CFA Level 1 - Fixed Income Session 15 - Reading 55 (Notes, Practice Questions, Sample Questions) 1. Often central governments will announce auctions to issue new bonds when they believe prevailing market conditions appearmost suitable. At the time of the auction, the amount to beauctioned and the maturity of the security to be oﬀered areannounced. This method of distributing new governmentsecurities is called: A)an ad hoc auction method. B)a regular auction cycle / single-price method.C)the tap method. Explanation — An ad hoc auction system is a method in which a central government distributes new government securities viaauction when it determines that market conditions areadvantageous 2. Fernando Golpas and Javier Solada were reviewing the ﬁnancial reports of several Latin American governments. They noticed thatthe central governments of many Latin American countries suchas Argentina, Chile, Peru, and Ecuador had recently been issuingsovereign debt. This sparked a discussion between the twoanalysts about sovereign debt ratings. During their discussion theymade the following statements:Golpas: The rating agencies, such as Moody's, generally assign tworatings to sovereign debt. One is a local currency debt rating andthe other is a foreign currency debt rating. The reason for the tworatings is that the default frequency has been greater on localcurrency denominated debt.
Solada: If a central government is willing to raise taxes and controlits internal ﬁnancial system, it should be able to generate suﬃcientlocal currency to meet its local currency obligation. That is why therating on local currency denominated debt is generally higher thanthe rating on foreign currency denominated debt.With regard to the statements made by Golpas and Solada: A)both are correct.B)both are incorrect. C)only one is correct. Explanation — Golpas’ statement is incorrect because the reason for the two ratings (the local currency and the foreign currencydebt ratings) is that the default frequency has been greater onforeign currency denominated debt. It is often easier for a centralgovernment to print local currency to meet its obligations in thehome currency than to exchange the local currency in the foreignexchange markets for a given amount of foreign currency 3. Which of the following statements regarding sovereign bonds is least accurate? A)A central government can issue sovereign bonds in its nationalbond market, in another country’s foreign bond market, or in theEurobond market. B)When a central government issues securities, those securitiescan only be denominated in the local currency regardless ofwhere the bonds are issued. C)Sovereign bonds denominated in domestic currency are subjectto default risk Explanation — When a central government issues securities, those securities are generally denominated in the currency of the issuingcountry, but a government can issue bonds denominated in anycurrency. Sovereign bonds are not necessarily free from defaultrisk
4. Which of the following is a diﬀerence between an on-the-run and an oﬀ-the-run issue? An on-the-run issue: A)is publicly traded whereas an oﬀ-the-run issue is not. B)is the most recently issued security of that type. C)tends to sell at a lower price Explanation — An on-the-run issue is the most recently auctioned Treasury issue. An oﬀ-the-run issue older issues, when morecurrent issues are brought to market 5. A well-oﬀ-the-run Treasury security is best described as an issue: A)that was traded within the last 12 months but has matured.B)which has a yield that is out of line with similar maturitysecurities. C)in a maturity range for which several more recent issues havebeen auctioned. Explanation — On-the-run Treasuries are the most recent auctioned by the Treasury. When new issues are brought tomarket, older issues are called oﬀ-the-run issues. After a series ofnew issues in a given maturity spectrum, older issues of thisoriginal maturity are called well-oﬀ-the-run issues 6. Given that a Treasury bond has a par value of $50,000 and is currently oﬀered at a quoted price of 98:5, what is the dollaramount that an investor must pay in order to purchase the bond? A)$98.16.B)$4,907,812.50. C)$49,078.13.
