ch.17

CHAPTER 18 BOND FUNDAMENTALS

TRUE/FALSE QUESTIONS (t) 1

Public bonds differ from other debt because they are sold to the public rather than to a single investor.

(t) 2

A nonrefunding provision prohibits a call and premature retirement of an issue from the proceeds of a lower-coupon refunding bond.

(t) 3

In the case of a bond, the only contractual factor is the amount of interest payments, since beginning and ending bond prices are determined by market forces.

(f) 4

In Germany, the government sector is the largest bond market segment.

(f) 5

Wealthy individual investors typically account for 90 to 95 percent of investors in the bond market.

(f) 6

High-yield bonds are considered “investment” grade.

(f) 7

Government bond issues require an annual sinking fund payment of not less than one percent of the outstanding issue.

(f) 8

Most U.S. municipal bonds are serial issues which are subject to state and local taxes when they are issued in the investor's home state.

(f) 9

The secondary bond market is significantly more active than the stock market.

(f) 10

High-yield bonds are considered “investment” grade.

(t) 11

A bond’s price is determined by the issue’s coupon rate, length to maturity, and the prevailing yield in the market.

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MULTIPLE CHOICE QUESTIONS (d) 1

The bond market segments that tend to be highly correlated and move together include a) Short and long term bonds. b) Short and intermediate term bonds. c) Intermediate and long term bonds. d) Short, intermediate and long term bonds. e) None of the above.

(c) 2

Of the following provisions that might be found in a bond indenture, which would tend to reduce the coupon interest rate? a) A call provision b) No restrictive covenants c) A sinking fund provision d) Change in bond rating from Aaa to Aa e) None of the above (that is, all will increase the coupon rate)

(a) 3

The refunding provision of an indenture allows bonds to be retired unless a) They are replaced with a lower coupon bond issue. b) The remaining time to maturity is less than five years. c) The remaining time to maturity is greater than five years. d) The stated time period in the indenture has not passed. e) The stated time period in the indenture has passed.

(b) 4

Serial bonds a) Can be callable. b) Can have sinking funds. c) Have different maturity dates. d) All of the above. e) None of the above.

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(c) 5

Which of the following statements is not true regarding bond ratings? a) The ratings assigned are meant to indicate the probability of default for the bond issuer. b) The bonds assigned one of the top four rating classes are considered investment grade bonds. c) Once a rating is assigned to an issue it cannot be changed for the first two years after which it is reviewed on a regular basis. d) Bonds rated BB and below are referred to as high yield or "junk" bonds. e) The rating agencies modify the ratings with + and - signs or numbers after the letters.

(c) 6

When a fixed income security is being traded but the issuer is not meeting interest payments it is trading a) Stamped. b) Registered. c) Flat. d) Round. e) No accrual.

(d) 7

The corporate bond market in Japan a) Consists of three components. b) Is largely unregulated. c) Has always been rated like the U.S. bond market. d) Is regulated by the Kisaikai. e) Is regulated by the Nikkei Exchange.

(a) 8

The bonds issued by the Bank of England are known as a) Gilts. b) Bunds. c) Limies. d) Treasuries. e) Benchmarks.

(d) 9

When a bond issue is secured by a legal claim on equipment it is known as a a) Junior bond. b) Income bond. c) Bearer bond. d) Trust certificate. e) Perpetuity.

(d) 10

Which set of conditions will result in a bond with the greatest volatility? a) A high coupon and a short maturity b) A high coupon and a long maturity c) A low coupon and a short maturity d) A low coupon and a long maturity e) A deferred call feature and a sinking fund.

(e) 11

The annual interest paid on a bond relative to its prevailing market price is called its a) Promised yield. b) Yield to maturity. c) Coupon rate. d) Effective yield. e) Current yield.

