Question 1

Which of the following is an example of a positive covenant?

Accepted Answer

Positive covenants are agreements that require the borrower to perform specific actions. Option E, which requires the company to maintain its working capital at or above a specified level, is an example of a positive covenant because it obligates the company to actively ensure its working capital meets a certain standard.

Question 2

Which of the following statement is incorrect if interest rates fall?

Accepted Answer

When interest rates fall, coupon payments on floating rate bonds will also fall, not rise, because the coupon rates on these bonds adjust to reflect current interest rates.

Question 3

Milner's Tools has a 9-year, 7% annual coupon bond outstanding with a $1,000 par value. Carter's Tools has a 10-year, 6% annual coupon bond with a $1,000 par value. Both bonds currently have a yield to maturity of 6.5%. Which of the following statements is correct if the market yield increases to 6.75%?

Accepted Answer

When market yield increases, bond prices decrease. The bond with the longer duration (Carter's 10-year bond) will experience a greater price change than the bond with the shorter duration (Milner's 9-year bond). Therefore, the statement that Carter's bond will decrease in value is correct, but the specific percentage or amount of decrease for either bond is not provided accurately in the other options.

Question 4

Which of the following is NOT a typical negative bond covenant?

Accepted Answer

Negative bond covenants are designed to protect bondholders by limiting the actions of the borrower that could undermine the firm's financial stability or the bond's value. A typical negative covenant might restrict dividend payments, mergers, additional debt issuance, or pledging assets to other lenders to ensure the company maintains a certain level of financial health and does not undertake excessive risk that could jeopardize its ability to repay the bondholders. However, a covenant that prevents a firm's bond rating from falling below its initial level is not typical because bond ratings are determined by external agencies and can fluctuate based on a variety of factors beyond the firm's immediate control, such as changes in the economic environment or industry-specific risks.

Question 5

Which of the following would NOT be listed on the face of a bond?

Accepted Answer

The market price of the bond would not be listed on the face of a bond because it fluctuates based on market conditions. The face of a bond typically includes fixed information such as the coupon interest rate, maturity date, coupon payment, and the name of the issuer.

Question 6

Jackson Central has a 6-year, 8% annual coupon bond with a $1,000 par value. Earls Enterprises has a 12-year, 8% annual coupon bond with a $1,000 par value. Both bonds currently have a yield to maturity of 6%. Which of the following statements are correct if the market yield increases to 7%?

Accepted Answer

When market yield increases, bond prices decrease. The longer the time to maturity, the more sensitive the bond price is to changes in market yield. Therefore, the Earls bond with a longer maturity will experience a greater change in value than the Jackson bond.

To calculate the change in value, we can use the following formula:

Change in value = -(C × (1 - 1/(1 + r)^n)/r) - (F/(1 + r)^n)

Where: 
C = coupon payment
r = market yield
n = number of years to maturity
F = par value

For the Jackson bond: 
C = $80 ($1,000 × 8%)
r = 7%
n = 6 years
F = $1,000
Using the formula, we get:

Change in value = -($80 × (1 - 1/1.07^6)/0.07) - ($1,000/1.07^6) = -$45.95

So the Jackson bond will decrease in value by $45.95 or 4.60%.

For the Earls bond: 
C = $80
r = 7%
n = 12 years
F = $1,000
Using the formula, we get:

Change in value = -($80 × (1 - 1/1.07^12)/0.07) - ($1,000/1.07^12) = -$75.68

So the Earls bond will decrease in value by $75.68 or 7.57%.

Therefore, the correct choice is D. Choice A is incorrect because the Jackson bond will decrease in value by a smaller percentage than the Earls bond. Choice B and C are incorrect because the change in value for the Earls bond is negative, not positive. Choice E is incorrect because the change in value for the Earls bond is greater than $50.68.

Question 7

Sensitivity to interest rate risk is directly dependent on:

Accepted Answer

Sensitivity to interest rate risk increases with longer time to maturity and lower coupon rates, as these factors make the bond's price more volatile in response to interest rate changes.

Question 8

A put provision in a bond indenture allows:

Accepted Answer

A put provision in a bond indenture gives the bondholder the right to force the issuer to buy back the bond at a predetermined price before maturity. This can be beneficial for the bondholder in a declining interest rate environment or if the credit quality of the issuer deteriorates.

