Question 1

Callable bonds generally:

Accepted Answer

Callable bonds are often associated with sinking funds, which are used to retire a portion of the bond issue before maturity.

Question 2

Which one of the following statements concerning bond ratings is correct?

Accepted Answer

Bond ratings primarily assess the creditworthiness of the bond issuer, evaluating the issuer's ability to pay back the bond's principal and interest as promised. Other options are incorrect because Standard and Poor's and Moody's (not Value Line) are the primary bond rating agencies, investment grade bonds are generally those rated BBB- or better by S&P and Baa3 or better by Moody's, bond ratings do not directly evaluate price volatility, and different rating agencies can assign different ratings to the same bond.

Question 3

Protective covenants:

Accepted Answer

Protective covenants are primarily designed to protect bondholders from future actions of the bond issuer. These covenants typically limit the issuer's ability to take certain actions that could negatively impact the bondholders' interests, such as issuing more debt or paying dividends.

Answer: E
 This statement is false. Protective covenants are primarily designed to protect bondholders, not the issuing corporation.

Question 4

Interest rate risk _____ as the time to maturity increases.

Accepted Answer

Interest rate risk increases at a decreasing rate as the time to maturity increases. This means that the risk of fluctuations in the value of a security due to changes in interest rates becomes less and less significant as the time to maturity of the security increases. However, the rate at which interest rate risk reduces slows down as the time to maturity increases, meaning that the risk reduction will be less significant for longer-term securities compared to shorter-term securities.

Question 5

You own a bond that has a 7% coupon and matures in 12 years.You purchased this bond at par value when it was originally issued.If the current market rate for this.type and quality of bond is 7.5%,then you would expect:

Accepted Answer

When the market interest rate increases, the value of existing bonds decreases because investors can earn a higher return on their money elsewhere. This means that if you were to sell the bond in the current market, you would likely receive less than what you originally paid for it, resulting in a capital loss. The coupon rate is fixed at 7%, so the yield to maturity (which takes into account the interest payments and the bond's purchase price) would increase to adjust for the higher market rate, making choices A and B incorrect. Choice D is also incorrect because when the market rate is higher than the coupon rate, the bond's price will be less than face value. Finally, choice E is incorrect because the current yield (annual interest payments divided by market price) would actually be higher than 7% since the bond's coupon rate is fixed at 7%.

Question 6

American Fortunes is preparing a bond offering with an 8% coupon rate.The bonds will be repaid in 10 years.The company plans to issue the bonds at par value and pay interest semiannually.Given this,which of the following statements are correct?
I.The initial selling price of each bond will be $1,000.
II.After the bonds have been outstanding for 1 year,you should use 9 as the number of compounding periods when calculating the market value of the bond.
III.Each interest payment per bond will be $40.
IV.The yield to maturity when the bonds are first issued is 8%.

Accepted Answer

The answer of American Fortunes is preparing a bond offering...

Question 7

A bond with semi-annual interest payments,all else equal,would be priced _________ than one with annual interest payments.

Accepted Answer

The answer of A bond with semi-annual interest payments,all else...

Question 8

Bonds issued by the U.S.government:
I.are considered to be free of default risk.
II.are considered to be free of interest rate risk.
III.provide totally tax-free income.
IV.pay interest that is exempt from federal income taxes.

Accepted Answer

U.S. government bonds are considered free of default risk because the government can print money to meet its obligations. However, they are not free of interest rate risk, and the interest is subject to federal income taxes, though some state and local taxes may be exempt.

Question 9

Which one of the following statements is correct concerning interest rate risk as it relates to bonds,all else equal?

Accepted Answer

The answer of Which one of the following statements is...

Question 10

Which of the following statements concerning bond features is (are)correct?
I.Bondholders generally have voting power in a corporation.
II.Bond interest is tax-deductible as a business expense.
III.The repayment of the bond principal is tax-deductible.
IV.Failure to pay either the interest payments or the bond principle as agreed can cause a firm to go into bankruptcy.

Accepted Answer

I is incorrect as bondholders typically do not have voting power in a corporation.
II is correct as bond interest is tax-deductible as a business expense.
III is incorrect as the repayment of the bond principal is not tax-deductible.
IV is correct as failure to pay interest or bond principal as agreed can cause a firm to go into bankruptcy.

Question 11

Which of the following is a (are)positive covenant(s)that might be found in a bond indenture?
I.The company shall maintain a current ratio of 1.5 or better.
II.The company must limit the amount of dividends it pays according to the stated formula.
III.The company cannot lease any major assets without approval by the lender.
IV.The company must maintain the loan collateral in good working order.

