Deck 6: Bonds, Bond Valuation, and Interest Rates

Question 1

Under no circumstances are bondholders allowed to turn in their holdings unless the bonds are retractable.

Answer 1

False

Question 2

The market value of any financial asset may be estimated by determining future cash flows and then discounting them back to the present.

Answer 2

True

Question 3

The risk in bond prices due to fluctuations in interest rates is called reinvestment risk.

Answer 3

False

Question 4

A call provision gives bondholders the right to demand, or "call for," repayment of a bond. Typically, calls are exercised if interest rates rise, because when rates rise the bondholder can get the principal amount back and reinvest it elsewhere at higher rates.

Question 5

When interest rates fall, investors have more incentive to sell their retractable bonds back to the issuer.

Question 6

The Canada call feature stops a bond being called prior to its maturity because a higher buyback price is involved.

Question 7

The desire for floating-rate bonds, and consequently their increased usage, arose out of the experience of the early 1980s, when inflation pushed interest rates up to very high levels.

Question 8

A zero coupon bond is a bond that pays no interest and is offered (and subsequently sells initially) at par. These bonds provide compensation to investors in the form of capital appreciation.

Question 9

Maple bonds are issued by the government of Canada in Canadian dollars but only sold to foreign investors.

Question 10

If a firm raises capital by selling new bonds, it is called the "issuing firm," and the coupon rate is generally set equal to the required rate on bonds of equal risk.

Question 11

A bond that is callable has a chance of being retired earlier than its stated term to maturity. Therefore, if the yield curve is upward sloping, an outstanding callable bond should have a lower yield to maturity than an otherwise identical noncallable bond.

Question 12

Sinking funds are devices used to force companies to retire bonds on a scheduled basis prior to their maturity. Many bond indentures allow the company to acquire bonds for a sinking fund by either purchasing bonds in the market or selecting the bonds to be acquired by a lottery administered by the trustee through a call at face value.

Question 13

With no interim interest payment, zero bonds are not a good investment kept in the RRSP account.

Question 14

There is an inverse relationship between bonds' quality ratings and their required rates of return.

Question 15

Junk bonds are high-risk, high-yield debt instruments. They are often used to finance leveraged buyouts and mergers, and to provide financing to companies of questionable financial strength.

Question 16

Although Maple bonds are foreign bonds, they have no currency risk.

Question 17

A bond that had a 20-year original maturity with 1 year left to maturity has more interest rate price risk than a 10-year original maturity bond with 1 year left to maturity. (Assume that the bonds have equal default risk and equal coupon rates, and they cannot be called.)

Question 18

For bonds, price sensitivity to a given change in interest rates is generally greater the longer before the bond matures.

Question 19

Other things being equal, a firm will have to pay a higher coupon rate on its subordinated debentures than on its second mortgage bonds.

Question 20

As a general rule, a company's debentures have higher required interest rates than its mortgage bonds because mortgage bonds are backed by specific assets while debentures are unsecured.

Question 21

Suppose a Chinese company in Canada issues a bond that is denominated in Canadian dollars. What is this an example of?

A) a domestic bond
B) a global bond
C) a foreign bond
D) a Eurobond

Question 22

Suppose you are considering two bonds that will be issued tomorrow. Both are rated triple B (BBB, the lowest investment-grade rating), both mature in 20 years, both have a 10% coupon, neither can be called except for sinking fund purposes, and both are offered to you at their $1,000 par values. However, Bond SF has a sinking fund while Bond NSF does not. Under the sinking fund, the company must call and pay off 5% of the bonds at par each year. The yield curve at the time is upward sloping. The bond's prices, being equal, are probably not in equilibrium, as Bond SF, which has the sinking fund, would generally be expected to have a higher yield than Bond NSF.

Question 23

In corporate bonds, what is a "Canada call" used for calculating?

A) the maturity date
B) the default probability
C) the market risk
D) the buy-back price

Question 24

You have funds that you want to invest in bonds, and you just noticed in the financial pages of the local newspaper that you can buy a $1,000 par value bond for $800. The coupon rate is 10% (with annual payments), and there are 10 years before the bond will mature and pay off its $1,000 par value. You should buy the bond if your required return on bonds with this risk is 12%.

