4th Ed

Chapter 6:

Bond Markets

True/False

1. TIPS are a Treasury offering that protects investors from unexpected increases in inflation. Answer: True Level: Easy

2. A callable bond is one where the issuer is required to retire a certain amount of the outstanding bonds each year to ensure that all the bond principle is paid by final maturity. Answer: False Level: Easy

3. Treasury notes and bonds and municipal bonds are default risk free. Answer: False Level: Easy 4. On the run Treasury notes and bonds are newly issued securities and off the run Treasuries are securities that have been previously issued. Answer: True Level: Medium

5. T-notes and T-bonds are issued in minimum denominations of $1,000 or multiples of $1,000. Answer: True Level: Easy

6. The dirty price plus accrued interest is called the clean price of the security. Answer: False Level: Easy

7. Accrued interest owed to the bond seller increases as the next coupon payment date approaches Answer: True Level: Easy

Ch 6 - 1

4th Ed

8. Revenue bonds are backed by the full revenue of the municipality. Answer: False Level: Easy

9. In a Treasury bond quote with a $1000 face value you find the bid is equal to 100:24 and the ask is equal to 100:26. You could buy this bond for $1008.125. Answer: True Level: Medium

10. An unsecured bond that has no specific collateral other than the general creditworthiness of the issuing firm is called a debenture. Answer: True Level: Easy 11. With TIPS, the securitys coupon rate is changed every six months by the inflation rate as measured by the CPI. Answer: False Level: Medium

12. Bond ratings use a classification system to give investors an idea of the amount of default rate risk associated with the bond issue. Answer: True Level: Easy

13. Bonds rated below Baa by Moody's or BBB by S&P are junk bonds. Answer: True Level: Medium

14. Euro bonds are bonds denominated in the issuer's home currency, but are issued outside their home country. Answer: True Level: Medium

15. Callable bonds have lower required yields than similar convertible bonds, ceteris paribus.

Ch 6 - 2

4th Ed

Answer: False Level: Medium

Multiple Choice

16. You buy a principal STRIP maturing in 5 years. The price quote per hundred of par for the strip is 75.75%. Using semiannual compounding what is the promised yield to maturity on the STRIP? A) 5.632% B) 5.712% C) 2.816% D) 2.945% E) 4.566% Answer: A Response: [(100 / 75.75) (1/(5x2)) 1] x 2 = 5.632% Level: Difficult

17. A T-Bond with a $1000 par is quoted at 97:14 Bid, 97:15 Ask. The clean price for you to buy this bond is A) $974.38 B) $975.42 C) $974.69 D) $975.77 E) None of the above Answer: C Level: Medium

18. The quoted ask yield on a 14 year $1000 par T-Bond with a 7% semiannual payment coupon and a price quote of 98:15 is A) 7.00% B) 7.18% C) 7.30% D) 3.59% E) 3.63% Answer: B Response: $984.688 = $35PVIFA(r%,28) + $1,000PVIF(r%,28 yrs) Level: Difficult

19. A Treasury security in which periodic coupon interest payments can be separated from each other and from the principal payment is called a A) STRIP

Ch 6 - 3

4th Ed

B) C) D) E)

T-Note T-Bond G.O. Bond Revenue Bond

Answer: A Level: Easy

20. An 18 year T-Bond can be stripped into how many separate securities? A) 18 B) 19 C) 36 D) 37 E) 38 Answer: D Level: Easy

21. A life insurer owes $550,000 in 8 years. To fund this outflow the insurer wishes to buy strips that mature in 8 years. The strips have a $5,000 face value per strip and pay a 6% APR with semiannual compounding. How much must the insurer spend now to fully fund the outflow (to the nearest dollar)? A) $110,000 B) $342,742 C) $355,224 D) $362,355 E) $370,890 Answer: B Response: (5000 / 1.0316) * (550,000 / 5000) Level: Easy

