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Chapter 6 Bond Markets

True/False Questions

1. A Treasury STRIP is sometimes referred to as a TIPS.

Answer: False Page: 158 Level: Easy

2. A callable bond is one where the issuer is required to retire a certain amount of the
outstanding bonds each year to ensure that all the bond principle is paid by final
maturity.

Answer: False Page: 175 Level: Easy

3. Of the three major sectors of bond issuers, corporations have the greatest dollar value
of bonds outstanding.

Answer: True Page: 155 Level: Medium

4. “On the run” Treasury notes and bonds are newly issued securities and “off the run”
Treasuries are securities that have been previously issued.

Answer: True Page: 156 Level: Medium

5. Bonds that give the bondholder the opportunity to purchase common stock at a
prespecified price up to a specified date are called convertible bonds.

Answer: False Page: 178 Level: Medium

6. The dirty price plus accrued interest is called the clean price of the security.

Answer: False Page: 164-165 Level: Easy

7. Accrued interest owed to the bond seller increases as the next coupon payment date
approaches

Answer: True Page: 165 Level: Easy

8. Revenue bonds are backed by the full revenue of the municipality.

Answer: False Page: 171 Level: Easy

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9. An institutional investor that pays no taxes and is looking for a bond investment will
probably not invest in municipal bonds.

Answer: True Page: 170 Level: Medium

10. An unsecured bond that has no specific collateral other than the general
creditworthiness of the issuing firm is called a debenture.

Answer: True Page: 175 Level: Easy

11. With TIPS, the security's coupon rate is changed every six months by the inflation rate
as measured by the CPI.

Answer: False Page: 164 Level: Medium

12. Bond ratings use a classification system to give investors an idea of the amount of
interest rate risk associated with the bond issue.

Answer: False Page: 180-181 Level: Easy

13. Bonds rated below Baa by Moody's or BBB by S&P are junk bonds.

Answer: True Page: 180 Level: Medium

14. Euro bonds are bonds denominated in the issuer's home currency, but are issued
outside their home country.

Answer: True Page: 187 Level: Medium

15. Callable bonds have lower required yields than similar convertible bonds, ceteris
paribus.

Answer: False Page: 178-179 Level: Medium

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Multiple Choice Questions

16. The largest component of bond market instruments outstanding in 2004 was
comprised of
A) T-Bills
B) T-Bonds
C) Municipal bonds
D) Corporate bonds
E) None of the above

Answer: D Page: 155 Level: Medium

17. A T-Bond with a $1000 par is quoted at 98:20 Bid, 98:24 Ask. The clean price for
you to buy this bond is
A) $986.25
B) $987.50
C) $982.00
D) $982.40
E) None of the above

Answer: B Page: 163 Level: Medium

18. The quoted ask yield on a 15 year $1000 par T-Bond with a 6% semiannual payment
coupon and a price quote of 104:12 is
A) 6.00%
B) 5.60%
C) 5.57%
D) 2.81%
E) 2.78%

Answer: C Page: 164 Level: Medium


Rationale: $1,043.75 = $30×PVIFA(r%,30) + $1,000×PVIF(r%,30 yrs)

19. A Treasury security in which periodic coupon interest payments can be separated from
each other and from the principal payment is called a
A) STRIP
B) T-Note
C) T-Bond
D) G.O. Bond
E) Revenue Bond

Answer: A Page: 157-158 Level: Easy

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20. An 18 year T-Bond can be stripped into how many separate securities?
A) 18
B) 19
C) 36
D) 37
E) 38

Answer: D Page: 160 Level: Easy

21. A life insurer owes $75,000 in 6 years. To fund this outflow the insurer wishes to buy
strips that mature in 6 years. The strips have a $3,000 face value per strip and pay a
7% EAR. How much must the insurer spend now to fully fund the outflow (to the
nearest dollar)?
A) $10,000
B) $25,000
C) $49,634
D) $45,649
E) $41,877

Answer: C Page: 161-162 Level: Easy


Rationale: (3000 / 1.03512) * (75,000 / 3000)