Question 25

A 10-year bond with a 9% annual coupon has a yield to maturity of 8%. Which statement about this bond is correct?

A) The bond is selling below its par value.
B) The bond is selling at a discount.
C) If the yield to maturity remains constant, the bond's price 1 year from now will be lower than its current price.
D) The bond's current yield is greater than 9%.

Question 26

Issued by the government of Canada, real return bonds are free from default risk. However, they are still subject to interest rate risk.

Question 27

Which event would make it more likely that a company would choose to call its outstanding callable bonds?

A) The company's bonds are downgraded.
B) Market interest rates decline sharply.
C) The company's financial situation deteriorates significantly.
D) Inflation increases significantly.

Question 28

The prices of high-coupon bonds tend to be less sensitive to a given change in interest rates than low-coupon bonds, other things held constant.

Question 29

A bond rating agency will rely exclusively on quantitative data to determine the risk that a firm may default on its debt servicing obligations.

Question 30

A 15-year corporate bond was issued 10 years ago. What is it today?

A) a long-term bond with 5 years to maturity
B) a medium-term bond with 5 years to maturity
C) a long-term bond with 15 years to maturity
D) a medium-term bond with 15 years to maturity

Question 31

Which of the following statements is correct?

A) All else being equal, senior debt generally has a lower yield to maturity than subordinated debt.
B) The expected return on a corporate bond will generally exceed the bond's yield to maturity.
C) If a bond's coupon rate exceeds its yield to maturity, then its expected return to investors exceeds the yield to maturity.
D) Under our bankruptcy laws, any firm that is in financial distress will be forced to declare bankruptcy and then be liquidated.

Question 32

A bond has a $1,000 par value, makes annual interest payments of $100, has 5 years to maturity, cannot be called, and is not expected to default. The bond should sell at a premium if interest rates are below 10% and at a discount if interest rates are greater than 10%.

Question 33

If the required rate of return on a bond (r_d) is greater than its coupon interest rate and will remain above that rate, then the market value of the bond will always be below its par value until the bond matures, at which time its market value will equal its par value. (Accrued interest between interest payment dates should not be considered when answering this question.)

Question 34

Because short-term interest rates are much more volatile than long-term rates, you would, in the real world, generally be subject to much more interest rate price risk if you purchased a 30-day bond than if you bought a 30-year bond.

Question 35

"Restrictive covenants" are designed primarily to protect bondholders by constraining the actions of managers. Such covenants are spelled out in bond indentures.

Question 36

Bond spread is the premium in interest rate that must be paid on a security that carries some risk that the issuer may not be able to meet all of its debt servicing obligations.

Question 37

Income bonds pay interest only if the issuing company actually earns the indicated interest. Thus, these securities cannot bankrupt a company, and this makes them safer from an investor's perspective than regular bonds.

Question 38

Which of the following statements best describes interest rates?

A) You hold two bonds. One is a 10-year, zero coupon issue, and the other is a 10-year bond that pays a 6% annual coupon. The same market rate, 6%, applies to both bonds. If the market rate rises from the current level, the zero coupon bond will experience the larger percentage decline.
B) The time to maturity does not affect the change in the value of a bond in response to a given change in interest rates.
C) The shorter the time to maturity, the greater the change in the value of a bond in response to a given change in interest rates.
D) The longer the time to maturity, the smaller the change in the value of a bond in response to a given change in interest rates.

Question 39

Floating-rate debt is advantageous to investors because the interest rate moves up if market rates rise. Since floating-rate debt shifts interest rate risk to companies, it offers no advantages to issuers.

Question 40

Which statement regarding bond maturity is true?

A) Any maturity is legally permissible.
B) The longest term of maturity for corporate bonds is 50 years.
C) Real return bonds have the shortest term of maturity.
D) Perpetuity bonds must have a specified maturity date.

Question 41

A 12-year bond has an annual coupon rate of 9%. The coupon rate will remain fixed until the bond matures. The bond has a yield to maturity of 7%. Which statement regarding the bond's price is true?

A) If market interest rates decline, the price of the bond will also decline.
B) The bond is currently selling at a price below its par value.
C) If market interest rates remain unchanged, the bond's price one year from now will be lower than it is today.
D) The bond should currently be selling at its par value.

