The Bond See-Saw

Many test questions based on math concepts are presented without numbers, which actually makes things harder to deal with. Let's take a look at an example early on a Sunday morning:

If your customer purchases a corporate bond whose face amount exceeds the market price, which of the following statements is inaccurate?
A. the bond's yield to maturity will exceed its current yield
B. the bond's curent yield will exceed its nominal yield
C. the bond's nominal yield will exceed its yield to maturity
D. all choices listed

EXPLANATION: first, the way this question is worded is intentionally deceptive. You see the word "exceeds," and you automatically read it as if the market price exceeds the par value. No--just the opposite. The phrase describes a discount bond. I bet 40% of all test-takers would miss that right off the bat and, therefore, continue down a path of doom. Second, the question exploits the inherently intimidating relationship between bond prices and bond yields. Third, by asking which statement is in-accurate, the test question takes it all up to an even higher, nastier level. What should you do? I recommend smiling and taking a deep breath, realizing that anyone who chooses to write tricky Series 7 questions as a career path can't be all that damned smart--this question can be figured out with patience and confidence. As always, attack a problem step-by-step. Step one--what the heck are you being asked? The question is saying, in its deceptive way, that a bond was purchased at a discount. Step two, what does that mean? It means that all yields will rise above the yield printed on the bond (nominal yield), and they go up in this order: current yield, yield to maturity, yield to call. Once you have that visual, you just start eliminating wrong answers. Unfortunately, if the statement is true, you have to eliminate it. Oy! Okay, the first statement is true--YTM will be higher than current yield, so A is eliminated. The next statement is true--current yield will be higher than nominal yield--so B is eliminated. Now, many test-takers get a false sense of rhythm and confidence. They feel a "flow" building and get too lazy to really read Answer Choice C, assuming that all three statements are probably false because, well because they're done thinking about this damned question.
No way. I learned from my years of throwing elbows on the basketball court that you have to hustle right through the final buzzer. You snooze for one second, and your man can get by you and win the game. When my opponent is some weasle like the Series 7, I am just not willing to let him shuck-and-jive his way past me for a cheap point. So, is Choice C true or false? Is the YTM lower than the nominal yield? No, so we eliminate it, right? Only if we want to lose--remember, we're still looking for the in-accurate statement. C is in-accurate and, therefore, it is the correct answer.

ANSWER: C

Don't get discouraged--not all Series 7 questions are this hard. In fact, if they were, few would pass it. Approximately 67% of all test-takers pass the Series 7 on any given day, so there is no way that all the questions could hit this hard. However, a certain percentage do hit this hard. Therefore, if you can get in shape to handle even the hard-hitting questions like the one we just looked at, you will pass with flying colors. Remember that the bond see-saw is fundamental on the Series 7, providing some of the trickiest questions of all. If you need extra help send me an email.

Bond yields

Let's look at a possible exam question on everybody's favorite topic: bond yields.

S&P just downgraded a corporate bond, pushing the bond’s yield
A. down
B. sideways
C. up
D. in a bond-ladder direction

EXPLANATION: if the rating goes down, so does the “quality,” which means the price falls. And, when the price falls, the yield rises. Would you pay as much for a junk bond as you'd pay for a Treasury bond? Not a chance--the riskier bonds cost less and yield more.



ANSWER: C

Bond prices, bond yields

Have you seen the yields on T-bills lately? Last time I checked, you could get yourself a 1/4 of 1% yield, which is also called "25 basis points." Why would anyone accept such a low yield? It's called a "flight to quality." When the stock market started to plummet around September, investors did what they usually do--they panicked. They pulled their dollars out of the stock market and lined up for a chance to buy Treasuries. The more willing investors are to pay for quality, the higher they drive the price of the T-bills, T-notes, and T-bonds. A T-bill is purchased at a discount from its face value. If you buy a $1 million T-bill, you'd prefer to buy it for $960,000 to a price of $999,400. When rates are high, you can make the $40,000 difference; when people are scrambling to put their money in T-bills, suddenly, you can make only $600 on your $1 million. So, the herd mentality doesn't just trample the stock market; it also messes with the bond markets. Mortgage rates are related pretty closely to the yield on 10-year Treasury notes, so as investors scramble to buy the government-guaranteed T-notes, they also push down yields, which then pushes or keeps down mortgage rates.
Why would interest rates start rising again? When the folks currently wimping out in Treasuries suddenly decide that the economy is about to take off again, they'll start pulling money out of the bond markets in order to buy stock. If they really want to sell the bonds, they'll accept lower and lower prices, which is the same thing as saying that the bonds will start trading at higher and higher yields.
I'm not sure why people panic so much over current interest rates or stock market levels. Most economic situations are a good news-bad news scenario, anyway. If yields are down now, that is bad news for the fixed-income retiree earning 2% on her bank CD if she's lucky. However, it also keeps mortgage rates down, which should eventually bring buyers back to the housing market. If mortgage and other interest rates creep back up, that will push down home values, but then the fixed-income retiree may be able to earn 6% on her bank CD and 9% on a T-bond. In any case, the "bond see-saw" is more than just something to draw on your scratch paper at the testing center.

Bond yields and prices

I just received a good, tough Series 7 practice question from a customer. She must be using a different company's questions, but this one is worth looking at in some detail:

QUESTION:
An investor bought 6% and 7% 15-year municipal bonds at a 5.50 basis. Which bond will have the greatest price appreciation if the market moves to 85.40?
a. 6% bond
b. 7% bond
c. both will appreciate equally
d. neither, since the market moved down

Answer is d. my question is how do we know that 85.40 means the market moved down?

RESPONSE:
Denise, thanks for sending in this question--not sure who wrote it, but it's about as tricky as it can possibly be. To ask about "the greatest price appreciation," when, in fact, the market price dropped is pretty evil. How do we know that "85.40 means the market moved down?" We have to use reasoning skills. If the coupon/nominal yield on a bond is 6% or 7% when the investor bought it at a yield/basis of just 5.50%, that is a premium bond. Right? If the yield is lower than the nominal/coupon rate, the price is above par. The question then gives you a market price well below par--$854.00. So, the market prices went from above par (premium) to below par (trading at a discount).
Wow. Not sure the actual test will be this evil, but I'm glad somebody's preparing you for even the most evil approach to a tough concept.