Explanation — If the quoted price is 98:5 this equals 98 5/32 which equals 98.15625% and means that the dollar amount is: 0.9815625 ×$50,000 = $49,078.13 7. If an investor purchases a 9 ¾s 2001 Feb. $10,000 par Treasury Note at 101:11 and holds it for exactly one year, what is the rate ofreturn if the selling price is 101:17? A)9.75%.B)8.75%. C)9.81% Explanation — Purchase price = [(101 + 11 / 32) / 100] × 10,000 = $10,134.375Selling price = [(101 + 17 / 32) / 100] × 10,000 = $10,153.125Interest = 9¾% of 10,000 = $975.00Return = (Pend − Pbeg + Interest) / Pbeg = (10,153.125 − 10,134.375 +975.00) / 10134.375 = 9.81% 8. Which of the following statements about U.S. Treasury Inﬂation Protection Securities (TIPS) is most accurate? A)Adjustments to principal values are made annually. B)The coupon rate is ﬁxed for the life of the issue. C)The inﬂation-adjusted principal value cannot be less than par. Explanation — The coupon rate is set at a ﬁxed rate determined via auction. This is called the real rate. The principal that serves as thebasis of the coupon payment and the maturity value is adjustedsemiannually. Because of the possibility of deﬂation, the adjustedprincipal value may be less than par (however, at maturity theTreasury redeems the bonds at the greater of the inﬂation-adjustedprincipal and the initial par value)
9. The annual payment of a 20-year, semi-annual pay bond with a $5,000 par value and a 6.875% coupon rate currently trading at89.28 is closest to: A)$343.75. B)$171.88.C)$153.45 Explanation — $5,000 × 0.06875 = $343.75 10. U.S. Treasury bonds that provide some protection from inﬂation by periodic adjustments of the principal value are called: A)CPI Adjustable Bonds.B)Inﬂation Linked Treasury Securities. C)Treasury Inﬂation Protected Securities Explanation — Beginning in 1997, the U.S. Treasury began to oﬀer Treasury Inﬂation Protected Securities, which are commonlyknown as TIPS. The principal value is periodically adjusted forchanges in CPI. The periodic coupon payment, based upon theadjusted principal amount, reﬂects any changes in inﬂation 11. Which of the following statements concerning U.S. Treasury securities is least accurate? A)Treasury bonds have original maturities of 20 to 30 years. B)Treasury notes carry no coupon. C)Treasury Inﬂation Protected Securities pay a ﬁxed coupon rate Explanation — T-notes are coupon-bearing instruments. TIPS pay a ﬁxed coupon rate on a par value that is adjusted for inﬂation
12. Which of the following statements regarding Treasury bills (T-bills) is CORRECT? T-bills: A)have maturities greater than 6 months. B)carry no coupon. C)are considered the risk-free instrument, which means thereexists no interest rate risk Explanation — The maturities of T-bills range from 4 weeks to 6 months. Risk-free means there is no credit risk, however, interestrate risk and price risk still exist 13. If a U.S. Treasury bond is quoted at 92-16, the price of the bond is: A)$92.50.B)$92.16. C)$925.00. Explanation — 92 − 16 = 92 16/32 = 92.5% of par value 0.925 × $1,000 = $925 14. Which reason for purchasing U.S. Treasury securities is least valid? A)The over-the-counter secondary market for Treasury securitiesis very liquid.B)Coupon strips synthesize a zero-coupon bond. C)Treasury-bonds are available in maturities of two years tonearly 30 years. Explanation — T-bonds are securities with maturities of more than 10 years. T-notes have maturities between two and 10 years.Coupon strips are coupon payments from a Treasury security thatare sold separately as zero-coupon securities. Government
securities dealers provide a continuous and highly liquidsecondary market for Treasury securities 15. Which of the following bond price calculations is NOT correct? An investor would pay: A)$941.00 for a $1,000 Treasury bond quoted at 94 10/32. B)$956.25 for a $1,000 corporate bond quoted at 95 20/32.C)$9,684.38 for a $10,000 Treasury note quoted at 96 27/32 Explanation — Bond prices are quoted in 32nds. A quote of 94 10/32 = 94.3125%, for a price of $943.125 for a $1,000 Treasurybond.The other calculations are correct. A quote of 96 27/32 = 96.84, for aprice of $9,684.38 for a $10,000 bond. A quote of 95 20/32 = 95.625,for a price of $956.25 for a $1,000 bond 16. Which of the following statements about primary bond markets is CORRECT? Government: A)bills are generally for terms of two years or less.B)bonds are generally for terms of ﬁve years or more. C)notes are generally for terms of two to ten years Explanation — Bills are for one to twelve months, notes for two to ten years and bonds for ten years or more 17. U.S. Treasury securities face several risks to varying degrees. Generally speaking, rank the following risks that an investor in a5% coupon, 25-year, oﬀ-the-run U.S. Treasury bond, issued after1984, would face. Order them from left to right with the least likelyrisk ﬁrst through the most likely risk faced by the investor last.1 = liquidity risk.2 = prepayment risk.
