Practice Question, Bonds

Which of the following corporate debt instruments issued by the same corporation would tend to offer the highest yield?
A. 10-year convertible bond
B. 10-year non-convertible bond
C. 15-year subordinated debenture
D. 15-year collateral trust certificate

EXPLANATION: bonds with longer terms pay higher interest rates to investors, just as you would expect to pay a higher rate on a 30-year vs. a 15-year mortgage. So, you can eliminate choice A and B. Now that you're left with two 15-year bonds, ask yourself which one is more secure? Choice D has collateral behind it (a portfolio of securities). So, eliminate D, and you're left with C. Subordinated debenture holders are the lowest creditors in the pecking order.
ANSWER: C

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.

Economic Indicators

Bond yields would be expected to rise due to a drop in which of the following indicators?
A. prime rate
B. unemployment claims
C. GDP
D. building permits

EXPLANATION: remember that bond yields rise as economic activity increases. So, a drop in GDP is associated with falling yields, as is a drop in building permits. If the prime rate is dropping, we would assume other interest rates are dropping. But, when unemployment claims are dropping, that means people are going back to work, which is the only indicator that might point toward an increase in economic activity.

ANSWER: B

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

The Dreaded Yield Spread

Let's enjoy a difficult practice question on a Saturday, shall we?

One of your customers, Joe Myers, calls to inquire about something he heard but did not quite understand on CNBC. "Why is the price differential between low-risk and high-risk debt securities smaller than usual?" he asks. You would respond
A. turn off the TV and get a life, Joe
B. it means investors are confident in the overall economy
C. it means investors are not insisting on safety to the same degree
D. both B and C

ANSWER: D
EXPLANATION: right now, investors will accept tiny yields on Tbills, Tnotes, and Tbonds and won't touch junk bonds (corporate and muni) unless the bonds offer ridiculously high rates. The "yield spread" has widened in other words because investors are freaking out. For a few days, investors dumped everything and ran to Treasuries, accepting NEGATIVE yields on Tbills. Seriously--people were giving Uncle Sam $1,005 in order to receive $1,000 in 3 months, essentially, which is known in financial textbooks as "really stupid." Now, if the difference in yields between ultrasafe Treasuries and junk bonds narrows, that expresses confidence. Investors aren't so worried about companies defaulting on them and will pay more for the bonds/accept lower yields.

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.

Tough Question on Bond Yields

Bond yield questions can really give people fits. Let's enjoy one that draws boos and hisses from any live class I've ever taught:

One of your investing clients purchased an ABC 5% debenture yielding 6.5%. Three years later the investor sells the bond when current interest rates are at 4%. Therefore
A. I have no idea what the hell you're talking about
B. The investor broke even on the investment
C. The investor suffered a capital loss
D. The investor realized a capital gain

Obviously, we have to rule out "A," no matter how tempting. Then, we have to break down the question slowly. If you buy a bond yielding more than the nominal yield printed on the bond, that means the bond is purchased at a discount. Yields can only go up because bond prices are dropping. So, step one, the investor bought at a discount. If rates then drop below the nominal yield, the price has to rise. The investor sold at a premium. This is just a funky way of saying "bought low--sold high." The answer is "D," the investor realized a capital gain. Before working on a question, spend some time figuring out what is being asked and what is going on in the question--what is it saying? What does it mean? Interpret the "5% nominal yield purchased at a 6.5% yield" into "discount" or "bought low," and then proceed. If you're not 100% sure on the next step, you have to fall back on something like, "Well, every other time rates go DOWN, bond prices RISE, so I pretty much have to go with that."
And, you do. No brain can absorb all the information on the Series 7, not even the folks who write the questions. You have to know the vocabulary, know the fundamentals, and make up for the surprises with some really good test-taking skills.

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.