CFA2020L1QbanksAnswers fixed income

Reading g 42:: Fixed Income Securities:: Defining g Elements Question #1 of 43 Question ID: 1206317 The indenture of a callable bond states that the bond may be called on the rst business day of any month after the rst call date The call option embedded in this bond is a(n): A) European style call option B) American style call option C) Bermuda style call option Explanation A bond with a Bermuda style embedded call option may be called on prespeci ed dates after the rst call date A European style embedded call option speci es a single date on which a bond may be called With an American style embedded call option, a bond may be called any time after its rst call date (Study Session 14, Module 42.2, LOS 42.f) Question #2 of 43 Question ID: 1206303 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 dollar amount of the semi-annual coupon payment? A) $238.33 B) $212.50 C) $425.00 Explanation The dollar amount of the coupon payment is computed as follows: Coupon in $ = $5,000 × 0.085 / = $212.50 (Study Session 14, Module 42.2, LOS 42.e) Question #3 of 43 Question ID: 1206288 Which of the following is least likely an example of external credit enhancement? A) Bank guarantee B) Surety bond C) Excess spread Explanation Excess spread is an internal credit enhancement External credit enhancements include bank guarantees, letters of credit, and surety bonds (Study Session 14, Module 42.1, LOS 42.d) Question #4 of 43 Question ID: 1206315 As compared to an equivalent nonputable bond, a putable bond's yield should be: A) the same B) higher C) lower Explanation A putable bond favors the buyer (investor) Hence, a premium will be paid for the option, which means the yield will be lower (Study Session 14, Module 42.2, LOS 42.f) Question #5 of 43 Question ID: 1206319 Which of the following embedded bond options tends to bene t the borrower? A) Interest rate cap B) Conversion option C) Put option Explanation The interest rate cap bene ts the borrower who issues a oating rate bond The cap places a restriction on how high the coupon rate can become during a rising interest rate environment Therefore, the oating rate borrower is protected against ever-rising interest rates (Study Session 14, Module 42.2, LOS 42.f) Question #6 of 43 Question ID: 1206300 Which of the following statements with regard to oating rate notes that have caps and oors is most accurate? A) A cap is a disadvantage to the bondholder while a oor is a disadvantage to the issuer B) A cap is an advantage to the bondholder while a oor is an advantage to the issuer C) A oor is a disadvantage to both the issuer and the bondholder while a cap is an advantage to both the issuer and the bondholder Explanation A cap limits the upside potential of the coupon rate paid on the oating rate bond and is therefore a disadvantage to the bondholder A oor limits the downside potential of the coupon rate and is therefore a disadvantage to the bond issuer (Study Session 14, Module 42.2, LOS 42.e) Question #7 of 43 Question ID: 1206312 Which of the following statements about oating-rate notes is most accurate? A) Floating-rate notes have built-in oors, while inverse oating-rate notes have built-in caps B) Inverse oating-rate notes are attractive to investors who expect interest rates to rise, while oating-rate notes are attractive to investors who expect interest rates to fall C) The coupon payment on a oating-rate note at each reset date is typically based on LIBOR as of that date Explanation The lowest possible reference rate is zero If this occurs, the coupon on a oating-rate note cannot go lower than its quoted margin Hence, the quoted margin is a oor coupon for a oating-rate note The coupon on an inverse oater is determined by a formula such as "15% – 1.5 × reference rate." If the reference rate goes to zero, the coupon on this inverse oater can go no higher than 15% (Study Session 14, Module 42.2, LOS 42.e) Question #8 of 43 Question ID: 1206279 Every six months a bond pays coupon interest equal to 3% of its par value This bond is a: A) 6% annual coupon bond B) 6% semiannual coupon bond C) 3% semiannual coupon bond Explanation The coupon rate on a bond is the percentage of its par value that it pays in interest each year The coupon frequency states how often the bond will pay interest A 6% semiannual coupon bond pays interest twice per year with each coupon equaling half of 6%, or 3%, of par value (Study Session 14, Module 42.1, LOS 42.a) Question #9 of 43 Securitized bonds are most likely to be issued by: A) special purpose entities B) supranational entities C) banking institutions Explanation Question ID: 1206295 The issuer of a securitized bond is typically a special purpose entity (SPE), also known as a special purpose vehicle (SPV) or special purpose company (SPC) An SPE is formed speci cally to purchase and administer assets that will provide the cash ows to pay interest and principal on bonds