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(c) 12

The institutions which invest most heavily in corporate bond issues are a) Life insurance companies and commercial banks. b) Life insurance companies and property and liability insurance companies. c) Life insurance companies and pension funds. d) Commercial banks and property and liability insurance companies. e) Commercial banks and pension funds.

(d) 13

Which of the following is not a major rating agency for bonds? a) Moody's b) Standard & Poor's c) Fitch Investor Services d) Value Line e) Duff and Phelps

(b) 14

Treasury bonds which can be purchased at a discount to be used at par to pay estate taxes are called a) Estate bonds. b) Flower bonds. c) Municipal bonds. d) Probate bonds. e) Survivor bonds.

(c) 15

The major owners of high-yield bonds have been a) Commercial banks. b) Savings and loans. c) Mutual funds. d) California Credit Unions (CCU’s). e) European banks.

(c) 16

When a fixed income security is being traded at the price above its face value it is trading a) At a discount. b) At par. c) At a premium. d) Flat. e) No accrual.

(a) 17

A security that has a coupon that is periodically adjusted is a a) Variable note. b) Variation note. c) Adjustable coupon note. d) Money market certificate. e) Deep discount bond.

(e) 18

The following are participating issuers in bond markets a) Governments. b) School districts. c) Corporations d) a) and c). e) a), b) and c).

(e) 19

The following are participating investors in bond markets. a) U.S. Treasury.

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b) c) d) e)

Life insurance companies. Commercial banks. a) and b). b) and c).

(a) 20

Institutional investors typically account for about a) 90 to 95 percent of bond market trading. b) 40 to 50 percent of bond market trading. c) 10 to 15 percent of bond market trading. d) Less than 5% of bond market trading. e) None of the above.

(b) 21

Alternative institutions favor different sectors of the bond market based on a) The level of interest rates. b) The tax code applicable to the institution. c) The nature of the institution’s asset structure d) a) and b). e) b) and c).

(b) 22

Bond ratings are positively related to a) Leverage. b) Size. c) Type of business. d) All of the above. e) None of the above.

(c) 23

Bond ratings are negatively related to a) Profitability. b) Cash flow coverage. c) Earnings instability. d) All of the above. e) None of the above.

(b) 24

TIPS are U.S Treasury securities where the coupon rate is a) Zero b) Indexed to the rate of inflation. c) Indexed to the discount rate. d) Indexed to the prime rate. e) None of the above.

(b) 25

If the yield to maturity for a par value TIPS bond with 8 years to maturity is 3%, and the yield to maturity of a U.S Treasury note with 8 years is 4.25%, this implies that a) The expected annual rate of inflation over the next 8 years is –1.25%. b) The expected annual rate of inflation over the next 8 years is 1.25%. c) The expected annual rate of inflation over the next 8 years is –2.25% d) The expected annual rate of inflation over the next 8 years is 2.25% e) None of the above.

(c) 26

The face value of a U.S. government agency security a) Is always $1000. b) Ranges from $1000 to $5000.

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c) d) e)

Ranges from $1000 to $100,000. Ranges from $1000 to $50,000. Is always $10,000.

(b) 27

A major source of risk faced by GNMA issues is a) Default risk. b) Prepayment risk. c) Counterparty risk. d) a) and b). e) a), b) and c).

(b) 28

When homeowners pay off mortgages when they sell their homes, or when homeowners refinance home mortgages, they effectively a) Make the maturities of GNMA securities longer. b) Make the maturities of GNMA securities shorter. c) Make the maturities of U.S. Treasury securities longer. d) Make the maturities of U.S. Treasury securities shorter. e) None of the above.

(c) 29

General obligation bonds are a) U.S. Treasury bonds backed by the full faith and credit of the issuer. b) U.S. Treasury bonds backed by income generated form specific projects. c) Municipal bonds backed by the full faith and credit of the issuer. d) Municipal bonds backed by income generated from specific projects. e) A type of U.S. agency security.

