Question 1

An important feature of the GNMA (GinnieMae) pass-through certificate is that there is no principal balance at maturity.

Accepted Answer

A major consideration in this investment is that the investor has fully consumed his or her capital at the end of the investment. (Not only has interest been received monthly but also all principal has been returned over the life of the certificate, and therefore, there is no lump-sum payment at maturity.)

Question 2

Changes in the market rate of interest are reflected in the semiannual interest payments of a variable rate note, while the price remains stable.

Accepted Answer

A few corporate bonds are termed variable-rate notes or floating-rate notes, meaning the coupon rate is fixed for only a short period and then varies with a stipulated short-term rate, such as the rate on U.S. Treasury bills. In this instance, the interest payment, rather than the price of the bond, varies up and down.

Question 3

A secured corporate bond is referred to as a debenture.

Accepted Answer

A corporate debt issue that is unsecured is referred to as a debenture.

Question 4

An investor in a municipal bond will receive 8% interest. He is in a 33% tax bracket. The comparable before-tax yield on a taxable investment is 14%.

Accepted Answer

The taxable equivalent yield (TEY) formula can be used to compare the after-tax returns of a tax-free investment, such as a municipal bond, to a taxable investment.

TEY = tax-free yield / (1 - tax rate)

Using the given information:

Tax-free yield = 8%
Tax rate = 33%

TEY = 8% / (1 - 0.33) = 11.94%

The comparable before-tax yield on a taxable investment is 14%, which is higher than the TEY of the municipal bond. Therefore, it would not make sense for the investor to choose the municipal bond over the taxable investment.

Thus, the statement in the question is false, and the answer is B.

Question 5

Income bonds are highly favored by corporations, because they provide the benefits of tax-deductible interest payments, without the contractual obligations of most debt instruments.

Accepted Answer

Income bonds specify that interest is to be paid only to the extent that it is earned as current income. There is no legally binding requirement to pay interest on a regular basis, and failure to make interest payments cannot trigger bankruptcy proceedings. These issues appear to offer the corporation the unusual advantage of paying interest as a tax-deductible expense (as opposed to dividends) combined with freedom from the binding contractual obligation of most debt issues.

Question 6

Like the stock market, there is a strong secondary market for bond issues, particularly corporate and municipal bonds.

Accepted Answer

While the secondary market is active for many types of Treasury and agency issues, such is not the case for corporate and municipal issues.

Question 7

The major provisions in the bond agreement are spelled out in the bond debenture.

Accepted Answer

The major provisions in a bond agreement are spelled out in the bond indenture, a complicated legal document often more than 100 pages long, and administered by an independent trustee (usually a commercial bank). A corporate debt issue that is unsecured is referred to as a debenture.

Question 8

Preferred stock dividends are tax-deductible to the corporation, and also provide tax advantages to the corporate investor.

Accepted Answer

While preferred stock dividends are not tax-deductible to the corporation, as would be true with interest on bonds, they do offer certain investors unique tax advantages. The tax law provides that any corporation that receives preferred or common stock dividends from another corporation must add only 30% of such dividends to its taxable income. Thus, if a $5 dividend is received, only 30% of the $5, or $1.50, would be taxable to the corporate recipient.

Question 9

Corporate bonds carry a higher yield than government issues, and are fully taxable for federal, state, and local purposes.

Accepted Answer

All income from corporate bonds is taxable for federal, state, and local purposes.

Question 10

A sinking fund may be used to pay off a perpetual bond.

Accepted Answer

A sinking-fund provision is when semiannual or annual contributions are made by a corporation into a fund administered by a trustee for purposes of debt retirement.

Question 11

While the stock market has an active secondary market, the bond market consists primarily of investors who buy and hold bond issues to maturity.

Accepted Answer

The bond market is heavily dominated by institutional investors. Bond investors are not constantly changing their portfolios with each new action of the corporation. Many institutional investors, such as insurance companies, are not active bond traders in existing issues but, instead, buy and hold bonds to maturity.

Question 12

A Treasury bill is a long-term obligation of the federal government.

Accepted Answer

A Treasury bill is a short-term obligation of the federal government. Treasury bills (T-bills) have maturities of 91 and 182 days.

Question 13

Corporate issues make up the largest percentage of new debt offerings in the bond market.

Accepted Answer

The answer of Corporate issues make up the largest percentage...

Question 14

An after-acquired clause requires that new property must be placed under the original mortgage.

Accepted Answer

Bondholders may attach an after-acquired property clause requiring that any new property be placed under the original mortgage.

Question 15

A call provision allows the corporation to retire a bond before maturity by paying a small discount below par value.

Accepted Answer

A call provision allows the corporation to call or force in all of the debt issue prior to maturity. The corporation usually pays a 3-5% premium over par value as part of the call provision arrangement. The ability to call is often deferred for the first 5 or 10 years of an issue (it can only occur after this time period).

Question 16

The IRS taxes zero-coupon bonds as if interest were paid annually, even though no cash flow is received until maturity.

Accepted Answer

The Internal Revenue Service taxes zero-coupon bonds, such as Treasury strips, as if interest were paid annually, even though no cash flow is received until maturity. The tax is based on amortizing the built-in gain over the life of the instrument. For tax reasons, zero coupons are usually only appropriate for tax-deferred accounts such as individual retirement accounts, 401(k) plans, or other nontaxable pension funds.

Question 17

The dollar volume of new corporate debt issues has exceeded the dollar volume of new corporate equity issues for many years.

Accepted Answer

Corporate bonds are the dominant source of new financing for U.S. corporations. Bonds normally supply 80-85% of firms' external financial needs.

Question 18

Income bonds specify that interest is to be paid only to the extent that it is earned in current income.

Accepted Answer

Income bonds specify that interest is to be paid only to the extent that it is earned as current income. There is no legally binding requirement to pay interest on a regular basis, and failure to make interest payments cannot trigger bankruptcy proceedings.

Question 19

Interest and capital gains on municipal bonds are tax-exempt by the IRS.

Accepted Answer

Income from municipal bonds cannot be taxed by the IRS. If there are capital gains, they will be taxed.

Question 20

Interest on federally-sponsored credit agency issues (such as the Federal Home Loan Bank) is not tax-free to the recipient.

Accepted Answer

Interest on agency issues is fully taxable for IRS purposes and is generally taxable for state and local purposes, although there are exceptions. (For example, interest on obligations issued by the Federal Farm Credit Bank is subject to state and local taxes, but those of the Federal Home Loan Bank are not.)

Quiz 11: Bond and Fixed-Income Fundamentals