3 = default risk.4 = interest rate risk. A)1, 2, 3, 4. B)2, 3, 1, 4. C)3, 4, 2, 1. Explanation — All U.S. Treasuries issued after 1984 are non-callable, so there is no prepayment risk. Treasuries are defaultrisk free although one might argue that a long-term Treasurymight have a minute level of default risk. Oﬀ-the-run Treasuriesface more liquidity risk than on-the-run issues. Finally, given thelong-term nature of the bond, the investor is deﬁnitely exposed tointerest rate risk. Given the available alternatives, we conclude thatthe answer is prepayment risk, default risk, liquidity risk, andinterest rate risk 18. Which of the following statements regarding U.S. Treasury securities is least accurate? A)Due to the way Treasury STRIPS are taxed, U.S. investors mayface negative cash ﬂows before the maturity date. B)The U.S. Treasury issues zero coupon notes, but not bonds. C)A 5-year Treasury note can be stripped into 11 diﬀerent zerocoupon securities. Explanation — The Treasury does not issue zero-coupon notes or bonds. That is why STRIPS were created. A 5-year Treasury notecan be stripped into 11 zero coupon securities, consisting of its 10coupon payments and the principal repayment. The U.S. InternalRevenue Service regards the accrued interest on a zero couponsecurity as income on which the security holder must pay taxeseven though he has not received a cash interest payment
19. Which of the following refers to the U.S. Treasury bonds that are sold in the form of zero-coupon securities? A)Strip-Ts. B)Treasury calls.C)Pass-throughs. Explanation — The U.S. Treasury does not issue zero coupon notes and bonds, therefore investment bankers began stripping thecoupons from Treasuries to create synthetic zeros to meet investordemand. The Separate Trading of Registered Interest and PrincipalSecurities (STRIP) was introduced in 1985 to meet this need 20. Which of the following statements regarding separate trading of registered interest and principal of securities (STRIPS) isCORRECT? A 20-year Treasury bond can be used as the basis for: A)40 principal strips and 1 coupon strip. B)40 coupon strips and 1 principal strip. C)41 coupon strips. Explanation — A 20-year Treasury bond can be used as the basis for 40 coupon strips and 1 principal strip 21. Which of the following statements about Treasury securities is NOT correct? A)Designated government securities dealers can buy treasuries,strip out the coupons and principal, and reissue these strippedcash ﬂows as zero-coupon bonds. B)The U.S. Treasury auctions 10-year Notes weekly. C)Taxable investors holding zero-coupon bonds can have negativecash ﬂows prior to maturity
Explanation — U.S. Treasury Notes are issued quarterly. Both of the other statements are true. It is possible that taxable investorswill have negative cash ﬂows from holding zero-coupon securities,since there is no cash income, but taxes must be paid at leastannually on the implicit interest 22. Which of the following statements about the taxation of separate trading of registered interest and principal of securities(STRIPS) is NOT correct? A)The STRIPS program began in 1985. B)Implicit interest taxation is a paramount issue for pensionplans. C)Treasury STRIPS can be based upon either coupon payments orprincipal payments. Explanation — Pension plans are not taxable entities so they do not have to worry about implicit interest taxation. Both of the otherstatements are true 23. Which of the following statements regarding federal agency securities is least accurate? A)Government sponsored enterprises are owned by the U.S.government and therefore have essentially no credit risk. B)Federally related institutions are not required to register theirsecurities with the Securities and Exchange Commission.C)Debentures and mortgage passthrough securities are two typesof securities issued by federal agencies Explanation — Government sponsored enterprises are privately owned, and therefore investors assume some credit risk. Federallyrelated institutions are agencies owned by the U.S. governmentwhich are exempt from SEC registration. Agencies issuedebentures, mortgage passthrough securities, or collateralized