Question 42

Assume that interest rates on 20-year Treasury and corporate bonds with different ratings, all of which are noncallable, are as follows: T-bond = 7.72%
A = 9.64%
AAA = 8.72%
BBB = 10.18%
What most probably caused the differences in rates among these issues?

A) real risk-free rate differences
B) default risk differences
C) maturity risk differences
D) inflation differences

Question 43

Three $1,000 face value bonds that mature in 10 years have the same level of risk, hence their YTMs are equal. Bond A has an 8% annual coupon, Bond B has a 10% annual coupon, and Bond C has a 12% annual coupon. Bond B sells at par. Assuming interest rates remain constant for the next 10 years, which statement about these bonds is true?

A) Bond A's current yield will increase each year.
B) Bond C sells at a premium (its price is greater than par), and its price is expected to increase over the next year.
C) Bond A sells at a discount (its price is less than par), and its price is expected to increase over the next year.
D) Over the next year, prices of Bond A, B, and C are expected to decrease, stay the same, and increase, respectively.

Question 44

Amram Inc. can issue a 20-year bond with a 6% annual coupon. This bond is not convertible, is not callable, and has no sinking fund. Alternatively, Amram could issue a 20-year bond that is convertible into common equity, may be called, and has a sinking fund. What is the coupon rate that Amram would have to pay on the convertible, callable bond?

A) It could be less than, equal to, or greater than 6%.
B) It is greater than 6%.
C) It is exactly equal to 6%.
D) It is less than 6%.

Question 45

If its yield to maturity declined by 1%, which bond would have the largest percentage increase in value?

A) a 1-year zero coupon bond
B) a 1-year bond with an 8% coupon
C) a 10-year bond with an 8% coupon
D) a 10-year zero coupon bond

Question 46

A 10-year corporate bond has an annual coupon of 9%. The bond is currently selling at par ($1,000). Which of the following statements is NOT correct?

A) The bond's expected capital gains yield is positive.
B) The bond's yield to maturity is 9%.
C) The bond's current yield is 9%.
D) The bond's current yield exceeds its capital gains yield.

Question 47

Assume that all interest rates in the economy decline from 10% to 9%. Which bond would have the largest percentage increase in price?

A) a 1-year bond with a 15% coupon
B) a 3-year bond with a 10% coupon
C) an 8-year bond with a 9% coupon
D) a 10-year zero coupon bond

Question 48

What does the yield to maturity on bonds refer to?

A) the number of years before the bond's maturity
B) the amount of interest income received by investors each year
C) the promised rate of return on the bonds if purchased at current price and held to maturity
D) the capital gain that investors can get in relation to the average industry price of the bonds

Question 49

You are considering two bonds. Bond A has a 9% annual coupon while Bond B has a 6% annual coupon. Both bonds have a 7% yield to maturity, and the YTM is expected to remain constant. Which of the following statements is correct?

A) The price of Bond B will decrease over time, but the price of Bond A will increase over time.
B) The prices of both bonds will remain unchanged.
C) The price of Bond A will decrease over time, but the price of Bond B will increase over time.
D) The prices of both bonds will increase over time, but the price of Bond A will increase by more.

Question 50

Which statement regarding sinking funds is true?

A) Sinking fund provisions sometimes adversely affect bondholders, and this is most likely to occur if interest rates decline after the bond has been issued.
B) Most sinking funds require the issuer to provide funds to a trustee, which saves the money so that it will be available to pay off bondholders when the bonds mature.
C) A sinking fund provision makes a bond more risky to investors at the time of issuance.
D) Sinking fund provisions never require companies to retire their debt; they only establish "targets" for the company to reduce its debt over time.

Question 51

Which bond has the greatest interest rate price risk?

A) a 10-year $100 annuity
B) a 10-year, $1,000 face value, zero coupon bond
C) a 10-year, $1,000 face value, 10% coupon bond with annual interest payments
D) All 10-year bonds have the same price risk since they have the same maturity.

Question 52

A 10-year Treasury bond has an 8% coupon, and an 8-year Treasury bond has a 10% coupon. Both bonds have the same yield to maturity. If the yield to maturity of both bonds increases by the same amount, which of the following statements would be correct?