the entity issues These bonds are called securitized bonds (Study Session 14, Module 42.1, LOS 42.d) Question #10 of 43 Question ID: 1206285 Which of the following bond covenants is considered negative? A) No additional debt B) Maintenance of collateral C) Payment of taxes Explanation Negative covenants set forth limitations and restrictions, whereas a rmative covenants primarily set forth administrative activities that the borrower promises to (Study Session 14, Module 42.1, LOS 42.c) Question #11 of 43 Question ID: 1206284 Features speci ed in a bond indenture least likely include the bond's: A) coupon rate and maturity date B) issuer and rating C) par value and currency Explanation Bond ratings are assigned by third-party credit rating agencies and may change during the life of a bond Features that are speci ed in the indenture for a xed income security include its issuer, maturity date, par value, coupon rate and frequency, and currency (Study Session 14, Module 42.1, LOS 42.b) Question #12 of 43 Which of the following statements about zero-coupon bonds is least accurate? A) All interest is earned at maturity B) A zero coupon bond may sell at a premium to par when interest rates decline C) The lower the price, the greater the return for a given maturity Explanation Question ID: 1206277 Zero coupon bonds always sell below their par value, or at a discount prior to maturity The amount of the discount may change as interest rates change, but a zero coupon bond will always be priced less than par (Study Session 14, Module 42.1, LOS 42.a) Question #13 of 43 Question ID: 1206297 Which of the following is least likely a form of internal credit enhancement for a bond issue? A) Covering the bond issue via a surety bond B) Structuring the asset pool such that it has an excess spread C) Including a tranche system to identify priority of claims Explanation A surety bond is issued by a third party and hence is an external form of credit enhancement (Study Session 14, Module 42.1, LOS 42.d) Question #14 of 43 Question ID: 1206302 Consider a oating rate issue that has a coupon rate that is reset on January of each year The coupon rate is de ned as one-year London Interbank O ered Rate (LIBOR) + 125 basis points and the coupons are paid semi-annually If the one-year LIBOR is 6.5% on January 1, which of the following is the semi-annual coupon payment received by the holder of the issue in that year? A) 3.875% B) 7.750% C) 3.250% Explanation This value is computed as follows: Semi-annual coupon = (LIBOR + 125 basis points) / = 3.875% (Study Session 14, Module 42.2, LOS 42.e) Question #15 of 43 Which of the following contains the overall rights of the bondholders? A) Indenture B) Rights o ering C) Covenant Explanation Question ID: 1206282 An indenture speci es the rights of bondholders and the obligations of the issuer Covenants are speci c provisions within the indenture A rights o ering is typically associated with an equity security (Study Session 14, Module 42.1, LOS 42.b) Question #16 of 43 Question ID: 1206294 Which of the following issues is most accurately described as a eurobond? A) South Korean rm’s euro-denominated bonds sold to investors in the European Union B) Brazilian rm’s U.S dollar-denominated bonds sold to investors in Canada C) European Union rm’s Japanese yen-denominated bonds sold to investors in Japan Explanation Eurobonds are denominated in a currency other than that of the countries in which they are issued The name "eurobond" does not imply that a bond is sold in Europe or by a European issuer, or denominated in the euro currency A U.S dollar-denominated bond sold to investors outside the United States is called a "eurodollar bond." (Study Session 14, Module 42.1, LOS 42.d) Question #17 of 43 Question ID: 1206286 A covenant that requires the issuer not to let the insurance coverage lapse on assets pledged as collateral is an example of a(n): A) negative covenant B) inhibiting covenant C) a rmative covenant Explanation Covenants are classi ed as negative or a rmative A rmative covenants specify administrative actions a bond issuer is required to take, such as maintaining insurance coverage on assets pledged as collateral Negative covenants are restrictions on a bond issuer's actions, such as preventing an issuer from selling any assets that have been pledged as collateral or pledging them again as collateral for additional debt (Study Session 14, Module 42.1, LOS 42.c) Question #18 of 43 In most countries including the United States, debenture is de ned as: A) a short-term debt instrument B) a bond secured by speci c assets C) an unsecured bond Question ID: 1206289 Explanation In most countries a debenture is de ned as unsecured debt (Study Session 14, Module 42.1, LOS 42.d) Question #19 of 43 Question ID: 1206304 Which of the following statements regarding a sinking fund provision is most accurate? A) It requires that the issuer retire a portion of the principal