CFA Level 1 - Fixed Income Session 15 - Reading 53 (Notes, Practice Questions, Sample Questions) 1. Which of the following contains the overall rights of the bondholders? A)Covenant.B)Rights offering. C)Indenture. Explanation — C: Covenants are part of the indenture. A rights offeringdescribes an equity offering—not fixed income 2. Which of the following is NOT a negative bond covenant? A)Credit rating must be investment grade. B)Current ratio of at least 2.25. C)Restriction on asset sales. Explanation — B: Current ratio covenants are positive (borrower promises toperform) versus the others listed (prohibitions on the borrower) 3. Which of the following is an example of a positive covenant? The company: A)must not use the same collateral to back more than one debt obligation.B)may not sell fixed assets that have been pledged as collateral for the bonds. C)must maintain a times interest earned ratio of at least two times.
Explanation — C: Positive covenants specify what the company must do,negative covenants specify what they must not do. Both of the alternativesare examples of negative covenants 4. Which of the following bond covenants is considered negative? A)No additional debt. B)Payment of taxes.C)Maintenance of collateral Explanation — A: Negative covenants set forth limitations and restrictions,whereas positive (affirmative) covenants set forth activities that theborrower promises to do 5. Which of the following statements regarding zero-coupon bonds and spot interest rates is most accurate? A)A coupon bond can be viewed as a collection of zero-coupon bonds. B)Price appreciation creates only some of the zero-coupon bond's return.C)Spot interest rates will never vary across time Explanation — A: Zero-coupon bonds are quite special. Because zero-couponbonds have no coupons (all of the bond’s return comes from priceappreciation), investors have no uncertainty about the rate at which couponswill be invested. Spot rates are defined as interest rates used to discount asingle cash flow to be received in the future. Any bond can be viewed as thesum of the present value of its individual cash flows where each of those cashflows are discounted at the appropriate zero-coupon bond spot rate 6. A coupon bond: A)does not pay interest on a regular basis, but pays a lump sum at maturity.
B)pays interest on a regular basis (typically semi-annually). C)always sells at par Explanation — B: This choice accurately describes a coupon bond.With an accrual bond, payments are deferred to maturity and then disbursedalong with the par value at maturity. Unlike a normal zero-coupon bond,these issues are sold at (or near) their par values and then the interestaccrues at a compound rate on top of that. So, they start at $1,000 and thenappreciate from there 7. Which of the following statements regarding zero-coupon bonds and spot interest rates is CORRECT? A)Price appreciation creates all of the zero-coupon bond's return. B)If the yield to maturity on a 2-year zero coupon bond is 6%, then the 2-yearspot rate is 3%.C)Spot interest rates will never vary across the term structure. Explanation — A: Zero-coupon bonds are quite special. Because zero-couponbonds have no coupons (all of the bond’s return comes from priceappreciation), investors have no uncertainty about the rate at which couponswill be invested. Spot rates are defined as interest rates used to discount asingle cash flow to be received in the future. If the yield to maturity on a2-year zero is 6%, we can say that the 2-year spot rate is 6% 8. Which of the following statements regarding zero-coupon bonds is CORRECT? A)Zero-coupon bonds have substantial amount of coupon reinvestment risk.B)An investor who holds a zero-coupon bond until maturity will receive anannuity of coupon payments plus recovery of principal at maturity. C)An investor who holds a zero-coupon bond until maturity will receive areturn equal to the bond's effective annual yield.