22. The January 1, 2005 ask yield on a Treasury STRIP maturing in 8 years is 5.488%. If
the face value is $1000, what should be the QUOTED cost of the strip today (use
semiannual compounding)?
A) 60:00
B) 64:03
C) 64:63
D) 64:27
E) 64:12

Answer: B Page: 162 Level: Medium


Rationale: $1,000 / (1+ (0.05488/2))16 = $648.479852

23. Which one of the following bonds is likely to have the highest required rate of return,
ceteris paribus?
A) AAA rated noncallable corporate bond with a sinking fund.
B) AA rated callable corporate bond with a sinking fund
C) AAA rated callable corporate bond with a sinking fund
D) High quality municipal bond
E) AA rated callable corporate bond without a sinking fund

Answer: E Page: 176-182 Level: Medium

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24. On June 1, 2000 you purchase a $10,000 par T-Note that matures in 5 years. The
coupon rate is 6% and the price quote is 98:6. The last coupon payment was May 1,
2000 and the next is November 1, 2000 (184 days total). The accrued interest is
A) $75.35
B) $101.00
C) $50.54
D) $40.65
E) $35.67

Answer: C Page: 163-164 Level: Medium

25. On September 1, 2000 an investor purchases a $10,000 par T-Bond that matures in
15.67 years. The coupon rate is 6% and the investor buys the bond 60 days after the
last coupon payment (120 days before the next). The ask yield is 7%. The dirty price
of the bond is:
A) $9,045.63
B) $9,157.47
C) $9,145.63
D) $9,200.02
E) $9,000.10

Answer: B Page: 164 Level: Difficult


Rationale: 300PVIFA*(3.5%,31.34) + 10,000PVIF*(3.5%,31.34) = 9057.47 ;
300*(60/180) = 100 ; 9057.47 + 100 = 9157.47

26. Interest income from Treasury securities is _____, and interest income from municipal
bonds is always _____.
A) Exempt from federal taxes; exempt from all taxes
B) Taxable at the state level only; exempt from state taxes only
C) Taxable at federal level only; exempt from federal taxes
D) Taxable at the state level; taxed at the federal level
E) Totally tax exempt; exempt from state taxes

Answer: C Page: 169 Level: Medium

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27. An investor is in the 28% federal tax bracket, pays an 8% state tax rate and 2% in local
income taxes. For this investor a municipal bond paying 6% interest is equivalent to a
corporate bond paying _____ interest
A) 15.79%
B) 8.33%
C) 9.38%
D) 9.68%
E) 8.47%

Answer: D Page: 169 Level: Medium


Rationale: 0.06 / [1 - (0.28 + 0.08 + 0.02)]

28. An investor is trying to decide between a muni paying 6% or an equivalent taxable


corporate paying 7.5%. What is the minimum marginal tax rate the investor must
have to consider buying the municipal bond?
A) 80.00%
B) 20.00%
C) 25.00%
D) 66.67%
E) 33.33%

Answer: B Page: 169 Level: Medium


Rationale: 1 – (0.06 / 0.075)

29. Standard revenue bonds are


A) Backed by the full taxing authority of the municipality
B) Collateralized by the earnings from a specific project
C) Bonds backed by mortgages
D) Backed by the U.S. Treasury
E) Always offered with a best efforts offering

Answer: B Page: 171 Level: Easy

30. When an investment banker purchases an offering from a bond issuer and then resells
it to the public this is known as a
A) Rights offering
B) Private placement
C) Firm commitment
D) Best efforts
E) Standby offering

Answer: C Page: 171-172 Level: Easy

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31. The entire contract between the bondholders and bond issuer is called the _____.
A) Covenant
B) Debenture
C) Indenture
D) Denture
E) Monitor

Answer: C Page: 174 Level: Easy

32. Which of the following is/are true about callable bonds?


I. Must always be called at par
II. Will normally be called after interest rates drop
III. Can be called by either the bondholder or the bond issuer
IV. Have higher required returns than non-callable bonds

A) I and II only
B) II and IV only
C) II and IV only
D) I, II and III only
E) I, II, III and IV are true