A) The prices of both bonds will decrease by the same amount.
B) Both bonds would decline in price, but the 10-year bond would have the greater percentage decline in price.
C) The prices of both bonds would increase by the same amount.
D) One bond's price would increase, while the other bond's price would decrease.

Question 53

A 15-year bond with a face value of $1,000 currently sells for $850. Which statement regarding the bond's yield is true?

A) The bond's coupon rate exceeds its current yield.
B) The bond's current yield exceeds its yield to maturity.
C) The bond's yield to maturity is greater than its coupon rate.
D) The bond's current yield is equal to its coupon rate.

Question 54

A 10-year bond pays an annual coupon, its YTM is 8%, and it currently trades at a premium. Which statement regarding the bond's yield is true?

A) The bond's current yield is less than 8%.
B) If the yield to maturity remains at 8%, then the bond's price will decline over the next year.
C) The bond's coupon rate is less than 8%.
D) If the yield to maturity remains at 8%, then the bond's price will remain constant over the next year.

Question 55

Which statement regarding bond yields is true?

A) A zero coupon bond's current yield is equal to its yield to maturity.
B) If a bond's yield to maturity exceeds its coupon rate, the bond will sell at par.
C) All else being equal, if a bond's yield to maturity increases, its price will fall.
D) If a bond's yield to maturity exceeds its coupon rate, the bond will sell at a premium over par.

Question 56

Which of the following statements about bond yields is true?

A) If a bond is selling at a discount, the yield to call is a better measure of return than the yield to maturity.
B) On an expected yield basis, the expected capital gains yield will always be positive because an investor would not purchase a bond with an expected capital loss.
C) If a coupon bond is selling at par, its current yield equals its yield to maturity.
D) The current yield on Bond A exceeds the current yield on Bond B; therefore, Bond A must have a higher yield to maturity than Bond B.

Question 57

Which bond would have the greatest percentage increase in value if all interest rates fall by 1%?

A) 10-year, zero coupon bond
B) 20-year, 10% coupon bond
C) 20-year, 5% coupon bond
D) 20-year, zero coupon bond

Question 58

Which statement regarding reinvestment rate risk is true?

A) All else equal, high-coupon bonds have less reinvestment rate risk than low-coupon bonds.
B) All else equal, low-coupon bonds have less reinvestment rate risk than high-coupon bonds.
C) All else equal, short-term bonds have less reinvestment rate risk than long-term bonds.
D) All else equal, long-term bonds have less reinvestment rate risk than short-term bonds.

Question 59

Under normal conditions, which action would be most likely to increase the coupon rate required to enable a bond to be issued at par?

A) adding additional restrictive covenants that limit management's actions
B) adding a call provision
C) the rating agencies changing the bond's rating from Baa to Aaa
D) adding a sinking fund

Question 60

Tucker Corporation is planning to issue new 20-year bonds. Initially, the plan was to make the bonds non-callable. If the bonds were made callable after 5 years at a 5% call premium, how would this affect their required rate of return?

A) Because of the call premium, the required rate of return would decline.
B) There is no reason to expect a change in the required rate of return.
C) The required rate of return would decline because the bond would then be less risky to a bondholder.
D) The required rate of return would increase because the bond would then be more risky to a bondholder.

Question 61

Which statement regarding bonds is true?

A) If a 10-year, $1,000 par, 10% coupon bond were issued at par, and if interest rates then dropped to the point where r_d = YTM = 5%, we could be sure that the bond would sell at a premium above its $1,000 par value.
B) Other things held constant, a corporation would rather issue noncallable bonds than callable bonds.
C) Other things held constant, a callable bond would have a lower required rate of return than a noncallable bond.
D) Reinvestment rate risk is worse from an investor's standpoint than interest rate price risk if the investor has a short investment time horizon.

Question 62

Which statement regarding bond yields is true?

A) The yield to maturity for a coupon bond that sells at a premium consists entirely of a positive capital gains yield; it has a zero current interest yield.
B) The market value of a bond will always approach its par value as its maturity date approaches. This holds true even if the firm has filed for bankruptcy.
C) Rising inflation makes the actual yield to maturity on a bond greater than a quoted yield to maturity that is based on market prices.
D) The yield to maturity on a coupon bond that sells at its par value consists entirely of a current interest yield; it has a zero expected capital gains yield.