Explanation — C: Zero-coupon bonds are quite special. Because zero-couponbonds have no coupons (all of the bond’s return comes from priceappreciation), investors have no uncertainty about the rate at which couponswill be invested. An investor who holds a zero-coupon bond until maturitywill receive a return equal to the bond’s effective annual yield 9. Which of the following statements about zero-coupon bonds is NOT correct? A)The lower the price, the greater the return for a given maturity.B)All interest is earned at maturity. C)A zero coupon bond may sell at a premium to par when interest ratesdecline. Explanation — C: Zero coupon bonds always sell below their par value, or at adiscount prior to maturity. The amount of the discount may change asinterest rates change, but a zero coupon bond will always be priced less thanpar 10. Which of the following statements concerning coupon rate structures is least accurate? A)Accrual bonds have only one cash inflow at maturity. B)Accrual bonds, like zero-coupon bonds, always sell at a discount to facevalue. C)Zero-coupon bonds have only one cash inflow at maturity. Explanation — B: Accrual bonds, unlike zero-coupon bonds, do not always sellat a discount to face value. The interest accrues forward and thus the bondsare likely to sell for more than face value
11. Which of the following statements regarding spot rates and zero-coupon bonds is least accurate? A)With zero coupon bonds, investors have no reinvestment risk.B)The yield to maturity on a zero coupon bond is called the spot interest rate. C)The graph of current corporate bond yields is called the spot yield curve Explanation — C: The graph of yields on zero-coupon bonds (spot rates) iscalled the spot yield curve. Note that the return on zero-coupon bonds isbased entirely on price appreciation. An investor in a default-freezero-coupon bond will not have to worry about reinvesting coupons to realizethe yield to maturity 12. Sometimes floating rate issues have caps and/or floors, which limit the maximum or minimum coupon rate that the issue will pay. Which of thefollowing statements is CORRECT with regard to floating rate issues that havecaps and floors? A)A floor is a disadvantage to both the issuer and the bondholder while a cap isan advantage to both the issuer and the bondholder.B)A cap is an advantage to the bondholder while a floor is an advantage to theissuer. C)A cap is a disadvantage to the bondholder while a floor is a disadvantage tothe issuer Explanation — C: A cap limits the upside potential of the coupon rate paid onthe floating rate bond and is therefore a disadvantage to the bondholder. Afloor limits the downside potential of the coupon rate and is therefore adisadvantage to the bond issuer 13. Allcans, an aluminum producer, needs to issue some debt to finance expansion plans, but wants to hedge its bond interest payments againstfluctuations in aluminum prices. Jerrod Price, the company’s investment
banker, suggests a non-interest rate index floater. This type of bond will provideall the following advantages EXCEPT: A)the bond agreement allows Allcans to set coupon payments based onbusiness results. B)the bond's coupon rate is linked to the price of aluminum.C)the payment structure helps protect Allcan's credit rating. Explanation — A: The coupon rate is set in the bond agreement (indenture)and cannot be changed unilaterally. Non-interest rate indexed floaters areindexed to a commodity price such as oil or aluminum. Business results couldbe impacted by numerous factors other than aluminum prices.Both of the other choices are true. By linking the coupon payments directly tothe price of aluminum (meaning that when aluminum prices increase, thecoupon rate increases and vice versa), the non-interest index floater allowsAllcans to protect its credit rating during adverse circumstances 14. Consider a floating rate issue that has a coupon rate that is reset on January 1 of each year. The coupon rate is defined as one-year London InterbankOffered Rate (LIBOR) + 125 basis points and the coupons are paidsemi-annually. If the one-year LIBOR is 6.5% on January 1, which of thefollowing is the semi-annual coupon payment received by the holder of theissue in that year? A)3.250%.B)7.750%. C)3.875%. Explanation — C: This value is computed as follows:Semi-annual coupon = (LIBOR + 125 basis points) / 2 = 3.875% 15. A bond issued by the government of Italy is likely to be denominated in which one of the following currencies?
A)Euros. B)U.S. dollars.C)Swiss francs. Explanation — A: Bonds issued by governments are likely to be denominatedin the currency of the country where the bond is issued. In this case, the Eurois the Italian currency and bonds issued by the Italian government wouldnormally be issued in Euros 16. A bond has a par value of $5,000 and a coupon rate of 8.5% payable semi-annually. The bond is currently trading at 112.16. What is the dollaramount of the semi-annual coupon payment? A)$238.33.B)$425.00. C)$212.50. Explanation — C: The dollar amount of the coupon payment is computed asfollows:Coupon in $ = $5,000 × 0.085 / 2 = $212.50 17. Peter Stone is considering buying a $100 face value, semi-annual coupon bond with a quoted price of 105.19. His colleague points out that the bond istrading ex-coupon. Which of the following choices best represents what Stonewill pay for the bond? A)$105.19 plus accrued interest.B)$105.19 minus the coupon payment. C)$105.19.