22. The ask yield on a 6% coupon Treasury bond maturing in 8 years is 5.488%. If the face value is $1000, what should be the QUOTED cost of the bond today (use semiannual compounding)? A) 103:6 B) 103:7 C) 103:8 D) 103:9 E) 103:10 Answer: D Response: $60 x PVIFA(0.05488/2, 16) + $1,000 x PVIF(0.05488/2,16) = $1,032.79488; To convert to fraction quote do the following Round down ($1,032.79488/10) + Round{{($1,032.79488 / 10) Round down ($1,032.79488/10)] x 32}} = 103 9/32 Level: Difficult

Ch 6 - 4

4th Ed

23. Which one of the following bonds is likely to have the highest required rate of return, ceteris paribus? A) AAA rated noncallable corporate bond with a sinking fund. B) AA rated callable corporate bond with a sinking fund C) AAA rated callable corporate bond with a sinking fund D) High quality municipal bond E) AA rated callable corporate bond without a sinking fund Answer: E Level: Medium

24. On July 1, 2008 you purchase a $10,000 par T-Note that matures in 5 years. The coupon rate is 8% and the price quote is 98:6. The last coupon payment was May 1, 2008 and the next is November 1, 2008 (184 days total). The accrued interest is A) $132.61 B) $101.00 C) $50.54 D) $40.65 E) $35.67 Answer: A Response: ((8%/2) x 10,000) x (61 days since last coupon / 184) = $132.61 Level: Difficult

25. On September 1, 2008 an investor purchases a $10,000 par T-Bond that matures in 12 years. The coupon rate is 6% and the investor buys the bond 70 days after the last coupon payment (110 days before the next). The ask yield is 7%. The dirty price of the bond is: A) $9,295.45 B) $9,300.55 C) $9,313.75 D) $9,321.82 E) $9,333.24 Answer: C Response: 300xPVIFA(3.5%,24) + 10,000xPVIF(3.5%,24) = 9,197.08 ; 300*(70/180) = 116.67 ; 9,197.08 + 116.67 = 9,313.75 Level: Difficult

26. Interest income from Treasury securities is _____, and interest income from municipal bonds is always _____. A) Exempt from federal taxes; exempt from all taxes B) Taxable at the state level only; exempt from state taxes only C) Taxable at federal level only; exempt from federal taxes D) Taxable at the state level; taxed at the federal level E) Totally tax exempt; exempt from state taxes

Ch 6 - 5

4th Ed

Answer: C Level: Medium

27. An investor is in the 28% federal tax bracket, pays an 9% state tax rate and 4% in local income taxes. For this investor a municipal bond paying 6% interest is equivalent to a corporate bond paying _____ interest A) 11.79% B) 10.17% C) 9.08% D) 9.68% E) 8.47% Answer: B Response: 0.06 / [1 - (0.28 + 0.09 + 0.04)] Level: Medium

28. An investor is trying to decide between a muni paying 5.75% or an equivalent taxable corporate paying 8.25%. What is the minimum marginal tax rate the investor must have to consider buying the municipal bond? A) 80.00% B) 20.00% C) 25.00% D) 66.67% E) 30.00% Answer: E Response: 1 (0.0575 / 0.0825) Level: Medium

29. Standard revenue bonds are A) Backed by the full taxing authority of the municipality B) Collateralized by the earnings from a specific project C) Bonds backed by mortgages D) Backed by the U.S. Treasury E) Always offered with a best efforts offering Answer: B Level: Easy

30. When an investment banker purchases an offering from a bond issuer and then resells it to the public this is known as a A) Rights offering B) Private placement C) Firm commitment D) Best efforts E) Standby offering

Ch 6 - 6

4th Ed

Answer: C Level: Easy

31. The largest type of municipal bonds outstanding are _______________. A) Revenue bonds B) Industrial development bonds C) Treasury STRIPS D) Convertible bonds E) General obligation bonds Answer: E Level: Easy

32. Which of the following is/are true about callable bonds? I. Must always be called at par II. Will normally be called after interest rates drop III. Can be called by either the bondholder or the bond issuer IV. Have higher required returns than non-callable bonds A) I and II only B) II and IV only C) II and IV only D) I, II and III only E) I, II, III and IV are true Answer: B Level: Medium

33. SEC Rule 144 A does which of the following? A) Allows privately placed investments to be traded on a limited basis B) Allows bond issuers to call their bonds when desired C) Determines the limits of responsibility of bond covenants D) Requires that bonds traded on the NYSE bond market utilize the ABS system E) None of the above Answer: A Level: Medium