mortgage obligations (CMO). CMOs are split into tranches, witheach tranche having a diﬀerent claim and risk structure on thepool of cash ﬂows 24. Which of the following institutions has debt that is backed by the full faith and credit of the U.S. government? A)Government National Mortgage Association (Ginnie Mae). B)Federal Home Loan Mortgage Association.C)Student Loan Marketing Association. Explanation — The Government National Mortgage Association is the only item listed that is backed by the full faith and credit of theU.S. government 25. A mortgage-backed security has the following characteristics: It was created by pooling a collection of more than a thousandmortgagesNot all investors face the same prepayment riskInvestors receive three distinct kinds of cash ﬂowsFreddie Mac issued the securityThis security is a(n): A)collateralized mortgage obligation. B)agency debenture.C)mortgage passthrough security. Explanation — While most mortgage-backed securities pay three types of cash ﬂows, only mortgage passthroughs and collateralizedmortgage obligations (CMOs) are formed by pooling mortgages.Only CMOs divide investors into tranches with diﬀerent cash ﬂowsand risk proﬁles. Debentures are securities not backed bycollateral
26. Which of the following institutions is NOT a government-sponsored enterprise (GSE)? A)Federal Farm Credit System.B)Student Loan Marketing Association. C)Government National Mortgage Association. Explanation — Federally-related (or government-owned) agencies are arms of the federal government. Both of the other institutionslisted are government-sponsored enterprises 27. Which of the following institutions are federally-related institutions? A)Government National Mortgage Association. B)Student Loan Marketing Association.C)Federal National Mortgage Association Explanation — Federally-related (or government-owned) agencies are arms of the federal government. Both of the other institutionslisted are government-sponsored enterprises 28. A debenture is: A)a short-term debt. B)an unsecured bond. C)a bond secured by speciﬁc assets Explanation — A debenture by deﬁnition is unsecured debt 29. Which of the following statements least likely describes a mortgage passthrough security?
A)Participation certiﬁcates are sold, representing shares of amortgage pool.B)The security may be retired before maturity at face value with nopenalty. C)The payment structure redistributes the prepayment riskamong various investors. Explanation — A collateralized mortgage obligation (CMO), not a passthrough security, redistributes the prepayment risk among theinvestors through tranches. Because mortgage holders may prepaythe mortgage, the passthrough may indeed be retired beforematurity at face value with no penalty 30. A payment made that is in excess of the required monthly mortgage payment is called: A)prepayment risk. B)prepayment. C)curtailment. Explanation — This is the deﬁnition of prepayment. Curtailment is when the prepayment is not for the entire amount. Prepaymentrisk is the risk that relates to the amount and timing of cash ﬂowsfrom a mortgage 31. When a prepayment is less than the entire outstanding principal amount it is called: A)prepayment risk.B)securitized. C)curtailment. Explanation — Curtailment is when the prepayment is not for the entire amount. Prepayment risk is the risk that relates to theamount and timing of cash ﬂows from a mortgage
32. The risk that relates to the amount and timing of cash ﬂows from a mortgage is known as: A)liquidity risk. B)prepayment risk. C)default risk. Explanation — Default risk is the risk that the borrower will not pay back the amounts borrowed. Liquidity risk deals with theability to sell a security easily at a fair price 33. If a prepayment of principal is for an amount that is less than the full outstanding balance of the loan, it is know as a(n): A)participation.B)intermediate payment. C)curtailment. Explanation — If a prepayment of principal is for an amount that is less than the full outstanding balance of the loan, it is know as acurtailment 34. Which of the following statements concerning mortgage-backed securities is most accurate? A)As rates rise, mortgage-backed security holders facereinvestment risk. B)Curtailment of a mortgage is a prepayment of less than the fullprincipal. C)Collateralized Mortgage Obligations (CMOs) prioritize theinterest payments on mortgages to diﬀerent sets of investors.