(d) 30

Revenue bonds are a) U.S. Treasury bonds backed by the full faith and credit of the issuer. b) U.S. Treasury bonds backed by income generated form specific projects. c) Municipal bonds backed by the full faith and credit of the issuer. d) Municipal bonds backed by income generated from specific projects. e) A type of U.S. agency security.

(b) 31

Collateralized Mortgage obligations are a) Mortgage pass-through securities. b) Mortgage pass-through securities with varying maturities. c) Mortgage pass-through securities with no default risk. d) Mortgage pass-through securities with variable coupon rates. e) None of the above.

(b) 32

A bond denominated in U.S. dollars and sold in Japan to Japanese investors is called a a) Samurai bond. b) Eurobond. c) Yankee bond. d) Euroyen bond e) Foreign bond. MULTIPLE CHOICE PROBLEMS

(c) 1

An 8.0 percent coupon bond issued by the State of Washington sells for $1,000. What coupon rate on a corporate bond selling at $1,000 par value would produce the

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same after tax return to the investor as the municipal bond if the investor is in the 28 percent marginal tax bracket? a) 10.19% b) 12.25% c) 11.11% d) 14.63% e) 30.71% (c) 2

A 9.0 percent coupon bond issued by the State of California sells for $1,000. What coupon rate on a corporate bond selling at $1,000 par value would produce the same after tax return to the investor as the municipal bond if the investor is in the 26 percent marginal tax bracket? a) 10.19% b) 11.25% c) 12.16% d) 14.63% e) 30.71%

(c) 3

An 11.0 percent coupon bond issued by the State of Ohio sells for $1,000. What coupon rate on a corporate bond selling at $1,000 par value would produce the same after tax return to the investor as the municipal bond if the investor is in the 25 percent marginal tax bracket? a) 10.19% b) 12.25% c) 14.67% d) 13.53% e) 30.71%

(c) 4

A 7.0 percent coupon bond issued by the State of Tennessee sells for $1,000. What coupon rate on a corporate bond selling at $1,000 par value would produce the same after tax return to the investor as the municipal bond if the investor is in the 29 percent marginal tax bracket? a) 7.59% b) 12.25% c) 9.86% d) 14.63% e) 30.71%

(d) 5

At what point would an investor be indifferent between a Drifton corporate bond yielding 14.0 percent and a tax-free municipal bond of equal financial strength if the investor's marginal tax rate is 25 percent? a) 6.05% b) 7.10% c) 8.15% d) 10.5% e) 16.27%

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(d) 6

At what point would an investor be indifferent between a Compco corporate bond yielding 10.0 percent and a tax-free municipal bond of equal financial strength if the investor's marginal tax rate is 25 percent? a) 6.05% b) 7.10% c) 8.15% d) 7.50% e) 16.27%

(c) 7

At what point would an investor be indifferent between a Trifton corporate bond yielding 12.0 percent and a tax-free municipal bond of equal financial strength if the investor's marginal tax rate is 25 percent? a) 6.00% b) 7.10% c) 9.00% d) 9.15% e) 14.00%

(e) 8

At what point would an investor be indifferent between a Bridgford corporate bond yielding 8.0 percent and a tax-free municipal bond of equal financial strength if the investor's marginal tax rate is 25 percent? a) 5.00% b) 7.10% c) 8.00% d) 9.15% e) 6.00%

(b) 9

You purchase a 10 3/8s 2001 Feb. $10,000 par Treasury Note at 103:11 and hold it for exactly one year at which time you sell it. What is your rate of return if your selling price is 101:13? a) 8.14% b) 8.16% c) 8.22% d) 8.32% e) 8.47%

(d) 10

You purchase a 9 3/4s 2001 Feb. $10,000 par Treasury Note at 101:11 and hold it for exactly one year at which time you sell it. What is your rate of return if your selling price is 101:17? a) 8.14% b) 8.75% c) 9.75% d) 9.81% e) 10.47%