through a series of principal payments over the life of the bond B) It requires that the issuer set aside money based on a prede ned schedule to accumulate the cash to retire the bonds at maturity C) It permits the issuer to retire more than the stipulated amount if they choose Explanation A sinking fund actually retires the bonds based on a schedule This can be accomplished through either payment of cash or through the delivery of securities A sinking fund provision may allow the issuer to retire more than is stipulated in the indenture, but not all sinking fund provisions allow this (Study Session 14, Module 42.2, LOS 42.e) Question #20 of 43 Question ID: 1206292 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 If the guarantor is downgraded, the issue itself could be subject to downgrade even if the structure is performing as expected (Study Session 14, Module 42.1, LOS 42.d) Question #21 of 43 Question ID: 1206293 To reduce the cost of long-term borrowing, a corporation with a below average credit rating could: A) decrease credit enhancement B) issue commercial paper C) issue securitized bonds Explanation Commercial paper is only issued by corporations with top credit ratings Decreasing credit enhancements increase the cost of borrowing (Study Session 14, Module 42.1, LOS 42.d) Question #22 of 43 Question ID: 1206310 Treasury In ation Protected Securities, which provide investors with protection against in ation by adjusting the par value and keeping the coupon rate xed, are best described as: A) interest-indexed bonds B) indexed-annuity bonds C) capital-indexed bonds Explanation Indexed bonds that adjust the principal value while keeping the coupon rate xed are best described as capital-indexed bonds Interest-indexed bonds adjust the coupon rate Indexed-annuity bonds are fully amortizing with the payments adjusted (Study Session 14, Module 42.2, LOS 42.e) Question #23 of 43 Question ID: 1206291 Which of the following is least likely an example of external credit enhancements? A) Letters of credit B) Bank guarantees C) Excess spread Explanation Excess spread is an example of internal, not external credit enhancement (Study Session 14, Module 42.1, LOS 42.d) Question #24 of 43 Question ID: 1206311 A bond initially does not make periodic payments but instead accrues them over a pre-determined period and then pays a lump sum at the end of that period The bond subsequently makes regular periodic payments until maturity Such a bond is best described as a: A) step-up note B) zero-coupon bond C) deferred-coupon bond Explanation Deferred-coupon bonds carry coupons, but the initial coupon payments are deferred for some period The coupon payments accrue, at a compound rate, over the deferral period and are paid as a lump sum at the end of that period After the initial deferment period has passed, these bonds pay regular coupon interest for the rest of the life of the issue (i.e., until the maturity date) Zero coupon bonds not pay periodic interest A step-up note has a coupon rate that increases on one or more speci ed dates during the note's life (Study Session 14, Module 42.2, LOS 42.e) Question #25 of 43 Question ID: 1206318 PRC International just completed a $234 million oating rate convertible bond o ering As stated in the indenture, the interest rate on the bond is the lesser of 90-day LIBOR or 10% The indenture also requires PRC to retire $5.6 million per year with the option to retire as much as $10 million Which of the following embedded options is most likely to bene t the investor? The: A) 10% cap on the oating interest rate B) sinking fund provision for principal repayment C) conversion option on the convertible bonds Explanation The conversion privilege is an option granted to the bondholder The cap bene ts the issuer A sinking fund is not an embedded option; it is an obligation of the issuer (Study Session 14, Module 42.2, LOS 42.f) Question #26 of 43 Question ID: 1206281 An analyst observes a 5-year, 10% coupon bond with semiannual payments The face value is £1,000 How much is each coupon payment? A) £100 B) £25 C) £50 Explanation The coupon rate is the percentage of par value paid annually With semiannual coupons, half of the annual coupon rate is paid every six months For a 5-year, 10% coupon bond with semiannual payments and a face value of £1,000, each coupon payment is half of 10% times £1,000, or £50 (Study Session 14, Module 42.1, LOS 42.a) Question #27 of 43 Question ID: 1206314 As compared to an equivalent noncallable bond, a callable bond's yield should be: A) the same B) lower C) higher Explanation A callable bond favors the issuer Hence, the value of the bond is discounted by the value of the option, which means the yield will be higher (Study Session 14, Module 42.2, LOS 42.f) Question #28 of 43 Question ID: 1206298 Which of the following securities is least likely classi ed as a eurobond? A bond that is denominated in: A) U.S dollars and issued