Question 9

The relationship between nominal interest rates on default-free, pure discount securities and the time to maturity is called the:

Accepted Answer

The term structure of interest rates describes the relationship between nominal interest rates on default-free, pure discount securities and the time to maturity. It is often represented by a yield curve, which plots the interest rates of bonds having equal credit quality but differing maturity dates.

Question 10

The difference between the clean price and the dirty price of a bond is:

Accepted Answer

The difference between the clean price and the dirty price of a bond is the accrued interest. The clean price is the price of a bond excluding any interest that has accrued since issue or during the last coupon payment. The dirty price includes this accrued interest.

Question 11

Which of the following would be classified as a positive protective covenant?

Accepted Answer

A positive protective covenant requires the firm to take certain actions, such as furnishing audited annual financial statements, to protect the interests of the bondholders.

Question 12

A corporation undertaking an expansion project issues 20 year bonds to finance the project. Which of the following is most likely true?

Accepted Answer

Issuing bonds means the company has borrowed money and is obligated to pay interest on the borrowed amount, regardless of its earnings.

Question 13

The written, legally binding agreement between the corporate borrower and the lender detailing the terms of a bond issue is called the:

Accepted Answer

The indenture is the formal debt agreement that outlines the terms of the bond issue, including the obligations of the issuer and the rights of the bondholders.

Question 14

Blackwater Industries just issued 12-year, 7% coupon bonds. Freshwater Enterprises just issued 12-year, 6% coupon bonds. Both bonds sold at par. Which one of the following statements is correct concerning these two bonds?

Accepted Answer

Given that both bonds have the same maturity but different coupon rates, the bond with the lower coupon rate (Freshwater Enterprises, 6%) is more sensitive to interest rate changes. This is because the present value of its lower coupon payments and principal will be more affected by changes in the discount rate (market interest rate) compared to the bond with the higher coupon rate (Blackwater Industries, 7%).

Question 15

Margaret wants to compute the present value of a six year semi-annual 8% coupon bond that has a 9% yield to maturity. Which one of the following is correct?

Accepted Answer

The bond pays interest semi-annually for six years, resulting in 6*2 = 12 interest payments.

Question 16

Lady Products, Inc. just issued 10-year, 8% coupon bonds at par. Outstanding Limbaugh Corp. bonds, which have a maturity of 10 years, sell at a premium to par and are viewed by investors as having the same risk as the Lady bonds. Therefore, it must be true that:

Accepted Answer

Since Limbaugh Corp. bonds sell at a premium and are considered to have the same risk as Lady Products, Inc. bonds, it indicates that the coupon rate on Limbaugh bonds is higher than the 8% coupon rate on Lady bonds. Bonds sell at a premium when the coupon rate is higher than the current market interest rate.

Question 17

A premium bond is defined as a bond which has a market price:

Accepted Answer

A premium bond is one whose market price exceeds its face value, meaning investors are willing to pay more than the bond's nominal value.

Question 18

The total interest paid on a zero-coupon bond is equal to:

Accepted Answer

The total interest paid on a zero-coupon bond is indeed the face value minus the issue price. This is because a zero-coupon bond is sold at a discount to its face value and does not pay periodic interest. The difference between the purchase price (issue price) and the face value (which is paid at maturity) represents the interest earned by the holder.

Question 19

"Disaster" bonds are primarily designed to help:

Accepted Answer

"Disaster" bonds, also known as catastrophe bonds, are primarily designed to help insurance companies recover from significant losses due to natural disasters. These bonds transfer the risk of catastrophic events from the insurer to investors, providing the insurer with immediate capital to cover claims from disasters like hurricanes, earthquakes, or floods.

Question 20

When pricing bonds, if a bond's coupon rate is less than the required rate of return, then:

Accepted Answer

When a bond's coupon rate is less than the required rate of return, it means that the bond is offering less interest than what investors demand for the given level of risk. Therefore, to make the bond attractive to investors, it must be sold at a discount (below its face value). If held to maturity, the investor will realize a capital gain because the bond will be redeemed at its face value, which is higher than the purchase price. Choices A, C, D, and E do not accurately describe the relationship between coupon rate, required rate of return, and bond pricing.

Quiz 7: Interest Rates and Bond Valuation