Unit 2 q questions

Which of the following is an example of an unsecured debt security?

I. Debenture

II. Preferred stock

III. Mortgage bond

IV. Income bond

• I and II

• II and IV

• I and III

• I and IV

Answer explanation

A debenture and income bonds are examples of unsecured debt instruments. Preferred stock is an equity security and a mortgage bond is secured (collateralized) by real estate.

When interest rates in the open market move up or down, a bond's coupon rate will

• move with the open-market interest rates.

• be adjusted to match the open-market rates.

• move inversely to the open-market interest rates.

• be unaffected by the open-market interest rates.

Answer explanation

Though the price of a bond will react to market forces, such as supply and demand, and be interest-rate sensitive (inverse), the coupon is always the same: A fixed percentage of par value established by the issuer when the bond was first issued.

A customer has a short-term investment time horizon and a fairly certain need for funds she wishes to invest. Which of the following might meet those two investment objectives?

• Common stock

• Government Bonds

• Money Market Instruments

• Corporate Bonds

Answer explanation

With a short-term time horizon and an already identified need for the funds, the only choice of those listed here would be money market instruments with a fixed rate of return. Bonds are generally long-term instruments, and equity investments, such as common stock, do not offer a fixed rate of return and can be volatile.

STRIPS are delivered in

• physical certificates.

• book entry

• bearer form

• registered as to principal only form.

Answer explanation

All U.S. government issues are delivered in book entry.

T-notes are the U.S. government's

• only callable debt.

• long-term debt of over 10 years.

• short-term debt of 1 year or less.

• intermediate-term debt of 2–10 years.

Answer explanation

T-notes have maturities of 2–10 years when issued. The 10-year T-note yield is an important benchmark for interest rates.

Which of the following is a debt instrument that pays no periodic interest?

• Treasury notes

• Treasury STRIPS

• Treasury bonds

• Corporate Bonds

Answer explanation

STRIPS are Treasury bonds with the coupons removed. With no coupons, STRIPS do not make regular interest payments. Instead, they are sold at a deep discount and mature at par value.

An investor holds a 5% bond callable in six years and maturing in eight years. The bond's current yield (CY) measures its annual coupon payment relative to

• its market price.

• its value when callable

• par value

• its value at maturity

Answer explanation

The CY measures a bond's annual coupon payment (interest) relative to its market price, as shown in the following equation: annual coupon payment ÷ market price = current yield.

A corporate bankruptcy liquidation took place. Of the following—general creditors, secured bondholders, subordinated debenture holders, accrued taxes—who was paid first and who was paid last?

• General creditors first, secured bondholders last

• Secured bondholders first, general creditors last

• Secured bondholders first, subordinated bondholders last

• Secured bondholders first, accrued taxes last

Answer explanation

The liquidation priority is as follows: secured debt, unsecured debt and general creditors, then subordinated debt, and then equity holders with preferred shareholders first, followed by common shareholders. Therefore, of those that are listed here, secured bondholders would be paid first, and subordinated bondholders last. General creditors and taxes are paid at the same level.

The current yield on a bond with a coupon (nominal) rate of 7.5% currently selling at 105½ is approximately

• 7.5%

• 7.1%

• 6.5%

• 8.2%

Answer explanation

A bond with a coupon rate of 7.5% pays $75 of interest annually. Current yield equals annual interest amount divided by bond market price, or $75 ÷ $1,055 = 7.109%, or approximately 7.1%.

A customer buys a 10% bond with a current yield of 12% and holds the bond until one year before maturity. The bond is sold when current interest rates are 8%. Which of the following statements are correct?

I. The bond was purchased at a premium.

II. The bond was purchased at a discount.

III. The bond was sold at a premium.

IV. The bond was sold at a discount.

• II and IV

• II and III

• I and IV

• I and III

Answer explanation

When the current yield (12%) is higher than the coupon (10%), it means the bond was purchased at a discount. Because the question tells us that current interest rates are now 8%, the bond maturing within a year with a 10% coupon would now be able to be sold at a premium.