in Japan B) euros and issued in the United States C) euros and issued in Germany Explanation Bonds denominated in the currency of the country or region where they are issued are domestic bonds Eurobonds are denominated in a currency other than those of the countries in which they are sold (Study Session 14, Module 42.1, LOS 42.d) Question #29 of 43 Question ID: 1206307 The coupon rate of a xed income security is stated as 90-day LIBOR plus 125 basis points This security is most accurately described as a(n): A) oating-rate note B) variable-rate note C) reference-rate note Explanation A oating-rate note has a coupon rate based on a market-determined reference rate such as 90-day LIBOR Typically the coupon rate will be stated as a margin above the reference rate A variable-rate note has a margin above the reference rate that is not xed over the life of the note An index-linked bond has a coupon payment or principal amount that adjusts based on the value of a published index such as an equity market, commodity, or in ation index (Study Session 14, Module 42.2, LOS 42.e) Reading g 47:: Fundamentals of Credit Analysis Question #1 of 38 Question ID: 1206618 Bond X and Bond Y have the same par value, coupon, maturity, and credit rating, but Bond X trades at a higher price than Bond Y A possible reason for this di erence is that: A) the market expects a downgrade to Bond Y’s credit rating B) Bond Y has a higher expected recovery rate in a default C) Bond X has a higher expected loss in a default Explanation The market price di erence can be accounted for by a lag in the bonds' credit rating behind the market's assessment of their creditworthiness The bond market may be expecting a downgrade of Bond Y or an upgrade of Bond X Bond X would have a lower price than Bond Y if it had a higher expected loss Bond Y would have a higher price than Bond X if it had a higher expected recovery rate (Study Session 15, Module 47.1, LOS 47.e) Question #2 of 38 Question ID: 1206609 A non-callable bond with 18 years remaining maturity has an annual coupon of 7% and a $1,000 par value The current yield to maturity on the bond is 8% Using a 50bp change in YTM, the approximate modi ed duration of the bond is: A) 8.24 B) 11.89 C) 9.63 Explanation First, compute the current price of the bond as: FV = $1,000; PMT = $70; N = 18; I/Y = 8%; CPT → PV = –$906.28 Next, change the yield by plus-or-minus 50 basis points Compute the price of the bond if rates rise by 50 basis points to 8.5% as: FV = $1,000; PMT = $70; N = 18; I/Y = 8.5%; CPT → PV = –$864.17 Then compute the price of the bond if rates fall by 50 basis points to 7.5% as: FV = $1,000; PMT = $70; N = 18; I/Y = 7.5%; CPT → PV = –$951.47 The formula for approximate modi ed duration is: (V- – V+) / (2V0ΔYTM) Therefore, approximate modi ed duration is: ($951.47 – $864.17) / (2 × $906.28 × 0.005) = 9.63 (Study Session 15, Module 47.1, LOS 47.c) Question #3 of 38 Question ID: 1206626 Becque Ltd is a European Union company with the following selected nancial information: € billions Year Year Year Operating income 262 361 503 Depreciation & amortization 201 212 256 Capital expenditures 78 97 140 Cash ow from operations 303 466 361 Total debt 2,590 2,717 2,650 Dividends 70 70 72 Becque's three-year average debt-to-EBITDA ratio is closest to: A) 4.6x B) 3.6x C) 7.6x Explanation EBITDA = Operating income + depreciation + amortization Year 1: 262 + 201 = €463 billion Year 2: 361 + 212 = €573 billion Year 3: 503 + 256 = €759 billion Debt/EBITDA ratio: Year 1: 2,590 / 463 = 5.6x Year 2: 2,717 / 573 = 4.7x Year 3: 2,650 / 759 = 3.5x Three-year average = 4.6x (Study Session 15, Module 47.2, LOS 47.g) Question #4 of 38 The "four Cs" of credit analysis include: A) capacity and character B) collateral and capital C) circumstances and covenants Explanation The "four Cs" of credit analysis are capacity, collateral, covenants, and character (Study Session 15, Module 47.1, LOS 47.f) Question ID: 1206623 Question #5 of 38 Question ID: 1206637 Support for revenue bonds comes from: A) property taxes based on the project B) the full faith and credit of the issuing municipality C) income generated by the underlying project Explanation Revenue bonds are serviced by the income generated from speci c projects (e.g., toll roads) (Study Session 15, Module 47.2, LOS 47.j) Question #6 of 38 Question ID: 1206629 Which of the following is the most appropriate strategy for a xed income portfolio manager under the anticipation of an economic expansion? A) Sell corporate bonds and purchase Treasury bonds B) Purchase corporate bonds and sell Treasury bonds C) Sell lower-rated corporate bonds and buy higher-rated corporate bonds Explanation During periods of economic expansion corporate yield spreads generally narrow, re ecting decreased credit risk If yield spreads narrow, the prices of corporate bonds increase relative to the prices of Treasuries Selling lower-rated bonds and buying