(b) 11

You purchase a 8 1/2s 2001 Feb. $10,000 par Treasury Note at 105:16 and hold it for exactly one year at which time you sell it. What is your rate of return if your selling price is 105:16? a) 8.00% b) 8.06% c) 8.22% d) 8.50% e) 8.47%

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(e) 12

You purchase a 11 3/8s 2001 Feb. $10,000 par Treasury Note at 103:11 and hold it for exactly one year at which time you sell it. What is your rate of return if your selling price is 100:13? a) 10.14% b) 11.75% c) 8.22% d) 8.32% e) 8.16%

(a) 13

You purchase a 10 1/4s 2001 Feb. $10,000 par Treasury Note at 102:15 and hold it for exactly one year at which time you sell it. What is your rate of return if your selling price is 104:14? a) 11.92% b) 8.16% c) 8.55% d) 8.61% e) 10.25 %

(c) 14

How much would you have to pay for a corporate bond quoted as follows? Bond GreyF Zr02 a) b) c) d) e)

(b) 15

Cur Yield -

Volume 27

Close 37 1/4

Net Change -

$99.00 $37.25 $372.50 $2700.00 None of the above

How much would you have to pay for a corporate bond quoted as follows? Bond IBM 9s01 a) b) c) d) e)

Cur Yield 8.4

Volume 39

Close 107 1/2

Net Change +3/8

$99.00 $1075.00 $372.50 $2700.00 None of the above

USE THE FOLLOWING INFORMATION FOR THE NEXT TWO PROBLEMS Bond Kmart 8 1/2 00

Cur Yield 8.1

Volume 250

Close 105 3/4

Net Change +1/8

(b) 16

How much would you expect to pay for the Kmart corporate bond quoted above? a) $10,575.00 b) $1057.50 c) $970.00 d) $850.00 e) $810.00

(a) 17

How much would you expect to earn in interest per year from this corporate bond?

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a) b) c) d) e)

$85.00 $97.00 $81.00 $250.00 $105.75

(a) 18

How much would you expect to pay for a $10,000 Treasury bond quoted at 98:17? a) $9,853.13 b) $10,000.00 c) $981.70 d) $9,817.00 e) None of the above

(d) 19

How much would you expect to pay for a $10,000 Treasury note quoted at 96:27? a) $9,627.00 b) $10,000.00 c) $968.44 d) $9,684.38 e) None of the above

(a) 20

How much would you expect to pay for a $10,000 stripped Treasury bond quoted at 101:16? a) $10,150.00 b) $10,000.00 c) $101.16 d) $10,160.00 e) None of the above

(e) 21

For bonds A and B below find the values of X and Y assuming each is a zero coupon bond with a $1,000 face value (semiannual compounding) Bond

Maturity (Years)

A

X

10

458.10

B

9

Y

212.00

a) b) c) d) e) (a) 22

Yield (Percent)

Price ($$)

8 years and 4 percent 10 years and 8 percent 12 years and 10 percent 14 years and 12 percent 8 years and 18 percent

Calculate the yield to maturity of a zero coupon bond with a face value of $1000, maturing in 10 years and selling for a price of $829.30. a) 6.44% b) 8.45% c) 4.16% d) 10% e) 12%

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(b) 23

Calculate the yield to maturity of a zero coupon bond with a face value of $1000, maturing in 5 years and selling for a price of $925.75. a) 12.56% b) 13.72% c) 14.87% d) 15.26% e) 16.27%

(c) 24

Calculate the price of a zero coupon bond with yield to maturity of 12.5%, a face value of $1000, and maturing in 8 years. a) $1000 b) $756.43 c) $389.74 d) $435.12 e) $875.14