Explanation — C: Since the bond is trading ex-coupon, the buyer will pay theseller the clean price, or the price without accrued interest. So, Stone will paythe quoted price.The choice $105.19 plus accrued interest represents the dirty price (alsoknown as full price). This bond would be said to trade cum-coupon. 18. The dirty, or full, price of a bond: A)is paid when a security trades ex-coupon.B)applies if an issuer has defaulted. C)equals the present value of all cash flows, plus accrued interest. Explanation — C: The dirty price of a bond equals the quoted price plusaccrued interest.If an issuer has defaulted, the bond trades without interest and is said totrade flat. When a security trades ex-coupon, the buyer pays the clean price,which is the quoted price without accrued interest 19. Which of the following statements regarding accrued interest on a bond is most accurate? A)If the buyer must pay the seller the accrued interest, the bond is said to betrading ex-coupon. B)The bond is trading flat if the bond issuer is in default and the bond istrading without accrued interest. C)The accrued interest is paid by the seller of the bond to the buyer (newowner) of the bond. Explanation — B: The accrued interest is paid by the new owner of the bondto the seller of the bond. If the buyer must pay the seller accrued interest, thebond is said to be trading cum-coupon. Otherwise, it is trading ex-coupon
20. In the context of bonds, accrued interest: A)equals interest earned from the previous coupon to the sale date. B)is discounted along with other cash flows to arrive at the dirty, or full price.C)covers the part of the next coupon payment not earned by seller. Explanation — A: This is a correct definition of accrued interest on bonds.The other choices are false. Accrued interest is not discounted whencalculating the price of the bond. The statement, "covers the part of the nextcoupon payment not earned by seller," should read, " … not earned by buyer." 21. If the issuer of a bond is in default, the bond will be trading: A)flat. B)on accrual.C)off the market. Explanation — A: If an issuer of a bond is in default (i.e., it has not beenmaking periodic contractual coupon payments), the bond is traded withoutaccrued interest and is said to trade flat 22. Assume a bond's quoted price is 105.22 and the accrued interest is $3.54. The bond has a par value of $100. What is the bond's clean price? A)$103.54.B)$108.76. C)$105.22 Explanation — C: The clean price is the bond price without the accruedinterest so it is equal to the quoted price
23. Austin Traynor is considering buying a $1,000 face value, semi-annual coupon bond with a quoted price of 104.75 and accrued interest since the lastcoupon of $33.50. If Traynor pays the dirty price, how much will the sellerreceive at the settlement date? A)$1,081.00. B)$1,014.00.C)$1,047.50. Explanation — A: The dirty price is equal to the agreed upon, or quoted price,plus interest accrued from the last coupon date. Here, the quoted price is1,000 × 104.75%, or 1,000 × 1.0475 = 1,047.50. Thus, the dirty price = 1,047.50+ 33.50 = 1,081.00 24. Which of the following statements about refunding and redemption is most accurate? A)Bonds redeemed at the special redemption price are typically redeemed atpar. B)An investor concerned about premature redemption is indifferent between anoncallable bond and a nonrefundable bond.C)A sinking fund is an example of refunding Explanation — A: This statement is accurate. When bonds are redeemed tocomply with a sinking fund provision or because of a property sale mandatedby government authority, the redemption prices (typically par value) arereferred to as "special redemption prices." When bonds are redeemed underthe call provisions specified in the bond indenture, these are known as aregular redemptions and the call prices are referred to as "regularredemption prices."The other statements are false. A sinking fund is a type of redemption, whichrefers to the retirement of bonds. An investor concerned about prematureredemption would prefer a noncallable bond because a noncallable bondcannot be called for any reason. A bond that is callable but nonrefundable
can be called for any reason other than refunding. The term refundingspecifically means redeeming a bond with funds raised from a new bondissued at a lower coupon rate. A nonrefundable bond can be redeemed withfunds from operations or a new equity issue 25. Which of the following is CORRECT about the call feature of a bond? It: A)stipulates whether and under what circumstances the bondholders canrequest an earlier repayment of the principal amount prior to maturity. B)stipulates whether and under what circumstances the issuer can redeemthe bond prior to maturity. C)describes the maturity date of the bond. Explanation — B: Call provisions give the issuer the right (but not theobligation) to retire all or a part of an issue prior to maturity. If the bonds are“called,” the bondholder has no choice but to turn in his bonds. Call featuresgive the issuer the opportunity to get rid of expensive (high coupon) bondsand replace them with lower coupon issues in the event that market interestrates decline during the life of the issue.Call provisions do not pertain to maturity. A put provision gives thebondholders certain rights regarding early payment of principal 26. Which of the following is most accurate about a bond with a deferred call provision? A)It could be called at any time during the initial call period, but not later.B)Principal repayment can be deferred until it reaches maturity. C)It could not be called right after the date of issue Explanation — C: A deferred call provision means the issue is initially (say, forthe first 5 to 7 years) non-callable, after which time it becomes freely callable.In other words, there is a deferment period during which time the bondcannot be called, but after that, it becomes freely callable