higher-rated bonds is an appropriate strategy if an economic contraction is anticipated (Study Session 15, Module 47.2, LOS 47.i) Question #7 of 38 Question ID: 1206605 The type of credit risk that is de ned as the possibility that a borrower will fail to pay interest or repay principal when due is: A) default risk B) downgrade risk C) credit spread risk Explanation Default risk refers to the failure of a borrower to make timely and complete payments of interest or principal (Study Session 15, Module 47.1, LOS 47.a) Question #8 of 38 Question ID: 1206604 Expected loss is greatest for a corporate bond with a low: A) recovery rate and a high probability of default B) loss severity and a high probability of default C) recovery rate and a low probability of default Explanation The combination of low recovery rate (high loss severity) and high probability of default will lead to greatest expected loss (Study Session 15, Module 47.1, LOS 47.a) Question #9 of 38 Question ID: 1206641 Structural subordination is most likely to be a credit rating consideration for: A) general obligation municipal bonds B) emerging market sovereign bonds C) high-yield corporate bonds Explanation Structural subordination is a credit consideration for corporate debt that results when a subsidiary has outstanding debt with a higher priority claim to the subsidiary's cash ows than the parent company's debt (Study Session 15, Module 47.2, LOS 47.j) Question #10 of 38 Question ID: 1206640 Compared to corporate bonds with the same credit ratings, municipal general obligation (GO) bonds typically have less credit risk because: A) default rates on GOs are typically lower for same credit ratings B) governments can print money to repay debt C) GOs are not a ected by economic downturns Explanation Municipal bonds usually have lower default rates than corporate bonds of the same credit ratings GO bonds' creditworthiness is a ected by economic downturns Sovereigns can print money to repay debt, but municipalities cannot (Study Session 15, Module 47.2, LOS 47.j) Question #11 of 38 Question ID: 1206625 Jequa is a Japanese company with the following selected nancial information: ¥ billions Net income from continuing operations 503 Depreciation & amortization 256 Capital expenditures 140 Cash ow from operations 361 Dividends 72 Jequa's funds from operations (FFO) is closest to: A) ¥247 billion B) ¥759 billion C) ¥149 billion Explanation FFO is de ned as net income from continuing operations plus depreciation, amortization, deferred taxes, and other noncash items FFO = ¥503 + ¥256 = ¥759 billion (Study Session 15, Module 47.2, LOS 47.g) Question #12 of 38 Question ID: 1206608 Loss severity is most accurately de ned as the: A) percentage of a bond’s value a bondholder will receive if the issuer defaults B) amount a bondholder will lose if the issuer defaults C) probability that a bond issuer will default Explanation Loss severity is the money amount or percentage of a bond's value a bondholder will lose if the issuer defaults The percentage of a bond's value a bondholder will receive if the issuer defaults is the recovery rate (Study Session 15, Module 47.1, LOS 47.b) Question #13 of 38 Question ID: 1206622 Fraud and malfeasance, soundness of strategy, and prior treatment of bondholders are criteria to evaluate a borrower's: A) capacity B) covenants C) character Explanation Character analysis includes soundness of strategy, management's track record, accounting policies and tax strategies, fraud and malfeasance record, and prior treatment of bondholders (Study Session 15, Module 47.1, LOS 47.f) Question #14 of 38 Question ID: 1206624 An increase in net income is most likely to decrease a borrower's: A) FFO-to-debt ratio B) operating margin C) debt-to-EBITDA ratio Explanation An increase in net income is likely a result from increases in earnings before interest, taxes, depreciation and amortization (EBITDA) and operating income An increase in net income is also likely to result in an increase in funds from operations (FFO) The only ratio listed that has earnings or operating cash ow in the denominator is the debt-to-EBITDA ratio As the denominator increases, the ratio will decrease (Study Session 15, Module 47.2, LOS 47.g) Question #15 of 38 Question ID: 1206615 Structural subordination means that a parent company's debt: A) ranks pari passu with a subsidiary’s debt with respect to the subsidiary’s cash ows B) has a lower priority of claims to a subsidiary’s cash ows than the subsidiary’s debt C) has a higher priority of claims to a subsidiary’s cash ows than the subsidiary’s debt Explanation Structural subordination means that cash ows from a subsidiary are used to pay the subsidiary's debt before they may be paid to the parent company to service its debt As a result, parent company debt is e ectively subordinate to the subsidiary's debt (Study Session 15, Module 47.1, LOS 47.d) Question #16 of 38 Question ID: 1206610 