Answer: B Page: 178-179 Level: Medium

33. SEC Rule 144 A does which of the following?


A) Allows privately placed investments to be traded on a limited basis
B) Allows bond issuers to call their bonds when desired
C) Determines the limits of responsibility of bond covenants
D) Requires that bonds traded on the NYSE bond market utilize the ABS system
E) None of the above

Answer: A Page: 173 Level: Medium

34. Convertible bonds are


A) Bonds that give the bondholder the right to purchase stock at a preset price
without giving up the bond
B) Bonds in which the issue matures (converts) a little each year
C) Bonds collateralized with certain types of automobiles
D) Bonds that allow the issuing company to require bondholders to purchase stock in
exchange for the bond
E) None of the above

Answer: E Page: 176 Level: Medium

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35. A holder of Rainbow Funds convertible bonds with a $1,000 price can convert the
bond to 20 shares of common stock. The stock is currently priced at $44/share. By
what percent does the stock price have to rise to make conversion potentially
attractive?
A) 10.00%
B) 14.73%
C) 11.11%
D) 13.64%
E) 10.69%

Answer: D Page: 177 Level: Difficult


Rationale: [(1000 / 20) / 44] - 1

36. With respect to private placements of bonds, which of the following is correct?
I. Issuers of privately placed bonds tend to be less well known than public bond
issues
II. Interest rates on privately placed debt tend to be higher than for similar public
issues
III. Purchasers of privately placed debt have assets of at least $100 million
IV. Once bonds have been privately placed, the original buyers must hold the
bonds until maturity

A) I only
B) I and III only
C) I, II and III only
D) I, III and IV only
E) I, II, III and IV

Answer: C Page: 173 Level: Medium

37. Which of the following statements about Euro bonds is/are true?
I. The issuer chooses the currency of denomination
II. Spreads on firm commitment offers are lower for Euro bonds than for U.S.
bonds
III. Euro bonds typically have denomination of $5,000 and $10,000
IV. Euro bonds are bearer bonds

A) I and II only
B) I, III and IV only
C) II, III and IV only
D) II and III only
E) I, II, III and IV are true

Answer: B Page: 187-188 Level: Medium

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38. Brady bonds are sometimes converted to _____ when the issuer's credit rating
improves.
A) Samurai bonds
B) Zombie bonds
C) Bulldog bonds
D) Sovereign bonds
E) Phoenix bonds

Answer: D Page: 188-189 Level: Medium

39. Bearer bonds are bonds


A) With coupons attached that are redeemable by whoever has the bond
B) Where the registered owner automatically receives bond payments when
scheduled.
C) In which the issue matures on a series of dates
D) Issued in another currency other than the bond issuer's home currency
E) Issued in a different country other than the bond issuer's home country

Answer: A Page: 174 Level: Easy

40. A T-Bond with a $1000 par is quoted at a bid of 110:12 and an ask of 110:15. If you
sell the bond you will receive
A) $1,103.75
B) $1,104.69
C) $1,101.20
D) $1,101.50
E) None of the above

Answer: A Page: 163 Level: Medium

41. A T-Bond with a $10,000 par is quoted at a bid of 96:10 and an ask of 96:14. If you
bought the bond and then immediately sold it at the same quotes, how much money
would you gain or lose (ignore commissions)?
A) $12.50
B) -$12.50
C) -$4.00
D) $4.00
E) $0.00

Answer: B Page: 159 Level: Medium

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42. The quoted ask yield on a 12 year $1000 par T-Bond with a 5% coupon and a price
quote of 106:22 is (use semiannual compounding)
A) 5.00%
B) 4.32%
C) 4.36%
D) 2.16%
E) 2.18%

Answer: B Page: 159 Level: Medium


Rationale: $1,062.73 = $25×PVIFA(r%,24) + $1,000×PVIF(r%,24 yrs)

43. An investor buys a $10,000 par, 3% coupon TIPS security with 2 years to maturity. If
inflation every six months over the investor's holding period is 2%, what is the final
payment the TIPS investor will receive?
A) $10,150.00
B) $10,344.15
C) $10,745.68
D) $10,824.32
E) $10,986.69