27. Most often the initial call price of a bond is its: A)par value plus one year's interest.B)par value. C)principal plus a premium. Explanation — C: Customarily, when a bond is called on the first permissiblecall date, the call price represents a premium above the par value. If thebonds are not called entirely or not called at all, the call price declines overtime according to a schedule. For example, a call schedule may specify that a20-year bond issue can be called after 5 years at a price of 110. Thereafter,the call price declines by a dollar a year until it reaches 100 in the fifteenthyear, after which the bonds can be called at par 28. A 5% coupon bond with semi-annual coupon payments on a coupon payment date when the coupon has not been paid yet and the bond has a$1,000 par value. What is the accrued interest of the bond and what is thebond's full price? Accrued Interest Full Price A) $25 $1,000 B) $50 $1,050 C) $25 $1,025 Explanation — C: Accrued interest is found by simply dividing the coupon rateby two and then multiplying the result by $1,000. The full price or dirty priceof the bond is the price of the bond plus accrued interest, if any
29. Which one of the following combinations represents an accurate classification of security owner options and security issuer options? Security Owner Options Security Issuer Options A) A call provision A prepayment option B) A floor A prepayment option C) A cap An accelerated sinking fund Explanation — B: A floor sets a minimum coupon rate for a floating-rate bondand protects the security owner from decreases in rates. A prepaymentoption is included in many amortizing securities and allows the holder of theoption to make additional payments against outstanding principal 30. The annual Fixed Income Analysts' Forum had just ended and two attendees, James Purcell and Frederick Hanes, were discussing some of thecomments made by the panelists. Purcell and Hanes were specificallyconcerned with the following two statements that were made: Panelist 1: Mortgage-backed securities and asset-backed securities are bothfixed income securities that are backed by pools of loans and are said to beamortizing securities. For many of the loans, no principal payments arerequired to be made prior to the maturity date. These securities are said tohave a bullet maturity structure.Panelist 2: If coupon Treasury bonds or corporate bonds are issued with theterms specifying that the principal be repaid over time at the option of theissuer, then these bonds are putable bonds; if the principal is to be repaid overtime at the option of the bondholder, then the bonds are termed callablebonds. With regard to the statements made by Panelist 1 and Panelist 2:
A)both are incorrect. B)both are correctC)only one is correct. Explanation — A: Panelist 1 is incorrect. These securities do not have a bulletmaturity structure. The payments are structured so that the loan is paid offwhen the last loan payment is made. Panelist 2 is incorrect. If coupon Treasury bonds or corporate bonds areissued with the terms specifying that the principal be repaid over time at theoption of the issuer, then these bonds are callable bonds – the call provisiongrants the issuer an option to retire part of the issue or the entire issue priorto the maturity date. On the other hand, if the principal is to be repaid overtime at the option of the bondholder, then these bonds are putable bonds –the put provision entitles the bondholder to put (sell) the issue back to theissuer at the put price (if interest rates increase and the bond’s price declinesbelow the put price) 31. Which of the following statements regarding nonrefundable bonds is most accurate? Nonrefundable bonds: A)must be refunded from funds generated from operations, not from outsidesources of capital such as new debt or equity issues. B)may only be called if the source of funds for the redemption is other than anew bond issue with a lower coupon rate. C)and noncallable bonds are essentially the same Explanation — B: Nonrefundable bonds may be called as long as the firmdoes not use less expensive debt to do so. They may be refunded withoutside capital, just not cheaper debt
32. Which of the following statements regarding a bond being called is CORRECT? Call prices are known as regular redemption prices when bonds arecalled at: A)under the call provisions specified in the bond indenture. B)at the par value.C)at a premium Explanation — A: When bonds are redeemed under the call provisionsspecified in the bond indenture, these are known as regular redemptions andthe call prices are referred to as regular redemption prices which can beeither at a premium or at par 33. Which of the following is the appropriate redemption price when bonds are called according to the sinking fund provision? A)Specific redemption price.B)Regular redemption price. C)Special redemption price Explanation — C: Regular redemption price refers to bonds being calledaccording to the provisions specified in the bond indenture. When bonds areredeemed to comply with a sinking fund provision or because of a propertysale mandated by government authority, the redemption prices (typically parvalue) are referred to as "special redemption prices." There is no such thingas a specific redemption price 34. Which of the following is the appropriate redemption price when redemption funds are obtained as a result of a forced sale of assets forderegulatory purposes? A)Regular redemption price.B)General redemption price.