Question 63

A bond with a par value of $1,000 has an annual interest payment of $85. The bond currently sells for $850 and has 8 years to maturity. Which of the following is true?

A) The current yield on the bond must be 8.5%.
B) The investor's required rate of return must be 8.5%.
C) The coupon rate must be 8.5%.
D) The yield to maturity must be 8.5%.

Question 64

Which statement regarding interest rate risk is true?

A) One advantage of a zero coupon Treasury bond is that no one who owns the bond has to pay any taxes on it until it matures or is sold.
B) Long-term bonds have less interest rate price risk but more reinvestment rate risk than short-term bonds.
C) If interest rates increase, all bond prices will increase, but the increase will be greater for bonds that have less interest rate risk.
D) Relative to a coupon-bearing bond with the same maturity, a zero coupon bond has more interest rate price risk but less reinvestment rate risk.

Question 65

Which statement regarding bonds is true?

A) The total yield on a bond is derived from dividends plus changes in the price of the bond.
B) Bonds are riskier than common stocks and therefore have higher required returns.
C) Bonds issued by larger companies always have lower yields to maturity (less risk) than bonds issued by smaller companies.
D) The market value of a bond will always approach its par value as its maturity date approaches, provided the bond's required return remains constant.

Question 66

Which statement regarding interest rate risk is true?

A) If the market interest rate for a bond is less than the bond's coupon rate, the bond will sell at a premium.
B) If the market interest rate for a bond is greater than the bond's coupon rate, the bond will sell at a premium.
C) If the market interest rate for a bond is less than the bond's coupon rate, the bond will sell at a discount.
D) If the market interest rate for a bond is greater than the bond's coupon rate, the bond will sell at a discount.

Question 67

A government bond has an 8% annual coupon and a 7.5% yield to maturity. Which statement regarding this bond is correct?

A) The bond sells at a price below par.
B) The bond has a current yield greater than 8%.
C) The bond's required rate of return is less than 7.5%.
D) If the yield to maturity remains constant, the price of the bond will decline over time.

Question 68

Which statement regarding bonds is true?

A) If a coupon bond is selling at par, its current yield equals its yield to maturity.
B) If rates fall after its issue, a zero coupon bond could trade at a price above its par value.
C) If rates fall rapidly, a zero coupon bond's expected appreciation could become negative.
D) If a firm moves from a position of strength toward financial distress, its bonds' yield to maturity would probably decline.

Question 69

Which statement regarding the yield curve is true?

A) If inflation is expected to increase in the future, and if the maturity risk premium (MRP) is greater than zero, then the yield curve will have an upward slope.
B) If the maturity risk premium (MRP) is greater than zero, then the yield curve must have an upward slope.
C) If the maturity risk premium (MRP) equals zero, the yield curve must be flat.
D) The yield curve can never be downward sloping.

Question 70

Which statement regarding bonds is true?

A) 10-year, zero coupon bonds have higher reinvestment rate risk than 10-year, 10% coupon bonds.
B) A 10-year, 10% coupon bond has less reinvestment rate risk than a 10-year, 5% coupon bond (assuming all else is equal).
C) The total return on a bond during a given year is the sum of the coupon interest payments received during the year and the change in the value of the bond from the beginning to the end of the year.
D) The price of a 20-year, 10% bond is less sensitive to changes in interest rates than the price of a 5-year, 10% bond.

Question 71

Which statement regarding bond prices is true?

A) If a coupon bond is selling at par, its current yield equals its yield to maturity.
B) If a coupon bond is selling at a discount, its price will continue to decline until it reaches its par value at maturity.
C) If interest rates increase, the price of a 10-year coupon bond will decline by a greater percentage than the price of a 10-year zero coupon bond.
D) If a bond's yield to maturity exceeds its annual coupon, then the bond will trade at a premium.

