Question 1

A 6 percent, annual coupon bond is currently selling at a premium and matures in 7 years. The bond was originally issued 3 years ago at par. Which one of the following statements is accurate in respect to this bond today?

Accepted Answer

The yield-to-maturity (YTM) is less than the coupon rate when a bond is selling at a premium. This is because the bond's price is above its face value due to the higher interest payments compared to current market rates, leading to a lower yield to maturity compared to the original coupon rate.

Question 2

A zero coupon bond:

Accepted Answer

The answer of A zero coupon bond:
...

Question 3

A newly issued bond has a 7 percent 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

The answer of A newly issued bond has a 7...

Question 4

Which one of the following bonds is the least sensitive to interest rate risk?

Accepted Answer

Bonds with shorter maturities and higher coupon rates are generally less sensitive to interest rate changes. Among the options, the 3-year bond with a 6 percent coupon (Option B) has the shortest maturity and the highest coupon rate, making it the least sensitive to interest rate risk.

Question 5

Bonds issued by the U.S. government:

Accepted Answer

Bonds issued by the U.S. government are considered to be free of default risk because they are backed by the full faith and credit of the U.S. government. However, they are not necessarily free of interest rate risk or exempt from federal income taxes. Option B is incorrect because generally, bonds issued by states have higher coupons than those issued by the federal government. Option E is incorrect because "munis" refer to municipal bonds, which are issued by state and local governments, not the U.S. government.

Question 6

Texas Foods has a 6 percent bond issue outstanding that pays $30 in interest every March and September. The bonds are investment grade and sell at par. The bonds are callable at a price equal to the present value of all future interest and principal payments discounted at a rate equal to the comparable Treasury rate plus 0.50 percent. Which of the following correctly describe the features of this bond?
I. bond rating of B
II. "make whole" call price
III. $1,000 face value
IV. offer price of $1,000

Accepted Answer

The bond is described as investment grade, which contradicts a rating of B (choice I), typically considered below investment grade. The call price is based on the present value of future cash flows discounted at a specific rate (choice II), indicating a "make whole" call provision. The bond pays $30 in interest semi-annually, which suggests a $1,000 face value assuming a 6 percent annual interest rate (choice III). It sells at par, meaning the offer price is equal to its face value of $1,000 (choice IV).

Question 7

Protective covenants:

Accepted Answer

Protective covenants are contractual provisions in bond indentures or loan agreements that are intended to protect the interests of bondholders or lenders. These covenants can include restrictions on the borrower's ability to take certain actions (such as incurring additional debt or selling assets), requirements for maintaining minimum financial ratios or levels of cash flow, and provisions that give bondholders or lenders the right to accelerate repayment of the debt if certain events occur (such as the borrower defaulting on other debts). These covenants are often more common in higher-risk bond issues, such as those of lower-rated companies or those with longer maturities.

Question 8

You own a bond that has a 6 percent annual coupon and matures 5 years from now. You purchased this 10-year bond at par value when it was originally issued. Which one of the following statements applies to this bond if the relevant market interest rate is now 5.8 percent?

Accepted Answer

When the relevant market interest rate decreases below the coupon rate of the bond, the bond becomes more valuable because its fixed coupon payments are more attractive compared to the prevailing interest rates. This leads to an increase in the bond's price and a capital gain for the investor who owns the bond. Therefore, you will realize a capital gain on the bond if you sell it today.

Question 9

As a bond's time to maturity increases, the bond's sensitivity to interest rate risk:

Accepted Answer

As a bond's time to maturity increases, its sensitivity to interest rate changes (interest rate risk) does indeed increase, but this increase occurs at a decreasing rate. This is because the impact of a change in interest rates on a bond's price becomes less pronounced as the bond approaches its maturity.

Question 10

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

Accepted Answer

The break-even tax rate can be expressed as follows:

Taxable bond yield / (1 - tax rate) = Municipal bond yield

Substituting the given values, we get:

0.07 / (1 - tax rate) = 0.05

Solving for tax rate, we get:

Tax rate = 0.05 / (0.07 + 0.05) = 0.4167 or 41.67%

Therefore, the break-even tax rate is 41.67%. The only choice that expresses this calculation is Choice A.

Question 11

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

Accepted Answer

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

Question 12

Callable bonds generally:

Accepted Answer

The answer of Callable bonds generally:
...

Question 13

Which of the following statements concerning bonds are correct?
I. Bonds provide tax benefits to issuers.
II. The risk of a firm financially failing increases when the firm issues bonds.
III. Most long-term bond issues are referred to as unfunded debt.
IV. All bonds are treated equally in a bankruptcy proceeding.

Accepted Answer

I. Bonds often provide tax benefits to issuers because the interest payments on bonds are tax-deductible.II. Issuing bonds increases a firm's financial obligations due to the required interest payments, thus potentially increasing the risk of financial failure if the firm cannot meet these obligations.

Question 14

Treasury bonds are:

Accepted Answer

Treasury bonds are typically issued as semi-annual coupon bonds, meaning they pay interest twice a year.

Question 15

Last year, Lexington Homes issued $1 million in unsecured, non-callable debt. This debt pays an annual interest payment of $55 and matures 6 years from now. The face value is $1,000 and the market price is $1,020. Which one of these terms correctly describes a feature of this debt?

Accepted Answer

The fact that the debt pays an annual interest payment and matures 6 years from now indicates that it is a note. The other choices do not apply to this particular debt.

Question 16

Municipal bonds:

Accepted Answer

Municipal bonds pay interest that is federally tax-free, making them a popular choice for investors who want to minimize their tax burden. However, municipal bonds do carry some level of risk, including the risk of default.

Question 17

A "fallen angel" is a bond that has moved from:

Accepted Answer

A "fallen angel" is a bond that was originally issued with an investment-grade rating but has since been downgraded to speculative grade (below BBB- by S&P or Moody's). This can happen for a variety of reasons, such as a decline in the issuer's financial health or changes in the industry or market conditions.

Question 18

Which of the following increase the price sensitivity of a bond to changes in interest rates?
I. increase in time to maturity
II. decrease in time to maturity
III. increase in coupon rate
IV. decrease in coupon rate

Accepted Answer

I and IV only - An increase in time to maturity and a decrease in coupon rate both increase a bond's sensitivity to changes in interest rates. Longer maturity bonds have more future payments affected by rate changes, and lower coupon rates mean less income before maturity, making the bond's price more sensitive to rate changes.

Question 19

Which of the following are negative covenants that might be found in a bond indenture?
I. The company shall maintain a current ratio of 1.10 or better.
II. No debt senior to this issue can be issued.
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

Negative covenants are restrictions imposed by the bond indenture that limit the actions of the issuer. 
I. The current ratio requirement is a positive covenant. 
II. Restricting the issuer from issuing any senior debt is a negative covenant. 
III. Requiring lender approval for leasing major assets is a negative covenant. 
IV. Requiring the loan collateral to be maintained in good working order is a positive covenant. 
Therefore, the negative covenants are II and III.

Question 20

You expect interest rates to decline in the near future even though the bond market is not indicating any sign of this change. Which one of the following bonds should you purchase now to maximize your gains if the rate decline does occur?

Accepted Answer

Zero coupon bonds have the longest duration and are most sensitive to changes in interest rates. If interest rates decline, the value of these bonds will increase the most compared to other types of bonds. As the bond market is not indicating any sign of a rate decline, it is best to choose a long-term bond to maximize gains in case the rate decline occurs in the future. Additionally, a zero coupon bond does not have interest payments, so it will not be affected by changes in interest rates in the same way as bonds with coupon payments.

Quiz 7: Interest Rates and Bond Valuation