34. Convertible bonds are I. Options attached to bonds that give the bondholder the right to purchase stock at a preset price without giving up the bond II. Bonds in which the issue matures (converts) a little each year III. Bonds collateralized with certain types of automobiles IV. Bonds that may be converted to a certain number of shares of stock determined by the conversion ratio A) I only

Ch 6 - 7

4th Ed

B) C) D) E)

I and II only I, II and III IV only I and II only

Answer: D Level: Medium

35. A holder of Rainbow Funds convertible bonds with a $1,000 par and a $1,100 price can convert the bond to 25 shares of common stock. The stock is currently priced at $36 per share. By what percent does the stock price have to rise to make conversion potentially attractive? A) 10.00% B) 14.73% C) 22.22% D) 23.64% E) 25.69% Answer: C Response: [(1100 / 25) / 36] - 1 Level: Difficult

36. With respect to private placements of bonds, which of the following is correct? I. Issuers of privately placed bonds tend to be less well known than public bond issues II. Interest rates on privately placed debt tend to be higher than for similar public issues III. Purchasers of privately placed debt have assets of at least $100 million IV. Once bonds have been privately placed, the original buyers must hold the bonds until maturity A) I only B) I and III only C) I, II and III only D) I, III and IV only E) I, II, III and IV Answer: C Level: Medium

37. Which of the following statements about Euro bonds is/are true? I. The issuer chooses the currency of denomination II. Spreads on firm commitment offers are lower for Euro bonds than for U.S. bonds III. Euro bonds typically have denomination of $5,000 and $10,000 IV. Euro bonds are bearer bonds A) I and II only B) I, III and IV only C) II, III and IV only D) II and III only E) I, II, III and IV are true

Ch 6 - 8

4th Ed

Answer: B Level: Difficult

38. Brady bonds are sometimes converted to _____ when the issuer's credit rating improves. A) Samurai bonds B) Zombie bonds C) Bulldog bonds D) Sovereign bonds E) Phoenix bonds Answer: D Level: Medium

39. Bearer bonds are bonds A) With coupons attached that are redeemable by whoever has the bond B) Where the registered owner automatically receives bond payments when scheduled. C) In which the issue matures on a series of dates D) Issued in another currency other than the bond issuers home currency E) Issued in a different country other than the bond issuers home country Answer: A Level: Easy

40. A T-Bond with a $1000 par is quoted at a bid of 105:7 and an ask of 105:9. If you sell the bond you will receive A) $1,052.81 B) $1,052.19 C) $1,057.22 D) $1,059.22 E) None of the above Answer: B Level: Medium

41. A T-Bond with a $10,000 par is quoted at a bid of 92:11 and an ask of 92:17. If you bought the bond and then immediately sold it at the same quotes, how much money would you gain or lose (ignore commissions)? A) $12.50 B) -$12.50 C) -$18.75 D) $18.75 E) $0.00 Answer: C Response: 9,234.38 - 9,253.13 = -18.75

Ch 6 - 9

4th Ed

Level: Medium

42. The quoted ask yield on a 30 year $1000 par T-Bond with a 6.25% coupon and a price quote of 106:16 is ___________ (use semiannual compounding). A) 2.94% B) 2.90% C) 5.79% D) 5.87% E) 4.95% Answer: C Response: $1,065.00 = $31.25PVIFA(r%,60) + $1,000PVIF(r%,60 yrs); trial and error or financial calculator for r Level: Medium

43. An investor buys a $10,000 par, 4.25% annual coupon TIPS security with 3 years to maturity. If inflation every six months over the investors holding period is 2.50%, what is the final payment the TIPS investor will receive? A) $10,213.00 B) $10,869.28 C) $11,822.25 D) $11,843.37 E) $12,201.11 Answer: D Response: ($10,000 * 1.0256) *(1 + (0.0425/2)) Level: Difficult

