CFA Level 1 - Fixed Income Session 15 - Reading 55

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 appear most suitable. At the time of the auction, the amount to be auctioned and the maturity of the security to be offered are announced. This method of distributing new government securities 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 via auction when it determines that market conditions are advantageous 2. Fernando Golpas and Javier Solada were reviewing the financial reports of several Latin American governments. They noticed that the central governments of many Latin American countries such as Argentina, Chile, Peru, and Ecuador had recently been issuing sovereign debt. This sparked a discussion between the two analysts about sovereign debt ratings. During their discussion they made the following statements: Golpas: The rating agencies, such as Moody's, generally assign two ratings to sovereign debt. One is a local currency debt rating and the other is a foreign currency debt rating. The reason for the two ratings is that the default frequency has been greater on local currency denominated debt. Solada: If a central government is willing to raise taxes and control its internal financial system, it should be able to generate sufficient local currency to meet its local currency obligation. That is why the rating on local currency denominated debt is generally higher than the 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 currency debt ratings) is that the default frequency has been greater on foreign currency denominated debt. It is often easier for a central government to print local currency to meet its obligations in the home currency than to exchange the local currency in the foreign exchange 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 national bond market, in another country’s foreign bond market, or in the Eurobond market. B)When a central government issues securities, those securities can only be denominated in the local currency regardless of where the bonds are issued. C)Sovereign bonds denominated in domestic currency are subject to default risk Explanation — When a central government issues securities, those securities are generally denominated in the currency of the issuing country, but a government can issue bonds denominated in any currency. Sovereign bonds are not necessarily free from default risk 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 more current 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 maturity securities. C)in a maturity range for which several more recent issues have been auctioned. Explanation — On-the-run Treasuries are the most recent auctioned by the Treasury. When new issues are brought to market, older issues are called off-the-run issues. After a series of new issues in a given maturity spectrum, older issues of this original 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 dollar amount 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 of return 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 = $10,134.375 Selling price = [(101 + 17 / 32) / 100] × 10,000 = $10,153.125 Interest = 9¾% of 10,000 = $975.00 Return = (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 the basis of the coupon payment and the maturity value is adjusted semiannually. Because of the possibility of deflation, the adjusted principal value may be less than par (however, at maturity the Treasury redeems the bonds at the greater of the inflation-adjusted principal 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 at 89.28 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 commonly known as TIPS. The principal value is periodically adjusted for changes in CPI. The periodic coupon payment, based upon the adjusted 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 there exists 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, interest rate 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 securities is very liquid. B)Coupon strips synthesize a zero-coupon bond. C)Treasury-bonds are available in maturities of two years to nearly 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 that are sold separately as zero-coupon securities. Government securities dealers provide a continuous and highly liquid secondary 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 Treasury bond. The other calculations are correct. A quote of 96 27/32 = 96.84, for a price 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 a 5% coupon, 25-year, off-the-run U.S. Treasury bond, issued after 1984, would face. Order them from left to right with the least likely risk 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 default risk free although one might argue that a long-term Treasury might have a minute level of default risk. Off-the-run Treasuries face more liquidity risk than on-the-run issues. Finally, given the long-term nature of the bond, the investor is definitely exposed to interest rate risk. Given the available alternatives, we conclude that the answer is prepayment risk, default risk, liquidity risk, and interest 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 may face 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 zero coupon securities. Explanation — The Treasury does not issue zero-coupon notes or bonds. That is why STRIPS were created. A 5-year Treasury note can be stripped into 11 zero coupon securities, consisting of its 10 coupon payments and the principal repayment. The U.S. Internal Revenue Service regards the accrued interest on a zero coupon security as income on which the security holder must pay taxes even 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 the coupons from Treasuries to create synthetic zeros to meet investor demand. The Separate Trading of Registered Interest and Principal Securities (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) is CORRECT? 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 stripped cash flows as zero-coupon bonds. B)The U.S. Treasury auctions 10-year Notes weekly. C)Taxable investors holding zero-coupon bonds can have negative cash flows prior to maturity Explanation — U.S. Treasury Notes are issued quarterly. Both of the other statements are true. It is possible that taxable investors will have negative cash flows from holding zero-coupon securities, since there is no cash income, but taxes must be paid at least annually 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 pension plans. C)Treasury STRIPS can be based upon either coupon payments or principal payments. Explanation — Pension plans are not taxable entities so they do not have to worry about implicit interest taxation. Both of the other statements 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 their securities with the Securities and Exchange Commission. C)Debentures and mortgage passthrough securities are two types of securities issued by federal agencies Explanation — Government sponsored enterprises are privately owned, and therefore investors assume some credit risk. Federally related institutions are agencies owned by the U.S. government which are exempt from SEC registration. Agencies issue debentures, mortgage passthrough securities, or collateralized mortgage obligations (CMO). CMOs are split into tranches, with each tranche