Senior subordinated bonds have a priority of claims over: A) subordinated bonds B) rst lien debt C) secured bonds Explanation First lien loans and secure bonds are senior to any unsecured debt Senior subordinated debt is senior to subordinated debt (Study Session 15, Module 47.1, LOS 47.c) Question #17 of 38 Question ID: 1206620 Which component of traditional credit analysis includes evaluation of industry structure, industry fundamentals, and company fundamentals? A) Covenants B) Collateral C) Capacity Explanation Analyzing a corporate borrower's capacity to repay its debt obligations is similar to the top-down process used in equity analysis Collateral analysis is evaluating the issuer's assets Analyzing covenants involves reviewing the terms and conditions of lending agreements (Study Session 15, Module 47.1, LOS 47.f) Question #18 of 38 Question ID: 1206627 When calculating credit ratios, an analyst should increase a company's reported total debt if the company has: A) a debt guarantee from a parent or third party B) a net pension asset on its balance sheet C) operating lease obligations Explanation Credit analysts should add to a company's total debt its obligations such as operating lease payments and underfunded pension plans A net pension asset results from an overfunded pension plan A credit analyst should include a debt guarantee in the total obligations of the company that is making the guarantee (Study Session 15, Module 47.2, LOS 47.h) Question #19 of 38 Question ID: 1206619 Which of the following best describes risks in relying on credit agency ratings? A) Credit ratings tend to lead market prices B) Event risk is di cult for rating agencies to assess C) Credit ratings are assigned only at issuance Explanation Risks speci c to a company or industry such as litigation, natural disasters, and corporate events are di cult to predict and incorporate into credit ratings Market prices tend to lead credit ratings Credit ratings can be revised after issuance (Study Session 15, Module 47.1, LOS 47.e) Question #20 of 38 Question ID: 1206635 Which of the following statements about municipal bonds is least accurate? A) A municipal bond guarantee is a form of insurance provided by a third party other than the issuer B) Revenue bonds have lower yields than general obligation bonds because there are more revenue bands and they have higher liquidity C) Bonds with municipal bond guarantees are more liquid in the secondary market and generally have lower required yields Explanation General obligation bonds are backed by the full faith, credit, and taxing power of the issuer and thus tend to have lower yields than revenue bonds (Study Session 15, Module 47.2, LOS 47.j) Question #21 of 38 Question ID: 1206634 Yield spreads tend to widen when equity market performance is: A) stable B) weak C) strong Explanation Conditions that cause equity markets to weaken, such as poor economic growth, also tend to widen yield spreads in the bond market Likewise, strong equity market performance tends to coincide with narrowing yield spreads Yield spreads tend to narrow when equity markets are stable because investors "reaching for yield" increase their demand for bonds (Study Session 15, Module 47.2, LOS 47.i) Question #22 of 38 Question ID: 1206628 Steven Company has EBITDA/interest and debt-to-capital ratios that are both higher compared to Joseph Company to a degree consistent with one level of issuer credit rating Based only on this information, the credit rating of Steven is most likely to be: A) the same as Joseph B) higher than Joseph C) lower than Joseph Explanation Steven's higher EBITDA/interest ratio is consistent with a higher credit rating than Joseph but its higher debt-to-capital ratio is consistent with a lower credit rating Steven is most likely to have the same credit rating as Joseph (Study Session 15, Module 47.2, LOS 47.h) Question #23 of 38 Question ID: 1206636 Consider three municipal bonds issued by the Greater Holmen Metropolitan Capital Improvement District, a local authority that carries an issuer rating of single-A from the major debt rating agencies All three bonds have the same coupon rate and maturity date Series W was issued to nance the rebuilding and expansion of local schools and is backed by the District's authority to levy property tax Series X was issued to build a water puri cation plant for the region The District charges fees to the surrounding municipalities for their use of the plant These fees are the only source of the interest and principal payments on the bonds Series Y was issued to raise funds for the general use of the District in its ordinary maintenance projects and is backed by the District's authority to levy property tax These bonds carry a third party guarantee of principal and interest payments What is most likely the order of the market yields on these three bond issues, from highest to lowest? A) Series X, Series Y, Series W B) Series