Question 72

Short Corp. just issued bonds that will mature in 10 years, and Long Corp. issued bonds that will mature in 20 years. Both bonds promise to pay a semiannual coupon, they are not callable or convertible, and they are equally liquid. Further, assume that the yield curve is based only on expectations about future inflation, i.e., that the maturity risk premium is zero for government bonds. Under these conditions, which of the following statements is correct?

A) If the yield curve is upward sloping and Short has less default risk than Long, then Short's bonds must have the lower yield under all conditions.
B) If the yield curve is downward sloping, Long's bonds must have the lower yield under all conditions.
C) If the yield curve is flat, Short's bond must have the same yield as Long's bonds under all conditions.
D) If Long's and Short's bonds have the same default risk, their yields must be equal under all conditions.

Question 73

Which statement regarding bond yields is true?

A) If a coupon bond is selling at a premium, then the bond's current yield is zero.
B) If a bond is selling at a discount, the yield to call is a better measure of the expected return than the yield to maturity.
C) The current yield on Bond A exceeds the current yield on Bond B. Therefore, Bond A must have a higher yield to maturity than Bond B.
D) If a coupon bond is selling at par, its current yield equals its yield to maturity.

Question 74

Assume that the current corporate bond yield curve is upward sloping. Under this condition, what could we be sure of?

A) Inflation is expected to decline in the future.
B) Long-term bonds are a better buy than short-term bonds.
C) Maturity risk premiums could help to explain the yield curve's upward slope.
D) Long-term interest rates are more volatile than short-term rates.

Question 75

An investor is considering buying one of two 10-year, $1,000 face value bonds: Bond A has a 7% annual coupon, while Bond B has a 9% annual coupon. Both bonds have a yield to maturity of 8%, which is expected to remain constant for the next 10 years. Which statement regarding these bonds is correct?

A) Bond B has a higher price than Bond A today, but one year from now the bonds will have the same price.
B) One year from now, Bond A's price will be higher than it is today.
C) Bond A's current yield is greater than 8%.
D) Bond A has a higher price than Bond B today, but one year from now the bonds will have the same price.

Question 76

What effect would a 100 basis point drop in yield have on bond prices?

A) It would have a larger impact on bond prices when yields are high.
B) It would have a larger impact on bond prices when yields are low.
C) It would have the same impact on bond prices regardless of whether yields are high or low.
D) It would cause bond prices to fall in general.

Question 77

Which of the following statements is correct?

A) If the maturity risk premium were zero and interest rates were expected to decrease in the future, then the yield curve for government securities would, other things held constant, have an upward slope.
B) Liquidity premiums are generally higher on government than corporate bonds.
C) Default risk premiums are generally lower on corporate than on government bonds.
D) Reinvestment rate risk is lower, other things held constant, on long-term than on short-term bonds.

Question 78

Bond X has an 8% annual coupon, Bond Y has a 10% annual coupon, and Bond Z has a 12% annual coupon. Each of the bonds has a maturity of 10 years and a yield to maturity of 10%. Which statement regarding bonds is true?

A) If the bonds' market interest rate remains at 10%, Bond Z's price will be lower 1 year from now than it is today.
B) Bond X has the greatest reinvestment rate risk.
C) If market interest rates remain at 10%, Bond Z's price will be 10% higher 1 year from today.
D) If market interest rates increase, Bond X's price will increase, Bond Z's price will decline, and Bond Y's price will remain the same.

Question 79

Bonds A, B, and C all have a maturity of 10 years and a yield to maturity of 7%. Bond A's price exceeds its par value, Bond B's price equals its par value, and Bond C's price is less than its par value. Which statement regarding bonds is true?

A) If the yield to maturity on each bond decreases to 6%, Bond A will have the largest percentage increase in its price.
B) Bond A has the most interest rate risk.
C) If the yield to maturity on the three bonds remains constant, the prices of the three bonds will remain the same over the next year.
D) If the yield to maturity on each bond increases to 8%, the prices of all three bonds will decline.

Question 80

Which of the following statements regarding bond current yields is NOT true?

A) If a bond is selling at a discount to par, then its current yield will be less than its yield to maturity.
B) If a bond is selling at its par value, then its current yield equals its yield to maturity.
C) If a bond is selling at a premium, then its current yield will be greater than its yield to maturity.
D) A bond's current yield will remain unchanged as the bond's term to maturity changes.