Accepted Answer

A positive covenant requires the issuer to take certain actions. Maintaining a current ratio and maintaining collateral in good order are actions the company must take, making them positive covenants.

Question 12

Which one of the following statements is correct concerning bond classifications?

Accepted Answer

A callable bond can be redeemed by the issuer before the original maturity date, usually with a call premium. A mortgage security is a bond backed by a pool of mortgages, a debenture is an unsecured long-term bond, a note is a short-term bond (original maturity date under 10 years), and a subordinated bond is a bond with a lower priority in repayment in case of bankruptcy.

Question 13

A "fallen angel" is a bond that:

Accepted Answer

A "fallen angel" bond refers to a bond that was once considered investment-grade but has been downgraded to junk bond status. This typically happens when the issuer's financial stability deteriorates, causing the credit rating agency to lower the bond's rating. As a result, the bond's price may fall, and the yield to maturity may increase.

Question 14

Which one of the following bonds has the greatest interest rate risk?

Accepted Answer

E) 9-year; 7% coupon bonds have the greatest interest rate risk because they have the longest maturity and the lowest coupon rate, making them more sensitive to changes in interest rates.

Question 15

The break-even tax rate between a taxable corporate bond yielding 7% and a comparable nontaxable municipal bond yielding 5% can be expressed as:

Accepted Answer

The break-even tax rate formula is expressed as follows: Taxable yield = Nontaxable yield / (1 - tax rate). Substituting the values given in the question, we get:
0.07 = 0.05 / (1 - tax rate)
0.07*(1 - tax rate) = 0.05
0.07 - 0.07*tax rate = 0.05
0.07*tax rate = 0.02
tax rate = 0.02 / 0.07 = 0.2857
Multiplying this by 100 to get the percentage, we get 28.57%, which is the break-even tax rate. Therefore, the correct answer is A.

Question 16

The newly issued bonds of the Wynslow Corp.offer a 8% coupon with semiannual interest payments.The bonds are currently priced at par value.The effective annual rate provided by these bonds must be:

Accepted Answer

Since the bonds are priced at par value, the yield to maturity (YTM) is equal to the coupon rate of 8%. However, since interest payments are made semiannually, the effective annual rate (EAR) must be calculated, which is slightly higher than the YTM. Using the formula,
EAR=(1+ (Coupon rate/n))^n - 1, where n is the number of compounding periods per year, we get:
EAR = (1+ (0.08/2))^2 -1 = 0.0816 or 8.16%
Therefore, the effective annual rate provided by these bonds is greater than 8% but less than 9%. Hence, the correct answer is D, greater than 8% but less than 9%.

Question 17

All else constant,as the market price of a bond increases the current yield _____ and the yield to maturity _____

Accepted Answer

As the market price of a bond increases, the current yield decreases because the current yield is calculated as the annual coupon payment divided by the market price. Similarly, the yield to maturity decreases because it reflects the total return anticipated on a bond if held until it matures, which inversely relates to the bond's price.

Question 18

Municipal bonds:

Accepted Answer

Municipal bonds offer income tax advantages because the interest income is often exempt from federal income taxes and may also be exempt from state and local taxes if the investor resides in the state where the bond is issued.

Question 19

Treasury bonds are:

Accepted Answer

Treasury bonds are typically issued as coupon bonds, which means they pay interest in the form of regular coupon payments.

Answer: B 
 Treasury bonds are considered to be virtually risk-free because they are backed by the full faith and credit of the U.S. government, making default extremely unlikely.

Answer: C 
 Treasury bonds are often preferred by high-income individuals because they offer tax advantages. While their interest income is subject to federal taxes, it is exempt from state and local taxes, making them particularly attractive to investors in high-tax states.

Answer: D 
 Treasury bonds are issued directly by the U.S. Department of Treasury, making them the safest and most secure type of government bond available.

Answer: E 
 This statement is false. Treasury bonds are issued throughout the year, not just on the first day of the fiscal year.

Question 20

Which of the following items are generally included in a bond indenture?
I.call provisions
II.security description
III.current yield
IV.protective covenants

Accepted Answer

Bond indentures generally include call provisions, security description, and protective covenants. Current yield may be mentioned in the prospectus or offering circular, but is not typically included in the indenture itself.

Quiz 5: Interest Rate and Bond Valuation