44. A bond investor has a 99% chance of receiving all of her promised payments on a particular bond issue in the first year of holding the bond, but only a 98% chance in the second year, and a 97% chance in the third year and beyond. What is the cumulative default probability over the first three years she holds the bond? A) 3.75% B) 4.24% C) 5.89% D) 6.85% E) 7.33% Answer: C Response: 1 [0.99*0.98*0.97] = 5.89% Level: Difficult

45. You purchase a $1000 face value convertible bond for $975. The bond can be converted into 150 shares of stock. The stock is currently priced at $5.25. At what minimum stock price would you be willing to convert? A) $4.50

Ch 6 - 10

4th Ed

B) C) D) E)

$5.26 $6.50 $7.10 $7.25

Answer: C Response: (975 / 150) = 6.50 Level: Easy

46. You purchased a five year annual payment 6% coupon bond for $1,000 and you planned on holding it to maturity. However right after you bought the bond it was called at $1,043.29 when all interest rates fell to 5% and remained there for the full five years. You reinvested the money for the full five years. What was your annual compound rate of return off your original investment? A) 6.00% B) 5.89% C) 5.75% D) 5.23% E) 5.00% Answer: B Response: [(1,043.29 x 1.055) / 1,000]1/5 - 1 Level: Medium

Short Answer

47. What ratings comprise investment grade bonds and what ratings are used for junk bonds? What are the primary differences between the two? In particular, why are investment grade bonds more marketable and why are junk bonds issued at all? Answer: Investment grade bonds are bonds rated AAA (Aaa) down to and including BBB(Baa3) by S&P and Moodys respectively. All lower ratings are considered speculative grade, or junk bonds. Investment grade bonds have a lower amount of default risk, particularly during strong economic times. Investment grade bonds have lower required returns than junk bonds although the credit spreads or default risk premiums (DRPs) vary inversely with economic performance. Investment grade bonds are more marketable because many institutions are only allowed to hold either only a small amount of junk bonds, or no junk bonds at all. Junk bonds carry significantly higher interest rates and are less marketable, but they are still used when a firm cannot obtain a higher rating and still wants to employ debt financing. Junk bonds are used to finance takeovers or so called highly levered transactions where the acquirer purchases a target firm by borrowing a high percentage of the purchase price. The acquirer usually hopes to be able to quickly buy back some of the debt to reduce the risk. Use of junk bonds allows for larger aggregate level of takeover activity and allows takeovers of larger firms. Level: Medium

Ch 6 - 11

4th Ed

48. The total sale proceeds from selling the stripped components of a Treasury security can sometimes be greater than the fair present value of the Treasury security. Why might this happen? Answer: STRIPS are useful tools to minimize interest rate risk. Because they are zero coupon bonds, a strip held to maturity has no interest rate risk; the investor is certain of the nominal rate of return. Investors are apparently willing to pay a small premium to eliminate this uncertainty. Level: Medium 49. What do bond rating agencies look at in setting a bonds rating? Answer: 1. Profitability of operations 2. Competitive position in the industry 3. Overall financial strength 4. Ability to pay interest and principle in full and on time 5. Issuers liquidity and additional debt capacity 6. Specific collateral and other bond provisions such as protection provided to bondholders in the event of bankruptcy, takeover, etc. Level: Difficult

50. A municipal bond holder buys a 5% coupon annual payment muni bond at a price of $4,900. The bond has a $5,000 face value. In one year she sells the bond for $4,975. The appropriate capital gains tax rate is 15% and her ordinary income tax rate is 28%. What is her after tax rate of return? Answer: ((4975 - 4900)(1 - .15)) + 250 = 6.40% 4900 Level: Medium

51. What is the difference between General Obligation and Revenue bonds? Answer: Both are bonds issued by state or local municipalities. G.O.s are backed by the full revenue stream of the municipality (often called the General Fund). They typically require voter approval. Revenue bonds are backed by a specific project's revenues, but not the general tax revenues of the municipality. Revenue bonds are thus riskier than G.O.s. Level: Easy

52. You are considering purchasing 5 year corporate bonds as an investment. You have a choice of terms available. Which of the following terms would you find desirable, ceteris paribus? How does each feature affect the bonds required rate of return? Explain a) call feature b) convertible feature c) warrants d) sinking fund