C)Special redemption price. Explanation — C: When redemption funds are obtained as a result of a forcedsale of assets for deregulatory purposes, the funds can be used to redeembonds at the special redemption price, which are typically par value 35. On November 15, 2006, Grinell Construction Company decided to issue bonds to help finance the acquisition of new construction equipment. Theyissued bonds totaling $10,000,000 with a 6% coupon rate due June 15, 2026.Grinell has agreed to pay the entire amount borrowed in one lump sumpayment at the maturity date. Grinell is not required to make any principalpayments prior to maturity. What type of bond structure has Grinell issued? A)Bullet maturity. B)Serial bonds.C)Income bonds Explanation — A: These bonds have a bullet maturity structure because theissuer has agreed to pay the entire amount borrowed in one lump-sumpayment at maturity 36. Which of the following statements regarding a sinking fund provision is most accurate? A)It requires that the issuer set aside money based on a predefined schedule toaccumulate the cash to retire the bonds at maturity. B)It requires that the issuer retire a portion of the principal through a seriesof principal payments over the life of the bond. C)It permits the issuer to retire more than the stipulated sinking fund amount ifthey choose Explanation — B: A sinking fund actually retires the bonds based on aschedule. This can be accomplished through either payment of cash or
through the delivery of securities. An accelerated sinking fund provisionallows the company to retire more than is stipulated in the indenture 37. The refunding provision found in nonrefundable bonds allows bonds to be retired unless: A)the funds come from the sale of new common stock.B)market interest rates have increased substantially. C)the funds come from a lower cost bond issue. Explanation — C: Refunding from a new debt issue at a higher interest rate isnot prohibited, however their purchase cannot be funded by thesimultaneous issuance of lower coupon bonds 38. Which of the following embedded options benefits the bond investor? A)Call provision.B)Prepayment option. C)Put provision Explanation — C: A put provision allows the investor to put the bond back tothe issuer. 39. Which of the following embedded options most likely benefits the bondholder? A)Prepayment option on an amortizing security.B)Interest rate cap on a floating-rate bond. C)Put provision at par on a bond that is trading at a premium Explanation — C: A put provision is an option that is exercisable by, andtherefore potentially of benefit to, the bondholder. Even though the put is
out of the money, it still has value to the bondholder. Interest rate caps andprepayment options both potentially benefit the issuer of the bond 40. Which of the following statements regarding financing bond purchases with margin accounts is NOT correct? A)The required margin percentage changes daily. B)In the U.S., margin accounts are regulated by the Federal Reserve.C)Individuals are more likely than institutions to use margin accounts to financebond purchases Explanation — A: The margin percentage is fixed by contract. The requiredmargin dollars may vary from day to day due to fluctuations in the underlyingcollateral 41. Which of the following statements regarding financing bond purchases is CORRECT? A)The rate the investor pays on the loan in a margin transaction is known asthe call money rate. B)Purchasing securities on margin allows investors to leverage assets andmake larger purchases. C)In margin transactions, the broker borrows from the bank at the call moneyrate plus a spread Explanation — B: Example: An investor has $5,000 cash, but wants to buy ten$1,000 face value bonds at par (for a total of $10,000). With cash only, he canonly purchase five of the bonds. With a 50% margin account, he can buy allten bonds ($5,000 cash equity contribution and $5,000 from the marginaccount). With the margin account, he will realize the gain or loss on all tenbonds rather than the five he could have purchased with cash only.The statements about the rates paid by the parties to a margin transactionare reversed. The statement, “In margin transactions, the broker borrows
from the bank at the call money rate plus a spread,” should read,“ … borrows … at the call money rate.” The statement, “The rate the investor pays on the loan in a margin transaction is known as the call money rate.”should read, “ … known as the call money rate plus a spread.” Remember that the broker needs to make profit, so the investor will pay a rate higher thanthe broker pays to the bank