Answer: E Page: 164 Level: Difficult


Rationale: ($10,000 * 1.024) *(1 + (0.03/2))

44. A bond investor has a 99% chance of receiving all of her promised payments on a
particular bond issue in the first year of holding the bond, but only a 97% chance in
the second year and beyond. What is the cumulative default probability over the first
three years she holds the bond?
A) 6.85%
B) 7.00%
C) 9.00%
D) 7.32%
E) 7.55%

Answer: A Page: 181 Level: Difficult


Rationale: 1 – [0.99*0.97*0.97] = 6.85%

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45. You purchase a $1000 par convertible bond that can be converted into 142 shares of
stock. The stock is currently priced at $5.42. What percentage price increase in the
stock is needed to make conversion worthwhile?
A) 15.5%
B) 29.9%
C) 18.2%
D) 23.7%
E) 19.8%

Answer: B Page: 177 Level: Medium


Rationale: ((1000 / 142) / 5.42) - 1

46. An investor buys a corporate callable bond at par that has a 6 year maturity. The bond
is called after three years at a call price of $1045.12. You reinvested your money for
the remaining three years in the same risk level of investment. Which one of the
following is true?
I. Over the full six years you earned less than the yield rate you were promised
when you originally purchased the bond.
II. At the end of the first three years, interest rates were probably higher than
when you bought the bond.
III. Over the full six years you earned more than the yield rate you were promised
when you originally purchased the bond.
IV. You were able to reinvest the coupons at a higher rate of interest in the last
three years than the reinvestment rate you earned in the first three years.

A) I only
B) III only
C) I and II only
D) III and IV only
E) II and IV only

Answer: A Page: 178-179 Level: Medium

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Short Answer Questions

47. From 1980 to 2004, 10 year Aaa rated bonds earned about how many more basis
points than comparable maturity Treasuries? What was the typical spread for 10 year
Baa rated bonds versus Treasuries? What do these spreads measure and why do they
differ?

Answer: Aaa rated bonds earned about 106 basis point more, Baa about 216 basis
points more. These spreads are an ex-post measure of the default risk premium for the
given ratings category. The much larger spread on the Baa indicates that investors
were much more concerned about the probability of these bonds defaulting and
charged an appreciably higher risk premium. Page: 181 Level: Medium

48. The total sale proceeds from selling the stripped components of a Treasury security
can sometimes be greater than the fair present value of the Treasury security. Why
might this happen?

Answer: STRIPS are useful tools to minimize interest rate risk. Because they are zero
coupon bonds, a strip held to maturity has no interest rate risk; the investor is certain
of the nominal rate of return. Investors are apparently willing to pay a small premium
to eliminate this uncertainty. Page: 158-159 Level: Medium

49. What do bond rating agencies look at in setting a bond's rating?

Answer:
1. Profitability of operations
2. Competitive position in the industry
3. Overall financial strength
4. Ability to pay interest and principle in full and on time
5. Issuer's liquidity and additional debt capacity
6. Specific collateral and other bond provisions such as protection provided to
bondholders in the event of bankruptcy, takeover, etc.
Page: 181-182 Level: Difficult

50. A municipal bond holder buys a 6% coupon annual payment muni bond at a price of
$4,924. The bond has a $5,000 face value. In one year she sells the bond for $4,950.
The applicable tax rate if any is 28%. What is her after tax rate of return?

Answer:
((4950 − 4924)(1 − .28)) + 600
= 12.57%
4924

Page: 169 Level: Medium

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51. What is the difference between General Obligation and Revenue bonds?