Ch 6 - 12

4th Ed

e) debenture Answer: a) The call feature favors the bond issuer, and unless the issue offers the investor a sufficiently higher rate of return, he would not want this feature. b) The convertible feature allows the bondholder to convert to stock if they so choose. This sounds like a good, deal but the quid pro quo is a reduced promised yield. This may be desirable if you believe the stock will increase sufficiently in price. c) Warrants allow the bondholder to purchase stock at a fixed price, and unlike convertible bonds, the bondholder does not have to surrender the bond. Offering warrants allows the bondholder to offer a lower required rate of return. This may be desirable if you believe the stock will increase sufficiently in price. d) Sinking funds help assure that the bond issuer will be able to pay off the principle when due. If these are term bonds and the issuer sets aside money each year to ensure availability of funds when the principle is due then the bondholders clearly benefit from this feature. Of course, this reduces the required promised yield. If the sinking fund requires retiring a certain percentage of the bonds each year, then the idea is not unambiguously better for bondholders. It may be that your bond is retired when rates have fallen and you must then reinvest at lower interest rates. e) The term debenture indicates that the bond has no specific collateral (other than the earnings and cash flows of the firm). The lack of security adds to bondholder risk and may imply a higher required rate of return than bonds with better collateral. Level: Medium

53. You find the following quote for a corporate bond ($1,000 par, pays interest semiannually):
Issuer Name Home Depot Symbol HD.GF Coupon 4.625% Maturity Aug 2010 Moodys/S&P/Fitch Baa1/BBB+/BBB+ High 98.281 Low 97.362 Last 97.726 Change 0.286 Yield% 5.49%

a) What was the range of the price for the given day? b) How many dollars would you receive from each coupon payment? c) Approximately what risk level is implied by the bond rating? d) What would have been the Last Price on the day before? Answer: a) The high price was 98.281% x 1000 = $982.81, the low price for the day was 97.362% x 1000 = $973.62 for a range of $9.19 b) $ Coupon = (4.625% / 2) x 1000 = $23.125 received every six months c) The bond rating implies this is a medium grade bond that lacks outstanding protection characteristics, in other words the bond issuer may have difficulty making the promised payments in full and on time, particularly if the economy does not perform well. d) The Last Price in the quote is 97.726 and the change was +0.286 so the prior Last quote was 97.726 0.286 = 97.44 or 97.44% x 1000 = $974.40 Level: Medium

54. A bondholder purchased a 9% coupon, $1,000 par 3 year bond at a 9% yield. Interest rates then immediately fell to 7% and his bond was called at a price of $1,040. He reinvested

Ch 6 - 13

4th Ed

his money and earned 7% on the $1,040 for 3 years. Did the call help or hurt the bondholder? What was his three year rate of return on his original investment? Answer: $1,040(1.07)3 = $1,274.04 $1000 (1+r)3 = $1,274.04 r = 8.41% The call hurt the bondholder; he earned 59 fewer basis points in rate of return. Level: Difficult

55. An investor is holding a $1,000 par, 10 year 9% coupon convertible bond with a 9% required bond yield. The bond is convertible into 40 shares of stock. Each share is worth $30. The bond has a current market value of $1,200. If interest rates don't change what is the maximum gain and loss on the bond? Answer: The maximum gain is unlimited; the bond's price will increase with the stock, which could increase an unlimited amount. The maximum loss on the bond given no interest rate change is $200. The bond has a floor price equal to its value as a bond and with a 9% coupon and 9% yield that gives a $1000 minimum value. Level: Difficult

56. You are an investment banker and one of your large U.S. corporate clients has come to you asking for help deciding on the best market in which to place a sizeable issue of bonds. You could try to issue dollar denominated bonds, or Euro or yen denominated bonds. You could also issue in the U.S. or overseas. What major factors should you consider in advising your client on where to market the issue? Answer: Some of the key variables would include: 1. Interest rates in the various markets 2. Underwriter spreads on different types of bonds 3. Expected changes in currency values; borrowers do not wish to borrow in currencies that are expected to appreciate in value. 4. Regulations and taxes in the various countries. 5. Ability to market large size issues in a given currency or country. Level: Difficult

Ch 6 - 14