the interest (the difference between the discounted purchase price and par value) is not actually paid until maturity, investors must still pay tax each year on the annual accretion.

An issuer may use SOFR as a benchmark to

Determine the tax liability of an interest payment to an investor

Adjust the coupon rate that it will pay to an investor

Calculate the capital gains tax from the sale of a bond

Calculate the amount of new debt that it needs to issue to raise capital for the next fiscal year.

Adjust the coupon rate that it will pay to an investor

SOFR may be used as a benchmark to set a new coupon rate on a bond. The SOFR (Secured Overnight Financing Rate) is a broad measure of the cost of borrowing cash overnight collateralized by Treasury securities.

Benchmark rates are used for variable rate bonds; the coupon rate remains the same until maturity for fixed-rate instruments.

DEF Corporate debenture is quoted at 103 and pays a $10 semiannual coupon. What is the current yield of this bond?

0.90%

1.90%

9.70%

19.40%

1.90%

Correct Answer

The current yield of a bond is found by dividing the annual interest by the bond’s market price. In this case, we divide the annual interest, which is $20 ($10 semiannual coupon x2), by the market price of $1,030, to arrive at the current yield of 1.9%. Note that bonds are quoted as a percentage of par, which is $1,000. Therefore, a quote of 103, means 103% of par or $1,030.

A zero coupon municipal security is most appropriate in which two of the following situations?

I. A middle aged investor in a high tax bracket who is looking to generate as much tax-free income as possible
II. A grandmother who would like to have a specified amount of money available to pay for her grandchild's college education in 10 years
III. A retired investor who holds a diversified portfolio of growth security and wishes to receive tax free income from 20% of his portfolio
IV. A head of household who is saving money to purchase a vacation home in 15 years

I and III

I and IV

II and III

II and IV

II & IV: Correct Answer

Zero coupon bonds are purchased at a discount and mature to face value. They are most suitable for investors that would like to plan for the availability of a lump sum at a defined date in the future. They do not pay interest income regularly; the interest is considered the difference between the purchase price and the par value

Which of the following factors affect a debt obligation's coupon?


I. Ratings

II. Maturity

III. Covenants

IV. Security

I only

I and II only

I, II, and III only

I, II, III, and IV

I, II, III, and IV

Coupon refers to the annual interest rate ("pricing") paid on a debt obligation's principal amount outstanding. It can be based on either a floating rate (typical for bank debt) or a fixed rate (typical for bonds). Bank debt generally pays interest on a quarterly basis, while bonds generally pay interest on a semiannual basis. There are a number of factors that affect a debt obligation's coupon, including the type of debt (and its investor class), ratings, security, seniority, maturity, covenants, and prevailing market conditions.

Which of the following statements is true about a callable bond that is trading at a premium?

The bond's YTM is lower than its YTC.

The bond is most likely to be called to save interest expense.

The bondholder will receive less than par value if the bond is called.

Because the bond is callable the coupon rate of the bond is probably lower than comparable non-callable bonds.

The bond is most likely to be called to save interest expense.

Correct Answer

Bonds are most likely to be called to save interest expense. It is most advantageous to an issuer to call bonds that are paying more interest than bonds that are already outstanding. Such bonds would be trading at a premium. Bonds are called at par, although at times a call premium is paid. Interest is no longer paid after a call.