Y, Series W, Series X C) Series X, Series W, Series Y Explanation Series X is a revenue bond Because they pay interest and principal only if revenues from the project they nance are su cient, revenue bonds are typically riskier and therefore have higher market yields than general obligation bonds Series Y is an insured bond Municipal bond insurance typically results in a higher rating, and therefore a lower market yield, than an equivalent bond from the same municipal issuer So of these three bonds, Series X should have the highest market yield and Series Y the lowest (Study Session 15, Module 47.2, LOS 47.j) Question #24 of 38 Question ID: 1206621 Analysis of a rm's intellectual capital, equity market capitalization, depreciation, and intangible assets is associated with which aspect of credit analysis? A) Covenants B) Capacity C) Collateral Explanation These items are part of analyzing a borrower's collateral Analyzing depreciation expense and equity market capitalization can provide insight into the quality of a rm's xed assets Intellectual capital and intangible assets can potentially be used as collateral if they can be separated from the rm and sold Capacity refers to a borrower's ability to repay its obligations Analysis of capacity focuses on industry structure and company fundamentals Covenants are terms and conditions of a bond issue (Study Session 15, Module 47.1, LOS 47.f) Question #25 of 38 Question ID: 1206612 Debt with a lower priority of claims than a rm's unsecured debt is best described as: A) subordinated B) pari passu C) second lien Explanation Subordinated debt has a lower priority of claims than unsecured debt Second lien is a form of secured debt, which has a higher priority of claims than unsecured debt "Pari passu" refers to the equal priority of claims for di erent debt issues in the same category (Study Session 15, Module 47.1, LOS 47.c) Question #26 of 38 Question ID: 1206633 What is the most likely e ect on yield spreads when demand for bonds is high and supply of bonds is low? A) Yield spreads are likely to widen B) Yield spreads are likely to narrow C) The e ect on yield spreads will depend on whether supply or demand is the stronger in uence Explanation Credit spreads tend to narrow in times of high demand for bonds and widen in times of low demand for bonds Credit spreads tend to widen under excess supply conditions, such as large issuance in a short period of time, and narrow when supply is low (Study Session 15, Module 47.2, LOS 47.i) Question #27 of 38 Question ID: 1206611 Recovery rates are greatest for classes of debt with the highest: A) default rates B) priority of claims C) loss severity Explanation High default rates and loss severity are indicators of potential lower recovery rates The highest priority of claims has the lowest credit risk (Study Session 15, Module 47.1, LOS 47.c) Question #28 of 38 Question ID: 1206607 The factors that must be considered when estimating the credit risk of a bond include: A) only the bond rating B) only the bond rating and the recovery rate C) the bond rating, the recovery rate, and the yield volatility Explanation Credit risk is calculated with the probability of default (estimated from the bond rating) and the estimated recovery value should the bond default Yield volatility is combined with duration to estimate the price risk of a bond (Study Session 15, Module 47.1, LOS 47.a) Question #29 of 38 Question ID: 1206631 If a U.S investor is forecasting that the yield spread between U.S Treasury bonds and U.S corporate bonds is going to widen, then which of the following is most likely to be CORRECT? A) The economy is going to contract B) The economy is going to expand C) The U.S dollar will weaken Explanation If economic conditions are expected to get worse, then the probability that corporations may default increases and causes credit spreads to widen (Study Session 15, Module 47.2, LOS 47.i) Question #30 of 38 Question ID: 1206638 A restricted payment covenant in a high yield bond indenture protects lenders by: A) making a parent company’s debt rank pari passu with a subsidiary’s debt B) requiring the borrower to buy back its debt if the company is sold C) limiting the amount of cash paid to equity holders Explanation A restricted payment covenant protects lenders by limiting the amount of cash that may be paid to equity holders Restricted subsidiaries' cash ows are used to service the debt of the parent or holding company and make a parent company's debt rank pari passu with the subsidiary's debt A change of control put protects lenders by requiring the borrower to buy back its debt in the event of an acquisition (Study Session 15, Module 47.2, LOS 47.j) Question #31 of 38 Question ID: 1206630 If investors expect greater uncertainty in the bond markets, yield spreads between AAA and B rated bonds are most likely to: A) slope downward B) narrow C) widen Explanation With greater uncertainty, investors