Explanation — Curtailment of a mortgage is a prepayment of less than full principal. The other statements are false. Holders ofmortgage-backed securities face reinvestment risk as ratesdecline. Also, CMO’s prioritize the principal payments onmortgages to diﬀerent sets of investors – all tranches receiveinterest payments, but each successive tranche does not receiveprincipal payments until the ﬁrst is paid oﬀ 35. Paul Blackburn is describing mortgage backed securities and makes the following statements:Statement 1: A mortgage passthrough security is formed by poolinga large number of mortgages and issuing certiﬁcates that representownership shares in the pool. Because each mortgage borrowerhas the right to prepay the mortgage, the value of a passthroughsecurity behaves as if the security has an embedded put feature.Statement 2: A collateralized mortgage obligation with sequentialtranches is created by pooling mortgage passthrough certiﬁcates.Securities are issued in diﬀerent tranches that have proportionateclaims on the cash ﬂows from the passthrough certiﬁcates.With regard to Blackburn’s statements: A)both are correct.B)only one is correct. C)both are incorrect. Explanation — Statement 1 is incorrect. A borrower who prepays a mortgage is in eﬀect exercising a call option, similar to a corporatebond issuer who calls a bond and prepays the principal. Thereforethe pool of mortgages and the securities created from it behave asif they had an embedded call feature.Statement 2 is also incorrect. Sequential tranches issued as acollateralized mortgage obligation do not have proportionateclaims on the cash ﬂows from the pool. Instead they havesequential claims. The shortest-term tranche receives principaland interest payments until it is paid oﬀ. The cash ﬂows then go tothe second tranche until it is paid oﬀ, and so on. This structure
allows securities with diﬀerent timing and risk proﬁles to beissued from the same pool of certiﬁcates 36. Which of the following is the least signiﬁcant risk faced by a holder of a mortgage-backed security? A)Scheduled principal payment risk. B)Reinvestment risk.C)Interest rate risk. Explanation — Interest rate risk and reinvestment risk are both signiﬁcant for mortgage-backed securities. There is no riskembedded in a scheduled principal payment 37. Which of the following reasons is the best reason NOT to enhance the credit quality of an asset backed security (ABS) pool? A)Liquidity. B)Cost. C)Increase the chance of bankruptcy. Explanation — Credit enhancements increase the costs associated with borrowing using ABS 38. Which of the following statements about asset backed securities (ABSs) is most accurate? A)The credit rating of an ABS must be the same as that of theissuer. B)Residential mortgages represent the largest type of asset thathas been securitized. C)Credit enhancements are uncommon for ABS.
Explanation — The credit rating of an ABS pool is a function of its credit enhancements, which are quite common. The more creditenhancements, the higher the ratings 39. Which of the following statements about special purpose vehicles (SPVs) is least accurate? A)They are only used in asset backed security transactions. B)SPVs are also known as bankruptcy remote entities.C)SPVs shield the assets of an asset backed security from creditorsof the corporation that is securitizing the assets. Explanation — There are other advantages of SPVs dealing with the ﬁnancial accounting of the assets sold 40. There are several types of external credit enhancements. All of the following are examples of external credit enhancementsEXCEPT: A)setting aside reserve funds. B)letters of credit.C)corporate guarantees. Explanation — Setting aside reserve funds is an example of internal, not external credit enhancement 41. Which of the following terms describe external credit enhancements for asset backed securities? A)Corporate guarantee. B)Both of these choices are external credit enhancements. C)Bond insurance
Explanation — Both of the choices are commonly used external credit enhancements 42. Which of the following is a general problem associated with external credit enhancements? External credit enhancements: A)are subject to the credit risk of the third-party guarantor. B)are very long-term agreements and are therefore relativelyexpensive.C)are only available on a short-term basis Explanation — According to the “weak link” philosophy adopted by rating agencies, the credit quality of an issue can not be higherthan the credit rating of the third-party guarantor. Along theselines, if the guarantor is downgraded, the issue itself could besubject to downgrade even if the structure is performing asexpected 43. External credit enhancement least likely includes: A)corporate guarantee.B)bond insurance. C)revenue fund. Explanation — External enhancements include corporate guarantees and bond insurance. A revenue fund is not an externalenhancement it is an internal enhancement 44. Which of the following statements concerning asset-backed securities (ABSs) is least accurate? A)ABSs typically have lower debt ratings than the ﬁrm's otherborrowings.
B)The asset-backed pool may be overcollateralized to provide acredit enhancement.C)Typical assets to securitize are auto loans and credit cardreceivables Explanation — The objective of the ﬁrm with an ABS issue typically is to get a higher debt rating (a lower cost of borrowing).Typically, the ABS has a higher debt rating, perhaps because ofcredit enhancements 45. A corporation may issue asset backed securities because: A)it wants to change the structure of its balance sheet. B)both of the reasons are valid. C)it wants to reduce the cost of borrowing. Explanation — Both of the reasons are valid 46. To reduce the cost of long-term borrowing, a corporation with a below average credit rating could: A)issue asset backed securities. B)decrease credit enhancement.C)issue commercial paper. Explanation — Commercial paper is a short-term promissory note. Decreasing credit enhancements increase the cost of borrowing 47. The issuance of asset backed securities (ABSs) versus straight debt would be desirable if: A)there are time constraints on the deal.B)the corporation's credit rating may go up in the future.