Answer: Both are bonds issued by state or local municipalities. G.O.s are backed by
the full revenue stream of the municipality (often called the General Fund). They
typically require voter approval. Revenue bonds are backed by a specific project's
revenues, but not the general tax revenues of the municipality. Revenue bonds are
thus riskier than G.O.s. Page: 170 Level: Easy

52. You are considering purchasing 5 year corporate bonds as an investment. You have a
choice of terms available. Which of the following terms would you find desirable,
ceteris paribus? How does each feature affect the bond's required rate of return?
Explain
a) call feature
b) convertible feature
c) warrants
d) sinking fund
e) debenture

Answer:
a) The call feature favors the bond issuer, and unless the issue offers the investor a
sufficiently higher rate of return, he would not want this feature.
b) The convertible feature allows the bondholder to convert to stock if they so
choose. This sounds like a good, deal but the quid pro quo is a reduced promised
yield. This may be desirable if you believe the stock will increase sufficiently in
price.
c) Warrants allow the bondholder to purchase stock at a fixed price, and unlike
convertible bonds, the bondholder does not have to surrender the bond. Offering
warrants allows the bondholder to offer a lower required rate of return. This may
be desirable if you believe the stock will increase sufficiently in price.
d) Sinking funds help assure that the bond issuer will be able to pay off the principle
when due. If these are term bonds and the issuer sets aside money each year to
ensure availability of funds when the principle is due then the bondholders clearly
benefit from this feature. Of course, this reduces the required promised yield. If
the sinking fund requires retiring a certain percentage of the bonds each year, then
the idea is not unambiguously better for bondholders. It may be that your bond is
retired when rates have fallen and you must then reinvest at lower interest rates.
e) The term debenture indicates that the bond has no specific collateral (other than
the earnings and cash flows of the firm). The lack of security adds to bondholder
risk and may imply a higher required rate of return than bonds with better
collateral.
Page: 175 Level: Medium

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53. The Wall Street Journal had the following quote for a Gillette corporate bond ($1,000
par, pays interest semiannually) (the last yield is smudged):

What was the promised yield if the bond had exactly 4 years to maturity? What must
have been the yield on the comparable Treasury? What maturity was the Treasury?

Answer: The closing price was 95.98% of $1,000 or $959.80. The promised yield (r)
is found from $959.80 = [($38/2)* (PVIFA r/2%, 8)] + $1000* PVIF (r/2%,8); r =
4.92%. The spread over the Treasury was 30 basis points, so the Treasury yield was
4.92% - 0.30% = 4.62%. The maturity of the comparable Treasury bond was 5 years.
Page: 175 Level: Medium

54. A bondholder purchased a 10% coupon, $1,000 par 5 year bond at a 10% yield.
Interest rates then immediately fell to 7% and his bond was called at a price of $1,055.
He reinvested his money and earned 7% on the $1,055 for 5 years. Did the call help
or hurt the bondholder? What was his five year rate of return?

Answer:
$1,055(1.07)5 = $1,479.69
$1000 (1+r)5 = $1,479.69
r = 8.15%

The call hurt the bondholder; he earned 185 fewer basis points in rate of return.
Page: 178-179 Level: Difficult

55. An investor is holding a $1,000 par, 10 year 9% coupon convertible bond with a 9%
required bond yield. The bond is convertible into 40 shares of stock. Each share is
worth $30. The bond has a current market value of $1,200. If interest rates don't
change what is the maximum gain and loss on the bond?

Answer: The maximum gain is unlimited; the bond's price will increase with the stock,
which could increase an unlimited amount. The maximum loss on the bond given no
interest rate change is $200. The bond has a floor price equal to its value as a bond
and with a 9% coupon and 9% yield that gives a $1000 minimum value.
Page: 177 Level: Difficult

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56. You are an investment banker and one of your large U.S. corporate clients has come to
you asking for help deciding on the best market in which to place a sizeable issue of
bonds. You could try to issue dollar denominated bonds, or Euro or yen denominated
bonds. You could also issue in the U.S. or overseas. What major factors should you
consider in advising your client on where to market the issue?

Answer:
Some of the key variables would include:
1. Interest rates in the various markets
2. Underwriter spreads on different types of bonds
3. Expected changes in currency values; borrowers do not wish to borrow in
currencies that are expected to appreciate in value.
4. Regulations and taxes in the various countries.
5. Ability to market large size issues in a given currency or country.
Page: 184-187 Level: Difficult

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