Question 1

Default risk premiums are usually smaller during periods of high economic growth.

Accepted Answer

During periods of high economic growth, the economy is generally strong, businesses perform well, and the likelihood of default on debt obligations decreases. This leads to smaller default risk premiums as lenders perceive lower risk in lending.

Question 2

Expected lower rates of inflation in the future will lead to an upward sloping yield curve.

Accepted Answer

An upward sloping yield curve typically indicates expectations of higher future interest rates, not lower inflation. Lower expected inflation would generally lead to a flatter or inverted yield curve.

Question 3

A downward sloping yield curve forecasts higher future interest rates.

Accepted Answer

A downward sloping yield curve typically forecasts lower future interest rates, as it suggests that investors expect future interest rates to decline, which is why they demand higher yields for short-term investments compared to long-term ones.

Question 4

Investment-grade bonds are more likely to default than speculative-grade bonds.

Accepted Answer

Investment-grade bonds are considered to be of higher credit quality and are less likely to default compared to speculative-grade bonds, which carry a higher risk of default.

Question 5

A put option sets a "floor" or minimum price of a bond at the exercise price, which is generally at or above par value.

Accepted Answer

A put option on a bond allows the holder to force the issuer to buy back the bond at a specified price before maturity, but it does not set a floor or minimum price of the bond in the market; it only provides an option to sell back to the issuer. The market price of the bond can still fluctuate below the exercise price based on market conditions.

Question 6

Callable bonds have higher market yields than otherwise similar noncallable bonds.

Accepted Answer

Callable bonds offer higher yields to compensate investors for the risk that the issuer may redeem the bond before its maturity date, which can happen when interest rates decline. This additional risk for the investor results in a higher yield compared to noncallable bonds.

Question 7

An inverted yield curve forecasts higher short-term rates in the future.

Accepted Answer

An inverted yield curve typically indicates that investors expect lower short-term interest rates in the future, as it occurs when long-term debt instruments have a lower yield than short-term debt instruments.

Question 8

Bonds rated BBB would have lower yields than AAA-rated bonds, and higher prices, everything else the same.

Accepted Answer

BBB-rated bonds have higher yields and lower prices compared to AAA-rated bonds due to their higher credit risk.

Question 9

The call price of a bond is usually below the bond's par value.

Accepted Answer

The call price of a bond is typically at or above the bond's par value to compensate the bondholder for the early redemption.

Question 10

An investor in the 33 percent tax bracket should buy a 6 percent municipal bond rather than a similarly rated 8.5 percent corporate bond.

Accepted Answer

Municipal bonds are often tax-exempt, meaning the interest income is not subject to federal income taxes, and sometimes state and local taxes as well. For an investor in the 33 percent tax bracket, the effective yield of a tax-exempt 6 percent municipal bond would be higher than the after-tax yield of an 8.5 percent corporate bond, which is subject to taxes. To compare, the after-tax yield of the corporate bond can be calculated as 8.5% * (1 - 0.33) = 5.695%, which is lower than the 6% yield from the municipal bond.

Question 11

The less marketable a security, the higher its yield.

Accepted Answer

Securities that are less marketable often come with a higher yield to compensate investors for the added risk of liquidity, making them less easily sold at a favorable price.

Question 12

A downward sloping yield curve is typically seen just before an economic expansion.

Accepted Answer

A downward sloping yield curve, also known as an inverted yield curve, is typically seen as a predictor of economic recession, not expansion. It indicates that short-term interest rates are higher than long-term rates, suggesting investor pessimism about the near-term economy.

Question 13

Everything else the same, the higher the marginal tax rate of an investor, the more likely the investor is to invest in municipal bonds as opposed to similarly rated corporate bonds.

Accepted Answer

Municipal bonds are often exempt from federal income taxes, and sometimes from state and local taxes as well, making them more attractive to investors in higher tax brackets because the after-tax return on municipal bonds increases as the investor's marginal tax rate increases, compared to taxable bonds like corporate bonds.

Question 14

The market segmentation theory allows for the possibility of a discontinuous yield curve.

Accepted Answer

The market segmentation theory suggests that the bond market is segmented on the basis of maturity, with investors having specific maturity preferences, which can lead to a discontinuous yield curve if there are gaps in demand for bonds of certain maturities.

Question 15

Treasury and corporate security yields are often combined on the same yield curve.

Accepted Answer

Treasury and corporate security yields are typically plotted on separate yield curves due to differences in credit risk. Treasury securities are considered risk-free, while corporate securities include a risk premium.

Question 16

Putable bonds offer higher yields than similar non-putable bonds

Accepted Answer

Putable bonds typically offer lower yields than non-putable bonds because they provide the bondholder with the option to sell the bond back to the issuer before maturity, which is an added benefit.

Question 17

If interest rates are expected to increase in the future, one would expect to see an upward sloping yield curve.

Accepted Answer

An upward sloping yield curve indicates that longer-term interest rates are expected to be higher than short-term rates, which is consistent with expectations of rising interest rates in the future.

Question 18

Liquidity premiums cause an observed yield curve to be less upward sloping than that predicted by the expectations theory.

Accepted Answer

Liquidity premiums cause the yield curve to be more upward sloping than predicted by the expectations theory, as they compensate investors for holding longer-term securities.

Question 19

The major reason that municipal bonds have lower yields than corporate bonds is that, as a class, municipal debt has less marketability than corporate debt.

Accepted Answer

The major reason that municipal bonds have lower yields than corporate bonds is that the interest income from most municipal bonds is exempt from federal income taxes, and often state and local taxes as well, making them more attractive to investors in high tax brackets despite their lower yields. This tax advantage effectively increases the bond's yield after taxes, reducing the need for municipalities to offer higher interest rates.

Question 20

A convertible bond will generally have a higher market yield relative to similar nonconvertible bonds.

Accepted Answer

Convertible bonds typically offer lower interest rates or yields compared to similar nonconvertible bonds because they also grant the holder the option to convert the bond into a predetermined number of shares of the issuing company, adding value through the potential for capital appreciation.

Quiz 6: The Structure of Interest Rates