having a different claim and risk structure on the pool 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 the U.S. government 25. A mortgage-backed security has the following characteristics: It was created by pooling a collection of more than a thousand mortgages Not all investors face the same prepayment risk Investors receive three distinct kinds of cash flows Freddie Mac issued the security This 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 collateralized mortgage obligations (CMOs) are formed by pooling mortgages. Only CMOs divide investors into tranches with different cash flows and risk profiles. Debentures are securities not backed by collateral 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 institutions listed 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 institutions listed 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 a mortgage pool. B)The security may be retired before maturity at face value with no penalty. C)The payment structure redistributes the prepayment risk among various investors. Explanation — A collateralized mortgage obligation (CMO), not a passthrough security, redistributes the prepayment risk among the investors through tranches. Because mortgage holders may prepay the mortgage, the passthrough may indeed be retired before maturity 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. Prepayment risk is the risk that relates to the amount and timing of cash flows from 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 the amount 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 the ability 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 a curtailment 34. Which of the following statements concerning mortgage-backed securities is most accurate? A)As rates rise, mortgage-backed security holders face reinvestment risk. B)Curtailment of a mortgage is a prepayment of less than the full principal. C)Collateralized Mortgage Obligations (CMOs) prioritize the interest 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 of mortgage-backed securities face reinvestment risk as rates decline. Also, CMO’s prioritize the principal payments on mortgages to different sets of investors – all tranches receive interest payments, but each successive tranche does not receive principal 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 pooling a large number of mortgages and issuing certificates that represent ownership shares in the pool. Because each mortgage borrower has the right to prepay the mortgage, the value of a passthrough security behaves as if the security has an embedded put feature. Statement 2: A collateralized mortgage obligation with sequential tranches is created by pooling mortgage passthrough certificates. Securities are issued in different tranches that have proportionate claims 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 corporate bond issuer who calls a bond and prepays the principal. Therefore the pool of mortgages and the securities created from it behave as if they had an embedded call feature. Statement 2 is also incorrect. Sequential tranches issued as a collateralized mortgage obligation do not have proportionate claims on the cash flows from the pool. Instead they have sequential claims. The shortest-term tranche receives principal and interest payments until it is paid off. The cash flows then go to the second tranche until it is paid off, and so on. This structure allows securities with different timing and risk profiles to be issued 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 risk embedded 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 the issuer. B)Residential mortgages represent the largest type of asset that has 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 credit enhancements, 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 creditors of 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 enhancements EXCEPT: 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 relatively expensive. 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 higher than the credit rating of the third-party guarantor. Along these lines, if the guarantor is downgraded, the issue itself could be subject to downgrade even if the structure is performing as expected 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 external enhancement 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 other borrowings. B)The asset-backed pool may be overcollateralized to provide a credit enhancement. C)Typical assets to securitize are auto loans and credit card receivables 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 of credit 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 the corporation Explanation — If there are time constraints, straight debt would be easier to issue. Also, if the corporation could be upgraded, it would benefit 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 of business loans, mortgages, emerging market debt, corporate bonds, asset-backed securities, or non-performing loans. A MTN is a medium-term note issued by a corporation. A CMO (collaterized mortgage obligation) is a debt obligation that is backed by mortgages 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 as a(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 the return paid to investors is referred to as an arbitrage CDO. A balance sheet CDO is created by a bank or insurance company wishing to reduce their loan exposure on the balance sheet. Spread CDO 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 of business loans, mortgages, emerging market debt, corporate bonds, asset-backed securities, or non-performing loans. A TIP is a Treasury Inflation-Protected Security. A CMO (collaterized mortgage obligation) is a debt obligation that is backed by mortgages 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 negotiated offering, occurs when an investment banker purchases an entire issue to resell. Statement 2: Registration with the SEC can be avoided with a private placement, but a higher yield will be required to compensate 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 investment banker purchases the entire issue and resells it. Statement 2 is accurate. Under a private placement, a firm can avoid registration with the SEC, but the buyer will require a higher yield 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 place on the secondary market. The other transactions in the responses take place in the primary market. When bonds are sold on a best-efforts basis, the investment banker does not take ownership of the securities and agrees to sell all she can. In a private placement, the bonds are sold privately to a small number of investors 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 and then resells them (i.e. they have underwritten the offer and the arrangement is termed a firm commitment). Bonds are sold in secondary markets after being sold the first time (after they have been issued in the primary market). The term over-the-counter does 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 is valuable to the issuer. The investor will require a slightly higher yield because the bonds cannot be resold to the public unless they are registered with the SEC. The other sales transactions in the responses represent secondary market offerings