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CHAPTER 18

ANSWERS TO PROBLEMS

1

8.0 ÷ (1.0 - 0.28) = 11.11%

2

9.0 ÷ (1.0 - 0.26) = 12.16%

3

11 ÷ (1.0 - 0.25) = 14.67%

4

7 ÷ (1.0 - 0.29) = 9.86%

5

(14)(1.0 - 0.25) = 10.5%

6

(10)(1.0 - 0.25) = 7.5%

7

(12)(1.0 - 0.25) = 9%

8

(8)(1.0 - 0.25) = 6%

9

Purchase Price = [(103 + 11/32) ÷ 100] x 10,000 = $10,334.375 Selling Price = [(101 + 13/32) ÷ 100] x 10,000 = $10,140.625 Interest = 10 3/8% of 10,000 = $1,037.50 Return = (Pend - Pbeg + Interest) ÷ Pbeg = (10,140.625 - 10,334.375 + 1,037.50) ÷ 10,334.375 = 8.16%

10

Purchase Price = [(101 + 11/32) ÷ 100] x 10,000 = $10,134.375 Selling Price = [(101 + 17/32) ÷ 100] x 10,000 = $10,153.125 Interest = 9 3/4% of 10,000 = $975.00 Return = (Pend - Pbeg + Interest) ÷ Pbeg = (10,153.125 - 10,134.375 + 975.00) ÷ 10,134.375 = 9.81%

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11

Purchase Price = [(105 + 16/32) ÷ 100] x 10,000 = $10,550.00 Selling Price = [(105 + 16/32) ÷ 100] x 10,000 = $10,550.00 Interest = 8 1/2% of 10,000 = $850.00 Return = (Pend - Pbeg + Interest) ÷ Pbeg = (10,550.00 - 10,550.00 + 850.00) ÷ 10,550.00 = 8.06%

12

Purchase Price = [(103 + 11/32) ÷ 100] x 10,000 = $10,334.375 Selling Price = [(100 + 13/32) ÷ 100] x 10,000 = $10,040.625 Interest = 11 3/8% of 10,000 = $1,137.50 Return = (Pend - Pbeg + Interest) ÷ Pbeg = (10,040.625 - 10,334.375 + 1,137.50) ÷ 10,334.375 = 8.16%

13

Purchase Price = [(102 + 15/32) ÷ 100] x 10,000 = $10,246.875 Selling Price = [(104 + 14/32) ÷ 100] x 10,000 = $10,443.75 Interest = 10 1/4% of 10,000 = $1,025.00 Return = (Pend - Pbeg + Interest) ÷ Pbeg = (10,443.75 - 10,246.875 + 1,025.00) ÷ 10,246.875 = 11.92%

14

Closing quote = 37 1/4, therefore price 37.25 x 100 = $372.50

15

Closing quote = 107 1/2, therefore price 107.50 x 100 = $1,075.00

16

Closing quote = 105 3/4, therefore price 105 3/4 x 100 = $1,057.50

17

Quote says “Kmart 8 1/2 00” therefore annual interest is 8.5% of $1,000 = $85.00

18

[(98 + 17/32) ÷ 100] x 10,000 = $9,853.13

19

[(96 + 27/32) ÷ 100] x 10,000 = $9,684.38

20

[(101 + 16/32) ÷ 100] x 10,000 = $10,150.00

21

Bond A $458.10 = 1,000 x (Present Value Factor at 5% and 2t periods) 0.4581 = Present Value Factor

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The value 0.4581 for 5% is found at 16 periods Then 2t = 16, and t = 8 years

Bond B $212.00 = $1,000 x (Present Value Factor at i/2 and 18 periods) 0.2120 = Present Value Factor The value 0.2120 for 18 periods is found at 9% Then i/2 = 9%, and i = 18% 22

Solve for i 1000 = 829.3(1 + i)3 i = (1000/829.3) 1/3 –1 = .0644 = 6.44%

23

Solve for i 1000 = 525.75(1 + i)5 i = (1000/525.75) 1/5 –1 = .1372 = 13.72

24

Solve for P P = 1000/(1 + .125)8 P = $389.74

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