C)a better credit quality is desired on the asset backed versus thecorporation Explanation — If there are time constraints, straight debt would be easier to issue. Also, if the corporation could be upgraded, it wouldbeneﬁt in straight debt but not its ABSs 48. A debt security that is collateralized by emerging market debt would be a(n): A)CMO.B)MTN. C)CDO Explanation — A CDO (collaterized debt obligation) is a debt obligation that is backed by an underlying diversiﬁed pool ofbusiness loans, mortgages, emerging market debt, corporatebonds, asset-backed securities, or non-performing loans. A MTN isa medium-term note issued by a corporation. A CMO (collaterizedmortgage obligation) is a debt obligation that is backed bymortgages 49. A CDO issued to proﬁt on the spread between the return on the underlying assets and the return paid to investors is referred to asa(n): A)arbitrage CDO. B)spread CDO.C)balance sheet CDO. Explanation — A CDO (collaterized debt obligation) issued to proﬁt on the spread between the return on the underlying assets and thereturn paid to investors is referred to as an arbitrage CDO. Abalance sheet CDO is created by a bank or insurance company
wishing to reduce their loan exposure on the balance sheet. SpreadCDO is a fabricated term 50. A debt security that is collateralized by various corporate bonds would be a(n): A)TIP. B)CDO. C)CMO. Explanation — A CDO (collaterized debt obligation) is a debt obligation that is backed by an underlying diversiﬁed pool ofbusiness loans, mortgages, emerging market debt, corporatebonds, asset-backed securities, or non-performing loans. A TIP is aTreasury Inﬂation-Protected Security. A CMO (collaterizedmortgage obligation) is a debt obligation that is backed bymortgages 51. Anthony Schmidt, CFA, makes the following statements while discussing issuance of new debt:Statement 1: A best-eﬀorts oﬀering, which is a form of a negotiatedoﬀering, occurs when an investment banker purchases an entireissue to resell.Statement 2: Registration with the SEC can be avoided with aprivate placement, but a higher yield will be required tocompensate for the limited liquidity. Are Schmidt’s statements accurate? A)Both of these statements are accurate.B)Neither of these statements is accurate. C)Only one of these statements is accurate.
Explanation — Statement 1 is incorrect. A ﬁrm commitment (not a best-eﬀorts oﬀering) is an arrangement where the investmentbanker purchases the entire issue and resells it.Statement 2 is accurate. Under a private placement, a ﬁrm canavoid registration with the SEC, but the buyer will require a higheryield to compensate for the illiquidity of the issue 52. Which of the following does NOT represent a primary market oﬀering? When bonds are sold: A)on a best-eﬀorts basis.B)in a private placement. C)from a dealer’s inventory. Explanation — When bonds are sold from a dealer’s inventory, the bonds have already been sold once and the transaction takes placeon the secondary market. The other transactions in the responsestake place in the primary market. When bonds are sold on abest-eﬀorts basis, the investment banker does not take ownershipof the securities and agrees to sell all she can. In a privateplacement, the bonds are sold privately to a small number ofinvestors 53. When bonds are sold in a bought deal, the transaction takes place on the: A)over-the-counter market.B)secondary market. C)primary market. Explanation — When bonds are sold in a bought deal, the transaction takes place on the primary markets. In a bought deal,the investment banker buys the issue of bonds from the issuer andthen resells them (i.e. they have underwritten the oﬀer and thearrangement is termed a ﬁrm commitment). Bonds are sold in
secondary markets after being sold the ﬁrst time (after they havebeen issued in the primary market). The term over-the-counterdoes not apply 54. Which of the following does NOT represent a secondary market oﬀering? When bonds are sold: A)on an exchange. B)in a Rule 144A oﬀering. C)in an over-the-counter dealer market. Explanation — When bonds are sold in a Rule 144A oﬀering, they are sold privately to a small number of investors or institutions.This oﬀering does not require registration with the SEC and this isvaluable to the issuer. The investor will require a slightly higheryield because the bonds cannot be resold to the public unless theyare registered with the SEC. The other sales transactions in theresponses represent secondary market oﬀerings