require a higher return for taking on more risk Therefore credit spreads will widen (Study Session 15, Module 47.2, LOS 47.i) Question #32 of 38 Question ID: 1206616 A rm with a corporate family rating (CFR) of A3/A- issues secured bonds Covenants to these bonds include a limitation on liens and a change of control put If credit rating agencies notch this issue, its credit rating is most likely to be: A) Baa1/BBB+ B) A2/A C) Baa2/BBB Explanation Both the priority of claims and the covenants suggest this issue has less credit risk than the issuer and therefore its issue credit rating may be notched upward The issuer's credit rating (corporate family rating) is based on its senior unsecured debt This issue is a secured bond, and therefore has a higher seniority ranking A change of control put protects lenders by requiring the borrower to buy back its debt in the event of an acquisition A limitation on liens limits the amount of secured debt that a borrower can carry Both covenants reduce the credit risk of the issue (Study Session 15, Module 47.1, LOS 47.d) Question #33 of 38 Question ID: 1206614 One notable di erence between an issuer credit rating and an issue credit rating is that an: A) issue credit rating is always notched below the issuer rating B) issuer credit rating re ects the borrower’s overall creditworthiness C) issue credit rating applies to the issuer’s senior unsecured debt Explanation An issuer credit rating re ects the borrower's overall creditworthiness Senior unsecured debt is usually the basis for an issuer credit rating Notching of issue ratings can be upward or downward relative to an issuer credit rating (Study Session 15, Module 47.1, LOS 47.d) Question #34 of 38 Question ID: 1206639 In a sovereign debt credit rating, a country's foreign reserves, its external debt, and the status of its currency in foreign exchange markets are key factors for evaluating the country's: A) monetary exibility B) international investment position C) scal exibility Explanation The ve key areas for evaluating and assigning a credit rating for sovereign bonds are institutional e ectiveness, economic prospects, international investment position, scal exibility, and monetary exibility International investment position includes analysis of the country's foreign reserves, its external debt, and the status of its currency (Study Session 15, Module 47.2, LOS 47.j) Question #35 of 38 Question ID: 1206632 Which of the following is the reason why credit spreads between high quality bonds and low quality bonds widen during poor economic conditions? A) interest risk B) indenture provisions C) default risk Explanation During poor economic conditions the probability of default increases and thus credit spreads widen (Study Session 15, Module 47.2, LOS 47.i) Question #36 of 38 Question ID: 1206606 The risk of receiving less than market value when selling a bond is referred to as: A) recovery rate risk B) loss severity risk C) market liquidity risk Explanation Market liquidity risk is the risk of receiving less than market value when selling a bond and is re ected in the size of the bid-ask spreads Market liquidity risk is greater for the bonds of less creditworthy issuers and for the bonds of smaller issuers with relatively little publicly traded debt Loss severity and recovery rate refer to defaults (Study Session 15, Module 47.1, LOS 47.a) Question #37 of 38 Question ID: 1206613 Which of the following bonds from the same corporate issuer has the lowest priority of claims? A) Collateral trust bond B) Senior unsecured debenture C) Equipment trust certi cate Explanation Secured bonds have a higher priority of claims than unsecured bonds Collateral trust bonds and equipment trust certi cates are secured bonds (Study Session 15, Module 47.1, LOS 47.c) Question #38 of 38 Bond investors should not rely exclusively on credit agency ratings because: A) market pricing tends to lag changes in credit ratings Question ID: 1206617 B) default rates are higher for lower-rated bonds C) credit ratings may change over time Explanation Credit ratings are not stable over time and bonds may be upgraded or downgraded during their lives Market pricing typically leads changes in credit ratings Default rates should be higher for lower-rated bonds if credit ratings are accurate (Study Session 15, Module 47.1, LOS 47.e) ... Question ID: 1206320 Fixed income classi cations by geography most likely include: A) municipal bonds B) supranational bonds C) emerging market bonds Explanation Classifying xed income securities... rating during adverse circumstances (Study Session 14, Module 42.2, LOS 42.e) Reading g 43:: Fixed Income Markets:: Issuance, Trading g, and Funding g Question #1 of 28 Question ID: 1206328 An... in one year Explanation Money market securities have original maturities of one year or less Fixed income securities originally issued with maturities longer than one year are classi ed as capital